By Tom Rogers. A version of this blog was published on Vendor Centric.
Every company knows that auditing third-party financial statements is an important piece of their due diligence. Financial statements are an endlessly valuable fact finding resource. After all, numbers don’t lie. In many instances, however, reviewers are uncertain what exactly it is they’re looking for. Getting ready to conduct an audit? Here’s a guide to the primary components of an audited financial statement as well as four red flags to watch for.
The Components of an Audited Financial Statement
Audits are intended to provide comfort and assurance. They affirm for an organization that its third-party partners have provided clean, accurate financial statements. A Certified Public Accountant carries out audits to provide “reasonable assurance” that statements are free from misstatements. Typically, an audited financial statement is segmented into three sections.
1. Auditor’s Report: This is the official opinion signed by an external auditor. This section is “owned” by the auditor themselves rather than the company in question.
2. Financial Statements: These offer a quantitative overview of the company’s current financial health. The section is broken into three sections of its own: a balance sheet, an income statement, and a cash flow statement.
3. Notes to the Financial Statement: This section – featuring additional disclosures and details – provides a more qualitative picture. Notes might includes details related to accounting, long-term commitments, and incoming litigation.
Four Red Flags to Watch For
Diving into third-party financial reports is an important – and often time-consuming – process. Most organizations can’t afford to sink hours and hours into in. If your team is short on time, urge them to focus on these four areas to quickly identify warning signs.
1. Modifications to the Auditor’s Opinions: Ideally, your third-party should have a ‘clean’ (or unqualified/unmodified) auditor’s opinion. This means that the auditor has reached a definitive conclusion that the financial statements are entirely accurate. An auditor would issue a modified opinion if they disagree with the organization about any aspect of the statements, if they haven’t been able to carry out the necessary work, or if they are missing crucial pieces of evidence.
An auditor might also modify their opinion by including additional paragraphs meant to highlight certain sections. These are typically known as emphasis of matter paragraphs. These are always a great place to start your review. If a report includes a number of them, consider bringing in additional subject matter experts from your financial team to assess them.
2. Declines in Profitability: Profitability is a good place to start your review for obvious reasons. These ratios reflect an organization’s ability to consistently earn an adequate return. When assessing a company’s margins, take care to compare them with those of the industry. Using ratios like profit margin and return on assets, determine whether or not the organization is truly profitable. Declining profitability could signal that the company is losing market share or seeing costs begin to outpace earnings.
3. Unpaid Near-Term Liabilities: Profitability is great, but ultimately cash is king. Lots of companies look great on paper while hemorrhaging money behind the scenes. A good way to assess a vendor’s ability to cover liabilities is taking a look at its liquidity ratios. These provide insights into whether or not the vendor can pay what it owes and keep things on track near-term. A liquidity ratio that trends low over time could be a sign that the company is losing money fast.
4. Long-Term Solvency Concerns: Solvency ratios are some of the best tools around for evaluating an organization’s long-term viability. These help you understand how a company uses its debt to fund operations and whether or not this debt is growing at too quick a rate. A solvency ratio that trends higher over a time could indicate that a company is taking on too much debt too quickly.
Remember, not every third-party vendor requires a financial statement review. When in doubt, let your third-party risk assessment guide you and determine the scope of your due diligence.
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