What Is an Auditor’s Report?

An auditor’s report is a written letter from the auditor containing their opinion on whether a company’s financial statements comply with generally accepted accounting principles (GAAP) and are free from material misstatement.

The independent and external audit report is typically published with the company’s annual report. The auditor’s report is important because banks and creditors require an audit of a company’s financial statements before lending to them.

How an Auditor’s Report Works

An auditor’s report is a written letter attached to a company’s financial statements that expresses its opinion on a company’s compliance with standard accounting practices. The auditor’s report is required to be filed with a public company’s financial statements when reporting earnings to the Securities and Exchange Commission (SEC).

However, an auditor’s report is not an evaluation of whether a company is a good investment. Also, the audit report is not an analysis of the company’s earnings performance for the period. Instead, the report is merely a measure of the reliability of the financial statements.

The Components of an Auditor’s Report

The auditor’s letter follows a standard format, as established by generally accepted auditing standards (GAAS). A report usually consists of three paragraphs.

• The first paragraph states the responsibilities of the auditor and directors.
• The second paragraph contains the scope, stating that a set of standard accounting practices was the guide.
• The third paragraph contains the auditor’s opinion.

An additional paragraph may inform the investor of the results of a separate audit on another function of the entity. The investor will key in on the third paragraph, where the opinion is stated.

The type of report issued will be dependent on the findings by the auditor. Below are the most common types of reports issued for companies.

Clean or Unqualified Report

A clean report means that the company’s financial records are free from material misstatement and conform to the guidelines set by GAAP. A majority of audits end in unqualified, or clean, opinions.

Qualified Opinion

A qualified opinion may be issued in one of two situations: first, if the financial statements contain material misstatements that are not pervasive; or second, if the auditor is unable to obtain sufficient appropriate audit evidence on which to base an opinion, but the possible effects of any material misstatements are not pervasive. For example, a mistake might have been made in calculating operating expenses or profit. Auditors typically state the specific reasons and areas where the issues are present so that the company can fix them.

Adverse Opinion

An adverse opinion means that the auditor has obtained sufficient audit evidence and concludes that misstatements in the financial statements are both material and pervasive. An adverse opinion is the worst possible outcome for a company and can have a lasting impact and legal ramifications if not corrected.

Disclaimer of Opinion

A disclaimer of opinion means that, for some reason, the auditor is unable to obtain sufficient audit evidence on which to base the opinion, and the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. Examples can include when an auditor can’t be impartial or wasn’t allowed access to certain financial information.

Example of an Auditor’s Report

Excerpts from the audit report by Deloitte & Touche LLP for Starbucks Corporation, dated Nov. 15, 2019, follow.

Paragraph 1: Opinion on the Financial Statements

“We have audited the accompanying consolidated balance sheets of Starbucks Corporation and subsidiaries (the ‘Company’) as of September 29, 2019, and September 30, 2018, the related consolidated statements of earnings, comprehensive income, equity, and cash flows, for each of the three years in the period ended September 29, 2019, and the related notes (collectively referred to as the ‘financial statements’).

In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of September 29, 2019, and September 30, 2018, and the results of its operations and its cash flows for each of the three years in the period ended September 29, 2019, in conformity with accounting principles generally accepted in the United States of America.”

Paragraph 2: Basis for Opinion

“We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks.

Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.”

What Is Arbitrage?

Arbitrage is the simultaneous purchase and sale of the same or similar asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms.

Arbitrage exists as a result of market inefficiencies, and it both exploits those inefficiencies and resolves them.

Understanding Arbitrage

Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader.

Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is eliminated, often in a matter of seconds.

Examples of Arbitrage

As a straightforward example of arbitrage, consider the following: The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE), while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE).

A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share.

The trader can continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or the LSE adjust their prices to wipe out the opportunity.

A More Complicated Arbitrage Example

A trickier example can be found in currencies markets using triangular arbitrage. In this case, the trader converts one currency to another, converts that second currency to a third bank, and finally converts the third currency back to the original currency.

Suppose you have $1 million and you are provided with the following exchange rates: USD/EUR = 1.1586, EUR/GBP = 1.4600, and USD/GBP = 1.6939.

With these exchange rates, there is an arbitrage opportunity:

1. Sell dollars to buy euros: $1 million ÷ 1.1586 = €863,110
2. Sell euros for pounds: €863,100 ÷ 1.4600 = £591,171
3. Sell pounds for dollars: £591,171 × 1.6939 = $1,001,384
4. Subtract the initial investment from the final amount: $1,001,384 – $1,000,000 = $1,384

From these transactions, you would receive an arbitrage profit of $1,384 (assuming no transaction costs or taxes).

The Bottom Line

Arbitrage is a condition where you can simultaneously buy and sell the same or similar product or asset at different prices, resulting in a risk-free profit.

Economic theory states that arbitrage should not be able to occur because if markets are efficient, there would be no such opportunities to profit. However, in reality, markets can be inefficient and arbitrage can happen. When arbitrageurs identify and then correct such mispricings (by buying them low and selling them high), though, they work to move prices back in line with market efficiency. This means that any arbitrage opportunities that do occur are short-lived.

There are many different arbitrage strategies that exist, some involving complex interrelationships between different assets or securities.

Correction—April 9, 2022: A previous version of this article had miscalculated the complicated arbitrage example.

What Is an Arm’s Length Transaction?

An arm’s length transaction refers to a business deal in which buyers and sellers act independently without one party influencing the other. Arm’s length transactions assert that both parties act in their own self-interest and are not subject to pressure from the other party. They also assure others that there is no collusion between the buyer and seller. In the interest of fairness, both parties usually have equal access to information related to the deal.

Understanding Arm’s Length Transactions

Arm’s length transactions are commonly used in real estate deals because the sale affects not only those who are directly involved in the deal but other parties as well, including lenders.

If two strangers are involved in the sale and purchase of a house, the final agreed-upon price is likely close to fair market value (FMV), assuming that both parties have equal bargaining power and the same information about the property. The seller would want a price that’s as high as possible, and the buyer would want a price that is as low as possible. Otherwise, the agreed-upon price is not likely to differ from the property’s actual FMV.

As noted above, the buyer and seller aren’t the only ones involved in an arm’s length transaction. This type of transaction also has a direct impact on the financing needed from a bank as well as municipal and local taxes. The transaction can also influence comparable prices in the market.

Arm’s Length vs. Non-Arm’s Length Transactions

Family members and companies with related shareholders generally don’t engage in arm’s length sales. Instead, the deals between them are non-arm’s length transactions. This type of transaction, which is also known as an arm-in-arm transaction, refers to a business deal in which buyers and sellers have an identity of interest. Put simply, buyers and sellers have an existing relationship that is either business-related or personal.

An existing relationship tends to influence the terms of a non-arm’s length transaction. For instance, it’s unlikely that a transaction involving a father and his son would yield the same result as a deal between strangers because the father may choose to give his son a discount.

If the sale of a house between father and son is taxable, tax authorities may require the seller to pay taxes on the gain he would have realized had he been selling to a neutral third party. They would disregard the actual price paid by the son.

In the same way, international sales between non-arm’s-length companies, such as two subsidiaries of the same parent company, must be made using arm’s length prices. This practice, known as transfer pricing, assures that each country collects the appropriate taxes on the transactions.

Arm’s Length Transactions and Fair Market Value (FMV)

As noted above, one of the main benefits of arm’s length transactions is that the transaction is fair and equitable. This is especially true when it comes to real estate deals. When the buyer and seller have no previous relationship, the terms of the deal—notably, the sale price—accurately reflect market conditions rather than being influenced by other factors. This value is referred to as the fair market value.

FMV is the best possible price that a neutral and impartial seller and buyer are willing to accept and pay to close the deal. The following are just some of the factors that are used to determine the FMV of a home:

• Location (city, neighborhood)
• Comparable home prices
• Condition and age of home
• Size and amenities
• Renovations and upgrades made to the property

Of course, other factors also work into the FMV of a home, including interest rates and the condition of the overall economy.

Example of an Arm’s Length Transaction

Let’s use a hypothetical example to show how arm’s length transactions work. We can start by expanding on the example above using the father and son and the real estate transaction. For clarity’s sake, let’s say the father’s name is John and the son’s name is Henry.

Assume that John is selling his home and puts the house up for sale for $350,000. He gets an offer for that amount based on the FMV. The potential buyer looked at some of the factors affecting the value, including the location, amenities, and comparable homes. If the sale goes through, it’s considered a arm’s length transaction.

But Henry throws John a loop saying he needs a new place and would like to buy the home for himself. He offers a lower price of $275,000 since it’s his father who’s selling the house. If John decides to accept, he would be conducting a non-arm’s length transaction.

The Bottom Line

Every buyer and seller wants to get the best price possible for their financial transactions. One of the best ways to do so is to conduct an arm’s length transaction. Being at arm’s length means there are no personal factors that influence the price and the decision to either accept or reject an offer. Those who execute non-arm’s length transactions may not get the best price, which can also affect the overall market and lending decisions.

What Is an Automatic Stabilizer?

Automatic stabilizers are a type of fiscal policy designed to offset fluctuations in a nation’s economic activity through their normal operation without additional, timely authorization by the government or policymakers.

The best-known automatic stabilizers are progressively graduated corporate and personal income taxes, and transfer systems such as unemployment insurance and welfare. Automatic stabilizers are called this because they act to stabilize economic cycles and are automatically triggered without additional government action.

Understanding Automatic Stabilizers

Automatic stabilizers are primarily designed to counter negative economic shocks or recessions, though they can also be intended to “cool off” an expanding economy or to combat inflation. By their normal operation, these policies take more money out of the economy as taxes during periods of rapid growth and higher incomes. They put more money back into the economy in the form of government spending or tax refunds when economic activity slows or incomes fall. This has the intended purpose of cushioning the economy from changes in the business cycle. 

Automatic stabilizers can include the use of a progressive taxation structure under which the share of income that is taken in taxes is higher when incomes are high. The amount then falls when incomes fall due to a recession, job losses, or failing investments. For example, as an individual taxpayer earns higher wages, their additional income may be subjected to higher tax rates based on the current tiered structure. If wages fall, the individual will remain in the lower tax tiers as dictated by their earned income.

Similarly, unemployment insurance transfer payments decline when the economy is in an expansionary phase since there are fewer unemployed people filing claims. Unemployment payments rise when the economy is mired in recession and unemployment is high. When a person becomes unemployed in a manner that makes them eligible for unemployment insurance, they need only file to claim the benefit. The amount of benefit offered is governed by various state and national regulations and standards, requiring no intervention by larger government entities beyond application processing.

Automatic Stabilizers and Fiscal Policy

When an economy is in a recession, automatic stabilizers may by design result in higher budget deficits. This aspect of fiscal policy is a tool of Keynesian economics that uses government spending and taxes to support aggregate demand in the economy during economic downturns.

By taking less money out of private businesses and households in taxes and giving them more in the form of payments and tax refunds, fiscal policy is supposed to encourage them to increase, or at least not decrease, their consumption and investment spending. In this case, the goal of fiscal policy is to help prevent an economic setback from deepening.

Real-World Examples of Automatic Stabilizers

Automatic stabilizers can also be used in conjunction with other forms of fiscal policy that may require specific legislative authorization. Examples of this include one-time tax cuts or refunds, government investment spending, or direct government subsidy payments to businesses or households.

Some examples of these in the United States were the 2008 one-time tax rebates under the Economic Stimulus Act and the $831 billion in federal direct subsidies, tax breaks, and infrastructure spending under the 2009 American Reinvestment and Recovery Act.

In 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act became the largest stimulus package in U.S. history. It provided over $2 trillion in government relief in the form of expanded unemployment benefits, direct payments to families and adults, loans and grants to small businesses, loans to corporate America, and billions of dollars to state and local governments.

Special Considerations

Since they almost immediately respond to changes in income and unemployment, automatic stabilizers are intended to be the first line of defense to turn mild negative economic trends around. However, governments often turn to other types of larger fiscal policy programs to address more severe or lasting recessions or to target specific regions, industries, or politically favored groups in society for extra-economic relief.