Warning Signals in Directors’ Report / Auditor Report
A Directors’ Report is a document included in a company’s annual financial filings that contains information about the company’s performance and operations during the previous fiscal year. The report usually contains information about the company’s financial position, operations, and prospects. To interpret the report, it is important to read it in conjunction with the company’s financial statements, such as the balance sheet, income statement, and cash flow statement, as well as any other relevant information in the filing. In addition, it is important to compare the company’s performance to industry standards and to the company’s performance in prior years. The management report therefore often provides us with many warning signals, and we must learn to interpret it.
The Auditor Report is usually published after the Directors’ Report in the annual financial filings. The external auditor provides an independent assessment of the company’s financial statements. The auditor report is intended to provide assurance to shareholders and other stakeholders that the company’s financial statements have been prepared in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
This is by no means an exhaustive list, but any one of the signals could mean there is a problem. The more warning signals there are, the higher the risk.
1. Any disclosure indicating serious financial or other difficulties?
Example of a disclosure indicating serious financial difficulties in a Director’s Report could include statements such as:
- Disclosure of a significant decline in revenue or profits: This could indicate that the company is facing serious financial difficulties.
- Disclosure of a material decrease in cash and cash equivalents: This could indicate that the company is facing serious financial difficulties as it may not be able to meet its short-term obligations.
- Disclosure of a material increase in liabilities: The company is facing serious financial difficulties as it may not be able to meet its long-term obligations.
- Disclosure of default or non-compliance with loan covenants: This could indicate that the company is facing serious financial difficulties.
- Disclosure of material uncertainty about the company’s ability to continue as a going concern: This indicates the company is facing serious financial difficulties.
It’s important to note that these disclosures can indicate the company is facing serious financial difficulties, but it doesn’t mean that the company is insolvent or bankrupt. However, if the company continues to face financial difficulties it can result in the company filing for bankruptcy or insolvency.
Following are example of public-listed companies that have disclosed financial issues in their Director’s Report:
- In 2019, General Electric (GE) disclosed in their Director’s Report that the company was facing financial difficulties due to a decline in revenue and profits, as well as significant debt and liquidity issues. GE’s report included statements about the company’s efforts to improve its financial position, including cost-cutting measures and asset sales.
- In 2018, Sears Holdings Corporation, the parent company of Sears and Kmart stores, announced in its Director’s Report that they would be filing for Chapter 11 bankruptcy due to significant financial difficulties. The company had been struggling with declining sales and liquidity problems for several years.
- In 2017, General Motors announced in their Director’s Report that the company had taken a $7.3 billion non-cash charge in the third quarter, primarily due to the impact of the new U.S. tax law and the sale of Opel, and Vauxhall.
- In 2020, the oil and gas company, Chesapeake Energy Corporation, announced in their Director’s Report that the company had filed for Chapter 11 bankruptcy due to the negative impact of low oil prices and a significant debt burden.
2. Accounts not fairly presented or liquidity problem?
If a company’s financial statements are not fairly presented, it means that the financial statements do not provide a true and accurate representation of the company’s financial position and performance. This could be due to a variety of reasons, including errors, fraud, or non-compliance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
If a company is experiencing a liquidity problem, it means that the company may not have enough cash or cash equivalents to meet its short-term obligations. This could be due to a variety of reasons, including a decline in revenue, an increase in expenses, or a decrease in cash and cash equivalents.
Both issues can be identified in the Director’s Report and the Auditor report. If there’s a problem with the fair presentation of the accounts, the auditor may issue a qualified, adverse or a disclaimer of opinion, indicating that the financial statements are not fairly presented. If a company is facing liquidity problems, the management will disclose this in the Director’s report and the auditor may also identify this in their report. This information can be important for shareholders and investors to assess the company’s financial performance and position and to make informed decisions about their investment.
Following are example of public-listed companies where their accounts not fairly presented once:
- In 2018, Toshiba, a Japanese multinational conglomerate, admitted to inflating its profits by over $1 billion over a period of several years. This resulted in the company restating its financial statements and issuing corrected reports to shareholders.
- In 2016, Olympus Corporation, a Japanese manufacturer of optics and reprography products, announced that it had inflated its profits for several years, and that the company’s accounts had not been fairly presented. The company restated its financial statements and issued corrected reports to shareholders.
- In 2015, Satyam Computer Services, an Indian multinational information technology services company, announced that its financial statements for several years had not been fairly presented. The company’s Chairman, B. Ramalinga Raju, admitted to inflating the company’s profits and assets, and the company restated its financial statements and issued corrected reports to shareholders.
- Enron was found to have engaged in accounting fraud, including the use of off-balance-sheet entities and improper accounting for certain transactions. This resulted in Enron’s financial statements not being fairly presented, and the company eventually filed for bankruptcy in 2001.
- WorldCom, a telecommunications company that was found to have engaged in accounting fraud, including the misclassification of expenses as capital expenditures. This resulted in WorldCom’s financial statements not being fairly presented, and the company also filed for bankruptcy in 2002.
3. Accounts qualified or any matters of emphasis in the audit report?
If an auditor issues a qualified opinion in their report, it means that the auditor has found some issues with the company’s financial statements that are significant enough to affect the auditor’s overall opinion, but are not significant enough to affect the overall fair presentation of the financial statements. A qualified opinion is less severe than an adverse opinion, but it still indicates that there are issues with the company’s financial statements that need to be addressed.
The auditor may include a “matter of emphasis” section in their report where they want to draw attention to certain matters related to the financial statements, that are not significant enough to qualify the opinion, but are important for the users of the financial statements to be aware of.
Examples of issues that may result in a qualified opinion or a matter of emphasis in the auditor’s report include:
- Uncertainty regarding the company’s ability to continue as a going concern
- Uncertainty regarding the recoverability of certain assets
- Material misstatement in the financial statements due to a lack of sufficient evidence to support the amounts or disclosures in the financial statements
- Lack of compliance with certain accounting standards
- Any other matter that the auditor believes is important to bring to the attention of the users of the financial statements.
It’s important to note that a qualified opinion or a matter of emphasis in the auditor’s report does not necessarily mean that the company is in financial difficulties, but it does indicate that there are issues with the company’s financial statements that need to be addressed. Shareholders and investors should carefully review the auditor’s report along with the company’s financial statements to understand the nature of the issues and their potential impact on the company’s financial performance and position.
Following are example of public-listed companies where their respective external auditor issued qualified opinion or adverse opinion:
- Lion Industries Corp Bhd’s auditor Deloitte PLT has issued a qualified opinion on the group’s financial statements for the 18-month period ended Dec 31, 2021 (FP21). This is related to the deconsolidation of a subsidiary of its associate, Parkson Holdings Bhd.
- Sarawak Consolidated Industries Bhd (SCIB) said its external auditor has expressed a qualified opinion on the group’s financial statement for the year ended June 30, 2022 (FY22), pertaining to a settlement agreement relating to six construction projects carried out in Qatar and Oman.
- Statutory auditors of PTC India, TR Chadha and Co, have issued a disclaimer opinion on the company’s financial results for the quarter and six months period that ended September 30 2022 after four directors quit from its Board, raising governance concerns in its subsidiary Services (PFS).
- Saudi Arabia’s sovereign wealth fund has committed more than $2bn to new long-term football sponsorship deals this year in a sign of the kingdom’s growing ambitions in the world’s most popular sport. The sovereign wealth fund received a qualified opinion from KPMG for its 2021 financial statements, which means the audit firm could not get comfortable with certain aspects of the accounting. In an audit letter dated August 2022, KPMG flagged that it was “unable to obtain sufficient appropriate audit evidence” around transactions with PIF’s board directors and their family members.
4. Risks identified in Management Discussion and Analysis (MD&A)?
Management Discussion and Analysis (MD&A) is a section of a company’s annual financial filings that provides a narrative discussion of the company’s financial performance and condition. In the MD&A section, the company’s management team is required to discuss the company’s results of operations, financial position, and cash flows, as well as provide an analysis of the company’s financial condition and results of operations.
The MD&A typically includes the following information:
- An overview of the company’s business operations and performance during the fiscal year
- A discussion of the company’s financial condition, including liquidity and capital resources
- A discussion of the company’s results of operations, including any significant changes in revenue or expenses
- A discussion of the company’s critical accounting policies and estimates
- A discussion of any material trends or uncertainties that may impact the company’s future performance
- A discussion of any material transactions or events that occurred during the fiscal year
- A discussion of the company’s future prospects
Risks identified in the MD&A section of a company’s annual financial filings may include:
- Business risks: such as intense competition, new market entrants, changes in consumer preferences, or technological advancements that could negatively impact the company’s business.
- Economic risks: such as changes in interest rates, inflation, unemployment, or currency exchange rates that could negatively impact the company’s financial performance.
- Operational risks: such as supply chain disruptions, natural disasters, or pandemics that could negatively impact the company’s operations.
- Financial risks: such as credit risk, liquidity risk, or market risk that could negatively impact the company’s financial position or performance.
- Legal and regulatory risks: such as changes in laws, regulations, or policies that could negatively impact the company’s operations or financial performance.
It’s important to note that companies are required to discuss the most significant risks that could have a material impact on their business, and the company’s management should discuss the steps that they are taking to mitigate these risks.
