The financial statements found in company’s financial reports must be audited according to specific guidelines. The auditor must provide a written opinion called the auditor’s report. International Standards on Auditing specify the objectives of an audit as:
To obtain reasonable assurance as to whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express and opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and
to report on the financial statements, and communicate as required by the ISAs, in accordance with the auditor’s findings.
The audit is conducted based on a sampling of transactions. It is impossible to guarantee that the resulting financial statements are accurate. However, the audit report can provide reasonable assurance that they are free from material errors.
Types of Audit Opinions
The four types of audit opinions are unqualified (or clean) opinions, qualified opinions, adverse opinions, and disclaimers of opinion.
Unqualified opinions
In most cases, the auditor will provide an unqualified opinion, essentially saying “yes, investors can rely on the information in this report.” An example can be found in the 20F (the annual report for a foreign company) for Sony. The key line is:
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Sony Corporation and its subsidiaries (“the Company”) at March 31, 2004 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended March 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
These statements assure investors that they can rely on the financial statements presented.
Qualified opinions
An example of a qualified opinion is available from the auditors report for DAIMLERCHRYSLER AUTO TRUST 2005A. (Note: this is not DaimlerChrysler the company but a separate security backed by auto loans the company made to consumers.) In this report, the auditors say:
Our examination disclosed the following material noncompliance with minimum servicing standard II.1 as set forth in USAP. As explained in the Management Assertion, minimum servicing standard II.1 requires timely remittances of cash collections to the trusts. The Company’s daily remittances are to include an estimate related to interest collections, which is calculated at the beginning of each month and allocated to each remittance during the month. The calculation and allocation of estimated interest collections related to the daily remittances for January 2005 was not performed and daily interest was not remitted during the month, but was calculated and remitted in February through December.
We do not express an opinion or any other form of assurance on management’s statement referring to the accuracy of the monthly settlements or the correctness of the remittance of actual interest collections on the Distribution Date for the affected month.
In our opinion, except for the material noncompliance described in the third paragraph, DaimlerChrysler Financial Services Americas LLC has complied, in all material respects, with the aforementioned applicable minimum servicing standards for the year ended December 31, 2005.
Because of the qualifier, these statements are often called “except for” statements. Investors should make sure they understand why the auditors expressed the particular reservations before relying on the information in the report.
Adverse opinions
In an adverse opinion, the auditor will state that the financial statements “do not present fairly, in all material respects, the financial position” of the company.
It is rare that investors will see such an opinion, but when they do they should proceed with caution.
Disclaimer of opinion
An example of a disclaimed auditor opinion for a large public company is available in the 10-K for FEDERAL NATIONAL MORTGAGE ASSOCIATION (FANNIE MAE):
Due to the nature of these weaknesses: the consolidated financial statements for the years ended December 31, 2003 and 2002 were restated to correct numerous significant misstatements related to debt and derivatives, commitments, investments in securities, trust consolidation and sale accounting, financial guaranties and master servicing, amortization of cost basis adjustments, and other items; the consolidated financial statements for the year ended December 31, 2004 and the quarter ended September 30, 2004 were not filed timely; and, there is more than a remote likelihood that a material misstatement to the Company’s financial statements might not be detected and prevented by the Company’s internal controls over financial reporting. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the consolidated financial statements as of and for the year ended December 31, 2004, of the Company and this report does not affect our report on such consolidated financial statements.
Because of the limitation on the scope of our audit described in the second paragraph of this report, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on management’s assessment referred to above. In our opinion, because of the effect of the material weaknesses, summarized above and described in Management’s Report on Internal Control over Financial Reporting, on the achievement of the objectives of the control criteria and the effects of any other material weaknesses, if any, that we might have identified if we had been able to perform sufficient auditing procedures necessary to form an opinion on management’s assessment, the Company has not maintained effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
Given that even the auditors are not willing to express an opinion on the validity of the included financial statements, investors should think hard before investing in companies that have been given a disclaimer of opinion.
The Going Concern Clause
The final type of auditor’s statement reflects the “going concern” clause. Accounting standards work under the assumption that the company will remain in business. If there is doubt that the company can remain in business the financial statements might not accurately reflect the company’s prospects even if they adhere to accounting standards. In this case, the auditor will append a “going concern” clause to the statement, similar to the one found in the10KSB for LABURNUM VENTURES INC:
The accompanying financial statements referred to above have been prepared assuming that the company will continue as a going concern. As discussed in Note 1 to the financial statements, the company is in the pre-exploration stage, and has no established source of revenue and is dependent on its ability to raise capital from shareholders or other sources to sustain operations. These factors, along with other matters as set forth in Note 1, raise substantial doubt that the company will be able to continue as a going concern. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Needless to say, investors should be particularly cautious when evaluating a company for which the auditor has included a “going concern” clause.
The Importance of Effective Internal Controls
Companies must have a system of internal controls to ensure that they have a sound process for generating financial reports. The Sarbanes-Oxley act in the US requires managers to explicitly accept responsibility for effective internal controls.