When one is considering buying stock in a company, as when one is buying a used car, it’s important to know if it’s a good deal or if it’s over-priced. With used cars, we can look at the CarFax report and Kelly Blue Book values, but we can’t know for sure if has hidden problems. Is the transmission about to go? was the frame bent in an unreported accident? One can take the salesman’s word for it, but it’s difficult for the average buyer to tell whether she’s telling the truth or whether she even knows the truth about the vehicle’s condition. When buying stocks, there is also publicly available information that can give us an indication of the stock’s value. Publicly available financial reports, however, are provided by the company’s internal accounting department which may have an inherent bias or reasons to paint a falsely positive (or more rarely, a falsely negative) picture of a company’s health.
When buying a car, one might have a trusted third-party mechanic inspect the car and provide a neutral opinion of the car’s condition and reliability. When evaluating financial reports, an approval from a qualified independent auditor is the equivalent of the mechanic’s inspection. Auditors can deliver four basic rulings after reviewing a company’s reports.
First, an unqualified opinion means that the auditor found no discrepancies in the reports and the company provided full cooperation during the audit. This means the auditor believes the reports to be accurate, complete and in compliance with accepted accounting practices. It doesn’t render an opinion on the condition of the company, just that the reports are accurate and, in the auditor’s professional judgment can be relied upon to make decisions about the company’s financial condition.
A qualified opinion, means that the auditor found some minor issue or issues with the report, but they are relatively small problems that don’t really affect the overall accuracy of the reports. Such discrepancies will be detailed in the auditor’s written opinion. These should be small enough that the reports still give an accurate picture of the company’s financial condition. Generally speaking, a qualified opinion also means that the auditor believes the provided reports can be relied upon to judge the company’s finances.
An adverse opinion means that the auditor has found inaccuracies in the financial statements that provide a misleading picture to anyone who relies upon the reports to make a judgment about the company’s condition. This is analogous to the salesman telling you the car runs great and has no problems, but the mechanic finds the transmission is about to fall apart and will need to be replaced or rebuilt immediately. It should change what you are willing to pay for the company or the car, if you are still willing to buy it at all. An adverse opinion from an auditor should also detail exactly what discrepancies the auditor found. It may mean that the company was deliberately falsifying information or the company’s accounting practices don’t meet accepted practices to the point where the reports cannot be trusted to make a good judgment about the company’s current state of affairs.
Finally, an auditor may offer a disclaimer or opinion, essentially refusing to give an opinion about the accuracy of the company’s financial reports. This might occur if the company failed to provide access to files that the auditor needed to verify the information in the financial reports. More rarely, it might mean that the auditor does not consider itself independent with regard to the company being audited. An audit provided by one branch of a financial company should not be relied upon to judge the parent company, for example.
Of course, an audit is only as good as the auditor, just as a car inspection is only as good as the mechanic. Even a good auditor can miss something or be fooled by a very dishonest client, but if the audit is performed by a reputable third party audit house, it can generally be relied upon to provide an accurate opinion of the financial reporting which it audits.