Understanding the Auditor’s Report
If all the facts concerning financial transactions were properly and accurately recorded and if the owners and managers of business enterprises were entirely honest and sufficiently skilled in matters of accounting and recording, there would be little need for independent auditing. However, human nature being as it is, there probably will always be a need for the auditor. Many businesses, depending on size and nature, employ internal auditors. Their responsibilities and functions, while similar to those of an independent auditor, are vitally different in a major respect having to do with impartiality and independence. For the purpose of this discussion the terms accountant, auditor and certified public accountant (CPA) are used interchangeably and only refer to the “outside” independent auditor.
The Role of the Auditor
Dependable financial information is essential to the very existence of our society. The credit professional making a decision to grant trade credit, the investor making a decision to buy or sell securities, the banker deciding whether to approve a loan, the government in obtaining revenue based on income tax returns, all are relying upon information provided by others. In many of these situations, the goals of the providers of information run directly counter to those of the users of the information. Implicit in this line of reasoning is recognition of the social need for independent auditors – individuals with a professional competence and integrity who can tell us whether the information on which we rely constitutes a fair picture of what is really going on.
Good accounting and financial reporting aid society in allocating its resources in the most efficient manner. The goal is to allocate our limited capital resources to the production of those goods and services for which demand is greatest. Economic resources are attracted to the industries and organizational entities that are shown by accounting measurements to be capable of using the resources to the best advantage. Inadequate accounting and inaccurate reporting, on the other hand, conceal waste and inefficiency and thereby prevent our economic resources from being allocated in a rational manner.
A decision by a credit professional to grant credit is usually based on careful study of the company’s financial statements along with other information. The credit manager’s purpose in granting credit is to facilitate the sale of product and collect payment when it is due. But what if the financial statements submitted by the company along with its credit application are not dependable? Assume, for example, that the financial statements overstate current assets and annual earnings, and omit major liabilities. Assume also that the credit manager, acting on the basis of such misleading information, grants trade credit. The end result is likely to be that the credit manager does not receive payment and may have to write the transaction off as a loss.
The contribution of the independent auditor is to give credibility to financial statements. Credibility, in this usage, means that the financial statements can be believed; that is, they can be relied upon by outsiders, such as trade creditors, bankers, stockholders, government and other interested third parties.
Audited financial statements are now the accepted means by which business corporations report their operating results and financial position. The word audit when applied to financial statements means that the balance sheet, statements of income and retained earnings, and statement of cash flows are accompanied by an audit report prepared by independent public accounts, expressing their professional opinion as to the fairness of the company’s financial statements.
The goal is to determine whether these statements have been prepared in conformity with generally accepted accounting principles (GAAP). Financial statement audits are normally performed by firms of certified public accountants; users of auditors’ reports include trade creditors, management, investors, bankers, financial analysts and government agencies.
The Public Accounting Profession
American Institute of Certified Public Accountants – AICPA
At the very heart of the public accounting profession is the AICPA, a voluntary national organization of more that 300,000 CPAs. The AICPA establishes standards and rules to guide CPAs in their conduct of professional services, carries on a continuous program of research and publications, promotes continuing professional education and contributes to the profession’s system of self-regulation.
Financial Accounting Standards Board – FASB
Auditors must determine whether financial statements are prepared in conformity with generally accepted accounting principles. The AICPA has designated the Financial Accounting Standards Board as the body with power to set forth these principles for entities other than state and local governments. Thus FASB Statements, exposure drafts, public hearings, and research projects are all of major concern to the public accounting profession.
Securities and Exchange Commission – SEC
The SEC is an agency of the U.S. Government. It administers the Securities Act of 1933, the Securities Exchange Act of 1934, and other legislation concerning securities and financial matters. The function of the SEC is to protect investors and the public by requiring full disclosure of financial information by companies offering securities for sale to the public. A second objective is to prevent misrepresentation, deceit or other fraud in the sale of securities.
The term registration statement is an important one in any discussion of the impact of the SEC on accounting practice. To register securities means to qualify them for sale to the public by filing with the SEC financial statements and other data in a form acceptable to the Commission. A registration statement contains audited financial statements, including balance sheets for a two-year period and income statements and statements of cash flow for a three year period. The legislation creating the SEC made the Commission responsible for determining whether the financial statements presented to it reflect proper application of accounting principles.
The Auditor Renders a Report on the Financial Statements, not on the Accounting Records
Contrary to some beliefs, a certified public accountant’s letter of opinion is not a certification and actually is nothing more than an opinion. It is not a guarantee. It is the accountant who is certified, not the financial statements. As a professional, the accountant expresses a detached judgement. He says, in effect, that proper accounting principles appear to have been applied consistently by management and that standard auditing procedures deemed applicable under particular circumstances have revealed nothing which would cause him to question the fairness of the resultant statements. Naturally, some of the items on a financial statement cannot be subjected to exact measurement. Unfortunately, many of these are important in that they may materially affect either or both the condition of the company at a given point in time, or the results of operations over a period of time. By their very nature, certain of these items must represent estimates and approximations. However, we are justified in looking to the certified public accountant for a value based on informed judgement. It is important to recognize that the financial statements and all supplemental data that may accompany the statements are the responsibility of the client. The accountant assumes responsibility only for the opinion that accompanies the report.
The primary purpose of an audit is to provide assurance to the users of the financial statements that these statements are reliable. Auditors do not express an opinion on the client’s accounting records. The auditors’ investigation of financial statement items includes reference to the client’s accounting records, but is not limited to these records. The auditors’ examination includes observation of tangible assets, inspection of such documents as purchase orders and contracts, and the gathering of evidence from outsiders including banks, customers, and suppliers, as well as analysis of the client’s accounting records.
A principal means of establishing the validity of a balance sheet and income statement is to trace the statement figures to the accounting records and back through the records to the original evidence of transactions. However, the auditors’ use of the accounting records is only a means to an end ñ and merely a part of the audit. It is, therefore, appropriate for the auditors to state in their report that they have made an audit of the financial statements rather than to say that they have made an audit of the accounting records.
Expressing an independent and expert opinion on the fairness of financial statements is the most important and valuable service rendered by the public accounting profession. The auditors’ standard report states that the examination was performed in conformity with generally accepted auditing standards and by expressing an opinion that the client’s financial statements are presented fairly in conformity with generally accepted accounting principles. However, if there are deficiencies in the client’s financial statements or limitations in the auditors’ examination, or if there are other unusual conditions about which the readers of the financial statements should be informed, auditors’ cannot issue the standard report. Instead, they must carefully modify their report to make these problems or conditions known to users of the audited financial statements.
The Company is Responsible for the Financial Statements
The management of a company has the responsibility for maintaining adequate accounting records and of preparing proper financial statements for the use of stockholders and creditors. Even though the financial statements are sometimes constructed and produced in the auditors’ office, primary responsibility for the statements remains with management.
The auditors’ product is their report. It is a separate document from the client’s financial statements, although the two are closely related and transmitted together to stockholders and to creditors.
Reporting Phase of the Audit
The reporting phase of an audit begins when the independent auditors have completed their field work and their proposed adjustments have been accepted and recorded by the client. Before writing their report, the auditors must review the client-prepared financial statements for form and content, or draft the financial statements on behalf of the client.
The financial statements on which the independent auditors customarily report are the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. Often, the statement of retained earnings is combined with the income statement. In some cases, the retained earnings statement may be expanded to a statement of stockholders’ equity. Financial statements generally are presented in comparative form for the current year and the preceding year and are accompanied by explanatory notes. The financial statements for a parent corporation usually are consolidated with those of the subsidiaries.
Financial Statement Disclosure
The purpose of notes to financial statements is to achieve adequate disclosure when information in the financial statements is insufficient to attain this objective. Although the notes, like the financial statements themselves, are representations of the client, the independent auditors generally assist in drafting the notes.
Adequate disclosure in the notes to financial statements is necessary for the auditors to issue an unqualified opinion on the financial statements. Disclosure requirements that have become a part of the basic financial statements include the disclosure of significant accounting policies, accounting changes, loss contingencies, and lease and pension information.
Generally accepted accounting principles require that the financial statements be free from material misstatements. The auditors have a responsibility to detect various types of material misstatements, including errors, irregularities and those caused by illegal acts.
The auditors are required to assess the risk that errors and irregularities have occurred affecting the client’s financial records. The audit is designed to provide reasonable assurance of detecting errors and irregularities that are material to the financial statements.
The Auditors’ Unqualified Report
The standard unqualified report is regarded as a clean bill of health, the auditor made no exceptions and inserts no qualifications in the report. An unqualified opinion can only be expressed when the independent auditor has formed the opinion on the basis of an examination made in accordance with generally accepted accounting principles, applied in a consistent basis and includes all informative disclosures necessary to make the statements not misleading. The standard unqualified report consist of three paragraphs. The first paragraph clarifies the responsibilities of management and the auditors, and is referred to as the introductory paragraph. The second paragraph describes the nature of the audit and is called the scope paragraph. The final paragraph is the opinion paragraph, which is a concise statement of the auditor’s opinion based on the audit. The auditors’ report is addressed to the persons who retained the auditors.
The Introductory Paragraph
The introductory paragraph emphasizes that the client company is primarily responsible for the financial statements and that the auditors render a report on the financial statements, not on the accounting records.
The Scope Paragraph
The scope paragraph describes the nature of the audit, that it was conducted in accordance with generally accepted auditing standards and provides reasonable assurance that the financial statements are free of material misstatement.
The Opinion Paragraph
In the opinion paragraph, the auditors are expressing nothing more than an informed opinion. They do not guarantee or certify that the statements are accurate.
Independent Auditors’ Report:
To the Board of Directors and Stockholders of ABC Company:
We have audited the accompanying balance sheet of ABC Company as of December 31, 2001, and the related statements of income, retained earnings, and cash flow for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company as of December 31, 2001, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles.
Callahan, Durant, Simms & Co.
Certified Public Accountants
March 1, 2002
Other Types of Auditors’ Reports
Alternatives to an unqualified report include unqualified opinion with explanatory language, a qualified opinion, an adverse opinion, or a disclaimer of opinion.
Explanatory Language Added to the Unqualified Opinion
Certain circumstances require auditors to add explanatory language to the standard report. Adding the additional language is not regarded as a qualification because it does not lessen the auditors’ reporting responsibility for the financial statements.
Auditors add explanatory language to an unqualified opinion to indicate:
- a division of responsibility with another CPA firm;
- to indicate an inconsistency in the application of accounting principles;
- to emphasize a matter;
- to justify a departure from officially recognized accounting principles and
- to refer to an uncertainty that could have a material impact on the financial statements.
A situation in which explanatory language is used is illustrated in the following example:
Ability to Continue as a Going Concern
A special type of significant uncertainty, that is important to the credit professional, concerns the ability of a company to continue as a going concern. Under generally accepted accounting principles, both assets and liabilities are recorded and classified on the assumption that the company will continue to operate. Assets, for example, may be presented at amounts that are significantly greater than their liquidation values.
Conditions that may cause the auditors to question the going-concern assumption include negative cash flows from operations, defaults on loan agreements, adverse financial ratios, work stoppages, and legal proceedings. If a substantial doubt exists about the company’s ability to continue as a going concern for a period of one year from the balance sheet date, the auditors modify their report by adding a final paragraph such as the following:
The accompanying financial statements have been prepared assuming that ABC Company will continue as a going concern. As discussed in Note 1 to the financial statements, ABC Company has suffered recurring losses from operations and has a net capital deficiency that raises substantial doubt about the entity’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.
Qualifications with respect to an auditor’s opinion may be broadly classified into two categories; those qualifications which relate to the scope of the examination, and those qualifications with respect to the fairness of presentation in accordance with generally accepted accounting principles consistently applied. A qualified opinion restricts the auditors’ responsibility for fair presentation in some areas of the financial statements. The opinion states that except for the effects of some deficiency in the financial statements, or some limitation in the scope of the auditors’ examination, the financial statements are presented fairly. All qualified reports include a separate explanatory paragraph before the opinion paragraph disclosing the reasons for the qualification.
An adverse opinion is the opposite of an unqualified opinion; it is an opinion that the financial statements do not present fairly the financial position, results of operations, and cash flows of the company, in conformity with generally accepted accounting principles.
The auditors should express an adverse opinion if the statements are so lacking in fairness that a qualified opinion would not be warning enough. Whenever the auditors issue an adverse opinion, they should disclose in a separate paragraph of the report the reasons for the adverse opinion and the principal effects on the financial statements of the matters causing the adverse opinion.
Disclaimer of Opinion
A disclaimer of opinion is no opinion. In an audit engagement, a disclaimer is required when substantial scope restricts or other conditions preclude the auditors’ compliance with generally accepted auditing standards.
Appraisal of Audit Reliability
The audit and certification is generally accepted as adequate endorsement of the correctness of a financial statement, but seasoned credit professionals should take two additional factors into consideration: the experience of the auditor with the type of business and how often the client’s books are examined.
Specialization by Auditors
Nearly every trade and industry has a group of auditors who concentrate their practice and become authorities in that field. Often this specialization is along functional lines. A business is best served by an auditing firm who understands the industry’s business cycle, practices, products, market conditions and characteristics.
Frequency of Audit
Two types of services performed by auditors – continuity of engagement and continuous audit – do not provide the same types of services. Continuity of engagement indicates an independent auditor is regularly employed to prepare annual and other statements, and does so for successive years. A continuous audit means the auditor makes periodic inspections of the books and records between annual statement periods, but not necessarily an audit, and may supervise or prepare monthly trial balances and quarterly or semi-annual statements. A continuous audit enables the auditor to follow the client’s affairs more closely then is possible during a single annual visit. Therefore, creditors can place greater credence on financial figures prepared under this arrangement.
Change in Auditor
When the regular auditor quits an engagement, it is important to discover the underlying reason. A desire to lower auditing costs is often given as the motive, but the move may also have credit implications. A substantial cut in auditing fees may lead to lower quality auditing work and less verification effort. The change in auditors may have been prompted by a difference of opinion between auditor and management regarding the treatment and certification of material items in the statement.
Some auditors announce they are no longer “on the books” of a former client, but, understandably do not give the reason. As a creditor, you should carefully compare the certification of the new auditor with that of the former one.
Auditors prepare financial statements and supporting schedules for clients, and not to meet the special needs of creditors. Their intensive training, strict regulation of auditing procedures and conventions, and their accountability to professional societies govern their work. They do, however, have a responsibility to clarify items in their audits when questions are raised, and should give such explanations willingly.
A conscientious credit professional should have the customer’s permission before asking the auditor for additional schedules, exhibits, or other information ordinarily withheld from publication. Auditors differ as to the degree of their cooperation with small- or medium-sized clients. Some believe their audit report meets the terms of their engagement; others give additional information, which may benefit the clients. In some cases, auditors accompany their clients during interviews with credit executives and will supply additional information to creditors. As a prudent credit professional, you should welcome an opportunity to become acquainted with an auditor on whom you expect to rely.