Balance Sheet Decoded | Analysis of Opinion
- Blog|Account & Audit|
- 12 Min Read
- By Taxmann
- |
- Last Updated on 29 October, 2022
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Topics covered in this article are as follows:
- Introduction
- Type of Opinion
- Circumstances under which Opinion is Qualified
- Action on the Basis of Types of Report
- Case Analysis | Explaining How to Read and Analyse the Opinion of the Auditor
Introduction
The concept of the audit, what is contained in the auditor’s report, the importance of the auditor’s report, the legal framework as applies to audit in India, and the newly introduced report on internal financial controls over financial reporting, has been explained.
As discussed, it is the opinion of the auditor on the financial statements, which is provided in the auditor’s report. The “opinion” is the heart of the auditor’s report. What opinion is provided on the financial statements by the auditor is most relevant to be seen for the purpose of analysis of auditor’s report and so as to financial statements.
In this part, how to read and decode such opinion, what is the meaning of such opinion, when such opinion is modified or qualified is explained?
What is the impact of such opinion provided by the auditor on the financial statements is also equally relevant, as the financial statement accompanied to the auditor’s report is subject to such opinion and therefore, for decoding the balance sheet, the secrets of the auditor’s report need to be known.
Type of Opinion
Since it is his/her opinion, which is expressed by the auditor in the auditor’s report, therefore, based on the nature of such opinion, the auditor’s report can be classified as:
| Nature of Opinion | Types of Audit Report |
| a. Unmodified opinion | Clean report |
| b. Modified opinion | Modified report |
| c. Qualified opinion | Qualified report |
| d. Adverse opinion | Adverse report |
| e. No opinion | Disclaimer report |
The various types of auditors report can be summarised as per the chart below:
| Clean Report | Modified Report |
| Issued where financial statements are- | Issued where financial statements- |
| · Prepared and presented in accordance with generally accepted accounting principles | · Does not give a true and fair view of financial position; OR |
| · In conformity with books of accounts | |
| · In conformity with accounting policies | |
| · All the material facts are disclosed | · Materially misstated the facts; OR*
|
| · Meet the statutory reporting requirements | |
| · Free from material misrepresentation of facts |
* The Modified Auditor’s Report can be of 3 Types
| Qualified Report | Adverse Report | Disclaimer of Report |
| Issued where | Issued where | Issued where |
| · Some matter or issue not reported by the management but reporting of which is necessary to understanding the financial statements | · Financial statements do not confirm with generally accepted accounting principles | · In extremely rare circumstances where auditors find multiple uncertainties in the financial statements |
| · Reporting of an issue that is not in conformity with generally accepted accounting principles | · financial statements are materially misstated | · Where it is not possible to form an opinion on the financial statements due to the cumulative effect of uncertainties |
| · Financial statements contain a material misstatement | · Financial statements are grossly misrepresented | |
| · Effect of the issue if material but not pervasive |
Circumstances under which Opinion is Qualified
Broadly, the following are the circumstances under which the opinion of the auditor is qualified:
-
- There is a violation of the Accounting Standards or Indian Accounting Standards as applicable to the company;
- There is a violation of the accounting policies, normally adopted by the company;
- Generally accepted accounting principles are not followed by the company;
- Any transaction which is prejudicial to the interest of the company;
- There is a change in accounting method or change in the treatment of a particular item in this year as compared to the last year; and
- It is significant in nature and has a material impact on the financials of the company
Action on the Basis of Types of Report
Only after the preparation of the financial statement, is the auditor’s report issued. Therefore, one should keep in mind that any qualified opinion or modified opinion, needs to be adjusted in the financial statements, for the purpose of analysis.
After analyzing the issue as referred by the auditor in the auditor’s report, necessary adjustments shall be made on account of such issue. The adjustment may be a reduction in profit, if the auditor has stated in the note, that the profit is overstated. If auditor states in the opinion that profit is understated, the profit shall be increased by such amount. There will be the corresponding effect in the balance sheet also, if the opinion relates to the profit/loss statement and in such cases necessary effect shall also be required to be given to the items of the balance sheet, such as reduction in reserves etc. If the assets/liabilities are overstated or understated, the adjustment will be needed with respect to such assets/liabilities.
Based on the types of auditor’s report, the following actions are to be taken to decode –
| Types of Report | Action |
| Clean report | No action |
| Qualified report | Make necessary adjustments in the profit/loss or assets/liability, as the case may be on the basis of such qualified opinion. |
| Modified report | It is the worst type of financial report and primarily such financial statements are not reliable and cannot be analysed. Still, in some cases, if the amount is quantified, necessary adjustments shall be made in profit/loss as well as in the balance sheet items, as the case may be. |
| Disclaimer
report |
Since the auditor has not expressed his opinion, such financial statements are required to be outright rejected and fresh opinion should be obtained after correcting the mistakes. |
Case Analysis
Explaining How to Read and Analyse the Opinion of the Auditor
This case analysis pertains to a leading energy company, listed on NSE and BSE. Though this pertains to F.Y. 2011, this is being selected as case analysis considering the importance of the issue referred to in the auditor’s report (qualified opinion) the amount involved, and for correlating the note with the actual fact of subsequent years.
The purpose of this case analysis is manifold:
-
- to explain the importance of such qualified opinion,
- how to analyse such opinion,
- for the purpose of analysis, what treatment is to be given to such opinion; and
- how to read between the lines of the report
The relevant portion relating to the qualified opinion of this case analysis for F.Y. 2011, included in auditor’s report is as per Box below:
| Without qualifying our opinion, we draw attention to note 4(c), Schedule P in the financial statements regarding non-provision of proportionate premium on redemption of US$ 479.04 million (INR 2,136.27 crores as on March 31, 2011), foreign currency convertible bonds amounting to INR 579.21 crores which has been considered by the company as a contingent liability. Since the ultimate outcome of the matter cannot be presently ascertained, no provision for the above liability that may result in future has been made in the accompanying financial statements. |
Analysis
- While giving the qualified opinion, the auditor has drawn attention to note 4(c) of Schedule P, relating to the issue about not making provision of proportionate premium amounting to INR 579 crore as of March 31, 2011, on the FCCB, which has been considered as a contingent liability.
- For the purpose of analysis of the opinion, the note which has been referred in the auditor’s report requires to be read in its entirety.
The said note being note 4(c) of Schedule P, as referred by the auditors in the Auditor’s Report is shown in the Box below:
| Schedule-P
Note 4(c) – Foreign Currency Convertible Bonds a. Initial terms of issue On June 11, 2007 the Company made an issue of zero-coupon convertible bonds aggregating USD 300 million (INR 1,223.70 crore) [Phase I bonds]. Further, on October 10, 2007, the Company made an additional issue of zero-coupon convertible bonds aggregating USD 200 million (INR 786.20 crore) [Phase II bonds] and on July 24, 2009, the company made an additional issue of zero-coupon convertible bonds aggregating USD 93.87 million (INR 452.64 crore) at an issue price of 104.30% of the principal amount of USD 90.00 million. The key terms of these bonds at the time of issue were as follows:
b. Restructuring of Phase I and Phase II bonds i. During the year 2009-10, the Company restructured Phase I and II Zero-Coupon Convertible Bonds with approval of the Reserve Bank of India (‘RBI’) wherein the bondholders were offered the following options as part of the restructuring;
As a result of the restructuring, the outstanding position of the foreign currency convertible bonds is as follows:
*19,000 bonds were converted into equity shares during the year 2009-10. ii. On April 29, 2010, the Company convened meetings of Bondholders of each of the series, who approved the respective resolutions proposed to them. Accordingly, post receipt of regulatory approvals, the Company changed the conversion price of the Phase I bonds from INR 359.68 per equity share to INR 97.26 per equity share and for Phase II bonds from INR 371.55 to INR 97.26 per equity share, subject to adjustments in accordance with terms and conditions of the bonds. The floor price for Phase I and Phase II bonds has been revised to INR 74.025 per equity share. The fixed exchange rate was changed to 1 USD = INR 44.60 from 1 USD = INR 40.83 for Phase I bonds and 1 USD = INR 39.87 for Phase II bonds. The Company has incurred INR 37.28 crore towards consent fee to bondholders and other cost and disclosed under exceptional items for the year ended March 31, 2011. c. Redemption Premium: The Phase I, Phase II, Phase I New, Phase II New, and Phase III bonds are redeemable subject to satisfaction of certain conditions mentioned in the offering circular and hence have been designated as a monetary liability. The Company has not provided for the proportionate premium on these bonds aggregating INR 579.21 crore (INR 377.22 crore) as shown below:
In the opinion of the management, the likelihood of redemption of these bonds cannot presently be ascertained. Accordingly, no provision for any liability been made in the financial statements, and hence the proportionate premium has been shown as a contingent liability. The Company has adequate securities premium to absorb the proportionate premium on redemption as of March 31, 2011. |
Analysis of the said note
- The analysis of the said note clearly reveals that the company has not provided for the proportionate premium of INR 579 crore as of March 31, 2011, in the profit &loss account as the management has considered the same as a contingent liability.
- The important issue is that had it really been a contingent liability, the auditor would not have highlighted the same in the auditor’s report. So, the preliminary analysis is that the same is not a contingent liability, but a provision which the company has not provided – and that is the reason the auditor has qualified his opinion on the financials of the company. (This is known as reading between the lines)
- Accounting Standards (AS) 29 -“Provisions, Contingent Liability and Contingent Assets” corresponding to Ind AS 37, deals with provisions and contingent liability. It applies to all companies, and accordingly, it is applicable to the case analysis also.
- Based on the said accounting standard, in order to fall within the definition of the ‘Provision’, there has to be marked:
- a past event;
- whether a present obligation exists;
- whether reliable estimate can be made of such obligation; and
- whether outflow of the funds is certain
(for detailed analysis of provision and contingent liability, refer to Taxmann’s Balance Sheet Decoded [3rd Edition] authored by G.C. Pipara
- Going back to the note, it is clear that in the year FY 2010 there was the restructuring of the phase-I and phase-II bonds, where the conversion price of the phase-I bond was changed from INR 360 to INR 97 and phase-II bonds conversion price was changed from INR 372 to INR 97.
- The conversion price for the FCCB indicates the prevailing market rate of the shares of the company. Therefore, considering the fall in the market rate of the shares of the company, management as well as auditors knew that the chances of converting bonds into shares were remote and therefore, the proportionate premium on the bonds will fall within the definition of the “Provision” following AS-29.
- However, maybe because there was no sufficient profit in the books of the company, the management might have decided not to provide for the proportionate premium on the bonds as it would have affected the profitability of the company.
- The conclusion is that for the purpose of proper analysis of the financials of this particular company, on the basis of the modified opinion of the auditor, the profit shown by the company should be reduced by an amount of INR 579 crore. Resultant reserves & surplus shown in the balance sheet will be lower by an equal amount as by not providing the proportionate premium, which is the nature of interest, profit is inflated, and reserves & surplus are also shown higher by this amount.
- It is also clarified that the opinion in the auditor’s report begins with the use of the words “without qualifying our opinion”. This does not mean that the opinion is not qualified. Rather, it is a qualified opinion. The normal practice in using these words means that indirectly the auditor wants to convey that the opinion is not qualified, whereas in fact, it is a qualified opinion.
One of the principles of analysis of financial statements is that one should always look into the financials of a particular company pertaining to 2-3 years and form a comparative analysis. Further, if a particular note referred to in an auditor’s report, is of such nature which is found to be recurrent, the financials of the subsequent year should always be looked into.
Therefore, in the case analysis below the financials of the very said company, for next FY 2012 are analyzed.
Case Analysis
In Box below, the auditor’s report for FY 2012, on the said issue is given.
| Auditor’s Report as of March 31st, 2012 |
| Without qualifying our opinion, we draw attention to Note 4 of the accompanying financial statements regarding the existence of certain liabilities on account of foreign currency convertible bonds (‘FCCB’) which are due for redemption during June 2012 and October 2012 having an aggregate redemption value of USD 568.96 million (INR 2,894.58 crore). The Company is in the process of tying up funds for redemption of these FCCB Liabilities and consequently, there exists a material uncertainty that may cast significant doubt about the Company’s ability to continue as a going concern, which is dependent on generating the required funds before the redemption date. Management’s plans for raising funds for such redemption have been more fully discussed in Note 4 to the accompanying financial statements, in view of which the accompanying financial statements have been prepared under the going concern assumption, and consequently, no adjustments have been made to the carrying values or classification of balance sheet accounts. |
Analysis of above observation in auditor’s report
From the above observation of the auditors in the auditor’s report of the subsequent year March 31, 2012, it is interesting to note that:
-
- now auditors are admitting about liability relating to FCCB bonds which are due for redemption;
- it is also clarified by the auditors that the company is in the process of tying up for funds for the redemption of the bond’s liability; and
- the auditor has also expressed doubt about the company’s ability to continue as a going concern.
Conclusion
It is important to note that in FY 2011, the auditor at the outset has not qualified the opinion relating to interest but started the note “without qualifying our opinion”, whereas it is a qualified opinion. It has become very clear that by not providing the proportionate premium in the profit & loss account, sufficient funds have not been reserved for the redemption of the bonds. Profits of the company have been inflated and the proportionate premium has wrongly been considered by the company as a contingent liability, which is in fact a provision.
In order to conclude the issue logically, the financials of the said company for the years ending March 31, 2013 and March 31, 2014, were also looked into.
Case Analysis
The auditor in the auditor’s report in FY 2013 has observed in the box below:
| Auditor’s Report as of March 31st, 2013 |
| “Emphasis of Matter
5. We draw attention to Note 5 of the accompanying financial statements in respect of material uncertainty about the Company’s ability to continue as a going concern which is in part dependent on the successful outcome of the discussions with the FCCB holders. Our opinion is not qualified in respect of this matter. Auditor’s Report as of March 31st, 2014 “Emphasis of Matter 5. We draw attention to Note 5 of the accompanying financial statements in respect of material uncertainty about the Company’s ability to continue as a going concern which is in part dependent on the successful outcome of the discussions with the FCCB holders and Company’s ability to generate sufficient funds to support its operations. Our opinion is not qualified in respect of this matter.” |
Analysis of the observation of the auditors in the Auditor’s Report, as of March 31, 2013 and March 31, 2014
- For the subsequent 2 years also, the same issue has been included by the auditor in the auditor’s report, with the observation that there is material uncertainty about the continuation of the business of the company as a going concern. This is for the reason that the company failed to redeem the FCCB bonds on the due date.
- Look at the contradiction in the stand taken by the company that in FY 2011, the company has not provided for the proportionate premium on the ground that FCCB bonds will be converted into shares and therefore, the premium was considered as a contingent liability.
- Whereas, truly speaking, it was a provision which has not been made by the company and on the almost similar set of facts from the auditor’s observation in the subsequent years, it becomes very clear that the company was not having sufficient funds to meet the redemption of the bonds and the going concern aspects of the company had become doubtful.
- Thus, on the basis of analysis it is clear that in earlier years the company had defaulted in not making provision in the financials, for the proportionate premium on the bonds and same was wrongly considered as a contingent liability, resulting into higher profit.
- The auditor has also erred in not issuing a modified opinion and was wrong in considering the said FCCB bond interest, as contingent liability.
- The auditor should have clearly stated that the company has not provided the interest and as a result the profit is overstated to the extent of such interest.
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