13.6. Checking for Ominous Skies in the Auditor's Report

The value of analyzing a financial report depends on the accuracy of the report's numbers. Understandably, top management wants to present the best possible picture of the business in its financial report. The managers have a vested interest in the profit performance and financial condition of the business; their yearly bonuses usually depend on recorded profit, for instance. As I mention several times in this book, the top managers and their accountants prepare the financial statements of the business and write the footnotes. This situation is somewhat like the batter in a baseball game calling the strikes and balls. Where's the umpire?

What if a private business's financial report doesn't include an audit report? Well, you have to trust that the business prepared accurate financial statements following authoritative accounting and financial reporting standards and that the footnotes to the financial statements cover all important points and issues.

Unfortunately, the audit report gets short shrift in financial statement analysis, maybe because it's so full of technical terminology and accountant doublespeak. But even though audit reports are a tough read, anyone who reads and analyzes financial reports should definitely read the audit report. Chapter 15 provides more information on audits and the auditor's report.

The auditor judges whether the business's accounting methods are in accordance with appropriate accounting and financial reporting standards — generally accepted accounting principles (GAAP) for businesses in the United States. In most cases, the auditor's report confirms that everything is hunky-dory, and you can rely on the financial report. However, sometimes an auditor waves a yellow flag — and in extreme cases, a red flag. Here are the two important warnings to watch out for in an audit report:

• The business's capability to continue normal operations is in doubt because of what are known as financial exigencies, which may mean a low cash balance, unpaid overdue liabilities, or major lawsuits that the business doesn't have the cash to cover.

• One or more of the methods used in the report are not in complete agreement with appropriate accounting standards, leading the auditor to conclude that the numbers reported are misleading or that disclosure is inadequate. (Look for language in the auditor's report to this effect.)

Although auditor warnings don't necessarily mean that a business is going down the tubes, they should turn on that light bulb in your head and make you more cautious and skeptical about the financial report. The auditor is questioning the very information on which the business's value is based, and you can't take that kind of thing lightly.

Also, just because a business has a clean audit report doesn't mean that the financial report is completely accurate and aboveboard. As I discuss in Chapter 15, auditors don't always catch everything, and they sometimes fail to discover major accounting fraud. Also, the implementation of accounting methods is fairly flexible, leaving room for interpretation and creativity that's just short of cooking the books (deliberately defrauding and misleading readers of the financial report). Some massaging of the numbers is tolerated, which may mean that what you see on the financial report isn't exactly an untarnished picture of the business. I explain window dressing and profit smoothing — two common examples of massaging the numbers — in Chapter 12.