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Auditor's report and going concern

An auditor is a third party hired by the board of directors (not by management, in theory) to examine a company's financial statements and attest that they are fairly presented in accordance with accounting standards. The auditor's report—the short letter at the beginning of the financial statements section of a 10-K—is the formal result of this examination. Most investors skip this report entirely. This is a mistake.

The auditor's report is one of the cleanest and most reliable signals of whether the financial statements are trustworthy. It is also the place where auditors disclose the most serious concerns about a company's financial condition, including doubt about whether the company will survive.

The clean opinion and what it means​

A clean audit opinion is a short letter (typically one page) stating that the auditor has audited the company's financial statements and that, in the auditor's opinion, the statements present fairly the company's financial position and results of operations in conformity with generally accepted accounting principles. A clean opinion is common and is usually what you see.

But a clean opinion does not mean the financial statements are perfect or that the company is financially healthy. It means that, based on the auditor's examination, the statements do not contain material misstatements and do follow GAAP rules. The auditor is not opining on the company's financial health, only on the accuracy of the statements.

An auditor can issue a clean opinion on the financial statements of a company that is on the verge of bankruptcy. The company might be financially distressed, but if the financial statements accurately reflect that distress, the auditor issues a clean opinion.

Qualified opinions and other red flags​

If an auditor issues anything other than a clean opinion, it is a major red flag. A qualified opinion is issued when the auditor has a concern about a specific aspect of the financial statements but believes the statements, taken as a whole, are fairly presented. A qualified opinion typically states something like "except for the matter described above, the financial statements present fairly..."

A disclaimer of opinion is issued when the auditor cannot form an opinion on the financial statements, typically because the company did not provide sufficient information for the auditor to examine the statements adequately. A disclaimer is serious; it means the auditor is saying "I cannot tell you whether these statements are reliable."

An adverse opinion is issued when the auditor believes the financial statements do not present fairly the company's financial position or results. An adverse opinion is extremely rare and is a severe warning sign.

Any of these non-clean opinions should be taken very seriously. If you see a qualified, disclaimer, or adverse opinion, investigate further. These are signals that something is significantly wrong with the company or the statements.

Going concern warnings​

The most important signal in an auditor's report, beyond the clean or qualified opinion itself, is a going-concern warning. If an auditor has substantial doubt about the company's ability to continue as a going concern—that is, to survive and operate in the foreseeable future—the auditor must disclose this in a separate section of the auditor's report.

A going-concern warning means the auditor believes there is material uncertainty about whether the company will survive. The company might be in financial distress, with inadequate cash flow to meet obligations. It might have violated loan covenants and be in default with lenders. It might have secured commitments to restructure its debt. It might be undertaking a major restructuring or asset sale to avoid bankruptcy. The specific facts vary, but a going-concern warning means the auditor has serious doubts about survival.

A going-concern warning is one of the most serious signals a financial statement can send. If you see this, the company is in distress and survival is not assured. This is more dire than any profit or cash flow number.

Changes in auditors​

Another important signal is a change in the company's auditor. If a company switches from one audit firm to another, this is disclosed in an 8-K filing. In rare cases, a change in auditors can signal that the company and its previous auditor disagreed about accounting treatments. If the previous auditor believed the company was being too aggressive in recognizing revenue or valuing inventory, and the company disagreed, the company might have fired the auditor and hired a different firm.

Auditor changes for legitimate reasons (the company is acquired, the auditor firm is closing an office, fees are too high) are common. But auditor changes that follow disputes about accounting are rare and concerning.

Auditor fees and audit quality​

The company's proxy statement discloses fees paid to the external auditor. These fees typically include audit fees (for the annual audit), audit-related fees (for other services related to the audit), tax fees (for tax advice), and other fees (for other consulting services).

A company that pays very high other fees to its auditor is concerning because it creates a conflict of interest. If the company's auditor is also making significant money from consulting fees, the auditor has financial incentive to keep the company happy. A company that keeps audit fees low but pays high other fees to the same firm is prioritizing cost over independence.

The auditor's independence is critical. If the auditor is too dependent on the company for fees, the auditor might be reluctant to challenge management aggressively on accounting treatments. A company's proxy statement discloses this, and an investor should review it.

Audit committee oversight​

The company's proxy statement also describes the audit committee—the board committee responsible for overseeing the external audit and internal controls. A strong audit committee is an important corporate governance safeguard. A weak or ineffective audit committee is a warning sign.

An effective audit committee typically meets regularly (at least quarterly), has independent members (not management), includes members with financial expertise, and has the authority to hire and fire the external auditor. A company whose audit committee meets only once per year, is dominated by company executives, or has no members with financial expertise has weaker oversight.

What the auditor's report tells you​

The auditor's report is a short document, typically only one page. But reading it carefully tells you:

  • Whether the auditor issues a clean opinion or has concerns
  • Whether the auditor has going-concern doubt about the company's survival
  • Whether the auditor and company disagreed about accounting treatments
  • How long the company has been with this auditor
  • Whether the auditor plans to continue with the company next year

Reading the auditor's report is one of the quickest ways to spot serious problems with a company's financial condition or financial reporting. If you see anything other than a clean opinion, investigate further. If you see a going-concern warning, the company is in distress. These signals are more reliable than many other financial metrics because they come from an independent third party with reputational interest in accuracy.

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