First of all let’s be clear on one point. We are talking about audits of financial reports by CPAs. There are many other types of audits, such as an audit of your income tax return by the Tax office, audits within an organization by its own internal auditors, and so on. The following discussion concerns audits by CPAs of financial reports prepared by a business that are released to the outside world—primarily to its owners and others who have a legitimate right to receive a copy of its financial report.
Financial report readers are not too concerned about how an audit is done, nor should they be. The bottom line to them is the opinion of the CPA auditor. They should read the opinion carefully, although there is evidence that most don’t or at best just give it a quick glance. Evidently, many financial report users simply assume that having the financial report audited is, by itself, an adequate safeguard. They may assume that the CPA would not be associated with any financial report that is incorrect or misleading.
Many financial report readers seem to assume that if the CPA firm gives an opinion and thereby is associated with a financial report, then the financial statements and footnotes must be okay and are not seriously wrong in any respect. Doesn’t the CPA’s opinion constitute a stamp of approval? No, not necessarily!
The CPA profession over the years has gone to great lengths to differentiate audit opinions. You’ve heard the old saying: “If you’ve seen one, you’ve seen them all.” This is not true about audit opinions. You must read the auditor’s report to find out which type of opinion the auditor is giving on the financial statements.
The best audit opinion is called an unqualified opinion, or more popularly a “clean” opinion, and is presented in an example I am posting below. Basically, this opinion states that the CPA has no material disagreements with the financial report. In other words, the CPA attests that the financial statements have been prepared according to generally accepted accounting principles (GAAP) and that the footnotes plus other information in the financial report provide adequate disclosure.
In a clean opinion the CPA auditor says, in effect, “I don’t disagree with the financial report“. The actual wording is:
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of ABC Company. . . .
The CPA might have prepared the financial statements differently and might have written the footnotes differently. In fact, the CPA might prefer that different accounting methods had been used. All the CPA states in a clean opinion is that the accounting and disclosure presented in the financial report are acceptable.
Independent Auditor’s Report
We have audited the accompanying balance sheets of ABC Company as of December 31, 20X7 and 20X8, and the related statements of income, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide 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 ABC Company as of December 31, 20X7 and 20X8, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Signature of CPA Firm
The three-paragraph clean (unqualified) audit report has been the standard wording for more than a decade. It was adopted for several reasons, one of which was to emphasize that the company’s management has the primary responsibility for preparing the financial report. This point is mentioned in the first paragraph.
Also, the accounting profession thought that it should be made clear that an audit provides reasonable but not absolute assurance that
….the financial statements are free of material misstatement.
And, it was thought that users of financial reports should be told briefly what an audit involves (the second paragraph).
The standard version of the CPA auditor’s report runs 200 words of fairly technical jargon, and demands a lot from the reader, in my opinion. Frankly, the changes over the years in the language of auditor reports were motivated primarily by the surge in lawsuits against auditors. Some audits failed to catch fraudulent financial statements; the CPA firms gave clean opinions on financial statements that later were discovered to be seriously misleading because of management fraud, or were based on accounting methods that in hindsight proved to be indefensible.
Looking at the universe of all companies that are audited, CPAs have an excellent track record. Not many fraudulent or materially misleading financial reports get a clean opinion from the CPA auditor.
Unfortunately some do; audits are not 100% perfect. Out of the more than 12,000 audits of public companies done each year, some get clean opinions when in fact the auditor should not have put a stamp of approval on the financial reports. But this number is a very small percent of the total number audited (The actual number of audit failures each year is difficult to ascertain).
The cost of making all audits fail-safe would be prohibitive. In the grand scheme of things a few audit failures are tolerated in order to keep the overall cost of audits within reason. In moments of deep cynicism it has occurred to me that, perhaps, the real reason for audits is to provide creditors and investors someone to sue when they suffer losses and there is evidence that the company’s financial reports were deficient or misleading.
Stock investors and creditors usually lose money when a business has to go back after the fact and revise its financial statements downward, or when because of misleading financial reporting the company ends up with serious legal problems. So, they look around for someone to sue to recover some of their losses.
CPA firms that have deep pockets are a convenient target. Because of this the public accounting profession decided to adopt more defensive language in their audit reports, to better cover their backsides when they are sued. I believe that the auditing profession, not with standing its legal problems, has lost sight of the users of financial reports.
The vast majority of financial report users, in my opinion, simply want to know whether the CPA has any objection to the financial statements and footnotes prepared by management. They don’t care that much about the specific wording used in the CPA auditor’s report. They want to know one thing: Does the CPA auditor give his or her blessing to management’s financial report? If not, they want the CPA auditor to make clear his or her objections to the financial report.
The best rule of thumb for financial report users to follow is to look at the CPA auditor’s report to see if there is a fourth paragraph. The standard audit report is only three paragraphs—see the example. The CPA auditor uses a fourth paragraph to communicate certain matters that financial report users should know about. It’s always a good idea to check and see if there a fourth paragraph and read what is in this addendum to the standard auditor’s report.
A fourth paragraph is used in the following situations:
- The CPA auditor wants to emphasize one or more points, such as related-party transactions reported in the financial statements, significant events during the year, unusual uncertainties facing the business, or other matters.
- The company has changed its accounting methods between the most recent year and previous years, which causes inconsistencies with the originally reported financial reports of the business.
- There is substantial doubt about the entity’s ability to continue as a going concern, because of financial difficulties in meeting the due dates for payment of its liabilities, or because of other large liabilities it may not be able to pay.
Creditors and investors should be informed in these situations, so the audit profession has decided that these matters should be mentioned explicitly in the auditor’s report. The fourth paragraph does not constitute a qualification on the company’s financial report; it just provides more information.
In contrast, the CPA auditor may have to take exception to an accounting method used by the company, or the lack of disclosure for some item that the CPA thinks is necessary for adequate disclosure. In this situation the CPA renders a qualified opinion that includes the key words ”except for” in the opinion paragraph. The grounds for the qualification (what the auditor takes exception to) are explained in the auditor’s report. To give a qualified opinion the CPA auditor must be satisfied that taken as a whole the financial report of the company is not misleading. Nevertheless, the CPA disagrees with one or more items in the financial report, especially if the company has departed from generally accepted accounting principles.
On the other hand, a qualified opinion may be due to a limitation on the scope of the CPA’s examination; the CPA was not able to gather evidence for one or more accounts in the financial statements, and therefore has to qualify or restrict his or her opinion with regard to the items not examined. This sort of qualified opinion may be accepted by the SEC as the best the CPA auditor could do in the circumstances.
How serious a matter is a qualified opinion? Basically, a qualified opinion has a fly–in–the –ointment–effect. The auditor points out a flaw in the company’s financial report, but not a fatal flaw. A qualified audit opinion is a yellow flag, but not a red flag.
One thing to remember: The CPA auditor must be of the opinion that the overall fairness of the financial report is satisfactory, even though there are one or more deviations from established accounting and disclosure standards. If the auditor is of the opinion that the deviations are so serious as to make the financial statements misleading, then the CPA must issue an adverse opinion. You hardly ever see an adverse opinion. No business wants to put out misleading financial statements and have the CPA auditor say so for everyone to see!
The CPA auditor may have to disclaim an opinion due to limitations on the scope of the audit or due to very unusual uncertainties facing the business. In some situations a CPA may have very serious disagreements with the client that cannot be resolved to the auditor’s satisfaction. The CPA may withdraw from the engagement (i.e., walk off the audit). This is not very common, but it happens every now and then. In these situations the CPA has to notify top management, the board of directors of the company, and its audit committee members and make clear the nature of the disagreements and why the CPA is withdrawing from the audit.
The CPA does not act as a whistle-blower beyond the inner confines of the company. For public companies, the CPA has to inform the securities exchange commission that the firm has withdrawn from the audit engagement and whether there were any unresolved disagreements between the CPA and the company.
For further reading about auditing, you may want to read the following entries as well: