In response to various pressures including the report of the National Commission on Fraudulent Reporting (i.e., "Treadway Commission") and the so-called "expectation gap," the ASB recently issued SAS 58, "Reporting on Audited Financial Statements," which provides for a new standard auditor's report (Exhibit 1). Effective for reports issued or reissued after January 1, 1989, the current two-paragraph report is replaced by a new three-paragraph report. The purpose of this article is to review the new report and the possible modifications to it.

Overview of Report and Modifications

Generally, the standard unqualified report contains a new opening (introductory) paragraph, a substantially revised scope paragraph, and an altered opinion paragraph which makes no reference to consistent application of generally accepted accounting principles (GAAP). Such consistency is now implicit, not explicit as in the former standard report. In what may prove to be a more frequent modification to the new report, an explanatory fourth paragraph may be added without affecting its unqualified nature.

The circumstances for the issuance of and the format for a qualified, adverse, or disclaimer of opinion are altered by SAS 58. For example, because consistency in application of GAAP is implied, the change from one acceptable principle to another acceptable principle no longer requires the issuance of an "except for ..., with which we concur" qualified opinion for consistency.

SAS 58 also repeals the use of a "subject to" qualified opinion. Previously, a "subject to" qualification was issued when the financial statements were affected by uncertainties concerning future events, the outcome of which were not susceptible to reasonable estimation at the date of the auditor's report. These uncertainties included issues concerning the continued existence of an entity.

Unqualified Opinion

The new report is designed to more clearly convey the responsibilities of the auditor and the nature of the auditing process. As illustrated in Exhibit 1, a title such as "Independent Auditor's Report" is required as part of the standard report. The opening paragraph differentiates between the responsibilities of management and the auditor for the financial statements and refers to the new cash flow statement. The expanded scope paragraph continues to specify the performance of the audit in accordance with generally accepted auditing standards (GAAS). However, it contains an extended explanation of an audit and acknowledges that an audit provides only reasonable assurance about whether the financial statements are free of material misstatement.

Unqualified Opinion with Additional Paragraph

Even before SAS 58, an auditor could issue an unqualified opinion with modifications to the standard two-paragraph report. However, such reports were uncommon. Because certain matters involving uncertainty (including going concern questions) and inconsistencies in the application of GAAP resulting from acceptable changes in accounting principles now must be reported in an explanatory paragraph, a four- paragraph unqualified opinion is likely to become more common. A complete summary of these and other circumstances which require the use of a fourth paragraph are detailed in Exhibit 2 and reviewed below.

Uncertainty as to Going Concern. SAS 59, "The Auditor's Considerations of an Entity's Ability to Continue as a Going Concern," supersedes audit procedures and reporting requirements previously discussed in SAS 34 (AU 340) concerning this topic. Under preceding standards, this type of uncertainty mandated the issuance of a qualified opinion, "subject to" the continued existence of the entity. Under SAS 59, generally the audit report should include an explanatory paragraph after the opinion paragraph if the auditor concludes that substantial doubt about the entity's ability to continue for a reasonable period of time remains. Because this uncertainty does not affect the division of responsibility between management and the auditor, the performance of the audit in accordance with GAAS, or the expression of an opinion, no changes are required in the opening, scope, or opinion paragraphs.

Other Uncertainties. Prior to SAS 58, other material uncertainties were also typically reported using a "subject to" qualified opinion. Pursuant to SAS 58, such uncertainties may require an explanatory paragraph depending on the probability of loss and ability to make a reasonable estimate. Specifically, when the outcome of future events is not susceptible to reasonable estimation by management and, therefore, it is impossible to determine whether the financial statements should be adjusted, no explanatory paragraph is needed if only a "remote likelihood of material loss" exists. However, if a "probable chance of material loss" exists but the amount of the loss cannot be reasonably estimated, a fourth paragraph is necessary. When the possiblity of a loss is more than remote but less than probable (i.e., a "reasonable possibility of material loss"), the auditor must consider the appropriateness of an explanatory paragraph. The auditor is likely to opt for this addition as the amount of reasonably possible loss and the likelihood of loss increase. With any of these situations, no changes are required in the other three paragraphs of the report.

Inconsistent Application of GAAP. As previously mentioned, a change to an acceptable accounting principle that has a material effect on comparability no longer results in an "except for" qualification. However, an explanatory fourth paragraph is added to describe the accounting change. No changes are required in the other three paragraphs.

Other Instances. SAS 58 does not significantly revise prior requirements on using an explanatory paragraph to emphasize a matter of importance or to explain when a departure from a promulgated accounting principle is sanctioned by Rule 203 of the Code of Professional Conduct of the AICPA. Such a departure is permitted only in the rare instance when the auditor determines that the financial statements would be misleading if the promulgated principle was used. The explanatory paragraph can either precede or follow the opinion paragraph. No changes are required in the other three paragraphs.

When a principal/"other" auditor relationship exists and reference is made to the other auditor in the auditor's report (see AU 543), an explanatory paragraph is not used, but the remaining three paragraphs are modified. Because the principal auditor does not accept full responsibility for the opinion on the consolidated financial statements, the opening paragraph is modified to explain the division of responsibility, and the scope and opinion paragraphs contain references to the other auditor.

Exhibit 2 lists several other less frequent circumstances when an explanatory paragraph may be used.

Qualified, Adverse, and Disclaimers of Opinion

Similar to pre-SAS 58, the inability to perform an audit in accordance with GAAS or a material departure from GAAP precludes the auditor from issuing an unqualified opinion. Depending on materiality, either a qualified option or a disclaimer of opinion is issued for a material departure from GAAP. Piece-meal opinions (as to specified line items in the financial statements) continue to be inappropriate, and, as previously noted, "subject to" qualifications are eliminated.

Scope Limitations. Scope restrictions may be imposed by the client or by circumstances, such as the timing of work on inadequacy of accounting records.

Under the new reporting format, a qualified opinion requires no change in the opening paragraph because a scope limitation does not change management/auditor responsibility. The scope paragraph contains a reference to the explanatory paragraph, which describes the reasons for the qualification and precedes the opinion paragraph. The opinion paragraph includes the appropriate qualifying language.

Because a disclaimer of opinion caused by a scope limitation means an incomplete audit was performed by the auditor, the opening paragraph contains no reference to the auditor's responsibility or to the word "audited." Also, the scope paragraph is eliminated. The explanatory paragraph (preceding the opinion paragraph) describes why GAAS was not followed. The concluding paragraph contains the usual language disclaiming an opinion.

Departures from GAAP. A material departure from GAAP does not affect management/auditor responsibility on the use of GAAS. Therefore, for reporting purposes, no change is made to either the standard opening or scope paragraphs in a qualified or adverse opinion. The reasons for the modification are described in the explanatory paragraph (preceding the opinion paragraph) and the appropriate modifying language is contained in the concluding paragraph.

Conclusion

SAS 58, substantially changes the format of the auditor's report. The elimination of the "subject to" qualification for uncertainties and the "except for" qualification for inconsistent application of changes in accounting principles are likely to increase the use of the four- paragraph report with an unqualified opinion, although the wording to qualified, adverse and disclaimers of opinion are revised, the circumstances of their issuance are virtually the same as before SAS 58, except for application of the new rules regarding uncertainties and inconsistent applications of GAAP.