When an auditor includes an emphasis of matter paragraph in his report the auditor is?

Do you know what you need to know about emphasis of matter and other matter paragraphs? Sometimes auditors elect to or are required to add an extra paragraph after the opinion paragraph. You need to know why and when. (This article was written prior to the amendments made by SAS numbers 134, 137, 140, and 141. Those amendments are effective for periods ending on or after December 15, 2021. See my new article regarding the amended guidance for emphasis of matter and other matter paragraphs.)

This post gives you the leg up on emphasis of matter (EOM) paragraphs and other matter (OM) paragraphs. 

First, let’s first define the two terms.

AU-C 706.05 provides the following definitions:

Emphasis-of-matter paragraph. A paragraph included in the auditor's report that is required by GAAS, or is included at the auditor's discretion, and that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor's professional judgment, is of such importance that it is fundamental to users' understanding of the financial statements.

Other-matter paragraph. A paragraph included in the auditor's report that is required by GAAS, or is included at the auditor's discretion, and that refers to a matter other than those presented or disclosed in the financial statements that, in the auditor's professional judgment, is relevant to users' understanding of the audit, the auditor's responsibilities, or the auditor's report.

Notice that an EOM refers to “a matter appropriately presented or disclosed in the financial statements,” while an OM refers to “a matter other than those presented or disclosed in the financial statements.”

Now, let's take a look at sample EOM and OM paragraphs. 

Sample Emphasis of Matter Paragraph

Here’s a sample EOM paragraph:

Emphasis of Matter

As discussed in Note X to the financial statements, the Company has elected to change its policy for determining cash equivalents in 20X 7. Our opinion is not modified with respect to that matter.

Sample Other Matter Paragraph

Here is a sample OM paragraph:

Other Matter

In our report dated April 18, 20X5, we expressed a qualified opinion since the Company’s main office had a material unrecognized impairment loss. As noted in Note 12, the Company has now recognized the impairment in conformity with accounting principles generally accepted in the United States of America. Accordingly, our present opinion on the restated 20X4 financial statements, as presented herein, is different from that expressed in our previous report.

You also need to know the presentation requirements for EOM and OM paragraphs.

Presentation Requirements for an EOM

AU-C 706.06 and 706.07 provides guidance in reference to EOMs. The auditor should:

• Refer only to information presented or disclosed in the financial statements
• Include the EOM immediately after the opinion paragraph in the auditor’s report
• Use the heading “Emphasis of Matter” or other appropriate heading
• Include a clear reference to the matter being emphasized and to where relevant disclosures that describe the matter can be found
• Indicate that the auditor’s opinion is not modified with respect to the matter emphasized

Presentation Requirements for an OM

AU-C 706.08 provides guidance in reference to OMs. The auditor should:

• Include the OM immediately after the opinion paragraph and any EOM paragraph (or elsewhere in the auditor’s report if the content of the OM paragraph is relevant to the “Other Reporting Responsibilities” section – see AU-C 706.A6--.A11)
• Use the heading “Other Matter” or other appropriate heading

AU-C Sections Requiring EOMs

Sometimes EOMs are required; here are examples:

• AU-C 570.15-.16 The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern
• AU-C 560-.16c Subsequent Events and Subsequently Discovered Facts
• AU-C 708.08-.09 and .11-.13 Consistency of Financial Statements

See exhibit B of AU-C 706 for a complete listing of AU-C sections requiring EOM paragraphs.

An EOM is commonly required when a company has a change in an accounting principle (that has a material impact). AU-C 708 Consistency of Financial Statements paragraphs .07-.08 provides guidance on when the EOM is required.

The auditor also has an option to use an EOM to emphasize matters that are not required by audit standards. So, sometimes EOMs are included because they are required (e.g., going concern) and, other times, they are optional (e.g., to highlight a related party transaction).

Sometimes OMs are required; here are examples:

• AU-C 725.09 Supplementary Information in Relation to the Financial Statements
• AU-C 800.20 Special Considerations—Audits of Financial Statements Prepared in Accordance With Special Purpose Frameworks

See exhibit C of AU-C 706 for a complete listing of AU-C sections requiring OM paragraphs.

Simple Summary

• Use EOMs to OMs to highlight important matters
• EOMs refer to matters presented or disclosed in the financial statements
• OMs refer to a matter other than those presented or disclosed in the financial statements
• EOMs and OMs are—in certain situations—required by audit standards
• An EOM should immediately follow the opinion paragraph and should refer to the note that describes the issue; include the heading “Emphasis of a Matter” or other appropriate heading
• An OM should immediately follow the opinion paragraph and any EOM (if one is included); include the heading “Other Matter” or other appropriate heading

Of course, creating your opinion is just a part of wrapping up your audits. 

An auditor may conclude that a matter disclosed in the financial statements is so important that it is fundamental to users’ understanding of those financial statements. In this case an emphasis of matter paragraph will be included in the auditor’s report, which draws the reader’s attention to the entity’s disclosures.

Coronavirus may lead to situations where an auditor considers including an emphasis of matter paragraph in the auditor’s report. However, even in the unprecedented circumstances brought about by COVID-19, inclusion in auditors’ reports is not expected to be widespread, and will occur only when the matter is considered to be ‘fundamental’. Widespread use of emphasis of matter paragraphs may diminish the effectiveness of the auditor’s communication about important matters. 

This Audit and Assurance Faculty Know-How guide covers where an emphasis of matter paragraph may be included, COVID-19 situations that might drive their use, and how to construct the wording.

It is important to note that emphasis of matter paragraphs are no longer used to draw attention to material uncertainties relating to going concern; these are disclosed in a separate section of the audit report. The faculty’s guide How to report on material uncertainty related to going concern - a guide for auditors provides guidance on how to report on material uncertainty related to going concern.

Emphasis of matter paragraphs

An emphasis of matter paragraph is included in the auditor’s report and refers to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements. 

Auditors should remember that the ‘fundamental’ (to users’ understanding) test is a high hurdle. The auditor will therefore need to document clearly in each case the justification for the inclusion of the matter they wish to highlight to users of the financial statements as fundamental. A policy of including an emphasis of matter paragraph in audit reports for most entities affected by COVID-19, or for all entities in a particular sector or industry, may be challenged by audit regulators, and so firms will need to be prepared to justify that decision with reference to the particular circumstances of each entity. 

ISA (UK) 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report requires that emphasis of matter paragraphs refer to a matter ’appropriately' presented or disclosed in the financial statements. If a matter is not appropriately presented or disclosed, then other changes to the audit report will need to be considered instead, for example the audit opinion may need to be qualified.

An emphasis of matter paragraph does not modify the audit opinion. Such a paragraph is also not a substitute for expressing a qualified or adverse opinion, or for disclaiming an opinion, where they are appropriate. 

The thought process that leads to an emphasis of matter is outlined in the following flowchart. For the purposes of this guide, we focus on emphasis of matter paragraphs, but the flowchart shows that in other situations, an ‘Other Matter paragraph’ may be appropriate. The use of Other Matter paragraphs to address matters in the financial statements is not appropriate. It is instead used to draw the reader’s attention to a specific matter relating to the audit.

How might an emphasis of matter arise due to COVID-19?

One of the possible reasons ISA (UK) 706 gives for inclusion of an emphasis of matter paragraph is ‘a major catastrophe that has had a significant effect on the entity’s financial position’. 

Whether the COVID‐19 pandemic amounts to a major catastrophe that has had a significant effect on the entity’s financial position is a matter of judgment for the auditor. Accordingly, it is not expected that an emphasis of matter will be used in every case, only where, in the auditor’s judgment, the matter is fundamental to the user’s understanding of the financial statements.

The following scenarios are examples of where COVID-19 might lead to the auditor including an emphasis of matter paragraph in the auditor’s report.

External valuations

An external specialist or expert, such as a property surveyor, has included a ‘material valuation uncertainty’ clause in a valuation report explaining that less certainty – and a higher degree of caution – should be attached to the valuation of property or other assets on the entity’s balance sheet. Management has appropriately disclosed the matter in the notes to the financial statements.

The Royal Institute of Chartered Surveyors (RICS) included in its Valuation practice alert – COVID-19 of 19 May 2020 guidance for RICS-regulated members for when they conclude there is a material uncertainty with respect to a valuation. 

The RICS guidance states that:

“Where a material uncertainty clause is being used, its purpose is to ensure that any client relying upon that specific valuation report understands that it has been prepared under extraordinary circumstances. The term is not meant to suggest that the valuation cannot be relied upon; rather, it is used in order to be clear and transparent with all parties, in a professional manner that – in the current extraordinary circumstances – less certainty can be attached to the valuation than would otherwise be the case. Indeed, with regard to the process itself, professional valuers will almost certainly have undertaken far more due diligence than normal, in order to arrive at their estimate of value.”

The auditor has nevertheless been able to obtain sufficient appropriate evidence of the valuation of the asset, but the auditor considers it appropriate to draw attention to the material valuation uncertainty which has been disclosed appropriately by management by including an emphasis of matter paragraph referring to management’s disclosures. Again, the auditor is encouraged to document clearly the judgment over why the property (or other asset) valuations are fundamental to the user’s understanding of the financial statements.

It is worth noting that this may not always be the case. Just because there is such an uncertainty, and while it may be material, that does not necessarily make it “fundamental” to users. For example, an emphasis of matter may not be appropriate for an entity with one property that, while material, is only a small proportion of total assets. However, it may be appropriate for an entity in the real estate sector holding a number of investment properties that make up a significant proportion of the company’s total assets, or similarly for a property fund.

If such a ‘material valuation uncertainty’ clause has been included in the valuation report, but the auditor has not been able to obtain sufficient appropriate evidence of the valuation of the asset, the auditor may need to consider qualification instead.

Basis other than going concern

Where the use of the going concern basis is inappropriate and the entity is required to prepare its financial statements on a basis other than that of going concern, the auditor may consider it appropriate or necessary to include an emphasis of matter paragraph in the audit report to draw the user’s attention to the basis on which the financial statements have been prepared and the reasons for its use. 

The Audit and Assurance Faculty’s helpsheet Going concern – basis other than going concern provides further guidance in this area.

Subsequent events

The notes to the financial statements include disclosures around subsequent events / post balance sheet events because, for many entities, the impact of COVID-19 started to emerge after the end of their financial periods. The auditor will need to assess whether the disclosures made by the entity regarding subsequent events, and whether they are adjusting or non-adjusting events, are appropriate. The auditor may conclude that it is necessary to include a related emphasis of matter paragraph in the auditor’s report to highlight management’s subsequent events disclosure, given its significance. 

Further information is available in the Financial Reporting Faculty’s Know-How articles on How to distinguish adjusting from non-adjusting post balance sheet events, under UK GAAP and under IAS 10.

Litigation outcome uncertainty

The entity is subject to litigation as a result of breaching the terms of a contract during the COVID-19 crisis. There is uncertainty relating to the outcome of the litigation, and a high level of judgment involved in deciding whether there is a liability, contingent liability or no liability to be recognised.

Other considerations for the auditor 

The auditor may also consider whether: 

• inclusion of an emphasis of matter paragraph leads to the entity breaching a loan covenant, and whether the lender would waive that covenant breach or not. In this context, it is important to understand that an audit report with an emphasis of matter is not a modification of the auditor’s opinion. 
• the explanation is specific to the entity’s circumstances. Boilerplate text should be avoided.

How is an emphasis of matter disclosed?

An emphasis of matter paragraph is included within a separate section of the auditor’s report with an appropriate heading that includes the term “Emphasis of Matter”. The heading may be expanded to include further context of the matter being referred to, eg, ‘Emphasis of Matter – subsequent event COVID-19 pandemic’.

The paragraph should:

• include a clear reference to the matter being emphasised and to where relevant disclosures that fully describe the matter are found in the financial statements; and  
• indicate that the auditor’s opinion is not modified in respect of the matter.

The paragraph should only refer to information presented or disclosed in the financial statements and should not provide additional information, explanation or interpretation.

According to ISA (UK) 7061, ‘the placement of an emphasis of matter paragraph in the auditor’s report depends on the nature of the information to be communicated, and the auditor’s judgment as to the relative significance of such information to intended users compared to other elements required to be reported in accordance with ISA (UK) 700 (Revised June 2016)’. Commonly, emphasis of matter paragraphs follow directly on from the opinion.

How does an emphasis of matter paragraph interact with KAMs?

For entities required to report on key audit matters (KAMs) in accordance with ISA (UK) 701 Communicating Key Audit Matters in the Independent Auditor’s Report, the use of emphasis of matter paragraphs is not a substitute for a description of individual KAMs.

Matters that are determined to be KAMs may also be, in the auditor’s judgment, fundamental to users’ understanding of the financial statements. Therefore, a KAM can also be used to satisfy the requirements of ISA (UK) 706 where the auditor might consider an emphasis of matter paragraph.

In such cases, in communicating the matter as a KAM, the auditor may wish to highlight or draw further attention to its relative importance. The auditor may do so by presenting the matter more prominently than other matters in the KAMs section, for example as the first matter, or by including additional information in the description of the KAM to indicate how fundamental the matter is to users’ understanding of the financial statements.

There may be a matter that is not determined to be a KAM in accordance with ISA (UK) 701, because it did not require significant auditor effort, but which, in the auditor’s judgment, is fundamental to users’ understanding of the financial statements. Disclosure of COVID-19 as a subsequent event might be one example of this. If the auditor considers it necessary to draw users’ attention to such a matter, the matter is included in an emphasis of matter paragraph before or after, but outside of the KAMs section.

Further guidance