CHAPTER 11

Audit Reports and Communication

Introduction

In this chapter we focus on the following with particular emphasis on differences (when differences exist) between International Standards on Auditing (ISA) and the standards set by Public Company Accounting Oversight Board (PCAOB):

  • What is the purpose of an auditor’s report?
  • What items should go into an auditor’s report?
  • What uncertainties should lead to a qualification of audit opinions?
  • When should the auditor issue a modified opinion as opposed to an unmodified opinion?
  • If and when should auditors communicate with those charged with corporate governance?
  • What criteria go into deciding on whether an audit report should be modified (by the United States) or qualified (internationally)?
  • What are subsequent events and how are auditors in the United States and internationally required to deal with them?

    Are there fundamental differences, and are these differences significant?

  • In the presence of going concern uncertainties, what are the requirements of ISA for testing and reporting and how does this differ from the PCAOB standards?

In this chapter, wherever differences between the ISA on the one hand and PCAOB on the other exist, we discuss those differences and the implications of these differences for auditors and regulators. Please note that, whereas ISA discusses this in ISA 570 Going Concern and the main relevant discussion for the PCAOB is in AU 341 entitled The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, other relevant PCAOB AUs are discussed for comparison at appropriate junctures of this chapter.

Background

The audit report is the final product of the audit. ISA 200 states that the objective of an audit of financial statements is to enable the auditor to express an opinion as to whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework. The wording of the auditor’s report is standard unless required by law or regulation to use different wording. The key words require that the financial statements give a true and fair view or are presented fairly, in all material respects. ISA 200 (paragraphs 37 and 38) describes the auditor’s responsibility to determine whether the financial reporting framework adopted by the management in preparing the financial statements is acceptable.

We now focus on the United States. Marden, Edwards, and Stout (2003) note that until 2002 corporate officers of publicly traded companies in the United States were not penalized for misstated financial statements unless fraud could be proven. This is because, prior to 2002, the law had no teeth. By fraud it is meant that the officers deliberately misstated. The U.S. Congress enacted the Sarbanes Oxley Act of 2002 (SOX) in response to a number of highly publicized business failures and allegations of corporate improprieties. Now corporate financial officers can face significant penalties if they certify that the company’s books are accurate when they are not. The executives could face up to a five-year prison sentence, fines, and other disciplinary action such as civil and criminal litigation. SOX (section 404) requires the management to acknowledge its responsibility for establishing and maintaining adequate internal controls, including asserting their effectiveness in writing. The auditor, in turn, must report on the management’s assertion about the effectiveness of its internal controls as of the company’s year end. SOX (section 302) requires that the chief executive officer or the equivalent and the principal financial officer or the equivalent certify, in each quarterly and annual report submitted to the U.S. Securities and Exchange Commission, the following (section 302 of SOX):

  • The signing officer has reviewed the report;
  • The report does not contain any untrue statement of a material fact or omit to state a material fact;
  • The financial statements, and other financial information, fairly present, in all material respects the financial condition of the company;
  • The signing officers are (1) responsible for establishing and maintaining internal controls, (2) have evaluated the effectiveness of the company’s internal controls, and (3) have presented in their report their conclusions about the effectiveness of their internal controls based on the evaluation of the controls that they are required to make under SOX;
  • The signing officers have disclosed to the company’s auditors and the audit committee of the board of directors, the following: (1) all significant deficiencies in the design or operation of internal controls which could adversely affect the company’s ability to record, process, summarize and report financial data, (2) have identified for the company’s auditors any material weaknesses in internal controls, and (3) any fraud, whether or not material, that involves the management or employees who have a significant role in the company’s internal controls;
  • The signing officers have indicated in the report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their internal control evaluation.

In essence, SOX has caused big changes for both auditors and the companies they audit. We note that auditors of public companies are now required to certify a company’s internal controls. From the management’s point of view, a key result involves much greater auditing costs. Under the American Institute of Certified Public Accountants (AICPA) auditing standards, however, the auditors are not required to report on internal controls. They are, however, required to understand the internal control system—as discussed in an earlier chapter—and use that understanding in developing and implementing the audit program for nonpublic company clients.

Key Elements in an Auditor’s Report

The audit report is the key outcome of the audit process, described earlier in this book. The report provides information as to the responsibility for the underlying financial reporting process and the statements and provides very general information of use in understanding the auditor’s procedures in generating the evidence that results in a particular type of report. The audit reports described here are those currently required by the ISA and the PCAOB. We present these but note that the AICPA, the IAASB, and the PCAOB are all looking at changing the auditor’s report to be more explanatory.

We now discuss the basic elements of an auditor’s report.

Paragraphs 18 to 60 of ISA 700 The Independent Auditor’s Report on a Complete Set of Financial Statements contains the basic elements of the auditor’s report, which include the following:

  • Title
  • Addressee
  • Introductory paragraph
    • Management’s responsibility for the financial statements
    • Auditor’s responsibility
  • Scope paragraph
  • Auditor’s opinion
  • Other matters
  • Other reporting responsibilities
  • Auditor’s signature
  • Date of the auditor’s report
  • Auditor’s address

These will be considered individually.

Title

Paragraph 18 of ISA 700 notes that the auditor’s report should have a title that clearly indicates that it is the report of an independent auditor. The most frequently used title is “Independent auditor” or “Auditor’s Report” in the title to distinguish the auditor’s report from reports that might be issued by others.

Addressee

Paragraph 20 of ISA 700 states that the auditor’s report should be addressed to those charged with governance of the entity whose financial statements are being audited. Hence, the report is addressed to either the shareholders or the supervisory board or the board of directors of the entity whose financial statements are being audited. The PCAOB has a similar requirement (paragraph 8), based on typical U.S. corporate governance setups. With respect to the ISA, such corporate governance setups will vary by country, as will the legal requirements for including an addressee as well. In some countries, such as the Netherlands, auditor’s reports are not addressed at all because the reports are meant to be used by (the anonymous) public at large.

Next we delve further into the auditor’s opinion. First we discuss the structure of the audit opinion, paragraph-by-required-paragraph. Then we expand on certain critical matters relevant to these individual paragraphs.

Introductory Paragraph

Paragraph 22 of ISA 700 states that the introductory paragraph in the auditor’s report should identify the entity whose financial statements have been audited and should state that the financial statements have been audited. The introductory paragraph should also:

  • identify the title of each of the financial statements that comprise the complete set of financial statements;
  • refer to the summary of significant accounting policies and other explanatory notes; and
  • specify the date and period covered by the financial statements.

There are certain requirements in the ISA that are not in the PCAOB’s AU 341. ISA 700 states that financial statements should be prepared in a compliance framework (also known as rules-based framework). The PCAOB standards require that financial reporting frameworks used in the United States should be prepared in accordance with a fair presentation framework. What is the difference and why is it important?

A compliance framework requires compliance with the provisions of the framework. That is, strict obedience to the instructions is required. The preparers of financial statements have no choice but to follow the requirements of the framework. The compliance framework does not allow any room for flexibility. PCAOB standards do not include any references to compliance frameworks because the PCAOB believes that all financial reporting frameworks used in the United States should be fair presentation frameworks. Hence AU 508 (paragraphs 3 and 4) requires preparation in accordance with a fair presentation framework. A fair presentation framework is based on a different philosophy.

A fair presentation framework requires compliance but it allows for alternatives if such alternatives help achieve better presentation of financial statements, that is financial statements that are more relevant and reliable. (This holds even if the management has to make additions or go against the requirements of the framework.) Accordingly, under PCAOB AU 341 and U.S. financial accounting rules (called in the U.S. Generally Accepted Accounting Principles [GAAP]), the management has to provide more relevant financial information but allows for alternatives if the management can justify such alternatives. Having more heavily judgmental accounting principles, such as those that prevail in the European Union, may provide a greater shield against legal liability than more thoroughly detailed accounting standards such as those which apply in the United States. For the interested reader, we provide a full discussion of fair presentation and compliance frameworks in the appendix.

We note that paragraph 7 of ISA 700 provides definitions of compliance frameworks and also of fair presentation frameworks. The reader has to be alert to notice the difference; otherwise there is an assumption that the PCAOB does not have a definition.

The introductory paragraph should include a statement that the financial statements are the responsibility of the entity’s management. The preparation of these statements requires the management to make significant accounting estimates and judgments as well as to determine the appropriate accounting principles and methods used when preparing the statements. The introductory paragraph is also required to refer to the summary of significant accounting policies and other explanatory information. The introductory paragraph should also have a statement that the responsibility of the auditor is to express an opinion on the financial statements based on the audit.

We now provide an illustration of an ISA opening (introductory) paragraph:

We have audited the accompanying balance sheet of XYZ Company as of December 31, 2013, and the related statements of income and cash flows for the year then ended. 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 audit.

At this juncture, we discuss other paragraphs that are important.

Scope Paragraph

Scope refers to the auditor’s ability to perform audit procedures deemed necessary in the circumstances. The scope paragraph is a factual statement of what an auditor did in the audit. Basically, the purpose of the scope paragraph is to provide the reader assurance that the audit has been carried out in accordance with established standards or practices for such engagements. It is required that the scope paragraph include a statement that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement and that the audit provides a reasonable basis for the opinions. Hayes et al. (2005) notes that the use of the above phrases serves to convey a signal that while the audit provides a high level of assurance, it is not a guarantee.

We provide an illustration of an ISA scope paragraph.

We conducted our audit in accordance with International Standards on Auditing (or refer to relevant national standards or practices). 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 audit provides a reasonable basis for our opinion.

If the company is traded on a U.S. stock exchange, there is another difference between PCAOB standards and ISA. PCAOB’s Auditing Standard (AS) No 1 References in Auditors’ Reports to the Standards of the Public Company Accounting Oversight Board requires that the audit report must refer to the standards of the PCAOB instead of United States generally accepted accounting standards or standards generally accepted in the United States wherever AS 1 has expressed views. This is emphasized in paragraph 1 of AS No. 1. This states that the SOX authorized the PCAOB to establish auditing and related professional standards to be used by registered public accounting firms.

Opinion Paragraph

The opinion paragraph of the auditor’s report should clearly indicate the financial reporting framework used to prepare the financial statements. It should state the auditor’s opinion as to whether the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the financial reporting framework and where appropriate, whether the financial statements comply with statutory requirements. The special terms used—give a true and fair view or present fairly, in all material respects—are considered equivalent by many. Both terms indicate, amongst others, that the auditor considers only those matters that are material to the financial statements. The ISA 200, for example, considers the terms equivalent and the PCAOB uses the term present fairly. For our purposes, we will consider them equivalent. An illustration of an opinion paragraph is as follows:

In our opinion, the financial statements give a true and fair view of (or present fairly, in all material respects) the financial position of the Company as of “December 31, 2015,” and of the results of its operations and its cash flows for the year then ended in accordance with International Financial Reporting Standards (or title of a financial reporting framework with reference to the country of origin).

Here we note some differences between the ISA and the PCAOB standards. ISA 700 discusses the preparation of financial statements that give a true and fair view (or present fairly in all material respects) in the auditor’s opinion. The Auditing Standards Board (ASB) originally and now the PCAOB (in AU 508) do not include any references to a true and fair view. The AICPA, in a report it published on the differences in wording (aicpa.org/FRC), notes that this could be because such wording has not historically been used in the United States.

The PCAOB recommends a continuation of using the words present fairly in all material respects in the auditor’s opinion. The ASB, according to the AICPA report, believes that this difference in wording does not result in a difference in the application of ISAs (internationally) or PCAOB (United States).

Finally, we note that we did not note any differences between the wordings of qualified and adverse opinions in the ISA and the PCAOB and, hence, do not discuss these here.

Other Matters Paragraph

This does not appear to be in ISA. It is unique to PCAOB and, prior to that, to AICPA standards. Hence, it is an important difference. What happens when a company is issued audit opinions in previous period(s) by predecessor auditors with which the current auditor does not agree? PCAOB’s AU 508 provides requirements on how to approach this. It is basically guidance on how to address the situation when an auditor’s opinion on prior period financial statements differs from an audit opinion previously expressed by a predecessor auditor. PCAOB’s AU 508 requires this be included in an other matter paragraph. A similar situation could arise if the prior period financial statements were not audited. Paragraphs 56 and 57 basically provide guidance to the auditor by requiring the auditor to disclose this also in an other matter paragraph. There appears to be no reference to this situation in the ISA based on our reading of ISA 700. ISA 710 entitled Comparatives also does not discuss this issue or any requirements the auditor should adhere to. PCAOB feels this is appropriate for the U.S. environment, and the relevant PCAOB standard is AU 508. Having described the order of paragraphs within the audit report, we next go further into discussing important issues that affect the responsibility for the financial statements themselves and the auditor’s responsibility with respect to, but not for, the financial statements.

Manager’s Responsibility for the Financial Statements Paragraph

Paragraph 26 of ISA 700 requires the auditor’s report to state that management is responsible for the preparation and fair presentation of financial statements in accordance with the applicable financial reporting framework. The management is also responsible for implementing such internal controls as it determines are necessary to enable the preparation of financial statements that are free from material misstatement (whether due to fraud or error). However section 700 of ASB requires the auditor’s report to state that the management’s responsibility includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of the financial statements. The PCAOB, following SOX, also holds the management responsible for the financial statements and for maintaining and performing annual evaluations of its own internal control system. In the earlier chapter on internal controls, we noted that internal control audits and, therefore, internal control reports are required for PCAOB audits (as per AS 5) but not for audits conducted under AICPA or ISA standards. Under these latter two sets of standards, the auditor is required to gain an understanding of internal controls but need not test the controls and issue a report on them.

Paragraph 24 of ISA 700 requires the report to use a term that is “appropriate in the context of the legal framework in the relevant jurisdiction” when the auditor’s report discusses the management’s responsibilities. Here there is a difference. The PCAOB’s AU 508 does not include this requirement. The ASB may have proceeded on the basis that this paragraph related to jurisdictions where the corporate law is different relative to the United States as per an AICPA report (refer aicpa.org). We assume this view is also held by the PCAOB, as they brought this under their aegis without change.

There are other issues that we feel should be addressed. These relate to requirements in PCAOB standards and not in the ISA. PCAOB AU 508 adds a requirement that the description in the auditor’s report of the management’s responsibilities for the financial statements should not be referenced to a separate statement by the management about such responsibilities (Appendix footnotes section, footnote 4). This is not in the ISA standard. PCAOB’s AS 3 states that the term sufficient appropriate audit evidence implies that the audit documentation has been reviewed and that it is possible to come to an appropriate opinion on the financial statements (or, for an internal control audit, the internal controls). ISA 700 does not contain these requirements. The PCAOB standard, and the related ASB standard, make explicit the responsibility of the auditor to both collect and come to a decision on the audit outcomes. Making this explicit may result in less chance of auditor error or oversight. The ISA 700, however, does not make these responsibilities explicit, perhaps on the assumption that auditors would naturally both collect enough evidence and carefully evaluate it. We refrain from drawing other conclusions as to why the sets of standards differ on what seems to us to be a key part of the audit.

Auditor’s Responsibility

Auditor’s Responsibility With Respect to Compliance With Ethical Requirements. Paragraph 32 of ISA 700 requires the auditor’s report to state that the responsibility of the auditor is to express an opinion on the financial statements based on the audit. The auditor’s report should state that the auditor’s report was conducted in accordance with international (or PCAOB if applicable in the United States) standards on auditing. The auditor’s report should say that the standards require that the auditor comply with ethical requirements (paragraph 30) and that the auditor plans and performs the audit to obtain reasonable assurance whether the financial statements are free from material misstatement.

There is a difference here. While paragraph 30 of ISA 700 requires the auditor’s report to include in the Auditor’s Responsibilities section a statement that the auditing standards require that the auditor should comply with ethical requirements, PCAOB’s AU 508 does not contain this requirement. This could be because, in the United States, auditors must comply with the ethical standards contained in the AICPA Code of Professional Conduct. The PCAOB may have proceeded on the basis that the title indicating that it is the report of an independent auditor affirms that the auditor has met the ethical requirements, and, therefore need not make an additional reference in the auditor’s report.

Auditor’s Responsibility With Respect to Supplementary Information. Paragraph 46 of ISA 700 contains requirements when supplementary information that is not required by the applicable financial reporting framework is presented with the audited financial statements. If such supplementary information is not clearly differentiated from the audited financial statements, ISA 700 requires the auditor to ask the management to change how the unaudited supplementary information is presented, and if the management refuses to do so, the auditor should explain in the auditor’s report that such supplementary information has not been audited. An example of supplementary information that may be required in certain jurisdictions is adequacy of accounting records. The auditor should express an opinion in a different paragraph following the auditor’s opinion. The auditor is required to differentiate and address these separately to clearly distinguish them from the auditor’s responsibilities for, and opinion on, the financial statements. In the United States, PCAOB AU 558 entitled Required Supplementary Information (paragraph 6) addresses the auditor’s responsibility when engaged to report on supplementary information, which is in addition to the regular audit report. (Required supplementary information differs from other types of information because, according to paragraph 6 of AU 558, the Financial Accounting Standards Board [FASB] considers the information an essential part of the financial reporting of certain entities. Accordingly, the auditor should apply certain limited procedures to required supplementary information and report deficiencies in the information or omission of such information. We do not notice this discussion in the ISA.) In conducting the financial statement audit, the auditor also has the responsibility of ascertaining whether any of the information in the annual report contradicts the audited financial information. At the present time, no ISA exist that correspond to AU 558. The PCAOB’s AU 558 does not include the requirement for the auditor to ask the management to change how the unaudited supplementary information is presented when the supplementary information is not clearly differentiated from the audited financial statements.

Auditor’s Responsibility With Respect to Audit Description. The auditor’s responsibility is also to describe the audit by stating in the audit opinion that:

  • an audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements;
  • the procedures selected depend on the auditor’s judgment including the assessment of risks of material misstatement of the financial statements, whether due to fraud or error; and
  • an audit also includes evaluating the appropriateness of the accounting policies used, the reasonableness of accounting estimates made by the management as well as the overall presentation of the financial statements.

There does not appear to be any difference with respect to ISA versus PCAOB, hence there is no further discussion here.

Auditor’s Opinion

An auditor can give different types of opinions. Paragraph 39 of ISA 700 states that an auditor can express an unqualified opinion if the auditor concludes that the financial statements give a true and fair view or are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. There does not appear to be any difference between ISA and PCAOB here. We will discuss the types of auditor opinion possible further below.

Other Reporting Responsibilities

In some international jurisdictions, the auditor may have additional responsibilities to report. For example, the auditor may be asked to report certain matters if they come to the auditor’s attention during the course of an audit. Alternatively, the auditor may be asked to perform and report on additional specified procedures or to express an opinion on specific matters such as the adequacy of accounting books and records. Auditing standards in the specific jurisdiction or country often provide guidance on the auditor’s responsibilities with respect to specific additional reporting responsibilities in the jurisdiction or country. This has been stated before but is worth repeating. Paragraph 24 of ISA 700 requires the report to use a term that is “appropriate in the context of the legal framework in the relevant jurisdiction” when the auditor’s report discusses management’s responsibilities. Here there is a difference. PCAOB AU 534 Reporting on Financial Statements Prepared for Use in Other Countries does not include this requirement. The ISAs have been adopted by over 100 nations and have been customized by different nations to fit their different national laws and corporate regulatory frameworks. The PCAOB standards, however, are only used within one nation, the United States and, therefore, do not need to confer flexibility on the auditor to respond to other, non-U.S. jurisdictional requirements. Paragraph 43 of ISA 700 discusses the auditor’s report prescribed by law or regulation. In the United States, PCAOB AU 534 does not contain this section. ISA 710 addresses reporting in other jurisdictions that are different to the United States, including requirements that are not covered by the auditor’s report. For example, if the prior period financial statements have been revised and reissued with a new auditor’s report, the auditor should obtain sufficient audit evidence that the corresponding figures agree with the revised financial statements. This is addressed in a separate section.

Auditor’s Signature

The auditor’s report should be signed. However, there is currently an unresolved controversy both in the United States and separately in the EU as to whether the partner’s name or just the firm name should be used. Because the issue is unresolved, we add no further discussion here.

Date of the Auditor’s Report

This is covered in paragraph 52 of ISA 700. The auditor should date the report on the financial statements no earlier than the date on which the auditor obtained sufficient appropriate audit evidence on which they base their opinion on the financial statements. ISA 700 states that sufficient appropriate audit evidence should include evidence that the entity’s complete set of financial statements have been prepared and that those with the responsibility for doing so have asserted that they have taken responsibility for them.

The date of the auditor’s report informs the reader that the auditor has considered the effect of events and transactions of which the auditor became aware and that occurred up to the auditor’s report date. The auditor’s report also includes the party addressed by the report, consistent with the standard for reporting. The auditor’s responsibility for events and transactions between yearend and the auditor’s report date is addressed in ISA 560 “Subsequent Events.” If the auditor perceives that there are problems, then the auditor may not be in a position to provide an unqualified opinion.

Types of Auditor’s Reports

There are four types of reports that can be given by an auditor. These are:

  • Standard unmodified opinion
  • Qualified opinion
  • Disclaimer of opinion
  • Adverse opinion

Standard Unmodified Opinion

The auditor should give a standard unmodified opinion when the auditor feels that the financial statements give a true and fair view (or present fairly in all material respects). To give a standard unqualified opinion, the auditor must be satisfied with respect to the following, namely:

  • The financial information has been prepared using acceptable accounting policies, which have been consistently applied.
  • The financial information complies with relevant regulations and statutory requirements.
  • The view presented by the financial information as a whole is consistent with the auditor’s knowledge of the business of the entity.
  • There is adequate disclosure of all material matters relevant to the proper presentation of the financial statements.

An auditor may not be able to express an unmodified opinion when either of the following circumstances exists and, in the auditor’s judgment, is material to the financial statements:

  • There is a limitation on the scope of the auditor’s work.
  • There is a disagreement with management regarding the acceptability of the accounting policies selected, the method of their application, or the adequacy of financial statement disclosures.

An auditor’s report which represents a standard unmodified opinion is also required to state that any changes in accounting principles or in the method of their application and their effects have been properly determined and disclosed in the financial statements.

Qualified Opinion

A qualified opinion should be expressed when the auditor concludes that an unmodified opinion cannot be expressed and that the effect of any disagreement with management that causes the auditor to issue a qualified opinion is material. A qualified opinion is expressed as fairly presenting the financial statement followed by except for, which clause is, in turn, followed by a discussion of the exceptions.

Disclaimer of Opinion

A disclaimer of opinion should be expressed when the possible effect of a limitation on the scope of the audit is considered so material and pervasive that the auditor is not able to obtain sufficient appropriate audit evidence and, accordingly, is unable to express an opinion on the financial statements. Paragraph 18 of ISA 701 requires that the auditor’s report should describe the limitation and indicate the possible adjustments to the financial statements that might have been determined to be necessary had the limitation not existed.

ISA 705, paragraphs 9 and 10, requires the auditor to disclaim an opinion in certain circumstances. This could be when the auditor concludes that it is not possible to form an opinion on the financial statements. This could be due to a number of factors including, but not limited to, interaction of a number of uncertainties and their possible cumulative effect on the financial statements. In the United States, PCAOB AU 508 does not include this requirement; this is based on the ASB’s initially and now PCAOB’s view that a disclaimer of opinion is appropriate only when the auditor is not able to obtain sufficient appropriate audit evidence. The PCAOB could presume that the guidance in paragraph 30 of PCAOB’s AU 508 entitled Reports on Audited Financial Statements, as amended, is appropriate in these circumstances. PCAOB AU 508 includes this guidance. There is also another difference. Paragraph 13(b) (1) of ISA 705 requires the auditor to withdraw from the audit when the auditor is unable to obtain sufficient appropriate audit evidence, and the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive with the result that a qualification of the opinion would be inadequate to communicate the gravity of the situation. We reviewed PCAOBs AS numbers 1 to 17 and other PCAOB’s AU standards and find no reference to the discussion of situations requiring auditors to withdraw from an audit. The paragraph 13b of ISA 705 states as follows:

If the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive so that a qualification of the opinion would be inadequate to communicate the gravity of the situation, the auditor shall

  1. Withdraw from the audit, where practicable and possible under applicable law or regulation or
  2. If withdrawal from the audit before issuing the auditor’s report is not practicable or possible, disclaim an opinion on the financial statements.

Hence, we conclude that this is a major difference between PCAOB and ISA. However, we note that PCAOB AU 561, Subsequent Discovery of Facts Existing at the Date of the Auditor’s Report, changes this requirement so that the auditor should only consider withdrawal from the engagement under such circumstances. Paragraph 4 of AU 561 states that “when the auditor becomes aware of information which relates to financial statements reported on by him but not known to him at the date of his report, and which is of such a nature that the auditor would have investigated it had it come to the auditor’s attention during the course of the audit the auditor should, as soon as practicable undertake to determine whether the information is reliable and whether the facts existed at the date of his report. In this connection, the auditor should discuss the matter with his client and whatever management levels the auditor deems appropriate, . . . .” As can be seen, there is no reference to withdrawing from the audit. The ASB initially, and now PCAOB, apparently presumes that, in the United States, the auditor should not be required to withdraw from an engagement but, rather, should consider whether to withdraw or disclaim an opinion.

An example which could also justify a disclaimer of opinion could be limitation of scope. For our immediate purposes, a scope limitation might include a refusal by client management to allow the auditor to audit some portion of the client entity’s assets. In the United States, auditing standards allow an auditor to accept an audit knowing that a limitation of scope exists and then provide a qualified audit report noting that the financial statements are presented fairly except for the limitation in scope. However, we note an important point: namely, the United States is significantly different from most European countries. In most European countries, the auditor would not be allowed to accept an audit with a limitation of scope.

Adverse Opinion

An adverse opinion should be expressed when the effect of a disagreement is so material and pervasive to the financial statements that the auditor concludes that just a qualification of the report may not be adequate to disclose the misleading or incomplete nature of the financial statements. The auditor may disagree with management about matters such as the acceptability of accounting policies selected, the method of their application, or the adequacy of disclosures in the financial statements. However, such disagreements may not be material. Paragraph 8 of ISA 705, entitled Modifications to the Independent Auditor’s Report states that an adverse opinion should be provided only if such disagreements are perceived to be material to the financial statements individually or in the aggregate. Ordinarily this information would be set out in a separate paragraph preceding the opinion or disclaimer of opinion on the financial statements and may include a reference to a more extensive discussion, if any, in a note to the financial statements. (Please note that the relevant standard on this was ISA 701 entitled Modifications to the Independent Auditor’s Report. This is now superceded. Effective December 15, 2009, the relevant standard is ISA 705 entitled Modifications to the Independent Auditor’s Report.)

The “Modified” Report

An audit report can be modified to include qualified, disclaimer, and adverse reports. ISA 705 allows the auditor, in certain circumstances, to modify the audit report by adding an emphasis of matter paragraph to highlight a matter affecting the financial statements. The addition of such an emphasis of matter paragraph should not affect the auditor’s opinion according to ISA 705. The paragraph should be included after the paragraph containing the auditor’s opinion but before the section on any other reporting responsibilities, if any. The emphasis of matter paragraph should refer to the fact that the auditor’s opinion is not qualified in this respect. A note in the financial statements is advised to more extensively discuss the matter.

When should the report be modified? The auditor can modify the report if there is a financial uncertainty problem. An uncertainty is defined (paragraph 5 of ISA 705) as a matter whose outcome depends on future actions or events not under the direct control of the entity but that may affect the financial statements. In this instance, the auditor according to ISA 705 should consider modifying the report by adding a paragraph discussing the uncertainty and stating that the resolution of the uncertainty is dependent upon future events that could affect the financial statements.

Paragraph 8 of ISA 701 provides an example of an emphasis of matter paragraph for a significant uncertainty as follows:

Without qualifying our opinion we draw attention to Note X to the financial statements. The Company is the defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The Company has filed a counter action, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot presently be determined, and no provision for any liability that may result has been made in the financial statements.

Issues Relating to Other Information in Annual Reports

ISA 720 states that the auditor should read the other information in documents containing audited financial statements) to identify material inconsistencies or material misstatements of fact with the audited financial statements. What is other information (refer paragraph 2, ISA 720)? Other information includes documents such as an annual report, a report by the management or the board of directors on operations, financial summary or highlights, employment data, planned capital expenditures, financial ratios, names of officers and directors among other information required by law, regulation, or custom. The auditor is required to look for material inconsistencies created by other information. There are two issues: material inconsistencies and material misstatements of fact. These will be considered individually.

What is a Material Inconsistency?

Paragraph 3 of ISA 720 notes that a material inconsistency exists when other information contradicts information contained in the audited financial statements. In paragraph 3 it is noted that a material inconsistency is something that could raise doubts about the audit conclusions drawn from audit evidence obtained and, possibly, about the basis for the auditor’s opinion on the financial statements. In some circumstances the auditor may have a statutory obligation to report specifically on this other information. In other circumstances, the auditor may have no such obligation. However, in paragraph 6 of ISA 720, it is noted that even when the auditor has no obligation, it is imperative for the auditor to determine whether the audited financial statements or the other information needs to be amended. If the auditor believes an amendment is necessary in the other information and the client refuses to make the amendment, the auditor should consider including an emphasis of matter paragraph describing the material inconsistency or taking other action. If an amendment is necessary for the audited financial statements and the entity refuses to allow it, the auditor should express a qualified or adverse opinion (refer paragraphs 11, 12, and 13 for this discussion).

What is Material Misstatement of Fact?

Paragraph 15 of ISA 720 defines material misstatements of fact as relating to information not related to matters appearing in the financial statements that is incorrectly stated or presented. Paragraph 16 ISA 720 notes that, if the auditor becomes aware that the other information appears to include a material misstatement of fact, the auditor should discuss the matter with the company’s management; if the auditor still considers there is an apparent misstatement of fact, the auditor should request that management consult with a qualified third party, such as the entity’s legal counsel, and consider the advice received. If management still refuses to correct the misstatement, the auditor should take appropriate action that could include notifying those charged with governance in writing of the auditor’s concern regarding the other information and also offer legal advice to prevent future law suits.

Up to now in the discussion, there were no significant differences (according to our observation) between the ISA and PCAOB in the discussion on audit reports. The ASB has roughly the same recommendations. However, there are minor differences. The purposes of the differences, as identified by an AICPA report (http://www.aicpa.org/interestareas/frc/auditattest/downloadabledocuments/clarity/substantive_differences_isa_gass.pdf) is to limit the auditor’s responsibilities. There are the issues in the PCAOB standards that are not found in the ISA:

  • Clarifying that the auditor’s opinion is the opinion on the financial statements (PCAOB AU 623)
  • Deleting the phrase either by law, regulation, or custom from the definition of other information to avoid confusion with required supplementary information (PCAOB AU 558)
  • Adding the phrase other matter to clarify the report modification (PCAOB’s AU 508)

ISA 720 requires the auditor to make appropriate arrangements with those charged with governance to report material misstatements and inconsistencies. However, there is one difference. The correction of material misstatements in ISA 720 relates to the date of the auditor’s report. However, the ASB initially and now the PCAOB (PCAOB’s AU 530 Dating of the Independent Auditor’s Report) determined that the report release date rather than the auditor’s report date would be more appropriate for the U.S. environment. Since the release date may be later than the report date, the audit firms in the United States have a longer time frame to evaluate the consequences of material misstatements and inconsistencies.

Subsequent Events

Auditors are required to perform audit procedures to determine what is referred to as subsequent events. Subsequent events are transactions and other pertinent events that occurred after the balance sheet date and which affect the fair presentation or disclosure of the statements being audited. ISA 560 entitled Subsequent Events provides a definition. Subsequent events are defined in paragraph 3 as events after the balance sheet date that deals with the treatment in financial statements of events, both favorable and unfavorable, that occur between the date of the financial statements and the date when the financial statements are authorized for issue (Paragraph 3 of ISB 560 entitled Subsequent Events).“When, after the financial statements are issued, the auditor becomes aware of a fact which existed at the date of the auditor’s report and which, if known at that date, may have caused the auditor to modify the auditor’s report, the auditor should discuss the matter with management and should take the appropriate action in the circumstances,” according to paragraph 15 of ISA 560. Paragraph 16 of ISA 560 notes that when the management revises the financial statements, the auditor should carry out the audit procedures necessary in the circumstances, the purpose being to review the steps taken by the management to ensure that anyone in receipt of the previously issued financial statements together with the auditor’s report is aware of the situation. The auditor should also inform the management that a new report will be issued. The audit procedures referred to should be extended to the new auditor’s report. Paragraph 27 states that the new report should include an emphasis of matter paragraph referring to a note in the financial statements that more extensively discusses the reason for the revision of the previously issued financial statements. The new auditor’s report should be dated no earlier than the date of the approval of the revised financial statements. “Date of approval of the financial statements is the date on which those with the recognized authority assert that they have prepared the entity’s complete set of financial statements, including the related notes, and that they have taken responsibility for them” (refer paragraph 4 of ISA 560, Subsequent events). ISA 560 notes that local regulations of some countries require the auditor to restrict the audit procedures regarding the revised financial statements to the effects of the subsequent events that necessitated the revision only. In such cases the new auditor’s report should contain a statement to that effect.

At this juncture, there are important differences that should be recognized.

Differences in Definition of Subsequent Events

In essence, paragraph 1 of ISA 560 defines subsequent events to include both events occurring between the date of the financial statements and the date of the auditor’s report and facts that become known to the auditor after the date of the auditor’s report. In the U.S. PCAOB AU 560 entitled Subsequent events includes separate definitions for subsequent events which are discussed in the section on subsequent events. AU 560 clearly states that for each category, the auditors’ responsibility is different and clearly distinguishes the auditor’s responsibility for each. ISA does not go into this in detail (that is separate definitions), nor does it clearly distinguish the auditors’ responsibilities for each.

Differences With Respect to Dates

As mentioned above, paragraph 5 of ISA 560 defines the date the financial statements are issued as the date the audited financial statements are available to third parties. However, this is addressed in AS 3 paragraphs 14 and 15. There is no significant difference between ISA (ISA 560) and PCAOB (AS 3) with respect to dating and issuing of audited financial statements to third parties.

Conflict With Laws Regarding Dating of the Financial Statements

Internationally, many European countries have laws that prohibit the management from revising the financial statements to include the effects of subsequent events. The implication is that subsequent events relate to the next period and should be treated as such. Hence paragraph 12 of ISA 560 has a reference to laws and regulations and notes that the auditor should include subsequent events and dual date the audited financial statements (release and issue dates) if the local laws do not prohibit reporting of subsequent events. In the United States, there is no such prohibition by law. Hence the equivalent paragraph (13) of (PCAOB AU 560) does not have any reference to law or regulation. This is totally omitted.

Requirement of New Auditor's Reports

Paragraph 12 of ISA 560 requires the auditor to provide a new or revised auditor’s report including the subsequent events (if there is no conflict with local laws). This should include an emphasis of matter paragraph that discusses the auditor’s procedures and note that these procedures were restricted solely to the revision of the financial statements. If management does not amend the financial statements to include the subsequent events, then the auditor is required to include an emphasis of matter paragraph and express a qualified opinion or even an adverse opinion depending on the significance of the events on the financial statements (contingent on no conflict with the local country’s laws). This is not included in the PCAOB’s AU 560. This is because it is uncommon in the United States to provide a new or revised auditor’s report that includes an emphasis of matter paragraph (Refer PCAOB AU 560).

PCAOB AU 390 entitled Consideration of Omitted Procedures after the Report Date addresses this. Paragraph 7 of AU 390 states that, if the auditor is unable to apply the previously omitted procedures or alternative procedures to test the impact of discovered subsequent events, then the auditor should consult an attorney to determine an appropriate course of action concerning the auditor’s responsibilities to its client. This also applies to regulatory authorities, if any, having jurisdiction over the client, and persons relying or likely to rely on his/her report. There is a clear and telling difference. The ISA, it appears, insist on a qualified or adverse auditor’s report with an emphasis of matter paragraph if there is no restriction by local laws. The PCAOB leaves this open ended, leaving the appropriate course of action to the auditor after consulting an attorney.

Types of Subsequent Events

Paragraph 3 of ISA 560 identifies two types of subsequent events. These include the following:

  • Those that provide evidence of conditions that existed at the date of the financial statements. This type requires adjustment to the financial statements. Some examples provided by Hayes et al. are settlement of litigation at an amount different from the amount recorded on the books. Other examples are sale of investments at a price below cost.
  • Those that are indicative of conditions that arose after the date of the financial statements. This type of material requires disclosure in the notes to the financial statements, but no adjustment in the financial statements is required. Examples provided by Hayes et al. are a decline in the market value of securities held for temporary investment or resale; a decline in the market value of inventory as a consequence of government action; and an uninsured loss of inventories as a result of a fire.

In the case of both of these, if the event is material, and the client did not adjust their financial statements, the auditor should include an emphasis of matter paragraph in a revised auditor’s statement (if there is no restriction by local laws). Whether the financial statements are revised depends on whether the subsequent event(s) falls into the (a) or (b) category noted earlier. If the management refuses, the auditor should include the emphasis of matter paragraph in either a qualified or, in rarer circumstances, an adverse report. In the United States, PCAOB 560 does not address this. But the PCAOB’s AU 390 leaves it open ended for the auditor, stating (paragraph 3) that “he should consult his attorney to determine an appropriate course of action concerning his responsibilities to his client.” It is interesting that nowhere in ISA is there a reference to consulting attorneys.

Issues Relating to Going Concern Status of the Firm

In certain cases, an uncertainty may be so grave as to potentially impact the survival of the company in the foreseeable future. This is referred to as a going concern problem. ISA allows the auditor to modify the report in the presence of going concern uncertainties as well. Paragraph 9 notes that the addition of a paragraph emphasizing a going concern problem is adequate to meet the auditor’s reporting responsibilities regarding such matters. However, in rare cases, such as situations involving multiple uncertainties, the auditor could issue a disclaimer of opinion instead of adding an emphasis of matter paragraph.

ISA 570 entitled Going Concern is premised on the assumption that the management has a responsibility to assess the entity’s ability to continue as a going concern, regardless of whether the financial reporting framework being applied requires management to do so. ISA 570 specifically states that one of the auditor’s objectives is to obtain sufficient evidence regarding the appropriateness of management’s use of the going concern assumption in the preparation of the financial statements (paragraphs 1 and 2). PCAOB AU 341 requires the auditor to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time (paragraph 2). ISA 570 requires consideration of the going concern assumption throughout the engagement. An AICPA report (http://www.aicpa.org/InterestAreas/FRC/AuditAttest/DownloadableDocuments/Clarity/Substantive_Differences_ISA_GASS.pdf) states that in planning the audit, the auditor is required to consider whether there are events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern and to remain alert throughout the audit for evidence of such events or conditions. Here, there is a significant difference with the PCAOB AU 341. PCAOB AU 341 does not require the auditor to design audit procedures solely to identify such events and conditions. It requires the auditor to consider whether the results of other procedures performed during the course of the engagement identify conditions and events that, when considered in the aggregate, indicate there could be substantial doubt about the entity’s ability to continue as a going concern. However, there is no material difference with the original standard by ASB except for the wording. The wording is important and is repeated here.

The auditor’s evaluation is based on his or her knowledge of relevant conditions and events that exist at or have occurred prior to the date of the auditor’s report. Information about such conditions or events is obtained from the application of auditing procedures planned and performed to achieve audit objectives that are related to management’s assertions embodied in the financial statements being audited. (PCAOB AU 341, paragraph 3)

There is no requirement to specifically test for going concern. Rather, the implication is that if results of other tests indicate the possibility of a going concern uncertainty the auditor should consider this when deciding on the report to be issued.

In essence, U.S. auditing standards are different in that the auditor is not required to specifically design and use procedures for testing the going concern status of the client. This only becomes a concern if the results of other procedures indicate there could be a going concern problem.

Under ISA if management decides that a going concern problem exists, then paragraph 10 of ISA 570 requires the auditor to discuss with management why the auditor believes a going concern paragraph should be added to the auditor’s report. There is an important difference with PCAOB AU 341. AU 341 does not contain these explicit requirements. Rather when the auditor believes there is substantial doubt about the entity’s ability to continue as a going concern, the auditor is required to consider the management’s plans for dealing with the adverse effects of the conditions and events that led to the auditor’s belief. In our opinion the ISA is more proactive in that the auditor is required to discuss with management the reasons for the going concern qualification. In the case of U.S. standards, if the auditor through other tests feels a going concern modified report has to be issued, they are first required to ask management their plans with special focus on extenuating factors, such as good news items, that could mitigate the going concern uncertainty threat. This difference could be due to the unique history of the United States with respect to going concern reporting. In the 1980s there was considerable opposition to the qualified going concern report with letters to the ASB that a qualified report had adverse consequences especially with respect to stock market prices. The ASB came up with a modified report and also required auditors to consider extenuating circumstances in the form of good news items in order to placate the opposition.

As regards the period of assessment, the approaches differ. Where there is substantial doubt about the entity’s ability to continue as a going concern, ISA 570 requires the auditor to consider the same period as that used by management in making its assessment, a period of at least, but not limited to, twelve months from the balance sheet date. In the United States, the PCAOB’s AU 341 requires the auditor to consider a period of time not to exceed one year beyond the date of the financial statements being audited. What happens if there is a delay in the signature or approval of the financial statements by the management after the balance sheet date? ISA 570 considers this to be important. The ISA requests the auditor to specifically consider the reasons for the delay. If the delay is related to events or conditions relating to the going concern assessment, the auditor should consider performing additional audit procedures to evaluate the effect on the auditor’s conclusion regarding the existence of the going concern uncertainty. The ASB does not contain similar guidance. In essence if there is a delay, under ISA the auditor is required to perform procedures to test for going concern during the period covered by the delay. The PCAOB does not cover this issue at all. The question is, is this important with respect to legal ramifications? We leave this issue to the reader.

Conclusions

The audit report is the key outcome of the audit. Without it, the investors and creditors and interested others are left wondering about the credibility of the financial statements and other related information in the annual reports. Accordingly, this chapter provides important information to the reader about the different audit reports that could be issued by auditors in the United States and in countries that conform to ISA. This information makes the audit reports interpretable. In addition, the contrasts drawn between ASB/PCAOB and ISA standard-based audit reports enables the reader to better understand how audit reports issued in one country may differ from those issued in another.

This chapter, then, is almost a capstone chapter to this book. What remains to be presented is information about other ways that audit regulation may differ depending on the nations within which the auditor conducts their audit. It is also important to briefly describe other things that may affect the reader’s understanding of audit reports issued in different places. That information is discussed in the next, final chapter.

Appendix: Discussion of Fair Presentation Frameworks versus Compliance Frameworks

The purpose of financial statements is to fulfill the information needs of its users. The financial reporting framework used is based on the jurisdiction in which the entity and its users exist. Two main and competing styles of reporting frameworks are:

  • fair presentation frameworks (also known as conceptual frameworks); and
  • compliance frameworks (also known as rules-based framework).

Fair Presentation Framework

Fazal (2013) notes that a fair presentation framework requires compliance with the provisions of the framework, but, in addition, Fazal acknowledges that:

  • in achieving fair presentation, the management might have to make additional disclosures that are not specifically required by the framework; and
  • in extremely rare circumstances, it might be necessary to depart from the requirements of the framework to achieve fair presentation in the financial statements of the entity’s financial position and performance.

Compliance Framework

Compliance frameworks require compliance with the provisions of the framework, that is, strict obedience to instructions is required, and the ones preparing financial statements have no choice but to follow the requirements of the framework. Compliance frameworks do not allow any room or flexibility as is given under fair presentation frameworks.

Fazal notes that fair presentation frameworks require compliance but still allow for alternatives that can achieve more relevant and reliable presentation of financial statements even if management has to make additions or go against the requirements of the framework. In the compliance framework, no such leverage is given, and under this framework, complete compliance is required under any condition.

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