ACCA P7 (INT) Advanced Audit & Assurance - Study Text - 2010 (Emile Woolf Publishing)
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Chapter 14: Reporting
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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.
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.)
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.
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Example: Emphasis of matter paragraph
The following illustrative wording is given in ISA 706.
Emphasis of matter
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.
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 audit report should be given. Such matters
are considered later in this chapter.)
Emphasis of matter
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:
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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
When the auditor must issue a modified opinion
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:
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 ISA 705 provides a useful summary of when each type of
modified opinion is required to be given 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
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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.
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’ modification is a matter of
judgement. There are no absolute cut-off points or dividing lines that separate one
from the other.
Limitations on scope
ISA 705 suggests that a limitation on scope may occur 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).
Management imposed limitations on scope
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
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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.
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
The form and content of a modified audit report with a modified opinion differs
from an unmodified audit report in several ways. ISA 705 includes the following
requirements.
Basis for modified opinion paragraph
When a modified opinion is issued, the audit report must 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 be headed ‘Qualified opinion’, ‘Adverse
opinion’, or ‘Disclaimer of opinion’, as appropriate.
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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 there auditor gives a disclaimer of opinion, more extensive amendments are
required by ISA 705.
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
appropriatetoprovideabasisforourqualifiedauditopinion.
Basisforqualifiedopinion
ABCCompany’sinvestmentinXYZcompany,aforeignassociateacquiredduring
the year and accounted 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. Consequently, we were unable to
determinewhetheranyadjustmentstotheseamountswerenecessary.
Qualifiedopinion
Inouropinion,exceptforthepossibleeffectsofthematterdescribedintheBasis
for Qualified Opinion paragraph, the financial statements give a true and fair
view….
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Example 2: Qualified opinion – material misstatement
This is an e xample of a qualified opinion, arising from a material misstatement of
the financial statements:
Auditor’s responsibility
… We believe that the audit evidence that we have obtained is sufficient and
appropriate to provide a basis for our qualified audit opinion.
Basis for qualified opinion
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 but has stated them solely at cost, which constitutes a departure
from International Financial Reporting Standards. The company’s records
indicate that had management stated the inventories at the lower of cost and net
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’
equity would have been reduced by $XXX, $XXX and $XXX, respectively.
Qualified opinion
In our opinion, except for the possible effects of the matter described in the Basis
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’s responsibility
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.
Basis for disclaimer of opinion
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
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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.
Disclaimer of opinion
Because of the significance of the matter described in the Basis for Disclaimer of
Opinion paragraph, we have not been able to obtain sufficient appropriate audit
evidence to provide a basis for an audit opinion. Accordingly, we do not express
an opinion on the financial statements.
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….
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3.8 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.
If the auditor is still satisfied that management is incorrect in their opinion, he
should meet with the management and:
Discuss their reasons for not depreciating the asset
Obtain a representation from them confirming that the asset will not be
depreciated
Decide whether the effect of this action by management on the financial
statements is material or ‘material and pervasive’ and so what form of modified
opinion is necessary
Warn management that the audit opinion will be modified unless management
change their view
If management still refuse to change their view, issue a modified opinion, which
will be either a qualified opinion or an adverse opinion.
3.9 Audit reports and the exam
For the exam, you may be expected to study an audit report that contains errors and
identify and explain what those errors are. Alternatively, you may be asked to
discuss what audit opinion would be appropriate.
The key issues to consider are as follows.
Do the financial statements give a true and fair view? (Misstatements do not
affect the true and fair view if they are immaterial.)
If they do, the audit opinion will be unmodified.
If the draft financial statements give a true and fair view, is there any item that
justifies an ‘emphasis of matter’ paragraph? Usually, an emphasis of matter
paragraph is something that could affect the going concern assumption.
If the financial statements do not give a true and fair view, what is the item of
contention? Is it something that involves a disagreement with management (a
misstatement) or is there inadequate audit evidence (a limitation on scope)?
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Is the matter material but not pervasive? If so, a qualified audit opinion is
appropriate (‘except for…’).
If the matter is material and pervasive, either an adverse opinion or a disclaimer
of opinion is appropriate. (These are rare in practice, but of course they could
feature in an exam question!)
Here are some examples.
Example 1
You are the manager in charge of the audit of Colorosso, a limited liability company.
Your auditors’ report for the previous financial year to 31 December Year 7 was
signed, without modification, in February Year 8.
The scope of the audit for the year to 31 December Year 8 has been limited. This is
because the company’s chief executive officer fled the country in April Year 8,
taking the accounting records with him.
You have identified a valuable training opportunity for Robin, one of your audit
team. As a training exercise, you have asked Robin to draft the extracts for the basis
of opinion and opinion paragraphs that would not be standard wording in an
unmodified auditor’s report.’
Robin’s draft extracts were produced as follows:
‘Basis of opinion (extract)
However, the evidence available to us was limited because accounting records were
missing at the beginning of the year and it was not possible to reconstruct them
completely.
Opinion (extract)
Because of the possible effect of the limitations in the information available to us, we
do not express an opinion on the financial statements.’
Requirement
(a) Identify and comment on the principal matters relevant to forming an
appropriate opinion on the financial statements of Colorosso for the year
ended 31 December Year 8.
(b) Discuss the suitability of Robin’s draft extracts.
Answer
Tutorial note
To answer this requirement, you need to:
identify the principal matters relevant to forming an appropriate opinion
comment on these matters
identify whether Robin’s report indicates that Robin has identified and
considered these matters