Circumstances requiring modifications to, or departures from, an unqualified auditor’s opinion are described, together with appropriate guidance, in AU-C section 705, “Modifications to the Opinion in the Independent Auditor’s Report,” for non-SEC entities, including governments, and in Auditing Standard (AS) 3105, Departures from Unqualified Opinions and Other Reporting Circumstances, for SEC issuers and other entities for which an auditor has been engaged to audit and report based on PCAOB standards. Such modifications include qualified opinions, adverse opinions (which are extremely rare), and disclaimers of opinion (which are auditor assertions that an opinion cannot be expressed). Depending on the nature, magnitude, and pervasiveness of the potential effects of the matters in question, as well as their significance to the financial statements, qualified opinions or disclaimers often result from scope limitations or restrictions that may be imposed by clients or by circumstances that preclude the auditor from forming an unqualified opinion.

This article, however, is primarily about matters that may affect an auditor’s report without affecting the opinion. Such matters may result in additions to a standard audit report of one of two different types: 1) “emphasis-of-matter” paragraphs that are considered necessary to draw users’ attention because the matter is of such importance that it is fundamental to users’ understanding of the financial statements, and 2) “other-matter” (referred to in PCAOB standards as “explanatory”) paragraphs. Some emphasis-of-matter and other-matter/explanatory paragraphs are required by the applicable auditing standards, and some are included based solely on auditor’s discretion. Emphasis-of-matter paragraphs report only matters that are appropriately presented or disclosed in the financial statements and are of such importance to be considered fundamental to users’ understanding of the financial statements. Other-matter paragraphs report matters considered relevant to users’ understanding of the audit, the auditor’s responsibilities, or the auditor’s report other than matters that are appropriately presented or disclosed in the financial statements.

Although these matters are described, together with appropriate guidance, in AU-C section 706, Emphasis-of-Matter Paragraphs and Other-Matter Paragraphs in the Independent Auditor’s Report, for reports on financial statements of non-SEC entities, including governments, and in AS 3101, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion, for reports on financial statements of SEC issuers and other entities for which the auditor has been engaged to report based on PCAOB standards, the requirements of the standards applicable to the use of such paragraphs are complicated, hard to find, and confusing.

Recent Changes

Recent amendments to AU-C section 706, which will be effective for years ending in December 2020 (early adoption is not permitted), will not affect the current requirements regarding circumstances in which a modification to an auditor’s report is necessary, or for determining the type of modification. Effective for years ending in or after December 2020, the new AU-C section 703 will add requirements applicable to reports on the financial statements of certain employee benefit plans.

Also effective for years ending in or after December 2020, if the auditor is engaged to communicate key audit matters (KAM), use of an emphasis-of-matter paragraph will not substitute for including the matter in the KAM section if it meets the definition of a KAM, but inclusion of such a matter in a KAM will preclude the need to include it elsewhere in the audit report. The same is true when reporting on critical audit matters (CAM) for SEC issuer clients.

Financial Statements of Private Entities

For audit reports on financial statements of private entities, emphasis-of-matter paragraphs are limited to those that are about material accounting or presentation matters, provided they are appropriately presented or disclosed in the financial statements. (If not appropriately presented, they would necessarily require an opinion modification.) These are distinguished from other-matter paragraphs, which are not about accounting or presentation matters and therefore not about matters presented or disclosed in the financial statements. Rather, they are included in the audit report because they are deemed relevant in the auditor’s professional judgment to users’ understanding of the audit, the auditor’s responsibilities, or the auditor’s report. In other words, other-matter paragraphs relate to auditing, rather than accounting, matters.

As shown in Exhibit 1, however, a major source of confusion about this topic for some practitioners is the blurring of this line of distinction in AS 3101, which states that in certain matters that are about accounting rather than auditing, subjects are required to be communicated in “explanatory,” rather than emphasis-of-matter, paragraphs, the latter of which are always discretionary under the PCAOB standard. As in AU-C 706, emphasis-of-matter paragraphs are always about accounting or disclosure matters that are appropriately presented in the financial statements.

Exhibit 1

Summary of Required and Discretionary Emphasis-of-Matter and Other-Matter/Explanatory Paragraphs in Audit Reports

For Non-SEC Entities (AU-C 706); For SEC Issuers (AS 3101)
Required emphasis-of-matter paragraphs:
When substantial doubt exists (i.e., that has not been satisfactorily mitigated) about an entity's ability to continue as a going concern; .A14 (& AU-C 570.15-.16)
When there has been a change in accounting principles or in the method of their application or a change in the reporting entity that has a material effect (accounting changes and other matters disclosed in the notes to the financial statements are assumed to have been judged to be material); .A14 (& AU-C 708. 08-.13)
When the auditor's (or a predecessor's) current opinion on prior-period financial statements presented differs from the original opinion issued thereon because of changes to the financial statements or related notes (may be an other-matter paragraph for a private company if it does not involve the financial statements or related notes); .A15 (& AU-C 560.16c & AU-C 700.54)
When financial statements have been prepared in accordance with a special purpose framework other than a regulatory basis of accounting; A14 (& AU-C 800.19)
Required other-matter/explanatory paragraphs:
When reporting on supplementary information in the body of audit report on the basic financial statements; .A15 (& AU-C 725.09)
When prior-period financial statements presented have not been audited, or have been audited by another auditor, and the report on the prior period's financial statements is not presented; .A15 (& AU-C 700.57–.58)
When reporting on special purpose financial statements prepared in accordance with a contractual, regulatory, or other basis of accounting when use of the audit report is restricted pursuant to AU-C 905.06; .A15 (& AU-C 800.20)
When a report on compliance with aspects of contractual agreements or regulatory requirements is included in an audit report on financial statements; .A15 (& AU-C 806.13)
When supplementary information required by the applicable financial reporting framework has been omitted or departs materially from applicable requirements, or the auditor is unable to complete prescribed procedures with respect to such information or has substantial doubt about whether the information meets such requirements; .A15 (& AU-C 730.07–.08); .18j (& AS 2705.03 & .08)
When other information contained in a document together with audited financial statements is materially inconsistent with the financial statements, and management refuses to make an appropriate revision; .A15 (& AU-C 720.12); .18l (& AS2710.04)
When substantial doubt exists (i.e., that has not been satisfactorily mitigated) about an entity's ability to continue as a going concern; .18a (& AS2415.12)
When the auditor decides to refer to the report of other auditors; .18b (& AS 1205.06–.09)
When there has been a change between periods in accounting principles or in the method of their application that has a material effect; .18c (& AS 2820.12–.15)
When a material change in the reporting entity (that does not result from a transaction or event) has occurred; .18d (& AS 2820.06
When a material misstatement in previously issued financial statements has been corrected; .18e (& AS 2820.09 &.16–.17
When the auditor performs an integrated audit and issues separate reports on the company's financial statements and internal control over financial reporting; .18f (& AS 2201.88)
When management's required report on internal controls over financial reporting is not required to be, and has not been, audited; .18g (& AS 3105.59–.60
When the auditor's (or a predecessor's) current opinion on prior-period financial statements differs from the original opinion issued thereon because of changes to the financial statements or related notes; .18h (& AS 3105.52–.53 & .56–.58
When selected quarterly financial data required by Item 302(a) of Regulation S-K is omitted, not appropriately presented, or not been reviewed; .18i (& AS 4105.50)
When there has been a change in an investee year-end that has a material effect on the financial statements; .18k (& AS 2503.32
Suggested examples of discretionary emphasis-of-matter paragraphs:
When there is an uncertainty relating to the future outcome of unusually important litigation or regulatory action; .A2; .19
When there has been a major catastrophe that has had, or continues to have, a significant effect on the entity's financial position; .A2
When there have been significant subsequent events; .A2; .19
When there have been significant transactions with related parties; .A2; .19
When there have been other significant transactions; .19
When there are accounting matters (that do not involve changes in accounting principles) affecting the comparability of the financial statements with the prior period; .19
When the entity is a component of a larger business enterprise; .19
Suggested examples of discretionary “other-matter” paragraphs:
When the auditor is unable to obtain sufficient appropriate audit evidence due to a limitation on audit scope is imposed by management that is pervasive, and is unable to withdraw from the engagement; .A6
When the auditor is permitted (or required) by law, regulation, or generally accepted practice to elaborate on matters providing further explanation of the auditor's responsibilities; .A7
When engaged to report on two sets of financial statements—that is, in accordance with a general purpose framework (e.g., U.S. GAAP) and another general purpose framework (e.g., International Financial Reporting Standards) and the frameworks are acceptable; .A9

In both standards, discretionary auditor communications are described as matters that an auditor “may consider” (not “should consider”) including in the audit report; thus, documentation of such consideration is not required but nevertheless may be considered beneficial.

In addition to the foregoing, AU-C 600.30 requires an auditor who refers to a report of other auditors that contains an emphasis-of-matter or an other-matter paragraph to make reference to such paragraph in a similar emphasis-of-matter or other-matter paragraph. Also, AU-C 930.42-.43 states that an auditor is required to include an other-matter paragraph when interim financial information that has been reviewed in accordance with AU-C 930, “Interim Financial Information,” is included in a document containing audited financial statements does not appear to be presented in accordance with the applicable financial reporting framework, and the auditor’s separate review report referring to the departure is not presented.

Similar Reporting for Reviews and Compilations

With the exception of reviews of interim financial statements performed for clients that have annual audits, reporting on compilation and review engagements are governed by Statements of Standards for Accounting and Review Services (SSARS), specifically, AR-C 80 and 90, respectively. AR-C 80 does not provide for emphasis-of-matter paragraphs specifically by name or, except as noted in the last bullet below, other-matter paragraphs, but does provide similarly for nonstandard additional paragraphs whenever—

  • the financial statements are prepared in accordance with a special purpose framework (AR-C 80.21),
  • the reporting accountant is not independent (AR-C 80.22),
  • the financial statements omit substantially all required disclosures (AR-C 80.27),
  • the financial statements are accompanied by supplementary information that was not subject to compilation procedures, but no separate report on the supplementary information is issued (AR-C 80.35), or
  • supplementary information is required by a designated accounting standards-setter (RSI). In this one instance, the mandatory additional report paragraph is referred to as an other-matter paragraph, and it has specified required content (AR-C 80.37 and .A44, and if the RSI is entirely omitted, AR-C 80.39).

AR-C 90 requires certain emphasis-of-matter paragraphs and other-matter paragraphs in review reports, if appropriate, under the circumstances listed in Exhibit 2.

Exhibit 2

Summary of Required and Discretionary Emphasis-of-Matter and Other-Matter Paragraphs in Review Reports for Non-SEC Entities (Except on Interim Financial Statements for Annual Audit Clients)

AR-C 90
Emphasis-of-Matter; Other-Matter
Required paragraphs:
When reporting on supplementary information or RSI in the body of main report; .83 or; .86
When the prior period financial statements were audited and the auditor's report on the prior period financial statements is not reissued; .50
When financial statements have been prepared in accordance with a special purpose framework unless prepared in accordance with a regulatory basis of accounting; .A43
When a report contains an alert that restricts its use; .A44,; .A61
When substantial doubt exists (i.e., that has not been satisfactorily mitigated) about an entity's ability to continue as a going concern; .A67
When the auditor's (or predecessor's) current conclusion on prior-period financial statements differs from the original opinion issued thereon because of changes to the financial statements or related notes (may be an other-matter paragraph if it does not involve the financial statements or related notes); .A76c; .A49
Suggested examples of discretionary paragraphs:
When there is an uncertainty (but less than substantial doubt) regarding the entity's ability to continue as a going concern for at least a year from the report date; .A96
When there is an uncertainty relating to the future outcome of unusually important litigation or regulatory action; .A96
When there has been a major catastrophe that has had, or continues to have, a significant effect on the entity's financial position; .A96
When there have been significant subsequent events; .A96
When there have been significant transactions with related parties; .A96
When engaged to report on two sets of financial statements—that is, in accordance with a general purpose framework (e.g., U.S. GAAP) and another general purpose framework (e.g., International Financial Reporting Standards) and the frameworks are acceptable; .A101

Reviews of interim financial statements or information performed for private and public clients that have annual audits are governed, respectively, by AU-C 930 and AS 4105, “Reviews of Interim Financial Information.”

AU-C 930.38 requires an emphasis-of-matter paragraph indicating substantial doubt if conditions that raise such doubt exist as of the interim reporting date, provided there is appropriate disclosure in the interim financial information of a private entity to the extent required under the applicable reporting framework. This requirement applies without regard to whether the previous annual audit report did or did not contain such an emphasis-of-matter paragraph.

Although not clearly stated in any ASB standard, AU-C 930.A61 implies only by illustration that an emphasis-of-matter paragraph is also required in an audit report when there is an inconsistency in the application of accounting principles. AU-C 930 contains no examples of discretionary emphasis-of-matter paragraphs.

AS 4105.41 suggests that an accountant may wish to emphasize in a separate explanatory paragraph any substantial doubt about a public entity’s ability to continue as a going concern or lack of consistency in the application of accounting principles affecting the interim financial information, provided that such matters are appropriately disclosed in the interim financial information. In addition, AS 4105.44 and .45 expressly state that without regard to whether the previous annual audit report did or did not contain an explanatory paragraph indicating substantial doubt, the reporting auditor is not required to modify the report when there is adequate and appropriate disclosure in the interim financial information, even if conditions that raise such doubt exist or continue to exist as of the interim reporting date. The auditor may, however, add a discretionary explanatory paragraph if a report is issued.

It should be noted that issuance of a report on an interim review for an SEC issuer is not required under any circumstances (unless engaged to do so). However, if a report is issued, AS 4105.50c-d requires an auditor to include an explanatory paragraph in circumstances when selected quarterly financial data is required by item 302(a) of Regulation S-K but is omitted or not reviewed.

AS 4105 makes no provision for emphasis-of-matter paragraphs.

Howard B. Levy, CPA is a principal and director of technical services at Piercy Bowler Taylor & Kern, CPAs, Las Vegas, Nev., and an independent technical consultant to other professionals. He is a former member of the AICPA Auditing Standards Board and its Accounting Standards Executive Committee, and a current member of its Center for Audit Quality’s Smaller Firms Task Force. He is a member of The CPA Journal Editorial Advisory Board.