And now we're going to look at the different types of audit report that can be produced.
And you can have, first of all, what I will call a basic audit report or a clean audit report, which simply says the financial statements show a true and fair view. There's no going concern problem. There's no emphasis on matter problems, no other matters problem. And then what I'll use, I'll say that we can change from that to what's called a modified report. Now, this is a slightly dangerous phrase to use, but there's no other convenient one. You could use a changed report because there's great confusion between the audit report and the audit opinion we saw in the previous lecture that the audit report is a great big long thing starting with you know independent audit report, opinion, basis of opinion, all your significant audit matters, key audit matters, managers responsibility, auditors responsibility, and so on. it can be a couple of pages now quite easily, but the audit opinion is really like the hub, the nub of the matter really. this is what would really matter, so we have to draw a distinction between changing something in the report and changing something in the opinion. So what we can start off saying here is you can begin to change the report in some way. And first of all, you can change it in a way, matters that do not affect the auditor's opinion. So in other words, we are still happy to say that the financial statements show a true and fair view, but we do not affect the auditor's opinion. so these are really little additions to the audit report to be of help to members but there is no criticism here of the financial statements, they are as good as they can be and the sorts of additions we can add on here, emphasis of matter emphasis of matter paragraph is where you draw somebody's attention to let's say a note in the financial statements but everything's been absolutely disclosed it's in the note you just say hey lads go and look at this note because if you don't you may misunderstand what's happening. if there is a material on certainly about going concern you would mention that, you say go and look at this note where it will explain there's a problem in renewing the bank loan or something and therefore there's a material uncertainty that the company is going to last for the next 12 months or there could be another matter where maybe the director's report is at odds with something in the financial statements but the financial statements are still as perfect as they can be so this is not a qualified or not a modified opinion of any sort. and then here we have what's the modified report in particular we are modifying the opinion we are no longer simply saying that the financial statements show a true and fair view end of the story, over this side there's some sort of kind of criticism some sort of problem with financial statements and we're not willing to say that the financial statements simply show a true and fair view, and there are three ways in which the opinion can be modified it can be a qualified opinion, it can be a disclaimer of opinion or can be an adverse opinion. We'll see what they are in a moment, but they could happen because, first of all, the financial statements contain a material misstatement. So basically you're saying there is something wrong, there is a wrong figure in the financial statements, or it omits a note, there is something wrong in the financial statements. Or what it might be is that we simply have not been able to collect the evidence, and if you don't have sufficient appropriate audit evidence you can't come to a reasonable or give reasonable assurance that the financial statements are free of material misstatement so basically you're left in here with a big question mark we're kind of saying well we don't actually know whether the financial statements show a true and fair view or not because we can't get the evidence, so remember you can have a qualified opinion This is making, if you like, not a mild criticism, but it's criticizing one relatively isolated part of the financial statements. You can have a disclaimer of opinion, which says we have no idea, and we're not prepared to give any sort of opinion on it at all. And there's an adverse opinion, which is basically saying the financial statements are so wrong that they're not really worth anything. The problem cannot be isolated in some way. It fatally undermines the financial statements.
So here's an example of an emphasis of matter paragraph. Remember the emphasis of matter paragraph is down this side here. This is where we're not criticizing the financial statements. We're just, as I say, waving like a red flag to the members saying, go and look here. So it's a paragraph in the auditor's report used when the auditor specifically wants to draw readers'attention to some matter already properly and clearly disclosed within the financial statements so the financial statements are as perfect as they can be in this respect it is not a qualification it is not a modification of the auditor's opinion. so here we have an example without qualifying our opinion we draw your attention to note 10 of the financial statements five days before the directors formally approved financial statements the company received notification that they're to be named as defendants in a proposed legal action, at this early stage it is not possible to estimate the ultimate outcome of this matter and no provision has been included within the financial statements. So we are coming clean. We are disclosing there's this little kind of problem hanging over the company. It is in Note 10, but in case you never get as far as reading the notes, you say in the audit report, go and look at Note 10 because this is really quite important to the company. But the financial statements are as good as they can be in the circumstances. They are admitting that this problem and now, and this again is new with this new audit report, there's a kind of standardization. special emphasis of matter paragraph if there's a material uncertainty as the going concern it'll be headed up that and this is very like emphasis of matter it's a paragraph in the auditor's report used to refer to a going concern problem that is already disclosed in the financial statements, again nothing wrong with financial statements, it is therefore not any sort of modification to the auditor's opinion any sort of qualification or adverse opinion, it's added as an additional warning to people go and look at here note 13, so here it says without qualifying our opinion above we draw attention to the fact that in note 13 the directors discuss the renewal of the company's bank loan and presumably it's going on to say that the bank isn't responding to their requests and therefore there may be difficulty in going for the foreseeable future. an other matter paragraph would be before we get on to that what would give rise to going concern problems we should assess the going concern over the twelve months from the balance sheet date and signs and this should be assessed by the directors it's their job to assess going concern and then the auditors audit the director's assessment of the going concern but typical sorts of signs that the company might be in trouble negative operating cash flows, in other words cash flowing out inability to pay suppliers as and when due, payments getting slower and slower and slower, operating losses don't immediately lead to going concern problems but they eventually will, borrowing facilities not agreed and the bank is kind of avoiding your phone calls and so on, loss of key staff, loss of key customers, if you're selling 80% of your output to one customer and they go somewhere else then you could be in serious kind of going concern problems, technology changes so what you're doing what you are making is no longer popular is no longer going to be selling legislative changes we've had recent in the UK big changes in our pension legislation and this meant that some financial companies in a way there's almost no purpose to many of the products which they were offering and some of them would be facing probably going concern issues and then non-compliance with regulations this could be a big fine which could bankrupt you, it could be removing your right to trade removing a license to trade in some way all of these are warning signs of outgoing concern. effect on the order report if it's disclosed it is well the special emphasis of matter now it's a special paragraph now it's it's not really ever some matter it's this special paragraph drawing attention to going concern issues if it's not disclosed then the financial statements are wrong they should be disclosing going concerns issues and probably it's going to be some sort of adverse opinion the financial statements do not show a true and fair view or potentially it could be an except for if it's simply missing a note, so if the directors do not make this assessment of going concern then I think we're likely to get to an adverse kind of opinion or a disclaimer of opinion. if they says going concern and it appears that there is no realistic prospect of the company's survival then the financial statements should be drawn up on a break-up basis but if there's only some doubt as to going concern you draw them up on a going concern basis and there should be a note in the financial statements referred to by this note in the audit report material uncertainty as to going concern.
an other matters paragraph if it requires one is used to refer to a matter not presented or disclosed in the financial statements and nor should it be disclosed in financial statements that is relevant to the user's understanding of the audit. For example, here, without qualifying our opinion above, we draw attention to the fact that the profit figure disclosed in the director's report does not agree with that in the financial statements. Now, you can't have a modified opinion about the financial statements. We're saying the profit as disclosed in the financial statements is right. Therefore, the audit opinion is fine. But we're saying it's the other stuff, the stuff that we're not reporting on in the director's report. That's what's wrong. Because people often look at the director's report maybe before they look at the financial statements they're going to get mixed messages so what we're doing is basically we're pointing out by the way what they said in the director's report is inconsistent with what's in the financial statements but we can't issue a modified opinion because the financial statements are still fine.
now the qualification matrix which arises here is important to look at if the financial statements contain a material misstatement first of all before you do any modification of opinion it has to be material it has to be of a size that would influence someone's economic decisions and here the phrase is 'except for' in other words we're saying except that this is wrong the rest of the financial statements show a true and fair view you can isolate the problem really If, however, the thing is pervasive, this means that really the error or the misstatement is so huge that really all the financial statements are undermined. Pervasive means almost affecting everywhere or appearing everywhere. If you talk about a pervasive smell in a building, it means every room you go into, you can smell the damp or something of that sort. Here we're saying the error is so big that really the financial statements are a waste of paper. Now, by and large, auditors will try and prefer to give an except for, because if you give an adverse opinion, it really means that your shareholders are left with nothing they can rely on. If at least you give an except for, you can say, well, that's wrong, but the rest is OK. It's rather more useful. The other reason you can qualify is you've been able to obtain sufficient appropriate audit evidence. And again, if this is material, that's your first hurdle. It has to be material absence of evidence, but it is limited. except for you know except for that we are unable to verify that the accruals figure was correct but it's kind of isolated but if it's a great big hole in the financial statements that we've been able to verify inventory and inventory is terribly material to the company then we say well we actually don't know whether financial statements show a true and fair view that's a disclaimer of opinion.
so here we have some examples insufficient evidence, qualified opinion except this is like this would be basically in the basis of opinion here we did not observe the counting of inventories at the end of the year and we are unable to determine the inventory quantities by any other methods. in our opinion except for the effects of such adjustments of inventory, if any, because we don't know if any would be necessary here, we the financial statements show a true and fair view. So we don't know about the inventory. We don't know if the profits are too little, too big, or just right. If you don't have the evidence, you don't have the evidence. But at least it's isolated. here is a disclaimer of opinion it's exactly the same reason we have been able to observe the counting of physical inventory but because these are so material such a huge effect perhaps on the profit and the total of the assets in the company we simply don't know whether the financial statements are true or not we are not going to express an opinion on them so it is not the nature of the error it is the size of it is it material but not pervasive or is it pervasive.
Here we have a material misstatement, a qualified opinion. As discussed in paragraph 13, no depreciation has been provided. This is not in accordance with certain accounting standards. The provision should have been X, the profits would then have been decreased by Y. In our opinion, except for the matter referred to above, the financial statements show a true and fair view. To be able to kind of carve out and isolate this problem, and note here that you quantify it. we can quantify the error we say the financial statements are showing this if they put the depreciation through if they'd done them right it should have been that we can't do that if there's insufficient evidence because if there's insufficient evidence you don't know whether the figures are too big too small or just about right
And then we have the adverse opinion as discussed in paragraph 14. No bad debt provision. The customer owed 2 million. They've gone into liquidation. We're not going to receive any of that. And here, because of the size of the 2 million compared perhaps to the profit, compared to the rest of the assets of a company, we're saying the financial statements do not show a true view. That's your adverse opinion. the financial statements are basically a load of rubbish a waste of paper don't even bother looking any further because you're not getting anything very useful from them