Response to an Audit Report Inquiry
Dear Dominique,
I am writing this email in response to your request for clarification and explanation on the different types of audit reports. Generally, audit reports give an appraisal of a company or business’s financial performance and status during a specified period of time. These reports are usually completed by an independent accounting professional (internal or external), and cover the company’s assets and liabilities. Audit reports represent the auditor’s assessment of the company’s financial position and future status. In many countries, audit reports are required by law if the company is publicly traded or operates in an industry that is regulated by the stock exchange commission. Companies seeking external funding and those looking to enhance their internal control systems also find audit reports useful (Needles. & Powers, 2013: 23-24).
There are four different types of audit reports: unqualified opinion; qualified opinion; adverse opinion and a disclaimer of opinion. Also called unmodified audit reports, unqualified opinion reports are issued when the auditor determines that the financial information provided is free from any form of misrepresentation and that it is accordance with the required accounting standards (Dorfman, 2007: 36). Unqualified opinion reports give an impression that a firm’s financial records have been maintained as required by law. Typically, such reports consist of an appropriate title with the word “independent” to show that it was prepared by a neutral third party. The title is followed by the main body, which highlights the responsibilities of the auditor as well as the purpose of the audit report and the findings. The auditor signs off the report to indicate that no additional information should be added to the report (Ladda, 2009: 72-74).
The qualified report is also called modified audit report. This type of report is issued if the contents of the financial statements represented are changed. Normally, qualified audit reports are issued when a company’s financial records have not been maintained in accordance with the required standards but no major misrepresentations have been identified. The writings of a qualified audit report are similar to that of an unqualified audit report but the former will include additional paragraphs detailing the reasons why the audit report is qualified (Sundem, 2007: 11-12).
An adverse opinion report is issued when a company’s financial reports are found not to conform to the required accounting standards. This means that the financial records provided by the company have been grossly misrepresented and do not indicate the company’s actual financial position and performance. Although misrepresentation of financial information may occur as a result of an error, it is often an indication of fraudulent activities either by the accountants or management. When an adverse audit report is issued, the company must take remedial action to correct its financial statements and have them re-audited so that they can be accepted by investors, creditors and shareholders (Needles & Powers, 2013: 23-25).
A disclaimer of opinion report is issued when the auditor is not in a position to complete an independent audit report. This may occur for various reasons such as lack of appropriate financial records. When this is the case, the auditor prepares an incomplete report but issues a disclaimer stating that a true opinion of the company’s financial status could not be determined. Disclaimers indicate that the possible effects on the company’s financial statements arising from the unaccounted information could be both pervasive and material (Khalid, 2011: 484-492).
For the case of Energy Beverage PLC, a modified audit report is required because important information regarding the company’s financial position and inventory levels has not been provided. As explained by the auditors, it was not possible to ascertain the company’s inventory a few months before the new auditing firm was appointed. This means that any unqualified audit report will not give a true indication of the firm’s financial performance in the absence of this essential information. While it is not clear why the information on inventory is missing, it is obvious that the company’s accounting system is not in accordance with the financial reporting requirement (Masten, 2012: 107-108).
There are two prime reasons why the auditors should be able to give a modified audit report for Energy Beverage PLC. First, there is a possibility that the company’s financial statements as represented are not free from aspects of material misstatements. This does not imply fraud but there is a strong indication that absence of information about the company’s inventory will compromise the audit process. Secondly, there is a high likelihood that the auditors will find it difficult to obtain significant evidence to conclude that the financial records have not been misrepresented. If the auditors are moved by either of the two reasons, then they must determine how significant the matter is and its possible impact on the materiality and pervasiveness of the audit report (Holton, 2006: 15-20).
All audit reports are usually accompanied by management letters. A management letter is a formal letter written by an external auditor and signed by a company’s executive management or board of directors. The letter is a statement of the accuracy of financial statements that the company submits to the auditors for review and analysis. Generally, auditors do not issue opinions on the company’s financial performance without a management letter. In essence, the management letter attests that all the information submitted by the company is accurate and that all required and pertinent information has been disclosed to the auditors. Auditors use management letters as part of the audit evidence. In a way, the letter shifts some blame to the management, if later on it turns out that some aspects of the audited financial statements do not represents an accurate statement of the company’s financial results, conditions or status of business (Lung, 2009: 53).
In many jurisdictions, auditing standards require specific management letter comments, which relate to the control deficiencies that may result in inappropriate collection of data for compliance purposes. The identified control deficiencies are called either material weaknesses or significant deficiencies depending on the potential likelihood of material errors or fraudulent activities passing through the system undetected (Schroeder, 2005: 43-44). Once identified, control deficiencies should be investigated and corrected as soon as possible and the same reflected in the management letter. For instance, if the control deficiency is related to compliance risks, the management letter should provide an overview of the integral controls designed to mitigate those risks. If the controls are missing or deficient, the impact should be addressed so as to reinforce the integrity of the system (Khalid, 2011: 484-492).
Typically, auditors do not allow management to make any changes to the contents of this letter before signing it. This is because doing so would reduce the extent of the management’s liability and shift the blame to the auditors (Gill, 2009:19). As such, management is responsible for the proper presentation of all financial records in accordance with the applicable financial accounting framework. Such records as well as the minutes obtained from the board of directors should be availed to the auditors. Where possible, management letters should contain communications from regulatory agencies regarding financial reporting compliance. Because the letter is an indication of utmost good faith on the part of the company’s management, it should make statements as to the possibility of any unrecorded transactions, which could adversely change the financial position of the firm. Where the net effects of uncorrected financial misstatements are immaterial, the management letter should acknowledge the responsibility of this misrepresentation for the purpose financial system controls (Holton, 2006: 15-20).
Management letters are important because they can be issued to outside parties such as bankers, regulatory agencies and financiers, and are often a determining factor as to whether a company qualifies for financing. These letters are also submitted to the company’s board of directors and can be used to evaluate the management’s performance against set targets during each financial year. Ultimately, any negative information in the management letters deters potential business partners from engaging in future business partnerships with the company. As such, preparation of management letters requires elaborate assessment and understanding of the company’s resources to ensure that the letters will elicit a positive appeal from the intended audience (Masten, K. 2012: 106).
I hope you will find this email useful.
Regards
References
Dorfman, M. S. 2007. Introduction to Risk Management and Insurance (9 ed.). Englewood Cliffs, N.J: Prentice Hall.
Gill, M. 2009. Accountants' truth knowledge and ethics in the financial world. United States: Oxford.
Holton, G. A. 2006. Investor Suffrage Movement. Financial Analysits Journal, 62 (6), 15–20.
Khalid, A. M. 2011. Ethical Theories of Corporate Governance. International Journal of Governance, 1 (2): 484–492.
Ladda, R. L. 2009. Basic Concepts Of Accounting. Solapur: Laxmi Book Publication. p. 58
Lung, H. 2009. Fundamentals of Financial Accounting. London: Elsevier.
Masten, K. 2012. Organizational Ethics in Accounting: A Comparison of Utilitarianism and Christian Deontological Principles. Chicago: Liberty University.
Needles, B. E. & Powers, M. 2013. Principles of Financial Accounting. Financial Accounting Series. New York: Cengage Learning.
Schroeder, R.G. 2005. Financial accounting theory and analysis. New Jersey: Wiley.
Sundem, G.L. 2007. A note on the information perspective and the conceptual framework. Boston: Springer.
