What it means
An audit ends with the auditor's report, and the report's central paragraph is the opinion. An unmodified opinion states that the financial statements give a true and fair view, or present fairly, in accordance with the applicable framework.
When the auditor cannot say that, the opinion is modified, and there are three kinds of modification, chosen according to two questions: is the problem a misstatement the auditor has found, or a lack of evidence the auditor could not obtain; and is the problem confined to specific items, or pervasive? A misstatement that is material but confined produces a qualified opinion ("except for"); a misstatement that is pervasive produces an adverse opinion (the statements are not fairly presented).
A lack of evidence that is material but confined produces a qualified opinion; a lack of evidence that is pervasive produces a disclaimer. The lack of evidence, called a scope limitation, can arise from circumstances or from the entity.
Circumstances include the destruction of records by fire or system failure, the inability to observe a physical inventory count because the auditor was appointed after the year end, the collapse of a key subsidiary whose records cannot be obtained, or the sheer unreliability of the accounting system. Limitations imposed by the entity include management's refusal to allow the auditor access to records, people or locations, refusal to provide written representations, or refusal to allow confirmation of balances with banks and customers.
An imposed limitation is treated more gravely, since it suggests management has something to hide, and auditors will often resign rather than accept it. A disclaimer may also be issued where there are multiple uncertainties, each of which might be resolved either way, whose combined effect on the financial statements could be so great that the auditor cannot form a view.
The commonest case is a going concern situation in which the company's survival depends on several events, such as a refinancing, a legal judgement and a regulatory decision, none of which has occurred. A single significant uncertainty, adequately disclosed, produces an unmodified opinion with an emphasis paragraph; a tangle of them can produce a disclaimer.
The report itself is distinctive. The opinion paragraph states that the auditor does not express an opinion, and the basis paragraph explains why, describing what could not be verified and its potential effects.
The auditor's responsibilities section is shortened, since the auditor could not complete the work the standard description assumes. Readers sometimes misread a disclaimer as a mild outcome, on the reasoning that the auditor has not said anything is wrong; the correct reading is that the auditor has said it cannot vouch for the statements at all, which for any purpose that depends on audited figures is worse than a specific qualification.
The consequences follow from that reading. Loan agreements commonly require audited accounts with an unmodified opinion, so a disclaimer is an event of default.
Stock exchanges may suspend the shares of a company whose accounts carry a disclaimer, and regulators of banks, insurers and other licensed businesses treat one as grounds for intervention. Tax authorities may open enquiries.
Suppliers and credit insurers tighten terms. And the company's next audit will be more expensive and more intrusive, since the auditor must address the limitation before it can opine on the following year, including the opening balances that the disclaimed year left unverified.
For a company, the cost of a disclaimer is measured in access to capital, and the path out of it is to fix the underlying records and controls so that the next audit can be completed.
In practice
Real-world examples.
Example
A retailer's stock system fails in the last week of its financial year, no physical count is possible, and the auditor disclaims because inventory and cost of sales, together most of the balance sheet and income statement, cannot be verified.
Example
A company's directors refuse to let the auditor contact the company's bank to confirm loan balances and covenant compliance, and the auditor disclaims on the grounds of an imposed scope limitation, then resigns.
Example
A shipping company faces a refinancing, a major legal claim and a regulatory investigation, each unresolved at the date of the report and each capable of ending the business, and the auditor disclaims on the basis of multiple material uncertainties.
Think of it
“A disclaimer means the auditor can't say whether the financials are right or wrong-they can't form an opinion.
Case study
Seen in the real world.
A wholesale distributor migrated its inventory and accounting systems to a new platform in the last quarter of its financial year. The migration went badly: stock balances were loaded with errors, transactions during the cut-over were double-posted or lost, and by the year end the system's inventory figure of $6,200,000 bore no reliable relationship to what was in the warehouse. No full physical count was held, because management assumed the system would be corrected.
When the auditors arrived they found that they could neither rely on the system nor reconstruct the year-end inventory from other evidence, and that the same problems affected purchases, cost of sales and payables. The auditors set materiality at $200,000 against a reported profit of $4,000,000; the unverifiable amounts ran to millions and touched most of the financial statements. They issued a disclaimer of opinion.
The consequences arrived within days. The company's bank facility required audited accounts with an unmodified opinion; the disclaimer was an event of default, and the bank invoked it, moving the facility to demand and imposing weekly reporting. A planned equity raise to fund expansion was postponed by the company's advisers, who could not market shares on the strength of accounts the auditor had not opined on.
Two credit insurers withdrew cover on the company, and several suppliers moved it to payment on delivery. The company's chief executive, who had regarded the migration problems as an IT matter, found that they had become a financing crisis.
The recovery took a year. The company commissioned a full physical count and a reconstruction of the inventory and purchase ledgers from supplier documents and warehouse records, engaged a specialist to stabilise the system, and appointed a finance director with systems experience. The following year's audit was completed with an unmodified opinion, though at twice the previous fee, and with the opening balances verified through the reconstruction.
The bank restored a committed facility and the equity raise proceeded fourteen months late and at a lower valuation. The board's post-mortem recorded that a disclaimer is not a comment on the company's honesty or its profitability but on whether its figures can be relied on at all, and that the cost of an unverifiable balance sheet had been far greater than the cost of a physical count would have been.
Watch out
Common mistakes.
- Reading a disclaimer as milder than a qualified opinion because the auditor has not said anything is wrong; it is more serious, because the auditor has said it cannot vouch for the statements at all.
- Treating record-keeping failures, system migrations or a missed inventory count as operational problems, when they can make the year unauditable and trigger defaults and suspensions.
- Restricting the auditor's access to records, people or third parties in the belief that it will avoid an awkward finding; an imposed limitation leads to a disclaimer and usually to the auditor's resignation.
Questions
People also ask.
What is the difference between a disclaimer of opinion and an adverse opinion?
An adverse opinion says the auditor has found that the financial statements are materially and pervasively misstated. A disclaimer says the auditor could not obtain enough evidence to form any opinion. The first is a conclusion that the statements are wrong; the second is an inability to conclude.
What is the difference between a disclaimer and a qualified opinion?
Both can arise from a lack of evidence. A qualified opinion is given when the unverified matter is material but confined to specific items, so the auditor can opine on everything else "except for" those items. A disclaimer is given when the unverified matter is so pervasive that no opinion is possible.
What happens to a company after a disclaimer?
Typically loan covenants requiring an unmodified opinion are breached, listed shares may be suspended, regulators of licensed businesses may intervene, and credit terms tighten. The way out is to resolve the underlying problem so that the next year's audit, including the opening balances, can be completed.
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