- ARE AUDITS MEANINGLESS?
by: Cary Christian
You may recall reading our story about the Andersen/Enron debacle a few
weeks ago and the potential affect on auditing public companies in this
country. The Senate Banking Committee voted 17 to 4 yesterday to adopt a far
reaching legislative response to the Enron collapse that promises to change
the way public companies are audited in this country. The Senate bill will
go much further than the proposed House bill.
The groundswell has begun. Changes are on the horizon. That's good news. But
I want to concentrate tonight on what an audit really means. If you rely on
financial statements for any purpose -- such as investing, evaluating a
business you'd like to purchase, or sizing up a joint venture partner -- you
need to understand what an audit does and does not tell you.
WHAT DO AUDITORS ACTUALLY LOOK AT?
Many people think an audit involves looking at every transaction a company
enters into during the year. For a company of any size at all, this is
literally impossible. Auditors use statistical sampling to review a portion
of the transactions in a given year to provide comfort that particular
accounts are properly stated. For many accounts, a particular audit "scope"
is set whereby the auditors will only look at transactions that exceed a
specific dollar level. For a company the size of Enron, that scope will be
very high, say $100,000 to $1,000,000 depending on the account and how much
risk is involved with that particular type of account.
There are two concepts in that last sentence that highlight two major areas
of risk in any audit:
1. If the auditors use the same or similar scopes each year for the audit, a
company official who desires to process misleading transactions can do so
through a series of transactions that each individually fall below the audit
scope. Yes, auditors do some random testing of transactions that are below
scope to attempt to catch this type of activity, but it is not likely that
2. The auditors set the scope on various accounts based on THEIR assessment
of the inherent risk related to that account. This is a judgment call. There
is no science involved. If the auditor's judgment is faulty, the entire
audit can be rendered meaningless.
THOSE IRRITATING GRAY AREAS!
The entire audit process, which in Enron's case cost millions of dollars in
professional time each year, culminates in a simple, standardized two or
three paragraph report. This report states that the company's financial
1. Fairly present the company's financial position in accordance with
Generally Accepted Accounting Principles,
2. Do NOT fairly present the company's financial position in accordance with
3. Fairly present "except for" certain transactions which are then briefly
Again, whether or not the financial statements fairly present the financial
position of the company is a judgment call BECAUSE there are so many
judgment calls required during the detail portions of the audit. That's
where the gray areas come in. Just as the application of tax laws is rarely
black and white, the application of accounting principles is also subject to
As an example, most larger companies maintain a LOT of reserve accounts. A
reserve account is set up to book an estimated liability where the company
knows there will be a liability of some magnitude, but the amount of the
liability is not known.
Let's say the company sells products under warranty. Under Generally
Accepted Accounting Principles, the company is required to record a
liability for warranty services it must provide free of charge in the
future. The company has no way of knowing what the exact amounts will be, so
the amounts must be estimated based on historical warranty claims and sales
It can be difficult to "certify" that these reserves are adequate,
particularly since the auditor does not know the business as well as the
company does. A company with hundreds of different reserve accounts can
overstate its income very easily if these reserves are understated by just a
few percentage points.
Of course, there are hundreds of other areas where material misstatements of
income can occur, but we do not have the time or space to go into more in
SO HOW CAN YOU TRUST ANY AUDIT?
The key to properly analyzing audited financial statements is to know where
the "risk areas" are with any particular industry. If you understand the
risks in an industry and understand the effect they might have on the
company you are reviewing, you will see the financial statements in a whole
Under current auditing and reporting standards, YOU have the responsibility
to learn what to look out for or to hire another accountant to interpret for
you. Having your own accountant do this for you is a very good idea. But
there is something else that should be done and this is where the
"editorial" piece of this article comes in.
In addition to the audit report, the auditors usually prepare a "management
letter" that covers areas of concern raised during the audit. This document
is not available to the general public, so the auditors tend to bring up
every single major risk area they have identified and provide management
with recommendations for minimizing the risk and improving controls. These
documents, or something very similar, should be required to be issued
publicly with every audit opinion issued. Management will take these
recommendations much more seriously if they know the public is watching.
Accounting firms, securities firms and corporate executives are going to be
lobbying feverishly for as little change from the status quo as possible.
This is unfortunate. If investor confidence is to be rebuilt, massive
changes must occur and now is the time to commit to them.
I do not know how many of you ever get worked up enough to write to your
Congressman, but if you do, this is a good issue to write about. It is
important and it affects us all. If you are so inclined, write and tell your
Congressman to keep the pressure on for meaningful change. If you need
assistance crafting your letter, let us know and we'll be glad to help.
Copyright (c) 2002
(For those new subscribers who might not have read the previous issue that
discussed Andersen and Enron, Cary started and spent the first eleven years
of his career as a tax and systems consultant with Andersen).