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