The auditor's report, critical audit matters and capstone

Everything in the audit leads to a single document of a page or two. The auditor's report is the only part of the audit that most users ever see, and its wording is closely prescribed so that readers can tell at a glance what kind of opinion is being expressed and what it covers. This final lesson works through the structure of the report, the types of opinion and when each applies, the reporting of critical audit matters, emphasis of matter and other paragraphs, and the auditor's responsibilities for other information in the annual report. It ends with a capstone that brings the Fairhaven audit to its conclusion and drafts its report. ACCT-431 extends these topics to review engagements, special-purpose frameworks, group audits and other assurance services, and ACCT-341 builds on the internal control material for accounting information systems.

The structure of the unmodified report

AS 3101 prescribes the elements of the auditor's report on an issuer's financial statements. Since 2017, the report has put the opinion first, followed by the basis for opinion, and has disclosed the auditor's tenure. AU-C 700, as revised by SAS 134, prescribes a similar opinion-first format for non-issuer audits.

The date of the report matters. It is no earlier than the date on which the auditor has obtained sufficient appropriate evidence, including evidence that the complete set of statements has been prepared and that those with authority have taken responsibility for them, usually by the board's approval. The auditor's responsibility for subsequent events searching runs to this date.

Types of opinion

The opinion depends on two questions. First, what is the nature of the problem? Either the statements are materially misstated, or the auditor has been unable to obtain sufficient appropriate evidence (a limitation on scope). Second, how pervasive are its effects? An effect is pervasive if it is not confined to specific elements, accounts or items, or if, though confined, it represents a substantial proportion of the statements, or if it concerns disclosures fundamental to users' understanding.

AS 3105 governs departures from unqualified opinions in issuer audits; AU-C 705 applies to non-issuers. The SEC generally does not accept qualified opinions or disclaimers in filings, so in practice issuer reports are almost always unqualified.

# Choosing the type of opinion: the nature of the problem and how pervasive it is
def opinion(problem, material, pervasive):
    if not material:
        return "Unmodified"
    if problem == "misstatement":
        return "Adverse" if pervasive else "Qualified (except for)"
    if problem == "scope limitation":
        return "Disclaimer of opinion" if pervasive else "Qualified (except for)"
    raise ValueError(problem)

cases = [
    ("Uncorrected projected misstatement of 146", "misstatement", False, False),
    ("Inventory write-down of 1,500 refused by management", "misstatement", True, False),
    ("Statements prepared on a going concern basis that is inappropriate", "misstatement", True, True),
    ("Count records destroyed; inventory of 38,500 cannot be verified", "scope limitation", True, True),
    ("One store's inventory of 900 inaccessible after a flood", "scope limitation", True, False),
]
for desc, prob, mat, perv in cases:
    print(f"{desc:<70} -> {opinion(prob, mat, perv)}")

Uncorrected projected misstatement of 146                              -> Unmodified
Inventory write-down of 1,500 refused by management                    -> Qualified (except for)
Statements prepared on a going concern basis that is inappropriate     -> Adverse
Count records destroyed; inventory of 38,500 cannot be verified        -> Disclaimer of opinion
One store's inventory of 900 inaccessible after a flood                -> Qualified (except for)

When the opinion is modified, the basis for opinion section is retitled (for example, Basis for Qualified Opinion) and explains the matter, quantifying its effects where practicable. A disclaimer is unusual: the auditor states that it does not express an opinion, explains why, and omits most of the description of the audit, because describing work that did not produce an opinion could mislead.

Critical audit matters

Critical audit matters (CAMs) are matters arising from the audit that were communicated or required to be communicated to the audit committee and that relate to accounts or disclosures material to the financial statements and involved especially challenging, subjective or complex auditor judgment. AS 3101 has required CAMs for large accelerated filers since fiscal years ending on or after June 30, 2019, and for other issuers since December 15, 2020, with exceptions such as emerging growth companies. For each CAM, the report identifies the matter, describes the principal considerations that led the auditor to determine it was a CAM, describes how it was addressed in the audit, and refers to the relevant accounts or disclosures.

The purpose is transparency: rather than a boilerplate report identical for every company, users see where the auditor focused and why. A CAM is not a modification of the opinion, and it should not be used to disclose information management has not disclosed, though it may lead management to improve its disclosures. For Fairhaven, the team identifies two matters.

• Valuation of inventory: slow-moving styles, a significant risk involving subjective judgments about selling prices and markdowns, addressed by testing the write-down against subsequent sales, evaluating management's assumptions for bias, and testing the data conversion of the new warehouse system.
• Revenue recognition for wholesale sales with return rights: a presumed fraud risk involving judgment about the refund liability, addressed by cut-off testing, confirmations, review of January credit notes and testing of the return-rate assumptions.

Emphasis of matter, other matter and other information

An emphasis of matter paragraph draws users' attention to a matter properly presented or disclosed in the statements that is fundamental to their understanding, such as a significant subsequent event or a major catastrophe. An other matter paragraph refers to something not presented in the statements that is relevant to users' understanding of the audit or the auditor's responsibilities, such as the fact that the prior period was audited by another auditor. Neither modifies the opinion. Under AS 3101, these are called explanatory paragraphs, which are required in some circumstances, such as substantial doubt about going concern or a change in accounting principle, and emphasis paragraphs, which are optional.

Other information in documents containing audited statements, such as the rest of the Form 10-K, is covered by AS 2710: the auditor reads it and considers whether it is materially inconsistent with the statements, and if so, determines whether the statements or the other information need revision. Unlike the international standards, AS 2710 does not require a section of the report on other information.

The integrated audit report

As an accelerated filer, Fairhaven receives an opinion on ICFR as well as on its financial statements. Bramble Shaw may issue a combined report or two separate reports that refer to each other. Because the credit approval deficiency found in lesson 6 was evaluated as a significant deficiency, not a material weakness (compensating controls in the monthly aging review reduced the likelihood of a material misstatement), the ICFR opinion is unqualified. Had it been a material weakness, the ICFR opinion would be adverse, while the financial statement opinion could still be unqualified.

Capstone: completing the Fairhaven audit

It is February 2027. The team has finished its procedures, management has agreed to the corrections described in lesson 11, and the engagement partner is preparing for the audit committee meeting. The program below posts the agreed adjustments to the draft figures and reassesses materiality and the debt covenant.

# Capstone: Fairhaven's audited figures after the corrections agreed with management (thousands of dollars)
draft = {"revenue": 184_000, "pretax": 12_600, "receivables_net": 21_400 - 650, "inventory": 38_500,
         "payables": 17_800, "equity": 64_400, "debt": 46_000}
tax_rate = 0.27
adj = [  # (description, revenue, pretax, receivables_net, inventory, payables)
    ("Revenue cut-off", -307, -123, -307, 184, 0),
    ("Unrecorded purchases and utilities", 0, -359, 0, 0, 359),
    ("Receivables items found in sample", -25, -25, -25, 0, 0),
    ("Allowance increase", 0, -254, -254, 0, 0),
    ("Inventory write-down increase", 0, -133, 0, -133, 0),
]
final = dict(draft)
for d, rev, pt, ar, inv, ap in adj:
    final["revenue"] += rev; final["pretax"] += pt; final["receivables_net"] += ar
    final["inventory"] += inv; final["payables"] += ap
after_tax = sum(a[2] for a in adj) * (1 - tax_rate)
final["equity"] = round(draft["equity"] + after_tax)
for k in draft:
    print(f"{k:<18}{draft[k]:>10,}{final[k]:>10,}{final[k] - draft[k]:>+9,}")
print(f"Debt to equity after corrections: {final['debt'] / final['equity']:.3f} (covenant 0.75)")
print(f"Materiality reassessed at 5% of final income before tax: {0.05 * final['pretax']:.0f}")
print("Remaining uncorrected misstatement: 146 (projected), below reassessed materiality")

revenue              184,000   183,668     -332
pretax                12,600    11,706     -894
receivables_net       20,750    20,164     -586
inventory             38,500    38,551      +51
payables              17,800    18,159     +359
equity                64,400    63,747     -653
debt                  46,000    46,000       +0
Debt to equity after corrections: 0.722 (covenant 0.75)
Materiality reassessed at 5% of final income before tax: 585
Remaining uncorrected misstatement: 146 (projected), below reassessed materiality

The corrections reduce income before tax from 12,600 to 11,706. Receivables, net of the allowance, fall by 586, inventory rises slightly because the cut-off correction puts back the cost of goods not yet shipped and is offset by the larger write-down, and payables rise by 359. Equity falls by about 650 after tax, and debt to equity rises to about 0.72, still inside the 0.75 covenant. Reassessed materiality, at 5 percent of final income, is about 585; the remaining projected misstatement of 146 is well below it, and below performance materiality, so it can be left uncorrected.

With all matters resolved, the remaining uncorrected misstatement immaterial, the representation letter signed and the engagement quality reviewer's concurrence obtained, the opinion is unmodified. The report is dated on the day the board approves the statements, and the engagement partner signs it for the firm.