CHAPTER SIX

6. AUDIT REPORTS

Chapter Outline
 Contents of Audit Reports
 Types of Audit Reports
 Materiality
 The Auditor's Decision Process for Audit Reports

Introduction
A good place to start in your study of auditing is at the end. The end result of an audit is the
audit report. Audit reports communicate the auditor’s findings. Users of financial statements
rely on the auditor’s report to provide assurance on the company’s financial statements. Thus,
the auditor will likely be held responsible if an incorrect audit report is issued.

An "unqualified" report suggests that the auditee (the company being audited) satisfactorily
met all audit requirements, and is the most common result. Thus, an "unqualified" report is
good news for the auditee. If the report is "qualified", this means that there were issues
present that must be documented by the auditor.

6.1 Contents of Audit Reports

A standard unqualified audit report contains seven parts, as discussed below.

1. Report title - Auditing standards require that the report be titled and that the title includes
the word independent. For example, appropriate titles include

– “independent auditor’s report,”

– “report of independent auditor,” or
– “independent accountant’s opinion.”
The requirement that the title includes the word independent conveys to users that the audit
was unbiased in all aspects.

2. Audit report address - The report is usually addressed to the company, its stockholders, or
the board of directors. In recent years, it has become customary to address the report to the
board of directors and stockholders to indicate that the auditor is independent of the
company.

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3. Introductory paragraph - The first paragraph of the report does three things:

First, it makes the simple statement that the CPA firm has done an audit. This is intended to
distinguish the report from a compilation or review report. The scope paragraph (see part 4)
clarifies what is meant by an audit.

Second, it lists the financial statements that were audited,

Third, it states that the statements were the responsibility of management and that the
auditor’s responsibility was to express an opinion on the statements based on an audit.

4. Scope paragraph - states that

– the auditor followed generally accepted auditing standards,

– the audit is designed to obtain reasonable assurance about whether the statements are
free of material misstatement,
– the audit evidence was accumulated on a "test basis", that is by sample, and
– the auditor believes that the evidence accumulated was appropriate for the
circumstances to express the opinion presented.

5. Opinion paragraph - states the auditor’s conclusions regarding the audit.

 The opinion paragraph is stated as an opinion rather than as a statement of absolute

fact or a guarantee.
 The intent is to indicate that the conclusions are based on professional judgment.
 The phrase in our opinion indicates that there may be some information risk
associated with the financial statements, even though the statements have been
audited.

6. Name of CPA firm - The name identifies the CPA firm or practitioner who performed the
audit. Typically, the firm’s name is used because the entire CPA firm has the legal and
professional responsibility to ensure that the quality of the audit meets professional standards.

7. Audit report date - The appropriate date for the report is the one on which the auditor
completed the auditing procedures in the field. This date is important to users because it
indicates the last day of the auditor’s responsibility for the review of significant events that
occurred after the date of the financial statements.

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Figure 6:1 Sample of a Standard Unqualified Audit Report

6.2 Types of Audit Reports

Generally there are four types of audit reports based on auditor’s opinion included in the
opinion paragraph.

A. The standard unqualified audit report: is issued when the following five conditions
have been met:

1. All statements (balance sheet, income statement, statement of retained earnings, and
statement of cash flows) are included in the financial statements.

2. The three general standards (adequate training, independence and due professional care)
have been followed in all respects during the audit engagement.

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3. Sufficient appropriate evidence has been accumulated, and the auditor has conducted the
engagement in a manner that enables him or her to conclude that the three standards of field
work (planning and supervision, understanding of internal control and sufficient competent
evidential matter) have been met.

4. The financial statements have been presented in accordance with generally accepted
accounting principles. This also means that adequate disclosures have been included in the
footnotes and other parts of the financial statements.

5. There are no circumstances requiring the addition of an explanatory paragraph or

modification of the wording of the report.

B. The unqualified audit report with explanatory paragraph or modified wording

The audit was complete, with satisfactory results, but the auditor feels compelled to provide
additional information. The auditor may choose to add an explanatory paragraph to the
report, or modify the wording of the report, depending on circumstances that might exist.
This is in spite of an otherwise unqualified report.

The following are the most important causes of the addition of an explanatory paragraph or a
modification in the wording of the standard unqualified report:

– A lack of consistent application of GAAP

– Substantial doubt about going concern
– The auditor agrees with the auditee's departure from GAAP
– Emphasis of a matter
– Reports involving other auditors

Each of these conditions, and the way in which each affects the audit report, is illustrated in
the text.

Lack of Consistent Application of GAAP

The Auditor should add explanatory paragraph in case GAAP is not consistently followed.
For instance, changes that affect consistency and therefore require an explanatory paragraph
include:

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1. Changes in accounting principles, such as a change from FIFO to LIFO inventory
valuation
2. Changes in reporting entities, such as the inclusion of an additional company in combined
financial statements
3. Corrections of errors involving principles

Substantial Doubt about Going Concern

The auditor has a responsibility under auditing standards to evaluate whether the company is
likely to continue as a going concern. For example, the existence of one or more of the
following factors causes uncertainty about the ability of a company to continue as a going
concern:

1. Significant recurring operating losses or working capital deficiencies

2. Inability of the company to pay its obligations as they come due
3. Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake
or flood, or unusual labor difficulties
4. Legal proceedings, legislation, or similar matters that have occurred that might jeopardize
the entity’s ability to operate
 When the auditor concludes that there is substantial doubt about the entity’s ability to
continue as a going concern, an unqualified opinion with an explanatory paragraph
is required.

The Auditor Agrees with a Departure from a Promulgated Principle

Rule 203 of Code of Professional Conduct states that in unusual situations, a departure from a
generally accepted accounting principle may not require a qualified or adverse opinion.
However, to justify an unqualified opinion, the auditor must be satisfied and must state and
explain, in a separate paragraph or paragraphs in the audit report, that adhering to the
principle would produce a misleading result in that situation.

Emphasis of a matter

Under certain circumstances, auditor may want to emphasize specific matters regarding the
financial statements, even though he or she intends to express an unqualified opinion.
Normally, such explanatory information should be included in a separate paragraph in the

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report. Examples of explanatory information the auditor may report as an emphasis of a
matter include the following:

– The existence of significant related party transactions

– Important events occurring subsequent to the balance sheet date
– The description of accounting matters affecting the comparability of the financial
statements with those of the preceding year
– Material uncertainties disclosed in the footnotes

Reports involving other auditors

When the CPA relies on a different CPA firm to perform part of the audit, which is common
when the client has several widespread branches or subdivisions, the principal CPA firm has
three alternatives.

I. Make No Reference in the Audit Report

– When the other auditor audited an immaterial portion of the statements,

– the other auditor is well known or closely supervised by the principal auditor, or
– the principal auditor has thoroughly reviewed the other auditor’s work.

II. Make Reference in the Report (Modified Wording Report)

– It is called a shared opinion or report.

– is appropriate when it is impractical to review the work of the other auditor or when
the portion of the financial statements audited by the other CPA is material in relation
to the whole.

Notice that the report does not include a separate paragraph that discusses the shared
responsibility, but does so in the introductory paragraph and refers to the other auditor in the
scope and opinion paragraphs.

III. Qualify the Opinion

It is required if the principal auditor is not willing to assume any responsibility for the work
of the other auditor. The principal auditor may also decide that a qualification is required in
the overall report if the other auditor qualified his or her portion of the audit.

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Departures from an unqualified audit report

The three conditions requiring a departure are briefly summarized as follows:

1. The Scope of the Audit Has Been Restricted (Scope Limitation) by the client and those
caused by circumstances beyond either the client’s or auditor’s control.
2. The Financial Statements Have Not Been Prepared in Accordance with GAAP (GAAP
Departure)
3. The Auditor Is Not Independent

• When any of the three conditions requiring a departure from an unqualified report
exists and is material, a report other than an unqualified report must be issued.

• Three main types of audit reports are issued under these conditions: qualified
opinion, adverse opinion, and disclaimer of opinion.

C. Qualified Audit Report

A qualified opinion report can result from a limitation on the scope of the audit or failure to
follow GAAP. A qualified opinion report can be used only when the auditor concludes that
the overall financial statements are fairly stated. Therefore, the qualified opinion is
considered the least severe type of departure from an unqualified report.

A qualified report can take the form of a qualification of both the scope and the opinion or of
the opinion alone. A key indicator of a qualified opinion is that the auditor must use the
phrase "except for" in the opinion paragraph, which points to the qualifying issue.

D. Adverse and Disclaimer Audit Report

An adverse opinion is used only when the auditor believes that the overall financial
statements are so materially misstated or misleading that they do not present fairly the
financial position or results of operations and cash flows in conformity with GAAP. The
adverse opinion report can arise only when the auditor has knowledge, after an adequate
investigation, of the absence of conformity.

A disclaimer of opinion is issued when the auditor has been unable to satisfy himself or
herself that the overall financial statements are fairly presented. The necessity for disclaiming
an opinion may arise because of a severe limitation on the scope of the audit or a non-

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independent relationship between the auditor and the client. Either of these situations
prevents the auditor from expressing an opinion on the financial statements as a whole. The
auditor also has the option to issue a disclaimer of opinion for a going concern problem.

 The disclaimer is distinguished from an adverse opinion in that it can arise only from
a lack of knowledge by the auditor, whereas to express an adverse opinion, the auditor
must have knowledge that the financial statements are not fairly stated.

Figure 6:2 Summary of Types of Audit Reports

6.3 Materiality

Misstatement in the financial statements can be considered material if knowledge of the

misstatement would affect a decision of a reasonable user of the statements. As with general
accounting, materiality is a factor in deciding whether a misstatement will affect the type of
opinion to render. There are three levels of materiality:
1. The amounts are immaterial---if the misstatement would not affect the decision of a
financial statement user, it is considered immaterial, and an unqualified report can
be issued;
2. If an amount is material, but does not destroy (overshadow) the fairness of the
overall financial statements, a qualified report may be generated with the "except
for" phrase indicating the offending item;
3. If the amount of the misstatement is so material (so pervasive) as to destroy the
fairness of the entire financial statement, the auditor must consider an adverse
opinion or a disclaimer of opinion.

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6.4 The Auditor's Decision Process for Audit Reports

A procedure for writing the audit report has been developed, and consists of the following
steps:
1. Determine whether any conditions exist requiring a departure from a standard
unqualified report;
2. Decide the level of materiality for each condition;
3. Decide the appropriate type of report for the condition, given the materiality level;
4. Write the audit report.

A decision table for unqualified reports with modified wording or explanatory paragraph is
given below:

Item If Immaterial If Material

GAAP Departure Unqualified Report Unqualified Report with explanatory paragraph
Substantial Going
Unqualified Report Unqualified Report with explanatory paragraph
Concern Doubt
Justified GAAP
Unqualified Report Unqualified Report with explanatory paragraph
Departure
Emphasis of a Matter Unqualified Report Unqualified Report with explanatory paragraph
Use of Another Auditor Unqualified Report Unqualified Report with modified wording

A decision table for conditions requiring departure from an unqualified report is also shown
below:

If Material, Fairness
Item Material but Overall FS OK
Immaterial Compromised
Qualified Scope and Qualified
Scope Restriction Unqualified Disclaimer
Opinion ("except for")
Statements Not Additional paragraph and Qualified
Unqualified Adverse Opinion
Following GAAP Opinion ("except for")
Auditor Not
Disclaimer Disclaimer Disclaimer
Independent

End of Chapter notes!

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