Qualified Audit Opinion: What a Lender Does With It

An audit opinion is a statement about a whole set of accounts. Most are unmodified, which is the term the standards now use for what people still call a clean or unqualified opinion. When the auditor cannot give that, the standard offers three alternatives, and the qualified opinion is the mildest. It gives the accounts a fair-presentation opinion, with one carve-out that the auditor sets out in a separate section headed Basis for Qualified Opinion.

To a lender the carve-out is the most useful paragraph in the report, because it says where the assurance stops. Stock at a site the auditor could not reach, a valuation with no support, a related-party balance nobody could confirm: each is a number that has been through the audit and come out without the auditor's backing. The rest of the accounts are no worse for it, but the lender needs to know which of its assumptions rest on the excepted number.

The international standard on the subject, ISA 705, is built on two questions: what is the problem, and how far does it spread? New Zealand's version, ISA (NZ) 705 (Revised), sets them out like this, and Australia's ASA 705 and ISA (UK) 705 use the same grid:

Pervasive means, broadly, that the effect is not confined to particular items or, if it is, those items make up a substantial part of the accounts. The wording shows which row applies. Where the accounts are misstated the auditor writes "except for the effects of" the matter. Where the evidence is missing the auditor writes "except for the possible effects of" it. The difference matters to a lender: the first says a number is wrong, and the second says nobody knows.

A wholesaler of vineyard and winery supplies, constructed for this page like every figure in it, holds stock of US$16.0m at its year-end. Of that, US$3.2m sits on consignment at vineyards across two regions, and its records of what each vineyard holds are poor. The auditor could not count that stock or get reliable replies from the vineyards, and writes an "except for the possible effects" opinion. The bank lends against stock at a 50% advance rate, has US$7.0m drawn, and has a net leverage covenant of 3.25 times. The advance rate and covenant level belong to the example and are not offered as a market norm.

The first calculation is the collateral. If the bank stops lending against stock nobody has verified, a US$1.0m cushion becomes a US$0.6m shortfall. The second is the covenant. The 25% is an assumption chosen to show the sensitivity, since the opinion does not say how much is missing, and it is enough to carry the borrower over the line. A write-off of that kind might also belong to an earlier year, which is a further question the qualification leaves open.

So the desk asks what is at the vineyards and why it could not be verified, then acts on the answer. It might commission a count through a field examiner, require confirmations from the larger consignees, and exclude consigned stock from the base until they arrive. The borrower has done nothing dishonest here. The bank is simply declining to lend against a number with no support.

DEFINED IN ONE PARAGRAPH → · AUDIT AND ASSURANCE, READ BY A LENDER → · FIELD EXAM, DEFINED →

An adverse opinion says the accounts as a whole do not present fairly. A disclaimer says the auditor could not form an opinion at all. Both are far more serious than a qualification, and a lender would generally want to know the full story before relying on those accounts for anything.

The confusion usually runs the other way, with paragraphs that look alarming but do not modify the opinion. An Emphasis of Matter paragraph draws attention to something already properly disclosed. A section on a material uncertainty related to going concern, where the disclosure is adequate, leaves the opinion unmodified too, though a lender may read it as the most important page in the accounts. A key audit matter is one the auditor judged to be of most significance in the audit, and these sections appear mainly in the reports of listed and other publicly accountable companies. None of these says the accounts are wrong.

The first stop is the facility agreement. Some agreements require the audited accounts to come with an unqualified opinion, some treat a qualification as a review event, and some make a qualification, or only a material or adverse one, an event of default. Others are silent. Wording varies by deal, so a lender reads its own document rather than assuming. Where it does give a right, the usual response is a conversation and a waiver on conditions, with enforcement a long way off if the excepted item is contained.

The second is repetition. A qualification that appears once because an auditor was appointed too late to see the opening count is a different file from one that recurs each year over the same warehouse. The first has a date on which it ends. The second tells a lender that a known weakness in the records has been left alone, and that says something about management as well as about the stock. Where a borrower has only reviewed or compiled accounts, no audit opinion exists to qualify, and a lender starts from a lower level of comfort.

THE BANK IN YOUR AUDIT FILE → · ONE-MINUTE FILE: THE WAREHOUSE →