How to Read the Auditor’s Report on the Annual Financial Report
Any publicly traded company must provide financial reports that outside auditors have examined. You usually find the auditors’ report (a letter from the auditors to the company's board of directors and shareholders) either before the financial information or immediately following it.
Before you read the financial statements or the notes to the financial statements, be sure that you've read the auditors’ report. You read the auditors’ report first to find out whether the auditor raised any red flags about the company's financial results.
To lend credibility to management's assurances, companies call in independent auditors from an outside accounting firm to audit their internal controls and financial statements. Auditors don't check every transaction, so their reports don't give you 100 percent assurance that the financial statements don't include misstatements about the company's assets and liabilities.
Most standard auditors’ reports include these three paragraphs:
Introductory paragraph: Here you find information about the time period the audit covers and who's responsible for the financial statements. In most cases, this paragraph states that management is responsible for the financial statements and that the auditors only express an opinion about the financial statements based on their audit. Essentially, this is a protect your fanny paragraph for possible inaccuracies.
Scope paragraph: In this paragraph, the auditors describe how they carried out the audit, including a statement that they used generally accepted audit standards. These standards require that auditors plan and prepare their audit to be reasonably sure that the financial statements are free of material misstatements. A material misstatement is an error that significantly impacts the company's financial position, such as reporting revenue before it's actually earned.
Opinion paragraph: Here the auditors state their opinion of the financial statements. If the auditors don't find any problems with the statements, they simply say that these statements are prepared in conformity with generally accepted accounting principles (or GAAP).
When an auditors’ report follows the outline described here, it's called a standard auditors’ report. And because no qualifiers (or red flags) limit the auditors’ opinions, it's also an unqualified audit report.
If the auditors find a problem, the report is a nonstandard auditors’ report. In a nonstandard report, auditors must explain their opinions in a qualified audit report — in other words, they qualify their opinions and note problem areas. A nonstandard auditors’ report and a standard auditors’ report have the same structure; the only difference is that the nonstandard report includes information about the problems the auditors found.
When you see a nonstandard auditors’ report, be sure that you find a discussion of the problems in the MD&A and in the notes to the financial statements. When reading the MD&A, be certain that you understand how management is handling the problems the auditors noted and how these problems may impact the company's long-term financial prospects.
A nonstandard auditors’ report may include paragraphs that discuss problems the auditors found, such as the following:
Work performed by a different auditor: In many cases, this isn't a major problem. Maybe a different auditor handled the audit in previous years or audited a subsidiary of a newly acquired company.
But whenever a company changes auditors, you need to know why it made the change. You probably won't find the reason for the change in the annual report, so you may have to research the change in news reports or analysts’ reports.
Accounting policy changes: If a company decides to change its accounting policies or how it applies an accounting method, the auditors must note the change in a nonstandard auditors’ report. These changes may not indicate a problem, and if the auditors agree that the company had a good reason for making the change, you most likely have no reason for concern.
If the auditors disagree with the company's decision to change accounting methods, they question the change and provide a qualified opinion in the nonstandard auditors’ report. If their report indicates a change in accounting policy, be sure to look in the notes for the full explanation of the change. When companies change an accounting policy, the change impacts your ability to compare the previous year's results to the current year's.
Material uncertainties: If the auditors find an area of uncertainty, it's impossible for management or the auditors to determine the potential financial consequences of an event. Uncertainties may include debt-agreement violations, damages the company must pay if it loses a pending lawsuit, or the loss of a major market share. If the auditors believe that these material uncertainties may impact future earnings, they give a qualified opinion.
If a loss is probable and the auditors can estimate it, the financial statements usually reflect this loss, and the auditors give an unqualified opinion. The company and the auditors have a responsibility to make you aware of the uncertainty so that you can factor it into any decisions you make about your potential dealings with or investment in the company.
Going-concern problems: If the auditors have substantial doubt that the company has the ability to stay in business, they indicate that the company has a going-concern problem. Problems that can lead to this include ongoing losses, capital deficiencies, or a significant contract dispute. If you see a statement by the auditors that the company has a going-concern problem, it's a good indication that you don't want to invest.
Specific disclosures: Sometimes auditors indicate concerns about a specific financial matter but still give the company a nonqualified opinion.
Qualified opinions: Any time the auditors issue a nonstandard report, they also issue a qualified opinion in the final paragraph of the report. A qualified opinion isn't always cause for alarm, but it does mean that you need to do additional research to make sure you understand the qualification. Look in the notes to the financial statements or the MD&A for any explanation of the matter.