CHAPTER SIX

AUDIT REPORTS

ISA:- 315, 700, 705,706, 710, 720

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STUDY OBJECTIVES
After studying this chapter, you should be able to:
• Describe the circumstances that result in
inclusion of additional explanatory language in
an unqualified audit report.
• Discuss how materiality affects the consideration
of the type of audit report to be issued.
• Identify circumstances that may result in
qualified opinions, adverse opinions and
disclaimers of opinion.
• Describe the auditors' responsibilities for
reporting on comparative financial statements.
• The (auditors') report shall either contain an
expression of opinion regarding the financial
statements, taken as a whole, or an assertion to
the effect that an opinion cannot be expressed.
• When an overall opinion cannot be expressed,
the reasons therefore should be stated.
• In all cases where an auditor's name is
associated with financial statements, the report
should contain a clear-cut indication of the
character of the auditor's work, if any, and the
degree of responsibility the auditor is taking.

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 Auditors considerations to report
 Financial Statements
• The reporting phase of an audit begins when the
independent auditors have completed their fieldwork and
they have proposed any necessary adjustments to the client.
Before drafting their report, the auditors must review the
client-prepared financial statements form and content, or
draft the financial statements on behalf of the client.
• Financial statements generally are presented in comparative
form for the current year and the preceding year and are
accompanied by explanatory notes.
• The financial statements for a parent corporation usually are
consolidated with those of the subsidiaries. 4
 Financial Statement Disclosures
• The purpose of notes to financial statements is to achieve
adequate disclosure when information in the financial
statements prepared is insufficient to attain this objective.
• Although the notes, like financial statements themselves, are
representations of the client, the independent auditors generally
assist in drafting the notes. The writing of notes to financial
statements is a challenging task because complex issues must be
summarized in a clear and concise manner.
• Adequate disclosure in the notes to the financial statements is
necessary for the auditors to issue an unqualified opinion on the
financial statements.
• The Financial Accounting Standards Board, the Government
Accounting Standards Board, and the Securities and Exchange
Commission have issued numerous pronouncements that have
added extensive disclosure requirements. Examples of note
disclosure requirements that have become a part of the basic
financial statements include the disclosure of significant
accounting policies, accounting changes, loss contingencies,
and lease and pension information. 5
 Cont…
• In addition to the note disclosures that are part of the basic
financial statements, many clients are required by the
FASB, the GASB, or the SEC to present supplementary
information.
• As an example, certain companies are required to disclose
selected interim financial data with their annual financial
statements.
• In evaluating financial reporting disclosures, the auditors
should keep in mind that disclosures are meant to
supplement the information in the financial statements and
not to correct improper financial statement presentation.
• Thus a note or supplementary schedule, no matter how
skillfully drafted, does not compensate for the erroneous
presentation of an item in the financial statements.
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 TYPES OF AUDIT REPORT
• There are four types of audit reports;
1. An unqualified opinion--standard report. This report represents a ''
clean opinion'' and when no conditions requiring explanatory language exist.
• An unqualified opinion--with explanatory language added to report.
This is an audit report with an unqualified opinion and explanatory
language resulting from certain circumstances. Examples of such
circumstances are those in which other auditors have performed a portion
of the audit, or when major uncertainties exist with respect to the
company being audited.
2. A qualified opinion. A qualified opinion states that the financial
statements are presented fairly '' except for'' the effects of some matter.
Qualified reports are issued when the financial statements depart materially
from generally accepted accounting principles, or when limitations are
placed on the scope of the auditors' procedures. The problems, while
materials, do not overshadow the overall fairness of the statements.

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 Cont…
3. An adverse opinion. An adverse opinion states that the
financial statements are not a fair presentation.
• Auditors will issue an adverse opinion when the deficiencies
in the financial statements are so significant that the financial
statements taken as a whole are misleading. All significant
reasons for the issuance of an adverse opinion should be set
forth in an explanatory paragraph.
4. A disclaimer of opinion. A disclaimer of opinion means that
due to a significant scope limitation (or very major uncertainties),
the auditors were unable to form an opinion on the fairness of
the financial statements. A disclaimer is neither a positive nor a
negative opinion.
• It simply means that the auditors do not have an adequate
basis for expressing an opinion.
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 Expression of an opinion (contents of audit report)
The Auditors' Standard Report
• Before continuing, let us mention a few details about this report. It has a title that
includes the word ''independent.''
• The first paragraph is referred to as the introductory paragraph. It clearly
indicates that (1) the financial statements have been audited; (2) the financial
statements are the responsibility of management, and (3) the auditors'
responsibility is to express an opinion on them.
• The second paragraph, which describes the nature of an audit, is called the scope
paragraph.
• Finally, the opinion paragraph presents the auditors' opinion on whether the
financial statements are in conformity with generally accepted accounting
principles.
• Notice that the report is signed with the name of the CPA firm, not the name of
an individual partner in the firm. This signature stresses that it is the firm, not an
individual that takes responsibility for the auditors' report. If the CPA performing
the audit is a sole practitioner, the report will be signed with the CPA's personal
signature.
• Also notice the date under the signature is the last day of fieldwork--that is, the
date upon which the auditors conclude their investigative procedures. This date is
quite significant, because the auditors have a responsibility to perform procedures
to that date to search for any subsequent events that may affect the fairness of the
client's financial statements. 9
 An unqualified auditors' report may be issued only
when the following conditions have been met:
• The financial statements are presented in conformity with
generally accepted accounting principles, including adequate
disclosure.
• The audit was performed in accordance with GAAS including
no significant scope limitations preventing the auditors from
gathering the evidence necessary to support their opinion.
• When considered material, departure from either of these
conditions results in a situation in which a report that is other
than unqualified is required.
• Additionally, when certain other conditions exist, the auditors
add explanatory language to the standard report, but still
express an unqualified opinion.

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 Cont…..
Materiality
• Auditors must qualify their report whenever there are material
deficiencies in the client's financial statements; when the deficiencies
are immaterial, an unqualified report may be issued.
• Accordingly, auditors must exercise professional judgment to evaluate
the materiality of any such departures. At this stage of the audit, the
auditors can consider both the quantitative and qualitative effects of
the deficiencies. For example, a related party transaction of a
relatively small amount may be considered to be material.
• Auditors are required to issue an adverse opinion when the
deficiencies in financial statements are '' so significant'' that a qualified
opinion would be inappropriate.
• the term material to describe problems sufficient to require
qualification of the auditors' report, but which do not overshadow the
fairness of the statements. Problems overshadowing the fairness of the
statements will be described as '' very material'' or as causing the
statements to be '' substantially misleading.''

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 Cont….
• Auditors express an unqualified opinion on the
client's financial statements when they have no
material exceptions as to the fairness of the
application of accounting principles and there
have been no unresolved restrictions on the scope
of their engagement.
• The unqualified opinion is, of course, the most
desirable report from the client's point of view.
• The client usually will make any necessary
adjustments to the statements to enable the
auditors to issue this type of opinion.

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 Cont. …
Explanatory Language Added to the Unqualified Opinion
• Under certain circumstances auditors add explanatory
language to the standard report, even when issuing an
unqualified opinion.
• Adding the additional language is not regarded as a
qualification because it does not lessen the auditors'
reporting responsibility for the financial statements.
• Rather, the language merely draws attention to a significant
situation. Auditors add explanatory language to an
unqualified opinion to indicate that a part of the audit was
performed by other auditors to refer to an uncertainty that
could have a material impact on the financial statements,
• to indicate an inconsistency in the application of accounting
principles, to emphasize a matter, and to indicate a justified
departure from officially recognized accounting principles.
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 Cont.…
 Part of the Audit Performed by Other Auditors: On occasion
it may be necessary for the principal auditors of a company to
rely upon another CPA firm to perform a portion of the audit
work. The most common situation in which CPAs rely upon the
work of other auditors is in the audit of consolidated entities. If
certain subsidiaries have been audited by other CPA firms, the
auditors reporting on the consolidated parent company will
usually decide to rely upon the work of these other CPAs rather
than conduct another audit of the subsidiaries.
• When more than one CPA firm participates in an engagement,
the auditors' report is issued by the principal auditors that is,
by the CPA firm that did the majority of the audit work and has
an overall understanding of the financial statements.
• The principal auditors have two basic alternatives in wording
their report:
 Make No Reference to the Other Auditors
 Make Reference to the Other Auditors:
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 Uncertainties: Substantial uncertainty as to the
outcome of a contingency affecting the client's
financial statements may require the auditors to
add an explanatory paragraph to their audit report
to indicate the existence of the uncertainty.
• It is when the contingency is reasonably possible
that the auditors should consider adding an
explanatory paragraph to their unqualified
opinion, based on should consider adding an
explanatory paragraph to their unqualified
opinion, based on the materiality of the
contingency and the probability of unfavorable
outcome.

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 Cont,,,,
 Question about A Company's Going--Concern
Status: A special type of significant uncertainty
concerns the ability of a client company to
continue as a going concern. Under generally
accepted accounting principles, both assets and
liabilities are recorded and classified on the
assumption that the company will continue to
operate.
• Conditions that may cause the auditors to question
the going concern assumption include negative
cash flows from operations, defaults on loan
agreements, adverse financial ratios, work
stoppages, and legal proceedings.
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 IFRS Not Consistently Applied If a client company
makes a change in accounting principle (including a change
in the reporting entity), the nature of, justification for, and
effect of the change are reported in a note to the financial
statements for the period in which the change is made.
• Any such change having a material effect upon the
financial statements will also require modification of the
auditors' report, even though the auditors are in full
agreement with the change.
• Changes in accounting estimates need not be reported in
the auditors' report.
• Changes from one generally accepted accounting principle
to another generally accepted accounting principle, when
justified; do not result in qualification of the auditors'
report. The report is merely modified to highlight the lack
of consistent application of acceptable accounting
principles.
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 Cont…
 Emphasis of a Matter: Auditors also may issue
an unqualified opinion that departs from the
wording of the standard report in order to
emphasize some element within the client's
financial statements.
• For example, the auditors may add an additional
paragraph to their unqualified opinion calling
attention to a significant related-party transaction
described in a note to the financial statements.

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 Qualified Opinions
• A qualified opinion expresses the auditors' reservations about fair
presentation in some areas of the financial statements.
• The opinion states that except for the effects of some deficiency in the
financial statements, or some limitation in the scope of the auditors'
examination, the financial statements are presented fairly.
• All qualified reports include a separate explanatory paragraph before
the opinion paragraph disclosing the reasons for the qualification.
• The opinion paragraph of a qualified report includes the appropriate
qualifying language and a reference to the explanatory paragraph.
• The materiality of the exception governs the use of the qualified
opinion. The exception must be sufficiently significant to warrant
mentioning in the auditors' report, but it must not be so significant as
to necessitate a disclaimer of opinion or an adverse opinion.

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Some indications:-
 Departure from a Generally Accepted Accounting Principle:
The auditors sometimes do not agree with the accounting
principles used preparing the financial statements.
• Usually, when the auditors' object icons are carefully
explained, the client will agree to change the statements in an
acceptable manner. If the client does not agree to make the
suggested changes, the auditors will be forced to qualify their
opinion (or if the exception is very material, to issue an
adverse opinion).
• When the report is qualified, the introductory and scope
paragraphs of the standard report are unaffected. The
modification involves adding an explanatory paragraph
following the scope paragraph and qualifying the opinion
paragraph. The qualifying language used in the opinion
paragraph always begins with the term except for. 20
 Scope Limitations: Limitations in the scope of an audit
arise when the auditors are unable to perform an essential
audit procedure. Limitations may be due either to
circumstances surrounding the audit for example, the
auditors were engaged too late.
• In this situation, the professional standards require issuance
of a qualified opinion. The basis of the qualification is that
when a balance sheet and statement of income are
presented, a statement of cash flows is required. However, if
only a balance sheet or a statement of income is presented, a
statement of cash flows is not required.
• When a circumstances-imposed scope limitation is
involved, the auditors attempt to perform alternative
procedures to gather sufficient competent evidential matter.
If such evidential matter is collected and the auditors
believe that it is sufficient, an unqualified opinion may be
issued. In situations in which alternative procedures do not
provide sufficient evidence, the auditors will either qualify
the opinion to reflect the scope limitation or disclaim an
opinion. 21
An auditors' report may be qualified because of both a
scope limitation and a separate problem involving
accounting principles. The wording of such a report
would include the appropriate qualifying language and
explanatory paragraphs for both types of qualifications.
• Note that even through this may be the ''fault'' of the
client; it is considered a circumstance-imposed limitation
because the client is not refusing to allow the auditor to
perform a procedure which is possible to perform.
• When there are several situations requiring the qualification
of an opinion, the auditors should consider the cumulative
effects of these problems. If the effect of the problems is to
overshadow the fairness of the statements viewed as a
whole or to prevent the auditors from forming an overall
opinion, a qualified opinion would be inappropriate. In such
cases, the auditors should issue either an adverse opinion or
a disclaimer of opinion, depending upon the circumstances.

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 Adverse Opinions
• An adverse opinion is the opposite of an unqualified opinion; it is an
opinion that the financial statements do not present fairly the
financial position, results of operations, and cash flows of the client,
in conformity with generally accepted accounting principles. When
the auditors express an adverse opinion, they must have accumulated
sufficient evidence to support their unfavorable opinion.
• The auditors should express an adverse opinion if the statements are
so lacking in fairness that a qualified opinion would not be warning
enough.
• Whenever the auditors issue an adverse opinion, they should disclose
in a separate paragraph of their report the reasons for the adverse
opinion and the principal effects on the financial statements of the
matters causing the adverse opinion, if the effects can be determined.
• Thus, an audit report that expresses and adverse opinion generally
includes standard introductory and scope paragraphs, one or more
explanatory paragraphs preceding the opinion paragraph and
describing the reasons for the adverse opinion, and an opinion
paragraph. Because the reasons for an adverse opinion are usually
lengthy and complex.
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 Disclaimer of Opinion
• A disclaimer of opinion is no opinion. In an audit
engagement, a disclaimer is required when substantial scope
restrictions or other conditions preclude the auditors'
compliance with generally accepted auditing standards.
• Substantial Circumstance- Imposed Scope Restrictions: If
a scope restriction is so severe that a qualified opinion is
inappropriate, the auditors should issue a disclaimer of
opinion. This might happen, for example, if the auditors were
engaged after year-end and the client did not take a physical
inventory. A disclaimer issued because of a scope limitation
will omit the scope paragraph of the standard report and will
include an explanatory paragraph describing the scope
limitation in its place.
• The wording of the opinion paragraph will change
considerably, because the auditors are not expressing an
opinion--rather, they are saying that they have no opinion.

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• Disclaimers of opinion because of scope restrictions are relatively
rare. The auditors should be able to foresee these types of problems
in the planning stage of the engagement. The client usually will not
want to incur the cost of an audit if it is apparent from the start that
the auditors must issue a disclaimer of opinion.
• Scope Restrictions Imposed by the Client: The professional
standards state that when client-imposed restrictions significantly
limit the scope of the audit, the auditor generally should disclaim an
opinion on the financial statements.
• Two reasons exist for this requirement. First, a disclaimer is
relatively useless to the client. Therefore, the fact that the auditors
may have to issue a disclaimer is a substantial deterrent to the client
imposing any scope restrictions in the first place. Second, a client
who imposed scope restrictions upon the auditors apparently has
something to hide. An audit must be undertaken with an atmosphere
of trust and cooperation. If the client is attempting to conceal
information, no audit can ensure that all of the problems have been
brought to light. 25
 Cont…
 Disclaimer because of Uncertainty: An unqualified
opinion with an explanatory paragraph is generally
appropriate for a material uncertainty that is described
adequately in notes to the client's financial statements.
However, the standards allow the issuance of a
disclaimer of opinion because of a material uncertainty,
including one about the company's ability to continue
as a going concern.
Other Disclaimers Issued by CPAs: In this section, we
have discussed only those disclaimers of opinion issued in
audit engagements. CPA firms issue disclaimers of
opinion in many other types of engagements

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 Cont…
• Disclaimers Are Not Alternatives to Adverse Opinions.
• A disclaimer can only be issued when the auditors do not
have sufficient information to form an opinion on the
financial statements.
• If the auditors have already formed an opinion that the
financial statements are not a fair presentation, the
disclaimer cannot be used as a way to avoid expressing an
adverse opinion.
• In fact, even when auditors issue a disclaimer of opinion, they
should express in explanatory paragraphs of their report any
reservations they have concerning the financial statements.
• These reservations include any material exceptions as to
generally accepted accounting principles, including
disclosure.
• In short, the issuance of a disclaimer can never be used to
avoid warning financial statement users about problems that
the auditors know to exist in the financial statements.
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