The annual report contains more than the financial statements. It contains the directors’ report, the management discussion and analysis (MD&A), the corporate governance report, the chairman’s message, the business review, the sustainability report and other narratives that describe the company’s strategy, performance, risks and outlook.
SA 720 requires the auditor to read this “other information” and assess whether it is materially inconsistent with the financial statements or with the auditor’s knowledge obtained during the audit. The auditor does not audit the other information (the audit opinion covers only the financial statements). But the auditor is responsible for reading it and identifying inconsistencies that could undermine the credibility of the financial statements or the audit report.
What constitutes a material inconsistency
A material inconsistency exists when the other information contradicts the financial statements or the auditor’s findings in a way that could mislead the reader.
Example 1: Revenue growth narrative versus financial statements. The chairman’s message states: “Your company delivered exceptional growth of 28% during the year, significantly outperforming the industry.” The audited financial statements show revenue growth of 12%. The inconsistency is factual: the chairman claims 28% growth, the financials show 12%. The inconsistency may be caused by: the chairman using a different metric (order book growth, not revenue growth), the chairman using a different period (trailing two years, not the current year) or an error in the chairman’s message.
If the inconsistency is not resolved, the audit report’s Other Information section describes it. The auditor does not modify the opinion (the financial statements are correct), but the auditor reports that the other information is materially inconsistent.
Example 2: Risk disclosure inconsistency. The MD&A states: “The company has no material concentration risk in its customer base.” The financial statements’ related-party disclosure shows that 45% of revenue comes from two customers, one of which is a related party. The MD&A’s assertion contradicts the financial data. The inconsistency undermines the MD&A’s credibility and, by extension, the annual report’s reliability as a complete communication to shareholders.
Example 3: Going concern narrative inconsistency. The directors’ report states: “The company’s financial position remains strong with adequate liquidity.” The financial statements contain a going concern disclosure noting that the company’s financing arrangements have expired, the company has been unable to obtain replacement financing and it is considering filing for bankruptcy. The directors’ report’s “strong financial position” narrative is materially inconsistent with the going concern disclosure.
Example 4: Capital expenditure inconsistency. The business review states: “The company invested Rs 120 crore in capacity expansion during the year.” The financial statements show capital expenditure of Rs 45 crore. The Rs 75 crore gap may represent: expenditure committed but not yet incurred (which is not an “investment” in accounting terms), capitalised expenses that were reclassified during the audit, or an error in the business review.
What the auditor does
When the auditor identifies a material inconsistency, the first step is to discuss it with management. The inconsistency may be in the other information (the chairman’s message got the number wrong) or in the financial statements (the auditor discovers a previously unidentified error while reading the other information against the financials). The discussion determines which document is wrong.
If the other information is wrong and management corrects it: no reporting required. The inconsistency is resolved.
If the other information is wrong and management refuses to correct it: the audit report’s Other Information section describes the inconsistency. The opinion on the financial statements is unmodified (the financial statements are correct). But the audit report explicitly states that the other information is materially inconsistent with the audited financials.
If the financial statements are wrong (the auditor discovers a new misstatement while reading the other information): the misstatement is evaluated under SA 705. If material, the opinion is modified. The other information, in this case, was more accurate than the financial statements, and the auditor’s reading of the other information led to the discovery of the misstatement.
Why this matters for credibility
The annual report is a single communication to shareholders, lenders, regulators and the public. The narrative sections (directors’ report, MD&A, chairman’s message) set the context. The financial statements provide the data. If the narrative and the data tell different stories, the reader does not know which to believe.
A management team that describes “robust growth” when the financials show stagnation is either careless (the narrative was not reviewed against the final audited numbers) or deliberate (the narrative was crafted to create an impression the financials do not support). Either explanation damages credibility.
What management teams should do
Before the annual report is published, conduct a formal consistency check: compare every quantitative claim in the narrative sections (directors’ report, MD&A, chairman’s message, business review) against the audited financial statements. Revenue, growth rates, margins, capital expenditure, debt levels, employee counts, production volumes, order book, customer numbers: each claim must be traceable to the audited data. If the narrative uses a different metric or a different period than the financial statements, the difference must be explained in the narrative itself so the reader is not misled.
The consistency check is a governance exercise, not an audit exercise. The auditor will read the other information and may identify inconsistencies, but the management team should not rely on the auditor as the quality control for its own annual report. The management team wrote the narrative. The management team should verify it against the numbers before the auditor does.
Northrop Management advises companies and audit committees on annual report quality, narrative consistency, MD&A drafting and the governance processes that ensure the management story matches the financial evidence.
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