The Clarity Project – Modified Opinions

Options include qualified, disclaimer and adverse

You are performing an audit that has a material misstatement, and the client is unwilling to  post the proposed adjustment. So you are wondering, “how do I modify the opinion under the new Clarity audit standards?”

First let’s take a look at a summary of opinion modification options, and then we will review sample opinion language.

OPINION

Opinion Modification Options

Opinion TypeCircumstance
QualifiedMaterial misstatement is not pervasive
AdverseMaterial misstatements are pervasive
DisclaimerSufficient audit evidence not available; potential material misstatements are pervasive
QualifiedSufficient audit evidence not available; potential material misstatement is not pervasive

Definitions

Before we explore potential opinions, let’s look relevant definitions included in AU-C 705:

Modified opinion. A qualified opinion, an adverse opinion, or a disclaimer of opinion

Pervasive. A term used in the context of misstatements to describe the effects on the financial statements of misstatements or the possible effects on the financial statements of misstatements, if any, that are undetected due to an inability to obtain sufficient appropriate audit evidence [my italics]. Pervasive effects on the financial statements are those that, in the auditor’s professional judgment

  •    are not confined to specific elements, accounts, or items of the financial statements;
  •    if so confined, represent or could represent a substantial proportion of the financial statements; or
  •    with regard to disclosures, are fundamental to users’ understanding of the financial statements.

Sample Opinion Language

1. Qualified Opinion

Let’s suppose your audit reveals inventories are materially misstated, the client will not record your proposed audit adjustment, and there are no other material misstatements. If this is your situation (a material misstatement exists that is not pervasive), then audit standards require the issuance of a qualified opinion.

The sample opinion language provided by AU-C 705 is as follows:

Basis for Qualified Opinion

The Company has stated inventories at cost in the accompanying balance sheets. Accounting principles generally accepted in the United States of America require inventories to be stated at the lower of cost or market. If the Company stated inventories at the lower of cost or market, a write down of $XXX and $XXX would have been required as of December 31, 20X1 and 20X0, respectively. Accordingly, cost of sales would have been increased by $XXX and $XXX, and net income, income taxes, and stockholders’ equity would have been reduced by $XXX, $XXX, and $XXX, and $XXX, $XXX, and $XXX, as of and for the years ended December 31, 20X1 and 20X0, respectively.

Qualified Opinion

In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company …

2. Adverse Opinion

Now let’s suppose that you are auditing a consolidated entity for which your client does not wish to include a material subsidiary and which, if it were included, would have a pervasive impact on the statements.

The sample opinion language provided by AU-C 705 is as follows:

Basis for Adverse Opinion

As described in Note X, the Company has not consolidated the financial statements of subsidiary XYZ Company that it acquired during 20X1 because it has not yet been able to ascertain the fair values of certain of the subsidiary’s material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis by the Company. Under accounting principles generally accepted in the United States of America, the subsidiary should have been consolidated because it is controlled by the Company. Had XYZ Company been consolidated, many elements in the accompanying consolidated financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined.

Adverse Opinion

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements referred to above do not present fairly the financial position of ABC Company and its subsidiaries as of …

3. Disclaimer of Opinion

Finally let’s suppose you are performing an audit in which insufficient audit information is provided with regard to receivables and inventories (both of which are material) and that the misstatements have a pervasive impact on the financial statements as a whole.

The sample opinion language provided by AU-C 705 is as follows:

Basis for Disclaimer of Opinion

We were not engaged as auditors of the Company until after December 31, 20X1, and, therefore, did not observe the counting of physical inventories at the beginning or end of the year. We were unable to satisfy ourselves by other auditing procedures concerning the inventory held at December 31, 20X1, which is stated in the balance sheet at $XXX. In addition, the introduction of a new computerized accounts receivable system in September 20X1 resulted in numerous misstatements in accounts receivable. As of the date of our audit report, management was still in the process of rectifying the system deficiencies and correcting the misstatements. We were unable to confirm or verify by alternative means accounts receivable included in the balance sheet at a total amount of $XXX at December 31, 20X1. As a result of these matters, we were unable to determine whether any adjustments might have been found necessary in respect of recorded or unrecorded inventories and accounts receivable, and the elements making up the statements of income, changes in stockholders’ equity, and cash flows.

Disclaimer of Opinion

Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on these financial statements.

Group Audits – Referencing Component Auditors

Does your firm audit consolidated financial statements that contain a subsidiary audited by another firm? How about a governmental audit that contains a component unit audited by another firm? Or maybe an audit of an entity that has an equity-method investment audited by another firm?

Decision – Assume Responsibility or Not

If you audit an entity (e.g., Father Company, Inc.) that contains a component (Son Company, Inc.) audited by another firm, you will, under the new Clarity standards, make a decision to reference or not reference the component auditor.

assume

If you reference the component auditors, you are not taking responsibility for the component.

If you don’t reference the component auditors, you are, in effect, taking responsibility for the audit of all entities comprising the entity. (There will be additional work for the group auditor as he directs audit activities related to the entity as a whole, including procedures of the component auditor.)

1. When to Reference Component Auditors

photo-1First Question – Are there any significant components of the consolidated financial statements that are audited by an external audit firm?

If yes, go to the second question below.

If no, then there is no need to reference the component auditor (and you – the group auditor – will probably just perform analytical procedures for the component).

Second Question – Do you (the group auditor) want to assume responsibility for the work of the component auditor?

Sometimes the answer will be “no,” and you will reference the other firm.

When referencing occurs, the group auditor’s report will normally state “we did not audit the financial statements of X Company” and that “those statements were audited by other auditors.”

The component auditor is usually not named, but you may, if you wish, provided that you:

  • Obtain permission from the component auditor
  • Include the component auditor’s report with the group auditor’s report

Communication with Component Auditor

Whether you name the component auditor or not, AU-C 600 requires the group auditor to check (orally or in writing) on the component auditor’s:

  • Compliance with independence and ethical requirements
  • Competence

Referencing should not occur unless the following are true:

  • The financial statements were prepared using the same accounting framework as the group financial statements.
  • The component auditor follows GAAS (or, when required by law, PCAOB audit standards).
  • The component auditor’s report is not restricted as to use.

2. How to Reference Component Auditors

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Changes will be made to two auditor’s report paragraphs:

Auditor’s Responsibility Paragraph

You will add a paragraph like the following:

We did not audit the financial statements of ABC Company, Inc., a wholly owned subsidiary, which statements reflect total assets of $3,020,000 as of March 31, 2013, and total revenues of $7,050,200 for the year then ended. Those statements were audited by other auditors, whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for ABC Company, Inc., is based solely on the report of the other auditors.

Notice you will disclose the magnitude of the financial statements not audited in:

  • Dollar amounts or
  • Percentages

Those magnitudes may be expressed using one or more of the following:

  • Total assets
  • Total revenues
  • Other appropriate criteria (whichever appropriately describes the portion not audited)

Opinion Paragraph

The opinion paragraph will state “In our opinion, based on our audits and the report of the other auditors…”

To see a full sample auditor’s report (with these changes), click here.

Your Thoughts

I’m curious. Do you think your firm will normally reference or not reference outside component auditors?

The Masters – A Georgia Tradition

This morning they are teeing it up in Augusta, and I feel the pride of being an old Georgia boy, one that has loved the game of golf since my father taught it to me as a youngster. The Masters makes me smile as I recall Sundays from years ago when I would watch the greats: Palmer, Nicklaus, Player…and so many more.

Augusta National is a special place, one of swaying pines and blooming azaleas, but in this pastoral scene the hearts of young players – for next four days – will toil to be the next to wear the green jacket.

Let the fun begin.

Illustrative Group Auditor’s Report – Component Audited by Component Auditor

Below is an illustration of a group auditor’s report when a component is audited by a component auditor (AU-C Section 600 – Exhibit A – Illustration 2 of Auditor’s Reports on Group Financial Statement).

If you audit a consolidated entity that has a component (e.g., subsidiary) audited by another CPA firm, then consider this sample report. If the group auditor does not reference the component audit, then he is assuming responsibility for the audit of the component.

Independent Auditor’s Report

[Appropriate Addressee]

Report on the Consolidated Financial Statements

We have audited the accompanying consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheets as of December 31, 20X1 and 20X0, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the years then ended, and the related notes to the financial statements.

Management’s Responsibility for the Financial Statements

Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

Auditor’s Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We did not audit the financial statements of B Company, a wholly-owned subsidiary, which statements reflect total assets constituting 20 percent and 22 percent, respectively, of consolidated total assets at December 31, 20X1 and 20X0, and total revenues constituting 18 percent and 20 percent, respectively, of consolidated total revenues for the years then ended. Those statements were audited by other auditors, whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for B Company, is based solely on the report of the other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Opinion

In our opinion, based on our audit and the report of the other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ABC Company and its subsidiaries as of December 31, 20X1 and 20X0, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America.

[Auditor’s signature]

[Auditor’s city and state]

[Date of the auditor’s report]

Sleeping with Your Decisions

Men are alike in their promises. It is only in their deeds that they differ. Molière

We’ve all been there…

Your client wants you to sign off on an issue, one that is in the land of gray – you know, that place where there is no black or white, just gray. And, of course, the issue has significant dollars attached to it, so it’s important.

Your anguish rises, so you try to see the Great Oz, but he’s not available today. You look at your feet for ruby slippers (if you’re a lady), but alas, just business shoes.

You want to do the right thing, but how do you know what that is?

Photo Courtesy of iStockPhoto.com

Four Questions for Clarity

Here are four questions I sometimes ask myself when faced with such a dilemma.

  1. How would I feel if my choice was placed on the front page of the local newspaper (or in the Journal of Accountancy)?
  2. What would my father (or anyone else I greatly respect) do if he had the same knowledge and facts?
  3. What would I advise my child to do in this situation? (If your child is three, pretend he or she is 30.)
  4. What’s the worst thing that could happen if I choose a particular direction? (I ask this question for each option and compare.)

Four Actions for Clarity

Here are four actions to take.

  1. Call the AICPA Ethics Hotline or the AICPA Technical Hotline (877-242-7212). (They are independent of the issue, so they will give you a straight-up answer.)
  2. Call a CPA with knowledge in the area of concern, and ask his or her opinion.
  3. Create a memo supporting your proposed decision, and share it with a partner, quality control department, or whoever is in charge. (I find that writing helps to clarify most anything I’m struggling with.)
  4. Sit on it (if you can). I find that I gain clarity as I allow the issue to percolate and as I pray about it. I try not to make a high-stakes decision quickly. A hurried decision is usually a flawed one.

Sleeping Well

Remember, a clear conscience is a precious commodity. If you believe a certain course of action is going to keep you awake at night, then your conscience is telling you not to go there.

Do right.

Sleep well.

Understanding and Communicating Control Weaknesses

How do you categorize a control weakness? Is it a material weakness, a significant deficiency or something less? This seems to be the greatest struggle in addressing internal control issues.

iStock_000014377944XSmall

Below we will answer this sometimes puzzling question, but first let’s take a look at how control weaknesses are defined. 

Definitions on Control Weaknesses

  1. Material weakness. A deficiency, or a combination of deficiencies, in internal control, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.
  2. Significant deficiency. A deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness yet important enough to merit attention by those charged with governance.
  3. Other deficiencies. For purposes of this blog post, we’ll define other deficiencies as any control deficiencies that are not material weaknesses or significant deficiencies.

How to Categorize a Control Weaknesses

First ask these two questions:

  1. Is there a reasonable possibility that a misstatement could occur?
  2. Could the misstatement be material?

If your answer to both questions is “yes”, then the client has a material weakness. (By the way, if you propose a material adjustment, it’s difficult to argue that there is no material weakness. As you write your control letter, consider examining your proposed audit entries for congruence.)

If your answer to either of the questions is “no”, then ask the following:

Is the weakness important enough to merit the attention of those charged with governance? In other words, are there board members who would see the weakness as important.

If the answer is “yes”, then it is a significant deficiency.

If the answer is “no”, then the weakness is an other deficiency.

Communicating Control Deficiencies

The following deficiencies must be communicated in writing to management and to those charged with governance:

  • Material weaknesses
  • Significant deficiencies

The written communication must include:

  • the definition of the term material weakness and, when relevant, the definition of the term significant deficiency
  • a description of the significant deficiencies and material weaknesses and an explanation of their potential effects
  • sufficient information to enable those charged with governance and management to understand the context of the communication
  • that the audit included consideration of internal control over financial reporting in order to design audit procedures that are appropriate in the circumstances and that the audit was not for the purpose of expressing an opinion on the effectiveness of internal control
  • that the auditor is not expressing an opinion on the effectiveness of internal control
  • that the auditor’s consideration of internal control was not designed to identify all deficiencies in internal control that might be material weaknesses or significant deficiencies, and therefore, material weaknesses or significant deficiencies may exist that were not identified
  • an appropriate alert, in accordance with section 905, Alert That Restricts the Use of the Auditor’s Written Communication

Other deficiencies can be communicated in writing or orally and need only be communicated to management (and not to those charged with governance). The communication must be documented in the audit file. So if you communicate orally, then follow up with a memo to the file addressing who you spoke with, what you discussed, and the date the discussion occurred.

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Stand-alone management letters are often used to communicate other deficiencies. Since there is no authoritative guidance for management letters, you may word them as you wish. Also, you may, if you like, include other deficiencies in your written communication of significant deficiencies or material weaknesses.

Here’s a slide deck summarizing control weakness issues. Feel free to use it to teach a class about this topic.