Question

In conducting financial statement analysis, the presumption is that a firm adheres to its designated accounting standards in preparing and presenting its financial statements, which permits the analyst to use the reported amounts to assess each type of risk. In some cases, however, firms intentionally manipulate the financial statements in an effort to portray a more profitable or less risky profile than is appropriate. If the financial statements are manipulated, they are not useful or worse, are misleading as the basis for analyzing various risks. Thus, assessing financial reporting manipulation risk is an integral part of using financial statement data as the basis of risk analysis.

Required:

(a) A “clean” audit opinion does not necessarily mean that the financial results are accurate. Discuss

(b) How can audited and unaudited financial statements affect financial statement analysis?

Answer 1

ANSWER TO Q(a)

An auditor’s good opinion is a remarkable accomplishment, to be sure, but it doesn’t mean everything is perfect or that no errors exist. The opinion principally indicates that your financial statements don’t contain any significant misstatements and that those who rely on them to make decisions can be confident that they are reasonably accurate.

Audits offer big-picture insights and often reveal opportunities for increasing efficiencies and improving operations, but they aren’t airtight — so don’t rest on your laurels. The fight against fraud calls for constant vigilance, and becoming a little too comfortable or over-reliant on audit results can lead to greater vulnerability.

Bridge the audit expectation gap

When leaders realize that a clean audit opinion is not a judgment of the effectiveness of their organization’s internal controls, they often become frustrated and wonder what an audit’s purpose truly is, if not to assure them of the unassailability of their processes and procedures.

Understanding what an audit provides (and what it doesn’t) helps to balance expectations with reality and keep you from letting down your guard in the never-ending battle against fraud. In most cases, an external audit is required by a regulator or third party. The auditor obtains financial data from the auditee that depicts the organization’s financial performance during the year, and its financial position at yearend.

The audit is an exercise in sampling and materiality — meaning the auditors don’t look at everything. In fact, they don’t even come close! It is just not practical for auditors to review every transaction throughout the year. Instead, auditors primarily look into the bigger, riskier, and more significant stuff to get a general but dependable assessment of exposure.

Ultimately, auditors give an opinion to those regulators or third parties to assure them that they can trust the financial information they see and that any errors behind the scenes wouldn’t otherwise influence their decisions.

Audits aren’t your best defense against fraud and error

Audits are not designed to test controls, nor to catch fraud or detect every error; that’s largely up to your organization’s management and governing body. In fact, only about 4 percent of known frauds are discovered by an external audit. Whistleblowing and internal tipoffs are, in fact, the most common way fraud is uncovered.

ANSWER TO Q(b)

Unaudited Financial Statements

Unaudited financial statements show the same financial data as audited ones. But it's quicker and cheaper to draw them up than to go through the audit process. If, say, you want a cash flow statement for the month because you want to know how much money you have on hand, you can pay for a statement. This is sometimes called compilation accounting because the accountant compiles the statements from the raw data you provide.

If you're presenting a prospectus to potential investors, however, they'll want the security of audited financial statements. If you're a publicly traded company, federal regulators require that you file audited statements every year. You can still compile unaudited statements for your own use.

Audited Financial Statements

One reason audited financial statements cost more is that you have to use a certified public accountant to do the job. Compilation accounting takes your word for the accuracy of the information, but the auditor has to dig deeper. An audited balance sheet means, for example, the auditor has double-checked the information. If you report $30,000 in inventory as an asset, the auditor may inspect the inventory, or all items over a certain value, to confirm its existence.

The auditor also looks at your internal controls. Controls include, for example, internal watchdogs who monitor how money is spent. If the people authorized to spend money have nobody checking behind them, the auditor will double-check for possible fraud.