All public companies get audited. And while the audit may once have seemed like just another formality for most investors, the Enrons and WorldComs of the world have shown us just how important auditors can be. So what do auditors actually do and how can you use their reports to make better investment decisions?
First, Who Are Auditors and What Do They Do?
Auditors are accountants who go to companies and check to make sure that their financial statements are accurate and fair. The result of the audit is known as the "Audit Report," which can be found near the end of the
10-K for every public company out there.
A prominent misconception is that auditors sign-off on a company's health or investment potential;
. For auditors, the only concern is whether or not a company is accurate in the financial statements that it presents to the public, and that those financial statements comply with Generally Accepted Accounting Principals (GAAP). This is essential for investors because it promises an even playing field -- numbers that one company presents are comparable to a similar company's numbers.
Auditors also don't prepare the financial statements for companies, though they may make suggestions that would make a statement comply with GAAP.
So then, why are audits such a big deal for companies? Consider a magazine publisher. Under GAAP, a magazine publisher wouldn't be allowed, for example, to recognize the
revenue it receives from subscribers when they get the subscription checks. No, they have to wait until they actually deliver issues of the magazine before they can recognize that money as "earned." If
magazine publisher under the same circumstances wasn't as concerned with GAAP and chose to recognize that revenue as soon as the money was in the bank, it would be impossible to fairly compare the two companies -- one would be showing a much higher
income even though, in reality, the two publishers had the same amount of sales. Bringing in auditors ensures that the two companies really are comparable. But that's just the tip of the iceberg.
What Do Auditors Look For?
When reviewing a company's financial statements, auditors have two primary concerns: errors and fraud. Because of the complex nature of accounting, it's not uncommon for auditors to find unintentional accounting errors when they look at a company's "books."
Of course, fraud is something that auditors must also look for. Before taking on a new client, auditors sit down and consider where frauds are most likely to occur, and put more resources toward checking those areas of the company. It's impossible for auditors to uncover every possible accounting issue during the course of an audit, so they make sure that they're spending more time looking for fraud where it's most likely to occur.
Sarbanes-Oxley has added a new responsibility for auditors: evaluating a company's internal control procedures. Internal controls are processes used by companies to avoid fraud, comply with laws and stay on a path toward profitability... You can probably see why these are so important. This is now found as an additional paragraph in the audit report.
The Audit Report
The audit report is that page near the end of every 10-K, but what exactly is it, and how might it affect your investment decisions?
The audit report is the document produced by the auditor at the conclusion of an audit. It lays out the auditor's opinion on the company's financial statements and the effectiveness of the company's internal controls. The audit report should contain paragraphs that present you with the responsibilities of the auditor and the company's board, the scope of the audit and -- of course -- the auditor's opinion.
There are three types of auditor opinions you'll see in an audit report:
- Unqualified Opinion: This is the most common type of audit opinion you'll see with a public company. It essentially says that the company is fairly reporting its financial position to us. An unqualified opinion is what we ideally want to see.
- Qualified Opinion: This type of opinion means that with the exception of one or two irregularities, the financial statements of the company seem to be all right. The reasons for the qualified opinion will be explained in the audit report.
- Adverse Opinion: If you're looking at a company with an adverse audit opinion, be afraid. With an adverse opinion, the financial statements provided by the company are materially misstated and aren't a fair representation of the company's operations.
How to Read an Auditor's Report
Some firms use slightly different wording in their audit reports, but for the most part the ideas are the same. Here's the audit and internal control opinion from
2006 Annual Report:
In our opinion, management's assessment that Google Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Google Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the accompanying consolidated balance sheets of Google Inc. as of December 31, 2005 and 2006, and the related consolidated statements of income, redeemable convertible preferred stock warrant and stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2006, and our report dated February 27, 2007, expressed an unqualified opinion thereon. -- Ernst & Young
In their audit report for Google, Ernst & Young is basically saying that Google's financial statements for 2006 are presented fairly and accurately. As an investor, this means that I can take a look at Google's
fundamentals without having to worry about whether or not someone "fudged the numbers."
It's also worth noting that auditors sign the name of the firm at the bottom of audit reports, not their own names. This assigns liability to the entire audit firm, not just the auditors on a particular job. For an investor familiar with audit firms, seeing a name like Ernst & Young can also instill faith in the way the audit was performed. In the post-Anderson auditing world, there are four big-name accounting firms who are responsible for auditing the majority of public companies: Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers.
The New Era of Accounting
In recent years, we've learned just how essential it is to get transparency in financial reporting. New legislation and regulations are making it harder for the likes of Jeff Skillings (former Enron President and CEO) and Bernie Ebbers (former WorldCom CEO) to cash in on the investing public, but that doesn't mean that these types of business leaders aren't still out there.
Auditors have historically been effective at catching and derailing frauds that take place in client firms. Because auditors have more insight into a company's financials (they get to look at stuff that's generally off-limits for the public), they're in a better position to protect a company's investors and creditors than almost anyone else.
Traditionally, auditors have been on the front lines of catching fraud. But that perception changed for some after Enron's auditor, now-defunct Arthur Anderson, was shown to have been in collusion with their client (Enron) in hiding the massive fraud that brought down both Enron
In order to placate the investing world after Enron and make sure that scandals like this never spread to independent auditors again, the accounting world has gone through some bumpy changes in the last few years. This started with the formation of the Public Company Accounting Oversight Board (PCAOB), and implementation of rules brought on by legislation like the Sarbanes-Oxley Act.
In order for an external auditor to be effective, he or she must be independent. Independence means that the auditor isn't affiliated with the client, and has nothing to gain by delivering a misleading audit opinion.
audit committee hires the firm that will be performing the external audit. The committee is usually composed of directors of the company, and is responsible for its financial reporting. Having auditors deal with the audit committee directly helps ensure independence by keeping the chain of command at a high level. When auditors do uncover fraud in a company, the audit committee is the first group they turn to (followed closely by the
So now you know that an audit opinion is a pretty important piece of paper -- probably something you shouldn't overlook the next time you're thumbing through a company's
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Jonas Elmerraji is the founder and publisher of Growfolio.com, an online business magazine for young investors.