The audit is supposed to be independent, aimed at advising stockholders about the accuracy of financial statements. In practice, you cannot rely on audited statements to objectively point out flaws in corporate financial reporting.
The system is full of problems, however. You cannot rely completely on the audit process nor on the objectivity of the auditing firm. The problem begins with the fact that corporations pay auditing firms to prepare their books. It is made worse by the fact that a substantial portion of the auditing company's revenue is derived from nonaudit work that it performs for the same client. So the incentive is to keep clients happy, and that means it can become a problem if and when disagreements arise over accounting decisions and the way that transactions are reported.
This was precisely what occurred when Arthur Andersen was auditing the books of Enron. There were numerous questionable practices and deceptions in the accounting system, including inaccurate operating results. Enron's books were complex and misleading. Arthur Andersen's Houston office knew of this problem but did not blow the whistle. Why? Enron was a huge client of the company and represented a good source of revenues. The home office of Arthur Andersen had instituted its own procedures requiring senior partners to generate nonauditing revenue that was equal to or higher than audit revenues. So the senior auditors were under pressure to keep clients and to increase revenues, which is not a healthy environment for auditors who are supposed to maintain independence and objectivity.
The problems were not unique to Arthur Andersen. Most of the large auditing firms had settled lawsuits from shareholders over many years, admitted inaccuracies in their statements, and had lived with their own conflicts of interest. The situation has not changed today. Rather than considered the corporate scandals as a sign that the industry needed to fix its conflict problems, the accounting industry has treated the problem as a public relations matter.
A lot of lip service has been paid to compliance with new laws and regulations, but the industry has only found ways to get around the legal attempts to do away with its conflict of interest. What this means for investors is that more caution is required. The fact is that the majority of audited statements are accurate and fair. It is not safe to rely completely on what those statements reveal, however, for several reasons:
1. The accounting rules are so complex that it is possible to create a number of different outcomes and to find justification within the rules.
2. The auditing rules are slow to change because the structure of the industry and its own regulatory system are complex.
3. Even with new laws designed to eliminate auditing firm conflicts of interest, it is too easy for firms to get around the rules. To this day, auditing firms continue performing both audit and nonau-dit work for the same clients.
4. Even with the most reliable financial statements, you need to perform your own fundamental tests. Even with a movement under way to improve corporate transparency, little chance has been seen in the way that corporations report to shareholders. If you are not able or willing to go beyond the statements to perform added research, you should be working with a financial planner or advisor who does know how to perform those tests. (Chapter 4 provides guidelines for navigating corporate websites and finding additional information.)
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