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5 Modified opinions in auditors' reports June 15, Specimen Exam

5 Modified opinions in auditors' reports June 15, Specimen Exam

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(2)

The application of selected accounting policies
The appropriateness or adequacy of disclosures in the financial statements

The auditor cannot obtain sufficient appropriate audit evidence on which to base the opinion but
concludes that the possible effects of undetected misstatements, if any, could be material but
not pervasive.
The auditor's inability to obtain sufficient appropriate audit evidence is also referred to as a
limitation on the scope of the audit and could arise from:




Circumstances beyond the entity's control (eg accounting records destroyed)
Circumstances relating to the nature or timing of the auditor's work (eg the timing of the
auditor's appointment prevents the observation of the physical inventory count)
Limitations imposed by management (eg management prevents the auditor from requesting
external confirmation of specific account balances)

1.5.3 Adverse opinions
An adverse opinion is expressed when the auditor, having obtained sufficient appropriate audit evidence,
concludes that misstatements are both material and pervasive to the financial statements. The table
below gives one example of why an adverse opinion might be expressed for each of the three possible
reasons for misstatements being determined as pervasive (as stated in the Key term box in Section 1.3.1).
Reason deemed pervasive

Example

Misstatements are not confined to specific
elements, accounts or items in the financial
statements

No depreciation has been provided on plant and
equipment, a receivable balance consisting half of
total receivables is irrecoverable and has not been
provided and trade payables have been
significantly understated. All misstatements are
material and these balances are significant on the
statement of financial position (SOFP).

Misstatements are confined to specific elements,
accounts or items in the financial statements and
represent a substantial portion of the financial
statements

A house building company has included all the
houses it has constructed in the year as noncurrent assets rather than inventory. The value of
these houses constitutes 90% of the total asset
value on the SOFP.

Misstatements relate to disclosures which are
fundamental to users' understanding of the
financial statements

There is a material uncertainty in respect of going
concern which has not been adequately disclosed.

Sometimes it is easier to think in more general terms when deciding whether an adverse opinion is
warranted (apart from specific instances where reasons for adverse opinions are specified by ISAs, such
as in relation to going concern).
The question to ask yourself is this: Am I significantly diverted from the real financial position of the
company as a result of the misstatement(s)?
In the house builder example above, the accounts presented would suggest that the company was holding
no property for sale but had significant company property that was being utilised by the business. The
effects of the misstatement are clearly pervasive.

1.5.4 Disclaimers of opinion
An opinion must be disclaimed when the auditor cannot obtain sufficient appropriate audit evidence on
which to base the opinion and concludes that the possible effects on the financial statements of
undetected misstatements, if any, could be both material and pervasive.
The opinion must also be disclaimed in situations involving multiple uncertainties when the auditor
concludes that, despite having obtained sufficient appropriate audit evidence for the individual

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uncertainties, it is not possible to form an opinion on the financial statements due to the potential
interaction of the uncertainties and their possible cumulative effect on the financial statements.
One example of when a disclaimer of opinion is used was given in Chapter 18 where, in relation to going
concern, management is unwilling to make or extend its assessment. Another example might be where the
auditor is unable to attend the inventory count and unable to request receivable confirmations, and there is
no other realistic means of gathering evidence on these two areas. If these two areas form a significant
element of the total assets value, a disclaimer may be appropriate.

1.5.5 Impact on the auditor's report
When the auditor has had to modify the auditor's opinion, the auditor's report must include a paragraph
before the opinion paragraph, which provides a description of the matter giving rise to the modification.
This paragraph will be entitled 'Basis for qualified opinion' or 'Basis for adverse opinion' or 'Basis for
disclaimer of opinion' depending on the type of modification.
The section of the auditor's report containing the opinion will be headed either 'Qualified opinion',
'Adverse opinion' or 'Disclaimer of opinion', again depending on the type of modification.
When the auditor expresses a qualified or adverse opinion, the section of the report on the auditor's
responsibilities must be amended to state that the auditor believes that the audit evidence obtained is
sufficient and appropriate to provide a basis for the auditor's modified audit opinion.
When the auditor disclaims an opinion due to being unable to obtain sufficient appropriate audit evidence,
the section on the auditor's responsibilities must be amended to include the following: 'Because of the
matter(s) described in the Basis for Disclaimer of Opinion paragraph, however, we were not able to obtain
sufficient appropriate audit evidence to provide a basis for an audit opinion.'
We will now look at some examples of extracts from auditors' reports with modified opinions for each of
the situations we have discussed above.
Example 1: Qualified opinion due to material misstatement
In this example, inventories are materially misstated but the effect is not pervasive.
Qualified Opinion
We have audited the financial statements of ABC Company (the Company), which comprise the statement
of financial position as at December 31, 20X1, and the statement of comprehensive income, statement of
changes in equity and statement of cash flows for the year then ended, and notes to the financial
statements, including a summary of significant accounting policies.
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph,
the financial statements present fairly, in all material respects, (or give a true and fair view of) the financial
position of ABC Company as at December 31, 20X1, and (of) its financial performance and its cash flows
for the year then ended in accordance with International Financial Reporting Standards.
Basis for qualified opinion
The company's inventories are carried in the statement of financial position at xxx. Management has not
stated inventories at the lower of cost and net realisable value but has stated them solely at cost, which
constitutes a departure from International Financial Reporting Standards. The company's records indicate
that, had management stated the inventories at the lower of cost and net realisable value, an amount of
xxx would have been required to write the inventories down to their net realisable value. Accordingly, cost
of sales would have been increased by xxx, and income tax, net income and shareholders' equity would
have been reduced by xxx, xxx and xxx, respectively.
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit
of the Financial Statements section of our report. We are independent of the Company in accordance with
the ethical requirements that are relevant to our audit of the financial statements in [jurisdiction], and we
have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the
audit evidence we have obtained is sufficient and appropriate to provide a basis for our qualified opinion.

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Example 2: Adverse opinion due to material misstatement with a pervasive effect
This example is an adverse opinion due to a pervasive material misstatement in the consolidated financial
statements..
Adverse Opinion
We have audited the consolidated financial statements of ABC Company and its subsidiaries (the Group),
which comprise the consolidated statement of financial position as at December 31, 20X1, and the
consolidated statement of comprehensive income, consolidated statement of changes in equity and
consolidated statement of cash flows for the year then ended, and notes to the consolidated financial
statements, including a summary of significant accounting policies.
In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion
paragraph, the financial statements do not present fairly (or do not give a true and fair view of) the
financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its
cash flows for the year then ended in accordance with International Financial Reporting Standards.
Basis for adverse opinion
As explained in Note X, the Group has not consolidated subsidiary XYZ Company that the Group acquired
during 20X1 because it has not yet been able to determine the fair values of certain of the subsidiary’s
material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost
basis. Under IFRSs, the Company should have consolidated this subsidiary and accounted for the
acquisition based on provisional amounts. Had XYZ Company been consolidated, many elements in the
accompanying consolidated financial statements would have been materially affected. The effects on the
consolidated financial statements of the failure to consolidate have not been determined.
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit
of the Consolidated Financial Statements section of our report. We are independent of the Group in
accordance with the ethical requirements that are relevant to our audit of the consolidated financial
statements in [jurisdiction], and we have fulfilled our other ethical responsibilities in accordance with
these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to
provide a basis for our adverse opinion.
Example 3: Qualified opinion due to inability to obtain sufficient appropriate audit evidence
In this example, the inventory count was not attended by the auditor, but, in the context of the financial
statements, even though inventory could be materially misstated (which the auditor can not conclude on –
so the phrase 'possible effects' is used), the effects would not be pervasive.
Qualified Opinion
We have audited the consolidated financial statements of ABC Company and its subsidiaries (the Group),
which comprise the consolidated statement of financial position as at December 31, 20X1, and the
consolidated statement of comprehensive income, consolidated statement of changes in equity and
consolidated statement of cash flows for the year then ended, and notes to the consolidated financial
statements, including a summary of significant accounting policies.
In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion
paragraph, the financial statements present fairly, in all material respects, (or give a true and fair view of)
the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its
cash flows for the year then ended in accordance with International Financial Reporting Standards.

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Basis for qualified opinion
With respect to inventory having a carrying amount of $X the audit evidence available to us was limited
because we did not observe the counting of the physical inventory as at 31 December 20X1, since that
date was prior to our appointment as auditor of the company. Owing to the nature of the company's
records, we were unable to obtain sufficient appropriate audit evidence regarding the inventory quantities
by using other audit procedures.
We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor’s Responsibilities for the Audit
of the Consolidated Financial Statements section of our report. We are independent of the Group in
accordance with the ethical requirements that are relevant to our audit of the consolidated financial
statements in [jurisdiction], and we have fulfilled our other ethical responsibilities in accordance with
these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to
provide a basis for our qualified opinion.
Example 4: Disclaimer of opinion due to inability to obtain sufficient appropriate audit evidence about
multiple elements of the financial statements
In this example, the auditor has not only been unable to attend the inventory count, but has also been
unable to gain evidence over other areas. As a result, the auditor has concluded that the effects of the
possible misstatements could be material and pervasive.
Disclaimer of Opinion
We were engaged to audit the consolidated financial statements of ABC Company and its subsidiaries (the
Group), which comprise the consolidated statement of financial position as at December 31, 20X1, and the
consolidated statement of comprehensive income, consolidated statement of changes in equity and
consolidated statement of cash flows for the year then ended, and notes to the consolidated financial
statements, including a summary of significant accounting policies.
Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we
have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion.
Accordingly, we do not express an opinion on the financial statements.
Basis for disclaimer of opinion
We were not appointed as auditors of the company until after December 31, 20X1 and thus did not
observe the counting of physical inventories at the beginning and end of the year. We were unable to
satisfy ourselves by alternative means concerning the inventory quantities held at December 31, 20X0 and
20X1 which are stated in the statement of financial position at xxx and xxx, respectively. In addition, the
introduction of a new computerised accounts receivable system in September 20X1 resulted in numerous
errors in accounts receivable. As of the date of our audit report, management was still in the process of
rectifying the system deficiencies and correcting the errors. We were unable to confirm or verify by
alternative means accounts receivable included in the statement of financial position at a total amount of
xxx as at December 31, 20X1. As a result of these matters, we were unable to determine whether any
adjustments might have been found necessary in respect of recorded or unrecorded inventories and
accounts receivable, and the elements making up the statement of profit or loss, statement of changes in
equity and cash flow statement.

1.5.6 Communication with those charged with governance
ISA 705 states that when the auditor expects to express a modified opinion, the auditor must
communicate with those charged with governance the circumstances leading to the expected
modification and the proposed wording of the modification in the auditor's report.
This allows the auditor to give notice to those charged with governance of the intended modification and
the reasons for it, to seek agreement or confirm disagreement with those charged with governance with
respect to the modification, and to give those charged with governance an opportunity to provide further
information and explanations on the matter giving rise to the expected modification.

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1.5.7 Summary of modifications and impact on the auditor's report
The following table summarises the different types of modified opinion that can arise.
Nature of circumstances

Material but not pervasive

Material and pervasive

Financial statements are
materially misstated

QUALIFIED OPINION

ADVERSE OPINION

Auditor unable to obtain
sufficient appropriate audit
evidence

QUALIFIED OPINION

DISCLAIMER OF OPINION

Question

Modified reports

During the course of your audit of the non-current assets of Eastern Engineering Inc at 31 March 20X4,
two problems have arisen.
(a)

The calculations of the cost of direct labour incurred on assets in the course of construction by the
company's employees have been accidentally destroyed for the early part of the year. The direct
labour cost involved is $10,000.

(b)

The company incurred development expenditure of $25,000 spent on a viable new product which
will go into production next year and which is expected to last for ten years. These costs have been
expensed in full to the statement of profit or loss.

(c)

Other relevant financial information is as follows.
Profit before tax
Non-current asset additions (excluding constructed assets)
Assets constructed by company
Non-current asset at net book value

$
100,000
133,000
34,000
666,667

Required
(a)

List the general forms of modification available to auditors in drafting their report and state the
circumstances in which each is appropriate.

(b)

State whether you feel that a modified audit opinion would be necessary for each of the two
circumstances outlined above, giving reasons in each case.

(c)

On the assumption that you decide that a modified audit opinion is necessary with respect to the
treatment of the development expenditure, draft the section of the report describing the matter (the
whole report is not required).

Answer
(a)

ISA 705 Modifications to the opinion in the independent auditor's report suggests that the auditor
may need to modify the opinion under one of two main circumstances:


The auditor concludes that the financial statements as a whole are not free from material
misstatements, or



The auditor cannot obtain sufficient appropriate audit evidence to conclude that the financial
statements as a whole are free from material misstatement.

For both circumstances there can be two 'levels' of modified opinion.

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(i)

Material but not pervasive, where the circumstances prompting the misstatement or
possible misstatement are material. These circumstances will result in a qualified opinion.

(ii)

Material and pervasive to the overall view shown by the financial statements, ie the
financial statements are or could be misleading. These will result in an adverse opinion

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(financial statements are misstated) or a disclaimer of opinion (the auditor is unable to
obtain sufficient appropriate audit evidence).
(b)

Whether a modification of the audit opinion would be required in the circumstances described
would depend on whether or not the auditors considered either of them to be material to the
financial statements as a whole. An item is likely to be considered material in the context of a
company's financial statements if its omission, misstatement or non-disclosure would prevent a
proper understanding of those statements on the part of a potential user.
(i)

Loss of records relating to direct labour costs for assets in the course of construction
The loss of records supporting one of the asset figures in the statement of financial position
would cause a limitation in scope of the auditor's work because the auditor would be unable
to obtain sufficient appropriate audit evidence. The $10,000 represents 29.4% of the
expenditure incurred during the year on assets in course of construction but only 6% of
total additions to non-current assets during the year and 1.5% of the year-end net book
value for non-current assets. The total amount of $10,000 represents 10% of pre-tax profit
but, the real consideration by the auditor should be the materiality of any over- or
understatement of assets resulting from error in arriving at the $10,000 rather than the total
figure itself.
Provided there are no suspicious circumstances surrounding the loss of these records and
the total figure for additions to assets in the course of construction seems reasonable in the
light of other audit evidence obtained, then it is unlikely that this matter would be seen as
sufficiently material to merit any modification of the audit opinion. If other records have
been lost as well, however, it may be necessary for the auditor to comment on the directors'
failure to maintain proper books and records.

(ii)

Development cost debited to the statement of profit or loss
The situation here is one of misstatement in the financial statements, since best accounting
practice as laid down by IAS 38 requires that development costs should be taken to the
statement of comprehensive income over the useful life of the product to which they relate.
This departure from IAS 38 does not seem to be justifiable and would be material to the
reported pre-tax profits for the year, representing 25% of that figure.
While this understatement of profit would be material to the financial statements, it is not
likely to been seen as pervasive and therefore a qualified opinion would be appropriate.

(c)

Qualified audit opinion extract
Qualified opinion
We have audited the consolidated financial statements of ABC Company and its subsidiaries (the
Group), which comprise the consolidated statement of financial position as at December 31, 20X1,
and the consolidated statement of comprehensive income, consolidated statement of changes in
equity and consolidated statement of cash flows for the year then ended, and notes to the
consolidated financial statements, including a summary of significant accounting policies.
In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion
paragraph, the financial statements present fairly, in all material respects, (or give a true and fair
view of) the financial position of Eastern Engineering Inc as at March 31, 20X4, and (of) its
financial performance and its cash flows for the year then ended in accordance with International
Financial Reporting Standards.
Basis for qualified opinion
As explained in note ... development costs in respect of a potential new product have been
deducted in full against profit instead of being spread over the life of the relevant product as
required by IAS 38; the effect of so doing has been to decrease profits before and after tax for the
year by $25,000.

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We conducted our audit in accordance with International Standards on Auditing (ISAs). Our
responsibilities under those standards are further described in the Auditor’s Responsibilities for the
Audit of the Financial Statements section of our report. We are independent of the Company in
accordance with the ethical requirements that are relevant to our audit of the financial statements in
[jurisdiction], and we have fulfilled our other ethical responsibilities in accordance with these
requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to
provide a basis for our qualified opinion.

Exam focus
point

If you are given a scenario in a question on audit reports and asked whether the opinion should be
modified and on what basis, always remember to calculate materiality and comment on it in the context of
its impact on the type of modification (ie qualified opinion, adverse opinion or disclaimer of opinion).

1.6 Reporting on Compliance with International Financial Reporting
Standards
As we have discussed above, the objective of an audit is to enable the auditor to express an opinion on
whether the financial statements are prepared, in all material respects, in accordance with an applicable
financial reporting framework. The auditor's report must indicate the financial reporting framework that
has been used to prepare the financial statements.

1.7 Other information in documents containing audited financial
statements
FAST FORWARD

Auditors shall review the other information in documents containing audited financial statements for
material inconsistencies and misstatements of fact.
ISA 720 (Revised) The auditor's responsibilities relating to other information in documents containing
audited financial statements provides guidance to auditors in this area. The objective of the auditor is to
respond appropriately when documents containing audited financial statements include other information
that could undermine the credibility of the financial statements and the auditor's report.

Key terms

Other information is financial and non-financial information (other than the financial statements and the
auditor's report thereon) included in an entity’s annual report
An annual report is a document, or combination of documents, prepared typically on an annual basis by
management or those charged with governance in accordance with law, regulation or custom.
Its purposes is to provide owners (or similar stakeholders) with information on the entity’s operations and
the entity’s financial results and financial position as set out in the financial statements.
A misstatement of the other information exists when the other information is incorrectly stated or
otherwise misleading (including because it omits or obscures information necessary for a proper
understanding of a matter disclosed in the other information).
Examples of other information include the following:








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A report by management or those charged with governance on operations
Financial summaries or highlights
Employment data
Planned capital expenditures
Financial ratios
Names of officers and directors
Selected quarterly data

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1.7.1 Material misstatements of the other information
ISA 720 states that the auditor shall read the other information to identity material inconsistencies with
the audited financial statements. If a material inconsistency is identified, the auditor shall determine
whether the audited financial statements or other information is misstated.
If the financial statements is materially misstated but management refuses to correct the misstatement,
the auditor shall modify the audit opinion.
If the other information is materially misstated and needs to be revised but management refuses, the
auditor shall communicate this matter to those charged with governance and:


Include an Other information section in the auditor's report that describes the material
inconsistency, or



Withdraw from the engagement (where this is legally permitted).

In reading and considering the other information, the auditor should also consider whether the auditor’s
understanding of the entity and its environment needs to be updated.

1.8 The audit report as a means of communication
1.8.1 Implied information
Audit reports with unmodified opinions may not appear to give a great deal of information. However, the
report says much by implication. Remember that the auditors report by exception, so a standard report
tells the user that, for example:






Adequate accounting records have been kept.
The accounts agree with the records.
The auditors have received all necessary information.
All directors' transactions have been disclosed.
The directors' report is consistent with the accounts.

The real problem here is that, unfortunately, most users do not know that this is what an auditor's report
tells them. This issue is also confused by the fact that many users do not understand the responsibilities
of either the auditors or the directors in relation to the financial statements.

1.8.2 Expectations gap
This difference between the actual and the public perception is part of what is called the 'expectations
gap', defined as the difference between the apparent public perceptions of the responsibilities of auditors
on the one hand (and therefore the assurance that their involvement provides) and the legal and
professional reality on the other. The question remains: how can we make the meaning of an unmodified
auditor's report clear to the user?
The above definition of the expectations gap is not definitive but we can highlight some specific issues.
(a)

Misunderstandings of the nature of audited financial statements, for example that:


The statement of financial position provides a fair valuation of the reporting entity.



The amounts in the financial statements are stated precisely.



The audited financial statements will guarantee that the entity concerned will continue to
exist.

(b)

Misunderstanding as to the type and extent of work undertaken by auditors

(c)

Misunderstanding about the level of assurance provided by auditors, for example that:


An unmodified auditor's opinion means that no frauds have occurred in the period.



The auditors provide absolute assurance that the figures in the financial statements are
correct (ignoring the concept of materiality and the problems of estimation).

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Different countries have tackled this problem in different ways. The role of auditors has been included in
the debate on corporate governance in many countries, leading to further rules which are nevertheless
voluntary, not mandatory, as we discussed in Chapter 3.

2 Reports to management
FAST FORWARD

Reports to management can be sent by external auditors after both the interim and final audits. They set
out deficiencies in internal control, the implications of those deficiencies on the business and suggested
recommendations to mitigate them.
ISA 265 Communicating deficiencies in internal control to those charged with governance and
management sets out guidance on internal control deficiencies. We covered the requirements of this
standard in detail in Chapter 9 of this Study Text. Many external auditors produce a report to management
as a by-product of an external audit, listing any deficiencies they have found in systems and making
recommendations for improvements. The report to management may also be referred to as the report to
management, letter of weakness or letter on internal control.
One of the PER performance objectives is to 'communicate effectively'. Examples of this in practice would
be to compile written reports for management or clients. This would therefore include a report to
management. The knowledge you attain in this section of the Study Text will help you in situations where
you are asked to draft a report to management and, therefore, assist you in achieving this particular PER
objective. At the same time it also applies to Objective 18 ('evaluate and report on audit') – examples
under this objective include drafting and presenting reports to management.

2.1 The report to management
Recommendations regarding internal control are a by-product of the audit of the financial statements, not
a primary objective, but nonetheless are frequently of great value to a client. The auditors shall
communicate with those charged with governance any material deficiencies in the design, implementation
or operating effectiveness of internal control which have come to their attention during the course of the
audit. This shall be done on a timely basis.
When auditors prepare a written communication on internal control matters, the following points should
be considered:
(a)

It should not include language that conflicts with the opinion expressed in the auditor's report.

(b)

It should state that the accounting and internal control system were considered only to the extent
necessary to determine the auditing procedures to report on the financial statements and not to
determine the adequacy of internal control for management purposes or to provide assurances on
the accounting and internal control systems.

(c)

It will state that it discusses only deficiencies in internal control which have come to the auditors'
attention as a result of the audit and that other deficiencies in internal control may exist.

(d)

It should also include a statement that the communication is provided for use only by
management (or another specific named party).

After the above items and the auditors' suggestions for corrective action are communicated to
management, the auditors will usually ascertain the actions taken, including the reasons for those
suggestions rejected. The auditors may encourage management to respond to the auditors' comments, in
which case any response can be included in the report.
The significance of findings relating to the accounting and internal control systems may change with the
passage of time. Suggestions from previous years' audits which have not been adopted, if any, should
normally be repeated or referred to.

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2.1.1 Example report to management
This is an example of a report to management with a covering letter which demonstrates how the
principles described above might be put into practice.
ABC & Co
Certified Accountants
29 High Street
The Board of Directors
Manufacturing Ltd
15 South Street
1 April 20X8
Members of the board,
Financial statements for the year ended 31 May 20X8
Please find below the report to management which includes sets out deficiencies in internal control we
identified as a result of our review of the accounting systems and procedures operated by your
company during our recent audit. The matters dealt with in the report came to our notice during the
conduct of our normal audit procedures which are designed primarily for the purpose of expressing our
opinion on the financial statements.
Purchases: ordering procedures
Deficiency
During the course of our work we discovered that it was the practice of the stores to order
certain goods from X Co orally without preparing either a purchase requisition or purchase
order.
Implication
There is therefore the possibility of liabilities being set up for unauthorised items and at a
non-competitive price.
Recommendation
We recommend that the buying department should be responsible for such orders and, if they
are placed orally, an official order should be raised as confirmation.
Payables ledger reconciliation
Deficiency
Although your procedures require that the payables ledger is reconciled against the control account
on the nominal ledger at the end of every month, this was not done in December or January.
Implication
The balance on the payables ledger was short by some $2,120 of the nominal ledger control
account at 31 January 20X8 for which no explanation could be offered. This implies a serious
breakdown in the purchase invoice and/or cash payment batching and posting procedures.
Recommendation
It is important in future that this reconciliation is performed regularly by a responsible official
independent of the day to day payables ledger, cashier and nominal ledger functions.
Receivables ledger: credit control
Deficiency
As at 28 February 20X8 trade receivables accounted for approximately 12 weeks of sales,
although your standard credit terms are cash within 30 days of statement, equivalent to an
average of about 40 days (6 weeks) of sales.
Implication
This has resulted in increased overdraft usage and difficulty in settling some key suppliers'
accounts on time.

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Recommendation
We recommend that a more structured system of debt collection be considered using standard
letters and that statements should be sent out a week earlier if possible.
Preparation of payroll and maintenance of personnel records
Deficiency
Under your present system, just two members of staff are entirely and equally responsible for
the maintenance of personnel records and preparation of the payroll. Furthermore, the only
independent check of any nature on the payroll is that the chief accountant confirms that the
amount of the wages cheque presented to him for signature agrees with the total of the net
wages column in the payroll. This latter check does not involve any consideration of the
reasonableness of the amount of the total net wages cheque or the monies being shown as due
to individual employees.
Implication
It is a serious weakness of your present system that so much responsibility is vested in the
hands of just two people. This situation is made worse by the fact that there is no clearly
defined division of duties between the two of them. In our opinion, it would be far too easy for
fraud to take place in this area (eg by inserting the names of 'dummy workmen' into the
personnel records and hence on to the payroll) and/or for clerical errors to go undetected.
Recommendations
(i)
Some person other than the two wages clerks be made responsible for maintaining the
personnel records and for periodically (but on a surprise basis) checking them against
the details on the payroll.
(ii)

The two wages clerks be allocated specific duties in relation to the preparation of the
payroll, with each clerk independently reviewing the work of the other.

(iii)

When the payroll is presented in support of the cheque for signature to the chief
accountant, he should be responsible for assessing the reasonableness of the overall
charge for wages that week.
Please note that this report only sets out those significant deficiencies identified during our audit. If
more extensive procedures on internal control had been carried out, we may have identified and
reported more deficiencies.
This letter has been produced for the sole use of your company. It must not be disclosed to a third party, or
quoted or referred to, without our written consent. No responsibility is assumed by us to any other person.
We should like to take this opportunity of thanking your staff for their co-operation and assistance
during the course of our audit.
Yours faithfully
ABC & Co

Exam focus
point

If you are answering a question which requires you to prepare a report to management you should only
include a covering letter if you are asked to provide one.
A question in the December 2010 exam asked for a report to management and included a requirement
which asked candidates to include a covering letter. Two marks were available for presentation.
If you are asked for a covering letter, in addition to including the report to management, you should make
sure your letter includes:

382



An address and the date



A short introduction explaining the purpose and content of the report to management



A closing paragraph that states the report only sets out those significant deficiencies identified
during the audit and more extensive procedures on internal control may have resulted in more
deficiencies being identified. It should also state that the report is solely for management's use

19: Reports  Part E Review and reporting