In Part I, of this series I discussed Compiled Financial Statements and in PART II I went over the salient facts of Reviewed Financial Statements. Here we will take a very brief view of Audited Financial Statements.
An Audit can be performed on the most common basis of accounting used in Compiled and Reviewed Financial statements. Modified Cash, GAAP and the Income Tax Basis of accounting and in some cases where the financials are prepared based on industry or other regulatory accounting rules -Statutory Basis may be used. However, unlike Compiled and Reviewed financial statements, here in the United States, the most common basis of accounting for Audits is GAAP. Perhaps, followed by Statutory Basis financials. Why? Simply put GAAP is the basis of accounting that is most used by public corporations that are traded by stock exchanges and is the United States financial reporting standard. The exception are insurance companies, utilities and other industry specific companies that have a regulatory basis of accounting. GAAP is a “rules based” method of accounting that is many, many years in the making with very precise and specific rules to aid, among many factors, in comparing financials among companies in an industry. Increasing demand and a trend towards allowing “IFRS” or International Financial Reporting Standards are well underway, for multinational public companies and foreign companies. IFRS is not rules based but more broad “principles based” form of accounting. This gives a great deal of flexibility but still maintains critical reporting standards. Where GAAP is based on historical costs, IFRS allows for fair market value reporting. This can be a very valuable contribution to financial reporting.
An audit is by far the most complicated set of financial statements that CPA’s prepare. Again, here too the financials are the assertions of management and the accountants render an opinion as to whether the financials, including the notes and other supplementary information, present fairly, the results of operations, financial position and cash flows of the company. Further CPA’s must be independent in order to render an opinion. The financials are not the responsibility of the CPA’s, only the opinion they render is the responsibility of the CPA’s. This is worth noting as it is a common misunderstanding of the general public.
An “Audit Program” is the game plan that accountants use in order to audit the company’s books and records. Some of the tools CPA’s use include trend analysis, industry metrics, observations, testing of transactions and internal controls and confirmations of accounts and notes receivables and accounts and notes payables. Physical observations and counts are performed on assets and inventories to make sure they not only exist but they are valued correctly. Inquiries are made of the company’s lawyers to determine law suits or potential lawsuits and claims. An accounting of uncertain tax positions are made to determine potential liabilities. Mathematical statistics and sampling techniques are applied and used extensively to make inferences as to the value of certain accounts. A great deal of professional judgment is applied as to whether the Audit Program is sufficient, as to whether the conclusions are correct, and simply as to whether all aspects of the company are properly accounted for and disclosed either in the body of the financial statements, supplementary information or in the notes and disclosures.
Audit services are extremely important to a capitalist market such as our own. I believe it safe to say, Wall Street would not be the center of financial power and wealth if it where not for the audited financial reports that auditors render opinions on. In other words, if you couldn’t compare companies on the same set of accounting rules and or you could not trust the financial statements of companies that trade their stocks, bonds and other financial instruments traded on Wall Street; bankers, investment funds, investors, brokerage houses and the public at large could not make good financial decisions. Essentially, capitalism would come to a screeching halt. Jobs would be lost, lending would dry up and a recession followed by a depression would follow only to be superseded by a global financial collapse. We got a bad taste of that in 2008, when the United States and the world lost faith in the United States. Not because the accounting was bad, but because it was good enough so that everyone could see that the underlying value of loans and real estate, on corporate books was no longer there and all the companies involved essentially plummeted in value. It was the beginning of a financial collapse.
The most common misunderstanding about audits are that that they are designed to detect fraud, theft and the misappropriation of funds. Audits do sometimes detect these matters. However, an audit has to be specifically designed to detect these types of matters. Even then, audits rely on the honesty of the management. If management is involved in fraud, theft or the misappropriation of funds it is often very difficult to detect. This is why audits rely heavily on internal controls and various other safeguards. It’s a lot harder to get away with any wrongdoing if it requires various levels of management to get away with it.
Audits are expensive simply because of the risk auditors take and because of the amount of work that needs to get done. For many small companies audits are cost prohibitive. Some small poorly run small companies may not even be auditable.
Although I do not perform audits, during the past years my firm has been involved in a number of audits either in preparing clients for audits, securing auditors, or assisting management who undergo an audit. For small and medium size companies that do not have internal auditors, having an external CPA is a valuable asset and company resource. It’s possible a relationship with my firm can save your company a great deal of money if you undergo an audit.