Reporting on a Modified Opinion and Key Audit Matters
You are completing the audit of Calder Engineering plc, a listed company with £300m revenue. Two issues remain at the reporting stage. First, inventory of £18m (of £60m total) is held at a third-party warehouse in a country where you could not obtain access or a confirmation; you have been unable to satisfy yourself by alternative procedures. Second, the company has changed its revenue recognition policy for long-term contracts, increasing revenue by £9m and profit by £4m; management says the change is 'more appropriate' but has not provided a convincing basis, and you believe the prior policy was correct. Group materiality is £6m; performance materiality is £4.5m. The audit committee has asked you to 'keep the report clean' because a modified opinion will affect a refinancing.
1. Determine the type of modification for each issue and explain your reasoning, including the effect of materiality.
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Treat the two issues separately, because they have different causes and different consequences.
Issue 1: Inventory at the third-party warehouse (£18m)
- You could not obtain access or confirmation and no alternative procedures were possible. This is a limitation of scope, not a disagreement. Management has not misstated anything you can prove; you simply cannot obtain evidence.
- £18m is material (above £6m materiality). It affects a real balance and potentially cost of sales.
- Therefore: qualified opinion ('except for') on the financial statements, due to inability to obtain sufficient appropriate audit evidence. It is not pervasive enough to be a disclaimer, because the rest of the statements are audited and the inventory is a discrete balance.
Issue 2: Revenue recognition change (£9m revenue, £4m profit)
- You believe the prior policy was correct and management has no convincing basis. This is a disagreement, not a scope limitation.
- £4m profit is below materiality of £6m, but £9m revenue is above it. The effect on the income statement and on the contract balances must be assessed. If the misstatement is material, it is a qualified opinion on the grounds of material misstatement.
- If the effect were pervasive (e.g., it changed the profit/loss position or affected many balances), an adverse opinion would be appropriate.
Combined
- Two separate qualifications can be combined into one 'except for' opinion with both matters described in the basis for qualified opinion.
- The audit committee's request to 'keep it clean' is not a factor. The opinion follows the evidence.
2. Explain what you would report as Key Audit Matters and how the modifications affect the KAM section.
Read the worked answer
KAMs are required for listed companies under ISA 701, and the modified opinion changes how they are presented.
KAMs to report
- Inventory at the third-party warehouse - the limitation of scope. This is a KAM because it is a significant risk and involved significant auditor judgement. It must be described in the KAM section, cross-referenced to the basis for qualified opinion.
- Revenue recognition on long-term contracts - the disagreement. Also a KAM, describing the policy change, management's rationale, and your conclusion.
- Possibly going concern / refinancing if the refinancing creates a material uncertainty, but only if it meets the KAM definition.
How the modification affects the KAM section
- The KAM section must not contradict the basis for qualified opinion. Where a matter is both a KAM and a basis for modification, describe it consistently and cross-refer to the basis paragraph.
- Do not present the modified matters as if they were resolved. The KAM description should make clear what the issue is and why it led to the modification.
- The basis for qualified opinion paragraph comes before the KAM section and must be clearly headed.
Communication
- The audit committee's request is noted but cannot change the report. Explain to them in writing why the modifications are necessary and what they mean for the refinancing, so they can manage their lenders.