The annual report is a single document, but it contains two fundamentally different categories of information. The first category is the audited financial statements: the balance sheet, the statement of profit and loss, the cash flow statement, the statement of changes in equity and the notes. These are audited. The opinion covers them. Every number in them has been tested against evidence.
The second category is everything else: the directors’ report, the management discussion and analysis, the chairman’s statement, the business review, the corporate governance report, the sustainability disclosures, the risk management framework description and any other narrative or data that accompanies the financial statements in the annual report. SA 720 calls this “other information.” It is not audited. The opinion does not cover it. But the auditor has a responsibility regarding it, and that responsibility is more significant than most management teams, boards and investors realise.
The auditor’s responsibility under SA 720
The auditor’s responsibility is threefold:
Read it. The auditor must read the other information before the audit report is issued (or, if the other information is published after the audit report, as soon as it becomes available). The reading is not casual. It is a structured assessment conducted with the auditor’s knowledge of the company, the industry and the financial statements in mind.
Identify material inconsistencies. The auditor compares the other information to the financial statements and to the auditor’s knowledge obtained during the audit. A material inconsistency exists when the other information states something that contradicts the audited financial statements or the auditor’s findings.
The inconsistency can be factual: the directors’ report states revenue grew 22%, the audited financials show 14%. The inconsistency can be contextual: the MD&A describes the company’s liquidity as “comfortable” while the financial statements show the company’s current liabilities exceeding current assets by Rs 8 crore, the working capital facility at 97% utilisation and a going concern disclosure in the notes. The narrative is technically not quoting a wrong number, but the impression it creates is materially inconsistent with the financial reality the audited statements reveal.
Identify material misstatements of fact. Beyond inconsistency with the financial statements, the auditor may identify information in the other information that appears to be materially misstated based on the auditor’s general knowledge. The MD&A states that the company has “no material litigation exposure.” The auditor, during the audit, reviewed correspondence with the company’s legal counsel that identified three pending cases with a combined potential exposure of Rs 12 crore. The MD&A statement is not inconsistent with the financial statements (the contingent liabilities may be properly disclosed in the notes). But it is a misstatement of fact in the other information: the company does have material litigation exposure, and the MD&A says it does not.
What happens when an inconsistency is identified
Step 1: Determine which document is wrong. The inconsistency may be in the other information (the directors’ report got the number wrong) or in the financial statements (the auditor discovers a previously unidentified error by comparing the narrative to the numbers). The determination is critical because it changes the response entirely.
If the financial statements are wrong: the auditor has discovered a new misstatement. The misstatement is evaluated under SA 705. If material, the opinion is modified. The other information, in this case, was more accurate than the audited numbers, and the reading process revealed an audit failure that might otherwise have gone undetected.
If the other information is wrong: the auditor communicates the inconsistency to management and requests correction.
Step 2: Communicate with management. The auditor explains the identified inconsistency and requests that management correct the other information before the annual report is published. In most cases, the inconsistency is an error (the chairman’s message was drafted before the final audit adjustments and was not updated, the MD&A used preliminary numbers rather than audited numbers, the directors’ report copied a figure from the wrong column of a spreadsheet). The correction is straightforward.
Step 3: Communicate with those charged with governance. If management refuses to correct the inconsistency, or if the auditor identifies a material misstatement of fact that management disputes, the auditor escalates to the audit committee. SA 720 requires the auditor to communicate with those charged with governance when the other information contains a material inconsistency or a material misstatement of fact that management has not corrected.
Step 4: Report in the audit report. If, after communicating with management and the audit committee, the inconsistency or misstatement remains uncorrected, the auditor’s response depends on the timing:
If the other information is published with the audit report (both appear in the same annual report): the auditor includes an “Other Information” section in the audit report describing the uncorrected material inconsistency. The opinion on the financial statements is not modified (the financial statements are correct; the other information is wrong). But the audit report explicitly states that the other information is materially inconsistent, which alerts every reader that the narrative and the numbers do not agree.
If the other information is published after the audit report: the auditor takes appropriate action to bring the inconsistency to the attention of users, which may include revising the auditor’s report or communicating with the regulators.
Step 5: Consider withdrawal from the engagement. SA 720 contemplates, in extreme cases, the auditor considering whether the uncorrected material inconsistency or misstatement of fact raises questions about management integrity that affect the auditor’s ability to continue the engagement. If management knowingly publishes materially misleading information in the annual report and refuses to correct it despite the auditor’s communication, the auditor may conclude that management’s integrity is insufficiently reliable for the audit relationship to continue.
Practical examples of other information risks
The selective metric. The business review presents “adjusted EBITDA” of Rs 45 crore as the primary performance measure. The adjusted EBITDA excludes Rs 8 crore of costs that management considers “non-recurring” (restructuring costs for the third consecutive year, litigation settlements, impairment charges). The audited P&L shows reported EBITDA of Rs 37 crore. The adjusted metric is not inconsistent with the financial statements (management is allowed to present non-GAAP measures). But if the adjustments are not clearly disclosed, or if the “non-recurring” items recur annually, the presentation is misleading. The auditor assesses whether the presentation creates a materially misleading impression.
The forward-looking claim. The chairman’s message states: “We are confident of achieving Rs 500 crore revenue by FY 2028.” The company’s current revenue is Rs 180 crore. The financial statements’ going concern note describes financing difficulties and a covenant breach. The confidence statement is materially inconsistent with the financial condition described in the audited notes. The chairman may believe the projection. The auditor’s concern is that a user reading the chairman’s confident message and the audited going concern disclosure will receive contradictory signals.
The ESG claim. The sustainability section states: “The company achieved zero discharge to water bodies during the year.” The auditor, during the audit, reviewed a correspondence file containing a pollution control board notice regarding discharge violations. The sustainability claim is materially misstated. The auditor communicates the misstatement to management.
Why this matters for governance
The annual report is a single communication. The user reads it as one document. If the narrative sections describe a thriving, growing, well-managed business and the audited financial statements describe a company with declining margins, covenant breaches and going concern uncertainty, the annual report as a whole is misleading even though the financial statements, taken alone, are correct.
The audit committee’s responsibility extends beyond the financial statements to the annual report as a whole. The committee should verify, before the annual report is published: every quantitative claim in the narrative sections matches the audited financial statements, every qualitative claim (about performance, risk, outlook, strategy) is consistent with the financial condition the audited statements reveal, and any non-GAAP measures presented in the narrative are clearly defined, reconciled to the audited figures and not misleading.
Northrop Management advises companies and audit committees on annual report quality, SA 720 compliance and the governance processes that ensure consistency between narrative and numbers.
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