Auditing and Attestation- Certified Public Accountant (CPA) Practice Exam -

When financial statements are prepared on an income tax basis, where should the description of how that basis differs from GAAP be included?

1. Auditor's engagement letter.

2. Introductory paragraph of the auditor's report.

3. Management representation letter.

4. Notes to the financial statements.

The correct answer is: Notes to the financial statements.

When financial statements are prepared on an income tax basis, it is essential to provide users with clear and transparent information about the specific accounting principles used. Including the description of how this basis differs from Generally Accepted Accounting Principles (GAAP) in the notes to the financial statements is the appropriate approach. The notes to the financial statements serve as a detailed explanatory component that provides additional context, policies, and disclosures regarding the financial statements. This includes significant accounting policies, the basis of accounting, and any deviations from GAAP. By including the differences in this section, readers of the financial statements can better understand how income tax basis accounting may affect reported assets, liabilities, income, and expenses compared to GAAP reporting. This disclosure enhances the clarity and utility of the financial statements for stakeholders who may rely on them for decision-making. The other options do not serve the primary purpose of disclosing the basis of accounting differences effectively. For instance, the auditor's engagement letter outlines the scope and terms of the audit but is not meant for clarifying accounting bases. The introductory paragraph of the auditor's report typically summarizes the auditor’s responsibilities and the financial statements they have audited, while the management representation letter focuses on assurances from management regarding the fairness of the financial statements. None of