The Audit Report — Practice

Question 1

List the prescribed elements of an unmodified auditor's report under SA 700 in order, and explain why the Opinion section is placed before the Basis for Opinion section rather than after it.

Accepted Answer

The prescribed elements, in order, are: the title, Independent Auditor's Report; the addressee; the Opinion section; the Basis for Opinion section; the Key Audit Matters section, for listed entities; the Other Information section, where applicable; the Responsibilities of Management and Those Charged with Governance for the Financial Statements section; the Auditor's Responsibilities for the Audit of the Financial Statements section; and the auditor's signature, place of signature and date of the report. The Opinion section is placed before the Basis for Opinion section, and indeed before every other substantive section of the report, as a deliberate feature of the modern report structure introduced specifically to serve the reader's most urgent need: a user of the financial statements picking up the audit report wants to know, immediately, what the auditor's conclusion is, and requiring them to read through several pages describing the basis of the opinion, key audit matters, and the respective responsibilities of management and the auditor before reaching the actual conclusion would delay access to the single most important piece of information the report conveys. Placing the Opinion first reflects a user-centred redesign of the traditional report format, and the reasoning behind it, that the reader's most pressing question deserves the most prominent placement, is itself an examinable point distinct from merely knowing the correct ordering.

Question 2

State the three limbs of SA 705's definition of pervasive, and apply them to determine whether a misstatement confined to a single, isolated inventory valuation error affecting 2% of total assets would typically be considered pervasive.

Accepted Answer

SA 705 defines pervasive as a term used to describe the effects on the financial statements of misstatements or, if applicable, the possible effects on the financial statements of misstatements that are undetected due to an inability to obtain sufficient appropriate audit evidence, and effects on the financial statements are considered pervasive if they satisfy any one of three limbs: they are not confined to specific elements, accounts or items of the financial statements; or, if so confined, they represent or could represent a substantial proportion of the financial statements; or, in relation to disclosures, they are fundamental to users' understanding of the financial statements. Applying this to a misstatement confined to a single, isolated inventory valuation error affecting 2% of total assets, it would typically not be considered pervasive: the misstatement is confined to a specific element, the inventory account, satisfying the first limb's exception rather than its general rule, and 2% of total assets is a relatively modest proportion that would not ordinarily be considered to represent a substantial proportion of the financial statements as a whole, so the second limb's exception is also not triggered; nor does the third limb apply, since this is not a disclosure matter. On these facts, the misstatement, while potentially material depending on the specific materiality threshold set for this engagement, would ordinarily be assessed as material but not pervasive, since it is confined to one specific, isolated item and does not represent a substantial proportion of the financial statements, which under the decision table would point towards a qualified opinion rather than an adverse opinion, assuming the misstatement is not corrected.

Question 3

Distinguish a misstatement from a scope limitation as the two possible natures of a matter under SA 705, and classify each of the following: (a) the auditor identifies that a fixed asset has been depreciated using an incorrect useful life, resulting in an overstated carrying value; (b) the client's accounting records for a foreign subsidiary were destroyed in a fire before the auditor could examine them, and no alternative records exist.

Accepted Answer

A misstatement is a known or identified difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework; it reflects something the auditor has actually found to be wrong in the figures themselves. A scope limitation, by contrast, is an inability of the auditor to obtain sufficient appropriate audit evidence, arising either from circumstances beyond the entity's control, from circumstances relating to the nature or timing of the auditor's work, or from limitations imposed by management; it reflects not a known error, but an inability to gather enough evidence to reach a conclusion at all about whether an error exists. Item (a) is a misstatement: the auditor has identified a specific, known error, the use of an incorrect useful life resulting in an identifiable overstatement of carrying value, which is a concrete difference from what the applicable framework requires, not merely an absence of evidence about whether the depreciation is correct. Item (b) is a scope limitation: the destruction of the foreign subsidiary's accounting records, with no alternative records available, means the auditor is simply unable to obtain sufficient appropriate audit evidence about that subsidiary's figures at all, and the auditor has no way of knowing whether those figures are correct or incorrect, only that the evidence needed to reach any conclusion about them does not exist; this is a limitation on what evidence can be gathered, not a known, identified error in the figures themselves.

Question 4

Using the decision table, determine the correct opinion for each: (a) a misstatement affecting a single receivable balance, immaterial to the financial statements as a whole; (b) a misstatement so extensive it affects revenue, cost of sales, receivables and multiple related disclosures across the whole set of financial statements, representing a substantial proportion of reported figures; (c) the auditor is denied access to the entity's primary records for the entire year due to a system failure, with no records recoverable, and this affects substantially the whole of the financial statements.

Accepted Answer

Item (a) requires no modification at all and an unmodified opinion should be issued, since the decision table and the resulting choice among the three modified opinions only becomes relevant once a matter is material; a misstatement described as immaterial to the financial statements as a whole does not meet the threshold for any modification in the first place, regardless of its nature, and this is worth stating explicitly since a candidate should not apply the decision table mechanically to every misstatement without first confirming materiality is actually crossed. Item (b) is a misstatement, its nature being a known, identified problem in the figures rather than an inability to obtain evidence, and it is described as pervasive, being not confined to specific elements and instead affecting revenue, cost of sales, receivables and multiple disclosures across the whole set of financial statements, representing a substantial proportion of reported figures, satisfying the pervasive definition on more than one limb; applying the decision table, a misstatement that is material and pervasive calls for an adverse opinion, the auditor concluding the financial statements do not present fairly, or do not give a true and fair view, in accordance with the applicable framework. Item (c) is a scope limitation, since the auditor has been unable to obtain sufficient appropriate audit evidence due to the destroyed records, this being an inability to gather evidence rather than a known misstatement, and the facts state this affects substantially the whole of the financial statements, satisfying the pervasive definition's first limb of not being confined to specific elements; applying the decision table, a scope limitation that is material and pervasive calls for a disclaimer of opinion, the auditor stating that no opinion is expressed on the financial statements at all, since the possible effects of undetected misstatements arising from the inability to obtain evidence could be both material and pervasive.

Question 5

An entity has adequately disclosed, in a note to its financial statements, a material uncertainty related to going concern arising from a significant pending litigation. The auditor is satisfied the disclosure is appropriate and adequate. Advise on the effect on the auditor's opinion, and the report element the auditor should include.

Accepted Answer

The auditor's opinion should not be modified, since the underlying matter, the material uncertainty related to going concern, has been adequately and appropriately disclosed by management in the financial statements themselves, and the auditor is satisfied with the adequacy of that disclosure; the going concern basis remains appropriate for preparing the financial statements, and there is accordingly no misstatement or scope limitation of the kind that would trigger a qualified, adverse, or disclaimer of opinion under SA 705. The correct report element is an Emphasis of Matter paragraph, drawing users' attention to this matter, already appropriately presented and disclosed in the financial statements, that is, in the auditor's judgement, of such importance that it is fundamental to users' understanding of the financial statements, a material uncertainty related to going concern being the paradigm example of exactly the kind of matter an Emphasis of Matter paragraph exists to highlight. This is the point most frequently tested and most frequently misunderstood in this area: an Emphasis of Matter paragraph does not modify the opinion at all, and its presence in an auditor's report is entirely consistent with, and indeed most commonly accompanies, an otherwise unmodified opinion; the auditor is not qualifying anything, merely ensuring that a matter management has already properly disclosed receives the prominence the auditor believes it deserves given its significance to a reader's understanding of the entity's position.

Question 6

Distinguish an Emphasis of Matter paragraph from an Other Matter paragraph, and classify: (a) drawing attention to a properly disclosed change in accounting policy that has a significant effect on the current year's figures; (b) noting that the prior year's financial statements were audited by a different auditor whose report is not being reissued.

Accepted Answer

An Emphasis of Matter paragraph refers to a matter that is already appropriately presented or disclosed in the financial statements and that the auditor judges to be of such importance that it is fundamental to users' understanding, so it always relates to something genuinely contained within the financial statements themselves. An Other Matter paragraph, by contrast, refers to a matter not presented or disclosed in the financial statements that is, in the auditor's judgement, relevant to users' understanding of the audit, the auditor's responsibilities, or the auditor's report itself, so it always relates to something outside the financial statements, concerning instead the audit or the reporting process surrounding it. Item (a), a properly disclosed change in accounting policy with a significant effect on the current year's figures, is an Emphasis of Matter paragraph, since the change in policy has already been disclosed within the financial statements, and the auditor is simply highlighting a matter genuinely present in the statements because of its significance to users' understanding of the current year's figures. Item (b), noting that the prior year's financial statements were audited by a different auditor whose report is not being reissued, is an Other Matter paragraph, since this fact is not, and could not sensibly be, disclosed within the financial statements themselves, being a matter about the audit and reporting history of the engagement rather than about the entity's financial position or performance, and it is relevant to a user's understanding of the audit and the current report rather than being a disclosure item within the statements at all.

Question 7

A candidate argues that including a Key Audit Matter in an auditor's report about the valuation of a complex financial instrument means the auditor has doubts about whether that valuation is correct. Correct this understanding, explaining what a KAM actually signals and why it can appear in a report carrying an entirely unmodified opinion.

Accepted Answer

This understanding is incorrect, and it reflects a common and specifically examined confusion between two entirely different questions. Key Audit Matters are those matters that, in the auditor's professional judgement, were of most significance in the audit of the financial statements of the current period, selected from matters communicated with those charged with governance, and the determination is guided by factors including areas of higher assessed risk of material misstatement, areas involving significant auditor judgement, including accounting estimates with high estimation uncertainty, and the effect on the audit of significant events or transactions during the period. Nothing in this definition requires, or even implies, that the auditor has any residual concern or doubt about the matter's correctness; the question KAM answers is which matters required the most significant audit attention and effort, not whether the auditor's opinion on those matters is anything other than clean. A complex financial instrument's valuation is very often precisely the kind of matter that generates a Key Audit Matter, not because the auditor doubts the valuation, but because valuing it required significant auditor judgement, involved estimation uncertainty, and consumed substantial audit effort and attention, all of which are exactly the factors that make a matter a Key Audit Matter in the first place; having applied that substantial effort and judgement, the auditor may well conclude the valuation is entirely appropriate and support a fully unmodified opinion on the financial statements as a whole, with the Key Audit Matter description simply explaining to readers what this significant area of audit focus was and how the auditor addressed it, a form of transparency about the audit process itself rather than a signal of any unresolved concern. A KAM section and an unmodified opinion are entirely compatible, and in practice a KAM section appears far more often in reports carrying an unmodified opinion than in reports carrying any form of modification.

Question 8

State to which entities Key Audit Matters reporting is required, and explain the reasoning behind confining the mandatory requirement to that category rather than applying it universally.

Accepted Answer

Key Audit Matters reporting is required specifically for audits of listed entities, and may additionally be included voluntarily, or required by law or regulation, for other entities, but it is not a universal requirement applying to every audit engagement regardless of the entity's nature. The reasoning behind confining the mandatory requirement to listed entities reflects the particular breadth and diversity of the user base such entities typically have: a listed company's financial statements are relied upon by a wide, dispersed body of shareholders and potential investors, none of whom typically has direct access to management or to the detailed workings of the audit, and greater transparency about what the auditor actually focused on and found significant provides meaningful additional insight to that broad, arm's-length user base in a way it may not for a smaller, closely held or unlisted entity, whose financial statement users, such as a small number of family shareholders, a bank providing a specific loan facility, or a small group of private investors, often have more direct access to management and to information beyond the financial statements themselves, reducing the marginal value of the additional KAM disclosure for them specifically. This is a proportionality judgement, weighing the genuine additional value KAM reporting provides to a dispersed public shareholder base against the additional cost and effort involved in preparing it, and concluding that mandatory application is justified where that dispersed, arm's-length user base is most clearly present.

Question 9

An auditor identifies that a company has failed to make an adequate provision for a known, quantifiable legal obligation, understating liabilities by an amount the auditor assesses as material but confined to this one specific provision, with no other issues identified anywhere else in the financial statements. Management refuses to correct it. Determine the appropriate opinion, draft the key wording the Basis for Opinion section would use, and state what would change if this same understatement instead pervaded numerous interconnected balances throughout the financial statements.

Accepted Answer

This is a misstatement, since the auditor has identified a known, quantifiable difference from what the applicable framework requires, namely an inadequate provision resulting in understated liabilities, rather than any inability to obtain evidence. It is assessed as material but confined to this one specific provision, with no other issues identified anywhere else in the financial statements, meaning it does not satisfy any of the three limbs of the pervasive definition: it is confined to a specific element, does not represent a substantial proportion of the financial statements given it is described as an isolated matter, and does not concern a fundamental disclosure issue. Applying the decision table, a material but not pervasive misstatement calls for a qualified opinion. The Basis for Opinion section would be headed Basis for Qualified Opinion and would include wording along the lines that, except for the effects of the matter described in the Basis for Qualified Opinion section, the financial statements present fairly, or give a true and fair view, in all material respects, together with a specific description of the matter itself, quantifying the understatement of the provision and its effect on the reported liabilities and, correspondingly, on reported profit or equity, so that a reader understands precisely what has not been corrected and its financial effect. If the same underlying type of understatement instead pervaded numerous interconnected balances throughout the financial statements, such that its effects were not confined to specific elements but spread across many accounts and disclosures, or represented a substantial proportion of the financial statements taken as a whole, the classification of the misstatement's nature would remain the same, still a misstatement rather than a scope limitation, but its pervasiveness assessment would change from not pervasive to pervasive, and the decision table would then indicate an adverse opinion rather than a qualified opinion, with the report stating outright that the financial statements do not present fairly, or do not give a true and fair view, in accordance with the applicable financial reporting framework, a materially more serious conclusion than the except-for wording of a qualified opinion.

Question 10

State the four things the Basis for Opinion section of an unmodified auditor's report must include.

Accepted Answer

The Basis for Opinion section must state that the audit was conducted in accordance with Standards on Auditing; describe the auditor's responsibilities under those Standards, with a reference to the section of the report describing the auditor's responsibilities in more detail; include a statement that the auditor is independent of the entity in accordance with the relevant ethical requirements relating to the audit, and has fulfilled the auditor's other ethical responsibilities in accordance with those requirements; and state whether the auditor believes that the audit evidence the auditor has obtained is sufficient and appropriate to provide a basis for the auditor's opinion. Together these four elements give the reader the specific grounding for the opinion just stated: confirmation of the framework the audit was conducted under, confirmation that the auditor genuinely met the independence and ethical standards that framework requires, and an explicit statement, in the exact vocabulary this whole paper is built around, that sufficient appropriate audit evidence was in fact obtained, directly tying the report back to SA 200's overall objectives stated at the very start of the syllabus.

Question 11

State the specific wording an unmodified opinion, a qualified opinion, an adverse opinion, and a disclaimer of opinion each use to describe the financial statements, and explain why these specific wording choices matter to a reader.

Accepted Answer

An unmodified opinion states that the financial statements present fairly, in all material respects, or give a true and fair view, in accordance with the applicable financial reporting framework, an unqualified, positive statement of conformity. A qualified opinion states that, except for the effects of the matter described in the Basis for Qualified Opinion section, the financial statements present fairly, or give a true and fair view, carving out a specific, identified exception while otherwise affirming the statements. An adverse opinion states that the financial statements do not present fairly, or do not give a true and fair view, in accordance with the applicable financial reporting framework, a direct, unqualified negative conclusion rather than a partial exception. A disclaimer of opinion states that the auditor does not express an opinion on the financial statements, and explicitly states that, because of the significance of the matter described, the auditor has not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion, which is different again from both a qualified and an adverse opinion, since it is not a conclusion about the statements at all, whether positive, partial, or negative, but an explicit statement that no conclusion can be reached. These specific wording differences matter enormously to a reader because each phrase carries a precise, different meaning under the Standards: a reader who understands the vocabulary can distinguish immediately between a minor, isolated exception (qualified), a fundamentally unreliable set of statements (adverse), and a situation where the auditor was simply unable to form any view at all (disclaimer), three conclusions with very different implications for how much weight to place on the financial statements, and using imprecise or interchangeable language across these categories would defeat the entire purpose of having a standardised, internationally recognised reporting vocabulary in the first place.

Question 12

Explain what the Other Information section of an auditor's report addresses, and why the auditor's responsibility for other information differs from the auditor's responsibility for the audited financial statements themselves.

Accepted Answer

The Other Information section addresses information included in an entity's annual report, such as a chairman's statement, a management commentary, or other narrative sections, that is not part of the financial statements themselves and is not covered by the auditor's opinion, but which the auditor is nonetheless required to read and consider for material inconsistency with the audited financial statements or with the auditor's knowledge obtained during the audit. The auditor's responsibility for this other information differs fundamentally from the responsibility for the financial statements themselves: for the financial statements, the auditor performs a full audit involving risk assessment, evidence gathering and forming an opinion, culminating in the Opinion section discussed elsewhere in this chapter; for other information, the auditor does not audit it at all and expresses no opinion or any form of assurance conclusion on it, but is required to read it and consider whether it is materially inconsistent with the financial statements or with the auditor's audit knowledge, and if a material inconsistency or a material misstatement of fact is identified, the auditor takes appropriate action, which may include requesting management to correct the other information or, in some circumstances, referring to the inconsistency in the auditor's own report. This more limited responsibility exists because other information typically includes narrative, forward-looking, or discursive content that is not itself financial statement information in the sense the Standards on Auditing are designed to audit, but a glaring inconsistency between what an entity's chairman says in a glossy narrative section and what the audited financial statements actually show would undermine the credibility of the annual report as a whole, which is why some level of auditor consideration, short of a full audit, is nonetheless required.

Question 13

A client refuses to allow the auditor to send confirmation requests to its largest customers, representing a material portion of receivables, and no alternative procedure can provide equally persuasive evidence. Explain the specific concern this raises beyond the ordinary evidence-gathering question, and state the likely opinion consequence.

Accepted Answer

The specific concern this raises beyond the ordinary evidence-gathering question is that the limitation has been imposed by management itself rather than arising from external circumstances beyond anyone's control, such as destroyed records or an unavoidable timing constraint, and a management-imposed restriction on the scope of the audit is treated with particular seriousness because it raises the further, separate question of why management would decline to allow a standard, ordinarily uncontroversial procedure like external confirmation of significant customer balances, potentially suggesting the restriction itself is a red flag pointing towards a heightened risk of fraud or misstatement in precisely the area management is unwilling to have independently verified; this connects directly to the professional scepticism principle running throughout this paper, since an auditor should be alert to exactly this kind of circumstance rather than accepting the restriction at face value. In terms of the mechanics, this is a scope limitation, an inability to obtain sufficient appropriate audit evidence, here specifically imposed by management, and if no alternative procedure can provide equally persuasive evidence about the existence and valuation of the affected receivables, and the amount involved represents a material portion of receivables, the auditor must assess pervasiveness in the usual way; given that the receivables represent a material portion of the balance and no alternative evidence is available, the effect could plausibly be assessed as material and, depending on how confined the affected population is relative to the financial statements as a whole, potentially pervasive, pointing towards a qualified opinion or, if sufficiently extensive and combined with continued lack of cooperation on further matters, potentially a disclaimer of opinion; separately, the auditor should also consider whether this management-imposed restriction itself, and any accompanying pattern of resistance to audit procedures, raises broader concerns about the integrity of management and the reliability of other representations made throughout the engagement, potentially affecting the auditor's approach to the rest of the audit as well as the eventual opinion.

Question 14

An auditor's report on a large manufacturing company includes three Key Audit Matters: revenue recognition on long-term contracts, valuation of a significant goodwill balance, and litigation provisions. Explain what these three items have in common that justified their inclusion, and why a routine, low-risk balance like a small petty cash account would never appear as a Key Audit Matter.

Accepted Answer

What these three items have in common is that each is likely to involve one or more of the specific factors SA 701 identifies as guiding the determination of Key Audit Matters: areas of higher assessed risk of material misstatement, areas involving significant auditor judgement including accounting estimates with high estimation uncertainty, and the effect on the audit of significant events or transactions during the period. Revenue recognition on long-term contracts typically involves significant judgement in estimating stage of completion and allocating consideration across performance obligations, both areas of genuine estimation uncertainty and elevated risk given the potential for management bias in timing revenue recognition. Valuation of a significant goodwill balance requires a complex impairment assessment involving forecasts of future cash flows, discount rates and other highly judgemental inputs, again an area of significant estimation uncertainty and higher risk given goodwill impairment's history as an area prone to both genuine difficulty and potential management optimism. Litigation provisions require judgement about the probability and quantum of future outflows from often genuinely uncertain legal proceedings, another area combining significant judgement with elevated risk. A routine, low-risk balance like a small petty cash account would never appear as a Key Audit Matter because it satisfies none of these factors: it typically involves straightforward, low-value, easily verified transactions with little scope for significant judgement, minimal estimation uncertainty, and a low assessed risk of material misstatement given its small scale, meaning it would not have been an area requiring significant audit attention or generating significant professional judgement calls during the engagement, which is precisely the threshold a matter must cross before it can be considered a Key Audit Matter at all.

Question 15

Summarise, in one sentence each, what a qualified opinion, an adverse opinion and a disclaimer of opinion each communicate to a reader about the reliability of the financial statements as a whole, distinguishing all three clearly from each other.

Accepted Answer

A qualified opinion communicates that the financial statements are reliable and fairly presented as a whole, except for one or more specifically identified matters that the reader should treat with caution, essentially telling the reader the statements can generally be relied upon subject to a clearly carved-out exception. An adverse opinion communicates that the financial statements, taken as a whole, cannot be relied upon at all as a fair presentation of the entity's position and performance, since the identified misstatements are so extensive and pervasive that no meaningful exception could be carved out to preserve confidence in the rest of the statements. A disclaimer of opinion communicates something different in kind from either of the other two: it tells the reader that the auditor is simply unable to say anything at all about the reliability of the financial statements, neither affirming them as generally reliable subject to an exception, nor condemning them as unreliable, because the auditor never obtained enough evidence to form any view either way; a disclaimer is not a negative verdict on the financial statements themselves but an admission that no verdict could be reached, which is a meaningfully different message for a reader to receive than either of the other two opinions, both of which represent the auditor having actually formed and expressed a substantive conclusion, whether qualified or wholly adverse, about what was found.

Practice — The Audit Report

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