Modified opinions under AU-C 705: qualified, adverse and disclaimer

In this lesson you will

Apply the AU-C 705.08 through .10 decision grid
Judge pervasiveness using the AU-C 705.06 definition
Draft the Basis for Qualified, Adverse or Disclaimer of Opinion section
Respond to a management-imposed scope limitation under AU-C 705.11 through .14

When the opinion must be modified

AU-C 705.07 requires a modification in two situations: the statements as a whole are materially misstated, or you cannot obtain sufficient appropriate evidence to conclude they are free of material misstatement. Everything else in AU-C 705 follows from which situation you are in and how pervasive the effects are.

The decision grid

Nature of the matter	Material, not pervasive	Material and pervasive
Statements are materially misstated	Qualified (AU-C 705.08a)	Adverse (AU-C 705.09)
Unable to obtain sufficient appropriate evidence	Qualified (AU-C 705.08b)	Disclaimer (AU-C 705.10)

AU-C 705.06 defines pervasive effects as those that, in your judgment, are not confined to specific elements, accounts or items; or, if confined, represent or could represent a substantial proportion of the statements; or, for disclosures, are fundamental to users' understanding.

Pervasiveness is a judgment you document. A misstatement in one account can be pervasive if that account is most of the balance sheet, such as investments in a holding company. A misstatement spread across several accounts can still be confined if its effect on the totals is limited.

Scope limitations imposed by management

AU-C 705.11 through .14 set the steps when management imposes a limitation after acceptance that is likely to lead to a qualified opinion or disclaimer:

Ask management to remove it.
If refused, communicate with those charged with governance (unless all are in management) and determine whether alternative procedures can provide the evidence.
If not, qualify when the possible effects could be material but not pervasive; when they could be material and pervasive, disclaim or withdraw when practicable.
Before withdrawing, communicate to governance any misstatements identified that would have led to a modification.

Two related rules: AU-C 580.25 requires a disclaimer or withdrawal when management will not provide the core representations, and AU-C 705.16 requires a disclaimer that states you are not independent when you lack independence but law or regulation requires you to report.

How the report changes

Heading. "Qualified Opinion", "Adverse Opinion" or "Disclaimer of Opinion" (AU-C 705.17), and the basis section becomes "Basis for Qualified Opinion" and so on (AU-C 705.21).
Opinion wording. Qualified: "except for the effects of" the matter, or "except for the possible effects of" for a scope limitation (AU-C 705.18). Adverse: because of the significance of the matter the statements do not present fairly (AU-C 705.19). Disclaimer: you do not express an opinion, cannot obtain sufficient evidence for a basis, and the opinion section says you were engaged to audit (AU-C 705.20).
Basis section content. Describe the matter; quantify the financial effects of a misstatement in specific amounts unless impracticable (AU-C 705.22); explain how qualitative disclosures are misstated (AU-C 705.23); for omitted disclosures, discuss with governance, describe the omission and include it if practicable (AU-C 705.24); for scope limitations, give the reasons (AU-C 705.25). Qualified and adverse reports add "qualified" or "adverse" to the sufficiency statement (AU-C 705.26).
Disclaimers. Drop the reference to the auditor's responsibilities section and the sufficiency statement (AU-C 705.27), and cut the auditor's responsibilities section down to the three statements in AU-C 705.29.
Other matters. Even with an adverse opinion or disclaimer, describe any other matter that would have required modification (AU-C 705.28). No piecemeal opinion alongside an adverse opinion or disclaimer (AU-C 705.15). No Key Audit Matters section with an adverse opinion or disclaimer, and no Other Information section with a disclaimer (AU-C 705.30).

AU-C 705.31 requires you to tell those charged with governance in advance about the circumstances and the proposed wording.

See modified opinion examples and the types of audit opinions guide.

File findings

No documented pervasiveness judgment.
Qualified opinion for a misstatement without the quantified effect.
Disclaimer reports that still describe the auditor's full responsibilities.
Management-imposed limitation never taken to governance.

Worked example

Granite Hills Supply, Inc.: qualified or adverse?

Granite Hills Supply, Inc. Total assets: $18,000,000. Pretax income: $1,400,000. Materiality: $140,000.

Matter: management refuses to record a lease liability and right-of-use asset for a warehouse lease under ASC 842. The team computes the lease liability at $2,300,000 and the right-of-use asset at $2,250,000. The income statement effect for the year is $60,000 of additional expense.

Is it material? The liability omission of $2,300,000 is 16.4 times materiality ($2,300,000 / $140,000). Yes.

Is it pervasive? The effect is confined to the lease accounts, debt and related disclosures. The liability is 12.8% of total assets ($2,300,000 / $18,000,000), and income moves by only $60,000. The team judges it not a substantial proportion of the statements and not fundamental to users' understanding: material but not pervasive.

Opinion: qualified under AU-C 705.08a. The Basis for Qualified Opinion section states that the company has not recognized a right-of-use asset of $2,250,000 and lease liability of $2,300,000 required by ASC 842, and that net income would decrease by $60,000. The opinion reads "except for the effects of the matter described in the Basis for Qualified Opinion section". Before release, the partner shares the wording with the board under AU-C 705.31.

Self-check

Answer each question before you open the answer.

You cannot observe inventory that makes up 60% of total assets and no alternative procedures work. Which opinion?
Show answer
A disclaimer under AU-C 705.10. It is an inability to obtain evidence, and the possible effects could be both material and pervasive because inventory is a substantial proportion of the statements.
What must the basis section include for a material misstatement in a specific amount?
Show answer
A description and quantification of the financial effects, unless impracticable, in which case you say so (AU-C 705.22).
Can you include a Key Audit Matters section in a report with an adverse opinion?
Show answer
No. AU-C 705.30 prohibits a Key Audit Matters section when you express an adverse opinion or disclaim.

Sources

AICPA Statements on Auditing Standards (AU-C sections), currently effective

Back to the syllabus

Standards are paraphrased from the primary sources listed above; read the source before relying on a requirement. This lesson is training material, not professional advice. Report an error