Explain how materiality and pervasiveness affect the audit reporting decisions

The five different opinions in an independent auditor's report

What are the Types of Audit Opinions?

In the independent auditor’s report, an auditor can issue one of five different opinions:

• Clean (unqualified) opinion;
• Qualified opinion due to a GAAP departure;
• Qualified opinion due to a scope limitation;
• Adverse opinion due to a GAAP departure; and
• Disclaimer of opinion due to a scope limitation.

A clean (unqualified) opinion refers to financial statements that are “presented fairly, in all material respects…”. Deviations from a clean opinion (where the financial statements are not presented fairly) result in a reservation (modification) in the independent auditor’s report.

Summary

• In the independent auditor’s report, an auditor can issue one of five different opinions.
• There are two types of reservations that can be made: a GAAP departure or a scope limitation.
• The opinion issued depends on the type of reservation, which depends upon (1) materiality, and (2) pervasiveness.

Understanding Reservations in an Independent Auditor’s Report

There are two types of reservations:

1. GAAP departure

Situations where the financial statements deviate from the established accounting criteria. For example, a company that uses an incorrect accounting method faces a GAAP departure.

2. Scope limitation

Situations where the auditor is unable to obtain sufficient appropriate audit evidence to base the audit on. This presents a scope limitation.

In addition, the type of opinion, based on the reservation made, depends on two factors:

1. Materiality

Misstatements to the financial statements are considered material if the misstatements (individually or in aggregate), are expected to influence the decisions made by users who rely on the financial statements.

2. Pervasiveness

Misstatements to the financial statements are considered pervasive if the misstatements affect a substantial portion of the financial statements.

What is a Qualified Opinion?

A qualified opinion can be issued due to a GAAP departure or a scope limitation. In both cases, the misstatements are material but not pervasive. In other words, there is a material impact on the financial statements, but the misstatements are not widespread (do not affect a large number of accounts).

Example 1: Qualified opinion due to a GAAP departure

The auditor noticed that the inventory of ABC Company faces a write-down due to obsolescence. However, the company refuses to write down the inventory. In such a scenario, a GAAP departure reservation is made. Since only the inventory and cost of goods sold accounts are wrong, a qualified opinion due to a GAAP departure would be issued.

Example 2: Qualified opinion due to a scope limitation

The auditor wants to send out confirmation letters to customers for the accounts receivable balance as audit evidence. However, ABC Company does not want the auditor to do so. In such a scenario, a scope limitation reservation is made. Since the auditor has been unable to verify the accounts receivable, a qualified opinion due to a scope limitation would be issued.

What is an Adverse Opinion?

An adverse opinion can only be issued due to a GAAP departure. In such a case, the misstatements are both material and pervasive. In other words, there is a material impact on the financial statements, and the misstatements affect a large number of accounts.

Example: Adverse opinion due to a GAAP departure

The auditor believes ABC Company faces a going concern issue and is unable to survive another year. The company disagrees and prepares its financial statements on a historical cost basis instead of on a liquidation basis. In such a scenario, a GAAP departure reservation is made. Since ABC Company prepared its financial statements on a historical cost basis, the majority of the company’s accounts are incorrect. An adverse opinion due to a GAAP departure would be issued.

What is a Disclaimer of Opinion?

A disclaimer of opinion can only be issued due to a scope limitation. In this case, the misstatements are material and pervasive. In other words, the auditor is unable to collect sufficient appropriate audit evidence to base its audit on and, as a result, a large number of accounts are not verifiable.

Example: Disclaimer of opinion due to a scope limitation

The auditor is looking to review the company’s minutes book, which contains important information regarding the board of directors meeting and the audit committee. ABC Company does not permit the auditor to review the minutes book. In such a scenario, a disclaimer of opinion reservation is made. Since the auditor is unable to access the minutes book, a majority of the company’s accounts cannot be verified. A disclaimer of opinion due to a scope limitation would be issued.

Related Readings

Thank you for reading CFI’s guide to Auditor Opinions. To keep learning and advancing your career, the following CFI resources will be helpful:

• Forensic Accounting
• IFRS vs. US GAAP
• Threats to Auditor Independence
• Top Accounting Scandals