There are two conditions that can result in a qualified audit report: scope limitation and departure from generally accepted accounting principles (GAAP). In either case the auditor must conclude that despite the situation the financial statements are fairly stated. If the auditor does not reach that conclusion, the result would be either an adverse opinion or a disclaimer of opinion.
The qualification can be for both the scope and opinion, or just the opinion. A key indicator of a qualified opinion is the use the phrase "except for" in the opinion paragraph, which points to the qualifying issue.
A scope limitation results when the CPA reaches a conclusion that "except for" something, the financial statements fairly present the financial position and operating results of the company. An "except for" opinion relates to a limitation placed on the scope of the audit. For example, the auditor was not able to observe and test inventory, but was able to audit everything else and found that everything else conformed to GAAP. The auditor would issue and opinion that except for inventory the financial statements are fairly stated.
Departure from GAAP
Many situations can arise where a company uses non GAAP accounting principles. Sometimes the non GAAP principles are used because using GAAP principles would make the financial statements misleading. If that is the case the auditor would most likely concur that the non GAAP principles are necessary and would disclose the departure from GAAP in the audit report along with an explanation and issue a qualified opinion.
A departure from GAAP may be the result of a misapplication of an accounting principle, but the auditor determines that it is an isolated incident which even if material does not affect the rest of the financial statements; that is, it is not pervasive throughout the accounting system. An example of this may be miscalculation of depreciation for some capital assets. In this case the auditor would disclose the departure from GAAP along with an explanation and issue a qualified opinion.
There are three levels of materiality to be considered when determining the type of audit report to issue: 1. Would the misstatement affect the decision of a financial statement user? If no, it is considered immaterial, and an unqualified report can be issued; if yes it is considered material and numbers 2 and 3 come into play. 2. If the amount is material, but the auditor concludes the overall financial statements are fairly stated, a qualified report may be issued with the "except for" phrase. 3. If the materiality of the misstatement is so great that it destroys the fairness of the entire financial statement, the auditor must decide between an adverse opinion or a disclaimer of opinion.
The auditor must also consider pervasiveness, that is, how an error in one part of the accounting system affects other areas of the accounting system.
Auditor Decision Process
The procedure for writing the audit report consists of the following steps: 1. Determine if conditions exist requiring modification to the standard unqualified report. 2. Determine the level of materiality for each condition. 3. Determine the appropriate type of report for the condition, given the materiality level. 4. Write the audit report.
Drew Nelson is a Certified Public Accountant with over 20 years experience. As a professional he has written dozens of reports, presentations and manuals. His articles appear on various websites, covering finance, economics, politics and health topics.