WHAT YOU REALLY NEED TO KNOW
CHAPTER 3: REPORTS ON AUDITED FINANCIAL STATEMENTS
Association is a term used within the profession to indicate a public accountant’s involvement with
information issued by an organization. The PA becomes associated with information through action
of the PA, by an enterprise indicating the PA’s involvement with or without the PA’s knowledge or
consent, or when a third party makes a reasonable assumption that the PA is involved.
Association means the PA is lending credibility to the information. A public accountant associates
him or herself with information when they either perform services, or consent to the use of their
name in connection with that information. When associated with information, a PA must
communicate the extent of their involvement with the information and the degree of credibility being
provided.
Auditing standards require a report in all cases where a PA’s name is associated with a financial
statement. A PA is associated with a financial statement when (1) they are reproduced on their
letterhead, (2) they are produced by their computer as part of a bookkeeping service, or (3) a
document containing financial statements identifies them as the public accountant or auditor for the
company. A report is required because users of financial statements will assume that an audit has
been conducted and that “everything is OK” on the basis of the association of a PA.
In practice, accountants and auditors can render three types of reports, or levels of assurance, about
financial statements. The highest level of assurance is the standard unqualified report, also known
as a clean opinion. Its opinion sentence reads, “In our opinion, the accompanying financial
statements present fairly, in all material respects.” This opinion sentence is sometimes called
positive assurance because it is a forthright and factual statement of the PA’s opinion based on an
audit. Positive assurance is the highest level of assurance in the Handbook.
Moderate assurance is based on a review engagement and is typical in the review report of
unaudited financial statements. Its report would read, “Based on my review, nothing has come to my
attention that causes me to believe that these financial statements are not, in all material respects, in
accordance with Canadian generally accepted accounting principles,” This conclusion is also called
negative assurance.
The lowest level of assurance is a no assurance engagement. The most common examples are
compilation engagements and specified procedures engagements. Compilation engagements are not
considered to be assurance engagements because the practitioner is not required to attempt to verify
the accuracy or completeness of the information provided by management. The PA’s involvement
presumably adds accounting credibility to the financial statements only.
The most important aspect to the concept of assurance levels is that it reflects the separate levels of
evidence the PA has gathered to support the conclusions in the various types of assurance
engagements. The reason there is less assurance in a review engagement is because the PA is
Student Study Guide
© The McGraw-Hill Companies, Inc., 2009
3-1
d
t
Reports on Audited Financial Statements
required to gather less evidence. Compilations are considered a no assurance engagement because
PAs are not required to gather any evidence on the financial information. In any of these
engagements, however, if the financial information is misleading, it is PA’s responsibility to not be
associated.
The standard unqualified report contains four basic segments: (1) introductory paragraph, (2)
management responsibility paragraph, (3) auditor responsibility paragraph(s), and (4) opinion
paragraph. Many users understand the audit report by counting the paragraphs. Prior to the new
CAS’s, there were three paragraphs in a clean audit report, so for a time, users may be reading the
opinion more closely. Analysts look at the client’s audit report to see if any major problems in using
the financial statements are identified.
The introductory paragraph declares that an audit has been conducted and identifies the specific
financial statements that the opinion applies to. The second paragraph declares the management’s
(or other preparer’s) responsibility to prepare the financial statements in conformity with a fair
presentation reporting framework (usually GAAP). The auditor responsibility paragraphs, also
referred to as the scope paragraphs, are the auditor’s report of the extent of the audit work. It
makes explicit the auditor’s responsibility to detect fraudulent reporting, abide by ethical standards,
and appropriately support the opinion with audit evidence. Lastly, users of audited financial
statements are generally most interested in the opinion paragraph, which contains the auditors’
conclusions about the financial statements. An overall opinion is expressed in the standard report, so
reasons for not doing so need not be stated.
In a standard clean opinion, disclosure is implied to be adequate for the users’ needs. This
assessment is made by the auditor who must not only be familiar with the specific guidance in the
CICA handbook, but must also be familiar with the underlying accounting concepts. In order for the
financial reporting to not be misleading, additional disclosures beyond those required by specific
accounting rules, may be needed. Simple mechanical application of rules may give misleading results
in some circumstances.
Audit reports other than the standard unqualified audit report are called audit report reservations.
The most common report reservations are called qualified reports. There are two basic types of
qualified reports: GAAP departure reports and scope limitation reports.
Financial statements may contain an accounting treatment or have disclosure that is not in
conformity with GAAP. If the departure is immaterial or insignificant, it can be treated as if it did
not exist and a clean opinion can be given.
If the auditor judges that the accounting deficiency is material enough to potentially affect users’
decisions, the opinion must be qualified. In this case the opinion sentence is changed to read “In my
opinion, except for the [nature of the GAAP departure], the financial statements present fairly, in all
material respects . . .” This identifies the particular departure but says that the financial statements
are otherwise in conformity with GAAP. The nature of the GAAP departure can also be explained in
a separate paragraph (called the reservation paragraph) between the scope paragraphs and the
opinion paragraph.
Smieliauskas/Bewley, 5e
What You Really Need to Know
© The McGraw-Hill Companies, Inc., 2010
3-2
Reports on Audited Financial Statements
If the GAAP departure is either (1) much more material or (2) pervasive, affecting numerous
accounts and financial statement relationships, there is a condition of pervasive materiality and an
adverse opinion should be given. An adverse opinion is exactly the opposite of the unqualified
opinion. In this type of opinion, auditors say the financial statements do not present the financial
position, results of operations, and changes in financial position in conformity with GAAP.
In both cases, the introductory, management responsibility, and auditor responsibility paragraphs
should not be qualified since the auditor must have sufficient evidence to support the qualification or
adverse report. Provincial securities commissions require public companies to file financial
statements without any departures from GAAP. In practice, it is rare to see such reports.
There are two kinds of situations where the auditors are unable to obtain sufficient appropriate
evidence: (1) management deliberately refuses to let auditors perform some procedures or (2)
circumstances, such as late appointment of auditor or loss of data that would make it impossible for
some procedures to be performed. If the effect of the missing data is minor or if sufficient
appropriate evidence can be obtained by other means, the audit can be considered to be unaffected,
and a clean report issued.
If the audit deficiency is considered material, but not pervasively or highly material enough to
overwhelm the usefulness of the remainder of the financial statements, the scope paragraph is
adjusted. The audit was not completed entirely in accordance with generally accepted auditing
standards. Whenever the scope paragraph is qualified for an important omission of audit work, the
opinion paragraph should also be qualified to state “… except for the effects of adjustments, if any,
as might have been determined to be necessary had we been able to examine evidence …”
If the missing evidence is too large and too important to say “except for adjustments, if any.” the
audit report then must be a disclaimer or denial of opinion. Missing evidence is not evidence that the
statements are misleading, it is simply that there is not enough evidence to make a determination.
Both auditor and client must work together to avoid a report reservation. It may take much
discussion and negotiation between the auditor and client to do this. However, in the vast majority of
cases the result of discussions is a standard, unqualified report.
An unqualified opinion paragraph can be modified even if there is no audit or accounting deficiency.
This may be because of issues related to consistency, uncertainty, emphasis, and going-concern.
As long as changes in accounting policies are properly disclosed in the financial statements, there is
no need to make reference to consistency. Changes in accounting estimates; error corrections that do
not involve a change in accounting principles; changes in the classification or aggregation of
financial statement amounts; changes in the format of the statement of cash flows; and changes in the
subsidiaries included in consolidated financials must be disclosed in the notes to the financial
statements. If they are, a clean opinion can be given. Failure to disclose any of these changes could
amount to a GAAP departure.
When a matter with significant uncertainty exists such as pending litigation, the auditor may decide
to place a paragraph in their report drawing attention to the uncertainty. Uncertainty situations may
cause audit reports to be qualified for departures from GAAP, if (1) management’s disclosure of the
Smieliauskas/Bewley, 5e
What You Really Need to Know
© The McGraw-Hill Companies, Inc., 2010
3-3
Reports on Audited Financial Statements
uncertainty is inadequate, (2) management uses inappropriate accounting principles to account for
the uncertainty, or (3) management makes unreasonable accounting estimates in connection with the
effects of the uncertainty. The audit report also may be qualified because of a scope limitation
regarding available evidence about an uncertainty.
Sometimes auditors add additional information in the audit report. There are two types of additions:
emphasis of matter (EOM) paragraphs or other matter (OM) paragraphs. These are used for enriching
the information content beyond the standard unqualified report wording. One or more paragraphs
can be added in the audit report regarding something the auditor believes readers should consider
important or useful even when the auditor gives unqualified opinion paragraph.
An emphasis of matter paragraph is required when there is material uncertainty regarding the
going-concern assumption. Generally accepted accounting principles are based on the going-concern
concept, which means the entity is expected to continue operations and meet its obligations as they
become due. An opinion that financial statements are in conformity with GAAP means that
continued existence may be presumed for a “reasonable time”—at least one year beyond the date of
the financial statements. When there is significant doubt about a company’s ability to continue as
such, the auditor needs to expand their reporting responsibilities and include an explanatory
paragraph, even if doubt is adequately disclosed in the notes.
This audit report reports the level of assurance to be associated with financial statements. These
levels of assurance are further explained in terms of (1) reports qualified for scope limitations and
departures from GAAP, (2) adverse reports resulting from GAAP departures, and (3) disclaimers of
opinion resulting from lack of independence and lack of sufficient appropriate evidence. Which
report to issue depends on materiality. When inaccuracies, departures from GAAP, accounting
changes, and uncertainties have a large enough financial impact, the standard audit report must be
changed.
In practice, when an auditor decides a matter is material enough to make a difference, a further
distinction must be made between misstatements of “materiality” and those of “pervasive
materiality.” Materiality means that the information cannot simply be ignored. Pervasive
materiality means that the item is important and has a significant impact on the reporting decision.
The distinction between the two materialities is the number of users affected by the potential
misstatements: pervasive materiality affects many more users than does materiality.
Smieliauskas/Bewley, 5e
What You Really Need to Know
© The McGraw-Hill Companies, Inc., 2010
3-4