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DISCUSSION OF CONDITIONS REQUIRING A DEPARTURE

You should now understand the relationships among the conditions requiring a departure from an
unqualified report, the major types of reports other than unqualified, and the three levels of
materiality. This part of the chapter examines the conditions requiring a departure from an unqualified
report in greater detail and shows examples of reports.

Two major categories of scope restrictions exist: those caused by a client and those caused by
conditions beyond the control of either the client or the auditor. The effect on the auditor’s report is
the same for either, but the interpretation of materiality is likely to be different. When there is a scope
restriction, the appropriate response is to issue an unqualified 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.

Two restrictions occasionally imposed by clients on the auditor’s scope relate to the observation of
physical inventory and 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.

The most common case in which conditions beyond the client’s and auditor’s control cause a scope
restriction is when the auditor is appointed after the client’s balance sheet date. The confirmation of
accounts receivable, physical examination of inventory, and other important procedures may be
impossible under those circumstances. 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 unqualified 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. In the case of a disclaimer, the entire scope paragraph is excluded
from the report. For example, the report in Figure 3-7 is appropriate for an audit in which the amounts
were material but not pervasive and the auditor could not obtain audited financial statements
supporting an investment in a foreign affiliate and could not satisfy himself or herself by alternate
procedures. When the amounts are so material that a disclaimer of opinion rather than a qualified
opinion is required, the auditor uses only three paragraphs. The first (introductory) paragraph is
modified slightly to say “We were engaged to audit . . ..” The second paragraph is the same as the
third paragraph in Figure 3-7. The scope paragraph is deleted, and the final (opinion) paragraph is
changed to a disclaimer. The reason for deleting the scope paragraph is 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. Figure 3-8 shows the audit report assuming the auditor had concluded that the
facts in Figure 3-7 required a disclaimer rather than a qualified opinion.

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 or an adverse opinion, depending on the materiality of the item in
question. The opinion must clearly state the nature of the departure from accepted principles and the
amount of the misstatement, if it is known. Figure 3-9 shows an example of a qualified opinion when
a client did not capitalize leases as required by GAAP.
When the amounts are so material or pervasive that an adverse opinion is required, the scope is still
unqualified and the qualifying paragraph can remain the same, but the opinion paragraph might be as
shown in Figure 3-10.

When the client fails to include information that is necessary for the fair presentation of financial
statements in the body of the statements or in the related footnotes, it is the auditor’s responsibility to
present the information in the audit report and to issue a qualified or an adverse opinion. It is common
to put this type of qualification in an added paragraph preceding the opinion (the scope paragraph will
remain unqualified) and to refer to the added paragraph in the opinion paragraph. Figure 3-11 (p. 62)
shows an example of an audit report in which the auditor considered the financial statement disclosure
inadequate.
Rule 203 Reports. Determining whether statements are in accordance with GAAP can be difficult.
Rule 203 in the Code of Professional Conduct permits a departure from generally accepted accounting
principles when the auditor believes that adherence to these would result in misleading financial
statements. When the auditor decides that adherence to GAAP would result in misleading statements,
there should be a complete explanation in a third paragraph. The paragraph should fully explain the
departure and why GAAP would result in misleading statements. The opinion paragraph should then
be unqualified except for the reference to the third paragraph. As discussed earlier in the chapter, this
is called an unqualified audit report with an explanatory paragraph.
Lack of Statement of Cash Flows. The client’s unwillingness to include a statement of cash
flows is specifically addressed in auditing standards. When the statement is omitted, there must be a
third paragraph stating the omission and an “except for” opinion qualification. If the auditor is not
independent as specified by the Code of Professional Conduct, a disclaimer of opinion is required
even though all the audit procedures considered necessary in the circumstances were performed. The
wording in Figure 3-12 is recommended when the auditor is not independent. 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.

AUDITOR’S DECISION PROCESS FOR AUDIT REPORTS

Auditors use a well-defined process for deciding the appropriate audit report in a given set of
circumstances. The auditor must first assess whether any conditions exist requiring a departure from a
standard unqualified report. If any conditions exist, the auditor must then assess the materiality of the
condition and determine the appropriate type of report.
Determine Whether Any Condition Exists Requiring a Departure from a Standard
Unqualified Report. The most important of these conditions are identified in Table 3-2. Auditors
identify these conditions as they perform the audit and include information about any condition in the
audit files as discussion items for audit reporting. If none of these conditions exist, which is the case
in most audits, the auditor issues a standard unqualified audit report.
Decide the Materiality for Each Condition. When a condition requiring a departure from a
standard unqualified opinion exists, the auditor evaluates the potential effect on the financial
statements. For departures from GAAP or scope restrictions, the auditor must decide among
immaterial, material, and highly material. All other conditions, except for lack of auditor
independence, require only a distinction between immaterial and material. The materiality decision is
a difficult one, requiring considerable judgment. For example, assume that there is a scope limitation
in auditing inventory. It is difficult to assess the potential misstatement of an account that the auditor
does not audit.
Decide the Appropriate Type of Report for the Condition, Given the Materiality Level.
After making the first two decisions, it is easy to decide the appro - priate type of opinion by using a
decision aid. An example of such an aid is Table 3-2. For example, assume that the auditor concludes
that there is a departure from GAAP and it is material, but not highly material. Table 3-2 shows that
the appropriate audit report is a qualified opinion with an additional paragraph discussing the
departure. The introductory and scope paragraphs will be included using standard wording.
Write the Audit Report. Most CPA firms have computer templates that include precise wording
for different circumstances to help the auditor write the audit report. Also, one or more partners in
most CPA firms have special expertise in writing audit reports. These partners typically write or
review all audit reports before they are issued.
Auditors often encounter situations involving more than one of the conditions requiring a departure
from an unqualified report or modification of the standard unqualified report. In these circumstances,
the auditor should modify his or her opinion for each condition unless one has the effect of
neutralizing the others. For example, if there is a scope limitation and a situation in which the auditor
is not independent, the scope limitation should not be revealed. The following situations are examples
when more than one modification should be included in the report:
• The auditor is not independent and the auditor knows that the company has not followed generally
accepted accounting principles.
• There is a scope limitation and there is substantial doubt about the company’s ability to continue as a
going concern.
• There is a substantial doubt about the company’s ability to continue as a going concern and
information about the causes of the uncertainties is not adequately disclosed in a footnote.
• There is a deviation in the statements’ preparation in accordance with GAAP and another accounting
principle was applied on a basis that was not consistent with that of the preceding year.

Many readers interpret the number of paragraphs in the report as an important “signal” as to whether
the financial statements are correct. A three-paragraph report ordinarily indicates that there are no
exceptions in the audit. However, three-paragraph reports are also issued when a disclaimer of
opinion is issued due to a scope limitation or for an unqualified shared report involving other auditors.
More than three paragraphs indicates some type of qualification or required explanation.
An additional paragraph is added before the opinion for a qualified opinion, an adverse opinion, and a
disclaimer of opinion for a scope limitation. This results in a four-paragraph report, except for the
disclaimer of opinion for a scope limitation. A disclaimer due to a scope limitation results in a three-
paragraph report because the scope paragraph is omitted. A disclaimer due to a lack of independence
is a one paragraph report.
When an unqualified opinion with explanatory paragraph is issued, an explanatory paragraph usually
follows the opinion. No explanatory paragraph is required for an unqualified shared report involving
other auditors, but the wording in all three paragraphs is modified.
Table 3-3 summarizes the types of reports issued for the audit of financial statements, the number of
paragraphs for each type, the standard wording paragraphs modified, and the location of the additional
paragraph. The table excludes a disclaimer for a lack of independence, which is a special, one-
paragraph report.
INTERNATIONAL ACCOUNTING AND AUDITING STANDARDS

The increasing globalization of the world’s capital markets and the expanding presence of business
operations in multiple countries are leading to calls for the establishment of a single set of accounting
standards to be used around the world. IFRS is increasingly accepted worldwide as the basis of
accounting used to prepare financial statements in other countries.

Currently, U.S. public companies are required to prepare financial statements that are filed with the
Securities and Exchange Commission (SEC) in accordance with generally accepted accounting
principles in the United States. The SEC is developing a work plan to determine whether to
incorporate IFRS into the U.S. financial reporting system. Approval of the work plan could lead to the
use of IFRS by U.S. public companies as early as 2015.
An auditor may be engaged to report on financial statements prepared in accordance with IFRS. When
the auditor reports on financial statements prepared in conformity with IFRS, the auditor refers to
those standards rather than U.S. generally accepted accounting principles as follows:
In our opinion, the financial statements referred to above present fairly, in all material respects, the
financial position of Carlos Incorporated as of December 31, 2011 and 2010, and the results of its
operations, comprehensive income, changes in equity, and its cash flows for the years then ended in
conformity with International Financial Reporting Standards as issued by the International
Accounting Standards Board.
As discussed in Chapter 2, the International Auditing and Assurance Standards Board (IAASB) issues
International Standards on Auditing (ISAs). Auditing standards in the United States now allow an
auditor to perform an audit of financial statements of a U.S. entity in accordance with both generally
accepted auditing standards in the U.S. and the ISAs. The auditor’s scope paragraph is modified to
indicate that the audit was conducted in accordance with auditing standards generally accepted in the
United States of America and in accordance with International Standards on Auditing.