An audit is a written opinion by a Certified Public Accounting (CPA) firm that states whether or not the financial statements are free of material misstatement. The financial statements are the responsibility of management; the auditor provides an opinion regarding the statements.
Most companies receive an unqualified audit opinion, which generally means that the financial statements comply with industry requirements. However, there are instances when the auditor must add or change language in the basic audit opinion.
Read this discussion to understand the factors that impact the audit opinion a company receives and what a business can do to avoid these issues. Knowing these things won’t just improve your chances at passing the CPA exam; they’ll also make you a better accountant!
An unqualified opinion states that, in the opinion of the auditor, the financial statements are free of “material misstatement.” In auditing, materiality refers to a dollar amount that the auditor believes would change the opinion of the financial statement reader.
Assume, for example, that a CPA is auditing a $5 million inventory balance. A $50 error may not be important for the financial statements reader, but a $30,000 mistake may be considered material.
Materiality is a matter of judgment. Hence, the CPA decides on the dollar amount of materiality before the audit is performed.
The unqualified opinion includes several other statements as well:
- The audit was conducted with Generally Accepted Auditing Standards (GAAS), which are a set of guidelines that the accounting industry uses for audits.
- An audit includes examining evidence that supports the amounts and disclosures in the financial statements, and that said examination is done on a test basis.
- The audit includes assessing the accounting principles used and significant estimates made by management.
People outside the accounting profession may be surprised to learn that accounting requires a great deal of judgment: not just strict calculation. CPAs make estimates about the dollar amount of accounts receivable that will not be paid, for example. The auditor’s job is to decide if the judgments are reasonable.
If the auditor finds that the financial statements comply with the statements listed above, an unqualified opinion is issued. Stakeholders, such as investors, creditors, and regulators, want to see an unqualified opinion because it verifies that the accounting systems are working properly.
Explanatory Language Added
In some cases, the auditor may add explanatory language to the audit report. While the audit opinion may still be considered unqualified, the extra text is added to provide important disclosures to the reader.
Here are several reasons why an audit opinion may include explanatory language:
- Another auditor’s work: The auditor relied on work performed by another auditor at some point during the audit. If, for example, another auditor performed the physical inventory count, that fact must be disclosed.
- Change in accounting principle: One important accounting standard is to use the same accounting principles consistently. If a company changes the depreciation method used for fixed assets, for example, the depreciation expense and net income will change in future years. A change in principle must be disclosed.
- Error corrections: Disclosure is required when a client corrects a material misstatement in previously issued financial statements. This disclosure alerts that reader that the prior year financial statements have changed.
Adding text informs the financial statement reader about unusual events that relate to the audit and the statements produced.
If a qualified audit opinion is issued, it means that the CPA has found information that potentially impacts the accuracy of the financial statements. A qualified audit opinion can limit the company’s ability to borrow money or to find investors, and regulators may ask the business for additional disclosures.
In many cases, the auditor will ask the client to make changes before the audit reports is issued. Furthermore, many companies make corrections so that an unqualified report is generated. Consequently, in order to avoid a qualified audit opinion, company management needs to communicate well with the auditors and provide support for accounting decisions.
Qualified audit opinions may be referred to as “except for” opinions, because the opinion explains that, except for a certain issue, the financial statements are free of material misstatement. A limitation of scope, for example, will generate a qualified opinion.
A scope limitation means that the auditor was not able to perform sufficient test work- or gather enough audit evidence- to make a decision about a particular account balance.
CPAs perform a number of procedures to audit a particular account balance, but some procedures are more reliable than others. In some cases, an auditor will insist that a task be performed in every instance, or the opinion must be qualified.
Inventory is a good example, because the best way to confirm the existence of inventory is to perform a physical count. In an inventory count, the auditor compares each item on the detailed inventory listing to the physical item in a warehouse or showroom, including the number of items, and a physical description.
To sum it up, in order to avoid being issued a qualified audit opinion, the client must ensure that the auditor can perform a physical count as close to the balance sheet date as possible.
Does that make sense? Then let’s move on!
An adverse opinion states that the financial statements do not conform to Generally Accepted Accounting Standards (GAAP) and that the financial data supporting the financial statements have been “grossly misrepresented.”
This situation is extremely serious and may be an indication of fraud. Hence, the company must respond by correcting the financial statements and having the audit performed again. Because of the heightened risk of error or fraud, the auditor will perform far more test work when the records are audited a second time.
In order to get an unqualified opinion during the second audit, management must invest time to investigate for possible fraud and to ensure that the company’s internal controls are strong enough to reduce the risk of fraud moving forward. One way to improve the accounting process is to create and use an accounting procedures manual.
As an example, companies are required to use the accrual method of accounting, which posts revenue when earned and expenses when incurred to generate revenue. The accrual method disregards cash inflows and outflows when posting revenue and expenses.
The cash basis method, on the other hand, records revenue when cash is received, and records expenses when cash is paid. If a firm used the cash basis of accounting and is not willing to restate the financial statements based on the accrual method, the auditor would issue an adverse opinion.
Find An Auditor
Understanding the differences between the audit reports can be difficult, and many CPA exam candidates and new accountants get lost in the opinion language. To learn more about this topic, speak with someone who has performed audits and worked on audit reports.
A person with an auditing background can provide examples to help you understand these auditing concepts. And in my opinion, this is the best way to prepare yourself for a long and rewarding accounting career!