Clarified Auditing Standards: Modifications of Audit Reports and Emphasis-of-Matter Paragraphsby
This article looks at two clarified auditing standards: AU-C Section 705, Modifications to the Opinion in the Independent Auditor's Report, and AU-C Section 706, Emphasis-of-Matter Paragraphs and Other-Matter Paragraphs in the Independent Auditor's Report.
Here are some examples of circumstances that may cause report modifications and suggestions for the type of opinion modification that may be necessary.
- Auditor is unable to perform certain required auditing procedures â€“ qualified.
- Auditor is unable to perform sufficient procedures to form an opinion â€“ disclaimer.
- Going-concern issues: explanatory paragraph emphasizing a matter, qualified, or disclaimer (adverse opinion under ASU 2014-15 on the going-concern assumption).
- Other uncertainties, such as lawsuits, contract disputes, performance under exit, and disposal or remediation agreements, etc. â€“ explanatory paragraph, qualified, or disclaimer.
- Insufficient disclosures of uncertainties â€“ qualified or disclaimer.
Departures from GAAP (or Applicable Reporting Framework)
- Unacceptable principle affecting only certain financial statement classifications â€“ qualified.
- Unacceptable principle that has a material effect on the financial statements taken as a whole â€“ adverse.
- Insufficient disclosure â€“ qualified or adverse.
- Code of Professional Conduct justified departure to prevent statements from being misleading â€“ explanatory paragraph before opinion.
Financial Statements Contain Errors or Fraud
- Client restricts determination of amounts â€“ qualified or disclaimer, depending on materiality of errors or fraud.
- Disclosure of material amounts is not sufficient â€“ qualified or adverse.
- Legality and amounts of issue can't be determined â€“ qualified or disclaimer.
- Client refuses to modify statements or accept report modification â€“ report should not be issued.
Adoption of an Unacceptable Principle
- Material effect on financial statement classifications â€“ qualified.
- Financial statements as a whole materially affected â€“ adverse.
- Client can't justify a change between acceptable alternative principles â€“ qualified.
Inconsistent Application of Principles
- Consistency exception â€“ explanatory paragraph.
- Inadequate disclosure of expected material future effect â€“ qualified.
Audit of Single Statement
- Only balance sheet audited â€“ modify report wording.
- Audit of balance sheet only, but other statements presented â€“ modify report wording and disclaimer for other statements.
- GAAP consistency determined â€“ no modification.
- Unable to determine GAAP consistency â€“ disclaimer.
- Beginning income-affecting balances not audited, but GAAP determined to be consistent â€“ disclaimer on income and cash-flow statements with explanatory paragraph.
Prior-Period Service Different Than Audit
- Compilation or review â€“ paragraph following opinion describing prior-period service.
Predecessor Audited Prior Period
- Predecessor reissues â€“ no modification.
- Prior-year report unqualified, but predecessor doesn't reissue â€“ first paragraph modified to describe predecessor's opinion.
- Predecessor qualified prior period, and restatement is necessary â€“ first paragraph modified to describe predecessor's opinion.
- Qualified prior period with subsequent restatement â€“ modify first paragraph to describe predecessor's opinion and the restatement.
- Re-audit of prior period by successor â€“ no mention of predecessor.
Relying on Specialists
- Differences between specialists' findings and financial statement amounts that can't be resolved â€“ qualified or disclaimer because of scope limitation.
Assertions in Financial Statements Don't Conform to GAAP or Applicable Reporting Framework
- Effects on financial statement classifications are material, but not statements as a whole â€“ qualified.
- Financial statements as a whole materially affected â€“ adverse.
Emphasis of a Matter
- Matter doesn't cause modification of opinion â€“ explanatory paragraph (AU-C Section 706).
Supplementary Information Included with Financials
- Information audited â€“ unmodified report on supplementary information.
- Part of information audited â€“ disclaimer on unaudited part.
- Information not audited â€“ disclaimer.
- Modified report on basic financials â€“ consider effects and modify if necessary.
- Disclaimer on basic financials â€“ disclaimer on supplementary information.
- Supplementary information departs from GAAP â€“ adverse.
- Supplementary information compiled or reviewed â€“ separate, appropriately worded report.
Several of these report modifications are presented and discussed below to illustrate the reasoning behind the modification process. First, an illustration of a standard audit report is presented below from the clarified auditing standards.
Examples of Report Modifications
Following are some common report modifications an auditor may experience, along with illustrative reasoning an auditor might use to determine the type of modification.
Determining the Type of Modification to the Auditor's Opinion (See table at the end of this article)
Qualified opinion â€“ when to express a qualified opinion. The auditor should express a qualified opinion when:
- Having obtained sufficient appropriate audit evidence, he or she concludes that misstatements, individually or in the aggregate, are material but not pervasive to the financial statements; or
- He or she is unable to obtain sufficient appropriate audit evidence on which to base the opinion, but the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be material but not pervasive.
Adverse opinion â€“ when to express an adverse opinion. The auditor should express an adverse opinion when:
- He or she, having obtained sufficient appropriate audit evidence, concludes that misstatements, individually or in the aggregate, are both material and pervasive to the financial statements.
Disclaimer of opinion â€“ when to disclaim an opinion. He or she should disclaim an opinion when the auditor:
- Is unable to obtain sufficient appropriate audit evidence on which to base the opinion.
- Concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive.
Inability to obtain sufficient appropriate audit evidence due to a management-imposed limitation after the auditor has accepted the engagement. This condition should result in communications with those charged with governance to request that management remove the limitation or withdraw from the engagement if the limitation remains and appropriate alternative procedures are not performed.
Other considerations relating to an adverse opinion or disclaimer of opinion. If it is necessary for the auditor to express an adverse or disclaimer of opinion, the auditor should not separately provide an unmodified opinion related to the same financial reporting framework on a single financial statement or one or more specific elements, accounts, or items of a financial statement.
Form and Content of the Auditor's Report When the Opinion is Modified
Basis for modification paragraph. Modifying the opinion on the financial statements requires the auditor to, in addition to the specific elements required by AU-C Section 700, Forming an Opinion and Reporting on Financial Statements, include a paragraph in the auditor's report that provides a description of the matter giving rise to the modification. The auditor should place this paragraph immediately before the opinion paragraph in the auditor's report and use a heading that includes â€œBasis for Qualified Opinion,â€ â€œBasis for Adverse Opinion,â€ or â€œBasis for Disclaimer of Opinion,â€ as appropriate.
Note: The application section of AU-C Section 705 contains this example of the auditor's qualified opinion in Exhibit A: Illustrations of Auditors' Reports With Modifications to the Opinion, Illustration 1: An Auditor's Report Containing a Qualified Opinion Due to a Material Misstatement of the Financial Statements.
I have included only the paragraphs concerning the qualified opinion and have changed some names, dates, and amounts.
Basis for Qualified Opinion
The Corporation has stated inventories at cost in the accompanying balance sheets. Accounting principles generally accepted in the United States of America require inventories to be stated at the lower of cost or market. If the Corporation stated inventories at the lower of cost or market, a write-down of $20,000 and $10,000 would have been required as of December 31, 20X2 and 20X1, respectively. Accordingly, cost of sales would have been increased by $20,000 and $10,000, and net income, income taxes, and stockholders' equity would have been reduced by $20,000, $4,000, and $16,000, and $10,000, $2,000, and $8,000 as of and for the years ended December 31, 20X2 and 20X1, respectively.
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of Always Best Corporation as of December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.
Form and Content of the Auditor's Report When the Opinion is Adverse
Section A of the standard contains an illustration of an auditor's report containing an adverse opinion. I have included the paragraphs that would be included in the adverse opinion.
Illustration: An Auditor's Report Containing an Adverse Opinion Due to a Material Misstatement of the Financial Statements
Basis for Adverse Opinion
As described in Note A, the Company has not consolidated the financial statements of subsidiary The Best Company that it acquired during 20X2 because it has not yet been able to ascertain the fair values of certain of the subsidiary's material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis by the Corporation. Under accounting principles generally accepted in the United States of America, the subsidiary should have been consolidated because it is controlled by the Corporation. Had The Best Company been consolidated, many elements in the accompanying consolidated financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements referred to above do not present fairly the financial position of Always Best Corporation and its subsidiaries as of December 31, 20X2, or the results of their operations or their cash flows for the year then ended.
AU-C Section 705, in the Application section, Paragraph A1, contains a table that you may find useful. It illustrates how the auditor's judgment about the nature of the matter giving rise to the modification and the pervasiveness of its effects or possible effects on the financial statements affects the type of opinion to be expressed:
|Nature of Matter Giving Rise to the Modification||Auditor's Judgment About the Pervasiveness of the Effects or Possible Effects on the Financial Statements|
|Material But Not Pervasive||Material and Pervasive|
|Financial statements are materially misstated||Qualified opinion||Adverse opinion|
|Inability to obtain sufficient appropriate audit evidence||Qualified opinion||Disclaimer of opinion|
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