Modified opinions and emphasis of matter paragraphs

An auditor finds that a company has not written down ₦300 million of obsolete inventory. Another cannot count the inventory because the company's records were destroyed in a fire. A third finds that all is well but that a major lawsuit has been disclosed in a note, which the auditor thinks every reader should notice. Each case needs a different kind of report.

The first is a misstatement, the second a limit on the evidence, and the third a matter to draw attention to. The auditor must choose the right form, and the exam asks for it again and again.

This topic covers the circumstances in which the opinion is modified under ISA 705, the three types of modified opinion, the choice between them by the nature of the matter and its pervasiveness, the structure of a modified report, and emphasis of matter and other matter paragraphs under ISA 706. The previous topic covered going concern, and the next begins the audit of information systems.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence, completion and reporting (25% of marks). It covers:

• types of audit opinion and the circumstances that lead to modification
• the effect of misstatements and limits on scope on the report
• emphasis of matter and other matter paragraphs

CAMA 2020 and modified opinions

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

When the opinion is modified

ISA 705 requires the auditor to modify the opinion when:

• the auditor concludes, on the evidence obtained, that the financial statements as a whole are not free from material misstatement; or
• the auditor is unable to obtain sufficient appropriate evidence to conclude that the statements as a whole are free from material misstatement.

The syllabus for this course asks for an understanding of the types of audit opinion and the circumstances that lead to each, but the detailed requirements of ISA 705 and ISA 706 are outside the main reading. They are still tested in practice, in scenario questions and in the going concern and expectation gap questions.

Material and pervasive

Material: misstatements are material if, individually or together, they could reasonably be expected to influence the economic decisions of users. Pervasive: an effect that is not confined to specific elements, accounts or items; or, if confined, represents or could represent a substantial proportion of the statements; or, in relation to disclosures, is fundamental to the users' understanding of the statements.

Pervasiveness is the key to choosing between a qualified and an adverse opinion or a disclaimer.

The three types of modified opinion

• Qualified opinion. The auditor concludes that, except for the effects of the matter, the statements give a true and fair view. The problem is material but confined.
• Adverse opinion. The auditor concludes that the misstatements are both material and pervasive, so the statements do not give a true and fair view.
• Disclaimer of opinion. The auditor could not obtain evidence on which to base an opinion, and concludes that the possible effects of undetected misstatements could be both material and pervasive. The auditor says that no opinion is expressed.

If the auditor has been unable to obtain evidence but the possible effects are not pervasive, the opinion is qualified. If a limitation of scope is imposed by management after the auditor has accepted the engagement, the auditor asks management to remove it. If management refuses, the auditor discloses the matter to those charged with governance and either qualifies or disclaims, or withdraws where possible.

Examples of each

• Material misstatement, not pervasive: inventory overstated by ₦300 million against profit of ₦4 billion and total assets of ₦40 billion. The auditor issues a qualified opinion, "except for the overstatement of inventory".
• Material and pervasive misstatement: the directors consolidated a subsidiary that they do not control, which inflates every line. The auditor issues an adverse opinion. Also a company that has prepared the statements on a going concern basis when it must close.
• Limitation, not pervasive: the auditor could not attend the inventory count and cannot satisfy herself on inventory by other means, which is material but affects one balance. Qualified, "except for the possible adjustments".
• Limitation, pervasive: records were destroyed and the auditor cannot test most items. A disclaimer.

Structure of a modified report

When the opinion is modified, the report has:

• the Opinion section headed "Qualified Opinion", "Adverse Opinion" or "Disclaimer of Opinion", which says "except for" or states that the statements do not give a true and fair view, or states that the auditor does not express an opinion;
• a Basis for Qualified Opinion, Basis for Adverse Opinion or Basis for Disclaimer of Opinion paragraph that describes the matter, and if the matter is a misstatement, quantifies the effect, or says that it is not practicable to do so; and
• the other normal sections, though for a disclaimer the statements about the auditor's responsibilities are changed so that they do not suggest that the audit was an adequate basis for an opinion.

For a disclaimer, the report no longer includes a section on key audit matters. For a qualified or adverse opinion, KAMs may be included but must not suggest that the matter is not a problem. The reasoning for the modification is explained in the basis paragraph, not in a KAM.

Sample qualified opinion wording. In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion section of our report, the accompanying financial statements give a true and fair view of the financial position of ABC Company as at 31 December 20X6 and of its financial performance and cash flows for the year then ended in accordance with IFRS.

Basis for Qualified Opinion: the Company's inventories are carried in the statement of financial position at ₦X. Management has not stated the inventories at the lower of cost and net realisable value but has stated them at cost, which is a departure from IFRS.

The company's records indicate that, had management stated the inventories at the lower of cost and net realisable value, an amount of ₦Y would have been required to write the inventories down. Accordingly, cost of sales would have been increased by ₦Y, and income tax, net income and shareholders' equity would have been reduced by ₦Z.

Emphasis of matter and other matter paragraphs

These paragraphs do not modify the opinion. They are decided by reference to the user.

• An emphasis of matter paragraph refers to a matter that is appropriately presented or disclosed in the statements and that, in the auditor's judgement, is of such importance that it is fundamental to the users' understanding of the statements. Examples are an unusual major litigation, a significant subsequent event, or a major catastrophe that has affected the entity's financial position. It must say that the opinion is not modified in respect of the matter and point to the note.
• An other matter paragraph refers to a matter other than those presented or disclosed in the statements that is relevant to users' understanding of the audit, the auditor's responsibilities or the report. Examples are that the prior year's statements were audited by another auditor, or that the report is restricted in distribution.

Both are placed after the opinion and the basis for opinion, in a separate section with a suitable heading. An auditor does not use an emphasis of matter paragraph in place of a modification when the statements are materially misstated, and does not use it for a material uncertainty on going concern, which has its own section.

Comparing the types of paragraph

Process for deciding the report

1. Accumulate and evaluate misstatements and limits on evidence.
2. Decide whether each matter is material, individually and together.
3. Decide whether it is pervasive.
4. Pick the opinion from the table.
5. Discuss with management and those charged with governance; give management a chance to correct.
6. Draft the basis paragraph and describe the effect.
7. Review the draft with the engagement partner and, where required, the quality reviewer.

Where a modification of the opinion arises in a listed company, the auditor also considers the regulatory consequences: the Financial Reporting Council of Nigeria and the stock exchange may require disclosure and follow-up.

Where the auditor has qualified the report because of a disagreement with directors on a major matter, the auditor also considers whether the matter should be reported to the audit committee and to the members at the annual general meeting.

Worked examples

1. The misstatement is material but confined to one balance.
2. The opinion is qualified: "except for".

1. The effect is material and pervasive.
2. The opinion is adverse.

1. The possible effect is material but confined to inventory, so qualified for the limitation.
2. If the auditor also cannot test receivables and cash, the possible effects become pervasive and a disclaimer follows.

1. The statements are fairly presented, so the opinion is unmodified.
2. An emphasis of matter paragraph may be added.

How to score full marks

• Use the two-by-two table of nature and pervasiveness.
• Apply the facts: material? pervasive? misstatement or limit?
• Draft the opinion and the basis paragraph if asked.
• Separate modifications from emphasis, other matter and KAM paragraphs.

Common mistakes in the exam

• Qualifying where the matter is pervasive.
• Using an emphasis paragraph to cover a material misstatement.
• Giving a disclaimer for a misstatement.
• Leaving out the basis for modification paragraph.

Quick revision

• Misstatement: qualified or adverse. Limit on scope: qualified or disclaimer.
• Pervasive: adverse or disclaimer.
• Basis paragraph is required.
• Emphasis, other matter and KAM do not modify.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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