Chapter 18

Finding Out How Companies Find Errors: The Auditing Process

In This Chapter

Getting acquainted with audits and auditors

Checking out the auditing process

Exploring accounting standards and principles

Most readers of financial reports don't work for the company whose reports they're reading and, therefore, must depend on the truthfulness of the company's management in reporting its financial statements. Can you depend on the numbers you see?

The question is valid, especially considering the corporate scandals that have rocked Wall Street since the collapse of Enron in December 2001. (To find out more about why the world's largest electricity and natural gas trader filed for bankruptcy, see Chapter 24.) The Enron scandal — followed by financial reporting scandals at other major corporations such as MCI WorldCom, Adelphia, AIG, and many others — led investors to be wary about the numbers companies put in their financial reports.

In this chapter, I explore how third parties get involved to keep company records on the up and up.

Inspecting Audits and Auditors

Company outsiders can't be sure the information they see is an accurate reflection of the company's financial situation unless a disinterested third party reviews the company's operations and financial statements and determines that the reports are free of fraud and misrepresentation. Called an audit, this process is crucial for verifying the accuracy of a firm's financial reports.

Every public company that sells stock on one of the public markets must hire an independent certified public accountant (CPA) to audit its financial statements. Investors, financial institutions, vendors, suppliers, and anyone else who depends on knowledge about a company's financial well-being expect these audited statements to be truthful. I talk about the process of auditing a company's books in the following sections, and I discuss the process of taking a company public in Chapter 3.

Looking for mistakes

Even when a company has no desire to mislead investors and others, honest mistakes can happen. Sometimes errors occur because a company's accounting system is flawed or isn't capable of handling changing company conditions, especially when a business is growing rapidly. Other times, a company's accountants present wrong numbers because they don't have a good understanding of the latest accounting principles related to the presentation of some of the numbers.

Fraudulent financial reporting results when management decides to deliberately distort the numbers to make the company's financial results look better than they actually are. Sometimes companies withhold negative information to avoid an investor backlash and a drop in stock value. Companies often deceive without the knowledge of the auditors, but sometimes the auditors permit deception by bending the rules. Turn to Chapter 23 to get the dirt on fraudulent financial reporting.

Meeting Mr. or Ms. Auditor

To become a licensed CPA, candidates must complete extensive training that includes having at least a bachelor's degree with a major emphasis in accounting, passing a national CPA exam, and showing that they know how to work with the information in the real world by satisfying work experience requirements that vary by state.

To keep a current license, CPAs must take continuing education courses each year. The amount of time devoted to continuing education varies by state.

Each state has a board of accountancy that monitors the activities of its CPAs. The state boards have the right to revoke or suspend a CPA's license if he violates the laws, regulations, or ethics governing CPAs. If a CPA's license is revoked or suspended, she can no longer serve her clients as an independent CPA unless she gets her license reinstated.

CPAs don't just audit financial reports. They also provide tax planning services and consulting to help a company set up its accounting system, develop the needed information systems to manage its accounting functions, evaluate its business, and even assist with personal financial planning. Some CPAs develop other specialties, such as production control and efficiency, to provide additional services to clients.

To audit a company's financial statements, a CPA must be in public practice and must not be an employee of any organization other than a CPA firm. A CPA's independence from the companies he serves is critical to ensure an independent report.

Examining Records: The Role of the Auditor

The Securities and Exchange Commission (SEC) requires most major corporations to have their financial reports checked by a third party, called an auditor, to be sure the reports truthfully portray the company's financial health.

Some partnerships that aren't corporations choose to pay for an audit, but they aren't required to do so. They do it primarily because the banks or financial institutions that loan them money request it. They may also choose to pay for an audit if several partners are involved in the company but only one of the partners runs its day-to-day operations. The partners who aren't involved in the day-to-day activities may want to have the books audited by a CPA to be sure the active partner is accurately reporting the company's financial activities to them.

If you've worked in a business, you know how nervous some managers become when auditors show up at their door. An audit isn't a complete surprise to a business, however. Auditors sit down with top management and an internal audit committee to discuss the audit process and to schedule the audit for a time that's least disruptive to the business. For example, a retail company certainly doesn't want auditors checking out its stores during the end-of-year holiday rush.

Auditors do more than just review financial statements, as you can see in the next three sections, which describe other elements of the auditing process.

Preliminary review

Before auditors show up at a business's door, they meet with key executives and board members from the audit committee to discuss the audit's scope and objectives. For example, an audit may include a complete review of the company's operations, or it may focus on just one aspect of the operation, such as collections from customers. The objectives of a full audit usually are to validate the company's financial statements. The objectives of an audit for one particular part of an operation usually involve reviewing the operation's efficiency or finding possible internal control problems that can lead to theft or fraud.

After the scope of the audit is determined, the auditors meet with key managers to gather information about internal accounting processes, to evaluate existing controls, and to plan how the audit will be conducted inside the company.

The internal accounting manager responsible for the audit then sends a letter to the staff members involved, announcing the audit and who's been assigned to do the audit. In the first meeting with accounting staff, the auditors review the available resources — including personnel, facilities, and funds — that are allocated to the audit. During these initial meetings, the auditors identify areas of special concern.

Auditors then meet with the departments being audited, which may include all departments in a company or just a few that are directly involved in the issues being investigated. The auditors survey key personnel and review financial reports, files, and other information deemed important to the audit. The auditors also review each department's internal control structure. This review helps the auditors determine where holes are in internal control processes and helps them identify the key areas that need to be tested in the field when auditing specific stores or other locations that the company owns.

After all the facts are determined in the preliminary review, the auditors design the audit process that's used in the field to collect needed information and to meet the objectives set out in the initial meetings with top executives and the board of directors.

Fieldwork

Auditors perform fieldwork when they visit a company's individual offices and locations to determine whether the internal controls discussed at the company's top levels are actually being implemented properly. For example, if a business requires a certain type of coding when an order is charged to a customer's account and that coding is not being used consistently, some customers may be getting merchandise without getting billed.

In the field, auditors watch a company's employees carry out certain tasks to be sure that they're performing them correctly. Additionally, auditors review files to be sure all the paperwork is in order to back up reports sent to the central corporate offices. For example, if the company requires a manager's signature before a customer is given a refund, the auditor randomly reviews company refund records to be sure that the signature process is being followed.

Although the top manager at a location likely knows when the auditors will arrive, the rest of the staff is usually surprised by their arrival. Any findings during the fieldwork become part of the draft audit report.

After the auditors complete a preliminary review of the specific location with the top managers, they randomly review various records to be sure that employees are following internal control procedures. For example, if an auditor is auditing a bank's operations, she wants to know whether employees are following the bank's procedures for approving a loan. She likely checks random files for loans to be sure all needed approvals are in place.

The type of fieldwork that may be required depends on the business type and the audit's scope. Auditors for a bank visit offices in the corporate headquarters, as well as bank branches, to complete their fieldwork. Auditors for a corporation with retail stores do their fieldwork in the corporate headquarters, regional headquarters, and individual stores. If the scope of the audit is just to review the customer order and bill-paying process, the fieldwork may take place only in the corporate accounts receivable section.

As the auditors work in the field, they discuss any significant discrepancies with top management at the field locations. Auditors often work with management to determine how best to resolve any problems before they complete the final audit report. If a problem can be easily resolved, they can do so orally. If the problems are more serious or complex, auditors compile written reports and circulate them to managers in the field, corporate executives, and board members. These reports summarize the auditors’ field findings, identifying problems and making recommendations, before the auditors turn in their final report.

Most companies work to fix problems internally to avoid being reported to their outside stakeholders: investors, creditors, employees, vendors, and suppliers. If you're a member of top management or the audit committee of the board of directors, you usually find out about problems long before they're detailed in the business press or on the front page of the newspaper, as some company scandals are. Audit reports from fieldwork aren't released publicly, so when scandals do make it to the front pages, it's usually after a whistle-blower comes forward or the SEC announces an investigation.

Audit report

After auditors complete their fieldwork, they start working on their audit report, which presents the audit findings and discusses recommendations for improvement. Auditors review their findings with top management and discuss any disagreement that managers in the field may have with the findings. Managers can then comment on the findings before auditors submit a final report to the operating managers, top executives, and the board of directors. Managers are usually given an opportunity to submit their own comments in areas of discrepancy.

If the auditor concludes that changes need to be made within the corporation, managers submit their plans to improve processes based on the auditor's recommendations. If managers disagree with the auditor for some reason, they have to explain in the final report why they disagree and what they plan to do to fix the problem.

Filling the GAAP

Although a CPA's primary role as an auditor is to make sure that a company's financial statements are presented fairly and accurately, he must also ensure that the generally accepted accounting principles (GAAP) are followed.

GAAP guidelines help a company determine the amount of financial information it must disclose and help it measure its assets, liabilities, revenues, expenses, and equity. That information makes up the financial statements, including the balance sheet (see Chapter 6), the income statement (see Chapter 7), and the statement of cash flows (see Chapter 8). The GAAP guidelines, which fill bookshelves in an accountant's office, are highly technical explanations of how a company must report the financial information on each line item of these financial statements, such as how to calculate the value of each asset, liability, or equity on the balance sheet, or how to report revenue and expenses on the income statement.

Accounting standards: Four important qualities

The primary accounting standard-setting body in the U.S. is the Financial Accounting Standards Board, or FASB (check out the sidebar “Exploring the FASB”). It's responsible for developing GAAP, as well as updating the already developed GAAP to reflect changes in the ways companies operate. These changes occur as new ways of doing business become common in the business world.

The FASB specifies four characteristics of useful accounting information that companies need to strive for in their financial reports. These four characteristics form the basis for designing the technical GAAP requirements:

• Relevance: Relevant information includes information needed to forecast a company's future earnings or confirm or correct prior expectations. The information must also be timely, which means it must be available to business decision makers before it loses the power to influence decisions. For example, if companies had to report their earnings only every five years, the information wouldn't be relevant to most company outsiders, who need to make decisions about the company more frequently than that.
• Reliability: For accounting information to be considered reliable, it must be verifiable, factual, and accurate. The information must also be neutral. In other words, a company can't cherry-pick the information it wants outsiders to see and hide any bad news that it doesn't want to report.
• Comparability: Not all companies must collect and present the information in exactly the same way. Some variation is allowed in accounting methods, but a company must disclose what accounting methods it uses. For example, as I discuss in Chapter 15, numerous methods are available for tracking inventory, so companies must state which method they use. This requirement makes comparing results from company to company easier.
• Consistency: The company must use the same accounting principles and methods from year to year so that financial report readers can compare results with the results of previous years. If a company changes the accounting principles or methods its financial reports are based on, it must tell the financial report readers about the change and provide information regarding how that change impacts previously reported financial results.

Changing principles: More work for the FASB

GAAP principles aren't set in stone. As business needs and the way companies do business change, so must the principles. The auditing industry is the most sensitive to emerging trends in day-to-day reporting practices, so it tends to be the profession that most frequently alerts the FASB to the need for new principles or changes in old ones. In addition to changes noticed in the field, new legislation or regulatory decisions can be the sources of needed changes in the GAAP.

After hearing from all sources about emerging issues, the FASB decides what technical issues it will add to its agenda to change the GAAP. The board looks at a number of factors when deciding whether an issue is worth changing:

• Pervasiveness of issue: The board determines how troublesome the issue is to users, preparers, auditors, and others. It also considers whether the practice being questioned impacts many different kinds of companies and whether the issue is likely to be transitory or to persist for a long time. Only issues that are likely to persist over time are considered for further action.
• Alternative solutions: The board considers which of the one or more alternative solutions will improve financial reporting in terms of the key characteristics of relevance, reliability, consistency, and comparability.
• Technical feasibility: The board determines whether it can develop a technically sound solution or whether the project under consideration must wait for another issue to be decided as part of a different project also underway. If another issue must be decided first, the board holds off working on the issue.
• Practical consequences: The board weighs whether the improved accounting solution is likely to be generally accepted and to what extent addressing a particular issue may cause others, such as the SEC or Congress, to act.
• Convergence possibilities: The board determines whether its action on the issue will lead to the elimination of significant differences in standards or practices between the U.S. and other countries, with resulting improvement in the quality of U.S. standards.
• Cooperative opportunities: The board considers whether there's international support by one or more other standard setters for undertaking the project jointly or through other cooperative means with the FASB.
• Resources: The board must determine whether adequate resources and expertise are available within the FASB or whether the FASB can leverage the work of other standard setters.

If the FASB decides it wants to work on an issue, it begins a long process that can take years before the issue is added to the GAAP. This process includes board meetings that are open to the public, exposure drafts circulated for public comment, and additional board meetings and comment periods, if necessary.