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; they don't. 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 another 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.