Why is the audit report important? Essentially, management is responsible for designing an accounting information system that will capture all of its business transactions and compile the financial statements. However, anyone outside the company, such as a current or potential investor or creditor, may be concerned about whether management has put the financial statements together without bias. Could management have intentionally or even unknowingly presented some events more optimistically than is warranted? Absolutely! And, worse, could management have intentionally included some fictitious revenues, omitted some actual expenses, or performed some other accounting trick so that the company’s financial results would appear better than in fact they are? Yes, if management is so inclined. An independent auditor’s report is designed to alleviate that concern and give the public assurance that the financial statements can be relied on. Assurance is a key word: In fact, it is common in the accounting profession to refer to auditing as an assurance service or attest service because the auditors are providing assurance or attesting (vouching for) to the fairness of the presentation of the information on the financial statements.
It is important to understand exactly how much assurance the auditors are providing in regard to the financial statements and to understand what their opinion means. For quite some time there has been a disconnection between what the accounting profession requires of auditors and what many in the general public believe auditors do. This misunderstanding has been referred to as the “expectations gap”. Through this post I attempt to narrow this gap by discussing a few key auditor’s report and audit concepts.
The purpose of the audit report is to give the public confidence that it can rely on the financial statements prepared by management. However, what assurance does the public have that it can rely on what the auditors have to say? To enhance the public’s confidence in the audit report, auditors are required to be independent with respect to the client (the company whose financial statements are being audited). Independence is a critical aspect of auditing. It is so important that if for some reason a public accounting firm discovers during an audit that the firm is not independent with respect to its client, it is required to stop auditing and issue a very short (one sentence) report stating that the public accounting firm is not independent and therefore it cannot and is not issuing any kind of opinion on the financial statements.
To enhance the public’s confidence in its work, the audit report is signed with the name of the public accounting firm that performed it, not with the names of the individual auditors on the engagement team. In other words, the entire firm is standing behind their opinion.
To underscore its independence, the public accounting firm is required to include the word independent in the title of its audit report. The rules for determining whether a firm is or is not independent are fairly complex but are in place essentially to help ensure that auditors are able to conduct their audits in an objective, unbiased, and impartial manner. In fact, the auditing profession defines independence as the ability to conduct an audit in an unbiased and objective manner. This definition does not imply that auditors automatically assume that management is dishonest, but they also should not assume that management is honest; professional skepticism is to be exercised during the conduct of an audit.
To help ensure independence, there are rules forbidding an auditor’s direct financial interest of any amount in a client (even owning one share of stock in a client is prohibited), as well as rules pertaining to the type of employment that an auditor’s dependents and other relatives may have with a client. The accounting profession traditionally has been concerned with auditors being not only independent in fact—truly independent with respect to their clients—but also independent in appearance because perception is as important as reality. Thus, some of the independence rules may appear harsh, but the auditing profession believes the public’s confidence in their work is worth it.
One factor that complicates the issue of independence is the fact that the audit fee is paid by the client to the auditors. Certainly, if the client becomes unhappy with the auditors for any reason, it can terminate the relationship and hire another public accounting firm to conduct the audit. Critics wonder how independent auditors truly can be when the client writes the check. This issue became even more controversial in the late 1990s, when many public accounting firms provided consulting services to their audit clients for large additional fees. For example, the public accounting firm that audited Enron earned millions more a year in consulting revenue than in audit fees. Many people were concerned that this type of relationship could cause auditors to agree with any questionable financial reporting on the part of their audit clients for fear of losing not only the audit fee but also the substantial consulting revenue. Primarily as a result of the numerous widely publicized corporate scandals of the late 1990s and early 2000s, Congress enacted the Sarbanes-Oxley Act of 2002, which greatly limited the types of nonaudit services public accounting firms can offer to their audit clients.
Reasonable Assurance versus Absolute Assurance
An audit report provides reasonable assurance that the financial statements are free of material misstatements, not absolute assurance. In fact the term reasonable assurance must be used in the audit report. However, reasonable assurance is never defined precisely in the professional auditing standards. Auditors understand that the term refers to the fact that audits cannot provide 100 percent guarantees that there are no material misstatements in the financial statements, although this is a concept that the public frequently misunderstands. When auditors have obtained reasonable assurance is a matter left to the auditor’s judgment.
Why do auditors provide reasonable assurance as opposed to absolute assurance? It is impossible for auditors to audit everything to provide such a guarantee. Even if they audited every single transaction throughout the year, which would be impossible in terms of time and cost, auditors could not know definitely whether there were unrecorded transactions that remained undetected. Thus, it is economically not feasible and impractical to expect auditors to look at everything: they cannot provide absolute assurance about financial statements.
Material Misstatements in Financial Statements
For all practical purposes, auditors cannot be held responsible for finding every misstatement of any amount in the financial statements.
Would it really matter to most financial statement readers if the company’s inventory was overstated by $1? $10? $100? At some point, it will matter because the misstatement could cause reasonable financial statement users to make decisions different from what they would have decided if the misstatement had not existed. It is at that point that misstatements are considered to be material.
Materiality varies from company to company. For example, overstating inventory by $10,000 may be material for a small business owner. However, when Lie-Mart presents its ? nancial statements in millions of dollars, the $33,685 inventory amount appearing on its January 31, 2007, balance sheet is actually $33,685,000,000 (or nearly $34 billion), a $10,000 overstatement of inventory surely is immaterial.
Because materiality will vary from company to company and even from year to year for a specific company, it is not defined in terms of dollars or percentages throughout the professional auditing standards. Once again, like reasonable assurance, materiality is a decision left to the auditors’ judgment. Also, like reasonable assurance, the word material is required by professional auditing standards to be in the auditors’ report.
With these basic auditing concepts in mind, let’s look at a standard audit report example below:
Financial Statements as of January 31, 2010
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholder’s, Lie-Mart Stores, Inc.
We have audited the accompanying consolidated balance sheets of Lie-Mart Stores, Inc., as of January 31, 2010, and 2009, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended January 31, 2007. These financial statements are the responsibility of the 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 the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable 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 fairly, in all material respects, the consolidated financial position of Lie-Mart Stores, Inc., at January 31, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended January 31, 2007, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 13 to the consolidated financial statements, effective January 31, 2007, the Company adopted Statement of Financial Accounting Standards No. 158, Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Lie-Mart Stores, Inc.’s internal control over financial reporting as of January 31, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 26, 2007, expressed an unqualified opinion thereon.
Dharma & Putra LLP (signed)
March 26, 2010
The audit report contains quite a bit of information. The professional auditing standards require fairly uniform wording, however, so that financial statement readers can assess the type of opinion being given without getting bogged down in variations in terminology and phrasing.
- The above example that the terms we discussed above—independent, reasonable assurance, and material—are all present.
- The audit opinion is signed with the public accounting firm’s name, not the names of the individual auditors who worked on the engagement, because the entire firm is standing behind the opinion.
The opinion shown above is called an “unqualified audit opinion“, and it is the best opinion the auditors can give. Often, this is referred to as a “clean opinion“. What the auditors are saying is that the financial statements, in their opinion, follow generally accepted accounting principles (GAAP) in all material respects. The auditors are giving this opinion without any qualifications. That is why the opinion is given the name unqualified. A qualification is a discovery by the auditors of some kind of problem; we’ll explain that shortly.
To determine whether a company received this best opinion, look for the paragraph that begins with “In our opinion…” and determine whether the auditors are stating that without any exceptions the financial statements “present fairly, in all material respects”.
Types of Auditor’s Opinion
. Type of Audit Opinion: Unqualified
Key Phrase(s): In our opinion, present fairly, in all material respects
Translation: Best opinion
. Type of Audit Opinion: Qualified
Key Phrase(s): In our opinion, except for, present fairly, in all material respects
Translation: There’s a problem (which the auditors will explain) with some aspect of the financial statements, but other than that, the financial statements as a whole are presented fairly. It is up to the reader to decide if the problem identified by the auditors affects the usefulness of the financial statements.
. Type of Audit Opinion: Adverse
Key Phrase(s): In our opinion, do not present fairly in all material respects
Translation: Worst opinion: The auditors are telling the readers they cannot rely on these financial statements.
. Type of Audit Opinion: Disclaimer
Key Phrase(s): We cannot and do not express an opinion
Translation: The auditors cannot give any opinion because of some very serious limitation on their work, either client-imposed or due to circumstances beyond anyone’s control (such as the fact that the accounting system is in terrible disarray) or because the auditors lack independence (rare).
Note: We will overview each of the auditor’s opinion later in this post. Read on…
The vast majority of audits of public companies result in this best opinion. If the auditors have found a significant misstatement in the financial statements, they will discuss it with management and the company will have an opportunity to adjust the books to the auditor’s satisfaction. In almost all cases, management will opt to do this so that it can acquire the best opinion. Why does management strongly prefer to receive an unqualified opinion? Because anything less can affect the reputation of the company adversely and consequently decrease the company’s stock price.
The Lie-Mart audit opinion contains the opinion paragraph as the third paragraph. Sometimes public accounting firms begin the report with the opinion because of its importance. However, the key phrases you are looking for do not vary regardless of the placement of the opinion paragraph.
Modifications to the Standard Audit Report
In a few circumstances, auditors may give an unqualified opinion but add an extra paragraph to the report. For example, auditors are required to add an extra paragraph after the opinion paragraph if the company did not apply the same generally accepted accounting principles consistently from last year to this year. Also, auditors must add an extra paragraph after the opinion paragraph if they have serious doubt about the company’s ability to continue as a going concern for a period of up to one year past the balance sheet date. Auditors also are allowed to add an extra paragraph to emphasize any matter they wish, but that choice is always at the discretion of the auditor.
Auditing standards require the addition of a consistency paragraph to indicate to the readers that if the financial statements are different this year (for example, either a higher or lower net income than last year), it could be because the use of accounting principles differed between the two years. In other words, the financial statements may not be directly comparable. However, this does not imply that the company is engaged in anything improper. Companies are allowed to switch from one generally accepted accounting principle (GAAP) to another as long as the change, its effects, and management’s justification for the change are disclosed.
Further, when the accounting profession issues a new standard that changes the way certain types of transactions previously were accounted for and requires that all companies follow the new standard, consistency comes into play and the auditors must include the additional paragraph again.
Because the accounting profession frequently issues new accounting pronouncements, auditors often include consistency paragraphs in their reports.
I have discussed the going concern assumption and explained that accounting methods are based on the assumption that the business will remain in existence indefinitely unless there is evidence to the contrary. Auditors cannot predict the future any better than the average person can, but they are required under auditing standards to add a going concern paragraph to an audit opinion if they uncovered evidence during the audit that gives them “substantial doubt” about the company’s ability to continue as a going concern for a period of up to one year beyond the balance sheet date. The content of the paragraph is up to the auditor’s judgment, but the two terms substantial doubt and going concern must be included.
The opinion on the historical financial statements still can be unqualified (the best opinion) because the financial statements relate to the past and the opinion states whether they are presented in conformity with GAAP. The auditor will refer the financial statement readers to the financial statement footnote (prepared by management) that discusses the circumstances that have given rise to the going concern issue as well as its plans to mitigate those circumstances. However, the absence of a going concern paragraph is never a guarantee from the auditors that the company will be in existence for a year beyond the balance sheet date.
Types of Auditor’s Opinion
Auditors have the option to add an extra paragraph after the opinion to stress any matter they believe should be emphasized. The professional auditing standards provide only a handful of examples of cases in which auditors may choose to exercise this option, for example, when the company has experienced an unusually important event subsequent to the date of the financial statements.
Thus, it is important to read the entire auditors’ opinion, not just the key phrases in the opinion sentence.
Auditor’s Opinion Type-1: Unqualified Opinion
Unqualified opinion has been discussed on the example. So, I don’t
Auditor’s Opinion Type-2: Qualified Opinion
When the auditors give a “qualified opinion“, the words except for will be included in the opinion sentence. The auditor is stating that except for the effects of either not following GAAP or not being able to perform a key auditing procedure, the financial statements are presented fairly in all material respects. The auditors will include an extra paragraph—termed an explanatory paragraph—before the opinion paragraph to explain to the readers why they believe the ? nancial statements have not been presented completely fairly.
A qualified opinion results from either a material (significant) departure from GAAP or a material limitation in the auditors’ ability to conduct the audit in accordance with professional auditing standards. For example, auditors generally are required to observe the client’s physical inventory count. If a company conducts its inventory count at the end of its fiscal year, for example, on December 31, and for some reason doesn’t hire the auditors until later, say, mid-January, it is not possible for the auditors to observe the count and comply with the auditing standards. If the auditors cannot satisfy themselves about the ending inventory balance (assuming it is material) through any alternative auditing procedures, there is a limitation on the scope of their audit and they must qualify their opinion.
Is a qualified opinion useful? Yes, but it’s not as good as an unqualified opinion, and so management generally prefers not to receive a qualified opinion. The auditors are stating that except for the item they have explained, the financial statements have been presented fairly in all material respects. It’s up to the readers to decide whether the qualification is important to them and whether they can use the financial statements for their decision-making purposes.
Auditor’s Opinion Type-3: Adverse Opinion
An “adverse opinion“, as the name implies, is the worst audit opinion that can be given. The auditors are stating that the financial statements are not presented fairly in all material respects, not even a portion of them. This is a strong statement coming from auditors, and it essentially means that the auditors are telling the readers that they cannot rely on the financial statements for their decision-making purposes.
Adverse opinions rarely are given because management does not want them for obvious reasons and will work closely with the auditors to make any adjustments the auditors consider necessary to avoid an adverse opinion. As with a qualified opinion, if the auditors are giving an adverse opinion, there will be at least one explanatory paragraph before the opinion paragraph explaining to the readers why the auditors have come to this conclusion.
Auditor’s Opinion Type-4: Disclaimer of Opinion
A “disclaimer of opinion“ is no opinion. Disclaimers are given, as explained earlier in this post, when the auditors discover that they are not independent with respect to the client. This discovery should happen rarely because before the acceptance of the audit engagement, the auditors should have investigated and determined the status of their independence diligently.
A disclaimer also is given when there is a highly material (very significant) limitation on the scope of the audit, in other words, when the auditors are unable for some reason to perform some essential audit procedure or procedures and are unable to satisfy themselves about the account balance or balances through any alternative auditing procedures. A disclaimer does not result from the auditors’ knowledge that the financial statements are materially misstated; instead, the auditors are unable to form an opinion because of a lack of knowledge that results from their inability to perform one or more essential audit procedures.
Management’s Responsibilities Vs. Auditor’s Responsibilities
The audit report makes it clear that the financial statements, including the footnotes, are management’s responsibility. The auditors are not responsible for preparing the financial statements or for any aspect of capturing the accounting data throughout the year that eventually generate the account balances reported on the financial statements. Instead, the auditors’ responsibility is to express an opinion that is based on the audit work.
Auditor’s Report on Internal Control Over Financial Reporting
Before the effective date of the Sarbanes-Oxley Act of 2002 (SOX), audit reports were somewhat shorter than they are today. In response to the numerous corporate scandals that occurred shortly before the act was passed (e.g., Enron), Section 404 of SOX requires that auditors also provide an opinion on the effectiveness of public companie’s internal control over financial reporting. The logic behind this requirement is essentially that if a public company has effective internal controls over financial reporting, there is a reduced risk of fraudulently misstated financial statements being published and relied on by the investing public.
Internal controls are processes and procedures that management puts in place to help ensure the accuracy of financial reporting as well as to safeguard assets and records and to help ensure compliance with all applicable laws and regulations. Controls are designed to help prevent, detect, and correct any errors (or fraud) that might occur. An example of an internal control is that somebody who has no cash handling or recording responsibilities should reconcile the monthly bank statement with the records to help ensure that there are no mistakes in recording cash. If this responsibility was assigned to someone who also handled cash and recorded cash transactions, it could be a simple matter to steal some cash and then cover up the theft by juggling the books and fudging the bank reconciliation.
Auditors of public companies now are required to perform enough additional audit work to allow them to express an opinion on the effectiveness of the company’s internal controls over ? nancial reporting as of the fiscal year end. Management is required to assess the effectiveness of those controls and report their assessment.
For the first several years after passage of the SOX Act, auditors also were required to express an opinion on management’s assessment. Thus, if the auditors issued a combined report, there were three opinions stated throughout the report:
- An opinion on whether the financial statements are presented fairly in all material respects, in accordance with GAAP.
- An opinion on whether management’s assessment of the effectiveness of the company’s internal controls over financial reporting as of the fiscal year end is fairly stated in all material respects, based on criteria related to internal controls that were developed by the accounting profession.
- An opinion on whether the company maintained in all material respects effective internal control over financial reporting as of the fiscal year end, based on the same criteria used for management’s assessment.
As of late 2007, however, the Public Company Accounting Oversight Board eliminated the requirement for auditors to give the second opinion listed above (the opinion on whether management’s internal control assessment was fairly stated). Management still must give its assessment, and the auditors still give their own opinion on the effectiveness of the internal controls (as well as on the financial statements themselves), but the additional opinion by the auditors on management’s internal control assessment no longer is considered necessary. However, the phrases we have discussed: “present fairly”, “except for”, or “do not present fairly” still will be present in regard to the opinion on the financial statements.