Question

In 10K/ annual reports, what is the Auditor's and Managements Reports and Certifications? Can you please summarize the following?

Auditor's report - general

Auditor's report - internal controls

Management report (certification) - fair presentation

Management report (certification) - internal controls.

Answer 1

          Most U.S. public companies are required to produce a 10-K each year and file it with the U.S. Securities and Exchange Commission (SEC). (Non-U.S. public companies usually file their annual reports with the SEC on different forms.) SEC rules require that 10-Ks follow a set order of topics.

SEC rules also require companies to send an annual report to their shareholders when they are holding annual meetings to elect members of their boards of directors. There is a lot of overlap in the requirements for the 10-K and the annual report to shareholders, but there are also important differences. The 10-K typically includes more detailed information than the annual report to shareholders. The annual report to shareholders, unlike the 10-K, sometimes appears as a colorful, glossy publication. A number of companies, however, simply take their 10-K and send it as their annual report to shareholders. In those cases, the 10-K filed with the SEC and the annual report to shareholders are the same document. For more information on the annual report to shareholders, please click here.

Following is a description of each section of Form 10-K, along with some suggestions on how to use the information. At the end of this document, we explain the role of public companies in ensuring the accuracy of their 10-Ks and the role of the SEC in reviewing the documents. We also tell you how to find company 10-Ks.

PART I

Item 1 - “Business” requires a description of the company’s business, including its main products and services, what subsidiaries it owns, and what markets it operates in. This section may also include information about recent events, competition the company faces, regulations that apply to it, labor issues, special operating costs, or seasonal factors. This is a good place to start to understand how the company operates.

Item 1A - “Risk Factors” includes information about the most significant risks that apply to the company or to its securities. Companies generally list the risk factors in order of their importance. In practice, this section focuses on the risks themselves, not how the company addresses those risks. Some risks may be true for the entire economy, some may apply only to the company’s industry sector or geographic region, and some may be unique to the company.

Item 1B - “Unresolved Staff Comments” requires the company to explain certain comments it has received from the SEC staff on previously filed reports that have not been resolved after an extended period of time. Check here to see whether the SEC has raised any questions about the company’s statements that have not been resolved.

Item 2 - “Properties” includes information about the company’s significant properties, such as principal plants, mines and other materially important physical properties.

Item 3 - “Legal Proceedings” requires the company to include information about significant pending lawsuits or other legal proceedings, other than ordinary litigation.

Item 4 - This item has no required information, but is reserved by the SEC for future rulemaking.

PART II

Item 5 - “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” requires information about the company’s equity securities, including market information, the number of holders of the shares, dividends, stock repurchases by the company, and similar information.

Item 6 - “Selected Financial Data” provides certain financial information about the company for the last five years. You can find much more detailed financial information on the past three years in a separate section – Item 8, “Financial Statements and Supplementary Data.”

Item 7 - “Management’s Discussion and Analysis of Financial Condition and Results of Operations” gives the company’s perspective on the business results of the past financial year. This section, known as the MD&A for short, allows company management to tell its story in its own words. The MD&A presents:

The company’s operations and financial results, including information about the company’s liquidity and capital resources and any known trends or uncertainties that could materially affect the company’s results. This section may also discuss management’s views of key business risks and what it is doing to address them.

Material changes in the company’s results compared to the prior period, as well as off-balance sheet arrangements and the company’s contractual obligations.

Critical accounting judgments, such as estimates and assumptions. These accounting judgments – and any changes from previous years – can have a significant impact on the numbers in the financial statements, such as assets, costs, and net income.

Item 7A - “Quantitative and Qualitative Disclosures about Market Risk” requires information about the company’s exposure to market risk, such as interest rate risk, foreign currency exchange risk, commodity price risk or equity price risk. The company may discuss how it manages its market risk exposures.

Item 8 - “Financial Statements and Supplementary Data” requires the company’s audited financial statements. This includes the company’s income statement (which is sometimes called the statement of earnings or the statement of operations), balance sheets, statement of cash flows and statement of stockholders’ equity. The financial statements are accompanied by notes that explain the information presented in the financial statements.

U.S. companies are required to present their financial statements according to a set of accounting standards, conventions and rules known as Generally Accepted Accounting Principles, or GAAP. An independent accountant audits the company’s financial statements. For large companies, the independent accountant also reports on a company’s internal controls over financial reporting. The auditor’s report is a key part of the 10-K. Most audit reports express an “unqualified opinion” that the financial statements fairly present the company’s financial position in conformity with GAAP. If, however, an auditor expresses a “qualified opinion” or a “disclaimer of opinion,” investors should look carefully at what kept the auditor from expressing an unqualified opinion. Likewise, investors should carefully evaluate material weaknesses disclosed on internal controls over financial reporting.

In addition, the Sarbanes-Oxley Act of 2002 requires the company’s CEO and CFO to certify that the 10-K is both accurate and complete. These are called Sections 302 and 906 certifications, and you can usually find them in Exhibits 31 and 32.

You may also find “non-GAAP financial measures” in the 10-K. That means that the numbers do NOT conform to GAAP. While companies are permitted to present non-GAAP measures, they must also show how they differ from the most comparable corresponding GAAP financial measure. As an investor, it is up to you to decide how much weight to give to non-GAAP measures.

Item 9 - “Changes in and Disagreements with Accountants on Accounting and Financial Disclosure” requires a company, if there has been a change in its accountants, to discuss any disagreements it had with those accountants. Many investors view this disclosure as a red flag.

Item 9A - “Controls and Procedures” includes information about the company’s disclosure controls and procedures and its internal control over financial reporting.

Item 9B - “Other Information” includes any information that was required to be reported on a different form during the fourth quarter of the year covered by the 10-K, but was not yet reported.

PART III

These items cover the following topics.

Item 10 “Directors, Executive Officers and Corporate Governance” requires information about the background and experience of the company’s directors and executive officers, the company’s code of ethics, and certain qualifications for directors and committees of the board of directors.

Item 11 “Executive Compensation” includes detailed disclosure about the company’s compensation policies and programs and how much compensation was paid to the top executive officers of the company in the past year.

Item 12 “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” requires information about the shares owned by the company’s directors, officers and certain large shareholders, and about shares covered by equity compensation plans.

Item 13 “Certain Relationships and Related Transactions, and Director Independence” includes information about relationships and transactions between the company and its directors, officers and their family members. It also includes information about whether each director of the company is independent.

Item 14 “Principal Accountant Fees and Services” requires companies to disclose the fees they paid to their accounting firm for various types of services during the year.

Although these disclosures are required by the 10-K, most companies meet this requirement by providing the information in a separate document called the proxy statement, which companies provide to their shareholders in connection with annual meetings. If the information is provided through the proxy statement, the 10-K would include a statement from the company that it is incorporating the information from the proxy statement by reference – in effect directing readers to go to the proxy statement document to find this information. Keep in mind that the proxy statement is typically filed a month or two after the 10-K. For more information on proxy statements and shareholder voting in corporate elections, see the SEC’s Spotlight on Proxy Matters. And for information on how to find company proxy statements on the SEC’s EDGAR database, click here.

PART IV

Item 15 - “Exhibits, Financial Statement Schedules” requires a list of the financial statements and exhibits included as part of the Form 10-K. Many exhibits are required, including documents such as the company’s bylaws, copies of its material contracts, and a list of the company’s subsidiaries.

Conclusion: The Roles of Companies and the SEC

The company writes the 10-K and files it with the SEC. Laws and regulations prohibit companies from making materially false or misleading statements in their 10-Ks. Likewise, companies are prohibited from omitting material information that is needed to make the disclosure not misleading. In addition, as noted above, the Sarbanes-Oxley Act requires a company’s CFO and CEO to certify the accuracy of the 10-K.

The SEC neither writes the 10-K nor vouches for its accuracy. The SEC sets the disclosure requirements and the SEC staff reviews 10-Ks to monitor and enhance companies’ compliance with the requirements. Both the SEC and the staff also provide interpretive advice about the disclosure requirements. All 10-Ks filed with SEC are available to the public on the SEC’s website.

More specifically:

· The SEC’s rules set forth the disclosure requirements – the topics that all companies must cover in their 10-Ks, and how the information should be presented.

· The SEC staff reviews 10-Ks and may provide comments to a company where disclosures appear to be inconsistent with the disclosure requirements or deficient in explanation or clarity. The Sarbanes Oxley Act requires the SEC to review every public company’s financial statements at least once every three years. The SEC staff may review the 10-Ks of certain companies more frequently.

· All 10-Ks are publicly available on the SEC’s EDGAR website. You can find all 10-Ks by accessing this website. For more information on how to use EDGAR, see Researching Public Companies Through EDGAR: A Guide for Investors. Most companies also post their 10-Ks on their own websites.

Auditor's report – general

An Audit Report can be defined as an opinion about the financial statements of the company. Issued by the auditors, the main purpose is to convey the overall opinion about the integrity, and completeness of the financial statements, of the engaging party.

The Audit Report is supposed to be published with the Annual Report of the Company. The main parties interested in Audit Reports, and the overall opinion presented are investors, analysts, Company’s Management, and lenders.

This is because it shows the overall performance and the manner in which operations are being carried out at the respective organization.

The overall necessity to have a properly structured Audit Report lies in the realms of assurance, and a guarantee, per se, regarding the overall free and fair reporting of financial position of the said organization, and the overall extent to which they have complied with internationally acclaimed accounting standards.

Therefore, the Audit Report is basically a proof, given by the auditor, after a thorough review of the financial statements, and other respective assertions.

What are the General Contents in the Audit Report?

An Audit Report should ideally have the following contents.

Title : This is generally addressed as ‘Independent Auditors Report’

Address : Given the fact that Auditors are appointed by the shareholders of the company, the Audit Report is addressed to them, and it is subsequently declared so.

Furthermore, since they are the most important stakeholder group for which Audit Report matters, the Audit Report is addressed to the shareholders.

Responsibility – (Responsibility of the Management, as well as the Auditor)

This clearly mentions the overall responsibility of the auditor to give a free and fair opinion about the financial statements, and it also stresses upon the management’s responsibility to cooperate with the auditor.

The Scope of the Audit : The Scope of the Audit part of the Audit Report mentions that the audit has been conducted bearing in mind the overall accounting and auditing standards in the specific country. In the same manner, it also talks about the role of the auditor in ensuring that there are no material misstatements, and all internal controls tests have been performed in order to determine the correctness of the financial statements.

The Opinion of the Auditor : The Opinion of the Auditor is the main crux, not only of the Audit Report but also of the overall auditing process that had been carried out. The Audit Opinion can be qualified, unqualified, adverse, or disclaimer of opinion, depending on the eventual outcome of the audit.

Basis of Opinion : This is an extension that explains the basis on which the auditor issued the particular judgment. It explains sufficient reasoning behind the judgment that was made.

Signature : This is duly signed by the auditor, as proof that he is well aware of his work, and it is accountable and responsible for the opinion that he has turned on.

· Place, Date of the Signature and Date of the Audit Report

Emphasis of Matter

Additionally, the Audit Report can also contain a part titled Emphasis of Matter. This is to bring attention to certain parts within the organization where the auditor believes attention should be drawn.

Financial statements

The audit report should also report the financial statements that the reporting is issuing. Those include the income statement, balance sheet, statement of change in equity, and note to financial statements.

Auditor's report - internal controls : If the auditor issues separate reports on the audit of internal control over financial reporting and the audit of the financial statements, both reports should include a statement that the audit was conducted in accordance with standards of the Public Company Accounting Oversight Board (United States). Committee of Sponsoring Organizations of the Treadway Commission (COSO)."]. W Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the company's internal control over financial reporting based on our audit.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. [Inherent limitations paragraph] Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. [Opinion paragraph] In our opinion, management's assessment that W Company maintained effective internal control over financial reporting as of December 31, 20X3, is fairly stated, in all material respects, based on [Identify control criteria, for example, "criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)."]. Also in our opinion, W Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 20X3, based on [Identify control criteria, for example, "criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)."]. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the [identify financial statements] of W Company and our report dated [date of report, which should be the same as the date of the report on the effectiveness of internal control over financial reporting] expressed [include nature of opinion].

Management report (certification) - fair presentation : Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with U.S. generally accepted accounting principles; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error.

Auditor's Responsibility

Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with U.S. generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement.

An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors' judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity's preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. Accordingly, we express no such opinion. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of significant accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.

We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion.

Management report (certification) - internal controls.: We have also audited management's assessment, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting, that the Company maintained effective internal control over financial reporting as of December 31, 20XX, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO").The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management's assessment that ABC Company maintained effective internal control over financial reporting as of December 31, 20XX, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by COSO. Furthermore, in our opinion, ABC Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 20XX, based on criteria established in Internal Control—Integrated Framework issued by COSO.