Modified Audit Report: Types and Meanings

An independent audit report provides stakeholders, such as investors and lenders, with a formal opinion from an external Certified Public Accountant (CPA) on whether a company’s financial statements are presented fairly. The process involves the auditor gathering evidence to determine if the statements conform to a financial reporting framework, like Generally Accepted Accounting Principles (GAAP). The auditing standards an auditor must follow depend on the company.

For private companies, non-profits, and government entities, standards are set by the American Institute of Certified Public Accountants (AICPA). For public companies traded on a stock exchange, standards are set by the Public Company Accounting Oversight Board (PCAOB).

The Clean Opinion: Unqualified and Unmodified Reports

The most common outcome of a financial audit is the issuance of a “clean” opinion. This signifies the auditor’s conclusion that the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. While the meaning is the same, the terminology differs: for public companies, this is called an unqualified opinion, while for private companies, it is an unmodified opinion.

For public companies, the audit is more extensive. Under PCAOB standards, the audit of a public company is an integrated audit, meaning the auditor must issue an opinion on not only the financial statements but also on the effectiveness of the company’s Internal Control over Financial Reporting (ICFR).

Furthermore, reports for public companies must include a section discussing Critical Audit Matters (CAMs). CAMs are issues that arose during the audit that involved especially challenging, subjective, or complex auditor judgment and were communicated to the audit committee. This section provides investors with deeper insight into the audit process.

Modifications Affecting the Auditor’s Opinion

When an auditor cannot issue a clean opinion, the report is modified to reflect specific problems. The type of modification depends on the nature and severity of the issue discovered, which directly affects the level of assurance the auditor provides.

Qualified Opinion

A qualified opinion is issued when the auditor concludes that, except for the effects of a specific matter, the financial statements are presented fairly. This situation arises from either a limitation on the scope of the audit or a departure from the financial reporting framework that is material but not pervasive. A matter is “material” if it could influence the economic decisions of a user, but it is not “pervasive” because the issue is confined to specific accounts and does not misrepresent the statements as a whole.

For example, an auditor might issue a qualified opinion if a company’s inventory is stated at a value that materially deviates from GAAP, but the rest of the financial statements are compliant. The report adds a “Basis for Qualified Opinion” paragraph explaining the matter, and the opinion paragraph states that “except for” this issue, the financial statements are fairly presented.

Adverse Opinion

An adverse opinion is issued when the auditor determines that the financial statements as a whole are materially misstated and misleading. This conclusion is reached when misstatements are both material and pervasive. Pervasive issues are not confined to specific elements; they affect numerous items or a substantial portion of the financial statements, rendering the entire financial picture unreliable.

An example is a company that fails to consolidate a major subsidiary. The report’s “Basis for Adverse Opinion” paragraph details the reasons, and the “Adverse Opinion” paragraph states the financial statements do not present fairly, which is a major red flag for investors.

Disclaimer of Opinion

An auditor issues a disclaimer of opinion when they are unable to obtain sufficient audit evidence to form an opinion, and the possible effects of undetected misstatements could be both material and pervasive. This is not an opinion on fairness but a declaration that one cannot be given. The primary cause is a severe limitation on the audit’s scope, which may be imposed by management or caused by circumstances like the destruction of accounting records. The auditor’s report states that they could not obtain sufficient evidence and, accordingly, do not express an opinion.

Modifications Not Affecting the Auditor’s Opinion

An auditor can add communication to the audit report without changing a clean opinion. These additions draw a user’s attention to important matters. For private entities under AICPA standards, reports may use the following paragraphs.

Emphasis-of-Matter Paragraph

An Emphasis-of-Matter paragraph refers to an issue that is appropriately presented in the financial statements but is fundamental to users’ understanding. This paragraph does not modify the opinion; it simply highlights information already detailed in the company’s notes. Common examples include significant doubt about the company’s ability to continue as a going concern or uncertainty about the outcome of exceptional litigation. The paragraph references the matter and where it is more extensively discussed in the financial statements.

Other Matter Paragraph

An Other Matter paragraph refers to a matter not presented or disclosed in the financial statements that is relevant to users’ understanding of the audit, the auditor’s responsibilities, or the report. This paragraph communicates context that the company is not required to disclose. An auditor might use this to explain that the audit was for a specific regulatory purpose or that a predecessor auditor audited prior financial statements.