AU-C 705 Modifications to the Opinion: Qualified, Adverse, Disclaimer and Pervasiveness

AU-C section 705, Modifications to the Opinion in the Independent Auditor's Report, tells the auditor of a nonissuer when the opinion cannot be unmodified, which of three modified opinions to give, and how to word the report. It works with AU-C 700, which governs the unmodified report. SAS No. 134 reshaped the report sections that carry a modified opinion. For a plain-language overview of the opinion types, see types of audit opinions.

This page paraphrases the standard. Read AU-C 705 in AICPA Professional Standards before relying on any point here.

What is the objective of AU-C 705?

The auditor's objective is to express clearly an appropriately modified opinion on the financial statements that is necessary when the auditor concludes, based on the audit evidence obtained, that the financial statements as a whole are not free from material misstatement, or when the auditor is unable to obtain sufficient appropriate audit evidence to conclude that they are free from material misstatement.

When must the opinion be modified?

Two circumstances require modification.

1. Material misstatement. The auditor concludes, based on audit evidence, that the financial statements as a whole are materially misstated.
2. Inability to obtain evidence. The auditor cannot obtain sufficient appropriate audit evidence to conclude that the financial statements as a whole are free from material misstatement.

How is the type of opinion chosen?

Two questions decide it: what is the nature of the matter, and how pervasive are its effects or possible effects?

A matter is pervasive when its effects on the financial statements are not confined to specific elements, accounts or items. If confined, it is pervasive when it represents or could represent a substantial proportion of the financial statements. If the matter relates to disclosures, it is pervasive when the disclosures are fundamental to users' understanding of the financial statements.

The three opinions differ as follows.

• Qualified. The financial statements are fairly presented except for the effects of the matter, or the possible effects of the matter where the limitation is on evidence. The opinion reads "except for", which makes the exception specific.
• Adverse. The financial statements as a whole are not fairly presented. This is a conclusion based on evidence, not a limitation.
• Disclaimer. The auditor does not express an opinion because the possible effects of undetected misstatements could be both material and pervasive.

Pervasiveness is a judgment, and the standard does not give a percentage. Where the effect is quantifiable, a misstatement that is a large multiple of materiality, or that affects the key subtotals, points toward pervasive. The auditor documents the reasoning. The size relative to materiality is an input, not the test.

Can a limitation be imposed by management?

When management imposes a limitation on the scope of the audit after the engagement was accepted, and the auditor believes the limitation will lead to a qualified opinion or disclaimer, the auditor requests that management remove it. If management refuses, the auditor communicates the matter to those charged with governance, and determines whether it is possible to perform alternative procedures to obtain sufficient appropriate evidence.

If the auditor cannot obtain sufficient appropriate evidence, the auditor determines the implications:

• if the possible effects of undetected misstatements could be material but not pervasive, qualify the opinion
• if the possible effects could be both material and pervasive, so that a qualification would not communicate the severity, either disclaim an opinion or withdraw from the audit when practicable

Before withdrawing, the auditor communicates to those charged with governance any matters about misstatements identified during the audit that would have given rise to a modification. Where withdrawal is considered, legal advice can be sensible (practice). If withdrawal is not possible, the auditor disclaims an opinion.

Limitations imposed by circumstances, such as a count that could not be observed, are not the same as management-imposed limitations. The auditor first tries alternative procedures, and if they work, there is no limitation.

How is the report worded?

Opinion and Basis sections

The section headings change to show the type.

The Basis section is placed immediately after the Opinion section and describes the matter that gave rise to the modification. For the Opinion section, the standard's illustrations use "except for" language for a qualified opinion and state that the financial statements do not present fairly for an adverse opinion. For a disclaimer, the auditor states that the auditor does not express an opinion, that the auditor was not able to obtain sufficient appropriate evidence to provide a basis for one, and changes the statement that the statements were audited to say the auditor was engaged to audit them.

Describing and quantifying the matter

For a material misstatement relating to specific amounts, the auditor includes in the Basis section a description and quantification of the financial effects, where practicable, such as the effect on income taxes, income before taxes, net income and equity. If quantification is not practicable, the report says so. For a misstatement from omitted required disclosures, the auditor discusses the omission with those charged with governance, describes the omitted information, and includes it if practicable and the auditor has obtained enough evidence to do so. For misstated qualitative disclosures, the Basis section explains how they are misstated. For a limitation on evidence, the Basis section describes the reasons the auditor could not obtain evidence.

Disclaimers have special rules

When the auditor disclaims an opinion, the Basis section leaves out the reference to the auditor's responsibilities section and the statement that the evidence is sufficient and appropriate to provide a basis for an opinion. The Auditor's Responsibilities section is cut back to three statements: the responsibility to conduct an audit under GAAS and to issue a report, that because of the matter in the Basis section the auditor was not able to obtain sufficient appropriate evidence, and the independence and ethics statement. No Key Audit Matters section is included for an adverse opinion or a disclaimer. For an adverse opinion or disclaimer, if there are other matters that would have required a modification, the Basis section describes them as well.

Other requirements

• Communication with governance. When the auditor expects to modify the opinion, the auditor communicates the circumstances that led to the expectation, and the wording of the modification, to those charged with governance. See AU-C 260.
• No piecemeal opinions. When the auditor expresses an adverse opinion or disclaims on the statements as a whole, the same report cannot also give an unmodified opinion on a single statement or element under the same framework.
• Lack of independence. A lack of independence is governed by the AICPA Code of Professional Conduct, which determines whether the firm may issue a report at all, not by the modification logic above.
• Emphasis paragraphs. An emphasis-of-matter paragraph cannot take the place of a modification. See AU-C 706.
• Going concern. Inadequate disclosure of substantial doubt leads to a qualified or adverse opinion. An inappropriate going concern basis leads to an adverse opinion. See AU-C 570.
• Opening balances. Unsupported opening balances in an initial audit can lead to qualification or disclaimer. See AU-C 510.
• Management representations. A failure to provide key representations can require a disclaimer. See AU-C 580.

What must be documented?

The file should show the matter, the evidence, the evaluation of pervasiveness, the communication with management and those charged with governance, the legal advice sought if any, and the wording chosen. See AU-C 230 audit documentation.

Common weaknesses in modified-opinion reports

Practice checks, not requirements of the standard. Gaps to avoid:

• Pervasiveness assessed by size alone, with no qualitative analysis
• Misstatement not quantified in the Basis section and no statement that quantification is impracticable
• Section headings left as the unmodified wording
• An emphasis-of-matter paragraph used where a qualification was needed
• No communication with those charged with governance before issuing
• Disclaimer reports that still include the standard responsibilities language

Related

• Types of audit opinions
• AU-C 700 forming an opinion and reporting
• AU-C 706 emphasis-of-matter and other-matter paragraphs
• AU-C 450 evaluation of misstatements
• AU-C 570 going concern
• Summary of uncorrected misstatements template

Sources

• AICPA, AU-C Section 705, Modifications to the Opinion in the Independent Auditor's Report, as amended by SAS No. 134
• AICPA, AU-C Sections 700, 706, 570, 510 and 580
• AICPA Code of Professional Conduct

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error