ACCA F8 (INT) Audit & Assurance - 2010 - Study text - Emile Woolf Publishing
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Chapter 16: The external audit report
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2.7 IAPS 1014: Reporting by auditors on compliance with International
Financial Reporting Standards
ISA 700 requires that the audit report should clearly indicate the financial reporting
framework that has been used to prepare the financial statements (for example,
International Financial Reporting Standards). IAPS 1014 was issued to provide
guidance on this area.
Financial statements might comply:
solely with International Financial Reporting Standards, or
with International Financial Reporting Standards and a national financial
reporting framework, or
solely with a national financial reporting framework with disclosure of the extent
of compliance with International Financial Reporting Standards.
An unmodified opinion can only be given where the relevant framework(s) has
been complied with. A company that complies with IFRSs should disclose the extent
of the compliance with International Financial Reporting Standards, in a note to the
financial statements.
The auditor will therefore need to consider the accuracy of this note in the same way
that he would consider the accuracy of any other notes to the financial statements. If
he disagrees with the note he will need to modify his audit report.
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The modified audit report: ISA 705 and ISA 706
The nature of a modified audit report
Emphasis of matter and other matter paragraphs: ISA 706
Emphasis of matter paragraphs
Other matter paragraphs
The modified opinion: ISA 705
Form and content of a modified opinion
Examples of modified opinions
Deciding to give a modified opinion
Audit reports and the exam
3 The modified audit report: ISA 705 and ISA 706
3.1 The nature of a modified audit report
An audit report is said to be modified where either:
a matter arises which does not affect the opinion given by the auditor, but
which gives rise to an ‘emphasis of matter paragraph’ or an ‘other matter
paragraph’ in the audit report (covered by ISA 706), or
a matter arises which does affect the opinion issued on the financial
statements. This will give rise to a qualified opinion, a disclaimer of opinion
or an adverse opinion (covered by ISA 705).
A modified audit report can therefore either have an unmodified audit opinion or a
modified audit opinion.
Before issuing a modified report, the auditor should discuss with management the
reason for the modification. The reason should be explained and the auditor should
ask the client entity’s management to amend the financial statements.
If management make the necessary adjustments, the auditor will not need to
issue a modified report.
If management refuse to make the amendments, a modified report may be the
only course of action available to the auditor.
3.2 Emphasis of matter paragraphs and other matter paragraphs: ISA 706
As discussed above, an audit report may be modified to include an ‘emphasis of
matter’ paragraph and/or an ‘other matter’ paragraph. These types of paragraph
are the subject of ISA 706 Emphasis of matter paragraphs and other matter paragraphs in
the independent auditor’s report.
The purpose of these paragraphs is to provide additional communication in the
audit report when the auditor wishes to draw the attention of users to a particular
matter in the financial statements. They do not modify the audit opinion.
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An emphasis of matter paragraph draws the attention of users to an item (or
‘matter’) that is included in the financial statements and which the auditor
considers fundamental to an understanding of the financial statements.
An other matter paragraph deals with a matter which is not included in the
financial statements but which is relevant to an understanding of the audit, the
auditor’s responsibilities or the audit report.
3.3 Emphasis of matter paragraphs
An ‘emphasis of matter’ paragraph is used to draw the reader’s attention to a matter
presented or disclosed in the financial statements which is fundamental to an
understanding of those financial statements.
When an audit report contains an emphasis of matter paragraph, the opinion is not
modified. It can therefore only be used where the auditor has obtained sufficient
appropriate audit evidence that the matter is not materially misstated in the
financial statements. (If the matter is materially misstated, a modified opinion is
required.)
Although the opinion is not modified, there is an item in the financial statements,
properly presented or disclosed, that the auditor wishes to bring to the attention of
users because it is fundamental to an understanding of the financial statements.
When the auditor includes as emphasis of matter paragraph in the audit report the
auditor is required to:
include it immediately after the opinion paragraph
use the heading ‘emphasis of matter’ for the paragraph (or another appropriate
heading)
include a clear reference to the matter being emphasised and to where relevant
disclosures that fully describe the matter can be found in the financial statements
indicate that his opinion is not modified in respect of the matter being
emphasised.
Circumstances in which an emphasis of matter paragraph may be necessary
ISA 706 gives the following examples of circumstances in which an emphasis of
matter paragraph may be necessary:
Where there is an uncertainty relating to the future outcome of exceptional
litigation or regulatory action.
Where the entity has adopted a new IFRS early and that has had a pervasive
effect on the financial statements.
To draw attention to a major catastrophe that has had, or continues to have, a
significant effect on the entity’s financial position.
Example: Emphasis of matter paragraph
The following illustrative wording is given in ISA 706.
We draw attention to Note X to the financial statements which describes the
uncertainty related to the outcome of the lawsuit filed against the company by
XYZ company. Our opinion is not qualified in respect of this matter.
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ISAs requiring emphasis of matter paragraphs
There are currently two ISAs which require the auditor to use an emphasis of
matter paragraph in certain circumstances.
ISA 560 Subsequent events requires an emphasis of matter paragraph to be used in
two specific circumstances. These were set out in a previous chapter.
ISA 570 Going concern requires an emphasis of matter paragraph to be used to
highlight the existence of a material uncertainty relating to a going concern
problem. The following illustrative wording for this type of emphasis of matter
paragraph is from ISA 570.
(Note that this is only appropriate where the issues relating to the going concern of
the entity are not such that a modified opinion should be given. Such matters are
considered later in this chapter.)
Without qualifying our opinion, we draw attention to Note X to the financial
statements which indicates that the company incurred a net loss of $… during the
year ended 31 December 20X1 and, as of that date, the company’s current
liabilities exceeded its total assets by $…. These conditions, along with other
matters as set forth in Note X, indicate the existence of a material uncertainty
which may cast significant doubt about the company’s ability to continue as a
going concern.
3.4 Other matter paragraphs
As stated above, an ‘other matter’ paragraph is used if the auditor considers it
necessary to communicate a matter other than those included in the financial
statements that, in his opinion, is relevant to users’ understanding of the audit, the
auditor’s responsibilities or the audit report. In this case the auditor is required to:
include the other matter paragraph immediately after the opinion paragraph
(and any emphasis of matter paragraph), or
elsewhere in the report if its content is relevant to the other reporting
responsibilities section.
Circumstances in which an other matter paragraph may be necessary
ISA 706 gives the following examples of circumstances in which an ‘other matter’
paragraph may be necessary:
Where the auditor is unable to resign from the engagement even though the
possible effect of a limitation of scope imposed by management is pervasive
(relevant to users’ understanding of the audit). This should be rare in practice.
Where local law or custom allows the auditor to elaborate on his responsibilities
in his report (relevant to users’ understanding of the auditor’s responsibilities or
audit report).
3.5 The modified opinion: ISA 705
ISA 705 Modifications to the opinion in the independent auditor’s report requires the
audit to modify his opinion in the audit report in two situations:
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Material misstatement. This occurs when the auditor concludes that, based on
the audit evidence obtained, the financial statements as a whole are ‘not free
from material misstatement’. In other words the auditor considers that there is a
material misstatement in the financial statements.
Limitation on scope. This occurs when the auditor is unable to obtain sufficient
appropriate evidence to conclude that the financial statements as a whole are free
from material misstatement. In other words, the auditor has been unable to
obtain sufficient appropriate audit evidence to reach an opinion that the financial
statements give a true and fair view; therefore the financial statements may
contain a material misstatement.
ISA 705 lists three types of modified opinions:
a qualified opinion
an adverse opinion, and
a disclaimer of opinion.
Each of these types of modifications are explained below.
Deciding the type of modified opinion required
The following table from ISA705 provides a useful summary of when each type of
modified opinion is required to give in the audit report:
Auditor’s judgement about the pervasiveness
of the effects (or possible effects) on the
financial statements
Nature of matter giving rise to
the modification
Material but not
pervasive
Material and pervasive
Financial statements are
materially misstated
Qualified opinion
Adverse opinion
Inability to obtain sufficient
appropriate audit evidence
(limitation on scope)
Qualified opinion
Disclaimer of opinion
Qualified opinions
A qualified audit opinion should be given when, in the opinion of the auditor, there
is a material misstatement or a limitation on scope, and the effect on the financial
statements is material but not pervasive.
Qualified audit opinions are sometimes called ‘except for’ opinions, because the
audit report should state that in the auditor’s opinion the financial statements give a
true and fair view except for the matter or matters described in the report.
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The meaning of pervasive: disclaimer of opinion or adverse opinion
Generally, a matter will be material but not pervasive when the auditor encounters
a material problem with one or more specific items in the financial statements (such
as a problem with inventory or revenue), but the remaining items and the financial
statements as a whole provide a true and fair view.
‘Pervasive’ effects on the financial statements are defined by ISA 705 as those that,
in the auditor’s judgement:
are not confined to specific elements, accounts or items of the financial
statements, or
are confined to specific elements in the financial statements, but these represent
(or could represent) a substantial proportion of the financial statements, or
in relation to disclosures in the financial statements, are fundamental to users’
understanding of those statements.
The difference between a ‘material’ and a ‘pervasive’ qualification is a matter of
judgement. There are no absolute cut-off points or dividing lines that separate one
from the other.
Limitations on scope
Limitations on scope occur when the auditor is unable to obtain sufficient
appropriate audit evidence about something that is material. ISA 705 suggests that
this may happen as a result of:
circumstances beyond the control of the entity, such as when the entity’s
accounting records have been destroyed
circumstances relating to the nature or timing of the auditors work: an example is
when the auditor is appointed too late to enable him to attend the physical
inventory count
limitations imposed by management. The management of the client entity may
prevent the auditor from obtaining the audit evidence required, for example by:
- preventing the auditor from observing the physical inventory count
- preventing the auditor from asking for confirmation of specific account
balances (for example, a receivables circularisation).
If, after accepting the engagement, the auditor becomes aware that management has
imposed a limitation on the scope of the audit which is likely to result in a
qualified or disclaimer of opinion, the auditor is required to ask management to
remove the limitation. If management refuse to do this, the auditor must:
communicate the matter to those charged with governance
consider whether it is possible to perform alternative audit procedures in order
to obtain sufficient appropriate audit evidence.
If it is not possible to obtain audit evidence in another way and the matter is
material but not pervasive the auditor must give a qualified opinion.
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If it is not possible to obtain audit evidence in another way and the matter is
material and pervasive the auditor must:
resign from the audit where practicable and not prohibited by law or regulation,
or
if not practicable or possible, issue a disclaimer of opinion.
3.6 Form and content of a modified opinion
Basis for modified opinion paragraph
When a modified opinion is issued, ISA 705 requires the audit report to include a
‘basis for opinion’ paragraph, which should appear just before the audit opinion in
the report.
The paragraph is headed ‘Basis for qualified opinion’, ‘Basis for adverse opinion’,
or ‘Basis for disclaimer of opinion’, as appropriate. Examples of these types of
opinion are shown later.
This ‘basis for opinion’ paragraph must include the following:
For a material misstatement relating to specific amounts – a description and
quantification of the impact on the financial statements (or a statement that
quantification is not possible).
For a material misstatement relating to narrative disclosures – an explanation of
how the disclosures are misstated.
For a material misstatement relating to the non-disclosure of information that
should have been disclosed – the nature of the omitted information and, unless
prohibited by law or regulation, the omitted disclosures.
If the modification results from an inability to obtain sufficient appropriate
audit evidence – the reasons for that inability.
Opinion paragraph
This paragraph in the audit report must now be headed ‘Qualified opinion’,
‘Adverse opinion’, or ‘Disclaimer of opinion’, as appropriate.
Specific wording is prescribed for the different types of modified opinions which is
best illustrated by the examples shown later.
Auditor’s responsibility paragraph
The auditor’s responsibility paragraph appears earlier in the audit report, after the
statement about management responsibilities for the financial statements. For a
qualified or adverse opinion this paragraph is amended to state that the auditor
believes that the audit evidence obtained is sufficient and appropriate to provide a
basis for the modified opinion.
Where the auditor gives a disclaimer of opinion, more extensive amendments are
required by ISA 705.
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3.7 Examples of modified opinions
Illustrative examples of the different types of modified opinion are shown below.
They are all taken from ISA 705. Where paragraphs in the examples are incomplete,
the wording of the report commences or concludes in the same way as in the
example of the unmodified report, shown in an earlier section of this chapter.
Example 1: Qualified opinion – limitation on scope
This is an example of a qualified opinion, arising from the auditor’s inability to
obtain sufficient appropriate audit evidence. The only paragraphs from the report
that are shown here are those that are relevant to the modified opinion.
Auditor’sresponsibility
… We believe that the audit evidence that we have obtained is sufficient and
appropriatetoprovideabasisforourqual ifiedauditopinion.
Basisforqualifiedopinion
ABCCompany’sinvestmentinXYZcompany,aforeignassociateacquiredduring
the year and accounte d for by the equity method, is carried at $XXX on the
statement of financial position at 31 December 20X1, and ABC’s share of XYZ’s
netincomeisincludedinABC’sincomefor
theyearthen ended.Wewereunable
to obtain sufficient appropriate audit evidence about the carrying amount of
ABC’s investment in XYZ at 31 December 20X1 and ABC’s share of XYZ’s net
income for the year because we were denied access to the financial information,
management and the auditors of
XYZ. Cons equently, we were unable to
determinewhetheranyadjustmentstotheseamountswerenecessary.
Qualifiedopinion
Inouropinion,exceptforthepossibleeffectsofthematterdescribedintheBasis
for Qualified Opinion paragraph, the financial statements give a true and fair
view….
Example 2: Qualified opinion – material misstatement
This is an example of a qualified opinion, arising from a material misstatement of
the financial statements:
Auditor’sresponsibility
… We believe that the audit evidence that we have obtained is sufficient and
appropriatetoprovideabasisforourqual ifiedauditopinion.
Basisforqualifiedopinion
The company’s inventories are carried in the statement of financial position at
$XXX. Management
has not stated the inventories at the lower of cost and net
realisable value buthasstatedthemsolelyatcost,whichconstitutesadeparture
from International Financial Reporting Standards. The company’s records
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indicatethathadmanagementstatedtheinventories atthelowerof costandnet
realisable value, an amount of $XXX would have been required to write the
inventories down to their net realisable value. Accordingly, cost of sales would
have been increased by $XXX, and income tax, net income and shareholders’
equitywouldhavebeenreducedby$XXX,$XXXand$XXX,respectively.
Qualifiedopinion
Inouropinion,exceptforthepossibleeffectsofthematterdescribedintheBasis
for Qualified Opinion paragraph, the financial statements give a true and fair
view….
Example 3: Disclaimer of opinion – limitation on scope
This is an example of a disclaimer of opinion where the auditor has been unable to
obtain sufficient appropriate audit evidence about a single element of the financial
statements:
This is an example of a disclaimer of opinion where the auditor has been unable to
obtain sufficient appropriate audit evidence about multiple elements of the
financial statements:
We were engaged to audit the accompanying financial statements of ABC
Company….
Management is responsible for…..
Auditor’sresponsibility
Our responsibility… International Standards on Auditing. Because of the matter
described in the Basis for Disclaimer of Opinion paragraph, however, we were not
able to obtain sufficient appropriate audit evidence to provide a basis for an audit
opinion.
Basisfordisclaimerofopinion
We were not appointed as auditors of the company until after 31 December 20X1
and thus did not observe the counting of physicals inventories at the beginning
and end of the year. We were unable to satisfy ourselves by alternative means
concerning the inventory quantities held at31 December 20X0 and 20X1 which are
stated in the statement of financial position at $XXX and $XXX, respectively. IN
addition, the introduction of a new computerised accounts receivable system in
September 20X1 resulted in numerous errors in accounts receivable. As of the date
of our audit report, management was still in the process of rectifying the system
deficiencies and correcting the errors. We were unable to confirm or verify by
alternative means accounts receivable included in the statement of financial
position at a total amount of $XXX as at 31 December 20X1. As a result of these
matters, we were unable to determine whether any adjustments might have been
found to be necessary in respect of recorded or unrecorded inventories and
accounts receivable, and the elements making up the income statement, statement
of changes in equity and statement of cash flows.
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Disclaimerofopinion
Because of the significance of the matter described in the Basis for Disclaimer of
Opinion paragraph,wehavenotbeenabletoobtainsufficientappropriateaudit
evidencetoprovidea basisforanauditopinion.Accordingly,wedonotexpress
anopiniononthefinancialstatements.
Example 4: Adverse opinion – material misstatements
Thisisanexampleofanadverseopinionisofagroupauditreport.Althoughgroup
auditreportsarenotexaminableinthispaper,itstillprovidesausefulillustration:
Auditor’s responsibility
… We believe that the audit evidence that we have obtained is sufficient and
appropriate to provide a basis for our adverse audit opinion.
Basis for adverse opinion
As explained in Note X, the company has not consolidated the financial
statements of subsidiary XYZ Company it acquired during 20X1 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. Under International Financial Reporting Standards,
the subsidiary should have been consolidated because it is controlled by the
company. Had XYZ been consolidated, many elements in the accompanying
financial statements would have been materially affected. The effects on the
financial statements of the failure to consolidate have not been determined.
Adverse opinion
In our opinion, because of the significance of the matter discussed in the Basis for
Adverse Opinion paragraph, the consolidated financial statements do not give a
true and fair view….
3.7 Deciding to give a modified opinion
The auditor will give a modified opinion only if he is satisfied that:
the reasons for giving a modified opinion are justified, and
the management of the client entity are unable or unwilling to take action to
remove the necessity for a modified opinion.
For example, suppose that the management of a client entity decides that a material
non-current asset should not be depreciated. The auditor should first of all satisfy
himself that there is no acceptable reason for the management’s view, and that the
asset should be depreciated.
The auditor should review the audit file and check for any information about this
matter from previous audits.
He should consider whether there might be an acceptable reason for a departure
from the requirements of international financial reporting standards and GAAP,
in order to give a true and fair view.