Forming an Opinion and Reporting
Forming an opinion on the financial statements is the culmination of the entire audit process. Everything the auditor does — from planning and risk assessment to testing and evaluation — leads to this moment: determining whether the financial statements present fairly, in all material respects, in accordance with the applicable financial reporting framework.
This section covers the professional standards that govern auditor reporting, the purpose and inherent limitations of an audit, general requirements under GAAS, when to modify an opinion, and several special reporting scenarios that are commonly tested on the AUD exam.
Professional Standards: Who Sets the Rules?
The standards governing how auditors form opinions and issue reports depend on who the client is:
| Client Type | Standard-Setter | Standards |
|---|---|---|
| Nonissuers (private companies, nonprofits, governments) | AICPA Auditing Standards Board (ASB) | Statements on Auditing Standards (SASs), codified as AU-C sections |
| Issuers (SEC-registered public companies) | Public Company Accounting Oversight Board (PCAOB) | Auditing Standards (ASs) |
For the AUD exam, you must know the difference between these two sets of standards. Many concepts are similar, but the specific requirements — especially around report format, critical audit matters vs. key audit matters, and certain independence rules — differ between PCAOB and AICPA standards.
- SASs are developed through the AICPA's standard-setting process and are converged with International Standards on Auditing (ISAs) to the extent appropriate for U.S. practice
- ASs are established by the PCAOB and approved by the SEC. The PCAOB also has the authority to inspect registered public accounting firms
Example: When Gies Co. (a private company) engages an auditor, the audit is performed under AICPA standards (SASs). When Kingfisher Industries (a publicly traded company registered with the SEC) engages an auditor, the audit is performed under PCAOB standards (ASs).
Primary Purpose of an Audit
The fundamental purpose of a financial statement audit is to enhance the degree of confidence that intended users can place in the financial statements. The auditor does this by expressing an opinion on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.
Key points:
- The audit opinion addresses fair presentation — not absolute correctness or freedom from any error
- The opinion provides reasonable assurance, which is a high level of assurance but is not a guarantee
- The auditor's opinion does not assure the future viability of the entity or the efficiency of management
Example: After completing the audit of MAS Inc., the auditor issues an opinion stating the financial statements present fairly, in all material respects, in conformity with U.S. GAAP. This tells users (lenders, investors, regulators) that a competent independent professional has examined the financial statements and found them reliable — but it does not mean every number is perfectly accurate or that MAS Inc. will be profitable next year.
Inherent Limitations of an Audit
An audit provides reasonable — not absolute — assurance. Several inherent limitations prevent the auditor from guaranteeing that the financial statements are completely free from material misstatement.
Nature of Financial Reporting
- Financial statements involve management judgments, estimates, and assumptions (e.g., useful lives of assets, allowance for doubtful accounts, fair values of financial instruments)
- The application of accounting standards often requires interpretation and the exercise of judgment by management
- These inherent uncertainties mean that even properly prepared financial statements involve a degree of imprecision
Nature of Audit Procedures
- An audit is conducted on a test basis (sampling) — the auditor does not examine every transaction or balance
- Internal control, no matter how well designed, can only provide reasonable assurance (not absolute) against misstatement
- Audit evidence is persuasive rather than conclusive
- Fraud may be difficult to detect, especially when it involves management collusion, falsified documents, or intentional failure to record transactions
Timeliness and Cost-Benefit
- There is an expectation that the audit be completed within a reasonable period of time and at a reasonable cost
- The auditor cannot spend unlimited resources chasing every possible issue
- The auditor must balance thoroughness with practicality, focusing effort on areas of higher risk
The inherent limitations of an audit mean that the auditor cannot be held responsible for detecting every misstatement or every fraud. However, the auditor must plan and perform the audit to obtain reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error.
Five General GAAS Requirements — The SEJEC Mnemonic
When conducting an audit in accordance with generally accepted auditing standards (GAAS), the auditor must satisfy five overarching requirements. A helpful mnemonic is SEJEC:
| Letter | Requirement | Description |
|---|---|---|
| S | Skepticism | Maintain professional skepticism throughout the audit — a questioning mind and critical assessment of audit evidence |
| E | Ethics | Comply with relevant ethical requirements, including independence |
| J | Judgment | Exercise professional judgment in planning and performing the audit |
| E | Evidence | Obtain sufficient appropriate audit evidence to reduce audit risk to an acceptably low level |
| C | Compliance | Comply with each SAS (or AS) relevant to the audit |
Professional Skepticism
Professional skepticism means the auditor does not simply accept management's explanations at face value. The auditor:
- Remains alert to conditions that may indicate misstatement due to fraud or error
- Critically evaluates audit evidence, including considering contradictory evidence
- Recognizes that management bias may exist
Example: BIF Partners' management provides an unusually optimistic explanation for a spike in fourth-quarter revenue. Rather than accepting the explanation without question, the auditor exercises professional skepticism by examining supporting contracts, confirming with customers, and analyzing the revenue pattern compared to prior periods.
Professional Judgment
Professional judgment involves applying relevant training, knowledge, and experience to make informed decisions throughout the audit. It affects:
- Materiality determinations
- Risk assessments
- The nature, timing, and extent of audit procedures
- Evaluating the sufficiency and appropriateness of evidence
- Drawing conclusions from the evidence obtained
Sufficient Appropriate Audit Evidence
- Sufficiency refers to the quantity of evidence — enough to support the opinion
- Appropriateness refers to the quality of evidence — its relevance and reliability
- The auditor must obtain enough high-quality evidence to reduce audit risk to an acceptably low level
Compliance with Standards
The auditor must comply with all SASs (or ASs) that are relevant to the specific engagement. If a standard is not relevant to the circumstances of the engagement, it need not be applied.
When to Modify an Opinion
The auditor must determine whether a modification to the standard unmodified opinion is necessary. There are two broad categories of issues that trigger a modification:
GAAP Issues (Financial Statement Problems)
The financial statements contain a material misstatement — a departure from the applicable financial reporting framework. Examples include:
- Inappropriate accounting policies selected or applied
- Failure to make required disclosures
- Unreasonable accounting estimates
- Misapplication of accounting standards (e.g., not recording impairment when required)
The auditor determines whether the misstatement is material or material and pervasive:
- Material but not pervasive → Qualified opinion ("except for")
- Material and pervasive → Adverse opinion
GAAS Issues (Audit Problems / Scope Limitations)
The auditor is unable to obtain sufficient appropriate audit evidence to conclude whether the financial statements are free from material misstatement. Examples:
- Management restricts access to records or personnel
- Records have been destroyed or are unavailable
- The auditor was engaged after inventory was counted and cannot apply alternative procedures
- Circumstances prevent observation of a significant foreign subsidiary
The auditor determines whether the scope limitation is material or material and pervasive:
- Material but not pervasive → Qualified opinion ("except for")
- Material and pervasive → Disclaimer of opinion
Think of it this way: GAAP issues = the financial statements are wrong. GAAS issues = the auditor could not get enough evidence to tell whether the financial statements are right or wrong.
Reporting with Different Opinions and Other Auditors
Different Opinions on Different Financial Statements
In some situations, the auditor may issue different opinions on different financial statements of the same entity. For instance:
- An unmodified opinion on the balance sheet but a qualified opinion on the income statement (perhaps due to a revenue recognition departure that affects results of operations but not financial position)
- This can also occur when a scope limitation affects one statement but not another
Example: Illini Entertainment's auditor is unable to observe inventory, which affects the cost of goods sold on the income statement and the inventory balance on the balance sheet. If alternative procedures are partially effective for the balance sheet but not for the income statement, the auditor might issue different opinions on the two statements.
Other Auditors
When the principal auditor relies on the work of another auditor (e.g., an auditor that audited a subsidiary), the principal auditor must decide whether to:
- Make reference to the other auditor in the report — This divides responsibility. The principal auditor's report mentions the portion of the financial statements audited by the other auditor. The opinion remains unmodified (assuming no other issues), but the report discloses the shared responsibility
- Not make reference (assume responsibility) — The principal auditor takes full responsibility for the opinion and does not mention the other auditor. This requires the principal auditor to perform additional procedures regarding the other auditor's work
Predecessor vs. Successor Auditor Considerations
When an entity changes auditors, the successor auditor (new auditor) and the predecessor auditor (former auditor) have specific responsibilities.
Successor Auditor's Responsibilities
Before accepting the engagement, the successor auditor should:
- Communicate with the predecessor auditor — to inquire about matters such as integrity of management, disagreements with management, reasons for the change in auditors, and any fraud or illegal acts the predecessor became aware of
- The predecessor must obtain the client's permission before responding to the successor's inquiries
- If the client refuses to allow the predecessor to respond, the successor should consider the implications for accepting the engagement
Predecessor Auditor's Responsibilities
- The predecessor auditor should respond to the successor's inquiries promptly and fully, subject to the client's consent
- If the predecessor's prior-year report is not reissued alongside the current-year report, the successor may reference the predecessor's report in the current report
Reissuance of the Predecessor's Report
If comparative financial statements are presented and the predecessor is asked to reissue the prior-year report, the predecessor should:
- Read the current-year financial statements
- Compare them with the prior-year statements on which the predecessor reported
- Obtain a representation letter from the successor auditor and from management
Example: MAS Inc. changes auditors. The new firm contacts the predecessor to discuss why MAS Inc. switched firms and whether the predecessor encountered any issues with management integrity. The predecessor (with MAS Inc.'s permission) shares that the relationship was amicable and no significant issues were identified.
Comparative Financial Statements with Different Service Levels
When comparative financial statements are presented and the current year and prior year were subject to different levels of service (e.g., the prior year was reviewed but the current year was audited), specific reporting rules apply.
Prior Period Reviewed, Current Period Audited
- The auditor includes an other-matter paragraph in the current-year audit report stating that the prior-year financial statements were reviewed (not audited)
- The paragraph discloses the type of service, the date of the review report, and that a review is substantially less in scope than an audit
- The auditor does not express or update an opinion on the prior-period financial statements in the audit report
Prior Period Compiled, Current Period Audited
- Similarly, the auditor adds an other-matter paragraph noting that the prior-year financial statements were compiled
- A compilation provides no assurance and is substantially narrower than an audit
Prior Period Audited by Predecessor, Current Period Audited by Successor
- If the predecessor's report is not reissued, the successor includes an other-matter paragraph identifying the predecessor, the type of opinion expressed, any modifications, and the date of the predecessor's report
- If the predecessor's report is reissued, both reports are presented
These comparative reporting rules are especially important for nonissuer engagements, where it is common for entities to present two or more years of financial statements and the prior year may have been subject to a different engagement type or audited by a different firm.
Component Auditor Considerations (Group Audits for Nonissuers)
When a group auditor is responsible for the audit of group financial statements (e.g., consolidated financial statements), and a component auditor has audited one or more components (such as a subsidiary or division), specific requirements apply.
Group Auditor's Responsibilities
The group auditor must:
- Determine whether to act as the group engagement partner and accept responsibility for directing the group audit
- Evaluate the competence, independence, and objectivity of the component auditor
- Communicate with the component auditor about significant matters, including the group's materiality levels, identified risks, and requested procedures
- Evaluate the sufficiency and appropriateness of the evidence obtained by the component auditor
Involvement in the Component Auditor's Work
The group auditor must be sufficiently involved in the work of the component auditor. This may include:
- Reviewing the component auditor's documentation and conclusions
- Participating in discussions about significant risks with the component auditor
- Performing additional procedures at the component level if deemed necessary
Reporting
Under AICPA standards, the group auditor may:
- Assume responsibility for the component auditor's work (no reference in the report)
- Make reference to the component auditor in the group audit report (dividing responsibility)
The decision depends on the group auditor's assessment of the component auditor and the significance of the component.
Example: Kingfisher Industries has a wholly owned subsidiary, Illini Security, which is audited by a separate firm. The group auditor evaluates the subsidiary auditor's qualifications, reviews their working papers, and determines whether to assume responsibility or make reference to the other auditor in the consolidated audit report.
Special Purpose Frameworks
Not all financial statements are prepared under U.S. GAAP. Some entities prepare financial statements using special purpose frameworks (SPFs), also known as "other comprehensive bases of accounting" (OCBOA). The auditor can still audit these financial statements and issue an opinion.
Types of Special Purpose Frameworks
| Framework | Description | Example |
|---|---|---|
| Cash basis | Revenue and expenses recognized only when cash is received or paid | A small consulting firm that tracks only cash inflows and outflows |
| Tax basis | Financial statements prepared using the income tax basis of accounting (consistent with the entity's tax return) | BIF Partners prepares financial statements using the same rules they use for their federal income tax return |
| Regulatory basis | Financial statements prepared in accordance with requirements of a regulatory agency (e.g., state insurance commissioner) | An insurance company preparing statements per state regulatory requirements |
| Contractual basis | Financial statements prepared in accordance with a specific contract or agreement | A franchisor requires franchisees to report on a specific basis defined in the franchise agreement |
| Other basis | A definite set of logical criteria applied to all material items (e.g., price-level adjusted statements) | An entity preparing inflation-adjusted financial statements |
Reporting on Special Purpose Frameworks
When issuing a report on financial statements prepared using an SPF, the auditor must:
- Describe the special purpose framework in the report (or reference the note in the financial statements describing the framework)
- Include an emphasis-of-matter paragraph (or equivalent) that alerts the reader that the financial statements are prepared on a basis other than GAAP and may not be suitable for another purpose
- Use modified titles for the financial statements (e.g., "Statement of Assets, Liabilities, and Equity — Tax Basis" rather than "Balance Sheet") unless the regulatory framework specifies titles
When reporting on special purpose framework financial statements, the auditor must make clear that the statements are not intended to be GAAP-basis financial statements. This prevents users from mistakenly treating them as if they were prepared under a general-purpose framework.
Example: Gies Co. prepares its financial statements on a tax basis because its primary users are the owners and the IRS. The auditor performs the audit and issues an opinion stating the financial statements present fairly, in all material respects, in accordance with the tax basis of accounting described in Note 1. An emphasis-of-matter paragraph alerts readers that the tax basis differs from U.S. GAAP.
Restriction on Use
For some SPFs (particularly contractual basis and regulatory basis when the statements are prepared solely for filing with the regulator), the auditor's report may include an alert restricting the use of the report to specified parties. This is because the financial statements may not be meaningful or appropriate for general-purpose users.
Summary
| Topic | Key Point |
|---|---|
| Standards | Nonissuers = SASs (AICPA); Issuers = ASs (PCAOB) |
| Audit purpose | Express an opinion on fair presentation with reasonable assurance |
| Inherent limitations | Estimates/judgments, sampling, fraud risk, time/cost constraints |
| GAAS requirements | SEJEC: Skepticism, Ethics, Judgment, Evidence, Compliance |
| GAAP issues | Material = qualified; material and pervasive = adverse |
| GAAS issues | Material = qualified; material and pervasive = disclaimer |
| Other auditors | Make reference (divide responsibility) or assume responsibility |
| Predecessor/successor | Successor communicates with predecessor before accepting engagement |
| Comparative statements | Other-matter paragraph for different service levels in prior period |
| Group audits | Group auditor must evaluate and be involved with component auditor's work |
| Special purpose frameworks | Cash, tax, regulatory, contractual, other — must describe framework and alert reader |