This outcome is about choosing the right type of auditor's opinion and putting the right paragraphs in the report. Examiners like it because one scenario forces you to apply ISA 705, 706 and 710 and reject tempting wrong answers.
The rule
First ask whether the issue is material. If not, issue an unmodified opinion. If it is material, ask whether it is pervasive. Then ask whether it is a misstatement or a limit on evidence. Material but not pervasive gives a qualified 'except for' opinion in either case. Material and pervasive gives an adverse opinion for a misstatement, or a disclaimer when evidence is unavailable. A modified opinion needs a 'Basis for Qualified/Adverse Opinion' or 'Basis for Disclaimer of Opinion' paragraph. An Emphasis of Matter paragraph is only for matters that are properly presented and disclosed, and it never replaces a modification.
Worked example
Receivables are $4,000,000 and materiality is $120,000. Confirmations and alternative procedures support all but $200,000. The customers have ceased trading and there are no dispatch records.
Step 1: Is it material? $200,000 > $120,000, so yes.
Step 2: Is it pervasive? No. It is confined to one balance, and evidence was obtained for all other balances.
Step 3: What is the cause? A limit on evidence, not a known misstatement.
Conclusion: issue a qualified opinion ('except for the possible effects of...'). Add a 'Basis for Qualified Opinion' paragraph describing the receivables limitation.
A disclaimer would only be right if the possible effects were spread across many balances or the financial statements as a whole.
Remember: the opinion depends on materiality and pervasiveness, and a lack of evidence leads to a qualified opinion or disclaimer, never an adverse opinion.
Where candidates lose marks
Using an Emphasis of Matter paragraph instead of a modified opinion when there is a material misstatement or the evidence can't be obtained.
Issuing an adverse opinion because evidence is missing; adverse applies only to material and pervasive misstatements.
Treating retrospective application and full disclosure as curing an unjustified voluntary change in accounting policy under IAS 8, which is still a misstatement.
Try it: 4 questions
The auditor expects to sign the auditor's report on Green Co's financial statements for the year ended 31 December 20X5 on 15 March 20X6. Green Co's current chief executive took office on 25 January 20X6. The finance director served throughout 20X5 and remains in office. Both have signed a written representation letter dated 31 December 20X5. The letter states that the chief executive 'does not make representations about matters relating to periods before taking office'. All other requested representations are included. Is the letter acceptable under ISA 580 Written Representations?
Answer: B. ISA 580 requires written representations to be dated as near as practicable to, but not after, the date of the auditor's report. A letter dated 31 December 20X5 fails to cover the period up to 15 March 20X6. ISA 580 also requires representations from current management for all periods referred to in the auditor's report. New management cannot exclude earlier periods simply because they were not in office, since their responsibility for the financial statements as a whole is unchanged. Option A ignores both defects. Option C is wrong because current management must sign whether or not they served all year. Option D is wrong because representations from former management do not cure a misdated and limited letter from current management.
The same auditor audits the financial statements of Hyde Co for the years ended 31 December 20X6 and 20X5, which are prepared under IFRS and presented as corresponding figures. During 20X6, Hyde Co changed its inventory cost formula from FIFO to weighted average cost. It applied the change retrospectively, restated 20X5 and gave full note disclosure. The auditor concludes that management has not shown that the change gives reliable and more relevant information, as IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires for a voluntary change in accounting policy. The effect is material to both years but not pervasive. During 20X6 Hyde Co also made two other changes. It revised the useful lives of its machinery based on new information and accounted for this prospectively. It also reclassified certain prior-year selling expenses to match current-year presentation. There are no other reporting issues. What should the auditor's report for 20X6 contain?
Answer: A. IAS 8 para 14 allows a voluntary change in accounting policy only if it results in reliable and more relevant information. An unjustified change is therefore a material misstatement, and retrospective application and disclosure do not cure it. Because the effect is material but not pervasive, ISA 705 requires a qualified opinion with a 'Basis for Qualified Opinion' paragraph, which, applying ISA 710, also addresses the effect on the 20X5 corresponding figures. An Emphasis of Matter paragraph is used only for matters that are appropriately presented, so it cannot replace a modification. An adverse opinion is reserved for pervasive misstatements, and an unmodified opinion ignores the misstatement. The useful-life revision is a change in accounting estimate and the reclassification is a presentation matter, so neither affects the opinion.
You are completing the audit of Hyde Co for the year ended 31 December 20X5. Trade receivables at 31 December 20X5 total $5,000,000, and overall materiality is $150,000. Positive confirmation requests were sent covering 70% of receivables by value ($3,500,000), and replies were received covering 90% of that amount ($3,150,000). Alternative procedures, including testing of after-date cash receipts and goods dispatched notes, corroborated $170,000 of the $350,000 with no reply. The remaining $180,000 could not be corroborated because several customers have ceased trading and the dispatch records are unavailable. Sufficient appropriate evidence was obtained for all other material balances and disclosures, management has provided written representations, and there is no indication of fraud. Which type of auditor's opinion should be issued?
Answer: A. Alternative procedures were performed for the non-replies as ISA 505 requires, but $180,000 ($350,000 - $170,000) remains unsupported. This exceeds materiality of $150,000. ISA 705 requires a qualified ('except for') opinion when the auditor cannot obtain sufficient appropriate evidence and the possible effects are material but not pervasive, as here, where the problem is confined to one balance. An Emphasis of Matter paragraph under ISA 706 cannot replace a modification. An adverse opinion applies to misstatements that are material and pervasive, not to a lack of evidence. A disclaimer is only appropriate where the possible effects are both material and pervasive.
The auditor of Hyde Co expects to include an Emphasis of Matter paragraph in the auditor's report for the year ended 31 December 20X5. According to ISA 706 (Revised), what must the auditor communicate to those charged with governance?
Answer: A. ISA 706 (Revised) para 12 requires the auditor to communicate with those charged with governance when the auditor expects to include an Emphasis of Matter or Other Matter paragraph. The communication must cover both the expectation and the proposed wording. Communicating only the topic is insufficient. Communicating after the report has been issued defeats the purpose, which is to give those charged with governance the chance to respond before the report is finalised. Pointing to the related disclosure does not replace communicating the wording of the paragraph.
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What is the difference between a qualified and an adverse opinion?
A qualified opinion is used when the effect of a misstatement (or of a limit on evidence) is material but not pervasive, so the financial statements are fairly presented 'except for' the issue. An adverse opinion is used only when a misstatement is material and pervasive.
When should an auditor issue a disclaimer of opinion?
When the auditor cannot obtain sufficient appropriate evidence and the possible effects on the financial statements are both material and pervasive. If the effects are material but not pervasive, the opinion is qualified instead.
Can an Emphasis of Matter paragraph replace a qualified opinion?
No. Under ISA 706 an Emphasis of Matter paragraph only draws attention to a matter that is appropriately presented or disclosed. It does not fix a material misstatement or a limitation of scope, which need a modified opinion under ISA 705.