What are audited financial statements and why?

boy, with homework

Working on an A+

Suppose that your child got to write their own report card. At the end of the semester, the child figures out their grades, writes them down, and then mails them to their parents.  How would the parent know that the grades were free of bias or error?

Such is the issue with financial statements.  Reported directly by managers, financial statements provide a “report card” of managers’ performance.  Corporate managers prepare their own report cards.  How can you, the investor, be assured that those financial statements are free of bias or error?

Enter the independent auditor.  The independent auditor goes through the books and issues a statement (called the auditor letter) that they were prepared in accordance with GAAP, generally accepted accounting principles, that they were properly prepared and can be relied upon by investors.

In the US, Independent auditors are firms of CPA’s, Certified Public Accountants, who are specifically licensed to conduct audits.  The largest CPA firms are called the “Big Four:” Deloitte, Ernst & Young, KPMG, and PricewaterhouseCoopers.  Many other CPA firms are qualified to conduct audits, and similar audits are typically conducted all over the world.  This is an international system.

Audits must be prepared in accordance with Generally Accepted Auditing Standards.  Public companies (those traded on a stock exchange) in the US must also comply with the “Sarbanes-Oxley Act” and the PCAOB, the Public Companies Accounting Oversight Board.

Who audits the auditors?  The auditors use a system of professional review, where different audit firms check each others’ work.  Auditors are also subject to review by the PCAOB.  They are legally responsible for their audits.

This system of independent audits is controversial.  Scandals like at Enron and WorldCom have plagued the accounting profession, and may have been caused by fundamental flaws in the audit system.  Auditors rely on statistical probabilities, so that they do not check and double-check every single transaction.  This means that, in any independent audit, there is a small probability of failure, i.e. that the financial statements are not accurate and cannot be relied upon.

[Image: boy, with homework by woodleywonderworks, on Flickr]

About Mark P. Holtzman

Chair of Accounting Department at Seton Hall University. PhD from The University of Texas at Austin. Worked at Deloitte's New York Office. BSBA from Hofstra University.

3 Responses to “What are audited financial statements and why?”

  1. Mark-

    Does the auditing standard apply only to publicly held companies or are privately held entities subject to the same?

    • Dion – Great question.

      All publicly-owned companies (traded on stock exchange, etc.) must have their financial statements audited at least once a year. This is the most rigorous type of audit, following Sarbanes-Oxley and PCAOB guidelines.

      For private companies, outside investors and creditors should require an independent audit. This will be a little less rigorous (and less expensive) than a public company audit, because it usually won’t comply with Sarbanes-Oxley and PCAOB.

      Start-ups that are run by their owners usually do not need an independent audit. However, if they are so successful that they plan to raise capital, then they will probably eventually need an independent audit.

      Many start-ups have faced problems because they did not bring in audit professionals early enough. Groupon.com is a recent example of this. Lack of accounting expertise delayed Groupon’s initial public offering.

      Great question, I should have put this in the blog post. Thanks!

      • Thanks for clarifying. A follow-up: what about private companies with substantial bank loans? Who is responsible for the audit what are the standards?

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