QUESTION 1

ISA 450 – Objectives and definitions

According to ISA 450, the objectives of the auditor are to evaluate:

 The effect of identified misstatements on the audit, and

 The effect of uncorrected misstatements, if any, on the financial statements

A misstatement occurs when something has not been treated correctly in the financial statements,
meaning that the applicable financial reporting framework, namely IFRS, has not been properly
applied. Examples of misstatement, which can arise due to error or fraud, could include:

 An incorrect amount has been recognised – for example, an asset is not valued in
accordance with the relevant IFRS requirement.

 An item is classified incorrectly – for example, finance cost is included within cost of sales in
the statement of profit or loss.

 Presentation is not appropriate – for example, the results of discontinued operations are not
separately presented.

 Disclosure is not correct or misleading disclosure has been included as a result of

management bias – for example, a contingent liability disclosure is missing or inadequately
described in the notes to the financial statements.

Specific requirements and application of ISA 450

ISA 450 requires that ‘the auditor shall accumulate misstatements identified during the audit, other
than those that are clearly trivial’.

The auditor should set a monetary benchmark below which misstatements are considered to be
clearly trivial and would not need to be accumulated because the auditor expects that the
accumulation of such amounts clearly would not have a material effect on the financial statements.
The application notes to ISA 450 make it clear that ‘clearly trivial’ is not another expression for ‘not
material.’ The auditor will need to use judgement to decide whether matters are clearly trivial, and
this may be affected by a range of issues including but not limited to the monetary size of the
matter, for example, the level of audit risk being applied in the situation.

ISA 450 also requires that ‘The auditor shall communicate on a timely basis all misstatements
accumulated during the audit with the appropriate level of management, unless prohibited by law or
regulation. The auditor shall request management to correct those misstatements.’

Simply put, this means that the auditor keeps a note of all misstatements (other than those which
are clearly trivial), raises them with management and asks for the misstatements to be corrected in
the financial statements.

It is useful, when evaluating misstatements and in making requests to management for

misstatements to be corrected, to consider and apply the framework as laid out in ISA 450, which
categorises misstatements as follows:

 Factual misstatements are misstatements about which there is no doubt. An example

would be a clear breach of an IFRS requirement meaning that the financial statements are
 incorrect, for instance if a necessary disclosure is missing – for example, non-disclosure of
EPS for a listed company.

 Judgmental misstatements are differences arising from the judgments of management

concerning accounting estimates that the auditor considers unreasonable, or the selection
or application of accounting policies that the auditor considers inappropriate. There are of
course many examples of using judgement in financial reporting, for instance, when
determining the fair value of non-current assets, the level of disclosure necessary in relation
to a contingent liability, or the recoverability of receivables.

 Projected misstatements are the auditor’s best estimate of misstatements in populations,

involving the projection of misstatements identified in audit samples to the entire
populations from which the samples were drawn.

For the auditor it is important to distinguish between these types of misstatements in order to
properly discuss them with management, and ask for the necessary corrections, where relevant, to
be made. For example, with a factual misstatement, there is little room for negotiation with
management, as the item has simply been treated incorrectly in the financial statements. With
judgemental misstatement there is likely to be more discussion with management. The auditor will
need to present their conclusion based on robust audit evidence, in order to explain the
misstatement which has been uncovered, and justify a recommended correction of the
misstatement.

With projected misstatements, because these are based on extrapolations of audit evidence, it is
normally not appropriate for management to be asked to correct the misstatement. Instead, a
projected misstatement should be evaluated to consider whether further audit testing is
appropriate.

Correction of Misstatements

Management is expected to correct the misstatements which are brought to their attention by the
auditor. If management refuses to correct some or all of the misstatements, ISA 450 requires the
auditor to obtain an understanding of management’s reasons for not making the corrections, and to
take that understanding into account when evaluating whether the financial statements as a whole
are free from material misstatement.

Evaluating the Effect of Uncorrected Misstatements

The auditor is required to determine whether uncorrected misstatements are material, individually
or in aggregate. At this point the auditor should also reassess materiality to confirm whether it
remains appropriate in the context of the entity’s actual financial results. This is to ensure that the
materiality is based on up to date financial information, bearing in mind that when materiality is
initially determined at the planning stage of the audit, it is based on projected or draft financial
statements. By the time the auditor is evaluating uncorrected misstatements at the completion
stage of the audit, there may have been many changes made to the financial statements, so
ensuring the materiality level remains appropriate is very important.

Some misstatements may be evaluated as material, individually or when considered together with
other misstatements accumulated during the audit, even if they are lower than materiality for the
financial statements as a whole. Examples include, but are not restricted to the following:
  Misstatements which affect compliance with regulatory requirements

 Misstatements which impact on debt covenants or other financing or contractual

arrangements

 Misstatements which obscure a change in earnings or other trends

 Misstatements which affect ratios used to evaluate the entity’s financial position, results of
operations or cash flows

 Misstatements which increase management compensation

 Misstatements which relate to misapplication of an accounting policy where the impact is

immaterial in the context of the current period financial statements, but may become
material in future periods

Communication with those charged with governance

ISA 450 requires the auditor to communicate uncorrected misstatements to those charged with
governance and the effect that they, individually or in aggregate, will have on the opinion in the
auditor’s report. The auditor’s communication shall identify material uncorrected misstatements
individually and the communication should request that uncorrected misstatements be corrected.
The auditor may discuss with those charged with governance the reasons for, and the implications
of, a failure to correct misstatements, and possible implications in relation to future financial
statements. Perhaps the key issue here is that that auditor should discuss the potential implications
for the auditor’s report, which is likely to contain a modified opinion, if material misstatements are
not corrected as requested by the auditor.

In addition the auditor is required to request a written representation from management and, where
appropriate, those charged with governance with regard to whether they believe the effects of
uncorrected misstatements are immaterial, individually and in aggregate, to the financial statements
as a whole.

Documentation

Finally, ISA 450 requires certain documentation in relation to misstatements:

 The amount below which misstatements would be regarded as clearly trivial

 All misstatements accumulated during the audit and whether they have been corrected, and

 The auditor’s conclusion as to whether uncorrected misstatements are material, individually

or in aggregate, and the basis for that conclusion.

This is an important part of the audit working papers, as it shows the rationale for the auditor’s
opinion in relation to material misstatements.

Conclusion

Candidates preparing for the Advanced Audit and Assurance exam should ensure that they are
familiar with the requirements of ISA 450 as ultimately in forming an opinion on the financial
statements the auditor must conclude on whether reasonable assurance has been obtained that the
financial statements as a whole are free from material misstatements and this conclusion takes into
account the auditor’s evaluation of uncorrected misstatements.
QUESTION 2

The basics

When an auditor is able to satisfactorily conclude that the financial statements are free from
material misstatement they express an unmodified opinion. The complete form and content of the
unmodified opinion are presented in ISA 700, forming an Opinion and Reporting on Financial
Statements. However, auditors typically use one of two well-known phrases to reflect their
conclusion, either:

 ‘The financial statements present fairly, in all material respects...’ or

 ‘The financial statements give a true and fair view of…’

Modifications to the opinion

There are two circumstances when the auditor may choose not to issue an unmodified opinion:

 When the financial statements are not free from material misstatement or

 When they have been unable to obtain sufficient appropriate evidence.

In these circumstances the auditor has to issue a modified version of their opinion. There are three
types of modification. Their use depends upon the nature and severity of the matter under
consideration.

They are:

 the qualified opinion

 the adverse opinion

 The disclaimer of opinion.

Guidance as to the usage of the three forms of modification is provided by ISA 705, Modifications to
the Opinion in the Independent Auditor’s Report. This has been summarised in Table 1.

Table 1: Guidance as to the usage of the three forms of audit modification

Auditor’s judgment about the pervasiveness of the

matter

Material but NOT

Nature of the matter Material AND pervasive
pervasive

Adverse opinion
Financial statements are materially Qualified opinion
('...do not present
misstated ('...except for...')
fairly...')
 Disclaimer of opinion
Unable to obtain sufficient Qualified opinion
('...we do not express an
appropriate audit evidence ('...except for...')
opinion...')

Pervasiveness is a matter that confuses many candidates as, once again, it is a matter that requires
professional judgment. In this case the judgment is whether the matter is isolated to specific
components of the financial statements, or whether the matter pervades many elements of the
financial statements, rendering them unreliable as a whole.

The bottom line is that if the auditor believes that the financial statements may be relied upon in
some part for decision making then the matter is material and not pervasive. If, however, they
believe the financial statements should not be relied upon at all for making decisions then the
matter is pervasive.

Emphasis of matter

Emphasis of matter (EOM) is rarely dealt with satisfactorily in an exam. This is mainly because
candidates believe that EOM is linked somehow to modifications of the opinion. This is not the case:
EOM and modified opinions are totally separate matters.

The purpose of an EOM paragraph is to draw the users attention to a matter already disclosed in the
financial statements because the auditor believes it is fundamental to their understanding. It is a
way of saying to the users: ‘you know that note in the financial statements, the one about the
uncertainty surrounding the legal dispute? Well we auditors think it’s really important, so make sure
you’ve read it!’

The usage of EOM paragraphs is described in ISA 706, Emphasis of Matter Paragraphs and Other
Matter Paragraphs in the Independent Auditor’s Report. This identifies three examples of
circumstances when the usage of EOM is appropriate:

 when there is uncertainty about exceptional future events

 early adoption of new accounting standards and

 When a major catastrophe has had a major effect on the financial position.

Of course, in all of these examples the auditor can only refer back to disclosures already made in the
financial statements. If the directors haven’t disclosed a matter as required by financial reporting
standards, then the auditor may conclude that the financial statements are materially misstated and
modify the opinion instead.

Other matters

‘Other matter’ paragraphs are used to refer to matters that have not been disclosed in the financial
statements that the auditor believes are significant to user understanding. One usage of these
paragraphs is where the auditor concludes that there is a material inconsistency between the
audited financial statements and the other (unaudited) information contained within the annual
report and accounts, as required by ISA 720, The Auditor’s Responsibilities Relating to Other
Information in Documents Containing Audited Financial Statements.

Application to exam questions

Now that we have recapped the basic principles of audit opinions let us consider how these may be
applied to an exam scenario.

Questions on audit reports in Paper P7 typically fall into two distinct types: critical appraisal of an
audit report that has already been written; or explanation of how matters will affect an audit
opinion. In both cases the principles affecting the choice of audit opinion are the same.

If you face a question of this nature simplify your task by asking the following questions:

 Is there a misstatement in the financial statements (ie a fraud or error)?

 Has the auditor gathered sufficient appropriate evidence?

 Is/could the matter be material?

 Does the matter pervade the financial statements?

 Does the scenario refer to a disclosure made in the financial statements concerning an
uncertain future event?

Based on this approach you should be able to pinpoint exactly what form of opinion is appropriate
and whether an EOM paragraph is necessary.

As an example, Question 5 in the June 2009 Paper P7 exam asked candidates to ‘critically appraise
the proposed audit report of Pluto Co for the year ended 31 March 2009’. Relevant extracts from the
audit report are given in Illustration 1. The full text may be downloaded from the ACCA website.

Please note that the extract is from the International version of the syllabus and refers to
International Accounting Standards.

This is largely irrelevant to our understanding of the audit opinion; however, the question does deal
with matters where the financial reporting requirements across different accounting regimes are
broadly similar. The company in the question is a listed company.

Illustration 1 (when this question was written, ISA 701 was examinable and disagreement with
management was a reason for qualifying a report)

Adverse opinion arising from disagreement about application of IAS 37

the directors have not recognised a provision in relation to redundancy costs… and so the
recognition criteria of IAS 37 have not been met. We disagree with the directors as we feel that an
estimate can be made… We feel that this is a material misstatement as the profit for the year is
overstated.

In our opinion, the financial statements do not show a true and fair view of the financial position of
the company as of 31 March 2009...

Emphasis of matter paragraph

the directors have decided not to disclose the Earnings per share for 2009… Our opinion is not
qualified in respect of this matter.

Response – redundancy provision

We are not going to consider the whole wording, merely the choice of opinion. A more complete
response is given in the model answer, which can be accessed via the ACCA website.
The first question to ask is whether there is a misstatement. The answer to this is clearly ‘yes’ as the
report concludes that the directors have failed to make a provision when they should have. This
contravenes the relevant accounting framework (IAS 37, Provisions, Contingent Liabilities and
Contingent Assets). The report also clearly states that this is considered to be material to the
financial statements.

Next we have to consider whether the auditor has been able to gather sufficient appropriate
evidence. Once again the answer is ‘yes;’ the auditor has been able to reach a considered conclusion
on the matter.

At this point we have established that there is a material misstatement. Therefore, we will have to
modify our opinion. However, the final version of the modification depends upon whether the
matter is pervasive or not.

There is no indication in the audit report that the auditor considers the matter pervasive. It should
also be considered that redundancy provisions will only affect two areas of the financial statements:
current liabilities and wages/salary costs. Does misstatement here render the remainder of the
financial statements unreliable? This is an unlikely conclusion.

It therefore appears unlikely that an adverse opinion is necessary in the circumstances. A qualified
(‘except for’) opinion would appear more appropriate.

Earnings per share (EPS)

The second issue is that of the EOM paragraph. Ask the question referred to earlier: does the
scenario refer to a disclosure made in the financial statements concerning an uncertain future
event? Clearly the answer is no. Therefore an EOM paragraph is not appropriate.

If this is the case how the matter should be dealt with? Well, go through the same questions again.
First, is there a misstatement?

The directors have failed to disclose the EPS for the year. This contravenes IAS 33, Earnings per
Share (and in the UK, FRS 22, Earnings per share), which requires the basic and diluted EPS to be
disclosed in the financial statements of all listed companies. There is, therefore, a misstatement in
the financial statements.

Next we consider whether the matter is material. The clarified ISA 320, Materiality in Planning and
Performing an Audit requires the auditor to consider the informational requirements of the users.
EPS is a vital investor analysis tool and can therefore be considered material by nature. For listed
companies, it is a requirement of financial reporting standards that EPS is disclosed with prominence
in the financial statements. There is therefore a material misstatement in the financial statements.

Finally the auditor should consider whether the matter is pervasive to the financial statements. The
lack of disclosure of the EPS ratio is unlikely to render other elements of the financial statements
unreliable; it is an isolated error.

In this instance a qualified opinion should be given on the basis of a material misstatement of the
financial statements.

Application to the Paper F8 exam

The concepts considered above are equally as relevant to the Paper F8 exam. However, the wording
of the questions to date has been slightly different from the Paper P7 exam. So far candidates have
been provided with short scenarios and asked to either state or explain the effects of the matters on
the audit report. The approach discussed above may be applied in the same way to these questions.

The matters considered so far (in the December 2007 and December 2009 exams) include: a failure
to depreciate non-current/fixed assets, an auditor not being able to attend the year-end
inventory/stock count, and a failure to disclose a contingent liability in the financial statements.

Candidates should also prepare for questions requiring them to define or explain the terms referred
to above.

This style of requirement is illustrated in Question 2 from the June 2009 exam paper.

Concluding thoughts

Audit reports are a fundamental part of the auditing process and are therefore significant for audit
students at all levels. This will continue to be a regular exam topic.

If you do struggle with these questions it is NOT a good strategy to suggest every possible form of
opinion hoping that one of them will be correct.

Auditing requires critical appraisal, the use of professional judgment and the ability to offer a
reasoned opinion.

By asking yourself a series of simplified questions you will go through a critical thought process that
allows you to come to your own conclusion and, more importantly, offer your own opinion.

This will undoubtedly allow you to present an answer that stands out from the others.