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. or the purpose of this discussion the terms accountant, auditor and
certified public accountant !"#$% are used interchangeably and only refer to the &outside&
independent auditor.
The Role of the Auditor
'ependable financial information is essential to the very e(istence 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 ta( 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.
*ood 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. +conomic 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. Inade,uate 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.
$ 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. .ut what if the financial statements submitted by the company along with its
credit application are not dependable/ $ssume, for e(ample, that the financial statements
overstate current assets and annual earnings, and omit major liabilities. $ssume 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.
"redibility, in this usage, means that the financial statements can be believed0 that is, they
can be relied upon by outsiders, such as trade creditors, bankers, stockholders,
government and other interested third parties.
$udited 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, e(pressing 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 !*$$#%. inancial statement audits are
normally performed by firms of certified public accountants0 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
$t the very heart of the public accounting profession is the $I"#$, a voluntary national
organization of more that 122,222 "#$s. The $I"#$ establishes standards and rules to
guide "#$s 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
$uditors must determine whether financial statements are prepared in conformity with
generally accepted accounting principles. The $I"#$ has designated the inancial
$ccounting 3tandards .oard as the body with power to set forth these principles for
entities other than state and local governments. Thus $3. 3tatements, e(posure drafts,
public hearings, and research projects are all of major concern to the public accounting
profession.
Securities and Exchange Commission - SEC
The 3+" is an agency of the 4.3. *overnment. It administers the 3ecurities $ct of 5611,
the 3ecurities +(change $ct of 5617, and other legislation concerning securities and
financial matters. The function of the 3+" is to protect investors and the public by
re,uiring full disclosure of financial information by companies offering securities for sale
to the public. $ 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
3+" on accounting practice. To register securities means to ,ualify them for sale to the
public by filing with the 3+" financial statements and other data in a form acceptable to
the "ommission. $ 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 3+" made the "ommission
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
"ontrary 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. $s a professional, the
accountant e(presses 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 ,uestion the fairness of the resultant statements.
8aturally, some of the items on a financial statement cannot be subjected to e(act
measurement. 4nfortunately, 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. .y their very nature, certain of these items must
represent estimates and appro(imations. 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. $uditors do not e(press 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- e(amination 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.
$ 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 9 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.
+(pressing an independent and e(pert 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 e(amination was performed in conformity
with generally accepted auditing standards and by e(pressing 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- e(amination, 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 ade,uate
accounting records and of preparing proper financial statements for the use of
stockholders and creditors. +ven 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. .efore 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. :ften, the statement of retained earnings is combined with the income
statement. In some cases, the retained earnings statement may be e(panded to a statement
of stockholders- e,uity. inancial statements generally are presented in comparative form
for the current year and the preceding year and are accompanied by e(planatory 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 ade,uate disclosure when
information in the financial statements is insufficient to attain this objective. $lthough the
notes, like the financial statements themselves, are representations of the client, the
independent auditors generally assist in drafting the notes.
$de,uate disclosure in the notes to financial statements is necessary for the auditors to
issue an un,ualified opinion on the financial statements. 'isclosure re,uirements 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.
Detecting isstatements
*enerally accepted accounting principles re,uire 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 re,uired 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 un,ualified report is regarded as a clean bill of health, the auditor made no
e(ceptions and inserts no ,ualifications in the report. $n un,ualified opinion can only be
e(pressed when the independent auditor has formed the opinion on the basis of an
e(amination 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 un,ualified 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.
!he Introductor" 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.
!he 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.
!he #pinion Paragraph
In the opinion paragraph, the auditors are e(pressing nothing more than an informed
opinion. They do not guarantee or certify that the statements are accurate.
Independent $uditors- ;eport<
To the .oard of 'irectors and 3tockholders of $." "ompany<
=e have audited the accompanying balance sheet of $." "ompany as of
'ecember 15, >225, and the related statements of income, retained earnings, and
cash flow for the year then ended. These financial statements are the
responsibility of the "ompany-s management. :ur responsibility is to e(press an
opinion on these financial statements based on our audit.
=e conducted our audit in accordance with generally accepted auditing standards.
Those standards re,uire that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. $n audit includes e(amining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. $n audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
=e 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 $." "ompany as of 'ecember 15,
>225, and the results of its operations and its cash flows for the year then ended in
conformity with generally accepted accounting principles.
"allahan, 'urant, 3imms ? "o.
"olumbia, Maryland
"ertified #ublic $ccountants
March 5, >22>
ther Types of Auditors' Reports
$lternatives to an un,ualified report include un,ualified opinion with e(planatory
language, a ,ualified opinion, an adverse opinion, or a disclaimer of opinion.
Explanator" $anguage Added to the %n&ualified #pinion
"ertain circumstances re,uire auditors to add e(planatory language to the standard report.
$dding the additional language is not regarded as a qualification because it does not
lessen the auditors' reporting responsibility for the financial statements.
$uditors add e(planatory language to an un,ualified opinion to indicate<
a division of responsibility with another "#$ firm0
to indicate an inconsistency in the application of accounting principles0
to emphasize a matter0
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.
$ situation in which e(planatory language is used is illustrated in the following e(ample<
Ability to Continue as a Going Concern
$ special type of significant uncertainty, that is important to the credit professional,
concerns the ability of a company to continue as a going concern. 4nder generally
accepted accounting principles, both assets and liabilities are recorded and classified on
the assumption that the company will continue to operate. $ssets, for e(ample, may be
presented at amounts that are significantly greater than their li,uidation values.
"onditions that may cause the auditors to ,uestion 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 e(ists 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 $."
"ompany will continue as a going concern. $s discussed in 8ote 5 to the financial
statements, $." "ompany 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 8ote 5. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty.
'ualified #pinions
@ualifications with respect to an auditor-s opinion may be broadly classified into two
categories0 those ,ualifications which relate to the scope of the e(amination, and those
,ualifications with respect to the fairness of presentation in accordance with generally
accepted accounting principles consistently applied. $ ,ualified opinion restricts the
auditors- responsibility for fair presentation in some areas of the financial statements. The
opinion states that e(cept for the effects of some deficiency in the financial statements, or
some limitation in the scope of the auditors- e(amination, the financial statements are
presented fairly. $ll ,ualified reports include a separate e(planatory paragraph before the
opinion paragraph disclosing the reasons for the ,ualification.
Ad(erse #pinions
$n adverse opinion is the opposite of an un,ualified opinion0 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 e(press an adverse opinion if the statements are so lacking in fairness
that a ,ualified opinion would not be warning enough. =henever 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 #pinion
$ disclaimer of opinion is no opinion. In an audit engagement, a disclaimer is re,uired
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 ade,uate endorsement of the
correctness of a financial statement, but seasoned credit professionals should take two
additional factors into consideration< the e(perience of the auditor with the type of
business and how often the client-s books are e(amined.
Speciali)ation b" Auditors
8early every trade and industry has a group of auditors who concentrate their practice
and become authorities in that field. :ften this specialization is along functional lines. $
business is best served by an auditing firm who understands the industry-s business cycle,
practices, products, market conditions and characteristics.
Fre&uenc" of Audit
Two types of services performed by auditors ) continuity of engagement and continuous
audit - do not provide the same types of services. "ontinuity of engagement indicates an
independent auditor is regularly employed to prepare annual and other statements, and
does so for successive years. $ 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 ,uarterly or
semi)annual statements. $ 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
=hen the regular auditor ,uits an engagement, it is important to discover the underlying
reason. $ desire to lower auditing costs is often given as the motive, but the move may
also have credit implications. $ substantial cut in auditing fees may lead to lower ,uality
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.
3ome auditors announce they are no longer &on the books& of a former client, but,
understandably do not give the reason. $s a creditor, you should carefully compare the
certification of the new auditor with that of the former one.
Conclusion
$uditors 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
,uestions are raised, and should give such e(planations willingly.
$ conscientious credit professional should have the customer-s permission before asking
the auditor for additional schedules, e(hibits, or other information ordinarily withheld
from publication. $uditors differ as to the degree of their cooperation with small) or
medium)sized clients. 3ome believe their audit report meets the terms of their
engagement0 others give additional information, which may benefit the clients. In some
cases, auditors accompany their clients during interviews with credit e(ecutives and will
supply additional information to creditors. $s a prudent credit professional, you should
welcome an opportunity to become ac,uainted with an auditor on whom you e(pect to
rely.