Chapter 11: Reporting

Chapter learning objectives

Upon completion of this chapter you will be able to:

• Describe and analyse the format and content of unmodified audit reports;
• Describe and analyse the format and content of modified audit reports; and  
• Identify and explain the contents of other reports made to management.

1 The audit report

The objectives of an auditor, in accordance with ISA 700 Forming an Opinion and Reporting on Financial Statements, are:

• to form an opinion on the financial statements based upon an evaluation of their conclusions drawn from audit evidence; and
• to express clearly that opinion through a written report.

2 Forming an opinion

The auditor forms an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. In order to do that they must conclude whether they have obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement (whether due to fraud or error).

In particular the auditor should evaluate whether:

• the financial statements adequately disclose the significant accounting policies;
• the accounting policies selected are consistently applied and appropriate;
• accounting estimates are reasonable;
• information is relevant, reliable, comparable and understandable;
• the financial statements provide adequate disclosures to enable the users to understand the effects of material transactions and events; and
• the terminology used is appropriate.

When the auditor concludes that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework they issue an unmodified opinion.

If they conclude that either:

• the financial statements as a whole are not free from material misstatement; or
• they have been unable to obtain sufficient appropriate evidence;

then they have to issue a modified opinion.

3 Contents of the audit report

ISA 700 provides guidance as to the nature and wording of the audit report. Most importantly the report must be in writing.

In addition it recommends that the audit report be broken into distinct sections that explain the purpose, nature and scope of an audit. The main reason for this is to ensure that the users of the audit report understand the nature of audit procedures and that only reasonable assurance is being offered. One of the primary purposes of this is to reduce the 'expectations gap.'

The recommended elements of the report are as follows:

Title

• The title should be 'appropriate'. The use of 'Independent Auditor's Report' distinguishes this report from any other report produced internally or by other non-statutory auditors.

Addressee

• The report should be addressed to the intended user of the report which is usually the shareholders, or other parties as required by the circumstances of the engagement.

Introductory paragraph

• Identifies the entity whose financial statements have been audited;
• States that the financial statements have been audited;
• Identifies the components of the financial statements (by name and even page reference);
• Refers to the accounting policies applied to the financial statements; and
• Specifies the date or period covered by the financial statements.

Statement of responsibilities of the auditors

• Express an opinion.
• The audit was conducted in accordance with ISA's;
• Requirement to comply with ethical standards;
• The fact that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free from material misstatement.
• Audit involves procedures designed to obtain evidence about amounts and disclosures in the financial statements;
• The procedures are based upon auditor judgement, including a risk assessment and consideration of internal controls;
• Obtain sufficient, appropriate audit evidence on which to base the opinion.

Auditor's opinion (headed 'Opinion')

• When expressing an unmodified opinion the auditor (unless otherwise required by relevant laws or regulations) uses one of the following phrases:
  • "the financial statements present fairly, in all material respects........"; or
  • "the financial statements show a true and fair view of .......................".

Statement of responsibilities of management

• Preparation of the financial statements in accordance with the applicable financial reporting framework; and
• Designing and implementing an effective internal control system to enable the preparation of financial statements that are free of material misstatement;

Auditor's signature

• The report may be signed in the name of the firm, or the personal name of the auditor, as appropriate for the particular jurisdiction.
• There may also be a requirement to state the auditor's professional accountancy designation or that the firm is recognised by the appropriate licensing authority (i.e. that the firm/partner is a member of a body such as ACCA and is registered to audit).

Date of report

• The audit report should be dated no earlier that the date on which the auditor has obtained sufficient appropriate evidence upon which to base their opinion.
• This requires that all the statements and notes/disclosure that comprise the financial statements are finalised and that those with responsibility for preparation of the financial statements have acknowledged their role.
• Practically this means that the auditor should sign their report after the directors have approved the financial statements.

Auditor's address

• The audit report should name a specific location, which is normally the city where the auditor maintains the office that has responsibility for the audit.

Illustration 1: Unmodified audit report

INDEPENDENT AUDITOR'S REPORT

(Appropriate Addressee)

Report on the Financial Statements

We have audited the accompanying financial statements of the ABC Company, which comprise the statement of financial position as at 31 December, 20X1, and the income statement, statement of changes in equity and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory information.

Management's Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.

Auditor's Responsibility

Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgement, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the presentation of the financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the financial statements present fairly, in all material respects (or give a true and fair view of) the financial position of ABC Company as at December 31 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards.

[Date of auditor's report]

[Auditor's address]

4 Modifications to the audit report

So far we have explored the nature and wording of an unmodified audit report. There are two ways that the audit report can be modified:

• by modifying the audit opinion; or
• through inclusion of additional paragraphs

Modifying the audit opinion

There are two reasons why an auditor would be unable to give an unmodified audit opinion:

• they conclude that the financial statements as a whole are not free from material misstatements; or
• they have been unable to obtain sufficient appropriate evidence to conclude that the financial statements as a whole are free from material misstatement.

If the auditor comes to either of the above conclusions they must then consider how significant the matter is. If the matter is considered immaterial then it should not affect the wording of the opinion and a 'present fairly' or 'true and fair' wording may be used.

However, if the auditor concludes that the matter is material they must modify the wording of their opinion. If, in addition to being material, the auditor considers the matter to be pervasive to the financial statements, then this must also be incorporated into the audit opinion (as shown below). Pervasive means that the matter is:

• not confined to specific elements of the financial statements;
• if confined represents a substantial proportion of the financial statements; or
• is fundamental to users understanding of the financial statements.

The affects on the wording of the opinion can be summarised as follows:

When the auditor modifies their opinion they have to include a 'Basis for Modification Paragraph' in the audit report that describes the matter giving rise to the modification. This paragraph should be placed before the opinion paragraph.

With a qualified opinion the auditor is basically stating that whilst there are, or maybe, material misstatements, they are confined to a specific element of the financial statements but the remainder may be relied upon. Accordingly the opinion usually states that "except for the matters described in the basis for modification paragraph, the financial statements present fairly (or give a true and fair view of) ............."

If the auditor concludes that the matter is pervasive they are claiming that the financial statements may not be relied upon in any part. Accordingly:

• if they give an adverse opinion they will state that the financial statements "do not present fairly (or give a true and fair view of).........."
• if they give a disclaimer they will state that they "do not express an opinion on the financial statements."

Illustration 2: Qualified opinion

Example of wording where the auditor concludes that the financial statements contain a material, but not pervasive, misstatement:

Basis for Qualified Opinion

As discussed in Note X to the financial statements, no depreciation has been provided in the financial statements which practice, in our opinion, is not in accordance with International Financial Reporting Standards. The provision for the year ended 31 December, 20X9, should be XXX based on the straight-line method of depreciation using annual rates of 5% for the building and 20% for the equipment. Accordingly, the non-current assets should be reduced by accumulated depreciation of XXX and the loss for the year and accumulated deficit should be increased by XXX and XXX, respectively.

Opinion

In our opinion, except for the effect on the financial statements of the matter referred to in the Basis for Qualified Opinion paragraph, the financial statements present fairly in all material respects (or give a true and fair view of) the financial position ...................(remainder of wording as per an unmodified report).

Illustration 3: Adverse opinion

Example where the auditor concludes that the financial statements are materially and pervasively misstated:

Basis for Adverse Opinion

As explained in Note X, the company has recognised a number of assets acquired under a lease and the associated liabilities at a fair value of $X, accounting for the leases as a finance leases. The fair value of these assets represent 80% of total assets. Under International Financial Reporting Standards the leases should have been classified as operating leases. The companies records indicate that had the leases been correctly accounted for as operating leases....[explanation of the various effects on the amounts presented in the financial statements].

Adverse Opinion

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph , the financial statements do not present fairly (or give a true and fair view of) the financial position.......

Illustration 4: Qualified opinion

Example where the auditor concludes that they have been unable to gather sufficient appropriate evidence and the possible effects are deemed to be material but not pervasive.

Basis for Qualified Opinion

We did not observe the counting of the physical inventories as at 31 December 20X9, since that date was prior to our appointment as auditor to the company. Owing to the nature of the company's records, we were unable to satisfy ourselves as to inventory quantities by other audit procedures.

Qualified Opinion

In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly (or give a true and fair view of) the financial position............

Illustration 5: Disclaimer of opinion

Example where the auditor concludes that they have been unable to gather sufficient appropriate evidence and the possible effects are deemed to be both material and pervasive.

Basis for Disclaimer of Opinion

A new computerised payroll system was introduced in October 20X1, that has caused significant errors in the payroll records, amounts paid to employees, and taxation paid in the year. At the date of our audit report, management was still in the process of identifying and quantifying the volume and amount of errors, and rectifying and correcting the system and errors that have arisen. We were unable to confirm or verify by alternative means the payroll expense of $X, included in the income statement for the year ended 31 December 20X1, and associated liabilities of $X owed to the tax authorities and affected employees in the statement of financial position as at 31 December 20X1.

As a result, we were unable to determine whether any adjustments to the financial statements might have been necessary in respect of recorded or unrecorded liabilities or expenses, and the associated elements of the statement of changes in equity and cash flow statement.

Disclaimer of Opinion

Because of the significance of the matter described in the Basis of Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements.

5 Additional paragraphs

Having formed their opinion there are circumstances where the auditor must also draw the users attention to additional matters that are significant to their understanding of the financial statements. These circumstances are categorised as follows:

• matters already presented/disclosed in the financial statements that are fundamental to understanding the financial statements. These are presented in "Emphasis of Matter" paragraphs; and
• other matters relevant to either understanding the audit, the auditor's responsibilities or the audit report. These are presented in "Other Matter" paragraphs.

Emphasis of Matter Paragraphs

These are presented immediately after the opinion paragraph. It is important to note that they have do not affect the audit opinion, nor are they a substitute for one.

These paragraphs simply draw the readers' attention to a note already disclosed in the financial statements. The matters referred to have to be fundamental to the readers' understanding of the financial statements. Widespread use of them would diminish their effectiveness.

Examples of where it may be necessary to add an Emphasis of Matter paragraph include:

• an uncertainty relating to the future outcome of exceptional litigation or regulatory action;
• early application of a new accounting standards that has a pervasive effect on the financial statements;
• a major catastrophe that has had, or continues to have, a significant effect on the entity's financial position.

Other Matter Paragraphs

Circumstances where these may be necessary include:

• when a pervasive inability to obtain sufficient appropriate evidence is imposed by management (e.g. denying the auditor access to books and records) but the auditor is unable to withdraw from the engagement due to legal restrictions;
• when national laws/regulations require, or permit, the auditor to elaborate on their responsibilities;
• when the client issues another set of financial statements (e.g. one according to IFRS and one according to UK GAAP) and the auditor has also issued a report on those financial statements;
• when a set of financial statements is prepared for a specific purpose and user group and the users have determined that a general purpose framework meets their financial information needs; and
• if there is a material inconsistency between the audited financial statements and the 'other information' contained in the annual report (such as the Chairman's Report).

Illustration 6: Emphasis of Matter Paragraph

Emphasis of Matter

We draw attention to Note X to the financial statements. The Company is the defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The Company has filed a counter action, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot presently be determined, and no provision for any liability that may result has been made in the financial statements. Our opinion is not qualified in respect of this matter.

6 Reporting to those charged with Governance

ISAs, in particular ISA 260 Communication with Those Charged with Governance and ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, require the external auditors to engage in communications with management.

The main forms of formal communication between the auditors and management are: the engagement letter (see 'Ethics and Acceptance' chapter); and another written communication, usually sent at the end of the audit, which is often referred to as 'the management letter.'

The objectives of these communications are:

• To communicate the responsibilities of the auditor and an overview of the scope and timing of the audit;
• To obtain, from those charged with governance, information relevant to the audit;
• To provide timely observations arising from the audit that are significant to the responsibilities of those charged with governance; and
• To promote effective two-way communication between the auditor and those charged with governance.

Whilst a formal communication is usually sent at the conclusion of the audit there may be a need to communicate particular matters at other times to help meet the third objective, for example; if a fraud is discovered.

Audit matters of governance interest include:

• Auditor independence;
• Effects of significant accounting policies and changes to them;
• Potential financial effect of risks/uncertainties;
• Material audit adjustments;
• Disagreements with management concerning the financial statements;
• Significant difficulties encountered during the audit;
• Expected modifications to the audit report; and
• Significant internal control deficiencies, including fraud.

Timing of communications

UK Syllabus Focus

ISA 720(b) (UK & Ireland) The Auditor's Statutory Reporting Responsibility in Relation to Directors' Reports

In the United Kingdom legislation (i.e. the Companies Act 2006) requires the auditor of a company to state in the auditor's report whether, in the auditor's opinion, the information given in the directors' report is consistent with the financial statements.

Objectives

The objective of the auditor is to form an opinion on whether the information given in the directors' report is consistent with the financial statements and to respond appropriately if it is not consistent.

Requirements

The auditor shall read the information in the directors' report and assess whether it is consistent with the financial statements.

The auditor is not required to verify, or report on, the completeness of the information in the directors' report. If, however, the auditor becomes aware that information that is required by law or regulations to be in the directors' report has been omitted the auditor communicates the matter to those charged with governance.

If the auditor identifies any inconsistencies between the information in the directors' report and the financial statements the auditor shall seek to resolve them.

If the auditor is of the opinion that the information in the directors' report is materially inconsistent with the financial statements, and has been unable to resolve the inconsistency, the auditor shall state that opinion and describe the inconsistency in the auditor's report.

If an amendment is necessary to the financial statements and management and those charged with governance refuse to make the amendment, the auditor shall express a qualified or adverse opinion on the financial statements.

Test your understanding 1

In terms of audit reports, explain the term 'modified'.

Test your understanding 2

ISA 260 (Revised and Redrafted) Communication with Those Charged with Governance deals with the auditor's responsibility to communicate with those charged with governance in relation to an audit of financial statements.

Required:

(i)Describe TWO specific responsibilities of those charged with governance; and

(ii) Explain FOUR examples of matters that might be communicated to them by the auditor.

Real exam question: December 2009

Test your understanding 3

Potterton is a listed company that manufactures body lotions under the 'ReallyCool' brand. The company's year end is 31 March 2011, and today's date is 1 June 2011. Draft profit before taxation is $4 million.

The audit is nearing completion, but two issues remain outstanding:

(1)On 27 May 2011 a legal claim was made against the company on behalf of a teenager who suffered severe burns after using ‘ReallyCool ExtraZingy Lotion’ in July 2010. Potterton is considering an out-of-court settlement of $100,000 per year for the remaining life of the claimant. However, no adjustment or disclosure has been made in the financial statements.

(2)At a Board Meeting on 30 April 2011, the directors of Potterton proposed a dividend of $2 million. It is highly likely that the shareholders will approve the dividend at the Annual General Meeting on 3 September 2011. The directors have recorded the dividend in the draft Statement of Changes in Equity for the year ended 31 March 2011.

Required:

(a)Explain whether the two outstanding issues are adjusting or non-adjusting events, in accordance with IAS 10, Events after the Reporting Period.

(b)Explain appropriate audit procedures in order to reach a conclusion on the two outstanding issues.

(c)Explain the likely impact on the audit opinion if the directors refuse to make any further adjustments or disclosures in the financial statements.

Test your understanding 4

Henry

(a)Aragon Co made a very poor attempt to conduct their inventory count. You attended, however there was insufficient evidence that the inventory valuation at $4 million is accurate. Sales revenue was $50 million and profit for the year was $15 million.

(b)Boleyn Co did not provide for a bad debt of $50,000 despite the fact that the customer went bankrupt just after the year end. Profit for the year was $500,000 and trade receivables $200,000.

(c)Seymour Co is being sued by a competitor company for the theft of intellectual property. The lawyers believe that this important but not vital and the case could go either way. However, this is not mentioned anywhere in the financial statements.

(d)Howard Co is a cash retailer. There is no system to confirm the accuracy of cash sales.

(e)Cleves Co has neglected to include an income statement in its financial statements.

(f) Parr Co is undergoing a major court case that would bankrupt the company if lost. The directors assess and disclose the case as a contingent liability in the accounts. The auditors agree with the treatment and disclosure.

Required:

For each of the above situations state what type of audit report should be issued and explain your choice.

Test your understanding 5

(1)List the main contents of an unmodified audit report?

(2)What opinion does the auditor give in an unmodified audit report?

(3)When should the audit report be signed?

(4)Who should sign the audit report and what further information about the signatory should be provided?

Test your understanding 6

You are currently engaged in reviewing the working papers of several audit assignments recently carried out by your audit practice. Each of the audit assignments is nearing completion, but certain matters have recently come to light which may affect your audit opinion on each of the assignments. In each case the year end of the company is 30 September 20X2.

(a)  Jones (Profit before tax $150,000)

(b)  Roberts (Profit before tax $500,000)

(c)  Williams (Net loss for the year $75,000)

(d)  Griffiths (Net profit before tax $250,000)

(e)  Evans (Net profit before tax $100,000)

Required:

Discuss each of the cases outlined above, referring to materiality considerations and, where appropriate, relevant accounting principles and appropriate accounting standards. You should also indicate, with reasons, the kind of audit report (including the type of qualification, if necessary) which you consider would be appropriate in each case.

You are not required to produce the full audit reports, and you may assume that all matters other than those specifically mentioned are considered satisfactory.

7 Chapter summary

Test your understanding answers

Test your understanding 1

Audit report term

Modified. An auditor modifies an audit report in any situation where it is inappropriate to provide an unmodified report.

For example, the auditor may provide additional information in an emphasis of matter (which does not affect the auditor's opinion) or modify the audit opinion because the financial statements as a whole are not free from material misstatement or the auditor is unable to obtain sufficient appropriate evidence to conclude.

Test your understanding 2

(i)Those charged with governance are responsible for overseeing:

• the strategic direction of the entity
• obligations related to the accountability of the entity. This includes overseeing the financial reporting process;
• promotion of good corporate governance;
• risk assessment processes;
• the establishment and monitoring of internal controls;
• compliance with applicable law and regulations; and
• implementation of controls to prevent and detect fraud and errors.

(ii) General audit matters that might be communicated to those charged with governance are:

• A statement that the auditor is responsible for forming and expressing an opinion on the financial statements.
• That the auditor's work is carried out in accordance with ISAs and in accordance with local laws and regulations.

• The audit approach to assessing the risk of serious misstatement, whether arising from fraud or error.
• The audit approach to the internal control system and whether reliance will be placed on it.
• The timing of interim and final audits, including reporting deadlines.

• Significant difficulties encountered during the audit, including delays in obtaining information from management.
• Material deficiencies in internal control and recommendations for improvement.
• Audit adjustments, whether or not recorded by the entity, that have, or could have, a material effect on the entity's financial statements. For example, the bankruptcy of a material receivable shortly after the year-end that should result in an adjusting entry.

• That the audit firm has ensured that all members of the audit team have complied with the ethical standards of ACCA.
• That appropriate safeguards are in place where a potential threat to independence has been identified.

Test your understanding 3

(a)Analysis of events

(b)Audit procedures

• Review legal correspondence in order to understand the likely outcome of the legal claim.
• Review customer correspondence/legal files in order to identify other similar claims which could give rise to additional liabilities.
• Discuss with Production Director the likely cause of the burns (e.g. allergy in user or inadequate printed instructions on product use) to determine the likelihood of any claim being successful in court.
• Review trade/consumer press to identify whether the claim might damage Reallycool's reputation which could impact future revenues or even create a going concern threat.
• Propose adjustment of the financial statements to the directors.

• Inspect Board Minutes in order to confirm the amount of the proposed dividend.
• Propose an adjustment to the financial statements to remove the dividend from being recognised in the Statement of Changes in Equity but ensure that the dividend proposal is disclosed within the notes.

(c)Impact on audit opinion.

Test your understanding 4

(a)There is a lack of sufficient appropriate audit evidence, specifically relating to the valuation of inventory. Inventory is a material amount since it is 8% of sales revenue and 27% of profit. A report with a qualified opinion will be issued (using the 'except for' wording) due an inability to obtain sufficient appropriate audit evidence.

(b)The financial statements are materially misstated as the event after the balance sheet date is an adjusting event in accordance with IAS 10 and therefore the debt should be written off. The debt of $50,000 is material since it is 10% of profit and 25% of the total receivables. A report with a qualified opinion will be issued (using the 'except for' wording) due to a material misstatement.

(c)The financial statements are materially misstated since this is a contingent liability in accordance with IAS 37 and so should be disclosed by note. The matter is material. A report with a qualified opinion will be issued (using the 'except for' wording) due to a material omission.

(d)There is a lack of sufficient appropriate audit evidence if there is no method available to confirm cash sales. The matter would be material and pervasive since if cash sales cannot be confirmed, it may also not be possible to verify other figures in the financial statements. A modified report with a disclaimer of opinion will be issued.

(e)The financial statements are materially misstated since legislation requires companies to publish an income statement. The matter would material and pervasive. A modified report with an adverse opinion will be issued.

(f)An unmodified opinion would be issued since the auditors agree with the treatment and disclosure of the contingent liability. However, there is a fundamental uncertainty (the outcome of the court case will be determined in the future). An modified report with an emphasis of matter paragraph would be issued.

Test your understanding 5

Test your understanding 6

(a)Jones

(b)Roberts

(c)Williams

(d)Griffiths

(e)Evans

Chapter 11: Reporting

Chapter learning objectives

Upon completion of this chapter you will be able to:

• Describe and analyse the format and content of unmodified audit reports;
• Describe and analyse the format and content of modified audit reports; and  
• Identify and explain the contents of other reports made to management.

1 The audit report

The objectives of an auditor, in accordance with ISA 700 Forming an Opinion and Reporting on Financial Statements, are:

• to form an opinion on the financial statements based upon an evaluation of their conclusions drawn from audit evidence; and
• to express clearly that opinion through a written report.

2 Forming an opinion

The auditor forms an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. In order to do that they must conclude whether they have obtained reasonable assurance about whether the financial statements as a whole are free from material misstatement (whether due to fraud or error).

In particular the auditor should evaluate whether:

• the financial statements adequately disclose the significant accounting policies;
• the accounting policies selected are consistently applied and appropriate;
• accounting estimates are reasonable;
• information is relevant, reliable, comparable and understandable;
• the financial statements provide adequate disclosures to enable the users to understand the effects of material transactions and events; and
• the terminology used is appropriate.

When the auditor concludes that the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework they issue an unmodified opinion.

If they conclude that either:

• the financial statements as a whole are not free from material misstatement; or
• they have been unable to obtain sufficient appropriate evidence;

then they have to issue a modified opinion.

3 Contents of the audit report

ISA 700 provides guidance as to the nature and wording of the audit report. Most importantly the report must be in writing.

In addition it recommends that the audit report be broken into distinct sections that explain the purpose, nature and scope of an audit. The main reason for this is to ensure that the users of the audit report understand the nature of audit procedures and that only reasonable assurance is being offered. One of the primary purposes of this is to reduce the 'expectations gap.'

The recommended elements of the report are as follows:

Title

• The title should be 'appropriate'. The use of 'Independent Auditor's Report' distinguishes this report from any other report produced internally or by other non-statutory auditors.

Addressee

• The report should be addressed to the intended user of the report which is usually the shareholders, or other parties as required by the circumstances of the engagement.

Introductory paragraph

• Identifies the entity whose financial statements have been audited;
• States that the financial statements have been audited;
• Identifies the components of the financial statements (by name and even page reference);
• Refers to the accounting policies applied to the financial statements; and
• Specifies the date or period covered by the financial statements.

Statement of responsibilities of the auditors

• Express an opinion.
• The audit was conducted in accordance with ISA's;
• Requirement to comply with ethical standards;
• The fact that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free from material misstatement.
• Audit involves procedures designed to obtain evidence about amounts and disclosures in the financial statements;
• The procedures are based upon auditor judgement, including a risk assessment and consideration of internal controls;
• Obtain sufficient, appropriate audit evidence on which to base the opinion.

Auditor's opinion (headed 'Opinion')

• When expressing an unmodified opinion the auditor (unless otherwise required by relevant laws or regulations) uses one of the following phrases:
  • "the financial statements present fairly, in all material respects........"; or
  • "the financial statements show a true and fair view of .......................".

Statement of responsibilities of management

• Preparation of the financial statements in accordance with the applicable financial reporting framework; and
• Designing and implementing an effective internal control system to enable the preparation of financial statements that are free of material misstatement;

Auditor's signature

• The report may be signed in the name of the firm, or the personal name of the auditor, as appropriate for the particular jurisdiction.
• There may also be a requirement to state the auditor's professional accountancy designation or that the firm is recognised by the appropriate licensing authority (i.e. that the firm/partner is a member of a body such as ACCA and is registered to audit).

Date of report

• The audit report should be dated no earlier that the date on which the auditor has obtained sufficient appropriate evidence upon which to base their opinion.
• This requires that all the statements and notes/disclosure that comprise the financial statements are finalised and that those with responsibility for preparation of the financial statements have acknowledged their role.
• Practically this means that the auditor should sign their report after the directors have approved the financial statements.

Auditor's address

• The audit report should name a specific location, which is normally the city where the auditor maintains the office that has responsibility for the audit.

Illustration 1: Unmodified audit report

INDEPENDENT AUDITOR'S REPORT

(Appropriate Addressee)

Report on the Financial Statements

We have audited the accompanying financial statements of the ABC Company, which comprise the statement of financial position as at 31 December, 20X1, and the income statement, statement of changes in equity and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory information.

Management's Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error.

Auditor's Responsibility

Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgement, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the presentation of the financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, the financial statements present fairly, in all material respects (or give a true and fair view of) the financial position of ABC Company as at December 31 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards.

[Date of auditor's report]

[Auditor's address]

4 Modifications to the audit report

So far we have explored the nature and wording of an unmodified audit report. There are two ways that the audit report can be modified:

• by modifying the audit opinion; or
• through inclusion of additional paragraphs

Modifying the audit opinion

There are two reasons why an auditor would be unable to give an unmodified audit opinion:

• they conclude that the financial statements as a whole are not free from material misstatements; or
• they have been unable to obtain sufficient appropriate evidence to conclude that the financial statements as a whole are free from material misstatement.

If the auditor comes to either of the above conclusions they must then consider how significant the matter is. If the matter is considered immaterial then it should not affect the wording of the opinion and a 'present fairly' or 'true and fair' wording may be used.

However, if the auditor concludes that the matter is material they must modify the wording of their opinion. If, in addition to being material, the auditor considers the matter to be pervasive to the financial statements, then this must also be incorporated into the audit opinion (as shown below). Pervasive means that the matter is:

• not confined to specific elements of the financial statements;
• if confined represents a substantial proportion of the financial statements; or
• is fundamental to users understanding of the financial statements.

The affects on the wording of the opinion can be summarised as follows:

When the auditor modifies their opinion they have to include a 'Basis for Modification Paragraph' in the audit report that describes the matter giving rise to the modification. This paragraph should be placed before the opinion paragraph.

With a qualified opinion the auditor is basically stating that whilst there are, or maybe, material misstatements, they are confined to a specific element of the financial statements but the remainder may be relied upon. Accordingly the opinion usually states that "except for the matters described in the basis for modification paragraph, the financial statements present fairly (or give a true and fair view of) ............."

If the auditor concludes that the matter is pervasive they are claiming that the financial statements may not be relied upon in any part. Accordingly:

• if they give an adverse opinion they will state that the financial statements "do not present fairly (or give a true and fair view of).........."
• if they give a disclaimer they will state that they "do not express an opinion on the financial statements."

Illustration 2: Qualified opinion

Example of wording where the auditor concludes that the financial statements contain a material, but not pervasive, misstatement:

Basis for Qualified Opinion

As discussed in Note X to the financial statements, no depreciation has been provided in the financial statements which practice, in our opinion, is not in accordance with International Financial Reporting Standards. The provision for the year ended 31 December, 20X9, should be XXX based on the straight-line method of depreciation using annual rates of 5% for the building and 20% for the equipment. Accordingly, the non-current assets should be reduced by accumulated depreciation of XXX and the loss for the year and accumulated deficit should be increased by XXX and XXX, respectively.

Opinion

In our opinion, except for the effect on the financial statements of the matter referred to in the Basis for Qualified Opinion paragraph, the financial statements present fairly in all material respects (or give a true and fair view of) the financial position ...................(remainder of wording as per an unmodified report).

Illustration 3: Adverse opinion

Example where the auditor concludes that the financial statements are materially and pervasively misstated:

Basis for Adverse Opinion

As explained in Note X, the company has recognised a number of assets acquired under a lease and the associated liabilities at a fair value of $X, accounting for the leases as a finance leases. The fair value of these assets represent 80% of total assets. Under International Financial Reporting Standards the leases should have been classified as operating leases. The companies records indicate that had the leases been correctly accounted for as operating leases....[explanation of the various effects on the amounts presented in the financial statements].

Adverse Opinion

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph , the financial statements do not present fairly (or give a true and fair view of) the financial position.......

Illustration 4: Qualified opinion

Example where the auditor concludes that they have been unable to gather sufficient appropriate evidence and the possible effects are deemed to be material but not pervasive.

Basis for Qualified Opinion

We did not observe the counting of the physical inventories as at 31 December 20X9, since that date was prior to our appointment as auditor to the company. Owing to the nature of the company's records, we were unable to satisfy ourselves as to inventory quantities by other audit procedures.

Qualified Opinion

In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly (or give a true and fair view of) the financial position............

Illustration 5: Disclaimer of opinion

Example where the auditor concludes that they have been unable to gather sufficient appropriate evidence and the possible effects are deemed to be both material and pervasive.

Basis for Disclaimer of Opinion

A new computerised payroll system was introduced in October 20X1, that has caused significant errors in the payroll records, amounts paid to employees, and taxation paid in the year. At the date of our audit report, management was still in the process of identifying and quantifying the volume and amount of errors, and rectifying and correcting the system and errors that have arisen. We were unable to confirm or verify by alternative means the payroll expense of $X, included in the income statement for the year ended 31 December 20X1, and associated liabilities of $X owed to the tax authorities and affected employees in the statement of financial position as at 31 December 20X1.

As a result, we were unable to determine whether any adjustments to the financial statements might have been necessary in respect of recorded or unrecorded liabilities or expenses, and the associated elements of the statement of changes in equity and cash flow statement.

Disclaimer of Opinion

Because of the significance of the matter described in the Basis of Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements.

5 Additional paragraphs

Having formed their opinion there are circumstances where the auditor must also draw the users attention to additional matters that are significant to their understanding of the financial statements. These circumstances are categorised as follows:

• matters already presented/disclosed in the financial statements that are fundamental to understanding the financial statements. These are presented in "Emphasis of Matter" paragraphs; and
• other matters relevant to either understanding the audit, the auditor's responsibilities or the audit report. These are presented in "Other Matter" paragraphs.

Emphasis of Matter Paragraphs

These are presented immediately after the opinion paragraph. It is important to note that they have do not affect the audit opinion, nor are they a substitute for one.

These paragraphs simply draw the readers' attention to a note already disclosed in the financial statements. The matters referred to have to be fundamental to the readers' understanding of the financial statements. Widespread use of them would diminish their effectiveness.

Examples of where it may be necessary to add an Emphasis of Matter paragraph include:

• an uncertainty relating to the future outcome of exceptional litigation or regulatory action;
• early application of a new accounting standards that has a pervasive effect on the financial statements;
• a major catastrophe that has had, or continues to have, a significant effect on the entity's financial position.

Other Matter Paragraphs

Circumstances where these may be necessary include:

• when a pervasive inability to obtain sufficient appropriate evidence is imposed by management (e.g. denying the auditor access to books and records) but the auditor is unable to withdraw from the engagement due to legal restrictions;
• when national laws/regulations require, or permit, the auditor to elaborate on their responsibilities;
• when the client issues another set of financial statements (e.g. one according to IFRS and one according to UK GAAP) and the auditor has also issued a report on those financial statements;
• when a set of financial statements is prepared for a specific purpose and user group and the users have determined that a general purpose framework meets their financial information needs; and
• if there is a material inconsistency between the audited financial statements and the 'other information' contained in the annual report (such as the Chairman's Report).

Illustration 6: Emphasis of Matter Paragraph

Emphasis of Matter

We draw attention to Note X to the financial statements. The Company is the defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The Company has filed a counter action, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot presently be determined, and no provision for any liability that may result has been made in the financial statements. Our opinion is not qualified in respect of this matter.

6 Reporting to those charged with Governance

ISAs, in particular ISA 260 Communication with Those Charged with Governance and ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management, require the external auditors to engage in communications with management.

The main forms of formal communication between the auditors and management are: the engagement letter (see 'Ethics and Acceptance' chapter); and another written communication, usually sent at the end of the audit, which is often referred to as 'the management letter.'

The objectives of these communications are:

• To communicate the responsibilities of the auditor and an overview of the scope and timing of the audit;
• To obtain, from those charged with governance, information relevant to the audit;
• To provide timely observations arising from the audit that are significant to the responsibilities of those charged with governance; and
• To promote effective two-way communication between the auditor and those charged with governance.

Whilst a formal communication is usually sent at the conclusion of the audit there may be a need to communicate particular matters at other times to help meet the third objective, for example; if a fraud is discovered.

Audit matters of governance interest include:

• Auditor independence;
• Effects of significant accounting policies and changes to them;
• Potential financial effect of risks/uncertainties;
• Material audit adjustments;
• Disagreements with management concerning the financial statements;
• Significant difficulties encountered during the audit;
• Expected modifications to the audit report; and
• Significant internal control deficiencies, including fraud.

Timing of communications

UK Syllabus Focus

ISA 720(b) (UK & Ireland) The Auditor's Statutory Reporting Responsibility in Relation to Directors' Reports

In the United Kingdom legislation (i.e. the Companies Act 2006) requires the auditor of a company to state in the auditor's report whether, in the auditor's opinion, the information given in the directors' report is consistent with the financial statements.

Objectives

The objective of the auditor is to form an opinion on whether the information given in the directors' report is consistent with the financial statements and to respond appropriately if it is not consistent.

Requirements

The auditor shall read the information in the directors' report and assess whether it is consistent with the financial statements.

The auditor is not required to verify, or report on, the completeness of the information in the directors' report. If, however, the auditor becomes aware that information that is required by law or regulations to be in the directors' report has been omitted the auditor communicates the matter to those charged with governance.

If the auditor identifies any inconsistencies between the information in the directors' report and the financial statements the auditor shall seek to resolve them.

If the auditor is of the opinion that the information in the directors' report is materially inconsistent with the financial statements, and has been unable to resolve the inconsistency, the auditor shall state that opinion and describe the inconsistency in the auditor's report.

If an amendment is necessary to the financial statements and management and those charged with governance refuse to make the amendment, the auditor shall express a qualified or adverse opinion on the financial statements.

Test your understanding 1

In terms of audit reports, explain the term 'modified'.

Test your understanding 2

ISA 260 (Revised and Redrafted) Communication with Those Charged with Governance deals with the auditor's responsibility to communicate with those charged with governance in relation to an audit of financial statements.

Required:

(i)Describe TWO specific responsibilities of those charged with governance; and

(ii) Explain FOUR examples of matters that might be communicated to them by the auditor.

Real exam question: December 2009

Test your understanding 3

Potterton is a listed company that manufactures body lotions under the 'ReallyCool' brand. The company's year end is 31 March 2011, and today's date is 1 June 2011. Draft profit before taxation is $4 million.

The audit is nearing completion, but two issues remain outstanding:

(1)On 27 May 2011 a legal claim was made against the company on behalf of a teenager who suffered severe burns after using ‘ReallyCool ExtraZingy Lotion’ in July 2010. Potterton is considering an out-of-court settlement of $100,000 per year for the remaining life of the claimant. However, no adjustment or disclosure has been made in the financial statements.

(2)At a Board Meeting on 30 April 2011, the directors of Potterton proposed a dividend of $2 million. It is highly likely that the shareholders will approve the dividend at the Annual General Meeting on 3 September 2011. The directors have recorded the dividend in the draft Statement of Changes in Equity for the year ended 31 March 2011.

Required:

(a)Explain whether the two outstanding issues are adjusting or non-adjusting events, in accordance with IAS 10, Events after the Reporting Period.

(b)Explain appropriate audit procedures in order to reach a conclusion on the two outstanding issues.

(c)Explain the likely impact on the audit opinion if the directors refuse to make any further adjustments or disclosures in the financial statements.

Test your understanding 4

Henry

(a)Aragon Co made a very poor attempt to conduct their inventory count. You attended, however there was insufficient evidence that the inventory valuation at $4 million is accurate. Sales revenue was $50 million and profit for the year was $15 million.

(b)Boleyn Co did not provide for a bad debt of $50,000 despite the fact that the customer went bankrupt just after the year end. Profit for the year was $500,000 and trade receivables $200,000.

(c)Seymour Co is being sued by a competitor company for the theft of intellectual property. The lawyers believe that this important but not vital and the case could go either way. However, this is not mentioned anywhere in the financial statements.

(d)Howard Co is a cash retailer. There is no system to confirm the accuracy of cash sales.

(e)Cleves Co has neglected to include an income statement in its financial statements.

(f) Parr Co is undergoing a major court case that would bankrupt the company if lost. The directors assess and disclose the case as a contingent liability in the accounts. The auditors agree with the treatment and disclosure.

Required:

For each of the above situations state what type of audit report should be issued and explain your choice.

Test your understanding 5

(1)List the main contents of an unmodified audit report?

(2)What opinion does the auditor give in an unmodified audit report?

(3)When should the audit report be signed?

(4)Who should sign the audit report and what further information about the signatory should be provided?

Test your understanding 6

You are currently engaged in reviewing the working papers of several audit assignments recently carried out by your audit practice. Each of the audit assignments is nearing completion, but certain matters have recently come to light which may affect your audit opinion on each of the assignments. In each case the year end of the company is 30 September 20X2.

(a)  Jones (Profit before tax $150,000)

(b)  Roberts (Profit before tax $500,000)

(c)  Williams (Net loss for the year $75,000)

(d)  Griffiths (Net profit before tax $250,000)

(e)  Evans (Net profit before tax $100,000)

Required:

Discuss each of the cases outlined above, referring to materiality considerations and, where appropriate, relevant accounting principles and appropriate accounting standards. You should also indicate, with reasons, the kind of audit report (including the type of qualification, if necessary) which you consider would be appropriate in each case.

You are not required to produce the full audit reports, and you may assume that all matters other than those specifically mentioned are considered satisfactory.

7 Chapter summary

Test your understanding answers

Test your understanding 1

Audit report term

Modified. An auditor modifies an audit report in any situation where it is inappropriate to provide an unmodified report.

For example, the auditor may provide additional information in an emphasis of matter (which does not affect the auditor's opinion) or modify the audit opinion because the financial statements as a whole are not free from material misstatement or the auditor is unable to obtain sufficient appropriate evidence to conclude.

Test your understanding 2

(i)Those charged with governance are responsible for overseeing:

• the strategic direction of the entity
• obligations related to the accountability of the entity. This includes overseeing the financial reporting process;
• promotion of good corporate governance;
• risk assessment processes;
• the establishment and monitoring of internal controls;
• compliance with applicable law and regulations; and
• implementation of controls to prevent and detect fraud and errors.

(ii) General audit matters that might be communicated to those charged with governance are:

• A statement that the auditor is responsible for forming and expressing an opinion on the financial statements.
• That the auditor's work is carried out in accordance with ISAs and in accordance with local laws and regulations.

• The audit approach to assessing the risk of serious misstatement, whether arising from fraud or error.
• The audit approach to the internal control system and whether reliance will be placed on it.
• The timing of interim and final audits, including reporting deadlines.

• Significant difficulties encountered during the audit, including delays in obtaining information from management.
• Material deficiencies in internal control and recommendations for improvement.
• Audit adjustments, whether or not recorded by the entity, that have, or could have, a material effect on the entity's financial statements. For example, the bankruptcy of a material receivable shortly after the year-end that should result in an adjusting entry.

• That the audit firm has ensured that all members of the audit team have complied with the ethical standards of ACCA.
• That appropriate safeguards are in place where a potential threat to independence has been identified.

Test your understanding 3

(a)Analysis of events

(b)Audit procedures

• Review legal correspondence in order to understand the likely outcome of the legal claim.
• Review customer correspondence/legal files in order to identify other similar claims which could give rise to additional liabilities.
• Discuss with Production Director the likely cause of the burns (e.g. allergy in user or inadequate printed instructions on product use) to determine the likelihood of any claim being successful in court.
• Review trade/consumer press to identify whether the claim might damage Reallycool's reputation which could impact future revenues or even create a going concern threat.
• Propose adjustment of the financial statements to the directors.

• Inspect Board Minutes in order to confirm the amount of the proposed dividend.
• Propose an adjustment to the financial statements to remove the dividend from being recognised in the Statement of Changes in Equity but ensure that the dividend proposal is disclosed within the notes.

(c)Impact on audit opinion.

Test your understanding 4

(a)There is a lack of sufficient appropriate audit evidence, specifically relating to the valuation of inventory. Inventory is a material amount since it is 8% of sales revenue and 27% of profit. A report with a qualified opinion will be issued (using the 'except for' wording) due an inability to obtain sufficient appropriate audit evidence.

(b)The financial statements are materially misstated as the event after the balance sheet date is an adjusting event in accordance with IAS 10 and therefore the debt should be written off. The debt of $50,000 is material since it is 10% of profit and 25% of the total receivables. A report with a qualified opinion will be issued (using the 'except for' wording) due to a material misstatement.

(c)The financial statements are materially misstated since this is a contingent liability in accordance with IAS 37 and so should be disclosed by note. The matter is material. A report with a qualified opinion will be issued (using the 'except for' wording) due to a material omission.

(d)There is a lack of sufficient appropriate audit evidence if there is no method available to confirm cash sales. The matter would be material and pervasive since if cash sales cannot be confirmed, it may also not be possible to verify other figures in the financial statements. A modified report with a disclaimer of opinion will be issued.

(e)The financial statements are materially misstated since legislation requires companies to publish an income statement. The matter would material and pervasive. A modified report with an adverse opinion will be issued.

(f)An unmodified opinion would be issued since the auditors agree with the treatment and disclosure of the contingent liability. However, there is a fundamental uncertainty (the outcome of the court case will be determined in the future). An modified report with an emphasis of matter paragraph would be issued.

Test your understanding 5

Test your understanding 6

(a)Jones

(b)Roberts

(c)Williams

(d)Griffiths

(e)Evans

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