Smoke detectors chirp. Automobile dashboards use an array of lights and colors. Computers flash messages in machine language. What do all of these things have in common? They are all methods of telling us when something we are using is about to stop working or go bad. Wouldn’t it be great if nonprofit organizations came equipped with built-in financial warning signals? How nice would it be if the accounting department chirped when cash was running out, or if boxes popped up on the chief executive’s computer when the year’s revenue is falling dangerously short of projections?

Financial statements do carry all kinds of warning signals — if you know where to look and how to interpret them. We call them red flags and yellow flags. Red flag indicators mean STOP; ask probing questions, and don’t move forward until you’re satisfied. Yellow flag indicators mean CAUTION; trouble may lie ahead depending on the answers to some well-formulated questions.

An auditor’s opinion letter is a rich source of red and yellow flags. It can be found just inside your audited financial statements, and is formatted like a regular letter.

YELLOW FLAG: s sentence that qualifies the auditors’ opinion, usually occurring somewhere in the third or fourth paragraph. The sentence may say something like “except for ...” or “it was not possible to ...”

This means the auditor is giving a qualified opinion. It may amount to little more than a technical provision, but it could suggest deeper problems in the organization. In rare instances, it can be a “disclaimer of opinion,” meaning the record keeping is so bad that the auditor is unable to give an opinion at all. Read carefully, and beware of the word “except.”

Read the full article about the red and yellow flags in financial statements by Thomas A. McLaughlin at BoardSource.