Audit: Chapter 3

The standard unmodified opinion audit report is issued when the following conditions have been met:

All statements—balance sheet, income statement, statement of changes in stockholders' equity, and statement of cash flows—as well as required disclosures, are included in the financial statements. Sufficient appropriate evidence has been accumulated, and the auditor has conducted the engagement in a manner that enables him or her to conclude that the audit was performed in accordance with the applicable auditing standards. The financial statements are presented fairly in all material respects in accordance with U.S. generally accepted accounting principles or other appropriate accounting framework. This also means that adequate disclosures have been included in the footnotes and other parts of the financial statements. There are no circumstances requiring the addition of an emphasis-of-matter paragraph or modification of the wording or auditor's opinion in the report.

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Amounts Are So Material or So Pervasive That Overall Fairness of the Statements Is in Question The highest level of materiality exists when users are likely to make incorrect decisions if they rely on the overall financial statements. To return to the previous example, if inventory is the largest balance on the financial statements, a large misstatement would probably be so material that the auditor's report should indicate the financial statements taken as a whole cannot be considered fairly stated. When the highest level of materiality exists, the auditor must issue either a disclaimer of opinion or an adverse opinion, depending on which conditions exist. When determining whether an exception is highly material, the extent to which the exception affects different parts of the financial statements must be considered. This is called pervasiveness. A pervasive misstatement is one that affects multiple elements of the financial statements, affects an account that is a significant portion of the financial statements, or affects any disclosure that is fundamental to understanding the financial statements. For example, a misclassification between cash and accounts receivable affects only those two accounts and is therefore not pervasive. On the other hand, failure to record a material sale is highly pervasive because it affects sales, accounts receivable, income tax expense, accrued income taxes, and retained earnings, which in turn affect current assets, total assets, current liabilities, total liabilities, owners' equity, gross margin, and operating income. As misstatements become more pervasive, the likelihood of issuing an adverse opinion rather than a qualified opinion increases. For example, suppose the auditor decides a misclassification between cash and accounts receivable should result in a qualified opinion because it is material; the failure to record a sale of the same dollar amount may result in an adverse opinion because of pervasiveness. Regardless of the amount involved, a disclaimer of opinion must be issued if the auditor is deemed to lack independence under the rules of the AICPA Code of Professional Conduct. This strict requirement reflects the importance of independence to auditors. Any deviation from the independence rule is therefore considered highly material. Table 3-1 summarizes the relationship between materiality and the type of opinion to be issued.

2. Make Reference in the Report

This type of report is called a shared opinion or report. A shared unmodified opinion audit report is appropriate when the portion of the financial statements audited by the other CPA is material in relation to the whole. An example of an audit report that includes an unmodified opinion but makes reference to the report of another auditor for a nonpublic company is shown in Figure 3-7. Notice that the report does not include a separate paragraph that discusses the shared responsibility but does so in the Opinion and Basis for Opinion sections. The portions of the financial statements audited by the other auditor can be stated as percentages or absolute amounts.

The audit report is the final step in the

entire audit process.

A disclaimer of opinion is issued when the auditor has been unable to satisfy himself or herself that the overall financial statements are

fairly presented. The necessity for disclaiming an opinion may arise because of a severe limitation on the scope of the audit or a nonindependent relationship under the AICPA Code of Professional Conduct between the auditor and the client. Either of these situations prevents the auditor from expressing an opinion on the financial statements as a whole. The auditor also has the option to issue a disclaimer of opinion for a going concern problem.

audit reports increasingly provide additional information about the audit, including

identification of critical audit areas and how the auditor addressed the risks associated with these audit areas.

For each critical matter communicated in the auditor's report, the auditor must

identify the critical audit matter. describe the principal considerations that led the auditor to determine that the matter is a critical audit matter. describe how the critical audit matter was addressed in the audit. refer to the relevant financial statement accounts or disclosures that relate to the critical audit matter.

Materiality is an essential consideration in determining the appropriate type of report for a given set of circumstances. For example,

if a misstatement is immaterial relative to the financial statements of the entity for the current period, it is appropriate to issue an unmodified opinion audit report. A common instance is the immediate expensing of office supplies rather than carrying the unused portion in inventory because the amount is insignificant.

The term explanatory paragraph was replaced in the AICPA auditing standards with emphasis-of-matter or other-matter paragraphs. Emphasis-of-matter paragraphs are used to draw the reader's attention to

information presented or disclosed in the financial statements, such as a footnote disclosure. Other-matter paragraphs refer to a matter that is not presented or disclosed in the financial statements, such as an explanation by the auditor of responsibilities related to a law or regulation.

When the auditor concludes that there is substantial doubt about the entity's ability to continue as a going concern, an unmodified opinion audit report with an explanatory paragraph containing an appropriate heading such as "Substantial Doubt About the Company's Ability to Continue as a Going Concern"

is required, regardless of the disclosures in the financial statements. Figure 3-6 provides an example in which there is substantial doubt about going concern.

The new PCAOB requirement to communicate critical audit matters (referred to as "CAMs") is intended to inform investors and other financial statement users about

matters identified in the audit that represent issues that involved especially challenging, subjective, or complex auditor judgment and how the auditor addressed those matters. The Critical Audit Matters section of the report notes that the communication of these matters does not alter the opinion on the financial statements. We discuss this requirement and the related disclosures in greater detail below.

The standard unmodified opinion audit report is sometimes called a clean opinion because there are

no circumstances requiring a modification of the auditor's opinion. The standard unmodified opinion audit report is the most common audit opinion. Sometimes circumstances beyond the client's or auditor's control prevent the issuance of an unmodified ("clean") opinion.

If any of the requirements for the standard unmodified opinion audit report are

not met, the standard unmodified opinion audit report cannot be issued.

When these conditions are met, the standard unmodified opinion audit report for an audit

of a nonpublic company

When the amounts are so material and pervasive that a disclaimer of opinion rather than a qualified opinion is required, the first paragraph is modified slightly to say, "We were engaged to audit . . ." The second paragraph provides the disclaimer of

opinion due to the inability to obtain sufficient appropriate evidence. The Basis for Disclaimer of Opinion section provides an explanation of the scope limitation, and the Auditor's Responsibilities section is modified to indicate that the auditor was unable to obtain sufficient appropriate evidence to provide a basis for an audit opinion.

Relative to the previous standard unmodified report, the proposed report presents the

opinion first and provides additional information related to the responsibilities of management for preparing the financial statements and responsibilities of the auditor in conducting the audit.

It is unacceptable to use the phrase "except for" with any

other type of audit opinion. Note that the modification in a PCAOB report is slightly different in that a separate paragraph explaining the qualification follows the opinion paragraph rather than modifying the Basis for Opinion section.

A qualified opinion report can result from a limitation on the scope of the audit or failure to follow generally accepted accounting principles. A qualified opinion report can be used only when

the auditor concludes that the overall financial statements are fairly stated. A disclaimer or an adverse report must be used if the auditor believes that the condition being reported on is highly material to the financial statements as a whole. Therefore, the qualified opinion is considered the least severe type of departure from an unmodified opinion audit report.

The PCAOB expects that in most audits the auditor will determine that at least one matter involved especially challenging, subjective, or complex auditor judgment. If

the auditor concludes there are no critical audit matters, then this conclusion will be disclosed in the audit report.

Even though the purpose of an audit is not to evaluate the financial health of the business,

the auditor has a responsibility under auditing standards to evaluate whether the company is likely to continue as a going concern.

The Basis for Opinion section of the report references the PCAOB auditing standards, and indicates that the financial statements are the responsibility of management, and the auditor's responsibility is to express an opinion on the financial statements. This is in contrast to

the standard unmodified report for nonpublic entities in Figure 3-1, which includes separate, more detailed sections on management and auditor responsibilities. The basis for opinion includes an affirmative statement that the audit firm is registered with the PCAOB and required to be independent of the company. The second basis for opinion paragraph includes a statement indicating that an audit is designed to provide reasonable assurance that the financial statements are free of material misstatement, whether due to error or fraud. This section also notes that auditing is done on a test basis.

The common definition of materiality as it applies to accounting and therefore to audit reporting is as follows:

A misstatement in the financial statements can be considered material if knowledge of the misstatement will affect a decision of a reasonable user of the statements.

Items that materially affect the comparability of financial statements generally require disclosure in the footnotes.

A qualified audit report for inadequate disclosure may be required if the client refuses to properly disclose the items.

3. Qualify the Opinion

A qualified opinion or disclaimer, depending on materiality, is required if the group engagement partner is not willing to assume any responsibility for the work of the other auditor. The group engagement partner may also decide that a qualification is required in the overall report if the other auditor qualified his or her portion of the audit. Qualified opinions and disclaimers are discussed in a later section of this chapter.

Disclaimer of opinion

A report issued when the auditor is not able to become satisfied that the overall financial statements are fairly presented or the auditor is not independent

three levels of materiality are used for determining the type of opinion to issue. Amounts Are Immaterial: 1

Amounts Are Immaterial When a misstatement in the financial statements exists but is unlikely to affect the decisions of a reasonable user, it is considered to be immaterial. An unmodified opinion is therefore appropriate. For example, assume that management recorded prepaid insurance as an asset in the previous year and decides to expense it in the current year to reduce record-keeping costs. Management has failed to follow GAAP, but if the amounts are small, the misstatement is immaterial and a standard unmodified opinion audit report is appropriate.

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Audit report address. The report is usually addressed to those for whom the report is prepared, including the company, its stockholders, or the board of directors. It has become customary to address the report to the board of directors and stockholders to indicate that the auditor is independent of the company.

The final two sections of the opinion include the signature, tenure, and city and state of the audit firm as well as the audit report date.

Disclosing within the audit report the year in which the auditor began serving the entity is a new requirement in the revised PCAOB reporting standard.

There are two significant audit reporting differences for public companies relative to nonpublic companies.

First, the standard unmodified opinion audit report is different for audits of financial statements of public companies. Second, auditors of larger public companies must also issue an opinion on internal control over financial reporting.

The AICPA Code of Professional Conduct states that in unusual situations, a departure from a generally accepted accounting principle may not require a qualified or adverse opinion.

However, to justify an unmodified opinion, the auditor must be satisfied and must state and explain, in a separate paragraph or paragraphs in the audit report, that adhering to the principle would produce a misleading result in that situation.

It is essential that auditors and readers of audit reports understand the circumstances when an unmodified opinion in the audit report is inappropriate and the type of audit report issued in each circumstance.

In the study of audit reports that depart from an unmodified opinion, there are three closely related topics: the conditions requiring a modification to the opinion, the types of opinions other than unmodified, and materiality.

We use the AICPA terminology to reference the different auditor responsibilities. When the CPA relies on a different CPA firm to perform part of the audit, the primary CPA firm has three alternatives.

Only the second is an unmodified opinion audit report with modified wording.

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Opinion section. The Opinion section, which states the auditor's conclusions based on the results of the audit, is presented first due to its importance and must include the heading "Opinion." The Opinion section is so important that often the entire audit report is referred to simply as the auditor's opinion. The first paragraph of the Opinion section indicates that the CPA firm has performed an audit, which distinguishes the report from a compilation or review report. The first paragraph also lists the financial statements that were audited, including the notes to the financial statements as well as the balance sheet dates and the accounting periods covered in the income statement and statement of cash flows. The wording of the financial statements in the report should be identical to the titles used by management on the financial statements. Notice that the report in Figure 3-1 is on comparative financial statements.

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Overshadow the Financial Statements as a Whole The second level of materiality exists when a misstatement in the financial statements would affect a user's decision, but the overall statements are still fairly stated and therefore useful. For example, knowledge of a large misstatement in fixed assets might affect a user's willingness to loan money to a company if the assets were the collateral. A misstatement of inventory does not mean that cash, accounts receivable, and other elements of the financial statements, or the financial statements as a whole, are materially incorrect. To make materiality decisions when a condition requiring a departure from an unmodified opinion audit report exists, the auditor must evaluate all effects on the financial statements. Assume that the auditor is unable to satisfy himself or herself whether inventory is fairly stated in deciding on the appropriate type of opinion. Because of the effect of a misstatement in inventory on other accounts and on totals in the statements, the auditor needs to consider the materiality of the combined effect on inventory, total current assets, total working capital, total assets, income taxes, income taxes payable, total current liabilities, cost of goods sold, net income before taxes, and net income after taxes. When the auditor concludes that a misstatement is material but does not overshadow the financial statements as a whole, a qualified opinion (using "except for") is appropriate.

Two restrictions occasionally imposed by clients on the auditor's scope relate to the observation of physical inventory and the confirmation of accounts receivable, but other restrictions may also occur.

Reasons for client-imposed scope restrictions may be a desire to save audit fees and, in the case of confirming receivables, to prevent possible conflicts between the client and customer when amounts differ.

standard unmodified opinion audit report contains eight distinct parts. Part 1

Report title. Auditing standards require that the report be titled and that the title include the word independent. For example, appropriate titles include "independent auditor's report," "report of independent auditor," or "independent accountant's opinion." The requirement that the title include the word independent conveys to users that the audit was unbiased in all aspects.

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Signature and address of CPA firm. The signature identifies the CPA firm or practitioner who performed the audit. Typically, the firm's name is used because the entire CPA firm has the legal and professional responsibility to ensure that the quality of the audit meets professional standards. The city and state of the audit firm should also be indicated.

For example, the existence of one or more of the following factors causes uncertainty about the ability of a company to continue as a going concern:

Significant recurring operating losses or working capital deficiencies Inability of the company to pay its obligations as they come due Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake or flood, or unusual labor difficulties Legal proceedings, legislation, or similar matters that have occurred that might jeopardize the entity's ability to operate

The most common case in which conditions beyond the client's and auditor's control cause a scope restriction is when the auditor is appointed after the client's balance sheet date.

The confirmation of accounts receivable, physical examination of inventory, and other important procedures may be impossible under those circumstances. When the auditor cannot perform procedures he or she considers desirable but can be satisfied with alternative procedures that the information being verified is fairly stated, a standard unmodified opinion report is appropriate. If alternative procedures cannot be performed, a qualified opinion or disclaimer of opinion is necessary, depending on materiality.

Measurability

The dollar amount of some misstatements cannot be accurately measured. For example, a client's unwillingness to disclose an existing lawsuit or the acquisition of a new company subsequent to the balance sheet date is difficult if not impossible to measure in terms of dollar amounts. The materiality question the auditor must evaluate in such situations is the effect on statement users of the failure to make the disclosure.

Auditor's Scope Has Been Restricted

Two major categories of scope restrictions exist: those caused by a client and those caused by conditions beyond the control of either the client or the auditor. The effect on the auditor's report is the same for either, but the interpretation of materiality is likely to be different. When there is a scope restriction, the appropriate response is to issue a report with an unmodified opinion, a qualified opinion, or a disclaimer of opinion, depending on materiality.

Materiality Decisions—Non-GAAP Condition

When a client has failed to follow GAAP, the audit report will contain an unmodified opinion, a qualified opinion, or an adverse opinion, depending on the materiality of the departure. Several aspects of materiality must be considered.

Make No Reference in the Audit Report

When no reference is made to the other auditor, a standard unmodified opinion is given unless other circumstances require a departure. This approach is typically followed when the other auditor audited an immaterial portion of the statements, the other auditor is well known or closely supervised by the group engagement partner, or the group engagement partner has thoroughly reviewed the other auditor's work. The other auditor is still responsible for his or her own report and work in the event of a lawsuit or SEC action.

In concept, the effect of materiality on the type of opinion to issue is straightforward. In application, deciding on actual materiality in a given situation is

a difficult judgment. There are no simple, well-defined guidelines that enable auditors to decide when something is immaterial, material, or highly material. The evaluation of materiality also depends on whether the situation involves a failure to follow GAAP or a scope limitation.

The disclaimer is distinguished from an adverse opinion in that a disclaimer can arise only from

a lack of knowledge by the auditor, whereas to express an adverse opinion, the auditor must have knowledge that the financial statements are not fairly stated. Both disclaimers and adverse opinions are used only when the condition is highly material.

Adverse opinion

a report issued when the auditor believes the FS are so materially misstated or misleading as a whole that they do not present fairly the entity's financial position or the results of its operations and cash flows in conformity with GAAP

The report title and address are quite similar to those in the

audit report for nonpublic entities

Combined report in FS and internal control over financial reporting

audit report on the FS and the effectiveness of internal control over financial reporting for larger public companies under section 404 of sarbanes oxley act

PCAOB auditing standards allow for, but do not require, the disclosure of the audit engagement partner's name in the audit report. Similarly,

auditors may disclose the names of other accounting firms participating in the audit engagement.

In certain situations, an unmodified opinion audit report on the financial statements is issued,

but the report deviates from the standard wording. The unmodified opinion audit report with emphasis-of-matter paragraph or nonstandard report wording meets the criteria of a complete audit with satisfactory results and financial statements that are fairly presented, but the auditor believes it is important to draw the reader's attention to certain matters or the auditor is required to provide additional information.

Reports are essential to audit and assurance engagements because they

communicate the auditor's findings. Users of financial statements rely on the auditor's report to provide assurance on the company's financial statements.

The most significant change to the auditor reporting standard for public companies is the requirement to disclose

critical audit matters ("CAMs"). As noted earlier, AICPA standards do not require, but do allow, disclosure of key audit matters in the auditor's report.

If the auditor also issues a separate report on

internal control over financial reporting, the additional paragraph following the opinion paragraph

The situation is totally different when the amounts are of such significance that the financial statements are

materially affected as a whole. In these circumstances, it is necessary to issue a disclaimer of opinion or an adverse opinion, depending on whether a scope limitation or GAAP departure is involved. In situations of lesser materiality, a qualified opinion is appropriate.

If the qualification is due to a scope limitation, the auditor would state in the opinion "except for the

possible effects of the matters described in the Basis for Qualified Opinion section."

The opinion paragraph is

presented first and is also similar to the opinion included

the AICPA Auditing Standard Board (ASB) sets standards for nonpublic entities, and the PCAOB sets auditing standards for

public companies. The PCAOB and AICPA recently developed new auditor reporting standards designed to provide more information to users about management and auditor responsibilities as well as certain aspects of the audit engagement, particularly areas considered high risk or requiring significant judgement

The Critical Audit Matters section of the

report is not required but is voluntary for audits of broker-dealers, certain investment companies, and emerging growth companies otherwise subject to PCAOB standards.

PCAOB auditing standards require the audit of internal control to be integrated with the audit of the financial statements. However, the auditor may choose to issue separate reports, such as the

separate report on internal control over financial reporting shown in Figure 3-4, or in a combined report. The combined report on financial statements and internal control over financial reporting addresses both the financial statements and management's report on internal control over financial reporting.

An adverse opinion is used only when the auditor believes that the overall financial statements are

so materially misstated or misleading that they do not present fairly the financial position or results of operations and cash flows in conformity with GAAP. The adverse opinion report can arise only when the auditor has knowledge, after an adequate investigation, of the absence of conformity. This is uncommon and thus the adverse opinion is rarely used.

Under certain circumstances, the CPA may want to emphasize specific matters regarding the financial statements, even though he or she intends to express an unmodified opinion. Normally,

such explanatory information should be included in a separate paragraph in the report.

CPAs often rely on a different CPA firm to perform part of the audit when the client has widespread operations. The primary auditor issuing the opinion on the financial statements is called

the principal auditor under PCAOB auditing standards and the group engagement partner under AICPA auditing standards. The other auditor who performs work on the financial information of a component is called the component auditor under AICPA auditing standards.

standard unmodified opinion audit report

the report a COA issues when all auditing conditions have been met, no significant misstatements have been discovered and left uncorrected, and it is the auditor's opinion that the FS are fairly stated in accordance with the applicable financial reporting framework

The first four reports all require the addition of an explanatory paragraph. In each case,

the standard report paragraphs, including the opinion paragraph, are presented without changes in wording, and a separate explanatory paragraph is added with an appropriate heading. Only reports involving other auditors use different wording in the opinion and basis for opinion paragraphs.

Critical audit matters (CAMs)

those matters during the audit of a public company that involved difficult, subjective, or complex auditor judgments or that posed difficulty to the auditor in obtaining sufficient appropriate evidence or in forming the opinion on the FS

PCAOB standards refer to the standard unmodified opinion audit report as an "unqualified opinion" audit report. Throughout this book,

we use the term unmodified opinion to represent the term unqualified opinion unless the setting is clearly applicable only to a public company, where we use the term unqualified opinion as in PCAOB auditing standards.

The auditor's concern in such situations is the possibility that the client may not be able to continue its operations or meet its obligations for a reasonable period. The Financial Accounting Standards Board (FASB) recently clarified that management should consider the ability of the entity to continue its operations for a reasonable period not to exceed 1 year from the date the financial statements are issued. Thus,

when the entity financial statements are based on FASB standards, the auditor's evaluation of the time horizon would be the same as that considered by management.

A qualified report contains modifications to both the opinion paragraph and the Basis for Opinion section. The auditor must use the term

"except for" in the opinion paragraph and then modify the Basis for Qualified Opinion section accordingly. If the qualification is due to a departure from GAAP, the auditor would state in the opinion "except for the effects of the matters described in the Basis for Qualified Opinion section, the accompanying financial statements present fairly."

International auditing standards and PCAOB auditing standards require communication of

"key audit matters" or "critical audit matters" in the standard unmodified audit report. The AICPA reporting standards do not require the communication of key audit matters ("KAMs")

PCAOB auditing standards define a critical audit matter as "any matter arising from the audit of the financial statements that was communicated or required to be communicated to the audit committee and that

(1) relates to accounts or disclosures that are material to the financial statements and (2) involved especially challenging, subjective, or complex auditor judgment."

To allow users to understand audit reports,

AICPA auditing standards provide uniform wording for the auditor's report.

his information is included in the signature section. The

AICPA does not require the disclosure of auditor tenure.

Unmodified opinion audit report with emphasis of matter paragraph or nonstandard report working

AN unmodified opinion audit report in which the FS are fairly presented, but the auditor believes it is important, or is required, to provide additional information or the wording of other paragraphs of the report require revision

Separate report on internal control over financial reporting

Audit report on the effectiveness of internal control over financial reporting required for larger public companies under Section 404 of the Sarbanes-Oxley Act that cross-references the separate audit report on the FS

Key audit matters, if disclosed, are included in a section following the

Basis for Opinion section. We define and discuss critical audit matters later in the chapter in the section on PCAOB auditor reporting standards.

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Basis for opinion. The basis for opinion paragraph states the audit was conducted in accordance with auditing standards generally accepted in the United States of America and references additional responsibilities as detailed in the Auditor's Responsibilities section of the report. The auditor also provides an affirmative statement that they are independent of the company and that they have fulfilled their professional ethical obligations. The final sentence indicates the auditor believes that sufficient appropriate evidence has been obtained to support the auditor's opinion.

3. The Auditor Is Not Independent

Independence ordinarily is determined by the AICPA Code of Professional Conduct. Auditor independence requirements and the AICPA Code are further discussed in Chapter 4. When any of the three conditions requiring a departure from an unmodified opinion exists and is material, the opinion in the audit report must be modified. Three main types of audit reports are issued under these conditions: qualified opinion, adverse opinion, and disclaimer of opinion.

The following are the most important causes of the addition of an emphasis-of-matter paragraph or a modification in the wording of the standard unmodified opinion audit report under both AICPA and PCAOB audit standards:

Lack of consistent application of generally accepted accounting principles Auditor agrees with a departure from promulgated accounting principles Substantial doubt about going concern Emphasis of other matters Reports involving other auditors

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Management's responsibility. The report must include the heading "Responsibilities of Management and Those Charged with Governance for the Financial Statements" and a paragraph that describes management's responsibility for the financial statements. Management's responsibility includes selecting the appropriate accounting principles and maintaining internal control over financial reporting sufficient for preparation of financial statements that are free of material misstatements due to fraud or error. This section references management's responsibility under accounting standards to assess the ability of the company to continue as a going concern and also references the responsibility of those charged with governance (e.g., the board of directors) to oversee the financial reporting process.

For client-imposed restrictions, the auditor should be concerned about the possibility that management is trying to prevent discovery of misstated information. In such cases,

PCAOB auditing standards indicate the auditor should issue a disclaimer of opinion, and AICPA auditing standards require a disclaimer of opinion or withdrawal from the engagement if the auditor is unable to perform alternative procedures to obtain sufficient appropriate evidence. When restrictions result from conditions beyond the client's control, a qualified opinion is more likely.

Continued

Therefore, a report on both years' statements is needed. The opinion paragraph is stated as an opinion rather than as a statement of absolute fact or a guarantee. The intent is to indicate that the conclusions are based on professional judgment. The phrase in our opinion indicates that there may be some information risk associated with the financial statements, even though the statements have been audited. The opinion paragraph also refers to the relevant financial reporting framework. In this text, we refer to generally accepted accounting principles as the relevant financial reporting framework unless otherwise indicated. A controversial part of the auditor's report is the meaning of the term present fairly. Does this mean that if generally accepted accounting principles are followed, the financial statements are presented fairly, or something more? Occasionally, the courts have concluded that auditors are responsible for looking beyond generally accepted accounting principles to determine whether users might be misled, even if those principles are followed. Most auditors believe that financial statements are "presented fairly" when the statements are in accordance with generally accepted accounting principles, but they also believe it is also necessary to examine the substance of transactions and balances for possible misinformation.

If reporting on a nonpublic entity under AICPA auditing standards, the explanatory paragraph should be preceded by the appropriate header (e.g., "Emphasis of Matter").

When the auditor wishes to emphasize other matters, the report should include the heading "Other Matters." These paragraphs continue to be referred to as explanatory paragraphs under PCAOB auditing standards. We refer to explanatory paragraphs in this chapter to include both emphasis-of-matter and other-matter paragraphs.

However, in most cases, companies make the

appropriate changes to their accounting records to avoid a qualification or modification by the auditor.

The reference to standard refers to the uniform wording typically used in audit reports, while unmodified opinion refers to the fact that the auditor's opinion about the

financial statements contains no material exceptions or qualifications. Different auditors may alter the wording or presentation slightly, but the meaning will be the same.

The separate report in Figure 3-4 is an unqualified opinion on the effectiveness of internal control over financial reporting prepared in accordance with PCAOB auditing standards (PCAOB AS 2201). The auditor may issue a

qualified opinion, adverse opinion, or disclaimer of opinion on the operating effectiveness of internal control over financial reporting. Conditions that require the auditor to issue a report other than an unqualified opinion on the operating effectiveness of internal control are discussed in Chapter 12, along with the effects of these conditions on the wording of the auditor's report on internal control over financial reporting.

When communicating critical audit matters in the auditor's report, the PCAOB notes that the auditor should avoid using language that could be viewed as disclaiming, qualifying, restricting, or minimizing the auditor's

responsibility for the critical audit matters or the auditor's opinion on the financial statements. The reporting requirements related to critical audit matters are being phased in over time. The Critical Audit Matters section of the report is required for audits of fiscal years ending on or after June 30, 2019, for large companies and fiscal years ending on or after December 15, 2020, for all other audits to which these requirements apply.

n a qualified, adverse, or disclaimer report,

the auditor either has not been able to perform a satisfactory audit, is not satisfied that the financial statements are fairly presented, or is not independent.

A restriction on the scope of the auditor's examination requires modifications to the opinion paragraph and Basis for Opinion sections. The headings are modified to reflect

the type of modification (for example, Qualified Opinion and Basis for Qualified Opinion), and the Basis for Opinion section provides an explanation for the modification. For example, the report in Figure 3-8 is appropriate for an audit of a nonpublic entity in which the amounts were material but not pervasive and the auditor could not obtain audited financial statements supporting an investment in a foreign affiliate and could not satisfy himself or herself by alternate procedures.

Key audit matters (KAMs)

those matters that, in the auditor's professional judgement, were of most significance in the audit of financial statements of the current period of a nonpublic entity, and they are selected from matters communicated with those charged with governance

2. The Financial Statements Have Not Been Prepared in Accordance with Generally Accepted Accounting Principles (GAAP Departure)

For example, if the client insists on using replacement costs for fixed assets or values inventory at selling price rather than historical cost as required by generally accepted accounting principles, a departure from the unmodified opinion audit report is required. When U.S. generally accepted accounting principles or international financial reporting standards (IFRS) are referred to in this context, consideration of the adequacy of all informative disclosures, including footnotes, is especially important. While most U.S. companies prepare their financial statements in accordance with GAAP, some entities might use other financial reporting frameworks, such as IFRS. References to GAAP in this chapter also apply to situations where the client has selected another appropriate financial reporting framework.

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Audit report date. The appropriate date for the report is the one on which the auditor completed the auditing procedures needed to obtain sufficient appropriate audit evidence. This date is important to users because it indicates the last day of the auditor's responsibility for the review of significant events that occurred after the date of the financial statements. In the audit report in Figure 3-1, the balance sheet is dated December 31, 2019, and the audit report is dated February 15, 2020. This indicates that the auditor searched for material unrecorded transactions and events that occurred up to February 15, 2020.

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Auditor's responsibility. This section must include the heading "Auditor's Respon-sibilities for the Audit of the Financial Statements" followed by three paragraphs that describe the auditor's responsibility. The first paragraph notes that the audit is designed to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to fraud or error. The inclusion of the word material conveys that auditors are only responsible to search for significant misstatements, not minor misstatements that do not affect users' decisions. The use of the term reasonable assurance is intended to indicate that an audit cannot be expected to completely eliminate the possibility that a material misstatement will exist in the financial statements. In other words, an audit provides a high level of assurance, but it is not a guarantee. The second paragraph describes the scope of the audit and the evidence accumulated about the amounts and disclosures in the financial statements. This paragraph indicates that the procedures depend on the auditor's professional judgment and includes an assessment of the risk of material misstatements in the financial statements. It also indicates that the auditor considers internal control relevant to the preparation and fair presentation of the financial statements in designing the audit procedures performed, but this assessment of internal control is not for the purpose of and is not sufficient to express an opinion on the effectiveness of the entity's internal control. The last two bullet points of this paragraph indicate that the audit includes evaluating the appropriateness of accounting policies selected, the reasonableness of accounting estimates, the overall financial statement presentation, and the ability of the company to continue as a going concern. Finally, the third paragraph indicates the auditor communicates to those charged with governance the planned scope and timing of the audit as well as any significant findings, including significant deficiencies and material weaknesses in internal control.

The auditor must be able to distinguish between changes that affect consistency and those that may affect comparability but do not affect consistency. The following are examples of changes that affect consistency and therefore require an explanatory paragraph if they are material:

Changes in accounting principles, such as a change from FIFO to LIFO inventory valuation Changes in reporting entities, such as the inclusion of an additional company in combined financial statements Corrections of errors involving principles, by changing from an accounting principle that is not generally acceptable to one that is generally acceptable, including correction of the resulting error

Changes that affect comparability but not consistency and therefore need not be included in the audit report include the following:

Changes in an estimate, such as a decrease in the life of an asset for depreciation purposes Error corrections not involving principles, such as a previous year's mathematical error Variations in format and presentation of financial information Changes because of substantially different transactions or events, such as new endeavors in research and development or the sale of a subsidiary

When determining whether a matter "involved especially challenging, subjective, or complex auditor judgment" the auditor would likely consider the following:

The auditor's assessment of the risks of material misstatement, including significant risks. The degree of auditor judgment related to areas in the financial statements that involved the application of significant judgment or estimation by management, including estimates with significant measurement uncertainty. The nature and timing of significant unusual transactions and the extent of audit effort and judgment related to those transactions. The degree of auditor subjectivity in applying audit procedures to address the matter or in evaluating the results of those procedures. The nature and extent of audit effort required to address the matter, including the extent of specialized skill or knowledge needed or the nature of consultations outside the engagement team regarding the matter. The nature of audit evidence obtained regarding the matter.

Nature of the Item

The decision of a user may also be affected by the kind of misstatement. The following may affect a user's decision and therefore the auditor's opinion in a different way than most misstatements: Transactions are illegal or fraudulent. An item may materially affect some future period, even though it is immaterial when only the current period is considered. An item has a "psychological" effect (for example, the item changes a small loss to a small profit, maintains a trend of increasing earnings, or allows earnings to exceed analysts' expectations). An item may be important in terms of possible consequences arising from contractual obligations (for example, the effect of failure to comply with a debt restriction may result in a material loan being called).

Examples of explanatory information the auditor may report as an emphasis of a matter include the following:

The existence of material related party transactions Important events occurring subsequent to the balance sheet date The description of accounting matters affecting the comparability of the financial statements with those of the preceding year Material uncertainties disclosed in the footnotes such as unusually important litigation or regulatory action A major catastrophe that has had or continues to have a significant effect on the entity's financial position

the Sarbanes-Oxley Act requires the auditor of a public company to report on the effectiveness of internal control over financial reporting. Larger public companies (known as accelerated filers)

are required by the SEC to annually obtain an auditor's report on internal control over financial reporting. nonaccelerated filers were permanently exempted from this requirement by the passage of the 2010 Dodd-Frank financial reform legislation.

Dollar Amounts Compared With a Benchmark

The primary concern in measuring materiality when a client has failed to follow GAAP is usually the total dollar misstatement in the accounts involved, compared with some benchmark or base. A $10,000 misstatement might be material for a small company but not for a larger one. Therefore, misstatements must be compared with some measurement base before a decision can be made about the materiality of the failure to follow GAAP. Common bases include net income, total assets, current assets, and working capital. For example, assume that the auditor believes there is a $100,000 overstatement of inventory because of the client's failure to follow GAAP. Also assume recorded inventory of $1 million, current assets of $3 million, and net income before taxes of $2 million. In this case, the auditor must evaluate the materiality of a misstatement of inventory of 10 percent, current assets of 3.3 percent, and net income before taxes of 5 percent. To evaluate overall materiality, the auditor must also combine all unadjusted misstatements and judge whether there may be individually immaterial misstatements that, when combined, significantly affect the statements. In the inventory example just given, assume the auditor believes there is also an overstatement of $150,000 in accounts receivable. The total effect on current assets is now 8.3 percent ($250,000 divided by $3,000,000) and 12.5 percent on net income before taxes ($250,000 divided by $2,000,000). When comparing potential misstatements with a base, the auditor must carefully consider all accounts affected by a misstatement (pervasiveness). For example, it is important not to overlook the effect of an understatement of inventory on cost of goods sold, income before taxes, income tax expense, and accrued income taxes payable.

While the combined report is permitted, the separate report on internal control over financial reporting is common and includes these elements:

The title includes the word "independent." The Opinion section, presented first, refers to the framework used to evaluate internal control and provides the auditor's opinion on effectiveness. Although the audit opinion on the financial statements addresses multiple reporting periods, the auditor's opinion about the effectiveness of internal control is as of the end of the most recent fiscal year. The next paragraph of the report includes a cross-reference to the auditor's separate report on the financial statements. The Basis for Opinion section first highlights management's responsibility and references the separate report that contains management's assessment of internal control over financial reporting. This section next describes the auditor's responsibility and reaffirms the auditor's requirement to be independent. The final paragraph in the Basis for Opinion section notes that the audit was conducted in accordance with PCAOB standards and outlines the procedures. The report includes a paragraph after the Basis for Opinion section defining internal control over financial reporting. The report also includes a final paragraph that addresses the inherent limitations of internal control.

1. The Scope of the Audit Has Been Restricted (Scope Limitation)

When the auditor has not accumulated sufficient appropriate evidence to conclude whether financial statements are stated in accordance with the appropriate financial reporting framework, a scope restriction exists. There are two major causes of scope restrictions: restrictions imposed by the client and those caused by circumstances beyond either the client's or auditor's control. An example of a client restriction is management's refusal to permit the auditor to confirm material receivables or to physically examine inventory. An example of a restriction caused by circumstances is when the auditor is not appointed until after the client's year-end. It may not be possible to physically observe inventories, confirm receivables, or perform other important procedures after the balance sheet date.

Materiality Decisions—Scope Limitations Condition

When there is a scope limitation in an audit, the audit report will be a standard unmodified opinion report, a qualified opinion, or a disclaimer of opinion report, depending on the materiality of the scope limitation. The auditor will consider the same three factors included in the previous discussion about materiality decisions for failure to follow GAAP, but they will be considered differently. The size of potential misstatements, rather than known misstatements, is important in determining whether an unmodified opinion report, a qualified opinion, or a disclaimer of opinion is appropriate for a scope limitation. For example, if recorded accounts payable of $400,000 was not audited, the auditor must evaluate the potential misstatement in accounts payable and decide how materially the financial statements could be affected. The pervasiveness of these potential misstatements must also be considered. It is typically more difficult to evaluate the materiality of potential misstatements resulting from a scope limitation than for failure to follow GAAP. Misstatements resulting from failure to follow GAAP are known. Those resulting from scope limitations must usually be subjectively measured in terms of potential or likely misstatements. For example, recorded accounts payable of $400,000 might be understated by more than $1 million, which may affect several totals, including gross margin, net earnings, and total assets.

Auditing standards permit but do not require a disclaimer of opinion when there is substantial doubt about going concern. The criteria for issuing a disclaimer of opinion instead of adding an explanatory paragraph are not stated in the standards, and this type of opinion is rarely issued in practice. An example for which

a disclaimer might be issued is when a regulatory agency, such as the Environmental Protection Agency, is considering a severe sanction against a company and, if the proceedings result in an unfavorable outcome, the company will be forced to liquidate.

The wording of the opinion and the nature of the paragraphs explaining the reason for a modified opinion are similar under PCAOB auditing standards,

although the explanation for the modification will follow the opinion paragraph in a PCAOB report rather than be included in the Basis for Opinion section.

The determination of critical audit matters requires significant auditor judgment. Those matters might include information related to significant management estimates

and judgments made in preparing the financial statements, areas of high financial statement and audit risk, significant and unusual transactions, and other significant changes to the financial statements.

It is implicit in the explanatory paragraph in Figure 3-5 that the auditor concurs with the

appropriateness of the change in accounting principles. If the auditor does not concur, the change is a violation of generally accepted accounting principles and the auditor's opinion must be qualified.