ACCA P7 Chapter 10 The external audit report

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Chapter 10

National legislation

Most national legislation requires an audit report on the truth and fairness of entity financial statements

Auditors’ report on financial statements 

The auditors’ report on financial statements should contain a clear expression of opinion on the financial statements as a whole, based on review and assessment of the conclusions drawn from evidence obtained in the course of the audit.

The financial statements should have been prepared in accordance with an acceptable financial reporting framework eg International Financial Reporting Standards.

Requirements of the standard

The audit report should include the following basic elements, normally in this layout:

• title
• addressee
• opening or introductory paragraph
• identification of the financial statements audited;
• statement of the responsibility of the entity’s management and responsibility of the auditor
• scope paragraph (describing the nature of an audit)
• a reference to IFRSs or relevant national standards or practices;
• a description of the work the auditor performed;
• opinion paragraph containing an expression of opinion on the financial statements;
• date of the report
• auditors’ address, and
• auditors’ signature.

An unmodified opinion of financial statements is expressed when, in the auditors’ judgement, they give a true and fair view and have been prepared in accordance with relevant accounting or other requirements. This judgement entails concluding whether, amongst other things

the financial statements have been prepared using appropriate accounting policies, which have been consistently applied

the financial statements have been prepared in accordance with relevant legislation, regulations or applicable financial reporting standards (and that any departures are justified and adequately explained in the financial statements) and

there is adequate disclosure of all information relevant to the proper understanding of the financial statements

Definitions

The ISAs define the following items in the glossary of terms:

Financial statements:
The Statements of Financial Position, Statement of Comprehensive Income, Statement of Changes in Equity, Statement of Cash Flows, notes and other statements and explanatory material which are identified as being part of the financial statements.

Materiality:
Information is material if its inclusion, omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its inclusion, omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

True and fair

There is an over-riding requirement in international financial reporting and auditing that financial statements give a true and fair view.

The IASC does not, however, define true and fair. Literally the phrase can be interpreted:-

True
information is not false but factual and conforming with reality. In addition, the information conforms with required standards and law. In practical terms the financial statements have been correctly extracted from the accounting records.

Fair
information is free from discrimination and bias and in compliance with expected standards and rules. Practically, the financial statements should reflect the commercial substance of the entity’s underlying transactions

The auditors’ report must include an opinion on whether such a true and fair view has been given.

The Courts will treat compliance with accepted accounting principles as evidence that the financial statements are true and fair.

Confirmed in Littlejohn v Lloyd Cheyham

Ultimately true and fair must be decided by……………..

When misstatements are identified by the auditor during the audit, the auditor should:

Communicate all such misstatements to management on a timely basis, unless they are considered to be trivial

Ask management to correct all material misstatements which the auditor has identified

Get an understanding of management’s refusal to adjust, if appropriate, and

Obtain written representations from management and from those charged with governance that they believe the effect of uncorrected misstatements is immaterial, both individually and in aggregate

Modifications in audit reports

In certain circumstances, it may not be appropriate to issue a completely unmodified opinion, as the auditors may disagree or have doubts about items in the entity’s financial statements. However, each situation is different and the wording needs to reflect how the auditors view the problem.

In summary, the audit report will be modified in the following situations:

Matters that do not affect the auditors’ opinion:

emphasis of matter – required to refer to a matter which is appropriately presented or disclosed in the financial statements but, in the auditors’ judgement, is fundamental to the users’ understanding of the financial statements

there may be other matters which require similar treatment – “Other matters”

the auditor is required to refer to a matter not presented or disclosed in the financial statements that, in the auditors’ judgement, is relevant to the users’ understanding of the audit, the auditors’ responsibilities or the audit report

Matters that do affect the auditors’ opinion

qualified opinion

disagreement – the financial statements include a material misstatement

scope limitation – the auditor is unable to obtain sufficient appropriate audit evidence

Each of these qualifications has two levels

material, but not pervasive

pervasive

Matters that do not affect the auditors’ opinion

If there is a significant matter affecting the financial statements, then an additional paragraph AFTER the opinion paragraph may be appropriate, specifically to draw the attention of the reader to the disclosed matter.

This paragraph will start by stating ‘Without qualifying our opinion above …’ It will then go on to describe the matter and make a reference to the note in the financial statements which explains the matter more fully.

Note that this does NOT change the auditors’ opinion – it is still unqualified. It merely serves to highlight something significant that may, or may not, affect the entity in the future.

Matters that do affect the auditors’ opinion

Here, the auditor feels that, because of certain circumstances, a true and fair view is not given.

It could either be because the auditor DISAGREES with something in the financial statements, or that he is UNCERTAIN about something.

2 degrees of qualified opinion

Material (affecting a part of the financial statements, but not the whole understanding)

Pervasive (affecting the whole understanding and basis of the financial statements)

for insufficient audit evidence, could make financial statements misleading (and so are meaningless)

for material misstatements, makes the financial statements misleading – the financial statements do not give a true and fair view

In all circumstances, when the auditor issues a modified audit opinion, the auditor should:

communicate with those charged with governance

explain the circumstances behind their decision, and

communicate the proposed wording of the modification

Material misstatement concerning accounting treatment or disclosure

Where the auditors conclude that there is a material misstatement concerning the accounting treatment or disclosure of a matter in the financial statements

The auditors should include in the opinion section of their report

description of all substantive factors giving rise to a disagreement

the implications for the financial statements

where practicable, a quantification of the effect on the financial statements, or

if not practicable, an explanation of why not

When the auditors conclude that the effect of the material misstatement is pervasive and the financial statements are seriously misleading, they should issue an adverse opinion.

In the case of other material misstatements, the auditors should issue a qualified opinion indicating that it is expressed except for the effects of the matter giving rise to the misstatement

Insufficiency of appropriate audit evidence

When the auditor has been unable to obtain sufficient evidence to express an unqualified opinion

the auditors’ report should include a description of the factors leading to the lack of evidence in the basis of opinion section of their report, and indicate the possible adjustments to the financial statements that might have been determined to be necessary had no limitation existed

the auditors should issue a disclaimer of opinion when the possible effect of this lack of evidence is so pervasive that they are unable to express an opinion on the financial statements

a qualified opinion should be issued when the effect of the lack of evidence is not so pervasive as to require a disclaimer, and the wording of the opinion should indicate that it is qualified as to the possible adjustments to the financial statements that might have been determined to be necessary had the limitation not existed.

In considering the importance of a lack of evidence the auditors should assess

the quantity and type of evidence which may reasonably be expected to be available to support the particular figure or disclosure in the financial statements, and

the possible affect on the financial statements of the matter for which insufficient evidence is available. When the possible affect is, in the opinion of the auditors, material to the financial statements, there will be insufficient evidence to support an unqualified opinion.

Example

During the audit of Mombasa Ltd it comes to your notice that the entity has valued a certain line of inventory at the cost price of $7,000. This inventory has not been sold for a number of years and it is unlikely to be sold in the future unless it is reduced to $3,000. If the write-down were charged it would have a material affect on the financial statements.

How will this affect your audit report?

Example

During the audit of Pratchett Ltd, you discover that the entity has not kept any records relating to their cash sales. Pratchett has pre-tax profits of $500,000 and cash sales total $100,000. The entity has total sales of $lm.

What affect will the above have on your audit report?