THE INDEPENDENT AUDITOR'S REPORT

Chapter - THE AUDITOR’S REPORT

1. Introduction
Now we begin to look at the auditor’s report. For many people, this is the only purpose of an audit and
it’s one of the few parts of an annual report containing the financial statements they really look at.

The auditor’s report includes a clear expression of opinion on the financial statements as a whole.

The two important phrases are:

๏ ‘Opinion’: there is nothing absolute here. Different firms of auditors could quite legitimately
come to different opinions.
๏ ‘Financial statements as a whole’. We are not just looking at the statement of financial
position in isolation from the statement of profit or loss or the notes. What’s important is the
impression given by the financial statements as a whole.

The audit opinion has to be based on evidence obtained in the course of the audit. Indeed if you had
to sum up the audit process in just a couple of words it the phrase would be ‘evidence gathering’.
Auditors need to collect evidence that will support their opinion on the financial statements.

We will see later that the auditor’s report is quite long and detailed.

2. Financial statements
The auditor’s report refers to financial statements and you need to know what these are. They consist of
the following:

๏ The statement of financial position (or balance sheet).

๏ The statement of profit or loss and other comprehensive income.
๏ The statement of changes inequity.
๏ The cash flow statement.
๏ The notes to the financial statements, including significant accounting policies.

A director’s report and chairman’s statement included in an annual report are not part of the financial
statements. However, the auditor may have reporting responsibilities for such "other information".
3. The parts of an auditor’s report
Now we are going to look at some of the key parts of an auditor’s report.

3.1 The title and addressees: Independent Auditor’s Report

First of all, it is clearly titled ‘Independent Auditors’ Report.’ That should mean that no one has any doubt
about what this document is. It next states to whom the auditor’s report is addressed - and that’s the
members (i.e. shareholders) of the company.

3.2 The audit opinion and identification of what’s been audited

The opinion paragraph comes right at the top of the report. This section summarises the financial
statements that have been audited (as listed in the previous section).

The report set out below includes an unmodified audit opinion which states that the financial
statements give a true and fair view (or present fairly, in all material respects), and have been prepared
in accordance with International Financial Reporting Standards (IFRSs).

As appropriate, depending on the type of opinion given, this paragraph can be named:

๏ Opinion
๏ Qualified opinion
๏ Adverse opinion
๏ Disclaimer of opinion

The title is modified to alert users about problems.

3.3 The Basis for Opinion

This will refer to compliance with the ISAs (complying with ISAs is key to the basis of opinion) and will
refer to the auditor’s responsibilities section of the report. It must include an assertion of the auditor’s
independence and that other ethical matters have been complied with.

If the audit opinion has been modified, the explanation would be here too.

As appropriate this paragraph would be called:

๏ Basis for opinion

๏ Basis for qualified opinion
๏ Basis for adverse opinion
๏ Basis for disclaimer of opinion
3.4 Emphasis of matter paragraph (ifone)
This paragraph is used to draw users’ attention to a matter already properly disclosed in the
financial statements. For example, a note stating that there had been a fire at the company’s premises
after the date of the statement of financial position.

An emphasis of matter paragraph is not a modification of the audit opinion and It will state that the audit
opinion is not modified in this respect. If the auditor's report also includes a key audit matters section
(see below), the emphasis of matter paragraph may follow that section, depending on their relative
importance.

3.5 Material uncertainty related to going concern (if one)

A separate paragraph is now required if there is a material uncertainty related to the going concern of
the company. This is covered more fully in the following chapter.

Such a paragraph is not a modification of the audit opinion – provided the uncertainty has been
adequately disclosed by the directors in the notes to the financial statements.

3.6 Key audit matters

Key audit matters are those matters that were of most significance during the audit.

There is then a full description of these matters in accordance with ISA 701. This is covered in more detail
below.

3.7 Other matter paragraph (ifone)

This paragraph is used, if necessary, to communicate a matter that is not required to be presented or
disclosed in the financial statements which is relevant to the user's understanding of the audit, the
auditor's responsibilities or the auditor's report.

Circumstances in which an other matter paragraph may be necessary:

๏ Where the auditor reports on two sets of financial statements prepared under different general
purpose frameworks (e.g. a national framework and IFRS).
๏ Where the financial statements have been prepared for a specific purpose, to state that the
auditor's report is solely for the intended users.
๏ In the rare circumstance where the auditor is unable to withdraw from an engagement even
though a management-imposed limitation on the audit may be pervasive.

3.8 Other information paragraph (ifone)

For example, an audit covers the financial statements but does not cover the directors’ report. So what
if the directors’ report contains something that conflicts with the financial statements? The audit opinion
cannot be modified because it does not cover the director’s report, but perhaps the shareholders need
to be alerted to this. This can be done in a paragraph, headed 'Other Information’.

This is not a modification of the audit opinion.

3.9 Management’s responsibilities
The next section is very important and points out that it is management’s responsibility to prepare the
financial statements in accordance with the International Financial Reporting Standards to maintain
the system of internal control and to consider the going concern position of the company.

3.10 Auditor’s responsibilities

The auditors’ responsibilities are to obtain reasonable assurance about whether the financial statements
as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s
report that includes their opinion.

Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement when it exists. Misstatements can arise
from fraud or error and are considered material if, individually or in the aggregate, they could reasonably
be expected to influence the economic decisions of users taken on the basis of these financial statements.

Read carefully in the Illustrative Example (later in this chapter) the details of the auditor's responsibilities,
which can be located in an appendix to the auditor's report.

3.11 Date, address and signature

Finally, the auditors must sign the report and must give their address and the date at which it is signed.
The date of the report is very important because before that date the auditor has an active duty: the
audit is not yet over. The auditor should still be investigating whether receivables are being paid and
inventory is selling at above cost. After that date the auditor has a passive duty only. This means that the
auditor is not ‘on the lookout’ for events affecting the truth and fairness of the financial statements, but
if any are brought to his attention he might have to act.
4. ISA 701 Communicating Key Audit Matters in the
Independent Auditor's Report
The first thing to note is that the auditor only reports on key audit matters ("KAMs") in respect of listed
entities.

The auditor shall determine, from the matters communicated with those charged with governance,
those matters that required significant auditor attention in performing the audit. In making this
determination, the auditor shall take into account the following:

(1) Areas of higher assessed risk of material misstatement or significant risks

(2) Significant auditor judgments relating to areas in the financial statements that involved
significant management judgment, including accounting estimates that have been identified as
having high estimation uncertainty

(3) The effect on the audit of significant events or transactions that occurred during the period.

The auditor therefore selects only those matters that were of most significance in the audit of the financial
statements of the current period and therefore are the key audit matters.

Key audit matters are therefore identified by:

๏ Starting with all matters communicated with those charged with governance
๏ Determining the matters that required significant auditor attention in performing the audit.
๏ The most significant of these are the “key audit matters”.

If the auditor disclaims an opinion on the financial statements (i.e. very rarely), there will be no KAMs
section in the auditor's report because the auditor has not obtained the evidence necessary to form an
opinion.
4. Illustrative example (from ISA 700 (revised))

INDEPENDENT AUDITOR’S REPORT To the Shareholders of ABC Company

Report on the Audit of the financial statements

Opinion

We have audited the financial statements of ABC Company (the Company), which comprise the statement of
financial position as at December 31, 20X1, and the statement of comprehensive income, statement of changes
in equity and statement of cash flows for the year then ended, and notes to the financial statements, including
a summary of significant accountingpolicies.

In our opinion, the accompanying financial statements present fairly, in all material respects, (or give a true and
fair view of) the financial position of the 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
(IFRSs).

Basis for Opinion

We conducted our audit in accordance with International Standards on Auditing (ISAs). Our responsibilities
under those standards are further described in the Auditor’s Responsibilities for the Audit of the financial
statements section of our report.

We are independent of the Company in accordance with the International Ethics Standards Board for
Accountants’ Code of Ethics for Professional Accountants (IESBA Code) together with the ethical requirements
that are relevant to our audit of the financial statements in [jurisdiction], and we have fulfilled our other ethical
responsibilities in accordance with these requirements and the IESBA Code. We believe that the audit evidence
we have obtained is sufficient and appropriate to provide a basis for our opinion.

Key Audit Matters

Key audit matters are those matters that, in our professional judgment, were of most significance in our audit
of the financial statements of the current period. These matters were addressed in the context of our audit of
the financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate
opinion on these matters. [Description of each key audit matter in accordance with ISA 701.]

Responsibilities of Management and Those Charged with Governance for the financial statements

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

In preparing the financial statements, management is responsible for assessing the Company’s ability to
continue as a going concern, disclosing, as applicable, matters related to going concern and using the going
concern basis of accounting unless management either intends to liquidate the Company or to cease
operations, or has no realistic alternative but to do so.

Those charged with governance are responsible for overseeing the Company’s financial reporting process.
Auditor’s Responsibilities for the Audit of the financial statements

Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our
opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement when it exists. Misstatements can arise from
fraud or error and are considered material if, individually or in the aggregate, they could reasonably be
expected to influence the economic decisions of users taken on the basis of these financial statements.

As part of an audit in accordance with ISAs, we exercise professional judgment and maintain professional
skepticism throughout the audit. Wealso:

• Identify and assess the risks of material misstatement of the financial statements, whether due to fraud or
error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is
sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material
misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve
collusion, forgery, intentional omissions, misrepresentations, or the override of internal control.
• Obtain an understanding of internal control relevant to the audit 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 Company’s internal control.
• Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates
and related disclosures made bymanagement.
• Conclude on the appropriateness of management’s use of the going concern basis of accounting and,
based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions
that may cast significant doubt on the Company’s ability to continue as a going concern. If we conclude that
a material uncertainty exists, we are required to draw attention in our auditor’s report to the related
disclosures in the financial statements or, if such disclosures are inadequate, to modify our opinion. Our
conclusions are based on the audit evidence obtained up to the date of our auditor’s report. However,
future events or conditions may cause the Company to cease to continue as a going concern.
• Evaluate the overall presentation, structure and content of the financial statements, including the
disclosures, and whether the financial statements represent the underlying transactions and events in a
manner that achieves fair presentation. We communicate with those charged with governance regarding,
among other matters, the planned scope and timing of the audit and significant audit findings, including
any significant deficiencies in internal control that we identify during our audit.
We also provide those charged with governance with a statement that we have complied with relevant ethical
requirements regarding independence, and to communicate with them all relationships and other matters that
may reasonably be thought to bear on our independence, and where applicable, related safeguards. From the
matters communicated withthose charged withgovernance, we determinethosemattersthatwereof
most significance in the audit of the financial statements ofthe current periodand are therefore the key audit
matters. We describe these matters inour auditor’s report unless law orregulationprecludes public disclosure
about the matter or when, in extremely rare circumstances, we determine that a matter should not be
communicated in our report because the adverse consequences of doing so would reasonably be expected to
outweigh the public interest benefits of such communication.

The engagement partner on the audit resulting in this independent auditor’s report is [name].

[Signature in the name of the audit firm, the personal name of the auditor, or both, as appropriate for the
particular jurisdiction]

[Auditor Address]

[Date]
5. What is meant by ‘true and fair’?
As near as probably matters, the word ‘true’ means that the information is factually correct and not
materially misstated (see next section).

‘Fair’ is a more difficult concept. You can have information which is accurate but which is nevertheless
presented in a way which is unfair, and which perhaps conceals or does not reflect the commercial
substance of transactions. For example, it would not be fair to present a bank loan as a non-current
liability if, in fact, it is repayable in the next 12 months (i.e. a current liability). This would distort the
financial position presented because the bank loan would not be included in assessing the company's
liquidity as shown, for example, by the current ratio.

6. Materiality
Again, we emphasise the point that an audit gives only a reasonable assurance that the financial
statements are free from material misstatement.

๏ A matter is material if it omission or misstatement would reasonably influence the economic

decisions by a user of the auditor’s report
๏ It is affected by the size and nature of the misstatement

The auditor’s judgment flows all the way through the audit process, from planning and deciding the
amount of work that should be done, to deciding what action should be taken should errors be found
in the accounts.

We are looking for material misstatements, and a material misstatement is defined through its effect on
decisions made by a user of the report. For example, if a misstatement would cause an investor to keep
those shares rather than selling those shares, there has been a real effect on that investor and the
misstatement would be material.

If misstatements are so small that they don’t really spark any reaction in the members, then they are
rather superficial. That’s not to say that auditors don’t want to get things right, but errors only really
matter when they trigger incorrect action.

Materiality has to be decided for the financial statements as a whole and it is the audit partner’s
judgements about whether or not a misstatement is material.
7. Guidance on materiality
It’s all very well saying that a matter is material if it would reasonably influence decisions of a user of the
auditor’s report, but that gives very little guidance to the audit team (or to you when you are doing a
question).

Therefore, some rules of thumb have been developed. These are only guidelines, but if something is
wrong to the extent of:

๏ 0.5% to 1% of revenue,
๏ 1% to 2% of total assets or
๏ 5% to 10% of profit

then you should assume that the matter is material. These percentages should take into account the
auditor’s knowledge of which items users will focus on, the nature of the entity (life cycle/ environment),
its ownership, structure and financing and the volatility of the benchmark.

Additionally, a lesser amount should be set for materiality when designing and carrying out audit
procedures to reduce the risk that misstatements in aggregate exceed financial statement materiality.
This is known as performance materiality: the materiality that is important in the performance of the
audit work.

Errors which are less than the suggested guidelines could still be regarded as being material. An error
which turns a small loss into a small profit could cause unfounded optimism in some situations,
perhaps a feeling that the company has turned a corner. So, although in absolute terms, the size of an
error is relatively small, the way in which the accounts are then interpreted could lead to
unreasonable decisions being made. Therefore, you can talk about both quantitative and qualitative
materiality.

Finally, there are some amounts in the financial statements where no errors are tolerable. For example,
there is often a statutory duty to disclose directors’ remuneration and that has to be stated with absolute
accuracy.

All misstatements identified should be communicated to management who should be asked to

correct them or to explain why not. The auditors must assess the materiality of uncorrected
statements and obtain written representations from management that they believe uncorrected
misstatements to be not material.

If management refuses to correct an error that the auditor thinks is material then the auditor will issue a
modified (qualified) audit opinion.

8. Other reporting responsibilities

An auditor’s report will explicitly state whether in the auditor’s opinion the accounts show a true and
fair view. In some jurisdictions, the auditor may have additional responsibilities to report on matters
such as the adequacy of accounting books and records. These may be included in the auditor's report
under a suitably headed section (e.g. "Report on Other Legal and Regulatory Requirements").
 REVIEW AND REPORTING

Chapter - AUDIT OPINIONS: UNMODIFIED/ MODIFIED

1. Unmodified opinion
Now we are going to look at the different forms of audit opinion and how other matters relevant to
understanding the financial statements are drawn to users attention.

First and simplest is the unmodified audit opinion. This is the audit opinion that you will see in most
auditor's reports. It simply states that the financial statements show "a true and fair view" (or "present
fairly"). There are no "ifs" or "buts".

An auditor's report with an unmodified opinion may, however, include any (or all) of the following
additional sections:

๏ "Emphasis of matter" paragraph;

๏ "Material uncertainty related to going concern" section;
๏ "Other matter" paragraph.

These matters do NOT affect the audit opinion.

2. Emphasis of matter and other matters

An emphasis of matter is where there is a paragraph in the auditor’s report which draws attention to
some matter already properly disclosed within the financial statements. Such a paragraph does
not affect the audit opinion: it is simply drawing attention to an important note in the financial statements
that shareholders ought to be aware of to properly appreciate the financial statements.

Here is an example:

We draw attention to Note 27 to the financial statements, which describes the effects of a fire in
the Company's warehouse. Our opinion is not modified in respect of this matter.

Note that the financial statements do contain a note explaining the effects of the fire. The financial
statements are therefore as comprehensive and as open as they can be. But obviously, the fire has
operational and financial implications and to understand the company's position (e.g. its ability to pay
dividends next year), the users of the financial statements need to be aware of this.

Therefore the auditor use the auditor’s report to emphasise this matter (and remember many readers
don’t get far past the auditor’s report and very few pore over the notes) and to draw users’ attention to
it.
An "other matters" paragraph refers to something which is NOT in the financial statements, nor
should be. The commonest example is when something in the directors’ report contradicts what is in
the financial statements and the auditor should point out the discrepancy in case users are misled by
the directors’ claims. Therefore an other matters paragraph is added to explain the contradiction.

The emphasis of matter paragraph generally comes directly after the basis of opinion paragraph. It
stresses that this does not mean that the financial statements are ‘qualified’, wrong or in any way
criticised.

The other matter paragraph comes directly after the Key Audit Matters paragraph (where applicable).

3. Going concern
We have already noted (in Chapter 5), that one of the auditor's responsibilities is to conclude on the
appropriateness of management’s use of the going concern basis of accounting and, based on
the audit evidence obtained, whether a material uncertainty exists related to events or conditions
that may cast significant doubt on the company’s ability to continue as a going concern.

If a material uncertainty exists which is adequately disclosed in the financial statements, the auditor
is required to draw attention to the related disclosure in a separate section of the auditor's report headed
“Material Uncertainty Related to Going Concern”.

For example:

We draw attention to Note 6 in the financial statements, which indicates that the Company
incurred a net loss of ZZZ during the year ended December 31, 20X1 and, as of that date, the
Company’s current liabilities exceeded its total assets by YYY. As stated in Note 6, these events or
conditions, along with other matters as set forth in Note 6, indicate that a material uncertainty
exists that may cast significant doubt on the Company’s ability to continue as a going concern.
Our opinion is not modified in respect of this matter.

Generally if the directors or the auditors think the company might not survive into the foreseeable future
there is a going concern problem. ‘Foreseeable future’ is not defined but under IFRS it should not be less
than 12 months from the end of the accounting period.

Remember: It is for management to make an assessment of an entity’s ability to continue as a going

concern. The auditor’s responsibilities are to obtain sufficient appropriate audit evidence, conclude
and report.
Evidence can consist of:

๏ Evaluating management’s plans for future actions in relation to its going concern and whether
the outcome of these plans are feasible and likely to improve the situation.
๏ Where the entity has prepared a cash flow forecast:
‣ Evaluating the reliability of the underlying data generated to prepare the forecast; and
‣ Determining whether there is adequate support for the assumptions underlying the forecast.
๏ Considering whether any additional facts or information have become available since the date
on which management made its assessment.
๏ Requesting written representations from management and, where appropriate, those charged
with governance, regarding their plans for future actions and the feasibility of these plans.

If there is no realistic prospect of the company surviving then the financial statements should be drawn
up on a break-up basis. Then all sorts of issues are going to arise over valuation of assets and the payment
of a certain statutory liabilities toemployees.

Signs that the company may have going concern difficulties include the following:

๏ Negative operating cash flows.

๏ An inability to pay suppliers when due (and auditors are usually rather sensitive if they see that the
payment of creditors has slowed down, so that the company is borrowing more from its suppliers).
๏ Operating losses. These do not mean that the company is going to fail immediately; going concern
tends to be rather more concerned with cash. An operating loss can be sustained for a number of
years provided that cash doesn’t run out. In the longer term, losses usually result in cash flow
problems.
๏ If the borrowing facilities are coming to an end and the new ones haven’t been agreed, what’s the
company going to do to repay the loan, when no cash is available?
๏ The loss of key staff or key customers can mean the company is unable to trade or unable to sell its
products.
๏ Technology changes can render the company’s purpose and main product redundant. Legislative
changes may mean that the company’s operations become illegal or the company has to go
through some sort of regulatory requirements before it can continue trading and that this is going
to be difficult for it.
๏ Non-compliance with regulations may mean a business loses its right or license to trade and in
such a case the company may simply have to be wound up. Non-compliance can also result in
crippling penalties and harmful damage to the organisation’s reputation.
4. Effect of going concern problems on the auditor’s report
So what are the effects of going concern issues on the auditor’s report? If the worries are fully disclosed
in a note to the financial statements, a "Material Uncertainty Related to Going Concern" section should
be included in the auditor's report to make sure that users do not overlook this important piece of
information.

If the going concern worries are not ADEQUATELY disclosed then the financial statements cannot be
true and fair and they are effectively concealing something which is important for the proper
understanding of them. In such a case, the audit opinion MUST be modified. (In this case, there will be
NOT be a "Material Uncertainty Related to Going Concern" section.)

A modified opinion would also be appropriate if the auditor felt that it was wrong to prepare the
financial statements on a going concern basis. That would happen if the company was in such a
precarious position that it had no realistic chance of survival.

Let's turn our attention now to the different forms of modified audit opinions.

5. Modified audit opinions

With respect to modified opinions there are two potential reasons for modification:

๏ The financial statements include one or more material misstatements; or

๏ The auditor has been unable to obtain sufficient appropriate audit evidence.

There are two degrees of seriousness for each of these problems.

First let’s look at material misstatement. This is where the auditor disagrees with the figure in the financial
statements. It could be the figure itself or the way the figure is presented or the disclosures which must
be made to comply with IFRS. First of all, if the misstatement is not material the audit opinion would not
be modified, so the first hurdle is a that disagreement must be for a material amount. In such a case the
auditor would put a paragraph in the report saying except for certain items in other respects the
financial statements show a true and fair view: the opinion has been qualified.

If however misstatements are so significant that it renders the financial statements, as a whole, useless
then the auditor would issue an adverse opinion and the auditor would say the financial statements
do not show a true and fair view.

The other reason for a modified opinion is where the auditor has been unable to obtain sufficient
appropriate audit evidence.

For some reason the auditor has not been able to get all the information required to draw conclusions.
If the matter about where there is missing information is material then the auditor will qualify his opinion
using an except for paragraph. For example, except that we could not verify the adequacy of the trade
receivables allowance (i.e. for irrecoverable balances), the financial statements showed a true and fair
view. If, however, the missing information is so significant that the auditors really have no idea whether
the financial statements showed, as a whole, a true and fair view, then they will issue a disclaimer of
opinion stating that they are unable to form any opinion.
The choices can be described in a matrix. Think of ‘pervasive’ as misstatements or lack of evidence that
affects the financial statements as a whole:

Nature of circumstance Material but not pervasive Pervasive

Financial statements are A qualified opinion:

Adverse opinion
materially misstated Except for ...

Unable to obtain sufficient, A qualified opinion:

Disclaimer of opinion
appropriate evidence Except for ...

6. Example of insufficient appropriate audit evidence

Here is an example of a qualification due to insufficient appropriate audit evidence. Here the problem
is material, but does not affect the financial statements as a whole and the report says the auditors are
unable to determine the inventory quantities and then says in their opinion, except for the effects of
such adjustments for inventory, if any, the financial statements give a true and fair view. So this is an
‘except for’: the financial statements are showing a true and fair view except for one particular item
which is material enough to cast some doubt on the amount of inventory.

Qualified Opinion (extract)

In our opinion, except for the possible effects of the matter described in the Basis for Qualified
Opinion section of our report, the financial statements give a true and fair view ...

Basis for Qualified Opinion (extract)

We were unable to obtain sufficient appropriate evidence about the carrying amount of
inventories because we were unable to attend the count of physical inventories at 31 December
20X1. Consequently, we were unable to determine whether any adjustments to this amount
was necessary.
7. Example of disclaimer of opinion
Here is a modified opinion caused by lack of sufficient appropriate audit evidence but which is
leading to disclaimer of opinion because multiple elements of the financial statements are affected.

Disclaimer of Opinion (extract)

We do not express an opinion on the accompany financial statements. Because of the significance
of the matter described in the Basis for Qualified Opinion section of our report, we have not be able
to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion on these
financial statements.

Basis for Disclaimer of Opinion (extracts)

8. Material misstatement/‘except for’

We have audited ...

In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion

Basis for Qualified Opinion

Here is an example of a qualified opinion caused by the auditors believing that there is a material
misstatement about something in the financial statements. Here the problem is that no depreciation has
been provided where they think it should have been. Note, where there is a material misstatement
auditors will normally be able to quantify its extent and the effect on the profits and is useful to the
shareholders for them to do that. Here the amount of depreciation in dispute is material, but the financial
statements as a whole still show a true and fair view.
9. Material misstatement/‘adverseopinion’
Finally, a modified opinion caused by one or more material misstatements that are so significant that the
auditor feels the financial statements do not give a true and fair view. Here the matter in dispute is the
basis of accounting used in the preparation of the financial statements which is clearly of such significance
that the financial statements do not show a true and fair view.

Adverse Opinion

We have audited ...

In our opinion, because of the significance of the matter described in the Basis for Adverse
Opinion section of our report, the accompanying financial statements do not present fairly ...

Basis for Adverse Opinion

The Company's financing arrangements expired ... and is considering filing for bankruptcy ... a
material uncertainty exists... The financial statements do not adequately disclose this fact ...
Chapter - SUBSEQUENT EVENTS

1. Events after the reporting period

Now we are going to look at the effect of events which occur after the end of the reporting period but
before the auditor’s report has been signed. These events fall into two types.

๏ An adjusting event as its name might suggest, means that the accounts have to be adjusted in
the light of what’s happened. The rule is that adjustments must be made if the event provides
evidenceofconditions that existed attheendofthereportingperiod(thereportingdate).

An example would be a major customer going into liquidation, let’s say at the end of January,
the year end was the end of December. That event tells us that the receivable at the end of
December was probably bad and should have been written off or an allowance made. It’s very
unlikely that the customer’s financial position worsened so remarkably during January. What the
liquidation tells us is that the customer was in the bad situation at the end of December and if
only we had known that then the receivable would have been written down.

๏ A non-adjusting event relates to conditions which arose after the reporting date.

A good example is the company’s factory burning down, let’s say in mid-January. At the end of
December the company’s factory was perfectly fine, it was standing, it was operating, it was a non-
current asset. It was only after the end of the year that it was destroyed. If the statement of financial
position is telling us the position at the year end, then the factory would have to appear in non-
current assets. It would be, of course, important to disclose in the notes that the factory was no
more. This will be a good example of an emphasis of matter paragraph in the auditor’s report.

2. 'Active' and 'passive' duty

Until the auditor’s report is signed auditors have an active duty to look out for events that might tell
them more about the financial statements. After signing the auditor’s report, the auditors have a
passive duty only. Occasionally events will occur after the accounts have been signed and issued and
these come to the auditor’s attention. Exceptionally it may be important for the addressees of the
auditor’s report to be made aware that something is wrong in the accounts. The auditor would then
discuss with the directors the need to reissue amended financial statements.
Chapter - CONTINGENT ASSETS AND LIABILITIES

1. Contingent liability

A contingent liability is a possible liability arising from past events but the existence of that
liability will only be confirmed by future events.

Note it’s very important that the possible liability arises from past events. We are not trying toforesee
events which may arise in the future and which give rise to liabilities.

The treatment of the liability depends on how probable it is that there will be an outflow of resources
from the company:

๏ If the present obligation probably requires the outflow of resources, a provision will be required for
the best estimate of the liability. In other words an expense account could be debited and some
sort of accrual or liability account will be credited.
๏ If it is a possible obligation that will probably not require the outflow resources, no provision is
required but disclosure should be made by way of a note to the financial statements.
๏ If the outflow of resources is remote, in other words very unlikely, no provision and no disclosure is
required.

A good example of contingent liability is a legal action arising from some past event: if it is probable that
you are going to have to pay up, set up a provision; if it’s merely possible you have to pay up, no provision
is needed but the risk should be disclosed. If it is very unlikely that you are going to have to pay up, no
provision and no disclosure.

It can be difficult to assess probability of a liability actually crystallizing and auditors will have to
review correspondence with, for example, solicitors and also look at board minutes.
2. Contingent asset

A contingent asset is a possible asset arising from past events but whose existence will only be
confirmed by future events.

The treatment of contingent asset is similar to that of contingent liabilities, but more cautious.

๏ If an inflow of economic benefits is virtually certain then the asset is not contingent: it’s a real
asset and should be showed in the statement of financial position.
๏ If the inflow of economic benefits is merely probable, not virtually certain, then it would be
imprudent to recognise an asset. However, as an asset is more likely than not to materialise, it
should be disclosed in a note to the financial statements..
๏ If the inflow is not probable, it is not expected to materialise and does not merit disclosure.

Note that the treatment of contingent assets and liabilities though similar is not symmetrical:

Flow of resources Outflow Inflow

Remote No disclosure No disclosure
Probably not, but possible Contingent liability disclosure No disclosure
Probable Provision (if reliable estimate) - Disclosure required
otherwise a contingent liability
Expected/virtually certain Provision Asset (i.e. not contingent)
Chapter - WRITTEN REPRESENTATIONS

1. Introduction
The final letter to be discussed is the management representation or letter of representation, which is addressed
to the auditor. The auditor must obtain written representations to confirm the responsibilities of management
and those charged with governance:

๏ That they have properly prepared and presented the financial statements and have provided
complete information to theauditor.
๏ That all transactions have been recorded.

Examples of other representations that are typically required are listed in section 2 below.

In particular, letters of representation are important where it could be difficult for the auditors to make sure
that certain problems do not exist, or that management does not have certain intentions or plans. If you don’t
know about a liability it can be difficult to discover. It can also be difficult to discover management plans if they
have not been discussed at board meetings and recorded in the board minutes.

Management representations cannot substitute for other audit evidence or performing audit procedures in
accordance with ISAs.

Written representation alone cannot provide sufficient appropriate audit evidence for an assertion. If, for
example, an assertion depends on management's intention (eg to settle a claim 'out-of-court'), the auditor must
consider:

๏ the reasons for management's intention

๏ management's ability to pursue its intention
๏ management's past history in carrying out intentions
๏ other information (or lack thereof) which might contradict management's intention.

2. Examples
Here are some examples of subject-matter specific representations that might be found in a typical letter
of representation:

๏ Any knowledge or suspicion of fraud has been disclosed to the auditor.

๏ All known actual or possible litigation and claims has been disclosed to the auditor and
accounted for/disclosed in accordance with financial reporting requirements.
๏ All events occurring subsequent to the date of the financial statements have been adjusted or
disclosed as required.
๏ Plans for future actions relating to management’s going concern assessment and the feasibility
of these plans.

You should appreciate the necessity of these representations to obtain sufficient appropriate evidence
about the assertion of completeness, inparticular.
3. Potential problems
If written representations are inconsistent with other audit evidence or management refuses to
provide one or more representations and the matter remains unresolved, the auditor should reassess:

๏ Management’s competence, integrity, ethical values, etc

๏ The reliability of all representations (oral or written) as audit evidence.

The auditor should disclaim an opinion on the financial statements if he concludes that the required
written representations concerning management’s responsibilities are not reliable or not provided by
management.
Chapter - THE AUDITOR’S REPORT – REVISITED

1. The purpose of the audit

Remember that the aim of an audit is to be able to report to the members on whether or not the
financial statements show a true and fair view. All the planning, investigation of internal control and
substantive tests were organised for this purpose. The auditor’s report was discussed in Chapters 5
and 6 so that you got an early insight into where the audit process was heading. It is important to
briefly remind you of the possible outcomes from the audit.

2. Outcome of the audit process

There are two sources of difficulty:
๏ Material misstatements
๏ Lack of sufficient appropriate auditevidence

Unmodified audit opinion

Neither of these difficulties has arisen

Qualified audit opinion (except for)

One or both has arisen. The problem is material but not pervasive, so the problem can be isolated. The
financial statements show a true and fair view except for…

Adverse opinion

One or more material misstatements that are so serious as to be pervasive so that the financial
statements, as a whole, do not show a true and fair view.

Disclaimer of opinion

A lack of sufficient appropriate audit evidence that is so serious as to be pervasive so that the auditor
cannot form an opinion on the financial statements as a whole.

Additions to the auditor’s report

Remember also that there can be additions to the auditor’s report that do not affect the
opinion. These are:
๏ Material uncertainty related to goingconcern - Draws attention to material uncertainty that has been
adequately disclosed.

๏ Emphasis of matter paragraph - Draws attention to a matter already properly disclosed in the financial
statements.

Other matter paragraph - To communicate a matter that is not presented or disclosed in the financial
statements which is relevant to the user's understanding of the audit, the auditor's responsibilities or the
auditor's report.

Other information paragraph - Typically, drawing attention to a statement in the directors’ report or
chairman’s report which is at odds with what is in the financial statements.