TOPIC 50: AUDIT REPORTING. AUDIT REPORTING (ISA 700 Forming an Opinion and Reporting on Financial Statements)

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1 TOPIC 50: AUDIT REPORTING AUDIT REPORTING (ISA 700 Forming an Opinion and Reporting on Financial Statements) A company s auditors must report their opinions to the shareholders/members on two primary matters: Whether the financial statements are true and fair; and Whether the financial statements have been properly prepared in accordance with relevant rules Basic Elements of The Audit Report The standard audit report contains the following: Title & Addressee - addressing the report (usually to the members) Introductory Paragraph identifying what has been audited. Accounts are often published as part of a larger Annual Report, not all of which is subject to audit Respective responsibilities of directors o Management/Directors are responsible for the preparation of the Financial Statements o Management/Directors are responsible for setting up internal controls to enable the preparation of financial statements that are free from material misstatements (Remember REC!) 1

2 Respective responsibilities of Auditors o Auditor responsible for expressing an opinion on the FS o Audit conducted in accordance with ISA s and Ethical Requirements Scope of the Audit o Audit involves procedures to obtain sufficient and appropriate audit evidence about amounts and disclosures in the financial statements in order to give reasonable assurance that the financial statements are free from material misstatement o Audit involves evaluation of appropriateness of accounting policies used, appropriateness of accounting estimates made by mgt, and the overall presentation of financial statements o Audit involves reading all the financial and non financial information in the annual report so as to identify material inconsistencies and material misstatements **Opinion whether the Accounts are true and fair, and whether they have been properly prepared Other Reporting Responsibilities If the auditor is required by law to report on any other matters, this will be done via an additional paragraph below the opinion paragraph Date, Auditor s Address and Signature Memory Aid : TIRA SOOD **Note: When the auditor has to modify the auditor s opinion, the auditor s report must include a paragraph before the opinion paragraph, which provides a description of the matter giving rise to the modification. This paragraph will be entitled Basis for qualified opinion or Basis for adverse opinion or Basis for disclaimer of opinion depending on the type of modification. 2

3 Unmodified and Modified Audit Reports Modifications ISA 705 Modifications to the Opinion in the Independent Auditor s report provides guidance in this area. - Unmodified or - Modified Modified Matters that do not affect the auditor s opinion Matters that do affect the auditors opinion Emphasis of Matter and Other Matter (ISA 706) - Contain a MM (Qualified or Adverse) or - Unable to Obtain Sufficient Appropriate Audit Evidence (Qualified or Disclaimer) 3

4 When an auditor gives a clean /unmodified audit report on a set of FS, by implication the auditor is stating that o Adequate accounting records have been kept o The books of account agree with the records o The auditors have received all the necessary information o All directors transactions have been disclosed o The directors report is consistent with the Accounts (ISA 720) o In effect the auditor is saying that the FS give a true and fair view However this is not always the case... ISA 705 Modifications to the Opinion in the Independent Auditor s Report sets out 3 different types of modified opinions Qualified Opinion Material But Not Pervasive Except For Adverse Opinion Disclaimer of Opinion 4

5 There are only TWO allowable reasons for modifying an audit opinion: 1. Auditor Concludes that the FS as a whole are not free from material misstatements Material but not Pervasive The auditor disagrees with an accounting treatment, or with the adequacy of disclosures. The only effect on the audit report is in the Opinion section, where the disagreement will be explained. The qualified opinion is in the form Except for, in that the Financial Statements are considered true and fair except for adjustments considered necessary to put the matter right. So Material or Pervasive This situation the auditor now concludes that the matter is so important as to make the entire Accounts seriously misleading. The opinion given is described as adverse. 2. Auditor cannot obtain sufficient appropriate audit evidence - meaning that the auditor s normal procedures have been limited in some way 5

6 Material But Not Pervasive Auditor cannot obtain sufficient appropriate audit evidence and concludes that the possible effect of undetected misstatements would be material but not pervasive The audit report is affected in 3 ways: The limitation will be explained in the Basis of Opinion section The Opinion section will be qualified except for There is likely to be some exception reporting at the base of the Opinion section So Material or Pervasive Similar to the above, except now the lack of evidence is so important the auditor feels unable to express an opinion on the financial statements at all, so issues a disclaimer. So for each reason (i.e. Material Misstatement or inability to gather audit evidence), there are also 2 levels of modification: Material, but not pervasive So material or pervasive 6

7 Pervasiveness is a term used to describe the effects or possible effects on the FS of misstatements or undetected misstatements. There are 3 types of pervasive effect 1. Those that are not confined to specific elements in the FS eg inappropriate use of going concern basis of preparation 2. Those that are confined to specific elements in the FS and could represent a substantial portion of the FS (Sales, Inventory and Receivables Cut Off Errors) 3. Those that relate to disclosures which are fundamental to users understanding of the Financial Statements A matter is pervasive if it seriously affects the view given by the financial statements The first thing to note is that an error or omission must be material for a modification to be necessary. A material modification will result in the auditor singling out the issue in the audit opinion, thus allowing a true and fair opinion to be given on the rest of the Financial Statements. (i.e. Except For ) The higher level modification ( Adverse Opinion / Disclaimer of Opinion ) is needed for errors/omissions or an inability to gather audit evidence, that have such an effect on the Financial Statements that the actual misstatements or the potential misstatements (arising from an inability to gather audit evidence about an area (s) of the financial statements) could seriously affect the view given by the financial statements. 7

8 Summary so Far on Audit Reports. 3 Steps to Decide if a Modification is required to the Audit Opinion 1. Is the matter material?? 2. Is the matter arising from an inability to gather audit evidence or a misstatement (i.e. error or omission) 3. Is the matter pervasive? Exam Focus Point: If qualifying the Audit Opinion, make a point concerning explaining the reasons for the qualification of the audit report in the basis of opinion section of the auditor s report. Summary Different Types of Modified Reports Nature of Circumstances FS are materially misstated Auditor Unable to Obtain sufficient appropriate Audit Evidence Material but not Pervasive Qualified Opinion Except For Qualified Opinion Except For Material and Pervasive Adverse Disclaimer of Opinion Exam Focus Point If you are given a scenario in a question on audit reports and asked whether the opinion should be modified and on what basis, remember to calculate materiality where possible and comment on it in the context of its impact on the type of modification - remember for a modification to arise, the misstatement must be material 8

9 Audit Report Unmodified Report/Unqualified Opinion Qualified Opinion Except For Meaning The Accounts give a true and fair view Except for the Effects of a Material misstatement of Inventory, the FS give a true and Fair view (Include description and quantification of misstatement/omitted disclosures in basis for modification paragraph) or Except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph (not present to observe the counting of the physical inventory), the FS give a true and fair view. (Include reasons for inability to obtain evidence in basis for modification paragraph (above opinion section) Adverse Opinion The FS do not give a true and fair view maybe due to non consolidation of a subsidiary (i.e. material and pervasive) (Include description and quantification of misstatement/omitted disclosures in basis for modification paragraph) Disclaimer of Opinion The auditor will not express an opinion on the FS maybe due to inability to obtain sufficient appropriate audit 9

10 evidence about inventories and accounts receivable (i.e. material and pervasive) Include reasons for inability to obtain evidence in basis for modification paragraph (above opinion section) N.B. Link to ISA 260 Communication of Audit Matters to Those Charged with Governance ISA 705 states that when the auditor expects to issue a modified opinion, the auditor must communicate with those charged with governance the circumstances leading to the expected modification and the proposed wording of the modification on the auditor s report. Allows auditor to give notice to directors of modification to seek agreement or confirm disagreement from directors and to give directors an opportunity to provide further info and explanations. See examples of Auditor Reports in Study Text 10

11 Emphasis Of Matter Paragraphs ISA 706 Emphasis of Matter Paragraphs and other matter paragraphs in the Auditors Report provides guidance in this area The inclusion, in the audit report on an emphasis of matter paragraph and/or other matter paragraph modifies the audit report, but, on their own, they do not modify the audit opinion. There are many uncertainties within a set of financial statements that auditors have to assess. For example: o Whether trade receivables will pay up o Whether inventory will be sold for more than cost o Whether the entity will continue as a going concern Auditors evaluate the figures prepared by the directors, and can modify if they feel the figures are materially wrong or have been omitted (misstated), or if they feel that expected evidence has not been available (inability to gather evidence). An emphasis of matter paragraph is included in the auditor s report to refer to a matter already appropriately presented or disclosed in the financial statements which, is of such importance that, it is fundamental to users understanding of the financial statements. 11

12 An emphasis of matter paragraph (inserted after the opinion paragraph) will o Identify the situation causing the uncertainty o Refer the reader to the note in the financial statements where the directors make their disclosures of the situation o Make it clear that the audit opinion is not qualified in this respect Examples of emphasis of matter paragraph Major catastrophe that has a significant effect on financial position e.g. a fire! Early application of a new accounting standard Major legal case that will finish after the audit is complete Major customer/supplier considering whether to renew agreement with client Major supplier of finance considering whether to continue funding company Major investigation into company by tax authorities or regulators Inconsistency with Other Information in the Annual Report See ISA 720 Other Matter Paragraph An other matter paragraph is included in the auditor s report to refer to a matter other than those presented or disclosed in the financial statements which is relevant to users understanding of the audit, the auditors responsibilities or the auditor report Situation requiring the insertion of an other matter paragraph include: 12

13 Prior Period Financial Statements Not Audited If the prior period financial statements were not audited, the auditor shall state in an Other Matter paragraph in the auditor s report that the corresponding figures are unaudited. Such a statement does not, however, relieve the auditor of the requirement to obtain sufficient appropriate audit evidence that the opening balances do not contain misstatements that materially affect the current period s financial statements. The Other Matter Paragraph must be included immediately after the opinion paragraph and any emphasis of matter paragraph. Note: ISA 706 states that when the auditor expects to include Emphasis of matter paragraph or An other matter paragraph, the auditor must communicate with those charged with governance the circumstances and the proposed wording of the paragraph in the auditor s report. 13

14 Summary of Emphasis of Matter and Other Matter Paragraphs EMPHASIS OF MATTER PARAGRAPHS & OTHER MATTER PARAGRAPHS EMPHASIS OF MATTER PARAGRAPHS Emphasis of Matter Paragraph A paragraph included in the auditors report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor s judgement, is of such importance that it is fundamental to users understanding of the financial statements Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter Paragraph are: - An uncertainty relating to the future outcome of exceptional litigation or regulatory action. - Early application (where permitted) of a new accounting standard (for example a new IFRS) that has a pervasive effect on the financial statements in advance of its effective date - A major catastrophe that has had, or continues to have, a significant effect on the entity s financial position Specific Situations Requiring the Use of an Emphasis of Matter Paragraph - ISA 570 Going Concern An event which significant doubt about the entities ability to continue as a going concern - ISA 560 Subsequent Events Review Where an amended set of FS is issued after the original FS were first issued 14

15 When the auditor includes an Emphasis of Matter paragraph in the auditors report, the auditor shall: (a) Include it immediately after the Opinion on Financial Statements paragraph in the auditors report; (b) Use the heading Emphasis of Matter, or other appropriate heading (c) Include in the paragraph a clear reference to the matter being emphasized and to where relevant disclosures that fully describe the matter can be found in the financial statements, and (d) Indicate that the auditor s opinion is not modified in respect of the matter emphasized OTHER MATTER PARAGRAPHS Other Matter Paragraph A paragraph included in the auditor s report that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor s judgement, is relevant to users understanding of the audit, the auditors responsibilities or the auditor s report. An other matter paragraph shall be included after the Opinion on Financial Statements and Emphasis of Matter Paragraph if applicable Specific Situations Requiring the Use of an Other Matter Paragraph - ISA Comparative Information If the financial statements of the prior period were audited by a predecessor auditor and the auditor is not prohibited by law or regulation from referring to the predecessor auditor s report on the corresponding figures and decides to do so, the auditor shall state in an Other Matter Paragraph in the auditors report the following 15

16 That the financial statements of the prior period were audited by the predecessor auditor, The type of opinion expressed by the predecessor auditor and if the opinion was modified, the reasons therefore, and The date of the report 16

17 Reporting on Opening Balances and Comparative Information See ISA 710 Comparative Information Corresponding Figures and Comparative Financial Statements ISA 710 states that the auditor must determine whether the financial statements include the comparative information required by the applicable financial reporting framework (IAS or UK&IRL GAAP) Are the accounting policies used for the comparative FS consistent with the current period? Do the comparative FS agree with the amounts presented in the prior period? ISA 710 requires the auditor to obtain a written representation for all periods referred to in the auditors opinion and a specific written representation regarding any restatements made to correct a material misstatement in prior period FS that affect the comparative information Scenario Opinion on Prior Period financial statements different from opinion previously expressed Prior Period FS audited by a Predecessor Auditor Material misstatement affecting prior period FS on which predecessor auditor had expressed an unmodified opinion Prior period FS not audited Impact on Auditor s Report Other matter paragraph to explain different opinion Other matter paragraph stating that prior period FS audited by a predecessor auditor, type of opinion expressed, date of the report If predecessor auditor is informed and FS are amended and new report issued, auditor reports only on current period Other matter paragraph stating that the comparative financial statements not audited 17

18 Reporting Implications of Going Concern Reviews Issues surrounding Going concern can result in Audit reports containing each of the modifications identified above. Scenario 1. Going Concern Assumption appropriate but material uncertainty exists which is adequately disclosed 2. Going Concern Assumption appropriate but material uncertainty exists which is not adequately disclosed 3. Use of going concern assumption inappropriate 4. Management unwilling to make or extend its assessment Impact on Audit Report Unqualified Opinion and Emphasis of Matter Paragraph Qualified or Adverse Opinion Adverse Opinion (i.e. FS do not give a true and fair view) Qualified or Disclaimer of Opinion See Study Text for Examples of the Above 18

19 Auditors Responsibility for Other Information in Documents (e.g. Annual Report) containing audited financial statements (ISA 720A) Auditors shall review the other information in documents containing audited financial statements for material inconsistencies and misstatements of fact Other information is financial and non financial information which is included in a document containing audited financial statements and the auditor s report i.e. an annual report An inconsistency means the other information contradicts information contained in the audited financial statements A misstatement of fact is when the other information that is unrelated to matters appearing in the audited financial statements is incorrectly stated or presented Examples of Other Information Include the Following: - Directors Report - Financial Summaries or Highlights - Employment data - Planned Capital Expenditures - Financial Ratios - Names of Officers and Directors - Selected Quarterly data 19

20 Material Inconsistencies These are inconsistencies between amounts/disclosures in the FS and Other Information in the Annual Report ISA 720 states the auditor shall read the other information to identify material inconsistencies with the audited financial statements If the financial statements need to be revised but management refuses, the auditor shall qualify the audit opinion (Except for/adverse) If the other information needs to be revised but management refuses, the auditor shall communicate this matter to those charged with governance and : - Include an emphasis of matter paragraph in the auditor report that describes the material inconsistency or - Address the shareholders at the AGM, or - Withhold the auditors report, or - Withdraw from the engagement (where this is legally permitted) Material Misstatements of Fact Misstatements of fact concern matters not related to the financial statements If the auditor becomes aware that the other information includes an apparent material misstatement of fact, he shall discuss this with management. If after the discussions, the auditor still considers there is an apparent material misstatement of fact, he shall request management to consult a qualified third party such as a lawyer and the auditor shall consider the advice received If management refuses to correct the other information, the auditor shall notify those charged with governance and take any appropriate further action such as consulting the auditors lawyer. 20

21 ISA 720B The Auditor s Statutory Reporting Responsibility in relation to directors Reports The external auditor is required to read the information in the directors report and assess whether it is consistent with the financial statements. If the inconsistency is in the directors report, the auditor should try to resolve the inconsistency with management and if unsuccessful, describe the inconsistency in the audit report. If the inconsistency is in the financial statements, the auditor should consider the need for a qualified or adverse opinion as appropriate. 21

22 Audit assignments and review assignments Suitable Subject Matter Suitable Criteria Practitioner Intended User Assurance Engagement Assurance Report Responsible Party SPAR IS (Everywhere!!) In some circumstances, external auditors provide extra/different audit reports. For example: - Abbreviated Accounts In many countries, smaller companies are allowed to submit a reduced version of their financial statements to Companies House (or equivalent). In such circumstances, Companies House needs to be assured that: o The abbreviated accounts are based on the same numbers in the full financial statements o The abbreviated accounts are properly prepared in the required format o The company satisfied the criteria to submit abbreviated accounts 22

23 As a result, the company s auditors attach a separate audit report to the submitted with abbreviated accounts, covering the above points. - Summary Financial Statements Large listed companies produce sets of financial statements that can be very detailed. For many shareholders they are likely to be too much information. As a result, the company can send its shareholders a summary version of the financial statements (although the shareholders can request full financial statements if they wish). When the shareholders receive the summary version, they need to be assured that: o The summary accounts are based on the same numbers in the full financial statements o The summary accounts are properly prepared in the required format The auditors will therefore attach a report to the summary version of the accounts that covers the above points (and is therefore very similar to the report on abbreviated accounts, described above). Level of Assurance Provided by Various Assignments. For many years, accountants have been providing a wide range of services in addition to the statutory audit. They are often asked to perform work that appears similar to the audit, without the same level of regulation. REVIEW ASSIGNMENTS Review of Interim Financial Statements will not be examined. The example below is purely to illustrate how a review report differs from an audit report. An auditor may be asked to review all sorts of financial information, for example: 23

24 Interim Financial Statements (i.e. half-year) Prospective Financial Information A set of financial statements that is exempt from a statutory audit In these circumstances, the accountant will carry out work similar to an audit however, the procedures are unlikely to be as extensive, and so the opinion given cannot provide the same level of assurance. It is important that those reading the resulting report from this work are aware what work was done, and that it was not a full audit. The level of assurance provided by review assignments is commonly referred to as negative assurance, due to the wording used in the opinion. An example follows, with the negative assurance shown in bold in the Opinion section. Example of Negative Assurance Financial Statements Independent Review Report by KPMG Audit Plc to Cookson Group plc Introduction We have been instructed by the Company to review the financial information set out in the Financial Statements and we have read the other information contained in the interim report and considered whether it contains any apparent misstatements or material inconsistencies with the financial information. Directors' responsibilities The interim report, including the financial information contained therein, is the responsibility of, and has been approved by, the Directors. The Listing Rules of the London Stock Exchange require that the accounting policies and presentation applied to the interim figures should be consistent with those applied in preparing the preceding annual accounts except where they are to be changed in the next annual accounts in which case any changes, and the reasons for them, are to be disclosed. 24

25 Review work performed We conducted our review in accordance with guidance contained in Bulletin 1999/4: Review of interim financial information issued by the Auditing Practices Board. A review consists principally of making enquiries of Group management and applying analytical procedures to the financial information and underlying financial data and, based thereon, assessing whether the accounting policies and presentation have been consistently applied unless otherwise disclosed. A review is substantially less in scope than an audit performed in accordance with Auditing Standards and therefore provides a lower level of assurance than an audit. Accordingly we do not express an audit opinion on the financial information. Review conclusion On the basis of our review we are not aware of any material modifications that should be made to the financial information as presented for the six months ended 30 June KPMG Audit Plc, Chartered Accountants 27 July 1999, London 25

26 Accountants are also often asked to carry out procedures that do not require an opinion to be provided. For example, they may be asked to: prepare a set of statutory financial statements from a company s nominal ledger attest to a company having done something (witness that a process was carried out) In the first example, the accountant is not forming any opinion on the figures, merely compiling them into a preagreed format. It is important the accountant makes it clear to the client, and to anyone reading the financial statements, that no audit work has been undertaken. Summary Different Types of Engagements and Level of Assurance Provided Use the memory aid RACE! Engagement Type of Assurance Provided Examples Review Negative Review of Interim Financial Statements Agreed Upon Procedures None Examination of SOFP Root & Branch Review Compilation None Accountant Report Preparation of FS Preparation of Tax Returns External Audit Reasonable Statutory External Audit Note: Assurance engagements involve the provision of a level of assurance External Audit Reasonable Assurance Review Engagement Negative Assurance 26