AUDIT

REPORTS
CHAPTER 3

1-1
 CHAPTER 3 LEARNING OBJECTIVES
3-1 Describe the parts of the standard unmodified opinion audit report for
nonpublic entities under AICPA auditing standards.
3-2 Specify the conditions required to issue the standard unmodified opinion audit
report.
3-3 Understand reporting on financial statements and internal control under
PCAOB auditing standards.
3-4 Describe the five circumstances when an emphasis-of-matter explanatory
paragraph or nonstandard wording is appropriate to include in an unmodified
opinion audit report.
3-5 Identify the types of audit reports that can be issued when an unmodified
opinion is not justified.
3-6 Explain how materiality affects audit reporting decisions.
3-7 Draft appropriately modified opinion audit reports under a variety of 2
 OBJECTIVE 3-1
Describe the parts of the standard unmodified
opinion audit report for nonpublic entities
under AICPA auditing standards.

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 STANDARD UNMODIFIED AUDIT REPORT FOR
NON-PUBLIC ENTITIES
• To allow users to understand audit reports, AICPA auditing
standards provide uniform wording for the auditor’s report,
as illustrated in the auditor’s standard unmodified audit
report in Figure 3-1.
• Different auditors may alter the wording or presentation
slightly, but the meaning will be the same.

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5
 PARTS OF STANDARD UNMODIFIED OPINION
AUDIT REPORT
1. Report title
2. Audit report address
3. Introductory paragraph
4. Management’s responsibility
5. Auditor’s responsibility
6. Opinion paragraph
7. Signature and address of CPA firm
8. Audit report date

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1. Report title. Auditing standards require that the report be titled and
that the title include the word independent. The requirement that the
title include 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 to indicate that the
auditor is independent of the company.

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3. Introductory paragraph. The first paragraph of the report indicates that
the CPA firm has performed an audit, which distinguishes the report from
a compilation or review report.
• It also lists the financial statements that were audited, including the notes
to the financial statements as well as the balance sheet dates and the
accounting periods for the income statement and statement of cash flows.
• Notice that the report in Figure 3-1 is on comparative financial
statements. Therefore, a report on both years’ statements is needed.
4. Management’s Responsibility. This paragraph states that the
statements are the responsibility of management. This responsibility
includes: (1) selecting the appropriate accounting principles and (2)
maintaining (ICOFR) sufficient for preparation of financial statements that
are free of material misstatements due to fraud or error.

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5. Auditor’s Responsibility. This section contains three paragraphs as
follows:
 The first paragraph states that the audit was conducted in accordance
with (GAAS). It also notes that the audit is designed to obtain reasonable
assurance about whether the statements are free of material misstatement.
• The inclusion of the word material conveys that auditors are only
responsible to search for significant misstatements, not minor
misstatements that do not affect users’ decisions.
• The use of the term reasonable assurance is intended to indicate that an
audit cannot be expected to completely eliminate the possibility that a
material misstatement will exist in the financial statements. In other
words, an audit provides a high level of assurance, but it is not a
guarantee.

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The second paragraph (Scope paragraph) describes the scope of the
audit and the evidence accumulated. It indicates that the procedures
depend on the auditor’s judgment and include an assessment of the risk of
material misstatements in the F.Ss.
It also indicates that the auditor considers I.C relevant to the preparation &
fair presentation of the F.Ss in designing the audit procedures performed,
but this assessment of I.C is not for the purpose & is not sufficient to
express an opinion on the effectiveness of the entity’s I.C.
• The last sentence of this paragraph indicates that the audit includes
evaluating the accounting policies selected, the reasonableness of
ACC. estimates, and the overall financial statement presentation.
The third paragraph indicates the auditor believes that sufficient
appropriate evidence has been obtained to support the auditor’s
opinion.
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6. Opinion paragraph. The final paragraph in the standard report
states the auditor’s conclusions based on the results of the audit.
This part of the report is so important that often the entire audit
report is referred to simply as the auditor’s opinion.
• 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.

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• One of the controversial parts of the auditor’s report is the meaning
of the term present fairly. Does this mean that if (GAAP) are followed,
the financial statements are presented fairly, or something more?
Occasionally, the courts have concluded that auditors are responsible
for looking beyond (GAAP) to determine whether users might be
misled, even if those principles are followed. Most auditors believe
that financial statements are “presented fairly” when the statements
are in accordance with (GAAP), but that it is also necessary to
examine the substance of transactions and balances for possible
misinformation.

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7. Signature and Address 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. The city & state of the audit firm should also be indicated.
8. 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.
In the audit report in Figure 3-1, the balance sheet is dated December 31,
2016, and the audit report is dated February 15, 2017. This indicates that
the auditor has searched for material unrecorded transactions and events
that occurred up to February 15, 2017.
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 OBJECTIVE 3-2
Specify the conditions required to issue the
standard unmodified opinion audit report.

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 CONDITIONS FOR STANDARD UNMODIFIED
OPINION AUDIT REPORT
1. All financial statements—balance sheet, income statement,
statement of changes in stockholders’ equity, and statement of
cash flows—are included
2. Sufficient appropriate evidence accumulated and the auditor
has conducted the engagement in a manner that enables him or
her to conclude that the audit was performed in accordance
with auditing standards.
3. Financial statements are presented fairly in accordance with
GAAP or other framework. This also means that adequate
disclosures have been included in the footnotes and other
parts of the financial statements.
4. No circumstances requiring the addition of an emphasis-of-
matter paragraph or modification of the wording of the report.
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• The standard unmodified audit report is sometimes called a clean
opinion because there are no circumstances requiring a qualification
or modification of the auditor’s opinion. It is the most common audit
opinion.
• Sometimes circumstances beyond the client’s or auditor’s control
prevent the issuance of a clean opinion. However, in most cases,
companies make the appropriate changes to their accounting records
to avoid a qualification or modification by the auditor.
• If any of the four requirements for the standard unmodified
audit report is not met, the standard unmodified report cannot
be issued.
• Figure 3-2 indicates the categories of audit reports that can
be issued by the auditor.
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• The departures from a standard unmodified report are
considered increasingly severe as one moves down the figure.
• Financial statement users are normally much more concerned
about a disclaimer or adverse opinion than an unmodified
report with an explanatory paragraph.

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 OBJECTIVE 3-3
Understand reporting on financial
statements and internal control under
PCAOB auditing standards.

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 STANDARD AUDIT REPORT AND REPORT ON
INTERNAL CONTROL OVER FINANCIAL REPORTING
UNDER PCAOB AUDITING STANDARDS

Two significant audit reporting differences for public

companies.
1. The standard unmodified opinion audit report is
different. The differences are detailed in Figure 3-
3.
2. Auditors of larger public companies must also
issue an opinion on internal control over financial
reporting.

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 STANDARD UNMODIFIED AUDIT REPORT FOR PUBLIC
COMPANIES
It includes 3 paragraphs as illustrated in Figure (3-3).
• The first paragraph is the introductory paragraph & indicates that an audit
was performed & the F.Ss that were audited.
It also indicates that the F.Ss are the responsibility of Mgt. & that the auditor’s
responsibility is to express an opinion on the F.Ss.
• The second paragraph is the scope paragraph. It is similar to the
second paragraph under the auditor’s responsibilities in Fig.(3-1), &
indicates that an audit is designed to provide reasonable assurance that
the F.Ss are free of material misstatement.
In addition, this paragraph notes that auditing is done on a test basis.
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• The third paragraph is the opinion paragraph & is similar to the
opinion paragraph included in Fig.(3-1).
• NOTICE: The report title, report address, signature & address of CPA
firm, and audit report date are similar for public CO.s & non-public
CO.s & are not included in Fig.(3-3).

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STANDARD AUDIT REPORT AND REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING UNDER PCAOB AUDITING STANDARDS

Section (404) of SOX requires the auditor of a public company to attest to

management′s report on the effectiveness of ICOFR.
Larger public companies have been required by the SEC to annually obtain an
auditor’s report on ICOFR.
PCAOB Auditing Standard 5 requires the audit of internal control to be integrated
with the audit of financial statements.
However, the auditor may issue separate reports, such as the separate report on
internal control over financial reporting shown in Figure 3-4, or a combined report
on F.Ss & ICOFR. However, the separate report on ICOFR is more common and
includes the following elements:

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1. The introductory, scope, and opinion paragraphs describe that the scope of
the auditor‘s work and opinion is on ICOFR, and the introductory paragraph
highlights management‘s responsibility for and its separate assessment of
ICOFR.
2. The introductory and opinion paragraphs also refer to the framework used
to evaluate internal control.
3. The report includes a paragraph after the scope paragraph defining ICOFR.
4. The report also includes an additional paragraph before the opinion that
addresses the inherent limitations of IC.
5. Although the audit opinion on the financial statements addresses multiple
reporting periods, the auditor‘s opinion about the effectiveness of IC is as of
the end of the most recent fiscal year.
6. The last paragraph of the report includes a cross-reference to the auditor‘s
separate report on the financial statements.
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 OBJECTIVE 3-4
Describe the five circumstances when an
emphasis-of-matter explanatory paragraph or
nonstandard wording is appropriate to
include in an unmodified opinion audit report.

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 UNMODIFIED OPINION AUDIT REPORT WITH
EMPHASIS-OF-MATTER EXPLANATORY PARAGRAPH
OR NONSTANDARD REPORT WORDING
In certain situations, an unmodified audit report on the
financial statements is issued, but the wording deviates from
the standard unmodified report.
The unmodified audit report with explanatory paragraph or
modified wording meets the criteria of a complete audit with
satisfactory results and financial statements that are fairly
presented, but the auditor believes it is important or is
required to provide additional information.

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• In a qualified, adverse, or disclaimer report, the auditor either:
(1) has not performed a satisfactory audit, (2) is not satisfied that the
financial statements are fairly presented, or (3) is not independent.

• The following are the most 5 important causes of the addition of

an explanatory paragraph or a modification in the wording of the
standard unmodified report under both AICPA & PCAOB auditing
standards:

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 UNMODIFIED OPINION AUDIT REPORT WITH EMPHASIS-OF-
MATTER EXPLANATORY PARAGRAPH OR NONSTANDARD
REPORT WORDING
The most important causes of the addition of an emphasis-of-matter
paragraph or a modification of wording under both AICPA and PCAOB
audit standards are as follows:
• Lack of consistent application of generally accepted accounting
principles as illustrated in Figure 3-5
• Substantial doubt about going concern as illustrated in Figure 3-6
• Auditor agrees with departure from promulgated accounting principles
• Emphasis of other matters
• Reports involving other auditors as illustrated in Figure 3-7
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NOTICE:
First, the first four reports all require an explanatory paragraph. In
each case, the standard report paragraphs are included without
modification, and a separate explanatory paragraph follows the
opinion paragraph.
Second, only reports involving the use of other auditors use a
modified wording report. This report contains three paragraphs, and
all three paragraphs are modified.
Third, the term “explanatory paragraph” was replaced in the AICPA
auditing standards with “emphasis-of-matter" or “other matter”
paragraphs. While these paragraphs continue to be referred to as
explanatory paragraphs under PCAOB auditing standards.
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 1. LACK OF CONSISTENT APPLICATION OF GAAP
• Auditing standards require the auditor to call attention to
circumstances in which accounting principles have not been
consistently observed in the current period in relation to the
preceding period.
• (GAAP) require that changes in accounting principles or their method
of application be to a preferable principle and that the nature and
impact of the change be adequately disclosed.
• When a material change occurs, the auditor should modify the report
by adding an explanatory paragraph after the opinion paragraph that
discusses the nature of the change and points the reader to the
footnote that discusses the change.
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• The materiality of a change is evaluated based on the current year
effect of the change. An explanatory paragraph is required for both
voluntary changes and required changes due to a new accounting
pronouncement. Figure 3-5 presents such an explanatory paragraph.
• It is implicit in the explanatory paragraph in Fig.(3-5) that the auditor
concurs with the appropriateness of the change in accounting
principles.
• If the auditor does not concur, the change is a violation of (GAAP), and
his or her opinion must be qualified (Qualified opinion).

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34
 CONSISTENCY VERSUS COMPARABILITY
• The auditor must be able to distinguish between changes that affect
consistency and those that may affect comparability but do not affect
consistency.
• The following are examples of changes that affect consistency and
therefore require an explanatory paragraph if they are material:
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, by changing from an
accounting principle that is not generally acceptable to one that is
generally acceptable, including correction of the resulting error
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Changes That Affect Comparability But Not Consistency And
Therefore Need Not Be Included In The Audit Report Include
The Following:
1. Changes in an estimate, such as a decrease in the life of an asset for
depreciation purposes.
2. Error corrections not involving principles, such as a previous year’s
mathematical error.
3. Variations in format and presentation of financial information.
4. Changes because of substantially different transactions or events,
such as new endeavors in research and development or the sale of a
subsidiary.

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• Items that materially affect the comparability of financial
statements generally require disclosure in the footnotes. A
qualified audit report for inadequate disclosure may be
required if the client refuses to properly disclose the items.

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 2. SUBSTANTIAL DOUBT ABOUT GOING CONCERN
• Even though the purpose of an audit is not to evaluate the financial health of
the business, 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

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• The auditor’s concern in such situations is the possibility that the
client may not be able to continue its operations or meet its
obligations for a reasonable period. For this purpose, a reasonable
period is considered not to exceed 1 year from the date of the
financial statements being audited.
• When the auditor concludes that there is substantial doubt about the
entity’s ability to continue as a going concern, an unmodified
opinion with an explanatory paragraph is required, regardless of
the disclosures in the financial statements.
• Figure 3-6 provides an example in which there is substantial doubt
about going concern.

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• Auditing standards permit but do not require a disclaimer of
opinion when there is substantial doubt about going concern.
• The criteria for issuing a disclaimer of opinion instead of adding
an explanatory paragraph are not stated in the standards, and
this type of opinion is rarely issued in practice.

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3. AUDITOR AGREES WITH A DEPARTURE FROM A PROMULGATED
PRINCIPLE
• Rule 203 of the AICPA 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 unmodified 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.

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 4. EMPHASIS OF OTHER MATTERS

• Under certain circumstances, the CPA may want to emphasize specific

matters regarding the financial statements, even though he or she
intends to express an unmodified opinion.
• Normally, such explanatory information should be included in a
separate paragraph in the report.
• Examples of explanatory information the auditor may report as an
emphasis of a matter include the following:

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• The existence of material 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 prior year
• Material uncertainties disclosed in the footnotes such as
unusually important litigation or regulatory action
• A major catastrophe that has had or continues to have a
significant effect on the entity’s financial position

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 EMPHASIS OF A MATTER

Under certain circumstances, the CPA may

want to emphasize specific matters regarding
the financial statements, even though the
CPA intends to express an unqualified opinion.

Subsequent Related Party

Events Transactions

Financial Material
Statement Uncertainties
Comparability Major catastrophe

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 5. REPORTS INVOLVING OTHER AUDITORS

• CPAs often rely on a different CPA firm to perform part of the audit
when the client has widespread operations.
• The primary auditor issuing the opinion on the F.Ss is called: the
principal auditor under PCAOB auditing standards & the group
engagement partner under AICPA auditing standards.
• The other auditor who performs work on the financial information of
a component is called the component auditor under AICPA auditing
standards.

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• 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 as follows:
1. Make No Reference in the Audit Report. When no reference is
made to the other auditor, a standard unmodified opinion is given
unless other circumstances require a departure.
This approach is typically followed when: (1) the other auditor
audited an immaterial portion of the statements, (2) the other
auditor is well known or closely supervised by the principal auditor,
or (3) the principal auditor has thoroughly reviewed the other
auditor’s work.

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2. Make Reference in the Report (Modified Wording Report) (an
unmodified report with modified wording).
• This type of report is called a shared opinion or report.
• A shared unmodified report is appropriate when the portion of the
financial statements audited by the other CPA is material in relation to
the whole.
• An example of an unmodified shared report for a non-public Co. is
shown in Fig. (3-7).
• Notice that the report does not include a separate paragraph that
discusses the shared responsibility, but does so in the auditor‘s
responsibility and opinion paragraphs.
• The portions of the financial statements audited by the other auditor
can be stated as percentages or absolute amounts. 48
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3. Qualify the Opinion.
• A qualified opinion or disclaimer, depending on materiality, 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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 OBJECTIVE 3-5
Identify the types of audit reports that can
be issued when
an unmodified opinion is not justified.

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 DEPARTURES FROM AN UNMODIFIED AUDIT REPORT

• In the study of audit reports that depart from an unmodified

report, there are three closely related topics:
1.The conditions requiring a departure from an unmodified
opinion,
2.The types of opinions other than unmodified, and
3.Materiality.

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 MODIFICATIONS TO THE OPINION IN THE
AUDIT REPORT
Three conditions requiring a modification to the
audit opinion:
1. The scope of the audit has been restricted (scope
limitation).
2. The financial statements have not been prepared
in accordance with generally accepted accounting
principles (GAAP departure).
3. The auditor is not independent.

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1. The Scope Of The Audit Has Been Restricted (Scope
Limitation)
• When the auditor has not accumulated sufficient appropriate
evidence to conclude whether financial statements are stated in
accordance with GAAP, a scope restriction exists.
There are two major causes of scope restrictions:
(1) Restrictions imposed by the client
(2) Those caused by circumstances beyond either the client’s or
auditor’s control.

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• An example of a client restriction is management’s refusal to
permit the auditor to confirm material receivables or to
physically examine inventory.
• An example of a restriction caused by circumstances is when
the auditor is not appointed until after the client’s year-end. It
may not be possible to physically observe inventories, confirm
receivables, or perform other important procedures after the
balance sheet date.

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2. The Financial Statements Have Not Been Prepared In
Accordance With Generally Accepted Accounting Principles
(GAAP Departure)

• For example, if the client insists on using replacement costs for

fixed assets or values inventory at selling price rather than
historical cost as required by generally accepted accounting
principles, a departure from the unmodified report is required.
• When U.S. (GAAP) or (IFRS) are referred to in this context,
consideration of the adequacy of all informative disclosures,
including footnotes, is especially important.

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3. The Auditor Is Not Independent

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 MODIFICATIONS TO THE OPINION IN THE
AUDIT REPORT
Three types of reports may be appropriate:
• Qualified opinion—Can be used for a scope limitation or departure
from GAAP, but only when the auditor concludes that the overall
financial statements are fairly stated.
• Adverse opinion—Used when financial statements are so materially
misstated or misleading that they do not present fairly the financial
position of the entity. This is uncommon and is rarely used.
• Disclaimer of opinion—Used when the auditor cannot form an
opinion on the financial statement due to a severe scope limitation,
lack of knowledge on the part of the auditor, or lack of independence.
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 QUALIFIED OPINION

• 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.
• A disclaimer or an adverse report must be used if the auditor believes
that the condition being reported on is highly material.
• Therefore, the qualified opinion is considered the least severe type of
departure from an unmodified report.
• A qualified report can take the form of a qualification of both the scope
and the opinion or of the opinion only.
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• A scope and opinion qualification can be issued only when the auditor
has been unable to accumulate all of the evidence required by auditing
standards. Therefore, this type of qualification is used when the
auditor’s scope has been restricted by the client or when circumstances
exist that prevent the auditor from conducting a complete audit.
• The use of a qualification of the opinion alone is restricted to situations
in which the financial statements are not stated in accordance with
GAAP.
• When an auditor issues a qualified report, he or she must use the term
except for in the opinion paragraph. The implication is that the auditor
is satisfied that the overall financial statements are correctly stated
“except for” a specific aspect of them.
• It is unacceptable to use the phrase except for with any other type of
audit opinion. 60
 ADVERSE OPINION
• 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. This is uncommon and thus the adverse opinion is
rarely used.

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 DISCLAIMER OF OPINION
• 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-independent relationship under
the Code of Professional Conduct 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. Both disclaimers and adverse opinions are
used only when the condition is highly material.
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 OBJECTIVE 3-6
Explain how materiality affects audit
reporting decisions.

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 MATERIALITY
• If a misstatement is immaterial relative to the financial
statements of the entity for the current period, it is appropriate
to issue an unmodified report.
• The situation is totally different when the amounts are of such
significance that the financial statements are materially affected
as a whole. In these circumstances, it is necessary to issue a
disclaimer of opinion or an adverse opinion, depending on
whether a scope limitation or GAAP departure is involved.
• In situations of lesser materiality, a qualified opinion is
appropriate.

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 MATERIALITY

A common definition of materiality as it applies to

accounting and auditing is:
A misstatement in the financial statements can be
considered material if knowledge of the misstatement
will affect a decision of a reasonable user of the
statements.

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Three levels of materiality are used for determining
the type of opinion to issue:
1. Amounts are immaterial: When a misstatement in
the financial statements exists but is unlikely to
affect the decisions of a reasonable user, , it is
considered to be immaterial, and a standard
unmodified opinion audit report is appropriate.

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2. Amounts are material but do not overshadow the
financial statements as a whole: The second level of
materiality exists when a misstatement in the financial
statements would affect a user’s decision, but the overall
statements are still fairly stated and therefore useful.
When the auditor concludes that a misstatement is
material but does not overshadow the financial
statements as a whole, a qualified opinion (using “except
for”) is appropriate.

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3. Amounts are so material or so pervasive that overall fairness
of the statements is in question: The highest level of materiality
exists when users are likely to make incorrect decisions if they
rely on the overall financial statements.
When the highest level of materiality exists, the auditor must
issue either a disclaimer of opinion or an adverse opinion,
depending on which conditions exist.
•When determining whether an exception is highly material, the
extent to which the exception affects different parts of the
financial statements must be considered. This is called
pervasiveness.
•A misclassification between cash and accounts receivable
affects only those two accounts and is therefore not pervasive.
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• On the other hand, failure to record a material sale is highly
pervasive because it affects sales, accounts receivable, income tax
expense, accrued income taxes, and retained earnings, which in turn
affect current assets, total assets, current liabilities, total liabilities,
owners’ equity, gross margin, and operating income.
• As misstatements become more pervasive, the likelihood of issuing
an adverse opinion rather than a qualified opinion increases.
• Regardless of the amount involved, a disclaimer of opinion must be
issued if the auditor is determined to lack independence under the
rules of the Code of Professional Conduct. This strict requirement
reflects the importance of independence to auditors. Any deviation
from the independence rule is therefore considered highly material.
• Table 3-1 summarizes the relationship between materiality and
the type of opinion to be issued. 69
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 Materiality Decisions
Decisions regarding materiality in specific audit situations
involves judgment on the part of the auditor. These decisions
are based on the following:
• Materiality decisions—Non-GAAP condition
• Dollar amounts compared with a benchmark
• Measurability
• Nature of the item
• Materiality decisions—Scope limitations conditions

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Materiality Decisions—non-GAAP Condition: When a client has
failed to follow GAAP, the audit report will be unmodified, qualified
opinion only, or adverse, depending on the materiality of the
departure. Several aspects of materiality must be considered.
Dollar Amounts Compared with a benchmark: The primary
concern in measuring materiality when a client has failed to follow
GAAP is usually the total dollar misstatement in the accounts
involved, compared with some base. A $10,000 misstatement might
be material for a small company but not for a larger one. Therefore,
misstatements must be compared with some measurement base
before a decision can be made about the materiality of the failure to
follow GAAP. Common bases include net income, total assets, current
assets, and working capital.
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• When comparing potential misstatements with a base, the auditor
must carefully consider all accounts affected by a misstatement
(pervasiveness). For example, it is important not to overlook
(neglect) the effect of an understatement of inventory on cost of
goods sold, income before taxes, income tax expense, and accrued
income taxes payable.
• Measurability: The dollar amount of some misstatements cannot
be accurately measured. For example, a client’s unwillingness to
disclose an existing lawsuit or the acquisition of a new company
subsequent to the balance sheet date is difficult if not impossible to
measure in terms of dollar amounts. The materiality question the
auditor must evaluate in such situations is the effect on statement
users of the failure to make the disclosure.
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• Nature of the Item: The decision of a user may also be affected by
the kind of misstatement. The following may affect a user’s
decision and therefore the auditor’s opinion in a different way
than most misstatements:
1. Transactions are illegal or fraudulent.
2. An item may materially affect some future period, even though it
is immaterial when only the current period is considered.
3. An item has a “psychic” effect (for example, the item changes a
small loss to a small profit, maintains a trend of increasing earnings,
or allows earnings to exceed analysts’ expectations).
4. An item may be important in terms of possible consequences
arising from contractual obligations (for example, the effect of
failure to comply with a debt restriction may result in a material
loan being called). 74
• Materiality Decisions—Scope Limitations Condition: When
there is a scope limitation in an audit, the audit report will be
unmodified, qualified scope and opinion, or disclaimer,
depending on the materiality of the scope limitation. The auditor
will consider the same three factors included in the previous
discussion about materiality decisions for failure to follow GAAP,
but they will be considered differently.

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 OBJECTIVE 3-7
Draft appropriately modified opinion
audit reports under a
variety of circumstances.

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DISCUSSION OF CONDITIONS REQUIRING A MODIFICATION
OF OPINION
Modification of the audit opinion can arise from several different
circumstances:
Auditor’s Scope Has Been Restricted— When there is a scope
restriction, the appropriate response is to issue an unmodified report,
a qualification of scope and opinion, or a disclaimer of opinion,
depending on materiality.
• For client-imposed restrictions, the auditor should be concerned
about the possibility that management is trying to prevent discovery
of misstated information. In such cases, auditing standards encourage
a disclaimer of opinion when materiality is in question.
• When restrictions result from conditions beyond the client’s
control, a qualification of scope and opinion is more likely.77
• Two restrictions occasionally imposed by clients on the auditor’s scope
relate to: (1) the observation of physical inventory and (2) the
confirmation of accounts receivable, but other restrictions may also occur.
• Reasons for client-imposed scope restrictions may be a desire to save audit
fees and, in the case of confirming receivables, to prevent possible conflicts
between the client and customer when amounts differ.
• When the auditor cannot perform procedures he or she considers desirable
but can be satisfied with alternative procedures that the information being
verified is fairly stated, an unmodified report is appropriate.
• If alternative procedures cannot be performed, a qualified scope and
opinion or disclaimer of opinion is necessary, depending on materiality.
• A restriction on the scope of the auditor’s examination requires a qualifying
paragraph preceding the opinion to describe the restriction.
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• When the amounts are so material that a disclaimer of opinion rather
than a qualified opinion is required, the first (introductory)
paragraph is modified slightly to say “We were engaged to audit….”
The first paragraph of the auditor’s responsibility is modified to
indicate that the auditor was not able to obtain sufficient appropriate
evidence to express an audit opinion.
• The last two paragraphs under auditor’s responsibility included in
the standard unmodified audit report are eliminated to avoid stating
anything that might lead readers to believe that other parts of the
financial statements were audited and therefore might be fairly
stated.

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Statements Are Not in Conformity with GAAP—
• When the auditor knows that the financial statements
may be misleading because they were not prepared in
conformity with GAAP, and the client is unable or
unwilling to correct the misstatement, he or she must
issue a qualified report (as illustrated in Figure 3-10)
• When the amounts are so material or pervasive that
an adverse opinion is required, the scope is still
unmodified and the qualifying paragraph can remain
the same, but the opinion paragraph might be as
shown in Figure 3-11.
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 Auditor Is Not Independent
If the auditor is not independent as specified by the AICPA Code of
Professional Conduct, a disclaimer of opinion is required even
though necessary audit procedures were performed. The
wording in Figure 3-12 is recommended in this situation.
The lack of independence overrides any other scope limitations.
Therefore, no other reason for disclaiming an opinion should be
cited. There should be no mention in the report of the
performance of any audit procedures. As a result, it is a one-
paragraph audit report.

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86
 OBJECTIVE 3-8
Determine the appropriate audit
report for a given audit situation.

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 AUDITOR’S DECISION PROCESS FOR AUDIT REPORTS

• Determine whether any condition exists requiring a departure

from a standard unmodified opinion report.
• Decide the materiality for each condition.
• Decide the appropriate type of report for the condition, given the
materiality level.
• Write the audit report.
Table 3-2 summarizes the conditions requiring a departure from a
standard unmodified opinion report.

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