Suppose you have invested a fair amount of money in a privately-owned business. You are not involved in managing the company; you’re an absentee owner, or a passive investor. Being a stockholder you receive the company’s financial reports, of course. You read the financial statements and footnotes to find out how the company is doing, and whether there might be any storm clouds on the horizon.
Let us ask ourselves a question:
How do you know whether the company’s financial statements provide adequate disclosure and whether the business uses approved accounting methods to measure its profit? Do you just presume this? Are you sure we can trust the company’s financial reports?
Or, suppose you are a bank loan officer. A business includes its latest financial statements in the loan application package, the question are:
Does the business use proper accounting methods to prepare its financial statements? Have, perhaps, the financial statements been “tweaked” for purposes of securing the loan, to make them look better than they really are?
It’s not unheard-of, you know.
Or, suppose you’re a mutual fund investment manager in charge of a large portfolio of stocks traded on the world stock exchange. Market values of stock shares depend on the net income and earnings per share amounts reported by companies in their financial reports.
How do you know that their profit numbers are reliable?
Financial statements can have errors or be misleading for two basic reasons:
- Honest mistakes happen because a company’s accounting system is inadequate and fails to detect and correct errors, or because the company’s accountants simply do not have adequate understanding of current accounting and financial reporting requirements and standards.
- Deliberate dishonesty can cause employees or top-level managers to intentionally distort the company’s profit performance and financial statements, or withhold vital information that should be disclosed in the financial report. This is called fraudulent financial reporting.
Bad accounting and fraud are ever-present dangers in financial statements. One way to protect against these potentially serious problems is to audit the accounting system and records of a business to ascertain whether the company’s financial statements are free of errors and adhere to generally accepted accounting principles.
An audit provides assurance that the company’s financial report is reliable and follows the rules. Audits of financial reports are done by certified public accountants, which we turn to next.
For further reading about auditing, you may want to read the following entries as well: