Clearing up the confusion

When drafting auditors’ reports, the auditor must take care to ensure that not only do they comply with the International Standards on Auditing (ISAs) governing reporting issues (i.e. the ISAs in the 700 series), but also that any additional paragraphs included in the auditor’s report are appropriate and technically correct.

Seemingly, there is a lot of confusion over when certain additional paragraphs should be included within an auditor’s report and so this article will tackle two of the most common paragraphs which appear to be the ‘culprits’, being:

● Emphasis of Matter paragraphs; and

● Material Uncertainties Related to Going Concern paragraphs.

The aim of this article is to clear up any ambiguity as to when such paragraphs should be included in an auditor’s report and when they should not.

Emphasis of Matter paragraphs

Emphasis of Matter (EoM) paragraphs and Other Matter (OM) paragraphs are dealt with in ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report. There is often confusion surrounding the appropriateness of an EoM paragraph within the auditor’s report. An EoM paragraph is defined as:

Example:The incorrect use of an Emphasis of Matter paragraph

The audit of Sunnie Ltd for the year ended 31 July 2022 revealed a number of misstatements which the auditor has concluded as being immaterial both in isolation and in the aggregate. The directors decided not to adjust the financial statements on the grounds that the misstatements were immaterial. The audit engagement partner has placed the following comment on the completion section of the audit file:

To err on the side of caution, I deem an EoM paragraph to be appropriate in these circumstances. When drafting the auditor’s report, I suggest we refer to there being a number of unadjusted misstatements which are immaterial in isolation and in the aggregate and confirm that our opinion is not modified in respect of these misstatements.

There are four fundamentally flawed points to the partner’s logic in including an EoM paragraph within the auditor’s report:

● An EoM paragraph can only be used when a matter has been adequately disclosed in the financial statements as it must cross-refer the user to the relevant disclosure note number.

● In this scenario, there is no disclosure note that can be cross-referred to as the company will not have made any disclosures concerning immaterial misstatements that remain uncorrected.

● There is no need to include an EOM paragraph in the auditor’s report in respect of immaterial misstatements because the mere fact that they are immaterial means they do not warrant the attention of shareholders.

● There would be no need to confirm that the audit opinion is not modified in respect of immaterial misstatements as an auditor’s opinion would never be qualified for misstatements that are immaterial in isolation and in the aggregate.

‘A paragraph included in the auditor’s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements.’

At the outset, it is worth noting that an EoM paragraph does not qualify the auditor’s opinion in any way. It is used to refer to a matter which has been adequately presented or disclosed in the financial statements by the directors. When the auditor concludes that these matters are of such fundamental importance to users’ understanding, the auditor draws attention to this matter through an EoM paragraph in their report.

Not every auditor’s report will contain an EoM paragraph because not every matter disclosed in the financial statements will be of fundamental importance to users’ understanding. What is, and is not, fundamental will be a matter of professional judgment for the auditor. However, examples of fundamental matters may include the following (note, the list below is not comprehensive):

● The client’s financial statements have been prepared on a basis other than the going concern basis.

● There is an uncertainty relating to the future outcome of a legal case or regulatory action.

● A significant post balance sheet event (a subsequent event) occurs between the balance sheet date and the date of the auditor’s report.

● The entity early adopts an accounting standard (or an amendment to a standard).

● A major catastrophe has occurred that has had a significant effect on the entity’s financial position.

● Corresponding figures have been restated.

● The financial statements have been reissued and the auditor has provided an amended auditor’s report.

ISA 706 states:

‘When the auditor includes an Emphasis of Matter paragraph in the auditor’s report, the auditor shall: a. include the paragraph within a separate section of the auditor’s report with an appropriate heading that includes the term “Emphasis of Matter”; b. include in the paragraph a clear reference to the matter being emphasised and to where relevant disclosures that fully describe the matter can be found in the financial statements. The paragraph shall refer only to information presented or disclosed in the financial statements; and c. indicate that the auditor’s opinion is not modified in respect of the matter emphasised.’

Material Uncertainty Related to Going Concern paragraphs

The auditor’s responsibilities in respect of going concern are dealt with in ISA 570 Going Concern (and ISA (UK) 570 Going Concern), which also covers some aspects concerning reporting.

Going concern has always been an important issue for auditors, but in recent years its importance has moved up the ranks in light of the global pandemic and, more recently, the effect of inflation.

Where management have concluded that there is a material uncertainty related to going concern and that uncertainty has been adequately disclosed in the financial statements, the auditor must make reference to the relevant disclosure note in their auditor’s report. This is done by way of a Material Uncertainty Related to Going Concern (MURGC) paragraph. ISA 570 (including ISA (UK) 570) states:

‘If appropriate disclosure about the material uncertainty related to going concern is made in the financial statements, the auditor shall express an unmodified opinion and the auditor’s report shall include a separate section under the heading “Material Uncertainty Related to Going Concern” to: a. draw attention to the note in the financial statements that discloses the matters set out in paragraph 19; and b. state that these events or conditions indicate that a material uncertainty exists that may cast significant doubt on the entity’s ability to continue as a going concern and that the auditor’s report is not modified in respect of the matter.’

ISA (UK) 570, para 22 also contains subparagraph (c) which states: c. For entities that are required, and those that choose voluntarily, to report on how they have applied the UK Corporate Governance Code, or to explain why they have not, a statement that the auditor has nothing to add or draw attention to in respect of the directors’ identification in the financial statements of any material uncertainties to the entity’s ability to continue to do so over a period of at least twelve months from the date of approval of the financial statements.

If management inadequately disclose material uncertainties related to going concern (or fail to make any disclosures at all) and refuse to resolve the issue, the auditor will not include a MURGC paragraph. Instead, the auditor will modify their audit opinion accordingly.

What is going wrong?

It seems that many auditors’ reports continue to include cross-references to adequate disclosures of going concern uncertainties within an EoM paragraph, which is technically incorrect. While the MURGC paragraph acts in much the same way as an EoM paragraph (in that it cross-references to the relevant disclosure note in the financial statements and contains a confirmation that the auditor’s opinion is not modified in respect of the matter), it is not the same thing. As going concern is such a fundamental concept, any material uncertainties need to be highlighted and the way to do that through the auditor’s report is to use a MURGC paragraph.

There have also been instances where an audit client has made adequate disclosure of a material uncertainty related to going concern, but no MURGC paragraph has been included in the auditor’s report. Indeed, some firms continue to include the ‘Conclusions related to going concern’ paragraph, stating that based on the work performed, the auditor has not identified any material uncertainties related to events or conditions that, individually or collectively, may cast significant doubt on the company’s ability to continue as a going concern for the foreseeable future. This means the auditor’s report is inconsistent with the financial statements and indicates a lack of attention on the part of the auditor, or a lack of awareness as to the requirements of ISA 570 or ISA (UK) 570.

Example:The correct use of an Emphasis of Matter paragraph

The audit of the financial statements of Crusader Ltd for the year ended 31 July 2022 has drawn to a close and the auditor’s report is being drafted. During the audit, the audit senior was made aware that one of the client’s bonded warehouses had suffered a fire that had destroyed a large amount of the client’s inventory. The fire occurred in mid-August 2022 and hence the inventory has not been written down to estimated selling price (net realisable value) in the 31 July 2022 financial statements as the event is a non-adjusting post balance sheet event.

The auditor has concluded that adequate disclosure has been made in the financial statements concerning this event and the event is fundamental to the users’ understanding. In this scenario, an EoM paragraph would be appropriate and may be drafted as follows:

Emphasis of Matter:

We draw attention to note 34 of the financial statements, which describes the effects of a fire at the premises of a third-party warehouse provider. Our opinion is not modified in respect of this matter.

In this example, the EoM paragraph has cross-referred to the relevant disclosure that adequately describes the non-adjusting event. It also correctly clarifies that the auditor’s opinion is not modified in respect of the matter being emphasised.

Example:Correct use of a Material Uncertainty Related to Going Concern paragraph

We draw your attention to note 23 which indicates that the company must retender for a large contract in June 2022. If the company were to fail to win the bid, the loss of the contract may have a detrimental impact on the company’s operations and cash flows. As stated in note 23, these events or conditions along with other matters as set forth in note 23 indicate that a material uncertainty exists that may cast significant doubt on the company’s ability to continue as a going concern. Our opinion is not modified in respect of this matter.

Conclusion

Auditors must keep in mind that an EoM paragraph should only be used when an issue is fundamental to users’ understanding. It is always worthwhile documenting the reasons on the audit file as to why the auditor deems a matter as being fundamental and hence why an EoM paragraph has been included in the auditor’s report. Never use an EoM paragraph as any sort of attempt to modify the auditor’s opinion. Keep in mind the requirements of ISA 706 (ISA (UK) 706) specifically require the paragraph to confirm that the auditor’s opinion is not modified in respect of the matter(s) being emphasised. ●