The five checks and where to find them
| # | Check | Where to Find It | Red Flag |
|---|---|---|---|
| 1 | Audit opinion unqualified? | 10-K, before financial statements | Qualified, adverse, or disclaimer |
| 2 | No going concern language? | Emphasis of Matter paragraph | Going concern doubt expressed |
| 3 | Clean Section 404 controls? | Management’s Report on Internal Control | Material weakness disclosed |
| 4 | Consistent auditor (3+ years)? | 10-K cover + Form 8-K history | Frequent changes, Big Four → small |
| 5 | No financial red flags? | 3-year ratio trends | Receivables/inventory growing faster than revenue |
Why multiple failed checks compound risk
A single failed check does not automatically disqualify a company. But multiple failures compound risk exponentially. Two or more red flags should significantly increase your required margin of safety or prompt you to pass entirely.
Turning checklist results into action
| Scenario | Checklist Result | Action |
|---|---|---|
| All 5 pass | Clean | Standard analysis applies |
| 1 flag (minor) | Caution | Investigate the specific issue, increase scrutiny |
| 1 flag (severe) | Warning | Must resolve before investing (e.g., going concern) |
| 2+ flags | Danger | Significantly increase margin of safety or pass |
| Restatement history | Historical risk | Check if root cause was addressed |
Run the checklist on a real company
Run the 5-point audit checklist on a company you own or are considering. Start with the audit opinion, then check Section 404, auditor history, and 3-year ratio trends.
When two flags override four clean checks
Your checklist: (1) Clean audit, (2) Clean controls, (3) Same auditor 10 years, (4) No ratio red flags, but (5) CFO resigned and a depreciation estimate change boosted earnings by 8%. Assessment?
The checklist as a risk-calibration tool
Why a clean audit is not a safety guarantee
You've audit-reviewed a company: clean opinion, no going-concern flags, no material weakness, strong internal controls. Is it safe to invest?
Check your understanding
Sit with the ideas.
You run the 5-point audit checklist on a company you own. Results: (1) Clean audit opinion, (2) Clean Section 404, (3) Same auditor for 8 years, (4) DSO increased from 45 to 72 days over 2 years while revenue grew 20% annually, (5) No restatements. How would you assess this?
Why: