CHAPTER SEVEN

AUDIT REPORT

INTRODUCTION
In the previous chapters you have seen overview of an audit and its professional and ethical
standards; audit planning, programming and process; use of internal control in an audit; and
obtaining audit evidence. In this chapter, the main objective is to help you understand the
different types of reports which may be issued by auditors based on their findings.

After obtaining the necessary evidence and completing the field work, the auditors should give
their opinion on whether the financial statements are fair and true in material aspects. The audit
report is the means by which the auditors express their opinion on the truth and fairness of a
company's financial statement addressed principally for the shareholders, but also for the users.
Statue has consistently recognized its importance by requiring that certain mandatory statements
appear in the report.

7.1 REQUIREMENTS FOR AUDIT REPORT

Expressing an independent and expert opinion on the fairness of financial statements is the most
frequently performed attestation service rendered by the public accounting profession. This
opinion, which is expressed in the auditors’ report, provides users financial statements with
reasonable assurance that the statements are in conformity with generally accepted accounting
principles. For users to understand the full implication of the auditors’ opinion, it is important for
the report to comply with the fourth standard of reporting which states as follows:

The (auditor’s) report shall either contain an expression of opinion regarding financial
statements, taken as whole, or an assertion to the effect that an opinion cannot be expressed.
When an overall opinion cannot be expressed, the reasons therefore should be stated. In all
cases where an auditors’ name is associated with financial statements, the report should
contain a clear-cut indication of the character of the auditors’ work, if any, and the degree of
responsibility the auditor is taking
The auditors’ standard report meets this reporting standard by;
a. stating that the audit was performed in conformity with generally accepted auditing
standards, and
b. Expressing an opinion that the client’s financial statements are presented fairly in

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 conformity with generally accepted accounting principles.

However, if there are material deficiencies in the client’s financial statements or limitation in the
audit, or if there are other unusual conditions about which the reader of the financial statements
should be informed, auditors’ cannot issue the standard report. Instead, they must carefully modify
their report to make these problems or conditions known to users of the audited financial statements.
International Auditing Standards require the auditors to state explicitly whether in the auditors'
opinion the annual accounts have been properly prepared in accordance with the GAAP and in
particular whether a true and fair view is given:

 In the balance sheet, of the state of the company's affairs at the end of financial year.
 In the profit and loss account, of the company's profit or loss for the financial year; and
 In the case of group accounts, of the state of affairs at the end of financial year and the
profit or loss for the year of undertakings included in the consolidation, so far as concerns
member of the company.

7.2 TYPE OF REPORTS EXPRESSING AUDIT OPINIONS

The auditors’ opinion when expressing an opinion on financial statements may be summarized as
follows:

1. An Unqualified Opinion
2. A Qualified Opinion
3. An Adverse Opinion
4. A Disclaimer of Opinion

1. STANDARD UNQUALIFIED AUDIT REPORT

To allow users to understand audit reports, AICPA professional standards provide uniform word
ing for the auditor’s report, as illustrated in the auditor’s standard unqualified audit report in
Figure 7-1. Different auditors may alter the wording or presentation slightly, but the meaning
will be the same.
Parts of Standard Unqualified Audit Report
The auditor’s standard unqualified audit report contains seven distinct parts, and these are
labeled in bold letters in the margin beside Figure 7-1.

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1. Report title. Auditing standards require that the report be title and that the title include the
word independent. For example, appropriate titles include “independent auditor’s report,” “report
of independent auditor,” or “independent accountant’s opinion.” The requirement that the title
include the word independent conveys to users that the audit was unbiased in all aspects.
2. Audit report address. The report is usually addressed to the company, its stockholders, or the
board of directors. In recent years, it has become customary to address the report to the board of
directors and stockholders to indicate that the auditor is independent of the company.
3. Introductory paragraph. The first paragraph of the report does three things: First, it makes the
simple statement that the CPA firm has done an audit. This is intended to distinguish the report
from a compilation or review report. The scope paragraph clarifies what is meant by an audit.
Second, it lists the financial statements that were audited, including the balance sheet dates and
the accounting periods for the income statement and statement of cash flows. The wording of the
financial statements in the report should be identical to those used by management on the
financial statements. Notice that the report in Figure7-1 is on comparative financial statements.
Therefore, a report on both years’ statements is needed. Third, the introductory paragraph states
that the statements are the responsibility of management and that the auditor’s responsibility is to
express an opinion on the statements based on an audit. The purpose of these statements is to
communicate that management is responsible for selecting the appropriate accounting principles
and making the measurement decisions and disclosures in applying those principles and to
clarify the respective roles of management and the auditor.

4. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the
audit. This paragraph first states that the auditor followed U.S. generally accepted auditing
standards. For an audit of a public company, the paragraph will indicate that the auditor followed
standards of the Public Company Accounting Oversight Board. Because financial statements
prepared in accordance with U.S. accounting principles and audited in accordance with U.S.
auditing standards are available throughout the world on the Internet, the country of origin of the
accounting principles used in preparing the financial statements and auditing standards followed
by the auditor are identified in the audit report.

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The scope paragraph states that the audit is designed to obtain reasonable assurance about
whether the statements are free of material misstatement. The inclusion of the word material
conveys that auditors are responsible only to search for significant misstatements, not minor
misstatements that do not affect users’ decisions. The use of the term reasonable assurance is
intended to indicate that an audit cannot be expected to completely eliminate the possibility that
a material misstatement will exist in the financial statements. In other words, an audit provides a
high level of assurance, but it is not a guarantee.

The remainder of the scope paragraph discusses the audit evidence accumulated and states that
the auditor believes that the evidence accumulated was appropriate for the circumstances to
express the opinion presented. The words test basis indicates that sampling was used rather than
an audit of every transaction and amount on the statements. Whereas the introductory paragraph
of the report states that management is responsible for the preparation and content of the
financial statements, the scope paragraph states that the auditor evaluates the appropriateness of
those accounting principles, estimates, and financial statement disclosures and presentations
given.

5. Opinion paragraph. The final paragraph in the standard report states the auditor’s conclusions
based on the results of the audit. This part of the report is so important that often the entire audit
report is referred to simply as the auditor’s opinion. The opinion paragraph is stated as an
opinion rather than as a statement of absolute fact or a guarantee. The intent is to indicate that the
conclusions are based on professional judgment. The phrase in our opinion indicates that there
may be some information risk associated with the financial statements, even though the
statements have been audited. The opinion paragraph is directly related to the first and fourth
generally accepted auditing reporting standards listed in chapter 2. The auditor is required to
state an opinion about the financial statements taken as a whole, including a conclusion about
whether the company followed U.S. generally accepted accounting principles or the International
Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board
(IASB). One of the controversial parts of the auditor’s report is the meaning of the term present
fairly. Does this mean that if generally accepted accounting principles are followed, the financial
statements are presented fairly, or something more? Occasionally, the courts have concluded that

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auditors are responsible for looking beyond generally accepted accounting principles to
determine whether users might be misled, even if those principles are followed. Most auditors
believe that financial statements are “presented fairly” when the statements are in accordance
with generally accepted accounting principles, but that it is also necessary to examine the
substance of transactions and balances for possible misinformation.

6. Name of CPA firm. The name identifies the CPA firm or practitioner who performed the
audit. Typically, the firm’s name is used because the entire CPA firm has the legal and
professional responsibility to ensure that the quality of the audit meets professional standards.

7. Audit report date. The appropriate date for the report is the one on which the auditor
completed the auditing procedures in the field. This date is important to users because it indicates
the last day of the auditor’s responsibility for the review of significant events that occurred after
the date of the financial statements. In the audit report in Figure 7-1 (p. 47), the balance sheet is
dated December 31, 2013, and the audit report is dated February 15, 2014. This indicates that the
auditor has searched for material unrecorded transactions and events that occurred up to
February 15, 2014
Standard Unqualified Report on Comparative Statements for a U.S. Public Company
ANDERSON and ZINDER, P.C.
Certified Public Accountants
Suite 100
Park Plaza East
Denver, Colorado 80110
303/359-0800
Independent Auditor’s Report Report Title
To the Stockholders Audit Report Address

General Ring Corporation

We have audited the accompanying balance sheets of General Ring Introductory Paragraph
Corporation as of December 31, 2012 and 2013, and the related
statements of income, retained earnings, and cash flows for the years (Factual Statement)
then ended. These financial statements are the responsibility of the

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 Company’s management. Our responsibility is to express an opinion
on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards Scope Paragraph

generally accepted in the United States of America. Those standards
require that we plan and perform the audit to obtain reasonable (Factual Statement)
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present Opinion Paragraph
fairly, in all material respects, the financial position of General Ring
Corporation as of December 31, 2012 and 2013, and the results of (Conclusions)
its operations and its cash flows for the years then ended in
conformity with accounting principles generally accepted in the
United States of America.

ANDERSON AND ZINDER, P.C., CPAs Name of CPA Firm

February 15, 2014 Audit Report Date (Date
Audit Field Work Is
Completed)

Conditions for Standard Unqualified Audit Report

The standard unqualified audit report is issued when the following conditions have been met:
1. All statements—balance sheet, income statement, statement of retained earnings, and
statement of cash flows—are included in the financial statements.
2. The three general standards have been followed in all respects on the engagement.
3. Sufficient appropriate evidence has been accumulated, and the auditor has conducted the
engagement in a manner that enables him or her to conclude that the three standards of field
work have been met.
4. The financial statements are presented in accordance with U.S. generally accepted accounting
principles. This also means that adequate disclosures have been included in the footnotes and
other parts of the financial statements.

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5. There are no circumstances requiring the addition of an explanatory paragraph or modification
of the wording of the report. When these conditions are met, the standard unqualified audit
report, as shown in Figure 7-1, is issued. The standard unqualified audit report is sometimes
called a clean opinion because there are no circumstances requiring a qualification or
modification of the auditor’s opinion. The standard unqualified report is the most common audit
opinion. Sometimes circumstances beyond the client’s or auditor’s control prevent the issuance
of a clean opinion. However, in most cases, companies make the appropriate changes to their
accounting records to avoid a qualification or modification by the auditor.

 Unqualified audit report with explanatory paragraph or modified word

The remainder of this chapter deals with reports, other than standard unqualified reports, on the
audit of financial statements. In certain situations, an unqualified audit report on the financial
statements is issued, but the wording deviates from the standard unqualified report. The
unqualified audit report with explanatory paragraph or modified wording meets the criteria of a
complete audit with satisfactory results and financial statements that are fairly presented, but the
auditor believes it is important or is required to provide additional information. In a qualified,
adverse, or disclaimer report, the auditor either has not performed a satisfactory audit, is not
satisfied that the financial statements are fairly presented, or is not independent.

The following are the most important causes of the addition of an explanatory paragraph or a
modification in the wording of the standard unqualified report:
 Lack of consistent application of generally accepted accounting principles
 Substantial doubt about going concern
 Auditor agrees with a departure from promulgated accounting principles
 Emphasis of a matter
 Reports involving other auditors
The first four reports all require an explanatory paragraph. In each case, the three standard report
paragraphs are included without modification, and a separate explanatory paragraph follows the
opinion paragraph. Only reports involving the use of other auditors use a modified wording
report. This report contains three paragraphs, and all three paragraphs are modified.

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  Lack of Consistent Application of GAAP
The second reporting standard requires the auditor to call attention to circumstances in which
accounting principles have not been consistently observed in the current period in relation to the
preceding period. Generally accepted accounting principles require that changes in accounting
principles or their method of application be to a preferable principle and that the nature and
impact of the change be adequately disclosed. When a material change occurs, the auditor should
modify the report by adding an explanatory paragraph after the opinion paragraph that discusses
the nature of the change and points the reader to the footnote that discusses the change. The
materiality of a change is evaluated based on the current year effect of the change. An
explanatory paragraph is required for both voluntary changes and required changes due to a new
accounting pronouncement.
 Consistency Versus Comparability
The auditor must be able to distinguish between changes that affect consistency and those that
may affect comparability but do not affect consistency. The following are examples of changes
that affect consistency and therefore require an explanatory paragraph if they are material:
1. Changes in accounting principles, such as a change from FIFO to LIFO inventory valuation
2. Changes in reporting entities, such as the inclusion of an additional company in combined
financial statements
3. Corrections of errors involving principles, by changing from an accounting principle that is
not generally acceptable to one that is generally acceptable, including correction of the resulting
error changes that affect comparability but not consistency and therefore need not be included in
the audit report include the following:
1. Changes in an estimate, such as a decrease in the life of an asset for depreciation purposes
2. Error corrections not involving principles, such as a previous year’s mathematical error
3. Variations in format and presentation of financial information
4. Changes because of substantially different transactions or events, such as new endeavors in
research and development or the sale of a subsidiary Items that materially affect the
comparability of financial statements generally require disclosure in the footnotes. A qualified
audit report for inadequate disclosure may be required if the client refuses to properly disclose
the items.
 Substantial Doubt about Going Concern

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Even though the purpose of an audit is not to evaluate the financial health of the business, the
auditor has a responsibility under auditing standards to evaluate whether the company is likely to
continue as a going concern. For example, the existence of one or more of the following factors
causes uncertainty about the ability of a company to continue as a going concern:
1. Significant recurring operating losses or working capital deficiencies
2. Inability of the company to pay its obligations as they come due
3. Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake or
flood, or unusual labor difficulties
4. Legal proceedings, legislation, or similar matters that have occurred that might jeopardize the
entity’s ability to operate the auditor’s concern in such situations is the possibility that the client
may not be able to continue its operations or meet its obligations for a reasonable period. For this
purpose, a reasonable period is considered not to exceed 1 year from the date of the financial
statements being audited.

When the auditor concludes that there is substantial doubt about the entity’s ability to continue as
a going concern, an unqualified opinion with an explanatory paragraph is required, regardless of
the disclosures in the financial statements. Auditing standards permit but do not require a
disclaimer of opinion when there is substantial doubt about going concern. The criteria for
issuing a disclaimer of opinion instead of adding an explanatory paragraph are not stated in the
standards, and this type of opinion is rarely issued in practice. An example for which a
disclaimer might be issued is when a regulatory agency, such as the Environmental Protection
Agency, is considering a severe sanction against a company and, if the proceedings result in an
unfavorable outcome, the company will be forced to liquidate.

 Auditor Agrees with a Departure from a Promulgated Principle

Rule 203 of the AICPA Code of Professional Conduct states that in unusual situations, a
departure from a generally accepted accounting principle may not require a qualified or adverse
opinion. However, to justify an unqualified opinion, the auditor must be satisfied and must state
and explain, in a separate paragraph or paragraphs in the audit report, that adhering to the
principle would produce a misleading result in that situation.
 Emphasis of a Matter

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Under certain circumstances, the CPA may want to emphasize specific matters regarding the
financial statements, even though he or she intends to express an unqualified opinion. Normally,
such explanatory information should be included in a separate paragraph in the report. Examples
of explanatory information the auditor may report as an emphasis of a matter include the
following:
• The existence of significant related party transactions
• Important events occurring subsequent to the balance sheet date
• The description of accounting matters affecting the comparability of the financial statements
with those of the preceding year
• Material uncertainties disclosed in the footnotes
 Reports Involving Other Auditors
When the CPA relies on a different CPA firm to perform part of the audit, which is common
when the client has several widespread branches or subdivisions, the principal CPA firm has
three alternatives. Only the second is an unqualified report with modified wording.
1. Make No Reference in the Audit Report When no reference is made to the other auditor, a
standard unqualified opinion is given unless other circumstances require a departure. This
approach is typically followed when the other auditor audited an immaterial portion of the
statements, the other auditor is well known or closely supervised by the principal auditor, or the
principal auditor has thoroughly reviewed the other auditor’s work. The other auditor is still
responsible for his or her own report and work in the event of a lawsuit or SEC action.
2. Make Reference in the Report (Modified Wording Report): This type of report is called a
shared opinion or report. A shared unqualified report is appropriate when it is impractical to
review the work of the other auditor or when the portion of the financial statements audited by
the other CPA is material in relation to the whole.
Notice that the report does not include a separate paragraph that discusses the shared
responsibility, but does so in the introductory paragraph and refers to the other auditor in the
scope and opinion paragraphs. The portions of the financial statements audited by the other
auditor can be stated as percentages or absolute amounts.

2. QUALIFIED OPINION

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A qualified opinion report can result from a limitation on the scope of the audit or failure to
follow generally accepted accounting principles. A qualified opinion report can be used only
when the auditor concludes that the overall financial statements are fairly stated. A disclaimer
or an adverse report must be used if the auditor believes that the condition being reported on is
highly material. Therefore, the qualified opinion is considered the least severe type of departure
from an unqualified report.

A qualified report can take the form of a qualification of both the scope and the opinion or of the
opinion alone. A scope and opinion qualification can be issued only when the auditor has been
unable to accumulate all of the evidence required by generally accepted auditing standards.
Therefore, this type of qualification is used when the auditor’s scope has been restricted by the
client or when circumstances exist that prevent the auditor from conducting a complete audit.
The use of a qualification of the opinion alone is restricted to situations in which the financial
statements are not stated in accordance with GAAP.
When an auditor issues a qualified report, he or she must use the term except for in the opinion
paragraph. The implication is that the auditor is satisfied that the overall financial statements are
correctly stated “except for” a specific aspect of them. Examples of this qualification are given
later in this chapter. It is unacceptable to use the phrase except for with any other type of audit
opinion.

3. ADVERSE OPINION
An adverse opinion is used only when the auditor believes that the overall financial statements
are so materially misstated or misleading that they do not present fairly the financial position or
results of operations and cash flows in conformity with GAAP.
The adverse opinion report can arise only when the auditor has knowledge, after an adequate
investigation, of the absence of conformity. This is uncommon and thus the adverse opinion is
rarely used.
4. DISCLAIMER OF OPINION
A disclaimer of opinion is issued when the auditor has been unable to satisfy himself or herself
that the overall financial statements are fairly presented. -The necessity for disclaiming an
opinion may arise because of a severe limitation on the scope of the audit or a non independent

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relationship under the Code of Professional Conduct between the auditor and the client. Either of
these situations prevents the auditor from expressing an opinion on the financial statements as a
whole. The auditor also has the option to issue a disclaimer of opinion for a going concern
problem.
The disclaimer is distinguished from an adverse opinion in that it can arise only from a lack of
knowledge by the auditor, whereas to express an adverse opinion, the auditor must have
knowledge that the financial statements are not fairly stated. Both disclaimers and adverse
opinions are used only when the condition is highly material.

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