CHAPTER SIX

AUDITORS' REPORTS
STUDY OBJECTIVES

After studying this chapter, you should be able to:

 Describe the circumstances that result in inclusion of additional explanatory language in an
unqualified audit report.
 Discuss how materiality affects the consideration of the type of audit report to be issued.
 Identify circumstances that may result in qualified opinions, adverse opinions and disclaimers of
opinion.
 Describe the auditors' responsibilities for reporting on comparative financial statements.

Introduction
Expressing an independent and expert opinion on the fairness of financial statements is the most
frequently performed attestation service rendered by the public accounting profession. The fourth
standard of reporting states:

The (auditors') report shall either contain an expression of opinion regarding the financial
statements, taken as a whole, or an assertion to the effect that an opinion cannot be
expressed. When an overall opinion cannot be expressed, the reasons therefore should be
stated. In all cases where an auditor's name is associated with financial statements, the
report should contain a clear-cut indication of the character of the auditor's work, if any,
and the degree of responsibility the auditor is taking.

In Chapter 2, we saw that the auditors' standard report meets this standard by (a) stating that the audit
was performed in conformity with generally accepted auditing standards and (b) expressing an opinion
2that the client's financial statements are presented fairly in conformity with generally accepted
accounting principles. However, if there are material deficiencies in the client's financial statements or
limitations in the audit, or if there are other unusual conditions about which the readers of the financial
statements should be informed, auditors cannot issue the standard report. Instead, they must carefully
modify their report to make these problems or conditions known to users of the audited financial
statements.

In this chapter, we discuss the different types of reports that auditors may issue in order to indicate clearly
the character of their work and the degree of responsibility they are taking.

Financial Statements
The reporting phase of an audit begins when the independent auditors have completed their fieldwork and
they have proposed any necessary adjustments to the client. Before drafting their report, the auditors must
review the client-prepared financial statements form and content, or draft the financial statements on
behalf of the client.

The financial statements on which the independent auditors customarily report are the balance sheet, the
income statement, the statement of retained earnings, and the statement of cash flows. Often, the
statement of retained earnings is combined with the income statement. In some cases, the retained
earnings statement may be expanded to a statement of stockholders' equity. Financial statements generally
are presented in comparative form for the current year and the preceding year and are accompanied by
explanatory notes. The financial statements for a parent corporation usually are consolidated with those of
the subsidiaries.

Financial Statement Disclosures

The purpose of notes to financial statements is to achieve adequate disclosure when information in the
financial statements proper is insufficient to attain this objective. Although the notes, like financial
statements themselves, are representations of the client, the independent auditors generally assist in
drafting the notes. The writing of notes to financial statements is a challenging task because complex
issues must be summarized in a clear and concise manner. Adequate disclosure in the notes to the
financial statements is necessary for the auditors to issue an unqualified opinion on the financial
statements.

The Financial Accounting Standards Board, the Government Accounting Standards Board, and the
Securities and Exchange Commission have issued numerous pronouncements that have added extensive
disclosure requirements. Examples of not disclosure requirements that have become a part of the basic
financial statements include the disclosure of significant accounting policies, accounting changes, loss
contingencies, and lease and pension information.

In addition to the note disclosures that are part of the basic financial statements, many clients are required
by the FASB, the GASB, or the SEC to present supplementary information. Such information, while not a
required part of the basic financial statements is required to be presented as unaudited supplementary
schedules accompanying the financial statements. As an example, certain companies are required to
disclose selected interim financial data with their annual financial statements.

In evaluating financial reporting disclosures, the auditors should keep in mind that disclosures are meant
to supplement the information in the financial statements and not to correct improper financial statement
presentation. Thus a note or supplementary schedule, no matter how skillfully drafted, does not
compensate for the erroneous presentation of an item in the financial statements.

TYPES OF AUDIT REPORT

The end product of a financial statement audit is an auditor’s report through which the auditor expresses
his/her opinion. There are four types of audit reports; namely, Unqualified, Qualified, Adverse, and
Disclaimer
1. An unqualified opinion--standard report. This report represents a '' clean opinion'' and may be
issued when the two conditions listed above have been met, and when no conditions requiring
explanatory language exist.
2. An unqualified opinion--with explanatory language added to report. This is an audit report with
an unqualified opinion and explanatory language resulting from certain circumstances. Examples
of such circumstances are those in which other auditors have performed a portion of the audit, or
when major uncertainties exist with respect to the company being audited.
3. A qualified opinion. A qualified opinion states that the financial statements are presented fairly ''
except for'' the effects of some matter. Qualified reports are issued when the financial statements
depart materially from generally accepted accounting principles, or when limitations are placed
on the scope of the auditors' procedures. The problems, while materials, do not overshadow the
overall fairness of the statements.
 4. An adverse opinion. An adverse opinion states that the financial statements are not a fair
presentation. Auditors will issue an adverse opinion when the deficiencies in the financial
statements are so significant that the financial statements taken as a whole are misleading. All
significant reasons for the issuance of an adverse opinion should be set forth in an explanatory
paragraph.
5. A disclaimer of opinion. A disclaimer of opinion means that due to a significant scope limitation
(or very major uncertainties), the auditors were unable to form an opinion on the fairness of the
financial statements. A disclaimer is neither a positive nor a negative opinion--it simply means
that the auditors do not have an adequate basis for expressing an opinion.

EXPRESSION OF AN OPINION (CONTENTS OF AUDIT REPORT)

The Auditors' Standard Report

Before continuing, let us mention a few details about this report. It has a title that includes the word
''independent.'' The first paragraph is referred to as the introductory paragraph. It clearly indicates that
(1) the financial statements have been audited; (2) the financial statements are the responsibility of
management, and (3) the auditors' responsibility is to express an opinion on them. The second paragraph,
which describes the nature of an audit, is called the scope paragraph. Finally, the opinion paragraph
presents the auditors' opinion on whether the financial statements are in conformity with generally
accepted accounting principles.

Notice that the report is signed with the name of the CPA firm, not the name of an individual partner in
the firm. This signature stresses that it is the firm, not an individual that takes responsibility for the
auditors' report. If the CPA performing the audit is a sole practitioner, the report will be signed with the
CPA's personal signature. In addition, a sole practitioner should use the word I instead of we in the
auditors' report. Also notice the date under the signature. This date is normally the last day of
fieldwork--that is, the date upon which the auditors conclude their investigative procedures. This date is
quite significant, because the auditors have a responsibility to perform procedures to that date to search
for any subsequent events that may affect the fairness of the client's financial statements.
INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders

XYZ Company.
We have audited the accompanying balance sheet of XYZ Company as of December 31,
2016, and the related statements of income, retained earnings, and cash flows for the year then
ended. These financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statements presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material
respects, the financial position of XYZ Company as of December 31, 2016, and the results of its
operations and its cash flows for the year then ended in conformity with generally accepted
accounting principles.
Name of Audit company
Certified Public Accountants
February 26, 2016

An unqualified auditors' report may be issued only when the following conditions have been met:
1. The financial statements are presented in conformity with generally accepted accounting
principles, including adequate disclosure.
2. The audit was performed in accordance with generally accepted
3. Auditing standards, including no significant scope limitations preventing the auditors from
gathering the evidence necessary to support their opinion.

When considered material, departure from either of these conditions results in a situation in which a
report that is other than unqualified is required. Additionally, when certain other conditions exist, the
auditors add explanatory language to the standard report, but still express an unqualified opinion.

Materiality
Auditors must qualify their report whenever there are material deficiencies in the client's financial
statements; when the deficiencies are immaterial, an unqualified report may be issued. Accordingly,
auditors must exercise professional judgment to evaluate the materiality of any such departures. At this
stage of the audit, the auditors can consider both the quantitative and qualitative effects of the
deficiencies. For example, a related party transaction of a relatively small amount may be considered to
be material.
Auditors are required to issue an adverse opinion when the deficiencies in financial statements are '' so
significant'' that a qualified opinion would be inappropriate. A qualified opinion is considered insufficient
when the deficiencies in financial statements are so material that they overshadow the fairness of the
financial statements viewed as a whole. For example, misstatements that make an insolvent business
appear to be solvent would be considered sufficiently material as to overshadow the farness of the
statements viewed as a whole.

The distinction between problems that are material but do not overshadow the fairness of the statements
and those problems that do overshadow the fairness of the statement is again a matter of professional
judgment. In our following discussions, it will not be practical to present sufficient detail for readers to
make these judgments. Therefore, we will use the term material to describe problems sufficient to require
qualification of the auditors' report, but which do not overshadow the fairness of the statements. Problems
overshadowing the fairness of the statements will be described as '' very material'' or as causing the
statements to be '' substantially misleading.''

The Unqualified Report

Auditors express an unqualified opinion on the client's financial statements when they have no material
exceptions as to the fairness of the application of accounting principles and there have been no unresolved
restrictions on the scope of their engagement. The unqualified opinion is, of course, the most desirable
report from the client's point of view. The client usually will make any necessary adjustments to the
statements to enable the auditors to issue this type of opinion.
Explanatory Language Added to the Unqualified Opinion
Under certain circumstances auditors add explanatory language to the standard report, even when issuing
an unqualified opinion. Adding the additional language is not regarded as a qualification because it does
not lessen the auditors' reporting responsibility for the financial statements. Rather, the language merely
draws attention to a significant situation. Auditors add explanatory language to an unqualified opinion to
indicate that a part of the audit was performed by other auditors to refer to an uncertainty that could have
a material impact on the financial statements, to indicate an inconsistency in the application of accounting
principles, to emphasize a matter, and to indicate a justified departure from officially recognized
accounting principles.

Part of the Audit Performed by Other Auditors: On occasion it may be necessary for the principal
auditors of a company to rely upon another CPA firm to perform a portion of the audit work. The most
common situation in which CPAs rely upon the work of other auditors is in the audit of consolidated
entities. If certain subsidiaries have been audited by other CPA firms, the auditors reporting on the
consolidated parent company will usually decide to rely upon the work of these other CPAs rather than
conduct another audit of the subsidiaries.

When more than one CPA firm participates in an engagement, the auditors' report is issued by the
principal auditors-- that is, by the CPA firm that did the majority of the audit work and has an overall
understanding of the financial statements. The principal auditors have two basic alternatives in wording
their report:
1. Make No Reference to the Other Auditors: If the principal auditors make no reference in their
report to the portions of the engagement performed by the other CPAs, the principal auditors
assume full responsibility for the other auditors' work. This approach is usually followed when
the other CPA firm is well known, or when the principal auditors hired the other auditors. When
no reference is made, the principal auditors should consider visiting the other auditors, reviewing
the other auditors' audit programs and working papers, or performing additional audit procedures.
If the principal auditors elect to make no reference, they may issue the standard auditors' report
with no additional working.
 2. Make Reference to the Other Auditors: Making reference to the work done by other auditors
divides the responsibility for the engagement among the participating CPA firms. This type of
report is called a shared responsibility opinion, even though it is signed only by the principal
auditors. A shared responsibility opinion is usually issued when the other auditors were engaged
by the client, rather than by the principal auditors.

A shared responsibility opinion should indicate the portion of the engagement performed by the other
auditors. A typical shared responsibility opinion is illustrated below, with emphasis on the special
wording added to the standard report:

INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders
XYZ Company:

We have audited the consolidated balance sheet of XYZ Company as of December 31,
2016, and the related statements of income, retained earnings, and cash flows for the year then
ended. These financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on our audit. We did
not audit the financial statements of Sub Company, a wholly owned subsidiary, which
statements reflect total assets of $ _____as of December 31, 2016 and total revenues of $____ for
the year then ended. These statements were audited by other auditors whose report has been
furnished to us, and our opinion, insofar as it relates to the amounts included for Sub Company, is
based solely on the report of the other auditors.

We conducted our audit in accordance with generally accepted auditing standards. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial statements. An audit also
includes assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that our audit and the
report of other auditors provide a reasonable basis for our opinion.

In our opinion, based on our audit and the report of other auditors, the consolidated
financial statements referred to above present fairly, in all material respects, the financial position
of XYZ Company as of December 31, 2016, and the results of its operations and its cash
flows for the year then ended in conformity with generally accepted accounting principles.

Name of audit firm

.
Certified Public Accountants
February 26, 2016

The additional wording found in a shared responsibility opinion is not a qualification, as it does not lessen
the auditors' collective responsibility for the fairness of the statements. Rather, the report merely divides
this responsibility between two or more CPA firms. What if the other auditors qualify their report on a
particular subsidiary? The principal auditors do not necessarily have to qualify their shared responsibility
report. The shared responsibility report focuses upon the consolidated entity, which may involve a very
different level of materiality than does the subsidiary examined by the other auditors. To determine
whether a qualification is in order, the principal auditors must evaluate the materiality of the matter in
relation to the consolidated financial statements.

Another acceptable, although less frequently used, option allows the principal auditor to obtain
permission of the other auditor to explicitly use that auditor's name in the audit report. In such
circumstances the other auditor's report must also be presented with that of the principal auditor.

Whether or not the principal auditors plan to make reference to the work of the other auditor, they should
make inquiries concerning the other auditors' professional reputation and independence. Inquiries
concerning the other auditors' reputation might be made of the ALCPA, other practitioners or bankers. A
letter should also be obtained from the other auditors stating that they are aware of the use of their report
and that they meet the ALCPA's and, for publicly traded clients, the SEC's standards of independence.

Principal auditors are never forced to rely on the work of other auditors. Instead, they may insist upon
personally auditing any aspect of the client's operations. If the client refuses to permit them to do so, the
auditors may regard this action as a scope limitation and, depending upon materiality, issue a qualified
report or a disclaimer of opinion. As a practical matter, opinions are seldom modified for this reason.
Satisfactory arrangements as to who will audit the various aspects of a client's business normally will be
worked out before the audit begins.

Uncertainties: Substantial uncertainty as to the outcome of a contingency affecting the client's financial
statements may require the auditors to add an explanatory paragraph to their audit report to indicate the
existence of the uncertainty. In accordance with FASB Statement No. 5, contingencies that are probable
and can be reasonably estimated should be accrued in the financial statements. Failure to do so is a
departure from generally accepted accounting principles that leads to a qualified or an adverse opinion by
the auditors. It is when the contingency is reasonably possible that the auditors should consider adding an
explanatory paragraph to their unqualified opinion, based on should consider adding an explanatory
paragraph to their unqualified opinion, based on the materiality of the contingency and the probability of
unfavorable outcome. When a material loss is probable, but management is unable to estimate it, the
auditors also should consider adding an explanatory paragraph to their unqualified report. Finally, no
explanatory paragraph is required for a loss with a remote likelihood of occurrence since FASB Statement
No.5 does not require disclosure of such contingent losses. Figure 18--1 summarizes proper financial
statement and audit report treatment of uncertainties.

The standard report modified for uncertainty includes a fourth paragraph following the opinion paragraph
that described the uncertainty.

Question about A Company's Going--Concern Status: A special type of significant uncertainty

concerns the ability of a client company to continue as a going concern. Under generally accepted
accounting principles, both assets and liabilities are recorded and classified on the assumption that the
company will continue to operate. Assets, for example, may be presented at amounts that are significantly
greater than their liquidation values.

SAS 59 (AU 341), '' The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern, ''
describes the auditors' responsibilities for evaluating an entity's ability to continue as a going concern.
Although the auditors are not required to perform procedures specifically related to the going--concern
assumption, they must evaluate the results of the normal procedures performed in planning, gathering
evidential matter, and completing the audit. Conditions that may cause the auditors to question the going
concern assumption include negative cash flows from operations, defaults on loan agreements, adverse
financial ratios, work stoppages, and legal proceedings. When such conditions or events are identified, the
auditors should gather additional information and consider whether management's plans for dealing with
the conditions are likely to negate the problem. If, after evaluating all the information and management's
plans, a substantial doubt still exists about the company's ability to continue as a going concern for a
period of one year from the balance sheet date, the auditors should modify their report by adding a final
paragraph such as the following:

The accompanying financial statements have been prepared assuming that XYZ Company will
continue as a going concern. As discussed in Note X to the financial statements, XYZ Company
has suffered recurring losses from operations and has a net capital deficiency that raises
substantial doubt about the entity's to continue as a going concern. Management's plans in
regard to these matters are also described in Note X. The financial statements do not include
any adjustments that might result from the outcome of this uncertainty.

GAAP Not Consistently Applied If a client company makes a change in accounting principle (including
a change in the reporting entity), the nature of, justification for, and effect of the change are reported in a
note to the financial statements for the period in which the change is made. Any such change having a
material effect upon the financial statements will also require modification of the auditors' report, even
though the auditors are in full agreement with the change. Changes in accounting estimates need not be
reported in the auditors' report.

Changes from one generally accepted accounting principle to another generally accepted accounting
principle, when justified; do not result in qualification of the auditors' report. The report is merely
modified to highlight the lack of consistent application of acceptable accounting principles. Of course, if
the client elects to change to an unacceptable accounting principles, or issue an adverse opinion. A report
modified for a change to an acceptable accounting principle includes an additional paragraph following
the opinion paragraph, such as the one illustrated below:
As discussed in Note 2 to the financial statements, XYZ Company changed its method of
computing depreciation in 19X2.

In the preceding example, Note 2 to the financial statements would describe the nature and justification
for the change in method of computing depreciation, as well as the effects on the financial statements.

Emphasis of a Matter: Auditors also may issue an unqualified opinion that departs from the wording of
the standard report in order to emphasize some element within the client's financial statements. For
example, the auditors may add an additional paragraph to their unqualified opinion calling attention to a
significant related-party transaction described in a note to the financial statements. The paragraph may
either precede or follow the opinion paragraph.

Justified Departures from Officially Recognized Accounting Principles:

FASB and GASB Statements and Interpretations and APB Opinions have the status of
authoritative body pronouncements. They represent the highest level of generally accepted
accounting principles. In unusual circumstances, however, auditors may consider it
appropriate for the financial statements to depart from these pronouncements in order to
achieve the more important objective of a fair presentation. In such cases, the CPAs may still
issue an unqualified report, but they must disclose the departure in an explanatory paragraph,
either before or after the opinion paragraph. Such reports are sometimes called ''203 reports,
'' because Rule 203 of the AICPA code of Professional Conduct officially recognizes that in
unusual circumstances a departure from authoritative accounting principles may be justified.

Qualified Opinions
A qualified opinion expresses the auditors' reservations about fair presentation in some areas of the
financial statements. The opinion states that except for the effects of some deficiency in the financial
statements, or some limitation in the scope of the auditors' examination, the financial statements are
presented fairly. All qualified reports include a separate explanatory paragraph before the opinion
paragraph disclosing the reasons for the qualification. The opinion paragraph of a qualified report
includes the appropriate qualifying language and a reference to the explanatory paragraph.

The materiality of the exception governs the use of the qualified opinion. The exception must be
sufficiently significant to warrant mentioning in the auditors' report, but it must not be so significant as to
necessitate a disclaimer of opinion or an adverse opinion. Consequently, the propriety of a qualified
opinion in the event of a significant exception is a matter for careful professional judgment by the
auditors.

Departure from a Generally Accepted Accounting Principle: The auditors sometimes do not agree with
the accounting principles used preparing the financial statements. Usually, when the auditors' object icons
are carefully explained, the client will agree to change the statements in an acceptable manner. If the
client does not agree to make the suggested changes, the auditors will be forced to qualify their opinion
(or if the exception is very material, to issue an adverse opinion). When the report is qualified, the
introductory and scope paragraphs of the standard report are unaffected. The modification involves
adding an explanatory paragraph following the scope paragraph and qualifying the opinion paragraph.
The qualifying language used in the opinion paragraph always begins with the term except for. Following
is an example of the explanatory and opinion paragraphs of an audit report qualified for a departure from
generally accepted accounting principles.

The Company has excluded from property and debt in the accompanying balance sheet certain
lease obligations that, in our opinion, should be capitalized in order to conform with generally
accepted accounting principles. If these lease obligations were capitalized, property would be
increased by $____, long-term debt by $____, and retained earnings by increased (decreased)
by $____and $____, respectively, for the year then ended.

In our opinion, except for the effects of not capitalizing lease obligations, as discussed
in the preceding paragraph, the financial statements referred to above present fairly, in all
material respects, the financial position of XYZ Company as of December 31, 2016, and the
results of its operations and its cash flows for the year then ended in conformity with generally
accepted accounting principles.

The third standard of reporting addresses a particular type of departure from generally accepted
accounting principles--inadequate disclosures--and states that:

Informative disclosures in the financial statements are to be regarded as reasonably adequate

unless otherwise stated in the (auditors') report.
Thus, auditors may need to issue a qualified or adverse opinion if they consider the disclosure in the
client's financial statements to be inadequate.

SAS 32 (AU 431), ''Adequacy of Disclosure in Financial Statements, '' requires auditors to include the
omitted disclosure in an additional paragraph of their report, if it is practicable to do so. The word
practicable in this context means that the information can reasonably be obtained and that its inclusion in
the report would not cast the auditors in the role of the preparer of the information. For example, the
omission by the client of the statement of cash flows from an otherwise complete set of financial
statements would not cause the auditors to include the statements in their report, but would result in a
qualified opinion.

Obviously a client who is reluctant to make a particular disclosure would rather make the disclosure in a
note than have it highlighted in the auditors' report. Therefore, very few auditors' reports actually are
qualified because of inadequate disclosure. Instead, the requirements of SAS 32 usually convince the
client to include the necessary disclosure among the notes to the financial statements.

Scope Limitations: Limitations in the scope of an audit arise when the auditors are unable to perform an
essential audit procedure. Limitations may be due either to circumstances surrounding the audit for
example, the auditors were engaged too late.

In this situation, the professional standards require issuance of a qualified opinion. The basis of the
qualification is that when a balance sheet and statement of income are presented, a statement of cash
flows is required. However, if only a balance sheet or a statement of income is presented, a statement of
cash flows is not required. in the year to observe the client's beginning inventory 3) or due to the client
( for example, the client refuses to allow the auditors to send confirmations).

When a circumstances-imposed scope limitation is involved, the auditors attempt to perform alternative
procedures to gather sufficient competent evidential matter. If such evidential matter is collected and the
auditors believe that it is sufficient, an unqualified opinion may be issued. In situations in which
alternative procedures do not provide sufficient evidence, the auditors will either qualify the opinion to
reflect the scope limitation or disclaim an opinion. The qualifying language and the explanatory
paragraph (which follows the opinion paragraph) that distinguish the qualified report from the auditors'
standard report are emphasized below.

Except as discussed in the following paragraph, we conducted our audit in accordance with
generally accepted auditing standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing the accounting principles
used and significant estimates made may management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis for our opinion.

We were unable to obtain audited financial statements supporting the Company's investment
in a foreign affiliate stated at $_____, or its equity in earnings of that affiliate of $____, which is
included in net income, as described in Note 8 to the financials statements; nor were we able to
satisfy ourselves as to the carrying value of the investment in the foreign affiliate or the equity in
earnings by other auditing procedures.

In our opinion, except for the effects as such adjustments, if any, as might have been
determined to be necessary had we been able to examine evidence regarding the foreign affiliate
investment and earnings, the financial statements referred to above present fairly, in all material
respects, the financial position of XYZ Company as of December 31, 19XX, and the results of its
operations and its cash flows for the year then ended in conformity with generally accepted
accounting principles.
If a circumstance-imposed scope limitation affects a ''very material'' portion of the financial statements or
if the client imposes a significant limitation, a qualified opinion would normally be considered
inappropriate, and the auditors should issue a disclaimer of opinion.

Two or More Qualification

An auditors' report may be qualified for two or more situations. For example, the report may be qualified
because of both a scope limitation and a separate problem involving accounting principles. The wording
of such a report would include the appropriate qualifying language and explanatory paragraphs for both
types of qualifications.
Note that even through this may be the ''fault'' of the client; it is considered a circumstance-imposed
limitation because the client is not refusing to allow the auditor to perform a procedure which is possible
to perform.

When there are several situations requiring the qualification of an opinion, the auditors should consider
the cumulative effects of these problems. If the effect of the problems is to overshadow the fairness of the
statements viewed as a whole or to prevent the auditors from forming an overall opinion, a qualified
opinion would be inappropriate. In such cases, the auditors should issue either an adverse opinion or a
disclaimer of opinion, depending upon the circumstances.

Adverse Opinions
An adverse opinion is the opposite of an unqualified opinion; it is an opinion that the financial statements
do not present fairly the financial position, results of operations, and cash flows of the client, in
conformity with generally accepted accounting principles. When the auditors express an adverse opinion,
they must have accumulated sufficient evidence to support their unfavorable opinion.

The auditors should express an adverse opinion if the statements are so lacking in fairness that a qualified
opinion would not be warning enough. Whenever the auditors issue an adverse opinion, they should
disclose in a separate paragraph of their report the reasons for the adverse opinion and the principal
effects on the financial statements of the matters causing the adverse opinion, if the effects can e
determined.

Thus, an audit report that expresses and adverse opinion generally includes standard introductory and
scope paragraphs, one or more explanatory paragraphs preceding the opinion paragraph and describing
the reasons for the adverse opinion, and an opinion paragraph. Because the reasons for an adverse opinion
are usually lengthy and complex, we illustrate only the opinion paragraph below:

In our opinion, because of the effects of the matters discussed in the preceding paragraph, the
financial statements referred to above do not present fairly, in conformity with generally
accepted accounting principles, the financial position of XYZ Company as of December 31,
19X5, or the results of its operations or its cash flows for the year then ended.
Adverse opinions are rare because most clients follow the recommendations of the independent auditors
with respect to fair presentation of financial statements. One possible source of adverse opinions is the
actions of regulatory agencies that require organizations to use accounting practices that are not in
accordance with generally accepted accounting principles.

Disclaimer of Opinion
A disclaimer of opinion is no opinion. In an audit engagement, a disclaimer is required when substantial
scope restrictions or other conditions preclude the auditors' compliance with generally accepted auditing
standards.

Substantial Circumstance- Imposed Scope Restrictions: If a scope restriction is so severe that a

qualified opinion is inappropriate, the auditors should issue a disclaimer of opinion. This might happen,
for example, if the auditors were engaged after year-end and the client did not take a physical inventory.
A disclaimer issued because of a scope limitation will omit the scope paragraph of the standard report and
will include an explanatory paragraph describing the scope limitation in its place. The wording of the
opinion paragraph will change considerably, because the auditors are not expressing an opinion--rather,
they are saying that they have no opinion. A disclaimer of opinion is illustrated below:

We were engaged to audit the accompanying balance sheet of XYZ Company as of

December 31, 19X2, and the related statements of income, retained earnings, and cash flows for
the year then ended. These financial statements are the responsibility of the Company's
management.
The company did not make a count of its physical inventory, stated in the
accompanying financial statements at $____as of December 31, 19X2. Further, evidence
supporting the cost of property and equipment acquired prior to December 31, 19X1, is no
longer available. The company's records do not permit the application of other auditing
procedures to inventories or property and equipment.
Since the Company did not take physical inventories and we were not able to apply
other auditing procedures to satisfy ourselves as to inventory quantities and the cost of property
and equipment, the scope of our work was not sufficient to enable us to express, and we do not
express, an opinion on these financial statements.

Disclaimers of opinion because of scope restrictions are relatively rare. The auditors should be able to
foresee these types of problems in the planning stage of the engagement. The client usually will not want
to incur the cost of an audit if it is apparent from the start that the auditors must issue a disclaimer of
opinion.

Scope Restrictions Imposed by the Client: The professional standards state that when client-imposed
restrictions significantly limit the scope of the audit, the auditor generally should disclaim an opinion on
the financial statements. Two reasons exist for this requirement. First, a disclaimer is relatively useless to
the client. Therefore, the fact that the auditors may have to issue a disclaimer is a substantial deterrent to
the client imposing any scope restrictions in the first place. Second, a client who imposed scope
restrictions upon the auditors apparently has something to hide. An audit must be undertaken with an
atmosphere of trust and cooperation. If the client is attempting to conceal information, no audit can ensure
that all of the problems have been brought to light.
Disclaimer because of Uncertainty: An unqualified opinion with an explanatory paragraph is generally
appropriate for a material uncertainty that is described adequately in notes to the client's financial
statements. However, the standards allow the issuance of a disclaimer of opinion because of a material
uncertainty, including one about the company's ability to continue as a going concern.

Other Disclaimers Issued by CPAs: In this section, we have discussed only those disclaimers of opinion
issued in audit engagements. CPA firms issue disclaimers of opinion in many other types of engagements;
these disclaimers are dealt with in Chapter19.

Disclaimers Are Not Alternatives to Adverse Opinions. A disclaimer can only be issued when the
auditors do not have sufficient information to form an opinion on the financial statements. If the auditors
have already formed an opinion that the financial statements are not a fair presentation, the disclaimer
cannot be used as a way to avoid expressing an adverse opinion. In fact, even when auditors issue a
disclaimer of opinion, they should express in explanatory paragraphs of their report any reservations they
have concerning the financial statements. These reservations include any material exceptions as to
generally accepted accounting principles, including disclosure. In short, the issuance of a disclaimer can
never be used to avoid warning financial statement users about problems that the auditors know to exist in
the financial statements.