The whole purpose behind an audit is for an auditor to issue an unbiased opinion regarding the financial statements. An auditor describes what he has audited, the procedures and also the opinion in an audit report.
An audit report is issued after an audit. An audit report contains three paragraphs. An introductory paragraph, a scope paragraph and a conclusion paragraph. Alongside a title and addressee. This is a sample break up of how an unqualified opinion is set up(US Standard):
Independent Auditor's Report
- Introductory Paragraph: In the introductory paragraph there is a statement referring to the financial statements (balance sheet, etc.) that were audited. Then there is a statement in reference to the responsibilities of both management and the auditor. Management of the company is responsible for preparation of the financial statements, while the auditor is responsible for expressing an opinion.
- Scope Paragraph: The scope paragraph outlines how the audit will be performed and in accordance with generally accepted auditing standards (GAAS). The standards require the auditor to obtain reasonable assurance that the financial statements are free from material error. The scope paragraph states that the auditor will assess all the estimates made by management. Lastly the auditor will mention that the audit has given them a reasonable basis for forming an opinion.
- Opinion Paragraph: The opinion paragraph states the financial statements such as the balance sheet, income statement, etc. are presented fairly in conformity with Generally Accepted Accounting Principles (GAAP).
Unqualified Opinion also known as a "clean opinion" states that audited financial statements are presented fairly in all material aspects. However if an unqualified opinion is rendered it does not mean that the company is a good company to invest into. Therefore it is very important to understand that an unqualified opinion only means that the financial statements are free of error and fraudulent activity.
Adjusted Unqualified Opinion is an unqualified opinion that is adjusted for with an explanatory paragraph after or before the opinion paragraph.
There are three reasons that an auditor would adjust the audit report and insert an explanatory paragraph after the opinion paragraph.
- Going Concern Assumption: An auditor must assess if there is substantial doubt of the entity’s ability to operate in the future. An auditor must determine if the entity may have possible financial issues in the future which could lead to bankruptcy/dissolution/termination. An auditor must evaluate if the business can operate in the near foreseeable future, normally one year after the date of the balance sheet. To determine a going concern issue for the business, an auditor should review financial hardships such as defaults on loans, work stoppages, legal issues and analyze financial ratios. There are many other ways an auditor can test to predict any going concern issues. The auditor should also consider “mitigating factors” which help a company stay afloat during tough financial time periods. All of this has to be taken into consideration before an auditor can state a possible going concern issue. The auditor will add an explanatory paragraph at the end of the opinion paragraph with the phrase stating "the company raises substantial doubt about its ability to continue as a going concern".
- Lack of Consistency: If a company changes GAAP principles that may cause the financial statements to have a material impact. If the change is immaterial, there is no revision needed by the auditor. The fact that the change is an acceptable change means that it is allowed and is not against GAAP however would require some extra disclosure since the change can effect the financial statements materially.
- Other Factors: Sometimes the auditor may have to include an additional paragraph after the opinion paragraph to emphasize that required supplementary information from GAAP is missing. The auditor does not have to audit the required supplementary information however, should revise them to make sure there are no inconsistencies with the financial statements.
There are two reasons why an auditor may add an explanatory paragraph before or after the opinion paragraph.
- A Justified Departure from GAAP: If a company were to follow GAAP rules that would make the financial statements appear misleading; then the auditor can add an explanatory paragraph stating that using these alternative methods allow users to obtain a better understanding of the financial position of the entity.
- Emphasizing an Issue: The auditor has the option to describe and emphasize certain issues such as a related party transaction or accounting matters that would affect the comparability of the financial statements.
Lastly there is one more exception to an Unqualified Opinion Audit report, which does not require any explanatory paragraph.
- Reliance of Another Auditor:During a course of an audit, an auditor may require the use of another auditor to do some of the required audit work. There are two options the principal CPA has when dealing with another auditor who did part of the required audit work. Regardless if the principal CPA would like to mention the other CPA in the audit report or not; the principal CPA must be satisfied of his/her audit documentation.
- Separation of Responsibility & Work: This is when the principal CPA includes in all three paragraphs the division of the other CPA's responsibility and work in the audit report.
- Consummation of Responsibility: This is when the principal CPA takes all of the responsibility of the work and does not mention the other auditors work in the audit report.
Qualified Opinion, also known as an "except for" opinion, is issued by an auditor when there is an issue in preparing the financial statements and also in executing the audit. Preparing the financial statements in accordance to GAAP rules are violated, not to an extent that it is very material, however it is prohibited under GAAP. Issues executing the audit is when the auditor is prevented in performing the audit through the guidelines in accordance with GAAS. For every opinion that is issued as a qualified or adverse opinion, the explanatory paragraph always comes before the opinion paragraph.
- GAAP Issue - Qualified Opinion:
In order for an auditor to render a qualified opinion; it is subject to materiality of the issue.
- A GAAP issue arises when a company changes methods to a NON-acceptable GAAP method. The most important thing here is if the change is not acceptable by GAAP. If it is not acceptable, then a qualified opinion (dependent upon materiality) is issued.
- Another GAAP issue is when a company does not properly disclose all information regarding material transactions. This is considered to be inadequate disclosure. This is also subject to the level of materiality.
- Another issue is an unjustified change to a method not allowed under GAAP rules. If the change is not needed, then it requires the auditor to report about the unjust change in an explanatory paragraph before the opinion paragraph.
- Lastly if an accounting estimate made by the company is not reasonable which causes the financial statements to be materially misstated.
- GAAP Issue: Adverse Opinion:
To define and make adverse opinion easier to understand. All the issues that are listed above (1-4) are also a reason to issue an adverse opinion. However if the materiality is more severe, it is an adverse opinion.
- GAAS Issue - Qualified Opinion:
In order for an auditor to render a qualified opinion due to a GAAS issue; it is subject to significant issues in performing and executing the audit.
- If the auditor cannot obtain proper evidence to support managements claims and assertions.
- If the auditor is faced with a scope limitation, such as time constraints, lack of sufficient accounting records, etc. However the biggest scope limitation is when the company declines to sign the management representation letter.
- GAAS Issue - Disclaimer of Opinion:
A disclaimer of opinion affects the audit report differently. When an auditor issues a disclaimer of opinion, the introductory paragraph is put into past tense (engaged to audit), the scope paragraph is eliminated and lastly the opinion paragraph states that the auditor could not express an opinion. To qualify as a disclaimer of opinion, the two issues stated above (depending upon significance), and the following two reasons would constitute a disclaimer of opinion.
- If the auditor lacks independence. Therefore the auditor would not be giving an unbiased opinion.
- If the financial statements are not audited, the auditor should make sure readers of the financial statements know they are not audited. The only responsibility an auditor has is to make sure there are no obvious mistakes and errors on the financial statements.