Disagreement on accounting policies – adverse opinion [ … ]
As more fully explained in note 7, no provision has been made for losses expected to arise on certain long-term contracts currently in progress, as the directors consider that such losses should be offset against amounts recoverable on other long-term contracts. In our opinion, provision should be made for foreseeable losses on individual contracts as required by IAS 11 Construction Contracts. If losses had been so recognised, the effect would have been to reduce the profi t before and after tax for the year and the contract work in progress at 31 December 20X0 by $2.3 million.
In our opinion, in view of the effect of the failure to provide for the losses referred to above, the fi nancial statements do not give a true and fair view of the fi nancial position of ABC as at 31 December 20X0 and its fi nancial performance and its cash fl ows for the year then ended in accordance with International Financial Reporting Standards and relevant statutes.
Auditor Date Address
THE ROLE OF THE EXTERNAL AUDITOR The report is headed ‘ adverse opinion ’ . Again it contains a clear description of a differ- ence of opinion between the directors and the auditor. This time, however, the auditor has concluded that the accounts do not give a true and fair view. Issuing such an opinion is an extreme step to take. Effectively, it suggests that the shareholders should not use the fi nan- cial statements for decision-making purposes.
You might be worried about distinguishing between the two types of qualifi ed report. In general, you should decide whether the matter is material. If it is, then the ‘ except for ’ form will almost always be appropriate. You do have to be aware of the adverse opinion, but it is unlikely that you will ever use it in answering an examination question. You will not be asked to write out a full audit report in the examination. A question might ask you to decide which type of report is appropri- ate or to explain what the different types of audit report are, but you do not have to memorise the wording of the reports.
9.4 Summary
The auditor is responsible for forming an opinion on the truth and fairness of the fi nancial statements and expressing this in a report addressed to the shareholders. This is necessary so that the readers of the fi nancial statements can have some confi dence that the directors have not manipulated the information in the accounts.
Having completed this chapter, we can now explain the purpose of an audit and the role and duties of the external auditor. We can describe the audit process and explain the con- tents of an audit report.
We can discuss the circumstances that could result in a qualifi ed opinion being given and how that opinion would be refl ected in the audit report.
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Question 1
What is the objective of an audit? (A) To check for fraud
(B) To check there are no errors in the accounts
(C) To enable the auditor to express an opinion as to whether the fi nancial statements give a fair presentation of the company affairs
(D) To enable the auditor to approve the accounts (2 marks)
Question 2
Who is responsible for the preparation of the fi nancial statements? (A) The entity accountant
(B) The auditors (C) The entity directors
(D) The shareholders (2 marks)
Question 3
What is the external auditor’s statutory duty? (max. 21 words).
The auditor has a statutory duty to________________________________________
(2 marks)
Question 4
If an auditor disagrees with the treatment of a material item in the fi nancial statements and the directors refuse to change their treatment, the auditor will in most situations:
(A) Issue a qualifi ed audit report using the ‘ except for ’ qualifi cation (B) Issue an unqualifi ed audit report
(C) Issue a qualifi ed audit report using the ‘ adverse opinion ’ qualifi cation
(D) Issue a qualifi ed audit report using the ‘ disagreement of treatment ’ qualifi cation
(2 marks)
Revision Questions
THE ROLE OF THE EXTERNAL AUDITOR
Question 5
If an external auditor does not agree with the directors ’ treatment of a material item in the accounts, the fi rst action they should take is to
(A) give a qualifi ed opinion of the fi nancial statements (B) give an unqualifi ed opinion of the fi nancial statements
(C) force the directors to change the treatment of the item in the accounts (D) persuade the directors to change the treatment of the item in the accounts
(2 marks)
Question 6
The external auditor has a duty to report on the truth and fairness of the fi nancial state- ments and to report any reservations. The auditor is normally given a number of powers by statute to enable the statutory duties to be carried out.
List THREE powers that are usually granted to the auditor by statute.
(3 marks)
Question 7
You are the partner in charge of the audit of G, a major quoted company. You are making a fi nal review of the fi nancial statements before fi nalising the audit report. The following matters have been marked for your attention:
(i) The draft fi nancial statements indicate a turnover of $500 m and a profi t of $50 m. (ii) The directors have made no provision for the costs that are likely to be incurred as a
result of a damages claim for $2.4 m, which is being pursued by one of the company’s customers. G’s legal department and its lawyers are quite sure that this claim will have to be met in full.
(iii) The directors have not provided for a sum of $2.3 m which ought to be written off in respect of debts that are almost certainly irrecoverable.
Requirements
(a) Explain the implications for your audit report of the matters described in (ii) and (iii) above.
Your answer should make a clear statement of the type of report which you consider
appropriate, although a full audit report is not required. (5 marks)
(b) It has been suggested that the quality of audit reporting could be improved enor- mously if accounting standards were clearer and auditors had more explicit guidance on issues such as materiality.
Discuss this suggestion, making it clear how improved guidance on fi nancial report-
ing might support the auditor. (5 marks)
THE ROLE OF THE EXTERNAL AUDITOR
Question 8
You are the partner in charge of the audit of K. The following matter has been brought to your attention in the audit working papers.
The entity has refused to write the closing inventory down to the lower of cost and net realisable value, despite the requirements to do so in IAS 2. The audit senior estimates that closing inventory has been overstated by $500,000 because of this.
The draft fi nancial statements show turnover of $40 million and profi t of $4.5 million.
Requirements
(a) Explain what is meant by the term ‘ materiality ’ . Explain whether the matter high-
lighted above is material, giving reasons. (5 marks)
(b) Assuming that the directors refuse to amend the fi nancial statements, explain what
type of audit report would be appropriate to the above statements. (5 marks)
(Total marks 10)
Question 9
An external auditor gives a qualifi ed audit report that is a “ disclaimer of opinion ” . This means that the auditor:
(A) has been unable to agree with an accounting treatment used by the directors in rela- tion to a material item.
(B) has been prevented from obtaining suffi cient appropriate audit evidence.
(C) has found extensive errors in the fi nancial statements and concludes that they do not show a true and fair view.
( D) has discovered a few immaterial differences that do not affect the auditor’s opinion.
(2 marks)
Question 10
The International Standard on Auditing 701 Modifi cations to the Independent Auditor’s Report, classifi es modifi ed audit reports into “ matters that do not affect the auditor’s opin- ion ” and “ matters that do affect the auditor’s opinion ” . This latter category is further sub- divided into three categories.
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In the real world, it is usually diffi cult to tell whether a problem is material or even if there is a serious disagreement. The nature of examination questions suggests that matters will always be more clear-cut.
Solution 1
The correct answer is (C).
The auditor does not check for fraud or errors specifi cally. The auditor does not ‘ approve ’ the accounts, see Section 9.1.1.
Solution 2
The correct answer is (C), see Section 9.1.2.
Solution 3
The auditor has a statutory duty to make a report to the company’s members, expressing an opinion on the truth and fairness of the company’s published fi nancial statements, see Section 9.1.2
Solution 4
The correct answer is (A), see Section 9.3.
Solution 5
The correct answer is (D), see Section 9.1.2.
Solution 6
Powers of the auditor can include:
● Right of access at all times to the books, records, documents and accounts;
● Right to be notifi ed, and attend meetings, of owners;
Solutions to
THE ROLE OF THE EXTERNAL AUDITOR
● Right to require offi cers of the entity to provide them with information and explanations;
● Right to speak at owners ’ meetings.
Note: Any three of the above would have gained the marks available.
Solution 7
(a) The fi rst question to be resolved is whether these amounts are material. If they are not then it would not matter whether the auditor disagreed or not.
Bear in mind that either item might be immaterial when taken on its own but the combined effect could be material. Both items tend to overstate profi ts and so we should consider whether their total value is misleading.
One half of 1 per cent of turnover $2.5 million, as does 5 per cent of profi t. This
suggests that neither item is material in itself, but that the two taken together lead to a material overstatement of profi ts. If the directors refuse to alter their treatment of them, then the auditor will have to qualify the audit report.
IAS 37 requires that item (ii) should be accrued. This is on the grounds that the payment is probable and the amount can be estimated with reasonable accuracy. This accrual would reduce profi ts by $2.4 million and would create a current liability of the same amount.
The bad debt should be written off because of the need for prudence in the valu- ation of assets and recognition of losses. There is also a need to match the loss to the same period as the loss arose. This means that both profi ts and receivables should be decreased by $2.3 million.
In the absence of any change by the directors, we will need to qualify the fi nancial statements on the grounds of disagreement. The extent of our disagreement is not so serious as to warrant an adverse opinion and so we will use the ‘ except for ’ form of words, see Section 9.3.
(b) The ambiguity of accounting standards is a major problem for the auditor. It is pos- sible to create a slightly misleading impression without breaching any of the formal standards. It can be diffi cult for the auditor to justify a change to the fi nancial state- ments if the directors argue that their treatment falls within the requirements of local company law and accounting standards. These same directors can, of course, seek out the loopholes and ambiguities in the standards in order to achieve the desired effect on the statements.
If accounting standards could be made clearer and less ambiguous, then the auditor could fi nd it easier to demonstrate that a particular treatment was unacceptable. On the other hand, the statements might not be any more useful because the greater clar- ity might be arrived at by making the requirements more rigid – thereby reducing the scope for deciding on the most realistic treatment.
The other major problem facing the auditor is over the determination of materiality. It is never clear where the precise cut-off between material and immaterial actually lies. The danger is that the directors are aware of this and could bias the fi gures until just before the point at which the auditor would be forced to treat the matter as a material disagreement.
Greater clarity over materiality might help, but it could also provide management with a better idea of exactly how far they could push the fi gures. This suggests that it might not improve the overall quality of fi nancial reporting and auditing.
THE ROLE OF THE EXTERNAL AUDITOR
Solution 8
(a) A matter is material if knowledge of it could infl uence users ’ decisions taken on the basis of the fi nancial statements.
In strictly numerical terms, 0.5 per cent of turnover is $200,000 and 5 per cent of profi t is $225,000.
The disagreement over inventory appears to be material because of its numerical sig- nifi cance. There is little point in considering the nature of the matter because it would be material by virtue of its effect on profi t.
(b) This is a material disagreement and so the auditor must qualify the audit report in respect of the overstatement of stock.
The disagreement is material, but not fundamental and so the adverse opinion is not required.
The auditor would state that the accounts gave a true and fair view except for the overstatement of closing inventory and profi ts by $500,000, see Section 9.3.
Solution 9
The correct answer is B, see Section 9.3.2.
Solution 10
Qualifi ed opinion Adverse opinion