Column AR – Qualified Audit

Cameron : Okay. So, again, they get a two for a yes, zero for a no. Next we get to column AQ – Does it have a qualified audit? Can you explain this one? 

Tony : Sure. We have been caught out a couple of times with companies who had the existence of a “qualified audit” buried in their financial statements. What this means is that the auditor had some genuine concerns about how the business has reported their financials. It doesn’t mean the business is in trouble, just tha the auditor has some questions they weren’t able to answer in time for the report. And for us, that’s a red flag. We don’t want to take the risk of investing in businesses that might have financial issues, because they might turn into genuine issues which can cause the share price to rapidly collapse. 

Cameron : A ‘qualified’ audit almost sounds like it could be a good thing, but to help with this, let me add some quotes from the discussion with had with QAV Club member James Oliver, who is an auditor with a large accounting firm. 

James (edited slightly for clarity): I can understand why a lot of people will get very confused reading any collection of audit reports, what to worry about or what not to. Let me start by explaining how an auditor talks and thinks about these reports. First of all, we start with the term ‘modified opinions’. So, an unmodified opinion is what you might describe as a clean opinion – everything else is effectively a modified opinion. And one of those modified opinions is actually a ‘qualified opinion’.

And that qualified opinion is where the auditor has discovered something, or been told about something, that is material to the users of the report, but it’s not so pervasive to the whole financial report that they’re basically casting a black mark on the whole set of accounts, it’s just something specific, and the wording you look for there is “except for”, so, it’ll say “except for”, let’s say, “the company’s treatment of leases under the accounting standard”. Effectively, everything else, we’re saying, is fine, except for this thing, and when we refer to a qualified opinion, that’s the instance we’re referring to. 

The next one is the ‘adverse opinion’. That is when something has been discovered that really is pervasive to the whole set of accounts. And it casts that on the all the books and records. And so that’s when the auditor says, no, the financial report does not fairly represent the Corporations Act, and the accounting standards and the like. So that’s what I would describe as probably the worst, although I think there are other bad ones from an investor’s point of view, and we’ll get to those. The third modified opinion is called a ‘disclaimer of opinion’. And this is when the auditor just doesn’t have enough information, to enable it to form an opinion on a certain matter.

And it might be, for example, where there’s been a large acquisition of a private business, where there hasn’t been a previous audit, and the books and records are in a terrible state. You don’t see that very often in this country, but you do overseas and so there are various reasons why the auditor might disclaim that opinion, they just don’t have the evidence. So, there are three types of what we call modified opinions. But there is one that I know that’s important to us, that is not a modified or qualified opinion, but it’s what we call an ’emphasis of matter’ paragraph in the audit report. And that’s where there’s something that is so material to the users of the report, that the auditor feels fit to emphasize that matter, through the audit report, so that the readers can see how important it is from the auditor’s point of view as well.

These are matters that are typically well disclosed already in their report. So the auditor is comfortable with the way the company has disclosed a certain matter and the key one that gets a lot of attention is this material uncertainty relating to going concern. So, the company will disclose that they’ve breached their loan covenants with their banks, it might be that they are seeking refinancing. And that hasn’t been signed up to yet. They’re still talking to their bank. It might be that there’s some material litigation going on and it’s just not certain yet. So, the company will disclose those matters but the auditor sees them as so fundamental that they emphasize it. And so it’s not that the auditor somehow has some crystal ball, that they know that there’s an issue and they’re calling it out any differently to what the company is calling out, it’s just they are wanting to emphasize the importance of that matter.

Cameron : How do we determine whether or not the company has a qualified audit? 

Tony : There’s no easy way to do this, unfortunately. We have to go to the financial statements of the company (which can be found on their website, the ASX or Stock Doctor) and make sure there is no mention of an audit. You will usually find it mentioned in their Appendix 4E (preliminary final report) or in the last pages of their final financial report. If it has anything like James mentioned, it immediately gets a fail from our perspective. We don’t want to take the risk.