Modified opinions: ISA 705

Most audit reports are unmodified. The few that are not draw the most attention, from shareholders, banks, regulators and the press. A qualified opinion on a listed company can move its share price. So the rules on when to modify, and how, are precise, and an exam question will often hand you a set of facts and ask which opinion follows.

This topic covers International Standard on Auditing (ISA) 705. It sets out the two reasons for a modification, the three types of modified opinion, the decision between them, the form of the report and a method for answering exam questions. The method matters more than the wording of the illustrations, because the same few questions decide the answer every time.

The nature of a modified report

Before issuing a modified report, the auditor discusses the reason with management, explains it and asks management to amend the financial statements. If management makes the adjustments, no modified report is needed. If management refuses, a modified report may be the only course.

An auditor’s report is modified in one of two ways:

• a matter arises that does not affect the opinion but gives rise to an emphasis of matter or other matter paragraph (ISA 706, the next topic); or
• a matter arises that does affect the opinion, giving a qualified opinion, a disclaimer of opinion or an adverse opinion (ISA 705).

A report with an emphasis of matter paragraph still has an unmodified opinion. A report with a qualified, adverse or disclaimed opinion has a modified opinion.

When the auditor must modify the opinion

ISA 705 requires the auditor to modify the opinion in two situations.

1. Material misstatement. Based on the evidence, the statements as a whole are not free from material misstatement.
2. Limitation on scope. The auditor cannot get sufficient appropriate evidence to conclude that the statements as a whole are free from material misstatement. The statements may therefore contain a material misstatement.

The decision table

Qualified opinions

A qualified opinion is given when there is a material misstatement or a limitation on scope and the effect is material but not pervasive. It is called an “except for” opinion, because the report says that the statements give a true and fair view except for the matter described.

What pervasive means

A matter is generally material but not pervasive when the auditor has a material problem with one or more specific items, such as inventory or revenue, but the other items and the statements as a whole still give a true and fair view. ISA 705 defines pervasive effects as those that, in the auditor’s judgement:

1. are not confined to specific elements, accounts or items of the statements;
2. are confined to specific elements but represent, or could represent, a substantial proportion of the statements; or
3. in relation to disclosures, are fundamental to users’ understanding of the statements.

The difference between material and pervasive is a matter of judgement. There are no absolute cut-off points.

Limitations on scope

A limitation on scope arises when the auditor cannot get sufficient appropriate evidence about something material. ISA 705 says it may result from:

• circumstances beyond the entity’s control, for example the destruction of the accounting records;
• the nature or timing of the auditor’s work, for example appointment too late to attend the physical inventory count; and
• limitations imposed by management, for example preventing the auditor from observing the inventory count or from asking for confirmation of specific balances, such as a receivables circularisation.

Limitations imposed by management

If, after accepting the engagement, the auditor finds that management has imposed a limitation that is likely to lead to a qualified opinion or a disclaimer, the auditor asks management to remove it. If management refuses, the auditor must:

1. tell those charged with governance; and
2. consider whether alternative procedures can give sufficient appropriate evidence.

If no other evidence is possible, and the matter is material but not pervasive, the auditor gives a qualified opinion. If the matter is material and pervasive, the auditor resigns from the audit where practicable and not prohibited by law, or, if that is not possible, issues a disclaimer of opinion.

Background: ISA 210 also says an auditor should decline an engagement if management limits the scope before the audit starts and a disclaimer is expected, unless the law requires the auditor to accept it.

Form and content of a modified opinion

The opinion section

The first section is headed Qualified Opinion, Adverse Opinion or Disclaimer of Opinion, as appropriate. The wording is prescribed, as the examples below show.

The basis section

The Basis for Opinion section is renamed Basis for Qualified Opinion, Basis for Adverse Opinion or Basis for Disclaimer of Opinion. It must include:

• for a misstatement of specific amounts, a description and quantification of the effect on the statements, or a statement that quantification is not possible;
• for a misstatement of narrative disclosures, an explanation of how the disclosures are misstated;
• for non-disclosure of information that should have been disclosed, the nature of the omitted information and, unless law prohibits, the omitted disclosures; and
• for a modification caused by an inability to get evidence, the reasons for that inability.

For qualified and adverse opinions the section ends by saying that the auditor believes the evidence obtained is sufficient and appropriate to provide a basis for the modified opinion.

The illustrative wording

Key audit matters in a modified report

In a qualified opinion the key audit matters (KAM) introduction is changed to say “in addition to the matter described in the Basis for Qualified Opinion section”. In an adverse opinion with no other matters, the section can say that there are no other key audit matters. In a disclaimer, key audit matters are not presented.

In a disclaimer the auditor’s responsibilities section also changes, to say that because of the matters described the auditor was not able to obtain evidence to provide a basis for an opinion.

Deciding to modify

The auditor modifies the opinion only if satisfied that:

• the reasons are justified; and
• management is unable or unwilling to act to remove the need for the modification.

For example, if management decides that a material non-current asset should not be depreciated, the auditor should first satisfy himself that there is no acceptable reason, review the audit file and any information from earlier audits, and consider whether there might be an acceptable reason for departing from International Financial Reporting Standards (IFRS) in order to give a true and fair view. If still satisfied that management is wrong, the auditor:

1. discusses management’s reasons;
2. obtains a representation that the asset will not be depreciated;
3. decides whether the effect is material or material and pervasive;
4. warns management that the opinion will be modified unless it changes its view; and
5. if management does not change, issues a qualified or adverse opinion.

Other actions when the opinion is modified

ISA 260 and ISA 705 require the auditor to tell those charged with governance of a planned modification so that they understand it and can give further information before the report is issued. The auditor may also consult legal counsel, reconsider management’s integrity and whether to change the audit strategy (especially for a management-imposed limitation) and, if the matter is serious enough and the law allows, withdraw, after taking legal advice.

A method for exam questions

The syllabus says that in the exam you may be asked to find the errors in an auditor’s report, or to decide what opinion suits a situation. The questions to ask, in order, are:

1. Do the statements give a true and fair view? Remember that immaterial misstatements do not affect it. If they do, the opinion is unmodified.
2. If they do give a true and fair view, does anything justify an emphasis of matter paragraph, such as uncertainty on litigation or a material subsequent event?
3. Is there a material uncertainty on going concern, and is it adequately described? If so, add the separate going concern section.
4. If they do not give a true and fair view, is the cause a disagreement with management (misstatement) or a lack of evidence (scope limitation)?
5. Is the matter material but not pervasive? If so, a qualified opinion is appropriate.
6. If it is material and pervasive, the opinion is adverse (misstatement) or a disclaimer (scope limitation). These are rare in practice, but could appear in an exam.

The rules in more depth

Why a disclaimer needs a pervasive limitation

A disclaimer says the auditor has no basis for any opinion. If only one item is unsupported, the rest of the audit still gives a basis, so a qualified opinion is enough. A disclaimer is for the case where the unsupported matters could be so widespread that the statements cannot be relied on at all.

Qualified, not adverse, for one wrong item

Failure to write down inventory affects only inventory and what flows from it. The rest of the statements are fair, so the opinion is qualified. A failure to consolidate a subsidiary changes nearly every line, so the opinion is adverse.

The effect of the prior year

A modification may follow from earlier years. If last year’s report was unmodified but the current evidence shows that last year’s figures were wrong, the current opinion may be modified on the comparatives or opening balances. The next topic covers this.

Worked example: the missing records

Scenario (adapted from the syllabus). Colorosso Ltd’s report for the year to 31 December Year 7 was unmodified. In April Year 8 the chief executive left the country with the accounting records. A trainee drafts: “The evidence available to us was limited because accounting records were missing at the beginning of the year” in the basis section, and “we do not express an opinion on the financial statements” in the opinion section.

The matters. The records for the first three or four months of the year are missing, so this is a limitation on scope. They were taken by the chief executive, which suggests fraud, so the auditor cannot be sure the earlier balances and last year’s comparatives are right.

If fraud was in progress at the start of the year, it may have affected last year too, even though last year’s report was unmodified.

The extent. If the missing records affect mainly the statement of comprehensive income for the first months, the limitation may be material but not pervasive, and a qualified opinion would follow. A disclaimer is for the case where the missing records could affect the whole of the statements. Because of the possible fraud, the opinion is likely to be modified even if records can be reconstructed.

The draft. The trainee is right that the opinion must be modified for a limitation on scope. But the draft should give the exact nature of the problem and the possible fraud, take account of a possible modification of the comparative figures. Consider that the problem may be limited to the statement of comprehensive income, which would make a qualified opinion suitable.

Second example: the factory closure. A company closed a loss-making factory that made 10% of sales this year and 14% last year. The closure is permanent. It is mentioned in the directors’ report but not in the statements. It is a discontinued operation, and failing to disclose it breaches IFRS 5, with related disclosure requirements in International Accounting Standard (IAS) 7 and IFRS 8. The matter is material but not pervasive.

If management does not give the disclosures, the opinion is qualified for a misstatement.

Applying the table with numbers. Materiality is ₦50 million. Inventory is overstated by ₦80 million against total assets of ₦2 billion. The overstatement is material (80 is above 50) and is 4% of total assets, confined to one item, so it is not pervasive. The opinion is qualified.

If, however, receivables of ₦900 million, inventory of ₦700 million and revenue could not be verified, the unsupported items would be a substantial proportion of the statements, and a disclaimer is likely.

How to score full marks

• Say whether the cause is a misstatement or a scope limitation. It decides the column of the table.
• Say whether it is pervasive and why. Use the three tests.
• Name the opinion and give the wording. “Except for” for qualified.
• Quantify where you can. Compare the amount with materiality and with total assets or profit.
• Describe the Basis section. It must describe the matter and its effect.
• Add the process. Discuss with management, warn, tell those charged with governance.

Common mistakes in the exam

• Giving a qualified opinion for a pervasive misstatement.
• Giving a disclaimer for a misstatement. A disclaimer is for a scope limitation.
• Modifying the opinion for an immaterial item.
• Putting the explanation of a modification in the KAM section.
• Forgetting to ask management to amend the statements first.
• Using “except for” wording in an adverse opinion.

Quick revision

• Discuss with management, ask to amend, then modify if management refuses.
• Two causes: material misstatement, limitation on scope.
• Material not pervasive: qualified. Pervasive: adverse (misstatement) or disclaimer (scope).
• Pervasive: not confined to items, or a substantial proportion, or fundamental disclosures.
• Headings: Qualified Opinion, Adverse Opinion, Disclaimer of Opinion, and the matching Basis section.
• Management-imposed limitation: ask to remove, tell governance, alternative procedures, qualify or resign or disclaim.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer. Full model answers follow the written questions.

Recall check: multiple choice

The real ICAN paper has no multiple-choice section. These questions are for quick recall. The written questions that follow are closer to the exam.

Written questions

Model answers

Spotted a mistake? Tell us and we will check it.