KING & SPALDING LLP CHIESA SHAHINIAN & pro hac vice …€¦ · 13-09-2016 · No....

KING & SPALDING LLP

James J. Capra, Jr. (admitted pro hac vice)

1185 Avenue of the Americas

New York, NY 10036-4003

Telephone: (212) 556-2100

Facsimile: (212) 556-2222

Kenneth Y. Turnbull (pro hac vice filed)

1700 Pennsylvania Avenue, NW

Washington, DC 20006-4707

Telephone: (202) 737-0500

Facsimile: (202) 626-3737

CHIESA SHAHINIAN &

GIANTOMASI PC

A. Ross Pearlson

James Van Splinter

One Boland Drive

West Orange, NJ 07052

Telephone: (973) 530-2100

Facsimile: (973) 530-2300

Attorneys for Defendant PricewaterhouseCoopers LLP

UNITED STATES DISTRICT COURT

DISTRICT OF NEW JERSEY

IN RE VALEANT PHARMACEUTICALS

INTERNATIONAL, INC. SECURITIES LITIGATION No. 3:15-CV-07658-MAS-LHG

ORAL ARGUMENT

REQUESTED

Motion Day: December 19, 2016

This Document Applies To:

All Actions.

DEFENDANT PRICEWATERHOUSECOOPERS LLP’S NOTICE OF

MOTION TO DISMISS THE CONSOLIDATED COMPLAINT

PLEASE TAKE NOTICE that the undersigned, counsel for Defendant

PricewaterhouseCoopers LLP (“PwC”), in accordance with Federal Rules of Civil Procedure

12(b)(6) and 8(a), will move for dismissal with prejudice of Count VII of the Consolidated

Complaint [ECF 80] as to PwC before the Honorable Michael A. Shipp on December 19, 2016 at

10:00 a.m., or as soon thereafter as the Court may schedule, for the reasons set forth in the

accompanying Memorandum of Law and Declaration of James J. Capra, Jr. Pursuant to Local

Civil Rules 7.1(b)(4) and 78.1(b), PwC respectfully requests that the Court grant oral argument

on this Motion.

Case 3:15-cv-07658-MAS-LHG Document 165 Filed 09/13/16 of 2 PageID: 3012

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Dated: September 13, 2016

Respectfully submitted,

CHIESA SHAHINIAN & GIANTOMASI PC

By: /s/ A. Ross Pearlson

A. Ross Pearlson

James Van Splinter

One Boland Drive

West Orange, NJ 07052

Telephone: (973) 530-2100

Facsimile: (973) 530-2300

KING & SPALDING LLP

James J. Capra, Jr. (admitted pro hac vice) 1185 Avenue of the Americas

New York, NY 10036-4003

Telephone: (212) 556-2100

Facsimile: (212) 556-2222

Kenneth Y. Turnbull (pro hac vice filed)

1700 Pennsylvania Avenue, NW

Washington, DC 20006-4707

Telephone: (202) 737-0500

Facsimile: (202) 626-3737

Attorneys for Defendant

PricewaterhouseCoopers LLP

Case 3:15-cv-07658-MAS-LHG Document 165 Filed 09/13/16 of 2 PageID: 3013

UNITED STATES DISTRICT COURT DISTRICT OF NEW JERSEY

IN RE VALEANT PHARMACEUTICALS INTERNATIONAL, INC. SECURITIES LITIGATION

No. 3:15-CV-07658-MAS-LHG ORAL ARGUMENT

REQUESTED

Motion Day: December 19, 2016


All Actions.

PRICEWATERHOUSECOOPERS LLP’S MEMORANDUM OF LAW IN SUPPORT

OF ITS MOTION TO DISMISS THE CONSOLIDATED COMPLAINT


KING & SPALDING LLP

James J. Capra, Jr. (admitted pro hac vice) 1185 Avenue of the Americas New York, NY 10036-4003 Telephone: (212) 556-2100 Facsimile: (212) 556-2222 Kenneth Y. Turnbull (pro hac vice filed) 1700 Pennsylvania Avenue, NW Washington, DC 20006-4707 Telephone: (202) 737-0500 Facsimile: (202) 626-3737 CHIESA SHAHINIAN & GIANTOMASI PC

A. Ross Pearlson James Van Splinter One Boland Drive West Orange, NJ 07052 Telephone: (973) 530-2100 Facsimile: (973) 530-2300 Attorneys for Defendant


Case 3:15-cv-07658-MAS-LHG Document 165-1 Filed 09/13/16 Page 1 of 23 PageID: 3014

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TABLE OF CONTENTS

Page

PRELIMINARY STATEMENT ................................................................................................ 1

FACTUAL BACKGROUND ..................................................................................................... 3

PwC’s Audit Opinions ......................................................................... 3 A.

Respective Roles of Valeant Management and PwC as B.Independent Auditor ............................................................................ 4

Valeant’s 2014 Financial Statements and Restatement ....................... 5 C.

Plaintiff’s Allegations Regarding PwC’s Purportedly D.False Statements .................................................................................. 8

PLEADING STANDARD ........................................................................................................ 10

ARGUMENT ............................................................................................................................ 10

Plaintiff fails to plead that PwC’s opinion statements were false.................. 10 I.

Under Omnicare, an opinion statement is actionable under A.Section 11 only if the speaker did not sincerely believe the opinion at the time. ............................................................................ 11

PwC’s opinions are subject to the Omnicare standard for B.Section 11 claims. .............................................................................. 11

Courts have applied Omnicare to dismiss Section 11 C.claims against independent auditors when plaintiffs do not allege subjective disbelief. ................................................................. 13

Plaintiff does not allege PwC’s subjective disbelief. ......................... 15 D.

Plaintiff lacks standing to bring a Section 11 claim relating to the II.March 2015 stock offering. ............................................................................ 16

CONCLUSION ......................................................................................................................... 16


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TABLE OF AUTHORITIES

Page(s)

Cases

Ashcroft v. Iqbal, 556 U.S. 662 (2009) .................................................................................................................10

Bell Atl. Corp. v. Twombly, 550 U.S. 544 (2007) .................................................................................................................10

In re Am. Int’l Grp., Inc., 2008 Sec. Litig., 2013 WL 1787567 (S.D.N.Y. Apr. 26, 2013)..........................................................................15

In re Burlington Coat Factory Sec. Litig., 114 F.3d 1410 (3d Cir. 1997).....................................................................................................3

In re IKON Office Solutions, Inc., 277 F.3d 658 (3d Cir. 2002).....................................................................................................13

In re Lehman Bros. Sec. & ERISA Litig., 799 F. Supp. 2d 258 (S.D.N.Y. 2011)................................................................................12, 13

In re Petrobras Sec. Litig., No. 14-cv-9662-JSR (S.D.N.Y. Feb. 19, 2016) .......................................................................13

In re Puda Coal Sec. Inc. Litig., 30 F. Supp. 3d 230 (S.D.N.Y. 2014)........................................................................................14

In re Velti PLC Sec. Litig., 2015 WL 5736589 (N.D. Cal. Oct. 1, 2015)................................................................13, 14, 15

Johnson v. CBD Energy Ltd., 2016 WL 3654657 (S.D. Tex. July 6, 2016) ......................................................................13, 14

Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, 135 S. Ct. 1318 (2015) ..................................................................................................... passim

Querub v. Moore Stephens Hong Kong, _ F. App’x _, 2016 WL 2942415 (2d Cir. May 20, 2016) (Summary Order) ............. 12-13, 14

Reiger v. Altris Software, Inc., 1999 WL 540893 (S.D. Cal. Apr. 30, 1999) ............................................................................12

SEPTA v. Orrstown Fin. Servs., Inc., 2015 WL 3833849 (M.D. Pa. June 22, 2015) ....................................................................13, 14


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Special Situations Fund III QP, L.P. v. Deloitte Touche Tohmatsu CPA, Ltd., 645 F. App’x 72, 2016 WL 1392280 (2d Cir. Apr. 8, 2016) (Summary Order) .....................14

United States v. Brassington, 2010 WL 3419430 (D.N.J. Aug. 26, 2010) .............................................................................13

Yang v. Tibet Pharm., Inc., 2015 WL 730036 (D.N.J. Feb. 20, 2015) ................................................................................13

Statutes

Section 11 of the 1933 Securities Act, 15 U.S.C. § 77k ........................................................ passim

Other Authorities

17 C.F.R. § 210.2-01 ........................................................................................................................4

Fed. R. Civ. P. 8(a) ..........................................................................................................................1

Fed. R. Civ. P. 12(b)(6)....................................................................................................................1

Auditing Standards

PCAOB Audit Standard No. 5 (AS 5) .............................................................................................4

PCAOB Audit Standard No. 15 (AS 15) .........................................................................................4

PCAOB Interim Auditing Standard (AU) 110.......................................................................4, 5, 11

PCAOB Interim Auditing Standard (AU) 230...............................................................................12

PCAOB Interim Auditing Standard (AU) 508.......................................................................4, 5, 11

PCAOB Interim Auditing Standard (AU) 625...............................................................................12

PCAOB Rule 3200T ........................................................................................................................3


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TABLE OF DEFINED TERMS

2014 Form 10-K Valeant’s Annual Report on Form 10-K for the year ended December 31, 2014, which Valeant filed with the SEC on February 25, 2015

2015 Form 10-K Valeant’s Annual Report on Form 10-K for the year ended December 31, 2015, which Valeant filed with the SEC on April 29, 2016, and which included Valeant’s restated financial statements for the year ended December 31, 2014

AICPA American Institute of Certified Public Accountants

AU PCAOB interim auditing standards, which consist of the auditing standards previously developed by the AICPA, which the PCAOB has adopted on an interim basis

AS PCAOB auditing standards

Carro Tanya Carro, Valeant’s former Corporate Controller

Company Valeant Pharmaceuticals International, Inc.

Complaint Consolidated Complaint filed on June 24, 2016 [ECF 80]

GAAP Generally Accepted Accounting Principles

GAAS Generally Accepted Auditing Standards

ICFR Internal Control over Financial Reporting

March 2015 stock offering As referred to in paragraph 559 of the Complaint

PCAOB The Public Company Accounting Oversight Board, which regulates accounting firms that perform audits of public companies and establishes standards for the conduct of those audits

Philidor Philidor Rx Services, LLC

Plaintiff The City of Tucson together with and on behalf of the Tucson Supplemental Retirement System, the sole plaintiff that has asserted a claim against PwC

Pre-agreement sales Valeant’s sales of its pharmaceutical products to Philidor in the time period immediately prior to the execution of the Purchase Option Agreement on December 15, 2014


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Prospectus Supplement Valeant’s March 18, 2015 prospectus supplement referred to in paragraph 559 of the Complaint.

Purchase Option Agreement December 15, 2014 agreement by which Valeant acquired an option to purchase Philidor, referred to in paragraph 99 of the Complaint

PwC PricewaterhouseCoopers LLP

Restatement Valeant’s restatement of its financial statements for the year ended December 31, 2014. Valeant’s restated 2014 financial statements were included in its 2015 Form 10-K.

SEC The Securities and Exchange Commission

Section 11 Section 11 of the Securities Act of 1933, 15 U.S.C. § 77k

Unaudited Valeant statements that are not audited by PwC, as to which PwC expressed no opinion, including (i) portions of Valeant’s Annual Reports on Form 10-K other than the audited financial statements, (ii) Valeant’s quarterly financial statements in its Quarterly Reports on Form 10-Q, (iii) other Valeant SEC filings, and (iv) Valeant press releases

Valeant Valeant Pharmaceuticals International, Inc.


Defendant PricewaterhouseCoopers LLP (“PwC”), in accordance with Federal Rules of

Civil Procedure 12(b)(6) and 8(a), moves to dismiss Count VII of the Consolidated Complaint

(“Complaint” or “Compl.”) [ECF 80], the sole claim against PwC in this action.

PRELIMINARY STATEMENT

PwC is Valeant’s independent registered public accounting firm. Plaintiffs devote most

of the 282-page Complaint to their allegations concerning Valeant’s alleged business practices

over a three-year putative class period. Although Plaintiffs assert nine claims against 23

defendants, only one plaintiff, the City of Tucson (“Plaintiff”), asserts one claim against PwC

based on one offering. That claim relates to a single PwC audit report, dated February 25, 2015,

which was incorporated by reference in Valeant’s prospectus supplement for its March 2015

stock offering. Compl. ¶ 563. PwC provided three opinions in that report. Id. ¶ 692. Plaintiff

asserts that PwC’s opinions were “false statements” under Section 11 of the 1933 Securities Act.

Id. ¶ 704. By its terms, however, that statute relates to misstatements or omissions of “fact” in

offering statements. 15 U.S.C. § 77k(a). Plaintiff’s claim fails under the United States Supreme

Court’s recent Omnicare decision, which sets forth strict requirements for pleading that an

opinion statement is false under Section 11. Plaintiff does not and cannot meet them.

More specifically, PwC opined that: (i) Valeant’s financial statements for the period

ended December 31, 2014 were fairly presented in all material respects; (ii) Valeant maintained

effective internal control over financial reporting for that same period; and (iii) PwC had

conducted its audits in accordance with applicable auditing standards. Compl. ¶ 692. Relying

entirely on hindsight, Plaintiff claims that these opinions were false statements of fact because, a

year later—after a substantial investigation by an independent committee of its Board—Valeant

identified a financial statement error and control weaknesses, and it restated its 2014 financial

statements. Id. ¶ 691. In its restatement, Valeant explained that certain Valeant officers had


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provided “incorrect information” to PwC, which “contributed to the misstatement” of financial

results. Id. ¶¶ 41, 380.

Significantly, Plaintiff disclaims any notion that PwC was part of any “fraud,” and asserts

instead that its claim sounds in “negligence.” Compl. ¶ 551. Plaintiff specifically “exclude[s]

allegations that could be construed as alleging fraud or intentional misconduct.” Id. ¶ 669.

Plaintiff also sues PwC within the separate Securities Act portion of the Complaint, which is

reserved for “non-fraud based” claims. Id. ¶ 551 (emphasis added). In other words, Plaintiff

alleges that PwC “fail[ed] to identify” the error in Valeant’s financial statements (id. ¶ 697)—not

that PwC knew about the error at the time and that PwC disbelieved its opinions. Nor could

Plaintiff do so in light of the acknowledgement in Valeant’s restatement that certain of its

officers had provided PwC with “incorrect information.” Id. ¶ 41.

Plaintiff’s failure and inability to allege that PwC disbelieved its audit opinions dooms its

claim under the Supreme Court’s Omnicare decision. The Court held that a statement of opinion

may be considered a false statement of fact under Section 11 only when the speaker disbelieves it

at the time, also known as “subjective disbelief.” Courts applying Omnicare have dismissed

Section 11 claims against independent auditors when, as here, a plaintiff alleges only negligence,

but no facts to suggest that the auditor subjectively disbelieved its opinions at the time they were

made. Following that precedent, this Court should do likewise.

Additionally, and as an independent basis for dismissal, PwC incorporates by reference

the argument in Part III(A) of the Bank Offering Defendants’ Memorandum of Law, filed

September 13, 2016, as if fully set forth herein. Plaintiff does not plausibly allege that it

purchased shares in or traceable to the March 2015 stock offering. Because that argument goes

to Plaintiff’s lack of standing, it applies equally to all defendants.


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FACTUAL BACKGROUND

The following background—drawn from Plaintiff’s allegations and the documents

referenced in the Complaint—is relevant to the Section 11 claim against PwC.1

PwC’s Audit Opinions A.

Plaintiff’s sole claim against PwC relates only to the March 2015 stock offering by

Valeant Pharmaceuticals International, Inc. (“Valeant” or “Company”). Compl. ¶ 557. For that

offering, Valeant filed a March 18, 2015 Prospectus Supplement with the Securities and

Exchange Commission (“SEC”). Id. ¶ 559. Valeant’s prospectus incorporated by reference its

2014 Annual Report on Form 10-K, which Valeant had previously filed with the SEC on

February 25, 2015. Id. Valeant’s 2014 Form 10-K, in turn, included PwC’s audit report. In that

report, PwC opined that Valeant’s financial statements for the year ended December 31, 2014

were fairly presented in all material respects in accordance with Generally Accepted Accounting

Principles (“GAAP”), that its internal control over financial reporting (“ICFR”) was effective as

of December 31, 2014, and that PwC had conducted its audits in accordance with PCAOB

auditing standards. Id. ¶¶ 563, 692.2 PwC’s audit opinions addressed only the Company’s

financial statements and ICFR. PwC’s report did not cover other, unaudited parts of Valeant’s

2014 Form 10-K, such as the Management, Discussion and Analysis (id. ¶ 385).

1 The Court may consider these referenced materials on this motion. See In re Burlington Coat

Factory Sec. Litig., 114 F.3d 1410, 1426 (3d Cir. 1997) (court may consider documents “integral

to or explicitly relied upon in the complaint” on Rule 12 motion) (internal quotation marks and citation omitted). These materials are attached to the accompanying Declaration of James J. Capra, Jr. and referred to as “Capra Ex. _”.

2 The Public Company Accounting Oversight Board (“PCAOB”) regulates certain audit firms

and promulgates auditing standards. The PCAOB has adopted the AICPA’s Generally Accepted Auditing Standards (“GAAS”) as interim auditing standards (referred to as “AU”) and has issued its own Audit Standards (referred to as “AS”). See Compl. ¶ 688 n.89; PCAOB Rule 3200T. The Court may consider PCAOB auditing standards because they are integral to the Complaint and Plaintiff refers to them. See also id. ¶¶ 338, 689, 693, 697, 699-701, 703.


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Respective Roles of Valeant Management and PwC as Independent Auditor B.

Company management: Valeant’s management was responsible for running the

Company’s business, e.g., pricing its products and negotiating contracts. Valeant’s management

was also responsible for its financial statements and for maintaining effective internal control

over financial reporting, i.e., controls intended to prevent or detect material misstatements in

Valeant’s financial statements. See AU 110.03 (“The financial statements are management’s

responsibility.”) (Capra Ex. A); AS 5.85(b) (same as to ICFR) (Capra Ex. B); supra note 2.

Independent auditor: As independent auditor, PwC was just that—independent of

Valeant and its management. See 17 C.F.R. § 210.2-01. PwC did not make decisions about how

Valeant should conduct its business or account for its transactions (and Plaintiff does not allege

otherwise). Instead, PwC performed audits. Compl. ¶ 686.

Audits of financial statements and ICFR: The auditor is responsible for conducting an

audit of a company’s financial statements in accordance with the relevant professional standards.

AU 110.01-.02 (Capra Ex. A). Under those standards, an audit consists of an examination, on a

test basis, of evidence supporting the amounts and disclosures in the company’s financial

statements. AU 508.08 (Capra Ex. C). That examination is necessarily on a test basis because,

practically, an auditor cannot obtain evidence to support the accounting for every one of a

company’s millions of transactions. Instead, the auditor obtains “sufficient appropriate audit

evidence” by designing tests to address risks of material misstatements. AS 15.4-.5 (Capra

Ex. D). An auditor also performs tests to obtain sufficient evidence concerning whether a

company maintains effective ICFR or, instead, has material weaknesses, which are defined as a

“reasonable possibility” that internal controls will not timely prevent or detect a material

misstatement in the financial statements. AS 5.3 & App’x A7 (Capra Ex. B). Significantly, an


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auditor opines only about internal control over financial reporting, not other kinds of controls,

such as those relating to operations or regulatory compliance.3

Audit opinions: The auditing standards prescribe that the objective of an audit is “the

expression of an opinion.” AU 110.01 (Capra Ex. A). At the conclusion of the audit, the auditor

gives its opinion in one of the standard reports required by professional standards. AU 508

(Capra Ex. C). Given materiality considerations and other inherent limitations, an audit provides

“reasonable, but not absolute, assurance” on whether financial statements are fairly presented in

material respects and whether a company’s ICFR is effective. AU 110.02 (Capra Ex. A).

Valeant’s 2014 Financial Statements and Restatement C.

Plaintiff alleges that Valeant’s 2014 financial statements were misstated, and its internal

control over financial reporting ineffective, based on Valeant’s subsequent restatement. Compl.

¶¶ 687, 691, 693-95.

Specifically, Plaintiff focuses on Valeant’s accounting for its relationship with Philidor

Rx Services, LLC (“Philidor”), a specialty pharmacy to which it distributed pharmaceutical

products. Compl. ¶ 54. As relevant to the 2014 financial statements, Valeant entered into a

December 15, 2014 agreement for the option to acquire Philidor (the “Purchase Option

Agreement”). Id. ¶ 99. Based on the benefits conferred by this agreement, Valeant concluded

that the agreement caused it to be the primary beneficiary of Philidor (as a variable interest

entity) and, therefore, that Valeant should consolidate Philidor’s results within its own year-end

financial statements. Id. ¶ 327. Plaintiff does not dispute that Valeant’s consolidation of

Philidor’s results in its 2014 financial statements was appropriate under GAAP.

3 See Committee of Sponsoring Organizations of the Treadway Commission, Internal Control –

Integrated Framework, Executive Summary (May 2013) at 3 (different types of controls relate, respectively, to “operations, reporting, and compliance”) (available at www.coso.org); Compl. ¶ 333 (referring to COSO).


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In the third quarter of 2015—months after Valeant had filed its 2014 Form 10-K in

February 2015—a short-seller made allegations concerning Valeant’s relationship to Philidor.

Compl. ¶ 213. Valeant formed a committee of independent directors of the Board to investigate

those allegations, with assistance from an outside law firm. Id. ¶ 252; 2015 Form 10-K at

Explanatory Note (Capra Ex. E). After incurring “substantial . . . expenses and costs,” and based

on the information the investigation unearthed, Valeant decided to restate its 2014 financial

statements. Compl. ¶ 308; 2015 Form 10-K at Item 1A (Capra Ex. E).

Specifically, Valeant determined that it had incorrectly recognized revenue on certain

sales to Philidor in the period immediately prior to the Purchase Option Agreement’s execution

on December 15, 2014 (“pre-agreement sales”). Compl. ¶ 315. That date, when Valeant

appropriately consolidated Philidor’s results, is significant with respect to revenue recognition.

In the period leading up to the agreement’s execution, Valeant could presumptively recognize

revenue on sales to Philidor (and did so) on a sell-in basis, i.e., when it delivered products to

Philidor, because Philidor was still an unconsolidated entity—a customer. Id. ¶¶ 694-95. But,

for items still held by Philidor at the Purchase Option Agreement date, Valeant could only

recognize revenue on those sales if they were made in the normal course of business. Id.4

Based on its subsequent investigation, Valeant “‘determined that certain sales

transactions for deliveries to Philidor in the second half of 2014 leading up to the execution of

the purchase option agreement were not executed in the normal course of business.’” Compl.

¶ 694 (quoting Valeant 2015 Form 10-K [Capra Ex. E]). Thus, with the benefit of hindsight, it

4 After the date of the Purchase Option Agreement, Valeant had to recognize revenue on sales to

Philidor (and did so) on a sell-through basis, i.e., when Philidor later sold the products to its customers. Compl. ¶ 316. The reason is essentially that, after the accounting consolidation, Valeant could not, in effect, sell products to itself. Plaintiff does not challenge Valeant’s revenue recognition on post-agreement sales.


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became apparent that Valeant had recorded revenue on certain pre-agreement sales too soon—on

a sell-in basis (when it sold product to Philidor) rather than on a sell-through basis (when

Philidor later sold that product to customers). On April 29, 2016, Valeant filed its 2015 Form

10-K, which included 2014 restated financial statements. Compl. ¶ 308. In its restatement,

Valeant identified material weaknesses in its ICFR as of year-end 2014 and adjusted its revenue

by $57.5 million. See Valeant 2015 Form 10-K at F-14 (Capra Ex. E). That adjustment is less

than one percent (0.7%) of Valeant’s total 2014 revenues of $8.2 billion. Id.

Although Valeant recognized this small amount of revenue prematurely at year-end 2014,

there is no allegation that the underlying sales had not occurred. For example, there are no

allegations that orders for the products were not actually received, that the products were not

actually shipped and paid for, or that they were not ultimately dispensed to patients. Rather, the

sales were not in the normal course—such that revenue could not be recognized on a sell-in

basis—because, for example, certain company officers had placed an “emphasis on delivering

product prior to the execution of the purchase option agreement.” 2015 Form 10-K at F-11

(Capra Ex. E). Importantly, there is no allegation that, based on the audit evidence it obtained,

PwC was aware of this “emphasis,” which only came to light in 2016 during the committee’s

investigation. On the contrary, Plaintiff relies on Valeant’s restatement, which includes the

committee’s finding that:

The improper conduct of the Company’s former Chief Financial Officer and former Corporate Controller, which resulted in the provision of incorrect

information to the [Audit and Risk Committee] and the Company’s independent

registered public accounting firm [i.e., PwC], contributed to the misstatement of financial results.

Id. at Explanatory Note (Capra Ex. E) (emphasis added).


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Plaintiff’s Allegations Regarding PwC’s Purportedly False Statements D.

As Plaintiff acknowledges, PwC provided opinions on Valeant’s financial statements and

ICFR for the year ending December 31, 2014. Compl. ¶ 692. PwC opined, in pertinent part:

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income (loss), comprehensive income (loss), shareholders’ equity, and cash flows present fairly, in all material respects, the financial position of Valeant Pharmaceuticals International, Inc. and its subsidiaries (the “Company”) at December 31, 2014 and December 31, 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014 in conformity with accounting principles generally accepted in the United States of America. . . . Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014 . . . . The Company’s management is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements . . . and on the Company’s internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). . . . We believe that our audits provide a reasonable basis for our opinions.

2014 Form 10-K at F-3 (Capra Ex. F) (emphasis added); see also Compl. ¶ 692.

There are three PwC opinions here, that: (i) Valeant’s 2014 financial statements were

fairly presented; (ii) Valeant maintained effective ICFR as of year-end 2014; and (iii) PwC had

performed its audits in accordance with PCAOB standards. Plaintiff asserts that these opinions

were “false statements” (Compl. ¶ 704), i.e., misstatements.5 Plaintiff does not allege that PwC

provided these opinions fraudulently or recklessly or that PwC disbelieved them at the time. See

id. ¶ 669 (“exclud[ing] allegations . . . [of] fraud or intentional misconduct”).

5 Plaintiff does not plead any PwC omission. Although Plaintiff makes a perfunctory reference

to the statutory language of Section 11, by referring to misstatements “and/or” omissions (Compl. ¶ 693), Plaintiff identifies PwC’s opinions as alleged “false statements” (id. ¶ 704), not omissions.


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Instead, Plaintiff alleges that PwC’s opinions on the Company’s 2014 financial

statements and ICFR were false statements because, a year later, with the benefit of hindsight

and a substantial investigation, the Company determined that it had prematurely recognized a

small amount of revenue—$57.5 million out of $8.2 billion in sales—and had not maintained

effective ICFR as of year-end 2014. Compl. ¶¶ 693-94.

Plaintiff also asserts that PwC’s opinion that it had performed its audit in accordance with

PCAOB auditing standards was false because PwC failed to do so, i.e., PwC was negligent.

Compl. ¶¶ 693(c), 697-703. As discussed below, negligence allegations do not suffice to plead

that a statement of opinion was a misstatement of fact under Section 11. In any event, these

allegations are entirely conclusory and therefore entitled to no weight. After describing various

auditing and accounting standards (id. ¶¶ 688-90, 699, 701-02) and Valeant’s restatement (id.

¶¶ 687, 691, 694-95), Plaintiff asserts that PwC’s audit did not comply with professional

standards because PwC “fail[ed] to identify the accounting for the Philidor Sales Transactions as

non-compliant with GAAP” (id. ¶ 697) and “failed to identify” the material weaknesses in ICFR

that later came to light (id. ¶ 703). Plaintiff does not, however, plausibly allege any audit

procedures PwC should have but did not perform, or explain how those procedures would have

identified that certain pre-agreement sales to Philidor were outside the normal course.

Indeed, Plaintiff’s only factual allegation is that PwC provided its opinions “even after

discussing and reviewing the facts of the Philidor Sales Transactions with Carro,” Valeant’s

former controller. Compl. ¶ 697. But Plaintiff does not plead any facts about the content of that

discussion, much less what information Carro provided that should have led PwC to reach a

different opinion. On the contrary, Plaintiff relies on Valeant’s restatement, which includes the

after-the-fact finding that Carro had provided “incorrect information” to PwC. Id. ¶ 41.


10

PLEADING STANDARD

To survive a motion to dismiss, “a complaint must contain sufficient factual matter,

accepted as true, to ‘state a claim to relief that is plausible on its face.’” Ashcroft v. Iqbal, 556

U.S. 662, 678 (2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). Whether a

claim is plausible depends on the factual allegations because “the tenet that a court must accept

as true all of the allegations contained in a complaint is inapplicable to legal conclusions.” Id.

Thus, a “pleading that offers ‘labels and conclusions’ or ‘a formulaic recitation of the elements

of a cause of action will not do.’” Id. (quoting Twombly, 550 U.S. at 555).

ARGUMENT

Plaintiff fails to plead that PwC’s opinion statements were false. I.

Section 11 relates to registration statements that:

contained an untrue statement of a material fact or omitted to state a material fact required to be stated therein or necessary to make the statements therein not misleading.

15 U.S.C. § 77k(a) (emphasis added).

The PwC statements that Plaintiff challenges as “false statements” (Compl. ¶ 704),

however, are explicitly presented as opinions (id. ¶ 692). The United States Supreme Court has

held that an opinion statement is not actionable under Section 11 merely because it later turns out

to be incorrect. Omnicare, Inc. v. Laborers Dist. Council Constr. Indus. Pension Fund, 135 S.

Ct. 1318, 1325-27 (2015). Rather, a statement of opinion is actionable as a factual misstatement

only if the speaker did not sincerely believe the opinion at the time. Id. at 1326. Plaintiff’s claim

fails because Plaintiff has not alleged that PwC disbelieved its opinions at the time.


11

Under Omnicare, an opinion statement is actionable under Section 11 only if A.

the speaker did not sincerely believe the opinion at the time.

In Omnicare, the Supreme Court explained that every opinion statement “explicitly

affirms one fact: that the speaker actually holds the stated belief.” 135 S. Ct. at 1326. Thus, the

speaker may be liable only if the speaker does not actually hold the stated belief, i.e., if the

speaker disbelieves her opinion. Id. But the speaker is not liable merely because a plaintiff

alleges that her “belief turned out to be wrong.” Id. at 1327. As the Court explained:

[Such an] allegation alone will not give rise to liability under § 11’s first clause [regarding misstatements] because, as we have shown, a sincere statement of pure opinion is not an “untrue statement of material fact,” regardless whether an investor can ultimately prove the belief wrong. That clause, limited as it is to factual statements, does not allow investors to second-guess inherently subjective and uncertain assessments.

Id.

The Court gave as a hypothetical example a CEO’s statement, “I believe our marketing

practices are lawful.” 135 S. Ct. at 1326. As the Court explained, if the CEO “actually did think

that, she could not be liable for a false statement of fact—even if she afterward discovered a

longtime violation of law. Once again, the statement would have been true, because all she

expressed was a view, not a certainty, about legal compliance.” Id. In short, a statement of

“pure opinion” is not actionable as a misstatement under Section 11 unless the speaker did not

actually hold it. Id. at 1327.

PwC’s opinions are subject to the Omnicare standard for Section 11 claims. B.

The very objective of an audit is the “expression of an opinion” in one of several

standardized reports prescribed by auditing standards. AU 110.01; AU 508 (Capra Exs. A, C).

In those prescribed reports, the auditor’s statement is an opinion. Consistent with that

requirement, PwC stated that it was providing its “opinion” on Valeant’s 2014 financial

statements and its “opinion” on whether Valeant maintained effective internal control over


12

financial reporting. See 2014 Form 10-K at F-3 (Capra Ex. F). That alone qualifies PwC’s

statements as opinions. See Omnicare, 135 S. Ct. at 1328 (distinguishing opinion statements by

the form of words used in those statements).

Ignoring both the nature of an audit and what PwC actually said in its audit report,

Plaintiff tries to characterize an audit as an “objective evaluation” of “underlying facts” in a

company’s financial statements. Compl. ¶¶ 690, 691. That conclusory statement is undercut by

the auditing standards on which Plaintiff relies and by courts that have considered them. The

auditing standards generally make clear that there are “differing interpretations” in applying

accounting principles and that auditing requires “judgment regarding both the areas to be tested

and the nature, timing, and extent of the tests to be performed.” AU 625.01, AU 230.11 (Capra

Exs. G, H). Courts likewise recognize that the “decision how and when to apply the provisions

of GAAP or GAAS requires an accountant or auditor to exercise its own judgment and consider

the specific circumstances of its client’s economic activities.” Reiger v. Altris Software, Inc.,

1999 WL 540893, at *6 (S.D. Cal. Apr. 30, 1999). Accordingly, the auditor’s statement that it

has complied with applicable auditing standards is also “inherently . . . one of opinion.” In re

Lehman Bros. Sec. & ERISA Litig., 799 F. Supp. 2d 258, 302 (S.D.N.Y. 2011).

Based on these considerations, courts addressing Section 11 claims against auditors have

held that the auditor’s statements, expressed in the same words as PwC’s, are opinions subject to

the Omnicare standard. For example, the Court of Appeals for the Second Circuit has recently

confirmed that “[a]udit reports, labeled ‘opinions’ and involving considerable subjective

judgment, are statements of opinion subject to the Omnicare standard for Section 11 claims.”

Querub v. Moore Stephens Hong Kong, _ F. App’x _, 2016 WL 2942415, at *3 (2d Cir. May 20,


13

2016) (Summary Order).6 District courts, including one in this Circuit, have likewise held that

an auditor’s statements are “pure statement[s] of opinion” under Omnicare. Johnson v. CBD

Energy Ltd., 2016 WL 3654657, at *10 (S.D. Tex. July 6, 2016) (emphasis added) (citing

Lehman); see also In re Velti PLC Sec. Litig., 2015 WL 5736589, at *17-18 (N.D. Cal. Oct. 1,

2015) (applying Omnicare standard to audit opinions); SEPTA v. Orrstown Fin. Servs., Inc.,

2015 WL 3833849, at *33-34 (M.D. Pa. June 22, 2015) (same).7 Accordingly, PwC’s opinions

are subject to the Omnicare standard for Section 11 claims.

Courts have applied Omnicare to dismiss Section 11 claims against C.

independent auditors when plaintiffs do not allege subjective disbelief.

Because Omnicare applies to audit opinions, it is insufficient to allege that those opinions

turned out to be wrong in light of a material misstatement in a company’s financial statements or

a material weakness in its ICFR. Instead, a plaintiff must plead facts showing that the auditor

did not sincerely believe its opinions at the time they were made. Omnicare, 135 S. Ct. at 1326.

In the absence of allegations of subjective disbelief, courts applying Omnicare have

dismissed Section 11 claims against independent auditors. For example, in this Circuit, in

SEPTA, supra, the plaintiff alleged that an auditor’s opinion was a false statement under Section

6 This court may “look[] to relevant authority in other Circuits” because, to PwC’s knowledge,

the Third Circuit has not yet applied Omnicare to a claim against an auditor. United States v.

Brassington, 2010 WL 3419430, at *1 (D.N.J. Aug. 26, 2010). Previous Third Circuit case law is consistent with the concept that an auditor provides an opinion. See In re IKON Office

Solutions, Inc., 277 F.3d 658, 673 (3d Cir. 2002) (“An audit does not guarantee that a client’s accounts and financial statements are correct any more than a sanguine medical diagnosis guarantees well-being.”).

7 One district court in the Second Circuit has asserted that audit opinions contain “embedded

statements of fact.” In re Petrobras Sec. Litig., No. 14-cv-9662-JSR, slip op. at 9 (S.D.N.Y. Feb. 19, 2016). But, as another district court has observed, the Second Circuit’s subsequent “holding in [Querub] directly contradicts” that proposition. Johnson v. CBD Energy Ltd., 2016 WL 3654657, at *11 (S.D. Tex. July 6, 2016). One court in this district has rejected the subjective disbelief pleading requirement, but the case was decided before Omnicare. See Yang v. Tibet

Pharm., Inc., 2015 WL 730036, at *3 & n.7 (D.N.J. Feb. 20, 2015).


14

11 because the auditor “failed to adhere to the PCAOB standards when conducting its audit”—in

other words, that the auditor was negligent. 2015 WL 3833849, at *33. The District Court for

the Middle District of Pennsylvania dismissed the claim because plaintiff “failed to point to a

factual basis supporting its allegation that [the auditor] did not believe its opinion.” Id. at *34.

Similarly, in Johnson, supra, the company determined that its previously issued audited

financial statements should no longer be relied upon because they did not account for a director’s

self-dealing transactions. 2016 WL 3654657, at *2. Plaintiffs alleged that the auditor’s opinion

on those financial statements was false because the auditor did not conduct its audits in

accordance with PCAOB standards—again, that the auditor was negligent. Id. at *9. The

district court dismissed the claim because “Plaintiffs do not allege that [the auditor] did not

subjectively believe any of the opinions it provided in its report, and [the auditor’s] opinions do

not contain any embedded statements of fact that are untrue.” Id. at *12. See also In re Velti,

2015 WL 5736589, at *17-24 (similar); Special Situations Fund III QP, L.P. v. Deloitte Touche

Tohmatsu CPA, Ltd., 645 F. App’x 72, 2016 WL 1392280, at *3 (2d Cir. Apr. 8, 2016)

(Summary Order) (affirming dismissal of Section 18 claim (15 U.S.C. § 78r) under Omnicare

because plaintiffs did not allege that the auditor “lacked a subjective belief in its opinions”).8

The take-away from these cases is that a plaintiff can only plead a factual misstatement

under Section 11 by alleging that the auditor did not sincerely hold its opinions, i.e., subjective

disbelief. An allegation of negligence of the kind asserted here—that the auditor did not comply

with PCAOB standards—does not suffice.

8 See generally In re Puda Coal Sec. Inc. Litig., 30 F. Supp. 3d 230, 259-60 (S.D.N.Y. 2014)

(granting summary judgment in favor of auditors based on lack of “subjective falsity” because there was no evidence that they knew of the misstatement, only that they had “failed to figure this fundamental fact out”), aff’d sub nom. Querub v. Moore Stephens Hong Kong, _ F. App’x _, 2016 WL 2942415, at *3 (2d Cir. May 20, 2016) (Summary Order).


15

Plaintiff does not allege PwC’s subjective disbelief. D.

Plaintiff does not allege that PwC knew its opinion statements were false at the time it

made them. For example, Plaintiff does not allege that PwC knew that Valeant had erroneously

recognized revenue on certain pre-agreement sales to Philidor, but that PwC nonetheless issued

its opinion stating that Valeant’s 2014 financial statements were fairly presented. On the

contrary, Plaintiff alleges that PwC “fail[ed] to identify the accounting for the Philidor Sales

Transactions as non-compliant with GAAP” and “failed to identify” material weaknesses in the

Company’s ICFR. Compl. ¶¶ 697, 703. These are (conclusory) allegations of negligence, not

subjective disbelief. Nor would it be plausible for Plaintiff to allege that PwC disbelieved its

own opinions when Valeant’s restatement indicates that PwC was provided with “incorrect

information.” Id. ¶ 41.

Finally, Plaintiff’s own pleading forecloses any allegation of PwC’s subjective disbelief.

Plaintiff “exclude[s] allegations that could be construed as alleging fraud or intentional

misconduct” from its Section 11 claim against PwC. Compl. ¶ 669. In Omnicare, the Supreme

Court noted that the “complaint explicitly ‘exclude[s] and disclaim[s]’ any allegation sounding in

fraud or deception,” and therefore plaintiffs “do not contest that Omnicare’s opinion was

honestly held.” 135 S. Ct. 1327 (alterations in original). Here, too, Plaintiff’s disclaimer of any

fraud allegations likewise precludes any assertion that PwC did not honestly hold its audit

opinions. See In re Velti, 2015 WL 5736589, at *18 (plaintiffs “effectively pleaded themselves

out of stating a claim under Section 11’s false-statements clause” by disclaiming any fraud

allegations); In re Am. Int’l Grp., Inc., 2008 Sec. Litig., 2013 WL 1787567, at *4-5 (S.D.N.Y.

Apr. 26, 2013) (similar disclaimer incompatible with subjective disbelief).

Based on the absence of any allegations that PwC did not sincerely believe its opinions,

and based on Plaintiff’s reliance on Valeant’s restatement, which acknowledges that PwC was


16

provided with incorrect information, Plaintiff has not pleaded and cannot plead that PwC

disbelieved the opinions expressed in its audit report. Under these circumstances, the Court

should dismiss the Section 11 claim against PwC with prejudice.

Plaintiff lacks standing to bring a Section 11 claim relating to the March 2015 stock II.

offering.

Plaintiff’s claim against PwC is based on the March 18, 2015 Prospectus Supplement for

the March 2015 stock offering, which incorporated by reference PwC’s audit report. Compl.

¶¶ 559, 670. For the reasons set forth in Part III(A) of the Bank Offering Defendants’

Memorandum of Law, filed September 13, 2016, which PwC incorporates by reference herein,

Plaintiff does not plausibly allege that it purchased shares in or traceable to the March 2015 stock

offering. Accordingly, the Court should also dismiss the claim against PwC because Plaintiff

lacks standing to assert it.

CONCLUSION

For all the foregoing reasons, the Court should dismiss Count VII of the Complaint as to

PwC with prejudice.


17


Respectfully submitted,


By: /s/A. Ross Pearlson

A. Ross Pearlson James Van Splinter One Boland Drive West Orange, NJ 07052 Telephone: (973) 530-2100 Facsimile: (973) 530-2300 KING & SPALDING LLP James J. Capra, Jr. (admitted pro hac vice) 1185 Avenue of the Americas

New York, NY 10036-4003 Telephone: (212) 556-2100 Facsimile: (212) 556-2222

Kenneth Y. Turnbull (pro hac vice filed) 1700 Pennsylvania Avenue, NW Washington, DC 20006-4707 Telephone: (202) 737-0500

Facsimile: (202) 626-3737

Attorneys for Defendant



KING & SPALDING LLP

James J. Capra, Jr. (admitted pro hac vice) 1185 Avenue of the Americas New York, NY 10036-4003 Telephone: (212) 556-2100 Facsimile: (212) 556-2222 Kenneth Y. Turnbull (pro hac vice filed) 1700 Pennsylvania Avenue, NW Washington, DC 20006-4707 Telephone: (202) 737-0500 Facsimile: (202) 626-3737


A. Ross Pearlson James Van Splinter One Boland Drive West Orange, NJ 07052 Telephone: (973) 530-2100 Facsimile: (973) 530-2300

Attorneys for Defendant PricewaterhouseCoopers LLP UNITED STATES DISTRICT COURT DISTRICT OF NEW JERSEY


No. 3:15-CV-07658-MAS-LHG Motion Day: December 19, 2016


All Actions.

DECLARATION OF JAMES J. CAPRA, JR. IN SUPPORT OF DEFENDANT PRICEWATERHOUSECOOPERS LLP’S MOTION TO DISMISS THE

CONSOLIDATED COMPLAINT


JAMES J. CAPRA, JR. hereby declares pursuant to 28 U.S.C. § 1746:

1. I am a partner in the law firm of King & Spalding LLP, attorney of record for

Defendant PricewaterhouseCoopers LLP (“PwC”) in the above-captioned action. I am a member

of the bar of the State of New York and have been admitted pro hac vice in this proceeding. I

respectfully submit this Declaration in support of PwC’s Motion to Dismiss the Consolidated

Complaint and accompanying Memorandum of Law, filed September 13, 2016.

2. Attached hereto are true and correct copies of the following documents, which are

referred to in PwC’s Memorandum of Law in Support of Its Motion to Dismiss:

Exhibit A: PCAOB Interim Auditing Standard 110 (AU 110).

Exhibit B: Composite exhibit consisting of: (1) PCAOB Audit Standard No. 5 (AS 5); and (2) Appendix A to PCAOB Audit Standard No. 5.

Exhibit C: PCAOB Interim Auditing Standard 508 (AU 508).

Exhibit D: PCAOB Audit Standard No. 15 (AS 15).

Exhibit E: Excerpts of Valeant’s Annual Report on Form 10-K for the year ended December 31, 2015, filed with the Securities and Exchange Commission on April 29, 2016.

Exhibit F: Excerpts of Valeant’s Annual Report on Form 10-K for the year ended December 31, 2014, filed with the Securities and Exchange Commission on February 25, 2015.

Exhibit G: PCAOB Interim Auditing Standard 625 (AU 625).

Exhibit H: PCAOB Interim Auditing Standard 230 (AU 230).

3. Plaintiffs refer in their Consolidated Complaint, filed on June 24, 2016 [ECF 80],

to PCAOB auditing standards. See Compl. ¶ 688 n.89 (“[T]he PCAOB was created to oversee

the audits of public companies, and has now adopted, amended, and expanded upon the auditing

standards and interpretations previously issued by the American Institute of Certified Public

Accountants (‘AICPA’) (referred to herein as ‘AU__’), and has also promulgated additional

auditing standards (referred to herein as ‘AS__’).”); see also id. ¶¶ 338, 689, 693, 697, 699-701,


2

703. Plaintiffs also refer in their Complaint to Valeant’s Annual Reports on Form 10-K for the

year ended December 31, 2014 (id. ¶¶ 43-50, 184, 187, 190, 228-29, 302, 315, 328, 418, 560-61,

563, 653-57, 659-61, 675, 680-83, 686, 688) and for the year ended December 31, 2015 (id. ¶¶

290-91, 308, 317, 343, 374, 510, 513, 694).

4. I declare under penalty of perjury that the foregoing is true and correct to the best

of my knowledge and belief.

Dated: New York, NY September 13, 2016 /s/ James J. Capra, Jr. James J. Capra, Jr.


EXHIBIT A


The following auditing standard reflects references to standards before their reorganization. The reorganized auditing standard is available here.

AU Section 110Responsibilities and Functions of the Independent Auditor

(.01)(.02 - .03) Distinction Between Responsibilities of Auditor and Management(.04 - .05) Professional Qualifications[.06 - .09] Detection of Fraud(.10) Responsibility to the Profession

Source: SAS No. 1, section 110; SAS No. 78; SAS No. 82.

Issue date, unless otherwise indicated: November, 1972.

.01

The objective of the ordinary audit of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present, in all material respects, financial position, results of operations, and its cash flows in conformity with generally accepted accounting principles. The auditor's report is the medium through which he expresses his opinion or, if circumstances require, disclaims an opinion. In either case, he states whether his audit has been made in accordance with generally accepted auditing standards. These standards require him to state whether, in his opinion, the financial statements are presented in conformity with generally accepted accounting principles and to identify those circumstances in which such principles have not been consistently observed in the preparation of the financial statements of the current period in relation to those of the preceding period.

Distinction Between Responsibilities of Auditor and Management

.02

The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the auditor is able to obtain reasonable, but not absolute, assurance that material misstatements are detected. The auditor has no responsibility to plan and perform the audit to obtain reasonable assurance that misstatements, whether caused by errors or fraud, that are not material to the financial statements are detected. [Paragraph added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.03

The financial statements are management's responsibility. The auditor's responsibility is to express an opinion on the financial statements. Management is responsible for adopting sound accounting policies and for establishing and maintaining internal control that will, among other things, initiate, record, process, and report transactions (as well as events and conditions) consistent with management's assertions embodied in the financial statements. The entity's transactions and the related assets, liabilities, and equity are within the direct knowledge and control of management. The auditor's knowledge of these matters and internal control is limited to that acquired through the audit. Thus, the fair presentation of financial statements in conformity with generally accepted accounting

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principles is an implicit and integral part of management's responsibility. The independent auditor may make suggestions about the form or content of the financial statements or draft them, in whole or in part, based on information from management during the performance of the audit. However, the auditor's responsibility for the financial statements he or she has audited is confined to the expression of his or her opinion on them. [Revised, April 1989, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards Nos. 53 through 62. As amended, effective for audits of financial statements for periods beginning on or after January 1, 1997, by Statement on Auditing Standards No. 78. Paragraph renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997. Revised, April 2002, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards No. 94.]

Professional Qualifications

.04

The professional qualifications required of the independent auditor are those of a person with the education and experience to practice as such. They do not include those of a person trained for or qualified to engage in another profession or occupation. For example, the independent auditor, in observing the taking of a physical inventory, does not purport to act as an appraiser, a valuer, or an expert in materials. Similarly, although the independent auditor is informed in a general manner about matters of commercial law, he does not purport to act in the capacity of a lawyer and may appropriately rely upon the advice of attorneys in all matters of law. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]

.05

In the observance of generally accepted auditing standards, the independent auditor must exercise his judgment in determining which auditing procedures are necessary in the circumstances to afford a reasonable basis for his opinion. His judgment is required to be the informed judgment of a qualified professional person. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]

Detection of Fraud

[.06–.09]

[Superseded January 1977 by Statement on Auditing Standards No. 16, as superseded by Statement on Auditing Standards No. 53, as superseded by section 316. Paragraphs renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]

Responsibility to the Profession

.10

The independent auditor also has a responsibility to his profession, the responsibility to comply with the standards accepted by his fellow practitioners. In recognition of the importance of such compliance, the American Institute of Certified Public Accountants has adopted, as part of its Code of Professional Conduct, rules which support the standards and provide a basis for their enforcement. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]

Footnotes (AU Section 110 — Responsibilities and Functions of the Independent Auditor):

[The following footnote is effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release No. 2010-004 . For audits

of fiscal years beginning before December 15, 2010, click here.]

See Auditing Standard No. 11, Consideration of Materiality in Planning and Performing an Audit. The auditor’s consideration of illegal acts and responsibility for detecting misstatements resulting from illegal acts is defined in section 317, Illegal Acts by Clients. For those illegal acts that are defined in that section as having a direct and material effect on the determination of financial statement amounts, the auditor’s responsibility to detect misstatements resulting from such illegal acts is the same as that for error or fraud.

fn1

fn3




See section 230, Due Professional Care in the Performance of Work, paragraphs .10 through .13. [Footnote added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

The responsibilities and functions of the independent auditor are also applicable to financial statements presented in conformity with a comprehensive basis of accounting other than generally accepted accounting principles; references in this section to financial statements presented in conformity with generally accepted accounting principles also include those presentations. [Footnote added, effective for audits of financial statements for periods beginning on or after January 1, 1997, by Statement on Auditing Standards No. 78. Footnote renumbered by the issuance of Statement on Auditing Standards No. 82, February 1997.]

Copyright © 2002, American Institute of Certified Public Accountants, Inc.

© Copyright 2003 – 2015 Public Company Accounting Oversight Board. All rights reserved. Public Company Accounting Oversight Board and PCAOB are registered trademarks of the Public Company Accounting Oversight Board.

fn2

fn3




EXHIBIT B


Auditing Standard No. 5

An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial StatementsSUPERSEDES AUDITING STANDARD NO. 2

Effective Date: Fiscal years ending on or after November 15, 2007

Final Rule:

SUMMARY TABLE OF CONTENTS

(1 - 8) Introduction (9 - 20) Planning the Audit (21 - 41) Using a Top-Down Approach (42 - 61) Testing Controls (62 - 70) Evaluating Identified Deficiencies (71 - 84) Wrapping-Up (85 - 98) Reporting on Internal Control Appendix A DefinitionsAppendix B Special TopicsAppendix C Special Reporting Situations

Introduction

1. This standard establishes requirements and provides direction that applies when an auditor is engaged to perform an audit of management's assessment of the effectiveness of internal control over financial reporting ("the audit of internal control over financial reporting") that is integrated with an audit of the financial statements.

2. Effective internal control over financial reporting provides reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes. If one or more material weaknesses exist, the company's internal control over financial reporting cannot be considered effective.

[The following paragraph is effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release

No. 2010-004 . For audits of fiscal years beginning before December 15, 2010, click here.]

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3. The auditor's objective in an audit of internal control over financial reporting is to express an opinion on the effectiveness of the company's internal control over financial reporting. Because a company's internal control cannot be considered effective if one or more material weaknesses exist, to form a basis for expressing an opinion, the auditor must plan and perform the audit to obtain appropriate evidence that is sufficient to obtain reasonable assurance about whether material weaknesses exist as of the date specified in management's assessment. A material weakness in internal control over financial reporting may exist even when financial statements are not materially misstated.

4. The general standards are applicable to an audit of internal control over financial reporting. Those standards require technical training and proficiency as an auditor, independence, and the exercise of due professional care, including professional skepticism. This standard establishes the fieldwork and reporting standards applicable to an audit of internal control over financial reporting.

5. The auditor should use the same suitable, recognized control framework to perform his or her audit of internal control over financial reporting as management uses for its annual evaluation of the effectiveness of the company's internal control over financial reporting.

INTEGRATING THE AUDITS

6. The audit of internal control over financial reporting should be integrated with the audit of the financial statements. The objectives of the audits are not identical, however, and the auditor must plan and perform the work to achieve the objectives of both audits.

7. In an integrated audit of internal control over financial reporting and the financial statements, the auditor should design his or her testing of controls to accomplish the objectives of both audits simultaneously -

To obtain sufficient evidence to support the auditor's opinion on internal control over financial reporting as of year-end, and

To obtain sufficient evidence to support the auditor's control risk assessments for purposes of the audit of financial statements.

8. Obtaining sufficient evidence to support control risk assessments of low for purposes of the financial statement audit ordinarily allows the auditor to reduce the amount of audit work that otherwise would have been necessary to opine on the financial statements. (See Appendix B for additional direction on integration.)

Note: In some circumstances, particularly in some audits of smaller and less complex companies, the auditor might choose not to assess control risk as low for purposes of the audit of the financial statements. In such circumstances, the auditor's tests of the operating effectiveness of controls would be performed principally for the purpose of supporting his or her opinion on whether the company's internal control over financial reporting is effective as of year-end. The results of the auditor's financial statement auditing procedures also should inform his or her risk assessments in determining the testing necessary to conclude on the effectiveness of a control.

Planning the Audit



7/

6/

5/




9. The auditor should properly plan the audit of internal control over financial reporting and properly supervise the engagement team members. When planning an integrated audit, the auditor should evaluate whether the following matters are important to the company's financial statements and internal control over financial reporting and, if so, how they will affect the auditor's procedures -

Knowledge of the company's internal control over financial reporting obtained during other engagements performed by the auditor;

Matters affecting the industry in which the company operates, such as financial reporting practices, economic conditions, laws and regulations, and technological changes;

Matters relating to the company's business, including its organization, operating characteristics, and capital structure;

The extent of recent changes, if any, in the company, its operations, or its internal control over financial reporting;

The auditor's preliminary judgments about materiality, risk, and other factors relating to the determination of material weaknesses;

Control deficiencies previously communicated to the audit committee or management;

Legal or regulatory matters of which the company is aware;

The type and extent of available evidence related to the effectiveness of the company's internal control over financial reporting;

Preliminary judgments about the effectiveness of internal control over financial reporting;

Public information about the company relevant to the evaluation of the likelihood of material financial statement misstatements and the effectiveness of the company's internal control over financial reporting;

Knowledge about risks related to the company evaluated as part of the auditor's client acceptance and retention evaluation; and

The relative complexity of the company's operations.

Note: Many smaller companies have less complex operations. Additionally, some larger, complex companies may have less complex units or processes. Factors that might indicate less complex operations include: fewer business lines; less complex business processes and financial reporting systems; more centralized accounting functions; extensive involvement by senior management in the day-to-day activities of the business; and fewer levels of management, each with a wide span of control.

ROLE OF RISK ASSESSMENT

10. Risk assessment underlies the entire audit process described by this standard, including the determination of significant accounts and disclosures and relevant assertions, the selection of controls to test, and the determination of the evidence necessary for a given control.

11. A direct relationship exists between the degree of risk that a material weakness could exist in a particular area of the company's internal control over financial reporting and the amount of audit attention that should be devoted to that area. In addition, the risk that a company's internal control over financial reporting will fail to prevent or detect misstatement caused by fraud usually is higher than the risk of failure to prevent or detect error. The auditor should focus more of his or her attention on the areas of highest risk. On the other hand, it is not necessary to test controls that, even if deficient, would not present a reasonable possibility of material misstatement to the financial statements.

8/




12. The complexity of the organization, business unit, or process, will play an important role in the auditor's risk assessment and the determination of the necessary procedures.

SCALING THE AUDIT

13. The size and complexity of the company, its business processes, and business units, may affect the way in which the company achieves many of its control objectives. The size and complexity of the company also might affect the risks of misstatement and the controls necessary to address those risks. Scaling is most effective as a natural extension of the risk-based approach and applicable to the audits of all companies. Accordingly, a smaller, less complex company, or even a larger, less complex company might achieve its control objectives differently than a more complex company.

ADDRESSING THE RISK OF FRAUD



14. When planning and performing the audit of internal control over financial reporting, the auditor should take into account the results of his or her fraud risk assessment. As part of identifying and testing entity-level controls, as discussed beginning at paragraph 22, and selecting other controls to test, as discussed beginning at paragraph 39, the auditor should evaluate whether the company's controls sufficiently address identified risks of material misstatement due to fraud and controls intended to address the risk of management override of other controls. Controls that might address these risks include -

Controls over significant transactions that are outside the normal course of business for the company or that otherwise appear to be unusual due to their timing, size, or nature ("significant unusual transactions"), particularly those that result in late or unusual journal entries;

Controls over journal entries and adjustments made in the period-end financial reporting process;

Controls over related party transactions;

Controls related to significant management estimates; and

Controls that mitigate incentives for, and pressures on, management to falsify or inappropriately manage financial results.



15. If the auditor identifies deficiencies in controls designed to prevent or detect fraud during the audit of internal control over financial reporting, the auditor should take into account those deficiencies when developing his or her response to risks of material misstatement during the financial statement audit, as provided in paragraphs 65-69 of Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement.

USING THE WORK OF OTHERS

16. The auditor should evaluate the extent to which he or she will use the work of others to reduce the work the auditor might otherwise perform himself or herself. AU sec. 322, The Auditor's Consideration of the Internal Audit Function in an Audit of Financial Statements, applies in an integrated audit of the financial statements and internal control over financial reporting.

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17. For purposes of the audit of internal control, however, the auditor may use the work performed by, or receive direct assistance from, internal auditors, company personnel (in addition to internal auditors), and third parties working under the direction of management or the audit committee that provides evidence about the effectiveness of internal control over financial reporting. In an integrated audit of internal control over financial reporting and the financial statements, the auditor also may use this work to obtain evidence supporting the auditor's assessment of control risk for purposes of the audit of the financial statements.

18. The auditor should assess the competence and objectivity of the persons whose work the auditor plans to use to determine the extent to which the auditor may use their work. The higher the degree of competence and objectivity, the greater use the auditor may make of the work. The auditor should apply paragraphs .09 through .11 of AU sec. 322 to assess the competence and objectivity of internal auditors. The auditor should apply the principles underlying those paragraphs to assess the competence and objectivity of persons other than internal auditors whose work the auditor plans to use.

Note: For purposes of using the work of others, competence means the attainment and maintenance of a level of understanding and knowledge that enables that person to perform ably the tasks assigned to them, and objectivity means the ability to perform those tasks impartially and with intellectual honesty. To assess competence, the auditor should evaluate factors about the person's qualifications and ability to perform the work the auditor plans to use. To assess objectivity, the auditor should evaluate whether factors are present that either inhibit or promote a person's ability to perform with the necessary degree of objectivity the work the auditor plans to use.

Note: The auditor should not use the work of persons who have a low degree of objectivity, regardless of their level of competence. Likewise, the auditor should not use the work of persons who have a low level of competence regardless of their degree of objectivity. Personnel whose core function is to serve as a testing or compliance authority at the company, such as internal auditors, normally are expected to have greater competence and objectivity in performing the type of work that will be useful to the auditor.

19. The extent to which the auditor may use the work of others in an audit of internal control also depends on the risk associated with the control being tested. As the risk associated with a control increases, the need for the auditor to perform his or her own work on the control increases.

MATERIALITY

20. In planning the audit of internal control over financial reporting, the auditor should use the same materiality considerations he or she would use in planning the audit of the company's annual financial statements.

Using a Top-Down Approach

21. The auditor should use a top-down approach to the audit of internal control over financial reporting to select the controls to test. A top-down approach begins at the financial statement level and with the auditor's understanding of the overall risks to internal control over financial reporting. The auditor then focuses on entity-level controls and works down to significant accounts and disclosures and their relevant assertions. This approach directs the auditor's attention to accounts, disclosures, and assertions that present a reasonable possibility of material misstatement to the financial statements and related disclosures. The auditor then verifies his or her understanding of the risks in the company's processes and selects for testing those controls that sufficiently address the assessed risk of misstatement to each relevant assertion.

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Note: The top-down approach describes the auditor's sequential thought process in identifying risks and the controls to test, not necessarily the order in which the auditor will perform the auditing procedures.

IDENTIFYING ENTITY-LEVEL CONTROLS

22. The auditor must test those entity-level controls that are important to the auditor's conclusion about whether the company has effective internal control over financial reporting. The auditor's evaluation of entity-level controls can result in increasing or decreasing the testing that the auditor otherwise would have performed on other controls.

23. Entity-level controls vary in nature and precision -

Some entity-level controls, such as certain control environment controls, have an important, but indirect, effect on the likelihood that a misstatement will be detected or prevented on a timely basis. These controls might affect the other controls the auditor selects for testing and the nature, timing, and extent of procedures the auditor performs on other controls.

Some entity-level controls monitor the effectiveness of other controls. Such controls might be designed to identify possible breakdowns in lower-level controls, but not at a level of precision that would, by themselves, sufficiently address the assessed risk that misstatements to a relevant assertion will be prevented or detected on a timely basis. These controls, when operating effectively, might allow the auditor to reduce the testing of other controls.

Some entity-level controls might be designed to operate at a level of precision that would adequately prevent or detect on a timely basis misstatements to one or more relevant assertions. If an entity-level control sufficiently addresses the assessed risk of misstatement, the auditor need not test additional controls relating to that risk.

24. Entity-level controls include -

Controls related to the control environment;

Controls over management override;

Note: Controls over management override are important to effective internal control over financial reporting for all companies, and may be particularly important at smaller companies because of the increased involvement of senior management in performing controls and in the period-end financial reporting process. For smaller companies, the controls that address the risk of management override might be different from those at a larger company. For example, a smaller company might rely on more detailed oversight by the audit committee that focuses on the risk of management override.

The company's risk assessment process;

Centralized processing and controls, including shared service environments;

Controls to monitor results of operations;

Controls to monitor other controls, including activities of the internal audit function, the audit committee, and self-assessment programs;

Controls over the period-end financial reporting process; and

Policies that address significant business control and risk management practices.

25. Control Environment. Because of its importance to effective internal control over financial reporting, the auditor must evaluate the control environment at the company. As part of evaluating the control environment, the auditor should assess -




Whether management's philosophy and operating style promote effective internal control over financial reporting;

Whether sound integrity and ethical values, particularly of top management, are developed and understood; and

Whether the Board or audit committee understands and exercises oversight responsibility over financial reporting and internal control.

26. Period-end Financial Reporting Process. Because of its importance to financial reporting and to the auditor's opinions on internal control over financial reporting and the financial statements, the auditor must evaluate the period-end financial reporting process. The period-end financial reporting process includes the following -

Procedures used to enter transaction totals into the general ledger;

Procedures related to the selection and application of accounting policies;

Procedures used to initiate, authorize, record, and process journal entries in the general ledger;

Procedures used to record recurring and nonrecurring adjustments to the annual and quarterly financial statements; and

Procedures for preparing annual and quarterly financial statements and related disclosures.

Note: Because the annual period-end financial reporting process normally occurs after the "as-of" date of management's assessment, those controls usually cannot be tested until after the as-of date.

27. As part of evaluating the period-end financial reporting process, the auditor should assess -

Inputs, procedures performed, and outputs of the processes the company uses to produce its annual and quarterly financial statements;

The extent of information technology ("IT") involvement in the period-end financial reporting process;

Who participates from management;

The locations involved in the period-end financial reporting process;

The types of adjusting and consolidating entries; and

The nature and extent of the oversight of the process by management, the board of directors, and the audit committee.

Note: The auditor should obtain sufficient evidence of the effectiveness of those quarterly controls that are important to determining whether the company's controls sufficiently address the assessed risk of misstatement to each relevant assertion as of the date of management's assessment. However, the auditor is not required to obtain sufficient evidence for each quarter individually.

IDENTIFYING SIGNIFICANT ACCOUNTS AND DISCLOSURES AND THEIR RELEVANT ASSERTIONS

28. The auditor should identify significant accounts and disclosures and their relevant assertions. Relevant assertions are those financial statement assertions that have a reasonable possibility of containing a misstatement that would cause the financial statements to be materially misstated. The financial statement assertions include -

Existence or occurrence

Completeness

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Valuation or allocation

Rights and obligations

Presentation and disclosure

Note: The auditor may base his or her work on assertions that differ from those in this standard if the auditor has selected and tested controls over the pertinent risks in each significant account and disclosure that have a reasonable possibility of containing misstatements that would cause the financial statements to be materially misstated.

29. To identify significant accounts and disclosures and their relevant assertions, the auditor should evaluate the qualitative and quantitative risk factors related to the financial statement line items and disclosures. Risk factors relevant to the identification of significant accounts and disclosures and their relevant assertions include -

Size and composition of the account;

Susceptibility to misstatement due to errors or fraud;

Volume of activity, complexity, and homogeneity of the individual transactions processed through the account or reflected in the disclosure;

Nature of the account or disclosure;

Accounting and reporting complexities associated with the account or disclosure;

Exposure to losses in the account;

Possibility of significant contingent liabilities arising from the activities reflected in the account or disclosure;

Existence of related party transactions in the account; and

Changes from the prior period in account or disclosure characteristics.

30. As part of identifying significant accounts and disclosures and their relevant assertions, the auditor also should determine the likely sources of potential misstatements that would cause the financial statements to be materially misstated. The auditor might determine the likely sources of potential misstatements by asking himself or herself "what could go wrong?" within a given significant account or disclosure.

31. The risk factors that the auditor should evaluate in the identification of significant accounts and disclosures and their relevant assertions are the same in the audit of internal control over financial reporting as in the audit of the financial statements; accordingly, significant accounts and disclosures and their relevant assertions are the same for both audits.

Note: In the financial statement audit, the auditor might perform substantive auditing procedures on financial statement accounts, disclosures and assertions that are not determined to be significant accounts and disclosures and relevant assertions.

32. The components of a potential significant account or disclosure might be subject to significantly differing risks. If so, different controls might be necessary to adequately address those risks.

33. When a company has multiple locations or business units, the auditor should identify significant accounts and disclosures and their relevant assertions based on the consolidated financial statements. Having made those determinations, the auditor should then apply the direction in Appendix B for multiple locations scoping decisions.

UNDERSTANDING LIKELY SOURCES OF MISSTATEMENT

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34. To further understand the likely sources of potential misstatements, and as a part of selecting the controls to test, the auditor should achieve the following objectives -

Understand the flow of transactions related to the relevant assertions, including how these transactions are initiated, authorized, processed, and recorded;

Verify that the auditor has identified the points within the company's processes at which a misstatement - including a misstatement due to fraud - could arise that, individually or in combination with other misstatements, would be material;

Identify the controls that management has implemented to address these potential misstatements; and

Identify the controls that management has implemented over the prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could result in a material misstatement of the financial statements.

35. Because of the degree of judgment required, the auditor should either perform the procedures that achieve the objectives in paragraph 34 himself or herself or supervise the work of others who provide direct assistance to the auditor, as described in AU sec. 322.



36. The auditor also should understand how IT affects the company's flow of transactions. The auditor should apply paragraph 29 and Appendix B of Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, which discuss the effect of information technology on internal control over financial reporting and the risks to assess.

Note: The identification of risks and controls within IT is not a separate evaluation. Instead, it is an integral part of the top-down approach used to identify significant accounts and disclosures and their relevant assertions, and the controls to test, as well as to assess risk and allocate audit effort as described by this standard.

37. Performing Walkthroughs. Performing walkthroughs will frequently be the most effective way of achieving the objectives in paragraph 34. In performing a walkthrough, the auditor follows a transaction from origination through the company's processes, including information systems, until it is reflected in the company's financial records, using the same documents and information technology that company personnel use. Walkthrough procedures usually include a combination of inquiry, observation, inspection of relevant documentation, and re-performance of controls.

38. In performing a walkthrough, at the points at which important processing procedures occur, the auditor questions the company's personnel about their understanding of what is required by the company's prescribed procedures and controls. These probing questions, combined with the other walkthrough procedures, allow the auditor to gain a sufficient understanding of the process and to be able to identify important points at which a necessary control is missing or not designed effectively. Additionally, probing questions that go beyond a narrow focus on the single transaction used as the basis for the walkthrough allow the auditor to gain an understanding of the different types of significant transactions handled by the process.

SELECTING CONTROLS TO TEST

39. The auditor should test those controls that are important to the auditor's conclusion about whether the company's controls sufficiently address the assessed risk of misstatement to each relevant assertion.




40. There might be more than one control that addresses the assessed risk of misstatement to a particular relevant assertion; conversely, one control might address the assessed risk of misstatement to more than one relevant assertion. It is neither necessary to test all controls related to a relevant assertion nor necessary to test redundant controls, unless redundancy is itself a control objective.

41. The decision as to whether a control should be selected for testing depends on which controls, individually or in combination, sufficiently address the assessed risk of misstatement to a given relevant assertion rather than on how the control is labeled (e.g., entity-level control, transaction-level control, control activity, monitoring control, preventive control, detective control).

Testing Controls

TESTING DESIGN EFFECTIVENESS

42. The auditor should test the design effectiveness of controls by determining whether the company's controls, if they are operated as prescribed by persons possessing the necessary authority and competence to perform the control effectively, satisfy the company's control objectives and can effectively prevent or detect errors or fraud that could result in material misstatements in the financial statements.

Note: A smaller, less complex company might achieve its control objectives in a different manner from a larger, more complex organization. For example, a smaller, less complex company might have fewer employees in the accounting function, limiting opportunities to segregate duties and leading the company to implement alternative controls to achieve its control objectives. In such circumstances, the auditor should evaluate whether those alternative controls are effective.

43. Procedures the auditor performs to test design effectiveness include a mix of inquiry of appropriate personnel, observation of the company's operations, and inspection of relevant documentation. Walkthroughs that include these procedures ordinarily are sufficient to evaluate design effectiveness.

TESTING OPERATING EFFECTIVENESS

44. The auditor should test the operating effectiveness of a control by determining whether the control is operating as designed and whether the person performing the control possesses the necessary authority and competence to perform the control effectively.

Note: In some situations, particularly in smaller companies, a company might use a third party to provide assistance with certain financial reporting functions. When assessing the competence of personnel responsible for a company's financial reporting and associated controls, the auditor may take into account the combined competence of company personnel and other parties that assist with functions related to financial reporting.

45. Procedures the auditor performs to test operating effectiveness include a mix of inquiry of appropriate personnel, observation of the company's operations, inspection of relevant documentation, and re-performance of the control.

RELATIONSHIP OF RISK TO THE EVIDENCE TO BE OBTAINED

46. For each control selected for testing, the evidence necessary to persuade the auditor that the control is effective depends upon the risk associated with the control. The risk associated with a control consists of the risk




that the control might not be effective and, if not effective, the risk that a material weakness would result. As the risk associated with the control being tested increases, the evidence that the auditor should obtain also increases.

Note: Although the auditor must obtain evidence about the effectiveness of controls for each relevant assertion, the auditor is not responsible for obtaining sufficient evidence to support an opinion about the effectiveness of each individual control. Rather, the auditor's objective is to express an opinion on the company's internal control over financial reporting overall. This allows the auditor to vary the evidence obtained regarding the effectiveness of individual controls selected for testing based on the risk associated with the individual control.

47. Factors that affect the risk associated with a control include -

The nature and materiality of misstatements that the control is intended to prevent or detect;

The inherent risk associated with the related account(s) and assertion(s);

Whether there have been changes in the volume or nature of transactions that might adversely affect control design or operating effectiveness;

Whether the account has a history of errors;

The effectiveness of entity-level controls, especially controls that monitor other controls;

The nature of the control and the frequency with which it operates;

The degree to which the control relies on the effectiveness of other controls (e.g., the control environment or information technology general controls);

The competence of the personnel who perform the control or monitor its performance and whether there have been changes in key personnel who perform the control or monitor its performance;

Whether the control relies on performance by an individual or is automated (i.e., an automated control would generally be expected to be lower risk if relevant information technology general controls are effective); and

Note: A less complex company or business unit with simple business processes and centralized accounting operations might have relatively simple information systems that make greater use of off-the-shelf packaged software without modification. In the areas in which off-the-shelf software is used, the auditor's testing of information technology controls might focus on the application controls built into the pre-packaged software that management relies on to achieve its control objectives and the IT general controls that are important to the effective operation of those application controls.

The complexity of the control and the significance of the judgments that must be made in connection with its operation.

Note: Generally, a conclusion that a control is not operating effectively can be supported by less evidence than is necessary to support a conclusion that a control is operating effectively.

48. When the auditor identifies deviations from the company's controls, he or she should determine the effect of the deviations on his or her assessment of the risk associated with the control being tested and the evidence to be obtained, as well as on the operating effectiveness of the control.

Note: Because effective internal control over financial reporting cannot, and does not, provide absolute assurance of achieving the company's control objectives, an individual control does not necessarily have to operate without any deviation to be considered effective.




49. The evidence provided by the auditor's tests of the effectiveness of controls depends upon the mix of the nature, timing, and extent of the auditor's procedures. Further, for an individual control, different combinations of the nature, timing, and extent of testing may provide sufficient evidence in relation to the risk associated with the control.

Note: Walkthroughs usually consist of a combination of inquiry of appropriate personnel, observation of the company's operations, inspection of relevant documentation, and re-performance of the control and might provide sufficient evidence of operating effectiveness, depending on the risk associated with the control being tested, the specific procedures performed as part of the walkthrough and the results of those procedures.

50. Nature of Tests of Controls. Some types of tests, by their nature, produce greater evidence of the effectiveness of controls than other tests. The following tests that the auditor might perform are presented in order of the evidence that they ordinarily would produce, from least to most: inquiry, observation, inspection of relevant documentation, and re-performance of a control.

Note: Inquiry alone does not provide sufficient evidence to support a conclusion about the effectiveness of a control.



51. The nature of the tests of effectiveness that will provide appropriate evidence depends, to a large degree, on the nature of the control to be tested, including whether the operation of the control results in documentary evidence of its operation. Documentary evidence of the operation of some controls, such as management's philosophy and operating style, might not exist.

Note: A smaller, less complex company or unit might have less formal documentation regarding the operation of its controls. In those situations, testing controls through inquiry combined with other procedures, such as observation of activities, inspection of less formal documentation, or re-performance of certain controls, might provide sufficient evidence about whether the control is effective.

52. Timing of Tests of Controls. Testing controls over a greater period of time provides more evidence of the effectiveness of controls than testing over a shorter period of time. Further, testing performed closer to the date of management's assessment provides more evidence than testing performed earlier in the year. The auditor should balance performing the tests of controls closer to the as-of date with the need to test controls over a sufficient period of time to obtain sufficient evidence of operating effectiveness.

53. Prior to the date specified in management's assessment, management might implement changes to the company's controls to make them more effective or efficient or to address control deficiencies. If the auditor determines that the new controls achieve the related objectives of the control criteria and have been in effect for a sufficient period to permit the auditor to assess their design and operating effectiveness by performing tests of controls, he or she will not need to test the design and operating effectiveness of the superseded controls for purposes of expressing an opinion on internal control over financial reporting. If the operating effectiveness of the superseded controls is important to the auditor's control risk assessment, the auditor should test the design and operating effectiveness of those superseded controls, as appropriate. (See additional direction on integration beginning at paragraph B1.)

54. Extent of Tests of Controls . The more extensively a control is tested, the greater the evidence obtained from that test.




55. Roll-Forward Procedures. When the auditor reports on the effectiveness of controls as of a specific date and obtains evidence about the operating effectiveness of controls at an interim date, he or she should determine what additional evidence concerning the operation of the controls for the remaining period is necessary.

56. The additional evidence that is necessary to update the results of testing from an interim date to the company's year-end depends on the following factors -

The specific control tested prior to the as-of date, including the risks associated with the control and the nature of the control, and the results of those tests;

The sufficiency of the evidence of effectiveness obtained at an interim date;

The length of the remaining period; and

The possibility that there have been any significant changes in internal control over financial reporting subsequent to the interim date.

Note: In some circumstances, such as when evaluation of the foregoing factors indicates a low risk that the controls are no longer effective during the roll-forward period, inquiry alone might be sufficient as a roll-forward procedure.

SPECIAL CONSIDERATIONS FOR SUBSEQUENT YEARS' AUDITS

57. In subsequent years' audits, the auditor should incorporate knowledge obtained during past audits he or she performed of the company's internal control over financial reporting into the decision-making process for determining the nature, timing, and extent of testing necessary. This decision-making process is described in paragraphs 46 through 56.

58. Factors that affect the risk associated with a control in subsequent years' audits include those in paragraph 47 and the following -

The nature, timing, and extent of procedures performed in previous audits,

The results of the previous years' testing of the control, and

Whether there have been changes in the control or the process in which it operates since the previous audit.

59. After taking into account the risk factors identified in paragraphs 47 and 58, the additional information available in subsequent years' audits might permit the auditor to assess the risk as lower than in the initial year. This, in turn, might permit the auditor to reduce testing in subsequent years.

60. The auditor may also use a benchmarking strategy for automated application controls in subsequent years' audits. Benchmarking is described further beginning at paragraph B28.

61. In addition, the auditor should vary the nature, timing, and extent of testing of controls from year to year to introduce unpredictability into the testing and respond to changes in circumstances. For this reason, each year the auditor might test controls at a different interim period, increase or reduce the number and types of tests performed, or change the combination of procedures used.

Evaluating Identified Deficiencies




62. The auditor must evaluate the severity of each control deficiency that comes to his or her attention to determine whether the deficiencies, individually or in combination, are material weaknesses as of the date of management's assessment. In planning and performing the audit, however, the auditor is not required to search for deficiencies that, individually or in combination, are less severe than a material weakness.

63. The severity of a deficiency depends on -

Whether there is a reasonable possibility that the company's controls will fail to prevent or detect a misstatement of an account balance or disclosure; and

The magnitude of the potential misstatement resulting from the deficiency or deficiencies.

64. The severity of a deficiency does not depend on whether a misstatement actually has occurred but rather on whether there is a reasonable possibility that the company's controls will fail to prevent or detect a misstatement.

65. Risk factors affect whether there is a reasonable possibility that a deficiency, or a combination of deficiencies, will result in a misstatement of an account balance or disclosure. The factors include, but are not limited to, the following -

The nature of the financial statement accounts, disclosures, and assertions involved;

The susceptibility of the related asset or liability to loss or fraud;

The subjectivity, complexity, or extent of judgment required to determine the amount involved;

The interaction or relationship of the control with other controls, including whether they are interdependent or redundant;

The interaction of the deficiencies; and

The possible future consequences of the deficiency.

Note: The evaluation of whether a control deficiency presents a reasonable possibility of misstatement can be made without quantifying the probability of occurrence as a specific percentage or range.

Note: Multiple control deficiencies that affect the same financial statement account balance or disclosure increase the likelihood of misstatement and may, in combination, constitute a material weakness, even though such deficiencies may individually be less severe. Therefore, the auditor should determine whether individual control deficiencies that affect the same significant account or disclosure, relevant assertion, or component of internal control collectively result in a material weakness.

66. Factors that affect the magnitude of the misstatement that might result from a deficiency or deficiencies in controls include, but are not limited to, the following -

The financial statement amounts or total of transactions exposed to the deficiency; and

The volume of activity in the account balance or class of transactions exposed to the deficiency that has occurred in the current period or that is expected in future periods.

67. In evaluating the magnitude of the potential misstatement, the maximum amount that an account balance or total of transactions can be overstated is generally the recorded amount, while understatements could be larger. Also, in many cases, the probability of a small misstatement will be greater than the probability of a large misstatement.




68. The auditor should evaluate the effect of compensating controls when determining whether a control deficiency or combination of deficiencies is a material weakness. To have a mitigating effect, the compensating control should operate at a level of precision that would prevent or detect a misstatement that could be material.

INDICATORS OF MATERIAL WEAKNESSES

69. Indicators of material weaknesses in internal control over financial reporting include -

Identification of fraud, whether or not material, on the part of senior management;

Restatement of previously issued financial statements to reflect the correction of a material misstatement;

Identification by the auditor of a material misstatement of financial statements in the current period in circumstances that indicate that the misstatement would not have been detected by the company's internal control over financial reporting; and

Ineffective oversight of the company's external financial reporting and internal control over financial reporting by the company's audit committee.

70. When evaluating the severity of a deficiency, or combination of deficiencies, the auditor also should determine the level of detail and degree of assurance that would satisfy prudent officials in the conduct of their own affairs that they have reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in conformity with generally accepted accounting principles. If the auditor determines that a deficiency, or combination of deficiencies, might prevent prudent officials in the conduct of their own affairs from concluding that they have reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in conformity with generally accepted accounting principles, then the auditor should treat the deficiency, or combination of deficiencies, as an indicator of a material weakness.

Wrapping-Up

FORMING AN OPINION

71. The auditor should form an opinion on the effectiveness of internal control over financial reporting by evaluating evidence obtained from all sources, including the auditor's testing of controls, misstatements detected during the financial statement audit, and any identified control deficiencies.

Note: As part of this evaluation, the auditor should review reports issued during the year by internal audit (or similar functions) that address controls related to internal control over financial reporting and evaluate control deficiencies identified in those reports.

72. After forming an opinion on the effectiveness of the company's internal control over financial reporting, the auditor should evaluate the presentation of the elements that management is required, under the SEC's rules, to present in its annual report on internal control over financial reporting.

73. If the auditor determines that any required elements of management's annual report on internal control over financial reporting are incomplete or improperly presented, the auditor should follow the direction in paragraph C2.

74. The auditor may form an opinion on the effectiveness of internal control over financial reporting only when there have been no restrictions on the scope of the auditor's work. A scope limitation requires the auditor to disclaim an opinion or withdraw from the engagement (see paragraphs C3 through C7).

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OBTAINING WRITTEN REPRESENTATIONS

75. In an audit of internal control over financial reporting, the auditor should obtain written representations from management -

a. Acknowledging management's responsibility for establishing and maintaining effective internal control over financial reporting;

b. Stating that management has performed an evaluation and made an assessment of the effectiveness of the company's internal control over financial reporting and specifying the control criteria;

c. Stating that management did not use the auditor's procedures performed during the audits of internal control over financial reporting or the financial statements as part of the basis for management's assessment of the effectiveness of internal control over financial reporting;

d. Stating management's conclusion, as set forth in its assessment, about the effectiveness of the company's internal control over financial reporting based on the control criteria as of a specified date;

e. Stating that management has disclosed to the auditor all deficiencies in the design or operation of internal control over financial reporting identified as part of management's evaluation, including separately disclosing to the auditor all such deficiencies that it believes to be significant deficiencies or material weaknesses in internal control over financial reporting;

f. Describing any fraud resulting in a material misstatement to the company's financial statements and any other fraud that does not result in a material misstatement to the company's financial statements but involves senior management or management or other employees who have a significant role in the company's internal control over financial reporting;

g. Stating whether control deficiencies identified and communicated to the audit committee during previous engagements pursuant to paragraphs 78 and 80 have been resolved, and specifically identifying any that have not; and

h. Stating whether there were, subsequent to the date being reported on, any changes in internal control over financial reporting or other factors that might significantly affect internal control over financial reporting, including any corrective actions taken by management with regard to significant deficiencies and material weaknesses.

76. The failure to obtain written representations from management, including management's refusal to furnish them, constitutes a limitation on the scope of the audit. As discussed further in paragraph C3, when the scope of the audit is limited, the auditor should either withdraw from the engagement or disclaim an opinion. Further, the auditor should evaluate the effects of management's refusal on his or her ability to rely on other representations, including those obtained in the audit of the company's financial statements.

77. AU sec. 333, Management Representations , explains matters such as who should sign the letter, the period to be covered by the letter, and when to obtain an updated letter.

COMMUNICATING CERTAIN MATTERS

78. The auditor must communicate, in writing, to management and the audit committee all material weaknesses identified during the audit. The written communication should be made prior to the issuance of the auditor's report on internal control over financial reporting.




79. If the auditor concludes that the oversight of the company's external financial reporting and internal control over financial reporting by the company's audit committee is ineffective, the auditor must communicate that conclusion in writing to the board of directors.



80. The auditor also should consider whether there are any deficiencies, or combinations of deficiencies, that have been identified during the audit that are significant deficiencies and must communicate such deficiencies, in writing, to the audit committee. This communication should be made in a timely manner and prior to the issuance of the auditor's report on internal control over financial reporting.



81. The auditor also should communicate to management, in writing, all deficiencies in internal control over financial reporting (i.e., those deficiencies in internal control over financial reporting that are of a lesser magnitude than material weaknesses) identified during the audit and inform the audit committee when such a communication has been made. The auditor should communicate this information to the audit committee in a timely manner and prior to the issuance of the auditor's report on internal control over financial reporting. When making this communication, it is not necessary for the auditor to repeat information about such deficiencies that has been included in previously issued written communications, whether those communications were made by the auditor, internal auditors, or others within the organization.

82. The auditor is not required to perform procedures that are sufficient to identify all control deficiencies; rather, the auditor communicates deficiencies in internal control over financial reporting of which he or she is aware.

83. Because the audit of internal control over financial reporting does not provide the auditor with assurance that he or she has identified all deficiencies less severe than a material weakness, the auditor should not issue a report stating that no such deficiencies were noted during the audit.

84. When auditing internal control over financial reporting, the auditor may become aware of fraud or possible illegal acts. In such circumstances, the auditor must determine his or her responsibilities under AU sec. 316, Consideration of Fraud in a Financial Statement Audit, AU sec. 317, Illegal Acts by Clients, and Section 10A of the Securities Exchange Act of 1934.

Reporting on Internal Control

85. The auditor's report on the audit of internal control over financial reporting must include the following elements -

a. A title that includes the word independent ;

b. A statement that management is responsible for maintaining effective internal control over financial reporting and for assessing the effectiveness of internal control over financial reporting;

c. An identification of management's report on internal control;

d. A statement that the auditor's responsibility is to express an opinion on the company's internal control over financial reporting based on his or her audit;

e. A definition of internal control over financial reporting as stated in paragraph A5;

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f. A statement that the audit was conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States);

g. A statement that the standards of the Public Company Accounting Oversight Board require that the auditor plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects;

h. A statement that an audit includes obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as the auditor considered necessary in the circumstances;

i. A statement that the auditor believes the audit provides a reasonable basis for his or her opinion;

j. A paragraph stating that, because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements and that projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate;

k. The auditor's opinion on whether the company maintained, in all material respects, effective internal control over financial reporting as of the specified date, based on the control criteria;

l. The manual or printed signature of the auditor's firm;

m. The city and state (or city and country, in the case of non-U.S. auditors) from which the auditor's report has been issued; and

n. The date of the audit report.

SEPARATE OR COMBINED REPORTS

86. The auditor may choose to issue a combined report (i.e., one report containing both an opinion on the financial statements and an opinion on internal control over financial reporting) or separate reports on the company's financial statements and on internal control over financial reporting.

87. The following example combined report expressing an unqualified opinion on financial statements and an unqualified opinion on internal control over financial reporting illustrates the report elements described in this section.

Report of Independent Registered Public Accounting Firm

[ Introductory paragraph ]

We have audited the accompanying balance sheets of W Company as of December 31, 20X8 and 20X7, and the related statements of income, stockholders' equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 20X8. We also have audited W Company's internal control over financial reporting as of December 31, 20X8, based on [ Identify control criteria, for example, "criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)." ]. W Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying [title of management's report]. Our responsibility is to express an opinion on these financial statements and an opinion on the company's internal control over financial reporting based on our audits.

[ Scope paragraph ]




We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

[ Definition paragraph ]

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

[ Inherent limitations paragraph ]

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

[ Opinion paragraph ]

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of W Company as of December 31, 20X8 and 20X7, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 20X8 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, W Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 20X8, based on [ Identify control criteria, for example, "criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)." ].

[ Signature ]

[ City and State or Country ]

[ Date ]




88. If the auditor chooses to issue a separate report on internal control over financial reporting, he or she should add the following paragraph to the auditor's report on the financial statements -

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), W Company's internal control over financial reporting as of December 31, 20X8, based on [ identify control criteria ] and our report dated [ date of report, which should be the same as the date of the report on the financial statements ] expressed [ include nature of opinion ].

The auditor also should add the following paragraph to the report on internal control over financial reporting -

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the [ identify financial statements ] of W Company and our report dated [ date of report, which should be the same as the date of the report on the effectiveness of internal control over financial reporting ] expressed [ include nature of opinion ].

REPORT DATE



89. The auditor should date the audit report no earlier than the date on which the auditor has obtained sufficient appropriate evidence to support the auditor's opinion. Because the auditor cannot audit internal control over financial reporting without also auditing the financial statements, the reports should be dated the same.

MATERIAL WEAKNESSES

90. Paragraphs 62 through 70 describe the evaluation of deficiencies. If there are deficiencies that, individually or in combination, result in one or more material weaknesses, the auditor must express an adverse opinion on the company's internal control over financial reporting, unless there is a restriction on the scope of the engagement.

91. When expressing an adverse opinion on internal control over financial reporting because of a material weakness, the auditor's report must include -

The definition of a material weakness, as provided in paragraph A7.

A statement that a material weakness has been identified and an identification of the material weakness described in management's assessment.

Note: If the material weakness has not been included in management's assessment, the report should be modified to state that a material weakness has been identified but not included in management's assessment. Additionally, the auditor's report should include a description of the material weakness, which should provide the users of the audit report with specific information about the nature of the material weakness and its actual and potential effect on the presentation of the company's financial statements issued during the existence of the weakness. In this case, the auditor also should communicate in writing to the audit committee that the material weakness was not disclosed or identified as a material weakness in management's assessment. If the material weakness has been included in management's assessment but the auditor concludes that the disclosure of the material weakness is not fairly presented in all material respects, the auditor's report should describe this conclusion as well as the information necessary to fairly describe the material weakness.

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92. The auditor should determine the effect his or her adverse opinion on internal control has on his or her opinion on the financial statements. Additionally, the auditor should disclose whether his or her opinion on the financial statements was affected by the adverse opinion on internal control over financial reporting.

Note: If the auditor issues a separate report on internal control over financial reporting in this circumstance, the disclosure required by this paragraph may be combined with the report language described in paragraphs 88 and 91. The auditor may present the combined language either as a separate paragraph or as part of the paragraph that identifies the material weakness.

SUBSEQUENT EVENTS

93. Changes in internal control over financial reporting or other factors that might significantly affect internal control over financial reporting might occur subsequent to the date as of which internal control over financial reporting is being audited but before the date of the auditor's report. The auditor should inquire of management whether there were any such changes or factors and obtain written representations from management relating to such matters, as described in paragraph 75h.

94. To obtain additional information about whether changes have occurred that might affect the effectiveness of the company's internal control over financial reporting and, therefore, the auditor's report, the auditor should inquire about and examine, for this subsequent period, the following -

Relevant internal audit (or similar functions, such as loan review in a financial institution) reports issued during the subsequent period,

Independent auditor reports (if other than the auditor's) of deficiencies in internal control,

Regulatory agency reports on the company's internal control over financial reporting, and

Information about the effectiveness of the company's internal control over financial reporting obtained through other engagements.

95. The auditor might inquire about and examine other documents for the subsequent period. Paragraphs .01 through .09 of AU sec. 560, Subsequent Events , provide direction on subsequent events for a financial statement audit that also may be helpful to the auditor performing an audit of internal control over financial reporting.

96. If the auditor obtains knowledge about subsequent events that materially and adversely affect the effectiveness of the company's internal control over financial reporting as of the date specified in the assessment, the auditor should issue an adverse opinion on internal control over financial reporting (and follow the direction in paragraph C2 if management's assessment states that internal control over financial reporting is effective). If the auditor is unable to determine the effect of the subsequent event on the effectiveness of the company's internal control over financial reporting, the auditor should disclaim an opinion. As described in paragraph C13, the auditor should disclaim an opinion on management's disclosures about corrective actions taken by the company after the date of management's assessment, if any.

97. The auditor may obtain knowledge about subsequent events with respect to conditions that did not exist at the date specified in the assessment but arose subsequent to that date and before issuance of the auditor's report. If a subsequent event of this type has a material effect on the company's internal control over financial reporting, the auditor should include in his or her report an explanatory paragraph describing the event and its effects or directing the reader's attention to the event and its effects as disclosed in management's report.

98. After the issuance of the report on internal control over financial reporting, the auditor may become aware of conditions that existed at the report date that might have affected the auditor's opinion had he or she been aware




of them. The auditor's evaluation of such subsequent information is similar to the auditor's evaluation of information discovered subsequent to the date of the report on an audit of financial statements, as described in AU sec. 561, Subsequent Discovery of Facts Existing at the Date of the Auditor's Report .

Terms defined in Appendix A, Definitions, are set in boldface type the first time they appear.

This auditing standard supersedes Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with An Audit of Financial Statements, and is the standard on attestation engagements referred to in Section 404(b) of the Act. It also is the standard referred to in Section 103(a)(2)(A)(iii) of the Act.

See Securities Exchange Act Rules 13a-15(f) and 15d-15(f), 17 C.F.R. §§ 240.13a-15(f) and 240.15d-15(f); Paragraph A5.

See Item 308 of Regulation S-K, 17 C.F.R. § 229.308.

See AU sec. 230, Due Professional Care in the Performance of Work, for further discussion of the concept of reasonable assurance in an audit.

See AU sec. 150, Generally Accepted Auditing Standards.

See Securities Exchange Act Rules 13a-15(c) and 15d-15(c), 17 C.F.R. §§ 240.13a-15(c) and 240.15d-15(c). SEC rules require management to base its evaluation of the effectiveness of the company's internal control over financial reporting on a suitable, recognized control framework (also known as control criteria) established by a body or group that followed due-process procedures, including the broad distribution of the framework for public comment. For example, the report of the Committee of Sponsoring Organizations of the Treadway Commission (known as the COSO report) provides such a framework, as does the report published by the Financial Reporting Council, Internal Control Revised Guidance for Directors on the Combined Code, October 2005 (known as the Turnbull Report).

If no audit committee exists, all references to the audit committee in this standard apply to the entire board of directors of the company. See 15 U.S.C. §§ 78c(a)58 and 7201(a)(3).

The SEC Advisory Committee on Smaller Public Companies considered a company's size with respect to compliance with the internal control reporting provisions of the Act. See Advisory Committee on Smaller Public Companies to the United States Securities and Exchange Commission, Final Report, at p. 5 (April 23, 2006).

[The following footnote is effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release No.

2010-004 . For audits of fiscal years beginning before December 15, 2010, click here.]

See Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement, regarding identifying risks that may result in material misstatement due to fraud.


2014-002 .]

See paragraphs .66–.67A of AU sec. 316, Consideration of Fraud in a Financial Statement Audit.



See Auditing Standard No. 11, Consideration of Materiality in Planning and Performing an Audit, which provides additional explanation of materiality.



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See Auditing Standard No. 15, Audit Evidence, which provides additional information on financial statement assertions.



This is because his or her assessment of the risk that undetected misstatement would cause the financial statements to be materially misstated is unacceptably high (see paragraph 14 of Auditing Standard No. 14, Evaluating Audit Results, for further discussion about undetected misstatement) or as a means of introducing unpredictability in the procedures performed (see paragraph 61 and paragraph 5 of Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement, for further discussion about predictability of auditing procedures).

For the purpose of this indicator, the term "senior management" includes the principal executive and financial officers signing the company's certifications as required under Section 302 of the Act as well as any other members of senior management who play a significant role in the company's financial reporting process.

See Financial Accounting Standards Board Statement No. 154, Accounting Changes and Error Corrections, regarding the correction of a misstatement.

See Item 308(a) of Regulations S-B and S-K, 17 C.F.R. §§ 228.308(a) and 229.308(a).

See 15 U.S.C. § 78j-1.

See Appendix C, which provides direction on modifications to the auditor's report that are required in certain circumstances.

See paragraph C3 for direction when the scope of the engagement has been limited.

[Effective pursuant to SEC Release No. 34-56152, File No. PCAOB-2007-02 (July 27, 2007)]

© Copyright 2003 - 2015 Public Company Accounting Oversight Board. All Rights Reserved.

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An Audit of Internal Control Over Financial Reporting that is Integrated with an Audit of Financial Statements

APPENDIX A - Definitions

(A1 - A11)

A1. For purposes of this standard, the terms listed below are defined as follows -

A2. A control objective provides a specific target against which to evaluate the effectiveness of controls. A control objective for internal control over financial reporting generally relates to a relevant assertion and states a criterion for evaluating whether the company's control procedures in a specific area provide reasonable assurance that a misstatement or omission in that relevant assertion is prevented or detected by controls on a timely basis.

A3. A deficiency in internal control over financial reporting exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.

A deficiency in design exists when (a) a control necessary to meet the control objective is missing or (b) an existing control is not properly designed so that, even if the control operates as designed, the control objective would not be met.

A deficiency in operation exists when a properly designed control does not operate as designed, or when the person performing the control does not possess the necessary authority or competence to perform the control effectively.

A4. Financial statements and related disclosures refers to a company's financial statements and notes to the financial statements as presented in accordance with generally accepted accounting principles ("GAAP"). References to financial statements and related disclosures do not extend to the preparation of management's discussion and analysis or other similar financial information presented outside a company's GAAP-basis financial statements and notes.

A5. Internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that -

(1) Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;

(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and

(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. 1/


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Note: The auditor's procedures as part of either the audit of internal control over financial reporting or the audit of the financial statements are not part of a company's internal control over financial reporting.

Note: Internal control over financial reporting has inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements will not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk.

A6. Management's assessment is the assessment described in Item 308(a)(3) of Regulations S-B and S-K that is included in management's annual report on internal control over financial reporting.

A7. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company's annual or interim financial statements will not be prevented or detected on a timely basis.

Note: There is a reasonable possibility of an event, as used in this standard, when the likelihood of the event is either "reasonably possible" or "probable," as those terms are used in Financial Accounting Standards Board Statement No. 5, Accounting for Contingencies ("FAS 5").

A8. Controls over financial reporting may be preventive controls or detective controls. Effective internal control over financial reporting often includes a combination of preventive and detective controls.

Preventive controls have the objective of preventing errors or fraud that could result in a misstatement of the financial statements from occurring.

Detective controls have the objective of detecting errors or fraud that has already occurred that could result in a misstatement of the financial statements.

A9. A relevant assertion is a financial statement assertion that has a reasonable possibility of containing a misstatement or misstatements that would cause the financial statements to be materially misstated. The determination of whether an assertion is a relevant assertion is based on inherent risk, without regard to the effect of controls.

A10. An account or disclosure is a significant account or disclosure if there is a reasonable possibility that the account or disclosure could contain a misstatement that, individually or when aggregated with others, has a material effect on the financial statements, considering the risks of both overstatement and understatement. The determination of whether an account or disclosure is significant is based on inherent risk, without regard to the effect of controls.

A11. A significant deficiency is a deficiency, or a combination of deficiencies, in internal control over financial reporting that is less severe than a material weakness, yet important enough to merit attention by those responsible for oversight of the company's financial reporting.

See Securities Exchange Act Rules 13a-15(f) and 15d-15(f), 17 C.F.R. §§ 240.13a-15(f) and 240.15d-15(f).

See 17 C.F.R. §§ 228.308(a)(3) and 229.308(a)(3).

See FAS 5, paragraph 3.


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EXHIBIT C



AU Section 508 Reports on Audited Financial Statements

(.01 - .06) Introduction(.07 - .10) The Auditor's Standard Report(.11 - .13) Explanatory Language Added to the Auditor's Standard Report[.14 - .15](.16 - .19)(.20 - .49) Departures From Unqualified Opinions[.50](.51 - .63)(.64) Piecemeal Opinions(.65 - .74) Reports on Comparative Financial Statements(.75 - .76) Effective Date and Transition

Supersedes sections 505, 509, 542, 545, and 546)

Source: SAS No. 58; SAS No. 64; SAS No. 79; SAS No. 85; SAS No. 93; SAS No. 98.

See section 9508 for interpretations of this section.

Effective for reports issued or reissued on or after January 1, 1989, unless otherwise indicated.

Introduction

.01

This section applies to auditors' reports issued in connection with audits of historical financial statements that are intended to present financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. It distinguishes the types of reports, describes the circumstances in which each is appropriate, and provides example reports.

[The following note is effective for audits of fiscal years ending on or after November 15, 2007. See PCAOB Release No. 2007-005A . For

audits of fiscal years ending before November 15, 2007, click here.]

Note: When performing an integrated audit of financial statements and internal control over financial reporting, the auditor may choose to issue a combined report or separate reports on the company's financial statements and on internal control over financial reporting. Refer to paragraphs 85-98 of PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, and Appendix C, Special Reporting Situations, of PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, for direction on reporting on internal control over financial reporting. In addition, see paragraphs 86-88 of PCAOB Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements, which includes an illustrative combined audit report.

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.02

This section does not apply to unaudited financial statements as described in section 504, Association With Financial Statements, nor does it apply to reports on incomplete financial information or other special presentations as described in section 623, Special Reports.

.03

[The following paragraph is effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). For the paragraph

effective before November 15, 2008, click here.]

Justification for the expression of the auditor's opinion rests on the conformity of his or her audit with generally accepted auditing standards and on the findings. Generally accepted auditing standards include four standards of reporting. This section is concerned primarily with the relationship of the fourth reporting standard to the language of the auditor's report.

.04

The fourth standard of reporting is as follows:

The report shall either contain an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons therefor should be stated. In all cases where an auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's work, if any, and the degree of responsibility the auditor is taking.

.05

The objective of the fourth standard is to prevent misinterpretation of the degree of responsibility the auditor is assuming when his or her name is associated with financial statements. Reference in the fourth reporting standard to the financial statements "taken as a whole" applies equally to a complete set of financial statements and to an individual financial statement (for example, to a balance sheet) for one or more periods presented. (Paragraph .65 discusses the fourth standard of reporting as it applies to comparative financial statements.) The auditor may express an unqualified opinion on one of the financial statements and express a qualified or adverse opinion or disclaim an opinion on another if the circumstances warrant.

.06

The auditor's report is customarily issued in connection with an entity's basic financial statements—balance sheet, statement of income, statement of retained earnings and statement of cash flows. Each financial statement audited should be specifically identified in the introductory paragraph of the auditor's report. If the basic financial statements include a separate statement of changes in stockholders' equity accounts, it should be identified in the introductory paragraph of the report but need not be reported on separately in the opinion paragraph since such changes are part of the presentation of financial position, results of operations, and cash flows.

The Auditor's Standard Report

.07

The auditor's standard report states that the financial statements present fairly, in all material respects, an entity's financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. This conclusion may be expressed only when the auditor has formed such an opinion on the basis of an audit performed in accordance with generally accepted auditing standards.

.08




The auditor's standard report identifies the financial statements audited in an opening (introductory) paragraph, describes the nature of an audit in a scope paragraph, and expresses the auditor's opinion in a separate opinion paragraph. The basic elements of the report are the following:

a. A title that includes the word independent

b. A statement that the financial statements identified in the report were audited

c. A statement that the financial statements are the responsibility of the Company's management and that the auditor's responsibility is to express an opinion on the financial statements based on his or her audit

d. A statement that the audit was conducted in accordance with generally accepted auditing standards and an identification of the United States of America as the country of origin of those standards (for example, auditing standards generally accepted in the United States of America or U.S. generally accepted auditing standards)

e. A statement that those standards require that the auditor plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement

f. A statement that an audit includes—

(1) Examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements

(2) Assessing the accounting principles used and significant estimates made by management

(3) Evaluating the overall financial statement presentation

g. A statement that the auditor believes that his or her audit provides a reasonable basis for his or her opinion

h. An opinion as to whether the financial statements present fairly, in all material respects, the financial position of the Company as of the balance sheet date and the results of its operations and its cash flows for the period then ended in conformity with generally accepted accounting principles. The opinion should include an identification of the United States of America as the country of origin of those accounting principles (for example, accounting principles generally accepted in the United States of America or U.S. generally accepted accounting principles )

i. The manual or printed signature of the auditor's firm

j. The date of the audit report

The form of the auditor's standard report on financial statements covering a single year is as follows:

Independent Auditor's Report

We have audited the accompanying balance sheet of X Company as of December 31, 20XX, 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.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the 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.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of [at] December 31, 20XX, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

[Signature]

[Date]

The form of the auditor's standard report on comparative financial statements is as follows:fn 8

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We have audited the accompanying balance sheets of X Company as of December 31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash flows for the years 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 audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the 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 audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of [at] December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

[Signature]

[Date]

k. When performing an integrated audit of financial statements and internal control over financial reporting, if the auditor issues separate reports on the company's financial statements and on internal control over financial reporting, the following paragraph should be added to the auditor's report on the company's financial statements:

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of X Company's internal control over financial reporting as of December 31, 20X3, based on [identify control criteria] and our report dated [date of report, which should be the same as the date of the report on the financial statements] expressed [include nature of opinions].

.09

The report may be addressed to the company whose financial statements are being audited or to its board of directors or stockholders. A report on the financial statements of an unincorporated entity should be addressed as circumstances dictate, for example, to the partners, to the general partner, or to the proprietor. Occasionally, an auditor is retained to audit the financial statements of a company that is not a client; in such a case, the report is customarily addressed to the client and not to the directors or stockholders of the company whose financial statements are being audited.

.10

This section also discusses the circumstances that may require the auditor to depart from the standard report and provides reporting guidance in such circumstances. This section is organized by type of opinion that the auditor may express in each of the various circumstances presented; this section describes what is meant by the various audit opinions:

Unqualified opinion. An unqualified opinion states that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity in conformity with generally accepted accounting principles. This is the opinion expressed in the standard report discussed in paragraph .08.

Explanatory language added to the auditor's standard report. Certain circumstances, while not affecting the auditor's unqualified opinion on the financial statements, may require that the auditor add an explanatory paragraph (or other explanatory language) to his or her report.

Qualified opinion. A qualified opinion states that, except for the effects of the matter(s) to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the entity in conformity with generally accepted accounting principles.




Adverse opinion. An adverse opinion states that the financial statements do not present fairly the financial position, results of operations, or cash flows of the entity in conformity with generally accepted accounting principles.

Disclaimer of opinion. A disclaimer of opinion states that the auditor does not express an opinion on the financial statements.

These opinions are discussed in greater detail throughout the remainder of this section.

Explanatory Language Added to the Auditor's Standard Report

.11

Certain circumstances, while not affecting the auditor's unqualified opinion, may require that the auditor add an explanatory paragraph (or other explanatory language) to the standard report. These circumstances include:

a. The auditor's opinion is based in part on the report of another auditor (paragraphs .12 and .13).

[Items .11b, c, and d are effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). For the items effective

before November 15, 2008, click here.]

b. There is substantial doubt about the entity's ability to continue as a going concern.

c. There has been a material change between periods in accounting principles or in the method of their application (paragraphs .17A through .17E).

d. A material misstatement in previously issued financial statements has been corrected (paragraphs .18A through .18C).

e. Certain circumstances relating to reports on comparative financial statements exist (paragraphs .68, .69, and .72 through .74).

f. Selected quarterly financial data required by SEC Regulation S-K has been omitted or has not been reviewed. (See section 722, Interim Financial Information, paragraph .50.)

g. Supplementary information required by the Financial Accounting Standards Board (FASB), the Governmental Accounting Standards Board (GASB), or the Federal Accounting Standards Advisory Board (FASAB) has been omitted, the presentation of such information departs materially from FASB, GASB, or FASAB guidelines, the auditor is unable to complete prescribed procedures with respect to such information, or the auditor is unable to remove substantial doubts about whether the supplementary information conforms to FASB, GASB, or FASAB guidelines. (See section 558, Required Supplementary Information, paragraph .02.)

h. Other information in a document containing audited financial statements is materially inconsistent with information appearing in the financial statements. (See section 550, Other Information in Documents Containing Audited Financial Statements, paragraph .04.)

In addition, the auditor may add an explanatory paragraph to emphasize a matter regarding the financial statements (paragraph .19). [As amended, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79. Revised, November 2002, to reflect conforming changes necessary due to the issuance of Statement on Auditing Standards No. 100.]

Opinion Based in Part on Report of Another Auditor

.12

When the auditor decides to make reference to the report of another auditor as a basis, in part, for his or her opinion, he or she should disclose this fact in the introductory paragraph of his or her report and should refer to the report of the other auditor in expressing his or her opinion. These references indicate division of responsibility for performance of the audit. (See section 543, Part of Audit Performed by Other Independent Auditors.)

.13

An example of a report indicating a division of responsibility follows:

fn 11

fn 10

fn 9





We have audited the consolidated balance sheets of ABC Company and subsidiaries as of December 31, 20X2 and 20X1, and the related consolidated statements of income, retained earnings, and cash flows for the years 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 audits. We did not audit the financial statements of B Company, a wholly-owned subsidiary, which statements reflect total assets of $_______ and $________ as of December 31, 20X2 and 20X1, respectively, and total revenues of $_______ and $_______ for the years then ended. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for B Company, is based solely on the report of the other auditors.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the 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 audits and the report of other auditors provide a reasonable basis for our opinion.

In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ABC Company and subsidiaries as of December 31, 20X2 and 20X1, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

[.14-.15]

[Paragraphs .14 and .15 deleted, effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). Click here to view

the paragraphs.]

Lack of Consistency

.16



The auditor should recognize the following matters relating to the consistency of the company's financial statements in the auditor's report if those matters have a material effect on the financial statements:

a. A change in accounting principle.

b. An adjustment to correct a misstatement in previously issued financial statements.

Change in Accounting Principle

[Paragraphs 17A through 17E are effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). For the

paragraph effective before November 15, 2008, click here.]

.17A

As discussed in PCAOB Auditing Standard No. 6, Evaluating Consistency of Financial Statements, the auditor should evaluate a change in accounting principle to determine whether (1) the newly adopted accounting principle is a generally accepted accounting principle, (2) the method of accounting for the effect of the change is in conformity with generally accepted accounting principles, (3) the disclosures related to the accounting change are adequate, and (4) the company has justified that the alternative accounting principle is preferable. A change in accounting principle that has a material effect on the financial statements should be recognized in the auditor's report on the audited financial statements through the addition of an explanatory paragraph following the

fn 12




opinion paragraph. If the auditor concludes that the criteria in this paragraph have been met, the explanatory paragraph in the auditor's report should include identification of the nature of the change and a reference to the note disclosure describing the change.

.17B

Following is an example of an explanatory paragraph for a change in accounting principle resulting from the adoption of a new accounting pronouncement:

As discussed in Note X to the financial statements, the company has changed its method of accounting for [describe accounting method change] in [year(s) of financial statements that reflect the accounting method change] due to the adoption of [name of accounting pronouncement].

.17C

Following is an example of an explanatory paragraph when the company has made a change in accounting principle other than a change due to the adoption of a new accounting pronouncement:

As discussed in Note X to the financial statements, the company has elected to change its method of accounting for [describe accounting method change] in [year(s) of financial statements that reflect the accounting method change].

.17D

The explanatory paragraph relating to a change in accounting principle should be included in reports on financial statements in the year of the change and in subsequent years until the new accounting principle is applied in all periods presented. If the accounting change is accounted for by retrospective application to the financial statements of all prior periods presented, the additional paragraph is needed only in the year of the change.

.17E

If the auditor concludes that the criteria in paragraph .17A for a change in accounting principle are not met, the auditor should consider the matter to be a departure from generally accepted accounting principles and, if the effect of the change in accounting principle is material, issue a qualified or adverse opinion.

[Paragraphs .18A through .18C are effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). For the

paragraph effective before November 15, 2008, click here.]

Correction of a Material Misstatement in Previously Issued Financial Statements

.18A

Correction of a material misstatement in previously issued financial statements should be recognized in the auditor's report through the addition of an explanatory paragraph following the opinion paragraph. The explanatory paragraph should include (1) a statement that the previously issued financial statements have been restated for the correction of a misstatement in the respective period and (2) a reference to the company's disclosure of the correction of the misstatement. Following is an example of an appropriate explanatory paragraph when there has been a correction of a material misstatement in previously issued financial statements.

As discussed in Note X to the financial statements, the 20X2 financial statements have been restated to correct a misstatement.

.18B

This type of explanatory paragraph in the auditor's report should be included in reports on financial statements when the related financial statements are restated to correct the prior material misstatement. The paragraph need not be repeated in subsequent years.

fn 13




.18C

[The following paragraph is effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release No. 2010-004

. For audits of fiscal years beginning before December 15, 2010, click here.]

The accounting pronouncements generally require certain disclosures relating to restatements to correct a misstatement in previously issued financial statements. If the financial statement disclosures are not adequate, the auditor should address the lack of disclosure as discussed beginning at paragraph .41.

Emphasis of a Matter

.19

In any report on financial statements, the auditor may emphasize a matter regarding the financial statements. Such explanatory information should be presented in a separate paragraph of the auditor's report. Phrases such as "with the foregoing [following] explanation" should not be used in the opinion paragraph if an emphasis paragraph is included in the auditor's report. Emphasis paragraphs are never required; they may be added solely at the auditor's discretion. Examples of matters the auditor may wish to emphasize are—

That the entity is a component of a larger business enterprise.

That the entity has had significant transactions with related parties.

Unusually important subsequent events.

Accounting matters, other than those involving a change or changes in accounting principles, affecting the comparability of the financial statements with those of the preceding period.

Departures From Unqualified Opinions

Qualified Opinions

.20

Certain circumstances may require a qualified opinion. A qualified opinion states that, except for the effects of the matter to which the qualification relates, the financial statements present fairly, in all material respects, financial position, results of operations, and cash flows in conformity with generally accepted accounting principles. Such an opinion is expressed when—

[The following subparagraph is effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release No. 2010-

004 . For audits of fiscal years beginning before December 15, 2010, click here.]

a. There is a lack of sufficient appropriate evidential matter or there are restrictions on the scope of the audit that have led the auditor to conclude that he or she cannot express an unqualified opinion and he or she has concluded not to disclaim an opinion (paragraphs .22-.34).

b. The auditor believes, on the basis of his or her audit, that the financial statements contain a departure from generally accepted accounting principles, the effect of which is material, and he or she has concluded not to express an adverse opinion (paragraphs .35-.57).

.21

When the auditor expresses a qualified opinion, he or she should disclose all of the substantive reasons in one or more separate explanatory paragraph(s) preceding the opinion paragraph of the report. The auditor should also include, in the opinion paragraph, the appropriate qualifying language and a reference to the explanatory paragraph. A qualified opinion should include the word exceptor exception in a phrase such as except for or with the exception of. Phrases such as subject to and with the foregoing explanationare not clear or forceful enough and should not be used. Since accompanying notes are part of the financial statements, wording such




as fairly presented, in all material respects, when read in conjunction with Note 1 is likely to be misunderstood and should not be used. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

Scope Limitations

.22



The auditor can determine that he or she is able to express an unqualified opinion only if the audit has been conducted in accordance with generally accepted auditing standards and if he or she has therefore been able to apply all the procedures he considers necessary in the circumstances. Restrictions on the scope of the audit, whether imposed by the client or by circumstances, such as the timing of his or her work, the inability to obtain sufficient appropriate evidential matter, or an inadequacy in the accounting records, may require the auditor to qualify his or her opinion or to disclaim an opinion. In such instances, the reasons for the auditor's qualification of opinion or disclaimer of opinion should be described in the report.

.23

The auditor's decision to qualify his or her opinion or disclaim an opinion because of a scope limitation depends on his or her assessment of the importance of the omitted procedure(s) to his or her ability to form an opinion on the financial statements being audited. This assessment will be affected by the nature and magnitude of the potential effects of the matters in question and by their significance to the financial statements. If the potential effects relate to many financial statement items, this significance is likely to be greater than if only a limited number of items is involved. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.24



Common restrictions on the scope of the audit include those applying to the observation of physical inventories and the confirmation of accounts receivable by direct communication with debtors. Another common scope restriction involves accounting for long-term investments when the auditor has not been able to obtain audited financial statements of an investee. Restrictions on the application of these or other audit procedures to important elements of the financial statements require the auditor to decide whether he or she has examined sufficient appropriate evidential matter to permit him or her to express an unqualified or qualified opinion, or whether he or she should disclaim an opinion. When restrictions that significantly limit the scope of the audit are imposed by the client, ordinarily the auditor should disclaim an opinion on the financial statements.

.25

When a qualified opinion results from a limitation on the scope of the audit or an insufficiency of evidential matter, the situation should be described in an explanatory paragraph preceding the opinion paragraph and referred to in both the scope and opinion paragraphs of the auditor's report. It is not appropriate for the scope of the audit to be explained in a note to the financial statements, since the description of the audit scope is the responsibility of the auditor and not that of the client. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.26

When an auditor qualifies his or her opinion because of a scope limitation, the wording in the opinion paragraph should indicate that the qualification pertains to the possible effects on the financial statements and not to the scope limitation itself. Wording such as "In our opinion, except for the above-mentioned limitation on the scope of our audit . . ." bases the exception on the restriction itself, rather than on the possible effects on the financial statements and, therefore, is unacceptable. An example of a qualified opinion related to a scope limitation concerning an investment in a foreign affiliate (assuming the effects of the limitation are such that the auditor has concluded that a disclaimer of opinion is not appropriate) follows:

fn 14





[Same first paragraph as the standard report]

Except as discussed in the following paragraph, we conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the 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 audits provide a reasonable basis for our opinion.

We were unable to obtain audited financial statements supporting the Company's investment in a foreign affiliate stated at $_______ and $_______ at December 31, 20X2 and 20X1, respectively, or its equity in earnings of that affiliate of $_______ and $_______, which is included in net income for the years then ended as described in Note X to the financial statements; nor were we able to satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the equity in its earnings by other auditing procedures.

In our opinion, except for the effects of such adjustments, if any, as might have been determined to be necessary had we been able to examine evidence regarding the foreign affiliate investment and earnings, the financial statements referred to in the first paragraph above present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

[Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.27

Other scope limitations.Sometimes, notes to financial statements may contain unaudited information, such as pro forma calculations or other similar disclosures. If the unaudited information (for example, an investor's share, material in amount, of an investee's earnings recognized on the equity method) is such that it should be subjected to auditing procedures in order for the auditor to form an opinion with respect to the financial statements taken as a whole, the auditor should apply the procedures he or she deems necessary to the unaudited information. If the auditor has not been able to apply the procedures he or she considers necessary, the auditor should qualify his or her opinion or disclaim an opinion because of a limitation on the scope of the audit. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.28

If, however, these disclosures are not necessary to fairly present the financial position, operating results, or cash flows on which the auditor is reporting, such disclosures may be identified as unaudited or as not covered by the auditor's report. For example, the pro forma effects of a business combination or of a subsequent event may be labelled unaudited. Therefore, while the event or transaction giving rise to the disclosures in these circumstances should be audited, the pro forma disclosures of that event or transaction would not be. The auditor should be aware, however, that section 530, Dating of the Independent Auditor's Report, states that, if the auditor is aware of a material subsequent event that has occurred after the completion of fieldwork but before issuance of the report that should be disclosed, the auditor's only options are to dual date the report or date the report as of the date of the subsequent event and extend the procedures for review of subsequent events to that date. Labelling the note unaudited is not an acceptable alternative in these circumstances. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.29

Uncertainties and scope limitations.A matter involving an uncertainty is one that is expected to be resolved at a future date, at which time conclusive evidential matter concerning its outcome would be expected to become available. Uncertainties include, but are not limited to, contingencies covered by Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, and matters related to estimates covered by Statement of Position 94-6, Disclosure of Certain




Significant Risks and Uncertainties. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.30

Conclusive evidential matter concerning the ultimate outcome of uncertainties cannot be expected to exist at the time of the audit because the outcome and related evidential matter are prospective. In these circumstances, management is responsible for estimating the effect of future events on the financial statements, or determining that a reasonable estimate cannot be made and making the required disclosures, all in accordance with generally accepted accounting principles, based on management's analysis of existing conditions. An audit includes an assessment of whether the evidential matter is sufficient to support management's analysis. Absence of the existence of information related to the outcome of an uncertainty does not necessarily lead to a conclusion that the evidential matter supporting management's assertion is not sufficient. Rather, the auditor's judgment regarding the sufficiency of the evidential matter is based on the evidential matter that is, or should be, available. If, after considering the existing conditions and available evidence, the auditor concludes that sufficient evidential matter supports management's assertions about the nature of a matter involving an uncertainty and its presentation or disclosure in the financial statements, an unqualified opinion ordinarily is appropriate. [Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.31

If the auditor is unable to obtain sufficient evidential matter to support management's assertions about the nature of a matter involving an uncertainty and its presentation or disclosure in the financial statements, the auditor should consider the need to express a qualified opinion or to disclaim an opinion because of a scope limitation. A qualification or disclaimer of opinion because of a scope limitation is appropriate if sufficient evidential matter related to an uncertainty does or did exist but was not available to the auditor for reasons such as management's record retention policies or a restriction imposed by management. [Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.32

Scope limitations related to uncertainties should be differentiated from situations in which the auditor concludes that the financial statements are materially misstated due to departures from generally accepted accounting principles related to uncertainties. Such departures may be caused by inadequate disclosure concerning the uncertainty, the use of inappropriate accounting principles, or the use of unreasonable accounting estimates. Paragraphs .45 to .49 provide guidance to the auditor when financial statements contain departures from generally accepted accounting principles related to uncertainties. [Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.33

Limited reporting engagements.The auditor may be asked to report on one basic financial statement and not on the others. For example, he or she may be asked to report on the balance sheet and not on the statements of income, retained earnings or cash flows. These engagements do not involve scope limitations if the auditor's access to information underlying the basic financial statements is not limited and if the auditor applies all the procedures he considers necessary in the circumstances; rather, such engagements involve limited reporting objectives. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.34

An auditor may be asked to report on the balance sheet only. In this case, the auditor may express an opinion on the balance sheet only. An example of an unqualified opinion on a balance-sheet-only audit follows (the report assumes that the auditor has been able to satisfy himself or herself regarding the consistency of application of accounting principles):





We have audited the accompanying balance sheet of X Company as of December 31, 20XX. This financial statement is the responsibility of the Company's management. Our responsibility is to express an opinion on this financial statement based on our audit.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the balance sheet is free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the balance sheet. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall balance sheet presentation. We believe that our audit of the balance sheet provides a reasonable basis for our opinion.

In our opinion, the balance sheet referred to above presents fairly, in all material respects, the financial position of X Company as of December 31, 20XX, in conformity with accounting principles generally accepted in the United States of America.


Departure From a Generally Accepted Accounting Principle

.35

When financial statements are materially affected by a departure from generally accepted accounting principles and the auditor has audited the statements in accordance with generally accepted auditing standards, he or she should express a qualified (paragraphs .36 through .57) or an adverse (paragraphs .58 through .60) opinion. The basis for such opinion should be stated in the report. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.36

In deciding whether the effects of a departure from generally accepted accounting principles are sufficiently material to require either a qualified or adverse opinion, one factor to be considered is the dollar magnitude of such effects. However, the concept of materiality does not depend entirely on relative size; it involves qualitative as well as quantitative judgments. The significance of an item to a particular entity (for example, inventories to a manufacturing company), the pervasiveness of the misstatement (such as whether it affects the amounts and presentation of numerous financial statement items), and the effect of the misstatement on the financial statements taken as a whole are all factors to be considered in making a judgment regarding materiality. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.37

When the auditor expresses a qualified opinion, he or she should disclose, in a separate explanatory paragraph(s) preceding the opinion paragraph of the report, all of the substantive reasons that have led him or her to conclude that there has been a departure from generally accepted accounting principles. Furthermore, the opinion paragraph of the report should include the appropriate qualifying language and a reference to the explanatory paragraph(s). [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.38

The explanatory paragraph(s) should also disclose the principal effects of the subject matter of the qualification on financial position, results of operations, and cash flows, if practicable. If the effects are not reasonably determinable, the report should so state. If such disclosures are made in a note to the financial statements, the explanatory paragraph(s) may be shortened by referring to it. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.39

An example of a report in which the opinion is qualified because of the use of an accounting principle at variance with generally accepted accounting principles follows (assuming the effects are such that the auditor has concluded that an adverse opinion is not appropriate):

fn 15





[Same first and second paragraphs as the standard report]

The Company has excluded, from property and debt in the accompanying balance sheets, certain lease obligations that, in our opinion, should be capitalized in order to conform with accounting principles generally accepted in the United States of America. If these lease obligations were capitalized, property would be increased by $_______ and $_______, long-term debt by $_______ and $_______, and retained earnings by $_______ and $_______ as of December 31, 20X2 and 20X1, respectively. Additionally, net income would be increased (decreased) by $_______ and $_______ and earnings per share would be increased (decreased) by $_______ and $_______, respectively, for the years then ended.

In our opinion, except for the effects of not capitalizing certain lease obligations as discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.


.40

If the pertinent facts are disclosed in a note to the financial statements, a separate paragraph (preceding the opinion paragraph) of the auditor's report in the circumstances illustrated in paragraph .39 might read as follows:

As more fully described in Note X to the financial statements, the Company has excluded certain lease obligations from property and debt in the accompanying balance sheets. In our opinion, accounting principles generally accepted in the United States of America require that such obligations be included in the balance sheets.


.41

Inadequate disclosure. Information essential for a fair presentation in conformity with generally accepted accounting principles should be set forth in the financial statements (which include the related notes). When such information is set forth elsewhere in a report to shareholders, or in a prospectus, proxy statement, or other similar report, it should be referred to in the financial statements. If the financial statements, including accompanying notes, fail to disclose information that is required by generally accepted accounting principles, the auditor should express a qualified or adverse opinion because of the departure from those principles and should provide the information in the report, if practicable, unless its omission from the auditor's report is recognized as appropriate by a specific Statement on Auditing Standards. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.42

Following is an example of a report qualified for inadequate disclosure (assuming the effects are such that the auditor has concluded an adverse opinion is not appropriate):



The Company's financial statements do not disclose [describe the nature of the omitted disclosures]. In our opinion, disclosure of this information is required by accounting principles generally accepted in the United States of America.

In our opinion, except for the omission of the information discussed in the preceding paragraph, . . .


fn 16




.43

If a company issues financial statements that purport to present financial position and results of operations but omits the related statement of cash flows, the auditor will normally conclude that the omission requires qualification of his opinion. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.44

The auditor is not required to prepare a basic financial statement (for example, a statement of cash flows for one or more periods) and include it in the report if the company's management declines to present the statement. Accordingly, in these cases, the auditor should ordinarily qualify the report in the following manner:


We have audited the accompanying balance sheets of X Company as of December 31, 20X2 and 20X1, and the related statements of income and retained earnings for the years 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.

[Same second paragraph as the standard report]

The Company declined to present a statement of cash flows for the years ended December 31, 20X2 and 20X1. Presentation of such statement summarizing the Company's operating, investing, and financing activities is required by accounting principles generally accepted in the United States of America.

In our opinion, except that the omission of a statement of cash flows results in an incomplete presentation as explained in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations for the years then ended in conformity with accounting principles generally accepted in the United States of America.


.45

Departures from generally accepted accounting principles involving risks or uncertainties, and materiality considerations.Departures from generally accepted accounting principles involving risks or uncertainties generally fall into one of the following categories:

Inadequate disclosure (paragraphs .46 and .47)

Inappropriate accounting principles (paragraph .48)

Unreasonable accounting estimates (paragraph .49)

[Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.46

If the auditor concludes that a matter involving a risk or an uncertainty is not adequately disclosed in the financial statements in conformity with generally accepted accounting principles, the auditor should express a qualified or an adverse opinion. [Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.47

The auditor should consider materiality in evaluating the adequacy of disclosure of matters involving risks or uncertainties in the financial statements in the context of the financial statements taken as a whole. The auditor's consideration of materiality is a matter of professional judgment and is influenced by his or her perception of the needs of a reasonable person who will rely on the financial statements. Materiality judgments involving risks or uncertainties are made in light of the surrounding circumstances. The auditor evaluates the materiality of reasonably possible losses that may be incurred upon the resolution of uncertainties both individually and




in the aggregate. The auditor performs the evaluation of reasonably possible losses without regard to his or her evaluation of the materiality of known and likely misstatements in the financial statements. [Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.48

In preparing financial statements, management estimates the outcome of certain types of future events. For example, estimates ordinarily are made about the useful lives of depreciable assets, the collectibility of accounts receivable, the realizable value of inventory items, and the provision for product warranties. FASB Statement No. 5, Accounting for Contingencies, paragraphs 23 and 25, describes situations in which the inability to make a reasonable estimate may raise questions about the appropriateness of the accounting principles used. If, in those or other situations, the auditor concludes that the accounting principles used cause the financial statements to be materially misstated, he or she should express a qualified or an adverse opinion. [Paragraph added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79.]

.49



Usually, the auditor is able to satisfy himself or herself regarding the reasonableness of management's estimate of the effects of future events by considering various types of evidential matter, including the historical experience of the entity. If the auditor concludes that management's estimate is unreasonable (see paragraph 13 of Auditing Standard No. 14, Evaluating Audit Results) and that its effect is to cause the financial statements to be materially misstated, he or she should express a qualified or an adverse opinion

[.50]

[Paragraph deleted, effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). Click here to view the

paragraph.]

.51



Departures from generally accepted accounting principles related to changes in accounting principle. Paragraph .17A states the criteria for evaluating a change in accounting principle. If the auditor concludes that the criteria have not been met, he or she should consider that circumstance to be a departure from generally accepted accounting principles and, if the effect of the accounting change is material, should issue a qualified or adverse opinion.

.52



The accounting standards indicate that a company may make a change in accounting principle only if it justifies that the allowable alternative accounting principle is preferable. If the company does not provide reasonable justification that the alternative accounting principle is preferable, the auditor should consider the accounting change to be a departure from generally accepted accounting principles and, if the effect of the change in accounting principle is material, should issue a qualified or adverse opinion. The following is an example of a report qualified because a company did not provide reasonable justification that an alternative accounting principle is preferable:






As disclosed in Note X to the financial statements, the Company adopted, in 20X2, the first-in, first-out method of accounting for its inventories, whereas it previously used the last-in, first-out method. Although use of the first-in, first-out method is in conformity with accounting principles generally accepted in the United States of America, in our opinion the Company has not provided reasonable justification that this accounting principle is preferable as required by those principles.

In our opinion, except for the change in accounting principle discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.


.53

Whenever an accounting change results in an auditor expressing a qualified or adverse opinion on the conformity of financial statements with generally accepted accounting principles for the year of change, the auditor should consider the possible effects of that change when reporting on the entity's financial statements for subsequent years, as discussed in paragraphs .54 through .57. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.54

If the financial statements for the year of such change are presented and reported on with a subsequent year's financial statements, the auditor's report should disclose his or her reservations with respect to the statements for the year of change. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.55

If an entity has adopted an accounting principle that is not a generally accepted accounting principle, its continued use might have a material effect on the statements of a subsequent year on which the auditor is reporting. In this situation, the independent auditor should express either a qualified opinion or an adverse opinion, depending on the materiality of the departure in relation to the statements of the subsequent year. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.56

If an entity accounts for the effect of a change prospectively when generally accepted accounting principles require restatement or the inclusion of the cumulative effect of the change in the year of change, a subsequent year's financial statements could improperly include a charge or credit that is material to those statements. This situation also requires that the auditor express a qualified or an adverse opinion. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.57



If the auditor issues a qualified or adverse opinion because the company has not justified that an allowable accounting principle adopted in an accounting change is preferable, as described in paragraph .52, the auditor should continue to express that opinion on the financial statements for the year of change as long as those financial statements are presented and reported on. However, the auditor's qualified or adverse opinion relates only to the accounting change and does not affect the status of a newly adopted principle as a generally accepted accounting principle. Accordingly, while expressing a qualified or adverse opinion for the year of change, the independent auditor's opinion regarding the subsequent years' statements need not express a qualified or adverse opinion on the use of the newly adopted principle in subsequent periods.

Adverse Opinions

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.58

An adverse opinion states that the financial statements do not present fairly the financial position or the results of operations or cash flows in conformity with generally accepted accounting principles. Such an opinion is expressed when, in the auditor's judgment, the financial statements taken as a whole are not presented fairly in conformity with generally accepted accounting principles. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.59

When the auditor expresses an adverse opinion, he or she should disclose in a separate explanatory paragraph(s) preceding the opinion paragraph of the report (a) all the substantive reasons for his or her adverse opinion, and (b) the principal effects of the subject matter of the adverse opinion on financial position, results of operations, and cash flows, if practicable. If the effects are not reasonably determinable, the report should so state. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.60

When an adverse opinion is expressed, the opinion paragraph should include a direct reference to a separate paragraph that discloses the basis for the adverse opinion, as shown below:



As discussed in Note X to the financial statements, the Company carries its property, plant and equipment accounts at appraisal values, and provides depreciation on the basis of such values. Further, the Company does not provide for income taxes with respect to differences between financial income and taxable income arising because of the use, for income tax purposes, of the installment method of reporting gross profit from certain types of sales. Accounting principles generally accepted in the United States of America require that property, plant and equipment be stated at an amount not in excess of cost, reduced by depreciation based on such amount, and that deferred income taxes be provided.

Because of the departures from accounting principles generally accepted in the United States of America identified above, as of December 31, 20X2 and 20X1, inventories have been increased $_______ and $_______ by inclusion in manufacturing overhead of depreciation in excess of that based on cost; property, plant and equipment, less accumulated depreciation, is carried at $_______ and $_______ in excess of an amount based on the cost to the Company; and deferred income taxes of $_______ and $_______ have not been recorded; resulting in an increase of $_______ and $_______ in retained earnings and in appraisal surplus of $_______ and $_______, respectively. For the years ended December 31, 20X2 and 20X1, cost of goods sold has been increased $_______ and $_______, respectively, because of the effects of the depreciation accounting referred to above and deferred income taxes of $_______ and $_______ have not been provided, resulting in an increase in net income of $_______ and $_______, respectively.

In our opinion, because of the effects of the matters discussed in the preceding paragraphs, the financial statements referred to above do not present fairly, in conformity with accounting principles generally accepted in the United States of America, the financial position of X Company as of December 31, 20X2 and 20X1, or the results of its operations or its cash flows for the years then ended.


Disclaimer of Opinion

.61

A disclaimer of opinion states that the auditor does not express an opinion on the financial statements. An auditor may decline to express an opinion whenever he or she is unable to form or has not formed an opinion as to the fairness of presentation of the financial statements in conformity with generally accepted accounting principles. If the auditor disclaims an opinion, the auditor's

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report should give all of the substantive reasons for the disclaimer. [Paragraph renumbered and amended, effective for reports issued or reissued on or after February 29, 1996, by the issuance of Statement on Auditing Standards No. 79.]

.62

A disclaimer is appropriate when the auditor has not performed an audit sufficient in scope to enable him or her to form an opinion on the financial statements. A disclaimer of opinion should not be expressed because the auditor believes, on the basis of his or her audit, that there are material departures from generally accepted accounting principles (see paragraphs .35 through .57). When disclaiming an opinion because of a scope limitation, the auditor should state in a separate paragraph or paragraphs all of the substantive reasons for the disclaimer. He or she should state that the scope of the audit was not sufficient to warrant the expression of an opinion. The auditor should not identify the procedures that were performed nor include the paragraph describing the characteristics of an audit (that is, the scope paragraph of the auditor's standard report); to do so may tend to overshadow the disclaimer. In addition, the auditor should also disclose any other reservations he or she has regarding fair presentation in conformity with generally accepted accounting principles. [Paragraph renumbered and amended, effective for reports issued or reissued on or after February 29, 1996, by the issuance of Statement on Auditing Standards No. 79.]

.63



An example of a report disclaiming an opinion resulting from an inability to obtain sufficient appropriate evidential matter because of the scope limitation follows:


We were engaged to audit the accompanying balance sheets of X Company as of December 31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management.

[Second paragraph of standard report should be omitted]

The Company did not make a count of its physical inventory in 20X2 or 20X1, stated in the accompanying financial statements at $_______ as of December 31, 20X2, and at $________ as of December 31, 20X1. Further, evidence supporting the cost of property and equipment acquired prior to December 31, 20X1, is no longer available. The Company's records do not permit the application of other auditing procedures to inventories or property and equipment.

Since the Company did not take physical inventories and we were not able to apply other auditing procedures to satisfy ourselves as to inventory quantities and the cost of property and equipment, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements.

Piecemeal Opinions

.64

Piecemeal opinions (expressions of opinion as to certain identified items in financial statements) should not be expressed when the auditor has disclaimed an opinion or has expressed an adverse opinion on the financial statements taken as a whole because piecemeal opinions tend to overshadow or contradict a disclaimer of opinion or an adverse opinion. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

Reports on Comparative Financial Statements

.65

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The fourth standard of reporting requires that an auditor's report contain either an expression of opinion regarding the financial statements taken as a whole or an assertion to the effect that an opinion cannot be expressed. Reference in the fourth reporting standard to the financial statements taken as a whole applies not only to the financial statements of the current period but also to those of one or more prior periods that are presented on a comparative basis with those of the current period. Therefore, a continuing auditor should update the report on the individual financial statements of the one or more prior periods presented on a comparative basis with those of the current period. Ordinarily, the auditor's report on comparative financial statements should be dated as of the date of completion of fieldwork for the most recent audit. (See section 530, Dating of the Independent Auditor's Report, paragraph .01.) [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. As amended, effective September 2002, by Statement on Auditing Standards No. 98.]

.66



During the audit of the current-period financial statements, the auditor should be alert for circumstances or events that affect the prior-period financial statements presented (see paragraph .68) or the adequacy of informative disclosures concerning those statements. (See paragraph 31 of Auditing Standard No. 14, Evaluating Audit Results.) In updating his or her report on the prior-period financial statements, the auditor should consider the effects of any such circumstances or events coming to his or her attention.

Different Reports on Comparative Financial Statements Presented

.67

Since the auditor's report on comparative financial statements applies to the individual financial statements presented, an auditor may express a qualified or adverse opinion, disclaim an opinion, or include an explanatory paragraph with respect to one or more financial statements for one or more periods, while issuing a different report on the other financial statements presented. Following are examples of reports on comparative financial statements (excluding the standard introductory and scope paragraphs, where applicable) with different reports on one or more financial statements presented.

Standard Report on the Prior-Year Financial Statements and a Qualified Opinion on the Current-Year Financial Statements



The Company has excluded, from property and debt in the accompanying 20X2 balance sheet, certain lease obligations that were entered into in 20X2 which, in our opinion, should be capitalized in order to conform with accounting principles generally accepted in the United States of America. If these lease obligations were capitalized, property would be increased by $_______, long-term debt by $_______, and retained earnings by $_______ as of December 31, 20X2, and net income and earnings per share would be increased (decreased) by $_______ and $_______, respectively, for the year then ended.

In our opinion, except for the effects on the 20X2 financial statements of not capitalizing certain lease obligations as described in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

Standard Report on the Current-Year Financial Statements With a Disclaimer of Opinion on the Prior-Year Statements of Income, Retained Earnings, and Cash Flows


[Same first paragraph as the standard report]

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Except as explained in the following paragraph, we conducted our audits in accordance with auditing standards generally accepted in the United States of America. 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 audits provide a reasonable basis for our opinion.

We did not observe the taking of the physical inventory as of December 31, 20X0, 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. Inventory amounts as of December 31, 20X0, enter into the determination of net income and cash flows for the year ended December 31, 20X1.

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, 20X1.

In our opinion, the balance sheets of ABC Company as of December 31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash flows for the year ended December 31, 20X2, present fairly, in all material respects, the financial position of ABC Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the year ended December 31, 20X2, in conformity with accounting principles generally accepted in the United States of America.


Opinion on Prior-Period Financial Statements Different From the Opinion Previously Expressed

.68

If, during the current audit, an auditor becomes aware of circumstances or events that affect the financial statements of a prior period, he or she should consider such matters when updating his or her report on the financial statements of the prior period. For example, if an auditor has previously qualified his or her opinion or expressed an adverse opinion on financial statements of a prior period because of a departure from generally accepted accounting principles, and the prior-period financial statements are restated in the current period to conform with generally accepted accounting principles, the auditor's updated report on the financial statements of the prior period should indicate that the statements have been restated and should express an unqualified opinion with respect to the restated financial statements. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

.69



If, in an updated report, the opinion is different from the opinion previously expressed on the financial statements of a prior period, the auditor should disclose all the substantive reasons for the different opinion in a separate explanatory paragraph(s) preceding the opinion paragraph of his or her report. The explanatory paragraph(s) should disclose (a) the date of the auditor's previous report, (b) the type of opinion previously expressed, (c) if applicable, a statement that the previously issued financial statements have been restated for the correction of a misstatement in the respective period, (d) the circumstances or events that caused the auditor to express a different opinion, and (e) if applicable, a reference to the company's disclosure of the correction of the misstatement, and (f) the fact that the auditor's updated opinion on the financial statements of the prior period is different from his or her previous opinion on those statements. The following is an example of an explanatory paragraph that may be appropriate when an auditor issues an updated report on the financial statements of a prior period that contains an opinion different from the opinion previously expressed:



In our report dated March 1, 20X2, we expressed an opinion that the 20X1 financial statements did not fairly present financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of

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America because of two departures from such principles: (1) the Company carried its property, plant, and equipment at appraisal values, and provided for depreciation on the basis of such values, and (2) the Company did not provide for deferred income taxes with respect to differences between income for financial reporting purposes and taxable income. As described in Note X, the Company has changed its method of accounting for these items and restated its 20X1 financial statements to conform with accounting principles generally accepted in the United States of America. Accordingly, our present opinion on the 20X1 financial statements, as presented herein, is different from that expressed in our previous report.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.


Report of Predecessor Auditor

.70

A predecessor auditor ordinarily would be in a position to reissue his or her report on the financial statements of a prior period at the request of a former client if he or she is able to make satisfactory arrangements with the former client to perform this service and if he or she performs the procedures described in paragraph .71. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

Predecessor Auditor's Report Reissued

.71

Before reissuing (or consenting to the reuse of) a report previously issued on the financial statements of a prior period, when those financial statements are to be presented on a comparative basis with audited financial statements of a subsequent period, a predecessor auditor should consider whether his or her previous report on those statements is still appropriate. Either the current form or manner of presentation of the financial statements of the prior period or one or more subsequent events might make a predecessor auditor's previous report inappropriate. Consequently, 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. 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 require disclosure in, the financial statements reported on by the predecessor auditor. Also, the predecessor auditor may wish to consider the matters described in section 543, Part of Audit Performed by Other Independent Auditors, paragraphs .10 through .12. However, the predecessor auditor should not refer in his or her reissued report to the report or work of the successor auditor. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. As amended, effective for reports reissued on or after June 30, 1998, by Statement on Auditing Standards No. 85.]

.72

A predecessor auditor who has agreed to reissue his or her report may become aware of events or transactions occurring subsequent to the date of his or her previous report on the financial statements of a prior period that may affect his or her previous report (for example, the successor auditor might indicate in the response that certain matters have had a material effect on the prior-period financial statements reported on by the predecessor auditor). In such circumstances, the predecessor auditor should make inquiries and perform other procedures that he or she considers necessary (for example, reviewing the working papers of the successor auditor as they relate to the matters affecting the prior-period financial statements). The auditor should then decide, on the basis of the evidential matter obtained, whether to revise the report. If a predecessor auditor concludes that the report should be revised, he or

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she should follow the guidance in paragraphs .68, .69, and .73 of this section. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]



.73

A predecessor auditor's knowledge of the current affairs of his former client is obviously limited in the absence of a continuing relationship. Consequently, when reissuing the report on prior-period 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 adjusted, he or she should dual-date the report. (See section 530, Dating of the Independent Auditor's Report, paragraph .05.) [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995.]

Predecessor Auditor's Report Not Presented

.74



If the financial statements of a prior period have been audited by a predecessor auditor whose report is not presented, the successor auditor should indicate in the introductory paragraph of his or her report (a) that the financial statements of the prior period were audited by another auditor, (b) the date of his or her report, (c) the type of report issued by the predecessor auditor, and (d) if the report was other than a standard report, the substantive reasons therefor. An example of a successor auditor's report when the predecessor auditor's report is not presented is shown below:


We have audited the balance sheet of ABC Company as of December 31, 20X2, 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. The financial statements of ABC Company as of December 31, 20X1, were audited by other auditors whose report dated March 31, 20X2, expressed an unqualified opinion on those statements.

[Same second paragraph as the standard report]

In our opinion, the 20X2 financial statements referred to above present fairly, in all material respects, the financial position of ABC Company as of December 31, 20X2, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.

If the predecessor auditor's report was other than a standard report, the successor auditor should describe the nature of and reasons for the explanatory paragraph added to the predecessor's report or the opinion qualification. Following is an illustration of the wording that may be included in the successor auditor's report:

. . . were audited by other auditors whose report dated March 1, 20X2, on those statements included an explanatory paragraph that described the change in the Company's method of computing depreciation discussed in Note X to the financial statements.

If the financial statements have been adjusted, the introductory paragraph should indicate that a predecessor auditor reported on the financial statements of the prior period before the adjustments. In addition, if the successor auditor is engaged to audit and applies sufficient procedures to satisfy himself or herself as to the appropriateness of the adjustments, he or she may also include the following paragraph in the auditor's report:

We also audited the adjustments described in Note X that were applied to restate the 20X1 financial statements. In our opinion, such adjustments are appropriate and have been properly applied.

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[Paragraph renumbered and amended, effective for reports issued or reissued on or after February 29, 1996, by the issuance of Statement on Auditing Standards No. 79.]

Effective Date and Transition

.75

This section is effective for reports issued or reissued on or after February 29, 1996. Earlier application of the provisions of this section is permissible. [Paragraph renumbered and amended, effective for reports issued or reissued on or after February 29, 1996, by the issuance of Statement on Auditing Standards No. 79.]

.76

An auditor who previously included an uncertainties explanatory paragraph in a report should not repeat that paragraph and is not required to include an emphasis paragraph related to the uncertainty in a reissuance of that report or in a report on subsequent periods' financial statements, even if the uncertainty has not been resolved. If the auditor decides to include an emphasis paragraph related to the uncertainty, the paragraph may include an explanation of the change in reporting standards. [Paragraph renumbered and amended, effective for reports issued or reissued on or after February 29, 1996, by the issuance of Statement on Auditing Standards No. 79.]

Footnotes (AU Section 508 — Reports on Audited Financial Statements):

This section has been revised to reflect the conforming changes necessary due to the issuance of Statement on Auditing Standards No. 93.

An audit, for purposes of this section, is defined as an examination of historical financial statements performed in accordance with generally accepted auditing standards in effect at the time the audit is performed. Generally accepted auditing standards include the ten standards as well as the Statements on Auditing Standards that interpret those standards. In some cases, regulatory authorities may have additional requirements applicable to entities under their jurisdiction and auditors of such entities should consider those requirements.

[Footnote deleted]

This section does not require a title for an auditor's report if the auditor is not independent. See section 504, Association With Financial Statements, for guidance on reporting when the auditor is not independent.

In some instances, a document containing the auditor's report may include a statement by management regarding its responsibility for the presentation of the financial statements. Nevertheless, the auditor's report should state that the financial statements are management's responsibility.

Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles, paragraphs .03 and .04, discuss the auditor's evaluation of the overall presentation of the financial statements. [As amended, effective for reports issued or reissued on or after June 30, 2001, by Statement on Auditing Standards No. 93.]

A U.S. auditor also may be engaged to report on the financial statements of a U.S. entity that have been prepared in conformity with accounting principles generally accepted in another country. In those circumstances, the auditor should refer to the guidance in section 534, Reporting on Financial Statements Prepared for Use in Other Countries. [Footnote added, effective for reports issued or reissued on or after June 30, 2001 by Statement on Auditing Standards No. 93.]

For guidance on dating the auditor's report, see section 530, Dating of the Independent Auditor's Report. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

If statements of income, retained earnings, and cash flows are presented on a comparative basis for one or more prior periods, but the balance sheet(s) as of the end of one (or more) of the prior period(s) is not presented, the phrase "for the years then ended" should be changed to indicate that the auditor's opinion applies to each period for which statements of income, retained earnings, and cash flows are presented, such as "for each of the three years in the period ended [date of latest balance sheet]." [Footnote renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

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Unless otherwise required by the provisions of this section, an explanatory paragraph may precede or follow the opinion paragraph in the auditor's report. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

See footnote 3. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

Section 341, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, describes the auditor's responsibility to evaluate whether there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time and, when applicable, to consider the adequacy of financial statement disclosure and to include an explanatory paragraph in the report to reflect his or her conclusions. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

The issuance of an accounting pronouncement that requires use of a new accounting principle, interprets an existing principle, expresses a preference for an accounting principle, or rejects a specific principle is sufficient justification for a change in accounting principle, as long as the change in accounting principle is made in accordance with the hierarchy of generally accepted accounting principles. See FASB Statement 154, paragraph 14.

The directions in paragraphs .68-.69 apply when comparative financial statements are presented and the opinion on the prior-period financial statements differs from the opinion previously expressed.

Circumstances such as the timing of the work may make it impossible for the auditor to accomplish these procedures. In this case, if the auditor is able to satisfy himself or herself as to inventories or accounts receivable by applying alternative procedures, there is no significant limitation on the scope of the work, and the report need not include a reference to the omission of the procedures or the use of alternative procedures. It is important to understand, however, that section 331, Inventories, states that "it will always be necessary for the auditor to make, or observe, some physical counts of the inventory and apply appropriate tests of intervening transactions." [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]



In this context, practicable means that the information is reasonably obtainable from management's accounts and records and that providing the information in the report does not require the auditor to assume the position of a preparer of financial information. For example, if the information can be obtained from the accounts and records without the auditor substantially increasing the effort that would normally be required to complete the audit, the information should be presented in the report.

See footnote 15. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

Because this paragraph included in the example presented contains all of the information required in an explanatory paragraph on consistency, a separate explanatory paragraph (following the opinion paragraph) as required by paragraphs .17A thorough .17E of this section is not necessary in this instance. A separate paragraph that identifies the change in accounting principle would be required if the substance of the disclosure did not fulfill the requirements outlined in these paragraphs. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

See footnote 15. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No 93, October 2000.]

[The following footnote is effective November 15, 2008. See PCAOB Release No. 2008-001 (January 29, 2008). For the footnote effective before

November 15, 2008, click here.]

When the auditor expresses an adverse opinion, he or she should also consider the need for an explanatory paragraph under the circumstances identified in paragraph .11, subsection (b), (c), (d), and (e) of this section. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]



Section 504, Association With Financial Statements, paragraph .05, provides guidance to an accountant who is associated with the financial statements of a public entity, but has not audited such statements. [Footnote renumbered and amended, effective for reports issued

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or reissued on or after February 29, 1996, by the issuance of Statement on Auditing Standards No. 79. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000. Footnote revised, November 2002, to reflect conforming changes necessary due to the issuance of Statement on Standards for Accounting and Review Services No. 9.]

The wording in the first paragraph of the auditor's standard report is changed in a disclaimer of opinion because of a scope limitation. The first sentence now states that "we were engaged to audit" rather than "we have audited" since, because of the scope limitation, the auditor was not able to perform an audit in accordance with generally accepted auditing standards. In addition, the last sentence of the first paragraph is also deleted, because of the scope limitation, to eliminate the reference to the auditor's responsibility to express an opinion. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

A continuing auditor is one who has audited the financial statements of the current period and of one or more consecutive periods immediately prior to the current period. If one firm of independent auditors merges with another firm and the new firm becomes the auditor of a former client of one of the former firms, the new firm may accept responsibility and express an opinion on the financial statements for the prior period(s), as well as for those of the current period. In such circumstances, the new firm should follow the guidance in paragraphs .65 through .69 and may indicate in its report or signature that a merger took place and may name the firm of independent auditors that was merged with it. If the new firm decides not to express an opinion on the prior-period financial statements, the guidance in paragraphs .70 through .74 should be followed. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

An updated report on prior-period financial statements should be distinguished from a reissuance of a previous report (see section 530, Dating of the Independent Auditor's Report, paragraphs .06 through .08), since in issuing an updated report the continuing auditor considers information that he or she has become aware of during his or her audit of the current-period financial statements (see paragraph .68) and because an updated report is issued in conjunction with the auditor's report on the current-period financial statements. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

A continuing auditor need not report on the prior-period financial statements if only summarized comparative information of the prior period(s) is presented. For example, entities such as state and local governmental units frequently present total-all-funds information for the prior period(s) rather than information by individual funds because of space limitations or to avoid cumbersome or confusing formats. Also, not-for-profit organizations frequently present certain information for the prior period(s) in total rather than by net asset class. In some circumstances, the client may request the auditor to express an opinion on the prior period(s) as well as the current period. In those circumstances, the auditor should consider whether the information included for the prior period(s) contains sufficient detail to constitute a fair presentation in conformity with generally accepted accounting principles. In most cases, this will necessitate including additional columns or separate detail by fund or net asset class, or the auditor would need to modify his or her report. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000. Revised, April 2002, to reflect conforming changes necessary due to the issuance of FASB Statement No. 117.]



It is assumed that the independent auditor has been able to satisfy himself or herself as to the consistency of application of generally accepted accounting principles. See PCAOB Auditing Standard No. 6, Evaluating Consistency of Financial Statements, for a discussion of consistency. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995; the former footnote 29 has been deleted and subsequent footnotes renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

See footnote 17. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

It is recognized that there may be reasons why a predecessor auditor's report may not be reissued and this section does not address the various situations that could arise. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

See section 333, Management Representations, appendix C [paragraph .18], "Illustrative Updating Management Representation Letter." [Footnote added, effective for reports reissued on or after June 30, 1998, by Statement on Auditing Standards No. 85. Footnote renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

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The successor auditor should not name the predecessor auditor in his or her report; however, the successor auditor may name the predecessor auditor if the predecessor auditor's practice was acquired by, or merged with, that of the successor auditor. [Footnote renumbered by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 85, November 1997. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

If the predecessor's report was issued before the effective date of this section and contained an uncertainties explanatory paragraph, a successor auditor's report issued or reissued after the effective date hereof should not make reference to the predecessor's previously required explanatory paragraph. [Footnote added, effective for reports issued or reissued on or after February 29, 1996, by Statement on Auditing Standards No. 79. Footnote renumbered by the issuance of Statement on Auditing Standards No. 85, November 1997. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

[Footnote renumbered and deleted by the issuance of Statement on Auditing Standards No. 79, December 1995. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 85, November 1997. Footnote subsequently renumbered by the issuance of Statement on Auditing Standards No. 93, October 2000.]

Copyright © 2001, 2002, 2003, 2004, American Institute of Certified Public Accountants, Inc.


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EXHIBIT D



Audit Evidence

Effective Date: For audits of fiscal years beginning on or after Dec. 15, 2010

Final Rule: PCAOB Release No. 2010-004

SUMMARY TABLE OF CONTENTS

(1 - 2) Introduction(3) Objective(4 - 10) Sufficient Appropriate Audit Evidence(11 - 12) Financial Statement Assertions(13 - 21) Audit Procedures for Obtaining Audit Evidence (22 - 28) Selecting Items for Testing to Obtain Audit Evidence (29) Inconsistency in, or Doubts about the Reliability of, Audit Evidence

Introduction

1. This standard explains what constitutes audit evidence and establishes requirements regarding designing and performing audit procedures to obtain sufficient appropriate audit evidence.

2. Audit evidence is all the information, whether obtained from audit procedures or other sources, that is used by the auditor in arriving at the conclusions on which the auditor's opinion is based. Audit evidence consists of both information that supports and corroborates management's assertions regarding the financial statements or internal control over financial reporting and information that contradicts such assertions.

Objective

3. The objective of the auditor is to plan and perform the audit to obtain appropriate audit evidence that is sufficient to support the opinion expressed in the auditor's report.

Sufficient Appropriate Audit Evidence

4. The auditor must plan and perform audit procedures to obtain sufficient appropriate audit evidence to provide a reasonable basis for his or her opinion.

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5. Sufficiency is the measure of the quantity of audit evidence. The quantity of audit evidence needed is affected by the following:

Risk of material misstatement (in the audit of financial statements) or the risk associated with the control (in the audit of internal control over financial reporting). As the risk increases, the amount of evidence that the auditor should obtain also increases. For example, ordinarily more evidence is needed to respond to significant risks.

Quality of the audit evidence obtained. As the quality of the evidence increases, the need for additional corroborating evidence decreases. Obtaining more of the same type of audit evidence, however, cannot compensate for the poor quality of that evidence.

6. Appropriateness is the measure of the quality of audit evidence, i.e., its relevance and reliability. To be appropriate, audit evidence must be both relevant and reliable in providing support for the conclusions on which the auditor's opinion is based.

RELEVANCE AND RELIABILITY

7. Relevance. The relevance of audit evidence refers to its relationship to the assertion or to the objective of the control being tested. The relevance of audit evidence depends on:

a. The design of the audit procedure used to test the assertion or control, in particular whether it is designed to (1) test the assertion or control directly and (2) test for understatement or overstatement; and

b. The timing of the audit procedure used to test the assertion or control.

8. Reliability. The reliability of evidence depends on the nature and source of the evidence and the circumstances under which it is obtained. For example, in general:

Evidence obtained from a knowledgeable source that is independent of the company is more reliable than evidence obtained only from internal company sources.

The reliability of information generated internally by the company is increased when the company's controls over that information are effective.

Evidence obtained directly by the auditor is more reliable than evidence obtained indirectly.

Evidence provided by original documents is more reliable than evidence provided by photocopies or facsimiles, or documents that have been filmed, digitized, or otherwise converted into electronic form, the reliability of which depends on the controls over the conversion and maintenance of those documents.

9. The auditor is not expected to be an expert in document authentication. However, if conditions indicate that a document may not be authentic or that the terms in a document have been modified but that the modifications have not been disclosed to the auditor, the auditor should modify the planned audit procedures or perform additional audit procedures to respond to those conditions and should evaluate the effect, if any, on the other aspects of the audit.

USING INFORMATION PRODUCED BY THE COMPANY

10. When using information produced by the company as audit evidence, the auditor should evaluate whether the information is sufficient and appropriate for purposes of the audit by performing procedures to:

Test the accuracy and completeness of the information, or test the controls over the accuracy and completeness of that information; and

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Evaluate whether the information is sufficiently precise and detailed for purposes of the audit.

Financial Statement Assertions

11. In representing that the financial statements are presented fairly in conformity with the applicable financial reporting framework, management implicitly or explicitly makes assertions regarding the recognition, measurement, presentation, and disclosure of the various elements of financial statements and related disclosures. Those assertions can be classified into the following categories:

Existence or occurrence – Assets or liabilities of the company exist at a given date, and recorded transactions have occurred during a given period.

Completeness – All transactions and accounts that should be presented in the financial statements are so included.

Valuation or allocation – Asset, liability, equity, revenue, and expense components have been included in the financial statements at appropriate amounts.

Rights and obligations – The company holds or controls rights to the assets, and liabilities are obligations of the company at a given date.

Presentation and disclosure – The components of the financial statements are properly classified, described, and disclosed.

12. The auditor may base his or her work on financial statement assertions that differ from those in this standard if the assertions are sufficient for the auditor to identify the types of potential misstatements and to respond appropriately to the risks of material misstatement in each significant account and disclosure that has a reasonable possibility of containing misstatements that would cause the financial statements to be materially misstated, individually or in combination with other misstatements.

Audit Procedures for Obtaining Audit Evidence

13. Audit procedures can be classified into the following categories:

a. Risk assessment procedures, and

b. Further audit procedures, which consist of:

(1) Tests of controls, and

(2) Substantive procedures, including tests of details and substantive analytical procedures.

14. Paragraphs 15-21 of this standard describe specific audit procedures. The purpose of an audit procedure determines whether it is a risk assessment procedure, test of controls, or substantive procedure.

INSPECTION

15. Inspection involves examining records or documents, whether internal or external, in paper form, electronic form, or other media, or physically examining an asset. Inspection of records and documents provides audit evidence of varying degrees of reliability, depending on their nature and source and, in the case of internal records and documents, on the effectiveness of the controls over their production. An example of inspection used as a test of controls is inspection of records for evidence of authorization.

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OBSERVATION

16. Observation consists of looking at a process or procedure being performed by others, e.g., the auditor's observation of inventory counting by the company's personnel or the performance of control activities. Observation can provide audit evidence about the performance of a process or procedure, but the evidence is limited to the point in time at which the observation takes place and also is limited by the fact that the act of being observed may affect how the process or procedure is performed.

INQUIRY

17. Inquiry consists of seeking information from knowledgeable persons in financial or nonfinancial roles within the company or outside the company. Inquiry may be performed throughout the audit in addition to other audit procedures. Inquiries may range from formal written inquiries to informal oral inquiries. Evaluating responses to inquiries is an integral part of the inquiry process.

Note: Inquiry of company personnel, by itself, does not provide sufficient audit evidence to reduce audit risk to an appropriately low level for a relevant assertion or to support a conclusion about the effectiveness of a control.

CONFIRMATION

18. A confirmation response represents a particular form of audit evidence obtained by the auditor from a third party in accordance with PCAOB standards.

RECALCULATION

19. Recalculation consists of checking the mathematical accuracy of documents or records. Recalculation may be performed manually or electronically.

REPERFORMANCE

20. Reperformance involves the independent execution of procedures or controls that were originally performed by company personnel.

ANALYTICAL PROCEDURES

21. Analytical procedures consist of evaluations of financial information made by a study of plausible relationships among both financial and nonfinancial data. Analytical procedures also encompass the investigation of significant differences from expected amounts.

Selecting Items for Testing to Obtain Audit Evidence

22. Designing substantive tests of details and tests of controls includes determining the means of selecting items for testing from among the items included in an account or the occurrences of a control. The auditor should determine the means of selecting items for testing to obtain evidence that, in combination with other relevant evidence, is sufficient to meet the objective of the audit procedure. The alternative means of selecting items for testing are:

Selecting all items;

Selecting specific items; and

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Audit sampling.

23. The particular means or combination of means of selecting items for testing that is appropriate depends on the nature of the audit procedure, the characteristics of the control or the items in the account being tested, and the evidence necessary to meet the objective of the audit procedure.

SELECTING ALL ITEMS

24. Selecting all items (100 percent examination) refers to testing the entire population of items in an account or the entire population of occurrences of a control (or an entire stratum within one of those populations). The following are examples of situations in which 100 percent examination might be applied:

The population constitutes a small number of large value items;

The audit procedure is designed to respond to a significant risk, and other means of selecting items for testing do not provide sufficient appropriate audit evidence; and

The audit procedure can be automated effectively and applied to the entire population.

SELECTING SPECIFIC ITEMS

25. Selecting specific items refers to testing all of the items in a population that have a specified characteristic, such as:

Key items. The auditor may decide to select specific items within a population because they are important to accomplishing the objective of the audit procedure or exhibit some other characteristic, e.g., items that are suspicious, unusual, or particularly risk-prone or items that have a history of error.

All items over a certain amount. The auditor may decide to examine items whose recorded values exceed a certain amount to verify a large proportion of the total amount of the items included in an account.

26. The auditor also might select specific items to obtain an understanding about matters such as the nature of the company or the nature of transactions.

27. The application of audit procedures to items that are selected as described in paragraphs 25-26 of this standard does not constitute audit sampling, and the results of those audit procedures cannot be projected to the entire population.

AUDIT SAMPLING

28. Audit sampling is the application of an audit procedure to less than 100 percent of the items within an account balance or class of transactions for the purpose of evaluating some characteristic of the balance or class.

Inconsistency in, or Doubts about the Reliability of, Audit Evidence

29. If audit evidence obtained from one source is inconsistent with that obtained from another, or if the auditor has doubts about the reliability of information to be used as audit evidence, the auditor should perform the audit procedures necessary to resolve the matter and should determine the effect, if any, on other aspects of the audit.

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Auditing Standard No. 14, Evaluating Audit Results, establishes requirements regarding evaluating whether sufficient appropriate evidence has been obtained. Auditing Standard No. 3, Audit Documentation, establishes requirements regarding documenting the procedures performed, evidence obtained, and conclusions reached in an audit.

Paragraph A5 of Auditing Standard No. 12, Identifying and Assessing Risks of Material Misstatement.

When using the work of a specialist engaged or employed by management, see AU sec. 336, Using the Work of a Specialist. When using information produced by a service organization or a service auditor's report as audit evidence, see AU sec. 324, Service Organizations, and for integrated audits, see Auditing Standard No. 5, An Audit of Internal Control Over Financial Reporting That Is Integrated with An Audit of Financial Statements.

There is a reasonable possibility of an event, as used in this standard, when the likelihood of the event is either "reasonably possible" or "probable," as those terms are used in the FASB Accounting Standards Codification, Contingencies Topic, paragraph 450-20-25-1.

For an integrated audit, also see paragraph 28 of Auditing Standard No. 5.

Auditing Standard No. 12.

Auditing Standard No. 13, The Auditor's Responses to the Risks of Material Misstatement.

AU sec. 331, Inventories, establishes requirements regarding observation of the counting of inventory.

AU sec. 333, Management Representations, establishes requirements regarding written management representations, including confirmation of management responses to oral inquiries.

AU sec. 330, The Confirmation Process.

AU sec. 329, Substantive Analytical Procedures, establishes requirements on performing analytical procedures as substantive procedures.

If misstatements are identified in the selected items, see paragraphs 12-13 and paragraphs 17-19 of Auditing Standard No. 14.

AU sec. 350, Audit Sampling, establishes requirements regarding audit sampling.

[Effective pursuant to SEC Release No. 34-63606, File No. PCAOB-2010-01 (December 23, 2010)]

© Copyright 2003 - 2015 Public Company Accounting Oversight Board. All Rights Reserved.

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EXHIBIT E


10-K 1 valeant2015form10-k.htm 10-K

UNITED STATESSECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549_____________________________

FORM 10-KANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2015OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from to

Commission file number 001-14956

VALEANT PHARMACEUTICALS INTERNATIONAL, INC.(Exact Name of Registrant as Specified in its Charter)

BRITISH COLUMBIA, CANADAState or other jurisdiction ofincorporation or organization

98-0448205(I.R.S. Employer Identification No.)

2150 St. Elzéar Blvd. WestLaval, Quebec

Canada, H7L 4A8(Address of principal executive offices)

Registrant's telephone number, including area code (514) 744-6792

Securities registered pursuant to Section 12(b) of the Act:

Title of each class Name of each exchange on which registered

Common Shares, No Par Value New York Stock Exchange, Toronto Stock ExchangeSecurities registered pursuant to section 12(g) of the Act:

None(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer Accelerated filer Non-accelerated filer Smaller reporting company (Do not check if a smaller reporting company)

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No

The aggregate market value of the common shares held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter was $75,445,451,000 based on the last reported sale price on the New York Stock Exchange on June 30, 2015.

The number of outstanding shares of the registrant’s common stock as of April 22, 2016 was 343,019,770.

DOCUMENTS INCORPORATED BY REFERENCE

Part III incorporates certain information by reference from the registrant’s proxy statement for the 2016 Annual Meeting of Shareholders. Such proxy statement will be filed no later than 120 days after the close of the registrant’s fiscal year ended December 31, 2015.

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EXPLANATORY NOTE

This Annual Report on Form 10-K for the year ended December 31, 2015 includes consolidated financial statements for the years ended December 31, 2013, 2014 and 2015. The audited consolidated financial statements for the year ended December 31, 2014 are restated. Valeant Pharmaceuticals International, Inc. and its subsidiaries (the “Company”) has also restated certain unaudited quarterly results related to the three months ended December 31, 2014, the three months ended March 31, 2015, the six months ended June 30, 2015, and the nine months ended September 30, 2015.

Restatement Background

On October 26, 2015, in light of allegations regarding the Company’s relationship with the Philidor Rx Services, LLC (“Philidor”) pharmacy network, the Company’s Board of Directors (the “Board”) established an ad hoc committee of independent directors of the Board (the “Ad Hoc Committee”) to review these allegations and related matters (the “AHC Review”). The scope of the review conducted by the Ad Hoc Committee was subsequently broadened to encompass other areas of potential concern, unrelated to Philidor, raised during the course of the review. The Ad Hoc Committee was chaired by Robert Ingram, the Company’s current independent chairman of the board (and formerly the Company’s lead independent director). Other members included Norma Provencio, chairperson of the Audit and Risk Committee (the “ARC”), Colleen Goggins, and Mason Morfit. The Ad Hoc Committee engaged the law firm of Kirkland & Ellis LLP to assist and advise in carrying out the AHC Review. On February 22, 2016, the Company announced that, based on the work of the Ad Hoc Committee, as well as additional work and analysis performed by the Company, the Company had preliminarily identified certain revenue on sales transactions to Philidor during the second half of 2014, prior to the Company entering into a purchase option to acquire Philidor, that should have been recognized when product was dispensed to patients rather than on delivery to Philidor.

On March 21, 2016, management of the Company, the ARC and the Board concluded that the Company’s audited financial statements for the year ended, and unaudited financial information for the quarter ended, December 31, 2014 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014 and the unaudited financial statements for the quarter ended March 31, 2015 included in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2015 should no longer be relied upon due to the misstatements and other qualitative factors described below. In addition, due to the fact that the first quarter 2015 results are included within the financial statements for the six-month period ended June 30, 2015 included in the Quarterly Report on Form 10-Q for the quarter ended June 30, 2015 and the financial statements for the nine-month period ended September 30, 2015 included in the Quarterly Report on Form 10-Q for the quarter ended September 30, 2015, management, the ARC and the Board also concluded that the financial statements for such six-month and nine-month periods reflected in those Quarterly Reports should no longer be relied upon. This determination was based on the AHC Review and additional work and analysis performed by the Company. Based on this work, the Company determined that the earnings impact of certain revenue transactions should have been recognized at a later date than when originally recognized.

As previously disclosed, on December 15, 2014, the Company entered into a purchase option agreement with Philidor and its members in which the Company received an exclusive option to acquire 100% of the equity interest in Philidor, and as of which time Philidor was consolidated with the Company for accounting purposes as a variable interest entity for which the Company was the primary beneficiary. Prior to consolidation, revenue on sales to Philidor was recognized by the Company on a sell-in basis (i.e., recorded when the Company delivered product to Philidor). In connection with the work of the Ad Hoc Committee, the Company determined that certain sales transactions for deliveries to Philidor in the second half of 2014 leading up to the execution of the purchase option agreement were not executed in the normal course of business under applicable accounting standards and included actions taken by the Company (including fulfillment of unusually large orders with extended payment terms and increased pricing, an emphasis on delivering product prior to the execution of the purchase option agreement and seeking and filling a substitute order of equivalent value for an unavailable product) in contemplation of the purchase option agreement. As a result of these actions, revenue for certain transactions completed prior to entry into the purchase option agreement should have been recognized on a sell-through basis (i.e., record revenue when Philidor dispensed the products to patients) rather than incorrectly recognized on the sell-in basis utilized by the Company. Additionally, related to these and certain earlier transactions, the Company has now concluded that collectability was not reasonably assured at the time the revenue was originally recognized, and, thus, these transactions should have been recognized at a later date (when collectability was reasonably assured which the Company determined coincides with when the inventory is sold through to the

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end customer) instead of on a sell-in basis. Following the consolidation of Philidor on the date of entry into the purchase option agreement, the Company began recognizing revenue as Philidor dispensed product to patients.

On April 5, 2016, the Company announced that the Ad Hoc Committee had determined that its review was complete, and that the Ad Hoc Committee had not identified any additional items that would require restatement beyond those required by matters previously disclosed. In addition, the Company announced that, given the completion of the AHC Review, the Board had determined to dissolve the Ad Hoc Committee and that the 12 independent directors on the Board, including the members of the ARC, would assume oversight responsibility for remaining work, including work associated with the completion of the Company's current and restated financial statements and disclosures, as well as its assessment of related internal controls and remediation matters.

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Impact of Restatement

The Company has identified misstatements that reduce previously reported fiscal year 2014 revenue by approximately $58 million, net income attributable to Valeant Pharmaceuticals International, Inc. by approximately $33 million, and basic and diluted earnings per share by $0.09 (as compared to the previously reported amounts for fiscal year 2014 of $8,264 million for revenue, $914 million for net income attributable to Valeant Pharmaceuticals International, Inc. and $2.72 and $2.67 for basic and diluted earnings per share, respectively). A substantial part of the earnings impact of these misstatements reversed in the first quarter of 2015. The Company has also identified misstatements in the first quarter of 2015, consisting primarily of the reversing effect on earnings of the 2014 misstatements, which reduce revenue by approximately $21 million (due to timing of recognition of and impact of consolidation for managed care rebates), increase net income attributable to Valeant Pharmaceuticals International, Inc. by approximately $24 million and increase basic and diluted earnings per share by $0.07 (as compared to the previously reported first quarter 2015 amounts of $2,191 million for revenue, $74 million for net income attributable to Valeant Pharmaceuticals International, Inc. and $0.22 and $0.21 for basic and diluted earnings per share, respectively).

Internal Control Over Financial Reporting and Disclosure Controls and Procedures

Based on the results of the AHC Review, the Company's review of its financial records, and other work completed by management, the Company and the ARC have concluded that material weaknesses in the Company's internal control over financial reporting existed that contributed to the material misstatements in the consolidated financial statements described above. These material weaknesses relate to the tone at the top of the organization and the accounting and disclosure for non-standard revenue transactions particularly at or near quarter ends. The improper conduct of the Company’s former Chief Financial Officer and former Corporate Controller, which resulted in the provision of incorrect information to the ARC and the Company’s independent registered public accounting firm, contributed to the misstatement of financial results. In addition, as part of this assessment of internal control over financial reporting, the Company has determined that the tone at the top of the organization, with its performance-based environment, in which challenging targets were set and achieving those targets was a key performance expectation, may have been a contributing factor resulting in the Company’s improper revenue recognition and the conduct described above.

In connection with the Ad Hoc Committee’s work, certain remediation actions have been recommended, and the Company is in the process of implementing them. For further information regarding management’s assessment of internal control over financial reporting and disclosure controls and procedures, as well as the related remediation actions, refer to Item 9A "Controls and Procedures" of this Form 10-K.

More Information

Note 2 titled “RESTATEMENT” to the Company's consolidated financial statements discloses the nature of the restatement matters and adjustments and shows the impact of the restatement matters on the Company's consolidated financial statements for 2014. Note 25 titled "SUMMARY QUARTERLY INFORMATION (UNAUDITED)" to the Company's consolidated financial statements discloses the nature of the restatement matters and adjustments and shows the impact of the restatement matters on the Company's consolidated financial information for the three months ended December 31, 2014 and on the Company's consolidated financial statements for the three months ended March 31, 2015, the six months ended June 30, 2015, and the nine months ended September 30, 2015. This footnote also discloses the impact of related revisions to the Company's consolidated financial statements for the three months and nine months ended September 30, 2014.

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Item 1A. Risk Factors

Our business, financial condition, cash flows and results of operations are subject to various risks and uncertainties. You should carefully consider the risks and uncertainties described below, together with all of the other information in this Form 10-K, including those risks set forth under the heading entitled “Forward-Looking Statements”, and in other documents that we file with the SEC and the CSA, before making any investment decision with respect to our common shares or debt securities. If any of the risks or uncertainties actually occur or develop, our business, financial condition, cash flows, results of operations and/or future growth prospects could change, and such change could be materially adverse. Under these circumstances, the market value of our common shares and/or debt securities could decline, and you could lose all or part of your investment in our common shares and/or debt securities.

Restatement and Related Risks

The restatement of our previously issued financial statements has been time-consuming and expensive and could expose us to additional risks that could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline.

As discussed herein, we have restated our previously issued audited financial statements for the year ended December 31, 2014 and the unaudited financial information for the quarter ended December 31, 2014 included in our Annual Report on Form 10-K for the year ended December 31, 2014 and the unaudited financial statements for the quarter ended March 31, 2015 included in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2015, as well as the financial statements for the six-month period ended June 30, 2015 included in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2015 and the nine-month period September 30, 2015 included in our Quarterly Report on Form 10-Q for the quarter ended September 30, 2015 (due to the fact that the financial results for the quarter ended March 31, 2015 are included within these financial statements). This restatement (including the review of the misstatements that necessitated our restatement of our financial statements) has been time consuming and expensive and could expose us to potential claims and additional risks that could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline. In particular, we have incurred substantial unanticipated expenses and costs, including audit, legal, consulting and other professional fees, in connection with the completed review conducted by the Ad Hoc Committee, the restatement of our previously issued financial statements and the ongoing remediation of material weaknesses in our internal control over financial reporting. Certain remediation actions have been recommended and we are in the process of implementing them (see Item 9A "Controls and Procedures" of this Form 10-K for a description of these remediation measures). To the extent these steps are not successful, we could be forced to incur additional time and expense. Our management’s attention has also been diverted from the operation of our business in connection with the restatement and these ongoing remediation efforts. In addition, as a result of these restatements, we could be subject to additional shareholder, governmental, or other actions in connection with the restatements or related or other matters. Any such proceedings would, regardless of the outcome, consume a significant amount of management’s time and attention and would result in additional legal, accounting and other costs. If we were not to prevail in any such proceedings, we could be required to pay substantial damages or settlement costs. In addition, the restatements and related matters could further impair our reputation or could lead to a further loss of investor confidence. Furthermore, this restatement and any future restatements may result in further downgrades by rating agencies in our corporate credit ratings, which may impact, among other things, our ability to raise debt and the cost of capital for additional debt issuances.

We have identified material weaknesses in our internal control over financial reporting which could, if not remediated, adversely affect our ability to report our financial condition, cash flows and results of operations in a timely and accurate manner and/or increase the risk of future misstatements, which could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/ordebt securities to decline.

Our management is responsible for establishing and maintaining adequate internal control over our financial reporting, as defined in Rule 13a-15(f) under the Exchange Act. Based on the review by the Ad Hoc Committee, the Company's review of its financial records, and other work completed by management, the Company and the ARC have concluded that material weaknesses in the Company's internal control over financial reporting existed that contributed to the material misstatements in the consolidated financial statements described above. As a result, certain remediation actions have been recommended and

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we are in the process of implementing them, but our remediation efforts are not complete and are ongoing. If we do not complete our remediation in a timely manner or if our remedial measures are insufficient to address the material weaknesses, or if additional material weaknesses in our internal controls are discovered or occur in the future, it may materially adversely affect our ability to report our financial condition and results of operations in a timely and accurate manner and there will continue to be an increased risk of future misstatements. Although we regularly review and evaluate internal control systems to allow management to report on the effectiveness of our internal control over financial reporting, we may discover additional weaknesses in our internal control over financial reporting or disclosure controls and procedures. The next time we evaluate our internal control over financial reporting and disclosure controls and procedures, if we identify one or more new material weaknesses or have been unable to timely remediate

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our existing material weaknesses, we would be unable to conclude that our internal control over financial reporting or disclosure controls and procedures are effective. If we are unable to conclude that our internal control over financial reporting or our disclosure controls and procedures are effective, or if our independent registered public accounting firm expresses an opinion that our internal control over financial reporting is ineffective, we may not be able to report our financial condition and results of operations in a timely and accurate manner, which could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline. In addition, any potential future restatements could subject us to additional adverse consequences, including sanctions or investigations by the SEC or the CSA, shareholder litigation and other adverse actions. Moreover, we may be the subject of further negative publicity focusing on the financial statement adjustments and resulting restatement and negative reactions from our shareholders, creditors or others with whom we do business. The occurrence of any of the foregoing could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline.

Delays in the filing of future Exchange Act reports, the related financial statements and other required securities reporting obligations may result in a default under one or more of the indentures governing our outstanding senior notes and/or under our Credit Agreement, which could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline.

If any future misstatements, restatements or material weaknesses in our internal control over financial reporting and disclosure controls and procedures are discovered or occur, this may result in a delay in filing future Exchange Act reports and other required filings under applicable securities laws.

Under the indentures governing our outstanding senior notes, if we do not file required reports within specified time periods, we will be in default due to the breach of the reporting covenant in the indentures and the trustee or holders of at least 25% of any series of notes may deliver a notice of default for such series of notes. If we do not cure this default by filing the delayed report within a 60-day cure period, the notes may be accelerated by the trustee or holders of at least 25% of the series of notes that provided the notice of default. Furthermore, the occurrence of a default in the reporting covenant under any of our senior note indentures would result in a cross default under our Credit Agreement which would impact our ability to draw on our revolving credit facility and could lead to an acceleration of the Credit Agreement.

The acceleration of one series of notes could result in a cross acceleration to other series of notes or the loans under the Credit Agreement, and the acceleration of the loans under the Credit Agreement could result in a cross acceleration to our senior notes. If any of our notes or any of the loans under our Credit Agreement are accelerated, we may not have sufficient funds to satisfy our debt obligations. While we may be successful in obtaining relief or an extension of time under the indentures and/or the Credit Agreement, we cannot guarantee that such relief or extension would be granted or, if granted, would provide us with a sufficient period of time to cure the reporting default. In addition, in order to obtain any such relief or extension, we may be required to accept terms that are adverse to us and we may incur significant costs.

Under our Credit Agreement, if we do not file required reports within specified time periods, we will be in breach of the reporting covenant in the Credit Agreement, which would permit a majority of the lenders in principal amount thereunder to accelerate the loans if we do not cure the default within a specified cure period. Although the April 2016 amendment extends the deadline to file our First Quarter 2016 Form 10-Q under our Credit Agreement to July 31, 2016, we may be delayed in filing beyond such date and we may be delayed in filing other required reports, any of which could result in a default under our Credit Agreement. In addition, while the filing of this Form 10-K has cured the default under our senior note indentures triggered by the failure to timely file this Form 10-K, any future delays in our required Exchange Act filings may result in additional defaults under our senior note indentures. Under the terms of our senior note indentures, if we do not file the First Quarter 2016 Form 10-Q by May 16, 2016, we will be in default under the terms of our senior note indentures. Although the April 2016 amendment waives any cross default that would be triggered under our Credit Agreement as a result of this default under the senior note indentures, the April 2016 amendment does not prevent the trustee or the holders under any of our senior note indentures from delivering a notice of default should we be delayed in filing the First Quarter 2016 Form 10-Q beyond the deadline for the filing of such report set forth in the applicable indenture. Any such notice of default related to a late filing of our First Quarter 2016 Form 10-Q may result in shortening the extended deadline of July 31, 2016 for filing such First Quarter 2016 Form 10-Q under the Credit Agreement.

Page 39 of 39410-K



We may also face further reputational harm or loss of investor confidence as a result of any future delays in the filing of Exchange Act reports or other required filings under applicable securities laws, including as a result of the expected delay in filing our First Quarter 2016 Form 10-Q.

A delay in making any of our required securities filings and the associated default under any of our indentures or Credit Agreement could have a material adverse effect on our business, financial condition, cash flows and results of operations and could cause the market value of our common shares and/or debt securities to decline.

12

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VALEANT PHARMACEUTICALS INTERNATIONAL, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(All tabular dollar amounts expressed in millions of U.S. dollars, except per share data)

beneficiary. Prior to consolidation, revenue on sales to Philidor was recognized by the Company on a sell-in basis (i.e., recorded when the Company delivered product to Philidor). In connection with the work of the Ad Hoc Committee, the Company determined that certain sales transactions for deliveries to Philidor in the second half of 2014 leading up to the execution of the purchase option agreement were not executed in the normal course of business under applicable accounting standards and included actions taken by the Company (including fulfillment of unusually large orders with extended payment terms and increased pricing, an emphasis on delivering product prior to the execution of the purchase option agreement and seeking and filling a substitute order of equivalent value for an unavailable product) in contemplation of the purchase option agreement. As a result of these actions, revenue for certain transactions completed prior to entry into the purchase option agreement should have been recognized on a sell-through basis (i.e., record revenue when Philidor dispensed the products to patients) rather than incorrectly recognized on the sell-in basis utilized by the Company. Additionally, related to these and certain earlier transactions, the Company has now concluded that collectability was not reasonably assured at the time the revenue was originally recognized, and, thus, these transactions should have been recognized at a later date (when collectability was reasonably assured which the Company determined coincides with when the inventory is sold through to the end customer) instead of on a sell-in basis. Following the consolidation of Philidor on the date of entry into the purchase option agreement, the Company began recognizing revenue as Philidor dispensed product to patients.

On April 5, 2016, the Company announced that the Ad Hoc Committee had determined that its review was complete, and that the Ad Hoc Committee had not identified any additional items that would require restatement beyond those required by matters previously disclosed. In addition, the Company announced that, given the completion of the AHC Review, the Board had determined to dissolve the Ad Hoc Committee and that the 12 independent directors on the Board, including the members of the ARC, would assume oversight responsibility for remaining work, including work associated with the completion of the Company's current and restated financial statements and disclosures, as well as its assessment of related internal controls and remediation matters.

Impact of Restatement

As a result of the foregoing, the Company has restated its financial statements for the year ended December 31, 2014. The restatement reduced revenue by approximately $58 million and reduced the Company's net income attributable to Valeant Pharmaceuticals International, Inc. and diluted earnings per share for the year ended December 31, 2014 by approximately $33 million and $0.09 per share, respectively.

The individual restatement matters that underlie the restatement adjustments are described below and are reflected and quantified, as applicable, in the footnotes to the below tables.

(a) Philidor revenue recognition adjustments - The correction of the misstatement from recognizing revenue related to sales to Philidor from a sell-in to sell-through basis had the effect of eliminating certain revenue recorded in 2014 prior to the date that Philidor was consolidated as a variable interest entity. The revenue that is being eliminated from 2014 does not result in an increase to revenue in subsequent periods as a result of the Company having previously recognized that revenue, subsequent to the consolidation of Philidor, when Philidor dispensed the product to patients. Under the sell-in method previously utilized by the Company with respect to sales to Philidor prior to its consolidation in December 2014, revenue was recognized upon delivery of the products to Philidor. At the date of consolidation, certain of that previously sold inventory was still held by Philidor. Subsequent to the consolidation, Philidor recognized revenue on that inventory when it dispensed products to patients, and that revenue was consolidated into the Company’s results. As long as those pre-consolidation sales transactions were in the normal course of business under applicable accounting standards and not entered into in contemplation of the purchase option agreement, the Company’s historical accounting for this revenue was in accordance with generally accepted accounting principles. The Company has now determined that certain sales transactions for deliveries to Philidor, leading up to the purchase option agreement, were not executed in the normal course of business under applicable accounting standards and included actions taken by the Company (including fulfillment of unusually large orders

Page 209 of 39410-K



with extended payment terms and increased pricing, an emphasis on delivering product prior to the execution of the purchase option agreement and seeking and filling a substitute order of equivalent value for an unavailable product) in contemplation of the purchase option agreement. As such, revenue, net of managed care rebates, of $58 million previously recorded in 2014 is now being corrected. However, because that revenue was also recorded by Philidor subsequent to consolidation, upon dispensing of products to patients, the elimination of this revenue in 2014, prior to consolidation, does not result in additional revenue being recorded in 2015. Additionally, provisions for managed care rebates of $21 million previously recorded in 2014 will now be recognized against that revenue in the first quarter of 2015.

F-11

Page 210 of 39410-K



VALEANT PHARMACEUTICALS INTERNATIONAL, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(All tabular dollar amounts expressed in millions of U.S. dollars, except per share data)

CONSOLIDATED STATEMENT OF INCOME(All dollar amounts expressed in millions of U.S. dollars, except per share data)

Year Ended December 31,2014

(As Previously Reported)

RestatementAdjustments

2014(Restated)

RestatementRef

Revenues

Product sales $ 8,103.6 $ (57.5) $ 8,046.1 (a)

Other revenues 159.9 — 159.9

8,263.5 (57.5) 8,206.0

Expenses

Cost of goods sold (Exclusive of amortization and impairments of

finite lived intangible assets shown separately below) 2,196.2 (18.5) 2,177.7 (a)

Cost of other revenues 58.4 — 58.4

Selling, general and administrative 2,026.3 — 2,026.3

Research and development 246.0 — 246.0

Amortization and impairment of finite-lived intangible assets 1,550.7 — 1,550.7

Restructuring, integration and other costs 381.7 — 381.7

In-process research and development impairments and other changes 41.0 — 41.0

Acquisition-related costs 6.3 — 6.3

Acquisition-related contingent consideration (14.1) — (14.1)

Other income (268.7) — (268.7)

6,223.8 (18.5) 6,205.3

Operating income (loss) 2,039.7 (39.0) 2,000.7

Interest income 5.0 — 5.0

Interest expense (971.0) — (971.0)

Loss on extinguishment of debt (129.6) — (129.6)

Foreign exchange and other (144.1) — (144.1)

Gain on investments, net 292.6 — 292.6

Income (loss) before provision for (recovery of) income taxes 1,092.6 (39.0) 1,053.6

Provision for (recovery of) income taxes 180.4 (6.2) 174.2 (c)

Net income (loss) 912.2 (32.8) 879.4

Less: Net income (loss) attributable to noncontrolling interest (1.3) — (1.3)

Net income (loss) attributable to Valeant Pharmaceuticals International, Inc. $ 913.5 $ (32.8) $ 880.7

Earnings (loss) per share attributable to Valeant Pharmaceuticals International, Inc.:

Basic $ 2.72 $ (0.09) $ 2.63

Diluted $ 2.67 $ (0.09) $ 2.58

Weighted-average common shares (in millions)

Basic 335.4 335.4

Diluted 341.5 341.5

Page 214 of 39410-K



F-14

Page 215 of 39410-K



EXHIBIT F


UNITED STATESSECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549_____________________________

FORM 10- Ký ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE

ACT OF 1934For the fiscal year ended December 31, 2014

ORo TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

EXCHANGE ACT OF 1934For the transition period from to

Commission file number 001- 14956VALEANT PHARMACEUTICALS INTERNATIONAL, INC.

(Exact Name of Registrant as Specified in its Charter)BRITISH COLUMBIA, CANADA

State or other jurisdiction ofincorporation or organization

98- 0448205(I.R.S. Employer Identification No.)

2150 St. Elzéar Blvd. WestLaval, Quebec

Canada, H7L 4A8(Address of principal executive offices)

Registrant's telephone number, including area code (514) 744- 6792Securities registered pursuant to Section 12(b) of the Act:

Title of each class Name of each exchange on which registeredCommon Shares, No Par Value New York Stock Exchange, Toronto Stock Exchange

Securities registered pursuant to section 12(g) of the Act:None

(Title of class)Indicate by check mark if the registrant is a well- known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No oIndicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No ýIndicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past90 days. Yes ý No oIndicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S- T during the preceding 12 months (or for such shorter period that the registrant was required to submit andpost such files). Yes ý No oIndicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S- K is not contained herein, and will not be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10- K or any amendment to this Form 10- K. oIndicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non- accelerated filer, or a smaller reporting company. See thedefinitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b- 2 of the Exchange Act. (Check one):

Large accelerated filer ý Accelerated filer o Non- accelerated filer o Smaller reporting company o(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b- 2 of the Exchange Act). Yes o No ýThe aggregate market value of the common shares held by non- affiliates of the registrant as of the last business day of the registrant’s most recently completed secondfiscal quarter was $37,219,586,000 based on the last reported sale price on the New York Stock Exchange on June 30, 2014.The number of outstanding shares of the registrant’s common stock as of February 18, 2015 was 336,202,718.

DOCUMENTS INCORPORATED BY REFERENCEPart III incorporates certain information by reference from the registrant’s proxy statement for the 2015 Annual Meeting of Shareholders. Such proxy statement will befiled no later than 120 days after the close of the registrant’s fiscal year ended December 31, 2014.


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Directors ofValeant Pharmaceuticals International, Inc.

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income (loss), comprehensive income (loss),shareholders’ equity, and cash flows present fairly, in all material respects, the financial position of Valeant Pharmaceuticals International, Inc. andits subsidiaries (the “Company”) at December 31, 2014 and December 31, 2013, and the results of their operations and their cash flows for each ofthe three years in the period ended December 31, 2014 in conformity with accounting principles generally accepted in the United States of America.In addition, in our opinion, the financial statement schedule appearing under item 15 (2) presents fairly, in all material respects, the information setforth therein, when read in conjunction with the related consolidated financial statements. Also in our opinion, the Company maintained, in allmaterial respects, effective internal control over financial reporting as of December 31, 2014, based on criteria established in Internal Control -Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company'smanagement is responsible for these financial statements and financial statement schedule, for maintaining effective internal control over financialreporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Managementon Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements, on the financial statementschedule, and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance withthe standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits toobtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control overfinancial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made bymanagement, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining anunderstanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design andoperating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considerednecessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions arerecorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts andexpenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could havea material effect on the financial statements.Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of anyevaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

/s/ PricewaterhouseCoopers LLPFlorham Park, New JerseyFebruary 25, 2015

F- 3


EXHIBIT G



AU Section 625Reports on the Application of Accounting Principles

(.01 - .06) Introduction(.07 - .09) Performance Standards(.10 - .11) Reporting Standards

Source: SAS No. 50; SAS No. 97.

Issue date, unless otherwise indicated: July, 1986.

Introduction

.01

There may be differing interpretations as to whether and, if so, how existing accounting principles apply to new transactions and financial products. Management and others often consult with accountants on the application of accounting principles to those transactions and products, or to increase their knowledge of specific financial reporting issues. Such consultations often provide relevant information and insights not otherwise available. [As amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

.02

For purposes of this section, reporting accountant refers to an accountant in public practice who prepares a written report or provides oral advice on the application of accounting principles to specified transactions involving facts and circumstances of a specific entity, or the type of opinion that may be rendered on a specific entity’s financial statements. Continuing accountant refers to an accountant who has been engaged to report on the financial statements of a specific entity. [Paragraph added, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

.03

This section provides guidance that a reporting accountant, either in connection with a proposal to obtain a new client or otherwise, should apply when preparing a written report on—

a. The application of accounting principles to specified transactions, either completed or proposed, involving facts and circumstances of a specific entity ("specific transactions").

b. The type of opinion that may be rendered on a specific entity's financial statements.

This section also applies to oral advice that the reporting accountant concludes is intended to be used by a principal to the transaction as an important factor considered in reaching a decision on the application of accounting principles to a specific transaction, or the type of opinion that may be rendered on a specific entity’s financial statements. [Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

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.04

Because of the nature of a transaction not involving facts or circumstances of a specific entity (“hypothetical transaction”), a reporting accountant cannot know, for example, whether the continuing accountant has reached a different conclusion on the application of accounting principles for the same or a similar transaction, or how the specific entity has accounted for similar transactions in the past. Therefore an accountant should not undertake an engagement to provide a written report on the application of accounting principles to a hypothetical transaction. [Paragraph added, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

.05

This section does not apply to a continuing accountant with respect to the specific entity whose financial statements he or she has been engaged to report on, to engagements either to assist in litigation involving accounting matters or to provide expert testimony in connection with such litigation, or to professional advice provided to another accountant in public practice. [Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

.06

This section also does not apply to communications such as position papers prepared by an accountant for the purpose of presenting views on an issue involving the application of accounting principles or the type of opinion that may be rendered. Position papers include newsletters, articles, speeches and texts thereof, lectures and other forms of public presentations, and letters for the public record to professional and governmental standard-setting bodies. However, if communications of the type discussed in this paragraph are intended to provide guidance on the application of accounting principles to a specific transaction, or on the type of opinion that may be rendered on a specific entity's financial statements, the provisions of this section should be followed. [Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

Performance Standards

.07

The reporting accountant should exercise due professional care in performing the engagement and should have adequate technical training and proficiency. The reporting accountant should also plan the engagement adequately, supervise the work of assistants, if any, and accumulate sufficient information to provide a reasonable basis for the professional judgment described in the report. The reporting accountant should consider the circumstances under which the written report or oral advice is requested, the purpose of the request, and the intended use of the written report or oral advice. [Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

.08

To aid in forming a judgment, the reporting accountant should perform the following procedures: (a) obtain an understanding of the form and substance of the transaction(s); (b) review applicable generally accepted accounting principles (see section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles); (c) if appropriate, consult with other professionals or experts; and (d) if appropriate, perform research or other procedures to ascertain and consider the existence of creditable precedents or analogies. [Paragraph renumbered by the issuance of Statement on Auditing Standards No. 97, June 2002.]

.09

When evaluating accounting principles that relate to a specific transaction or determining the type of opinion that may be rendered on a specific entity's financial statements, the reporting accountant should consult with the continuing accountant of the entity to ascertain all the available facts relevant to forming a professional judgment. The continuing accountant may provide information not otherwise available to the reporting accountant regarding, for example, the following: the form and substance of the transaction; how




management has applied accounting principles to similar transactions; whether the method of accounting recommended by the continuing accountant is disputed by management; or whether the continuing accountant has reached a different conclusion on the application of accounting principles or the type of opinion that may be rendered on the entity's financial statements. The reporting accountant should explain to the entity’s management the need to consult with the continuing accountant, request permission to do so, and request the entity’s management to authorize the continuing accountant to respond fully to the reporting accountant's inquiries. The responsibilities of an entity’s continuing accountant to respond to inquiries by the reporting accountant are the same as the responsibilities of a predecessor auditor to respond to inquiries by a successor auditor. See section 315, Communications Between Predecessor and Successor Auditors, paragraph .10. [Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

Reporting Standards

.10

The accountant's written report should be addressed to the requesting entity (for example, management or the board of directors of the entity), and should ordinarily include the following:

a. A brief description of the nature of the engagement and a statement that the engagement was performed in accordance with applicable AICPA standards.

b. Identification of the specific entity, a description of the transaction(s), a statement of the relevant facts, circumstances, and assumptions, and a statement about the source of the information.

c. A statement describing the appropriate accounting principle(s) (including the country of origin) to be applied or type of opinion that may be rendered on the entity's financial statements, and, if appropriate, a description of the reasons for the reporting accountant's conclusion.

d. A statement that the responsibility for the proper accounting treatment rests with the preparers of the financial statements, who should consult with their continuing accountant.

e. A statement that any difference in the facts, circumstances, or assumptions presented may change the report.

f. A separate paragraph at the end of the report that includes the following elements: ◦ A statement indicating that the report is intended solely for the information and use of the specified parties;

◦ An identification of the specified parties to whom use is restricted; and

◦ A statement that the report is not intended to be and should not be used by anyone other than the specified parties.

[Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

.11

The following is an illustration of sections of the report described in paragraph .10.

Introduction

We have been engaged to report on the appropriate application of accounting principles generally accepted in [country of origin of such principles] to the specific transaction described below. This report is being issued to ABC Company for assistance in evaluating accounting principles for the described specific transaction. Our engagement has been conducted in accordance with standards established by the American Institute of Certified Public Accountants.

Description of Transaction

The facts, circumstances, and assumptions relevant to the specific transaction as provided to us by the management of ABC Company are as follows:

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Appropriate Accounting Principles

[Text discussing generally accepted accounting principles]

Concluding Comments

The ultimate responsibility for the decision on the appropriate application of accounting principles generally accepted in [country of origin of such principles] for an actual transaction rests with the preparers of financial statements, who should consult with their continuing accountant. Our judgment on the appropriate application of accounting principles generally accepted in [country of origin of such principles] for the described specific transaction is based solely on the facts provided to us as described above; should these facts and circumstances differ, our conclusion may change.

Restricted Use

This report is intended solely for the information and use of the board of directors and management of ABC Company and is not intended to be and should not be used by anyone other than these specified parties.

[Paragraph renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

Footnotes (AU Section 625 — Reports on the Application of Accounting Principles):

Accounting principles include generally accepted accounting principles and other comprehensive bases of accounting. See section 623, Special Reports, paragraph .04 for a description of other comprehensive bases of accounting.

[Footnote deleted by the issuance of Statement on Auditing Standards No. 97, June 2002.]

See ET section 92.25 of the AICPA Code of Professional Conduct for a definition of “practice of public accounting.”

Written report, for purposes of this section, includes any written communication that expresses a conclusion on the appropriate accounting principle(s) to be applied or the type of opinion that may be rendered on an entity’s financial statements. [Footnote added, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

An accountant engaged by the entity to perform services other than reporting on the entity’s financial statements is not considered to be a continuing accountant. [Footnote added, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

Although the reporting standards in this section apply only to written reports, accountants may find this guidance useful in providing oral advice. [Footnote renumbered and amended, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]

See section 532, Restricting the Use of an Auditor’s Report. Although restricted, this is not intended to preclude distribution of the report to the continuing accountant. [Footnote added, effective for written reports issued or oral advice provided on or after June 30, 2002, by Statement on Auditing Standards No. 97.]



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EXHIBIT H



AU Section 230Due Professional Care in the Performance of Work

(.01 - .06)(.07 - .09) Professional Skepticism(.10 - .13) Reasonable Assurance

Source: SAS No. 1, section 230; SAS No. 41; SAS No. 82; SAS No. 99.

Issue date, unless otherwise indicated: November, 1972.

.01

The third general standard is:

Due professional care is to be exercised in the planning and performance of the audit and the preparation of the report.

[As amended, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.02

This standard requires the independent auditor to plan and perform his or her work with due professional care. Due professional care imposes a responsibility upon each professional within an independent auditor's organization to observe the standards of field work and reporting. [As amended, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.03

Cooley on Torts, a legal treatise, describes the obligation for due care as follows:

Every man who offers his services to another and is employed assumes the duty to exercise in the employment such skill as he possesses with reasonable care and diligence. In all these employments where peculiar skill is requisite, if one offers his services, he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employment, and if his pretentions are unfounded, he commits a species of fraud upon every man who employs him in reliance on his public profession. But no man, whether skilled or unskilled, undertakes that the task he assumes shall be performed successfully, and without fault or error; he undertakes for good faith and integrity, but not for infallibility, and he is liable to his employer for negligence, bad faith, or dishonesty, but not for losses consequent upon pure errors of judgment.

[As amended, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.04

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The matter of due professional care concerns what the independent auditor does and how well he or she does it. The quotation from Cooley on Torts provides a source from which an auditor's responsibility for conducting an audit with due professional care can be derived. The remainder of the section discusses the auditor's responsibility in the context of an audit. [As amended, April 1982, by Statement on Auditing Standards No. 41. As amended, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.05

An auditor should possess "the degree of skill commonly possessed" by other auditors and should exercise it with "reasonable care and diligence" (that is, with due professional care). [Paragraph added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.06



Auditors should be assigned to tasks and supervised commensurate with their level of knowledge, skill, and ability so that they can evaluate the audit evidence they are examining. The engagement partner should know, at a minimum, the relevant professional accounting and auditing standards and should be knowledgeable about the client. The engagement partner is responsible for the assignment of tasks to, and supervision of, the members of the engagement team.

Professional Skepticism

.07

Due professional care requires the auditor to exercise professional skepticism. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor uses the knowledge, skill, and ability called for by the profession of public accounting to diligently perform, in good faith and with integrity, the gathering and objective evaluation of evidence. [Paragraph added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.08

Gathering and objectively evaluating audit evidence requires the auditor to consider the competency and sufficiency of the evidence. Since evidence is gathered and evaluated throughout the audit, professional skepticism should be exercised throughout the audit process. [Paragraph added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

.09

The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest. [Paragraph added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

Reasonable Assurance

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[The following paragraph is effective for audits of fiscal years ending on or after November 15, 2007. See PCAOB Release 2007-005A .

For audits of fiscal years ending before November 15, 2007, click here.]

The exercise of due professional care allows the auditor to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud, or whether any material weaknesses exist as of the date of

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management's assessment. Absolute assurance is not attainable because of the nature of audit evidence and the characteristics of fraud. Although not absolute assurance, reasonable assurance is a high level of assurance. Therefore, an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States) may not detect a material weakness in internal control over financial reporting or a material misstatement to the financial statements.

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The independent auditor's objective is to obtain sufficient appropriate evidential matter to provide him or her with a reasonable basis for forming an opinion. The nature of most evidence derives, in part, from the concept of selective testing of the data being audited, which involves judgment regarding both the areas to be tested and the nature, timing, and extent of the tests to be performed. In addition, judgment is required in interpreting the results of audit testing and evaluating audit evidence. Even with good faith and integrity, mistakes and errors in judgment can be made. Furthermore, accounting presentations contain accounting estimates, the measurement of which is inherently uncertain and depends on the outcome of future events. The auditor exercises professional judgment in evaluating the reasonableness of accounting estimates based on information that could reasonably be expected to be available prior to the completion of field work. As a result of these factors, in the great majority of cases, the auditor has to rely on evidence that is persuasive rather than convincing.

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Because of the characteristics of fraud, a properly planned and performed audit may not detect a material misstatement. Characteristics of fraud include (a) concealment through collusion among management, employees, or third parties; (b) withheld, misrepresented, or falsified documentation; and (c) the ability of management to override or instruct others to override what otherwise appears to be effective controls. For example, auditing procedures may be ineffective for detecting an intentional misstatement that is concealed through collusion among personnel within the entity and third parties or among management or employees of the entity. Collusion may cause the auditor who has properly performed the audit to conclude that evidence provided is persuasive when it is, in fact, false. In addition, an audit conducted in accordance with generally accepted auditing standards rarely involves authentication of documentation, nor are auditors trained as or expected to be experts in such authentication. (See paragraph 9 of Auditing Standard No. 15, Audit Evidence.) Furthermore, an auditor may not discover the existence of a modification of documentation through a side agreement that management or a third party has not disclosed. Finally, management has the ability to directly or indirectly manipulate accounting records and present fraudulent financial information by overriding controls in unpredictable ways.

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[The following paragraph is effective for audits of fiscal years ending on or after November 15, 2007. See PCAOB Release 2007-005A .

For audits of fiscal years ending before November 15, 2007, click here.]

Since the auditor's opinion on the financial statements or internal control over financial reporting is based on the concept of obtaining reasonable assurance, the auditor is not an insurer and his or her report does not constitute a guarantee. Therefore, the subsequent discovery that either a material misstatement, whether from error or fraud, exists in the financial statements or a material weakness in internal control over financial reporting exists does not, in and of itself, evidence (a) failure to obtain reasonable assurance, (b) inadequate planning, performance, or judgment, (c) the absence of due professional care, or (d) a failure to comply with the standards of the Public Company Accounting Oversight Board (United States).

Footnotes (AU Section 230 — Due Professional Care in the Performance of Work):

[Title amended, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

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This amendment revises the third general standard of the ten generally accepted auditing standards. [Footnote added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

D. Haggard, Cooley on Torts, 472 (4th ed., 1932). [Footnote added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

[Footnote deleted, effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release No. 2010-004 . For

audits of fiscal years beginning before December 15, 2010, click here.]



See Auditing Standard No. 10, Supervision of the Audit Engagement.

See section 342, Auditing Accounting Estimates. [Footnote added, effective for audits of financial statements for periods ending on or after December 15, 1997, by Statement on Auditing Standards No. 82.]

[Footnote deleted, effective for audits of fiscal years beginning on or after December 15, 2010. See PCAOB Release No. 2010-004 . For

audits of fiscal years beginning before December 15, 2010, click here.]



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KING & SPALDING LLP






No. 3:15-CV-07658-MAS-LHG


All Actions.

[PROPOSED] ORDER GRANTING DEFENDANT PRICEWATERHOUSECOOPERS LLP’S MOTION TO DISMISS THE CONSOLIDATED COMPLAINT

THIS MATTER having come before this Court on motion brought by Defendant

PricewaterhouseCoopers LLP (“PwC”) seeking to dismiss Count VII of the Consolidated

Complaint [ECF 80] as to PwC, and this Court having considered all arguments and submissions

proffered by the parties in respect of this Motion, and for good cause having been shown, it is

ON THIS _________ day of ______________________, ____, hereby:

ORDERED that Defendant PwC’s Motion is hereby GRANTED; and it is


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FURTHER ORDERED that Count VII of the Complaint is dismissed as to PwC with

prejudice.

Honorable Michael A. Shipp, U.S.D.J.


KING & SPALDING LLP





IN RE VALEANT PHARMACEUTICALS INTERNATIONAL, INC. SECURITIES LITIGATION No. 3:15-CV-07658-MAS-LHG


All Actions.

CERTIFICATE OF SERVICE

I hereby certify that on September 13, 2016, I caused to be served by electronic case

filing on all counsel of record copies of: (i) Defendant PricewaterhouseCoopers LLP’s Notice of

Motion to Dismiss the Consolidated Complaint; (ii) the Memorandum of Law in Support of

Defendant PricewaterhouseCoopers LLP’s Motion to Dismiss the Consolidated Complaint; (iii)

the Declaration of James J. Capra, Jr. in Support of Defendant PricewaterhouseCoopers LLP’s

Motion to Dismiss the Consolidated Complaint and the exhibits attached thereto; and (iv) the

accompanying Proposed Order.


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/s/ A. Ross Pearlson A. Ross Pearlson

CHIESA SHAHINIAN & GIANTOMASI PC One Boland Drive West Orange, NJ 07052 Telephone: (973) 530-2100 Facsimile: (973) 530-2300 Attorneys for Defendant PricewaterhouseCoopers LLP


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