Understanding Business Accounting For Dummies, 2nd Edition (113 page)

Chapter 15
:
Professional Auditors and Advisers

In This Chapter

Cutting the deck for a fair deal: Why audits are needed

Interpreting the auditor's report

Knowing what auditors catch and don't catch

Growing beyond audits: Professional accountancy practices as advisers and consultants

Questioning the independence of auditors

I
f we'd written this chapter 50 years ago, we would have talked almost exclusively about the role of the professional chartered or certified accountant as the
auditor
of the financial statements and footnotes presented in a business's annual financial report to its owners and lenders. Back then, in the ‘good old days', audits were a professional accountancy firm's bread-and-butter service - audit fees were a large share of these firms' annual revenue. Audits were the core function that accountants performed then. In addition to audits, accountants provided accounting and tax advice to their clients - and that was pretty much all they did.

Today, accountants do a lot more than auditing. In fact, the profession has shifted away from the expression
auditing
in favour of broader terms like
assurance
and
attest.
More importantly, accountants have moved into consulting and advising clients on matters other than accounting and tax matters. The movement into the consulting business while continuing to do audits - often for the same clients - has caused all sorts of problems, which this chapter looks at after discussing audits by accountants.

Why Audits?

When I (John) graduated from college, I went to work for a big national accountancy firm. The transition from textbook accounting theory to real-world accounting practice came as a shock. Some of our clients dabbled in window dressing (refer to Chapter 8), and more than a few used earnings management tactics (see profit smoothing in Chapter 8). A few of our clients were engaged in accounting fraud, but just a very few. I was surprised how many businesses cut corners to get things done. Sometimes they were close to acting illegally, and some went over the edge. I soon realised that I had been rather naive, and I came to tolerate most of the questionable practices in the rough and tumble world of business.

I mention my early experience in public accounting to remind you that the world of business is not like Sunday school. Not everything is pure and straight. Nevertheless, legal and ethical lines of conduct separate what is tolerated and what isn't. If you cross the lines, you are subject to legal sanctions and can be held liable to others. For instance, a business can deliberately deceive its investors and lenders with false or misleading numbers in its financial report. Instead of ‘What You See Is What You Get' in its financial statements, you get a filtered and twisted version of the business's financial affairs - more of a ‘What I Want You to See Is What You Get' version. That's where audits come in.

Audits are the best practical means for keeping fraudulent and misleading financial reporting to a minimum. A business having an independent accounting professional who comes in once a year to check up on its accounting system is like a person getting a physical exam once a year - the audit exam may uncover problems that the business was not aware of, and knowing that the auditors come in once a year to take a close look at things keeps the business on its toes.

The basic purpose of an annual financial statement audit is to make sure that a business has followed the accounting methods and disclosure requirements of generally accepted accounting principles (GAAP) - in other words, to make sure that the business has stayed in the ballpark of accounting rules. After completing an audit examination, the accountant prepares a short auditor's report stating that the business has prepared its financial statements according to GAAP - or has not, as the case may be. In this way, audits are an effective means of enforcing accounting standards.

An audit by an independent accountant provides assurance (but not an iron-clad guarantee) that the business's financial statements follow accepted accounting methods and provide adequate disclosure. This is the main reason why accountancy firms are paid to do annual audits of financial reports. The auditor must be
independent
of the business being audited. The auditor can have no financial stake in the business or any other relationship with the client that may compromise his or her objectivity. However, the independence of auditors has come under scrutiny of late. See the section ‘From Audits to Advising' later in the chapter.

The core of a business's financial report is its three primary financial statements - the profit and loss account, the cash flow statement, and the balance sheet - and the necessary footnotes to these statements. A financial report may consist of just these statements and footnotes and nothing more. Usually, however, there's more - in some cases, a lot more. Chapter 8 explains the additional content of financial reports of public business corporations, such as the transmittal letter to the owners from the chief executive of the business, historical summaries, supporting schedules, and listings of directors and top-level managers - items not often included in the financial reports of private businesses.

The auditor's opinion covers the financial statements and the accompanying footnotes. The auditor, therefore, does not express an opinion of whether the chairman's letter to the shareholders is a good letter - although if the chairman's claims contradicted the financial statements, the auditor would comment on the inconsistency. In short, auditors audit the financial statements and their footnotes but do not ignore the additional information included in annual financial reports.

Although the large majority of audited financial statements are reliable, a few slip through the audit net. Auditor approval is not a 100 per cent guarantee that the financial statements contain no erroneous or fraudulent numbers or that the statements and their footnotes provide all required disclosures, as the all too frequent Enron-like events attest.

Who's Who in the World of Audits

Chapter 1 explains that to be a qualified accountant, a person usually has to hold a degree, has to pass a rigorous national exam, have audit experience, and satisfy continuing education requirements. Many accountants operate as sole practitioners, but many form partnerships (also called firms). An accountancy firm has to be large enough to assign enough staff auditors to the client so that all audit work can be completed in a relatively short period - financial reports are generally released about four to six weeks after the close of the fiscal year. Large businesses need large accountancy firms, and very large global business organisations need very large international accountancy firms. The public accounting profession consists of four very large international firms, several good-sized second-tier national firms, often with international network arrangements, many regional firms, small local firms, and sole practitioners.