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Why would the auditor issue a Qualified Opinion on Financial Statements?

Qualified Opinion on Financial Statements
Qualified Opinion on Financial Statements

The audit firm’s team under the leadership of the engagement partner checks the client’s (entity’s) financial statements, accounting & control systems, and related information in order to express an opinion as to how well the financial reports prepared by the company reflect reality (usually for the last date of the previous reporting period in full, and for the current period – partially).

The International Standard on Auditing (ISA) 700 defines the objectives of the auditor in just two points:

  1. Forming an opinion on financial statements based on the assessment of the conclusions drawn according to the obtained audit evidence;
  2. Expressing this opinion clearly through a written report (conclusion).

If, as a result of the inspection of the client company, the auditor concludes that the entity has prepared the financial statements, taking into account all essential aspects, in accordance with the proper basis for presenting financial statements (that is, if the statements reflect reality) – they (the auditor) must express an unmodified opinion. Such – the so-called “clean” – an opinion is issued when the auditor [no longer] has serious unanswered questions about the audited entity and confirms the financial statements on the basis of solid evidence.

 

Modification of opinion

International Standard on Auditing (ISA) 705 defines the prerequisites for modifying an opinion. When the auditor is unable to express an unmodified opinion under ISA 700, the auditor has three options for modifying the opinion:

  1. Expression of qualified opinion;
  2. Adverse opinion and
  3. Refusal to express an opinion (disclaimer of opinion).

 

Basics of expression of qualified opinion

The auditor should express a qualified opinion when:
(a) they obtain sufficient appropriate audit evidence but conclude that the misstatements, individually or in the aggregate, are material, but not pervasive, to the financial statements; or

(b) they are unable to obtain sufficient appropriate audit evidence on which to base their opinion but conclude that the possible effect of undetected misstatements on the financial statements may be material, but not pervasive.

 

That is, the detected or possible inaccuracies in the financial statements – if they are material, but not comprehensive – should become the basis of a qualified opinion.

The five most common grounds for expressing a qualified opinion are as follows:

  1. Accounting of assets with incorrect value;
  2. Errors in recognition of revenue;
  3. Inconsistency of accounting and reporting with the applicable accounting and financial reporting standards;
  4. Violation of the rule of classification of expenses;
  5. Errors in the consolidation of financial information.

 

The reasons for recording assets at the wrong value can be:

  • changes in market prices, due to which the company’s asset is no longer worth as much as it was worth recently;
  • unexpected depreciation of the asset, which may be caused by the use of improved analogs of fixed assets by competitors;
  • incorrect accrual of depreciation and/or amortization expense;
  • difficulties related to determining the fair value of intangible assets.

 

The most common mistakes made in revenue recognition are:

  • determination of the wrong period of income generation: the inaccuracy of the final or intermediate realization date;
  • determination of the price of the sold product, which may be caused by discounts, retro-bonuses, bonuses and/or fine sanctions;
  • Error in the classification “enterprise or agent”.For the correct recognition of income, it is necessary to separate the agent from the enterprise.
  • Ignoring or late taking into account the changes made in the contracts signed with clients.

 

Inconsistency of accounting and reporting with the applicable standards of accounting and financial reporting is most often manifested in the following:

  • incorrect accounting of expenses – e.g.: capitalizing expenses as current expenses;
  • reflecting foreign currency transactions in national currency at the wrong [date] exchange rate;
  • Errors in accounting assumptions, such as, for example, asset usage/useful life, depreciation period & rate, recognition/recording of receivables and underestimation of fair value of financial instruments.
  • Cut-off in spending of project costs and revenues.

 

Common reasons for violating the cost classification rule are:

  • blurring the line between cost of goods sold and operating costs;
  • difficulties in recording complex transactions;for example: classification of multi-component and step-by-step economic operations;
  • misunderstanding the essence and details of contracts agreed upon with customers;
  • manipulation of numbers in order to reduce taxes.

 

Errors made during the consolidation of financial information are often due to the following circumstances:

  • complex structure of owners of companies included in the group;
  • incompatible accounting systems;
  • Features of goodwill and depreciation accounting (it manifests itself, especially at the completion of mergers and acquisitions).
  • operations between companies included in the group and failure to consider transfer pricing methodology.

 

Material inaccuracy or lack of evidence

When the auditor expresses a qualified opinion on a material misstatement of the financial statements, the auditor shall state that, in the auditor’s opinion, apart from the effect of the matter(s) described in the Basis for Qualified Opinion section: “The accompanying financial statements present fairly, in all material respects, in accordance with [the fair presentation basis] – when giving an opinion on the financial statements prepared in accordance with the fair presentation basis.”

If the need to modify the opinion is due to the auditor’s inability to obtain sufficient appropriate audit evidence, the auditor should use the appropriate phrase “except for the possible effect of these matter(s) …” for the modified opinion.

The auditor is obliged to justify why they issued the qualified opinion – this block is called “the basis of the conditional opinion.”

We will discuss the prerequisites for the auditor to express a negative opinion and to refuse to express an opinion in subsequent blogs.

Alexander Margishvili

Managing Partner
Kudos Georgia

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