Chapter 3 Review

Parts of Standard Unmodified Opinion Audit Report

The standard unmodified opinion audit report has 8 distinct parts:

1. Report title

2. Auditor report address — who the report is addressed to

3. Opinion section — the auditor's conclusion

4. Basis for opinion — paragraph supporting the opinion

5. Management's responsibility

6. Auditor's responsibility

7. Signature and address of the CPA firm

8. Audit report date

For public companies, PCAOB standards also require the communication of Critical Audit Matters (CAMs), making the report have 9 parts.

The auditor's opinion communicates

the auditor's conclusion about whether the financial statements are fairly presented.

There are 5 possible Auditor opinions:

1. Unmodified / Unqualified — Best

2. Unmodified with Emphasis of Matter

3. Qualified Opinion

4. Adverse Opinion

5. Disclaimer of Opinion — Worst

Unmodified / Unqualified —

Best

The financial statements are fairly presented, and there are no material problems requiring a modified opinion.

• Public company: Unqualified

• Private company: Unmodified

• This is essentially a clean/passing audit.

Unmodified with Emphasis of Matter

The financial statements are still fairly presented, but the auditor believes something important should be highlighted.

Example:

• A change in accounting principles, such as changing from LIFO to FIFO

• Substantial doubt about going concern

Important: This is still a good/clean opinion. The financial statements are not considered materially misstated.

Qualified Opinion

The financial statements are generally fairly presented, but there is a material issue that is limited rather than pervasive.

Think:

"There is a problem, but it is not bad enough to affect the financial statements as a whole."

Adverse Opinion

The auditor determines that the financial statements are materially and pervasively misstated.

Think:

"We know what is wrong, and it is really bad."

Disclaimer of Opinion —

Worst

The auditor cannot obtain enough evidence to form an opinion, or the auditor is not independent.

Think:

"We cannot give an opinion because we do not know enough, or we are not independent."

Going concern refers to

whether the company is likely to be able to continue operating for a reasonable period of time, usually about one year.

If there is substantial doubt about going concern, the auditor may add an emphasis-of-matter paragraph or other appropriate report wording.

Key idea:

Going concern does not automatically mean the financial statements are misstated. It means the auditor wants users to pay attention to the company's ability to continue operating.

Auditors provide

reasonable assurance, not absolute assurance.

Reasonable assurance means

the auditor provides a high level of assurance, but does not guarantee that the financial statements are completely free of misstatements.

Why only reasonable assurance?

An audit cannot provide absolute certainty because auditors must make judgments and cannot examine every piece of information or transaction.

Therefore:

Reasonable assurance = high level of confidence, but not a guarantee that there are zero errors or fraud.

Critical Audit Matters (CAMs) are required for public companies under PCAOB standards.

They are matters from the audit that:

• Were communicated or required to be communicated to the audit committee

• Relate to accounts or disclosures that are material

• Involved especially challenging, subjective, or complex auditor judgment

Easy way to remember:

CAM = Public company + material area + difficult auditor judgment

A financial statement audit examines whether

the financial statements are fairly presented in accordance with the applicable accounting framework, such as GAAP.

The auditor gathers evidence and determines whether the financial statements contain material misstatements.

The main question is:

"Are the financial statements fairly presented?"

An internal control audit examines

the effectiveness of the company's internal control over financial reporting.

The main question is:

"Are the company's controls over financial reporting operating effectively?"

For larger public companies, the internal control audit is required under Section 404 of the Sarbanes-Oxley Act and is integrated with the financial statement audit.

The auditor can issue:

• 
  

• A separate report on internal control, or

• A combined report covering both the financial statements and internal controls.

Are all companies required to have both?

No.

Larger public companies are subject to the Section 404 internal control reporting requirement.

So, you should remember:

Public company → financial statement audit + internal control audit may be required under applicable requirements.

Private company → financial statement audit may be performed, but the Section 404 public-company internal control audit requirement does not apply.

A scope limitation occurs when

the auditor's ability to perform the audit is restricted.

In other words:

The auditor cannot obtain the evidence needed to complete the audit.

Example from your notes:

The auditor cannot audit a company's plant in Mexico.

Scope limitation + materiality

• 
  

• Material but limited: Qualified opinion

• Material and pervasive: Disclaimer

Easy way to remember:

Scope problem = We don't know.

If the problem is so significant that the auditor cannot form an overall opinion → Disclaimer.

Materiality asks whether

a misstatement is significant enough that knowing about it would affect the decision of a reasonable user of the financial statements.

Your notes identify three levels of materiality:

• Immaterial

  • The issue is not significant enough to affect the opinion.

    • → Unmodified/Unqualified

• Material but not pervasive

  • The issue is significant, but it does not affect the financial statements as a whole.

    • → Qualified

• Material and pervasive (Highly matterial)

  • The issue is so significant or widespread that the overall fairness of the financial statements is in question.

    • → Adverse for a GAAP departure

    • → Disclaimer for a scope limitation

A material misstatement is:

A misstatement in the financial statements that, if known, would affect the decision of a reasonable user of the financial statements.

• Example

  • If a company incorrectly reports a small amount that would not affect a reasonable investor's decision:

    • → Immaterial

  • If the company significantly overstates its assets and this could affect an investor's decision:

    • → Material misstatement

Auditor Independence

The auditor must be independent of the client.

If the auditor is not independent:

→ Disclaimer of opinion

Lack of independence requires

a disclaimer regardless of materiality.

PWC audits Pepsi. PWC also consults for Lay's potato chips, and Pepsi purchases Lay's during the year. If the consulting relationship creates an independence violation:

→ Auditor independence is violated

→ Disclaimer

→ This overrides other issues.

Given a specific situation, what is the appropriate audit opinion and why?

Use this decision process:

Step 1: Is there a problem?

No material problem:

→ Unmodified / Unqualified

Step 2: Is there something important that needs to be highlighted?

If the audit is otherwise clean:

→ Unmodified with Emphasis of Matter

Step 3: Is there a material problem?

Ask whether it is a scope problem or a GAAP departure.

---

If it is a Scope Limitation

Material but limited:

→ Qualified

Material and pervasive:

→ Disclaimer

Think:

Scope = We don't know.

---

If it is a GAAP Departure

Material but limited:

→ Qualified

Material and pervasive:

→ Adverse

Think:

GAAP departure = We know what is wrong.

If it is justified and does not result in a material misstatement, an unmodified opinion with emphasis of matter may be appropriate.

---

If Auditor Is Not Independent

→ Disclaimer

Regardless of materiality.

Financial statements are fairly presented and no material problems exist

Unmodified/Unqualified: All audit requirements are met

Company changes from LIFO to FIFO and the auditor wants to highlight the change

Unmodified with emphasis of matter: Financial statements are still fairly presented

Material GAAP departure affecting one limited area

Qualified: Material, but not pervasive

Material GAAP departure affecting the financial statements as a whole

Adverse: Material and pervasive misstatement

Auditor cannot obtain sufficient evidence and the limitation is pervasive

Disclaimer: Auditor cannot form an opinion

Auditor is not independent

Disclaimer: Lack of independence automatically requires a disclaimer

A company has failed to properly account for one significant inventory account in accordance with GAAP. The error is material, but it is limited to that particular area and does not affect the financial statements as a whole.

Qualified Opinion

Material vs. Immaterial and Pervasive vs. Limited

This is one of the most important things to know.

• First ask: Is it material?

  • Immaterial → generally no modification.

  • If material, then ask:

    • Second ask: Is it pervasive?

      • Limited / not pervasive → Qualified

      • Pervasive → Adverse or Disclaimer, depending on the problem.

GAAP Problem

• 
  

• Immaterial → Unmodified

• Material + limited → Qualified

• Material + pervasive → Adverse

Scope Problem

• 
  

• Immaterial → Unmodified

• Material + limited → Qualified

• Material + pervasive → Disclaimer

Independence Problem

• 
  

• Disclaimer — regardless of materiality

One-sentence memory trick:

• GAAP = We know it's wrong → Qualified or Adverse.

• Scope = We don't know → Qualified or Disclaimer.

• No independence = Disclaimer.

Which of the following is not a required element of a standard unmodified opinion audit report issued in accordance with AICPA auditing standards?

The name of the engagement partner

The date of the CPA’s opinion on the financial statements of the client should be the date of the

completion of all important audit procedures.

If a principal auditor decides to refer in his or her report to the audit of another auditor, he or she is required to disclose the

portion of the financial statements audited by the other auditor.

An entity changed from the straight-line method to the declining-balance method of depreciation for all newly acquired assets. This change has no material effect on the current year’s financial statements but is reasonably certain to have a substantial effect in later years. If the change is disclosed in the notes to the financial statements, the auditor should issue a report with a(n)

unmodified opinion.

When the financial statements are fairly stated but the auditor concludes there is substantial doubt whether the client can continue in existence, the auditor should issue a(n)

unmodified opinion with explanatory paragraph.

The auditor’s report contains the following: “We did not audit the financial statements of EZ, Inc., a wholly owned subsidiary, which statements reflect total assets and revenues constituting 27 percent and 29 percent, respectively, of the consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for EZ, Inc., is based solely on the report of the other auditors.” These sentences

indicate a division of responsibility.

As compared to an unmodified opinion, an opinion qualified due to a material departure from generally accepted accounting principles would

indicate that, except for the problem noted, the financial statements are presented fairly

1. An auditor who qualified an opinion because of an insufficiency of audit evidence should refer to the scope limitation in the

	Auditor’s Responsibility Section	Opinion Section	Note to the Financial Statements
(1)	Yes	No	Yes
(2)	No	Yes	No
(3)	Yes	Yes	No
(4)	Yes	Yes	Yes

No Yes No

An adverse opinion and a disclaimer of opinion

both require modification of the opinion section.

A number of frozen yogurt stores have opened in the last few years and your client, YogurtLand, has experienced a noticeable decline in customer traffic over the past several months that has caused you to have substantial doubt about YogurtLand’s ability to continue as a going concern.

For each situation, do the following:

• a.Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.

• b.State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

• c.Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):

  • (1)Unmodified opinion—standard wording

  • (2)Unmodified opinion—explanatory paragraph

  • (3)Unmodified opinion—nonstandard report wording

  • (4)Qualified opinion only—GAAP departure

  • (5)Qualified opinion—scope limitation

  • (6)Disclaimer

  • (7)Adverse*

• a. Condition requiring a deviation:

  • Substantial doubt about going concern. YogurtLand has experienced a noticeable decline in customer traffic, causing substantial doubt about its ability to continue operating.

• b. Materiality:

  • Material. The situation is significant enough that the auditor has substantial doubt about the company's ability to continue as a going concern.

• c. Appropriate audit report:

  • (2) Unmodified opinion — explanatory paragraph

  • Why: The financial statements can still be fairly presented, but the auditor believes it is important to draw users' attention to the substantial doubt about going concern. Your notes specifically list substantial doubt about going concern as a reason for adding an emphasis-of-matter paragraph/nonstandard report wording while still issuing an unmodified opinion.

Intelligis Electronics is a manufacturer of advanced electrical components. During the year, changes in the market resulted in a significant decrease in the demand for their products, which are now being sold significantly below cost. Management refuses to write off the products or to increase the reserve for obsolescence.

For each situation, do the following:

• a.Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.

• b.State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

• c.Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):

  • (1)Unmodified opinion—standard wording

  • (2)Unmodified opinion—explanatory paragraph

  • (3)Unmodified opinion—nonstandard report wording

  • (4)Qualified opinion only—GAAP departure

  • (5)Qualified opinion—scope limitation

  • (6)Disclaimer

  • (7)Adverse*

• a. Condition requiring a deviation:

  • GAAP departure. Management refuses to write down the products or increase the reserve for obsolescence even though the products are now being sold significantly below cost. This indicates the financial statements may not be properly stated under GAAP.

• b. Level of materiality:

  • Materiality cannot be determined from the information given. We would need to know the dollar amount of the inventory overstatement and how significant it is relative to the financial statements as a whole.

• c. Appropriate audit report:

  • If the misstatement is immaterial:
    → (1) Unmodified opinion — standard wording

  • If the misstatement is material but not pervasive:
    → (4) Qualified opinion only — GAAP departure

  • If the misstatement is highly material/pervasive:
    → (7) Adverse opinion

• Your notes indicate that a GAAP departure results in a qualified opinion when material but limited, and an adverse opinion when highly material/pervasive.

In the last 3 months of the current year, Oil Refining Company decided to change direction and go significantly into the oil drilling business. Management recognizes that this business is exceptionally risky and could jeopardize the success of its existing refining business, but there are significant potential rewards. During the short period of operation in drilling, the company has had three dry wells and no successes. The facts are adequately disclosed in footnotes.

For each situation, do the following:

• a.Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.

• b.State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

• c.Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):

  • (1)Unmodified opinion—standard wording

  • (2)Unmodified opinion—explanatory paragraph

  • (3)Unmodified opinion—nonstandard report wording

  • (4)Qualified opinion only—GAAP departure

  • (5)Qualified opinion—scope limitation

  • (6)Disclaimer

  • (7)Adverse*

• a. Condition requiring a deviation:

  • Substantial doubt about going concern / emphasis of matter. The company has entered a highly risky new business that could jeopardize its existing refining business. However, the facts are adequately disclosed in the footnotes, so there is no indication of a GAAP departure.

• b. Level of materiality:

  • Material. The new drilling operation is significant enough to potentially jeopardize the success of the existing business, and the risks are important to users of the financial statements.

• c. Appropriate audit report:
  
  

  • (2) Unmodified opinion — explanatory paragraph.

• Why: The financial statements are fairly presented and the situation has been properly disclosed in the footnotes. The auditor would add an explanatory/emphasis-of-matter paragraph to draw attention to the significant risks associated with the company's new drilling operations. This is consistent with your notes, which state that an unmodified opinion can include an emphasis-of-matter paragraph when the auditor believes it is important to draw attention to a significant matter.

Your client, Harrison Automotive, has changed from straight-line to sum- of-the-years’ digits depreciation. The effect on this year’s income is immaterial, but the effect in future years may be highly material. The change is not disclosed in the footnotes.

For each situation, do the following:

• a.Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.

• b.State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

• c.Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):

  • (1)Unmodified opinion—standard wording

  • (2)Unmodified opinion—explanatory paragraph

  • (3)Unmodified opinion—nonstandard report wording

  • (4)Qualified opinion only—GAAP departure

  • (5)Qualified opinion—scope limitation

  • (6)Disclaimer

  • (7)Adverse*

• a. Condition requiring a deviation:

  • Lack of consistent application of GAAP / accounting principle change. Harrison Automotive changed from straight-line depreciation to sum-of-the-years’ digits depreciation. Your notes specifically identify a change in accounting rules, such as LIFO to FIFO, as a reason for an emphasis-of-matter paragraph.

• b. Level of materiality:

  • Immaterial for the current year. The effect on this year's income is specifically stated to be immaterial. Although the effect could be highly material in future years, the current-year audit opinion is based on the current financial statements.

• c. Appropriate audit report:

  • (2) Unmodified opinion — explanatory paragraph.

• Why: The change is an accounting principle change, but its effect on the current year's financial statements is immaterial. Since the change is not disclosed in the footnotes, the auditor should draw attention to the change through an explanatory paragraph rather than issue a qualified or adverse opinion.

Circumstances prevent you from being able to observe the counting of inventory at Brentwood Industries. The inventory amount is material in relation to Brentwood Industries’ financial statements. But, you were able to perform alternative procedures to support the existence and valuation of the inventory at year-end.

For each situation, do the following:

• a.Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.

• b.State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

• c.Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):

  • (1)Unmodified opinion—standard wording

  • (2)Unmodified opinion—explanatory paragraph

  • (3)Unmodified opinion—nonstandard report wording

  • (4)Qualified opinion only—GAAP departure

  • (5)Qualified opinion—scope limitation

  • (6)Disclaimer

  • (7)Adverse*

• a. Condition requiring a deviation:

  • Scope limitation. Circumstances prevented the auditor from observing the physical inventory count. This limits the auditor's ability to perform the audit.

• b. Level of Materiality

  • The inventory amount is material to the financial statements. However, because alternative procedures were successfully performed to support the inventory's existence and valuation, the scope limitation is not pervasive and does not prevent the auditor from obtaining sufficient evidence.

• c. Appropriate Audit Report

  • (1) Unmodified opinion — standard wording.

• Because the alternative procedures provided sufficient appropriate evidence, there is no remaining scope limitation that requires a modification to the audit opinion.

Approximately 20 percent of the audit of Lumberton Farms, Inc., was performed by a different CPA firm, selected by you. You have reviewed their audit files and believe they did an excellent job on their portion of the audit. Nevertheless, you are unwilling to take complete responsibility for their work.

For each situation, do the following:

• a.Identify which of the conditions requiring a deviation from a standard unmodified opinion audit report is applicable, if any.

• b.State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision.

• c.Given your answers in parts a. and b., state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b., state the appropriate report for each alternative materiality level):

  • (1)Unmodified opinion—standard wording

  • (2)Unmodified opinion—explanatory paragraph

  • (3)Unmodified opinion—nonstandard report wording

  • (4)Qualified opinion only—GAAP departure

  • (5)Qualified opinion—scope limitation

  • (6)Disclaimer

  • (7)Adverse*

• a. Condition requiring a deviation:

  • Reports involving the use of other auditors. About 20% of the audit was performed by another CPA firm. You reviewed their work and believe they did an excellent job, but you are unwilling to take complete responsibility for their work. Your notes specifically identify “reports involving other auditors” as a circumstance that may require additional report wording.

• b. Level of materiality:

  • Materiality cannot be determined from the information given. We would need to know whether the portion audited by the other CPA firm is material to the financial statements as a whole.

• c. Appropriate audit report:

  • If the portion audited by the other firm is immaterial:
    → (1) Unmodified opinion — standard wording

  • If the portion is material but not pervasive:
    → (3) Unmodified opinion — nonstandard report wording

  • If the portion is highly material/pervasive:
    → The facts given do not indicate that a disclaimer or adverse opinion is required; the key issue is the auditor's decision to refer to the other auditor's work rather than take responsibility for it.