Are Audits Required or Just a Good Idea

Corporations whose debt and stock securities are traded on a stock exchange are required by federal securities law to have their annual financial reports audited by an independent CPA firm. At the time of this writing the five large international CPA firms audit more than 12,000 companies in the United States. Beyond these large public companies, relatively few businesses are legally required to have their financial statements audited by independent CPAs.

A recent study by the international CPA firm Coopers & Lybrand (since merged with Price Waterhouse) analyzed federal income tax data and found that there are more than 8.5 million business corporations, partnerships, and limited liability companies, as well as several million sole proprietorships (one-owner business ventures). Not very many of these business entities are required to have audits. Nevertheless, a business may decide to have its financial reports audited even though federal or state securities laws do not apply.

I served on the board of directors (and was a stockholder) of a privately owned bank, and we had CPA audits every year. Lawyers should be consulted regarding state corporation and securities laws; an audit may be required in certain situations. A business may sign a contract or agree informally to have its annual financial reports audited as a condition of borrowing money or when issuing capital stock to new investors in the business.

As just mentioned, public corporations have no choice; they are legally required to have audits of their annual financial reports by independent CPA firms. But, if not required should a business hire a CPA firm to audit its annual financial report? What's the payoff? Basically, an audit adds credibility to the financial report of a business. Audited financial reports have a higher credibility index than unaudited statements.

Audits by CPAs provide insurance against misleading financial statements. Auditors are expert accounting system detectives, and they thoroughly understand accounting principles and financial reporting standards. Being independent of a business, the CPA auditor will not tolerate fraud in the financial report.

Audits don't come cheap. CPAs are professionals who command high fees. A business cannot ask for a "once-over lightly" audit at a cut rate. An audit is an audit. CPAs are bound by generally accepted auditing standards (GAAS)—the authoritative guidelines in doing audits. There is no such thing as a "bargain basement" audit, or a quick-and-dirty audit that only skims over a company's accounting records. Violations of GAAS can result in lawsuits against the CPA and may damage the CPA's professional reputation.

An audit takes a lot of time because the CPA has to examine a great deal of evidence and make many tests of the accounting records of the business before the CPA is able to express an opinion on the company's financial statements. This time requirement causes the relatively high cost of an audit. A business manager, assuming an audit is not legally required, has to ask whether the gain in credibility is worth the cost of an audit.

A bank may insist on audits as a condition of making loans to a business. Or, the outside (nonmanagement) stockholders of a business may insist on annual audits to protect their investments in the business. In these situations the audit fee is a cost of using outside capital. In many situations, however, outside investors and creditors do not insist on audits. Even so, a business may choose to have an audit as a checkup on its accounting system. A business may decide it needs to have a security check—an independent examination focusing on whether the business is vulnerable to fraud and embezzlement schemes.

There is always a chance of embezzlement and fraud by employees or managers who take advantage of their positions—for example, accepting kickbacks or other under-the-table payments from customers and vendors. Employee theft and dishonesty are, unfortunately, rather prevalent. A financial report audit may uncover theft and fraud. However, the detection of fraud is not the main purpose for auditing financial reports, even though many people are under the false impression that this is the primary purpose of an audit. It is not.

CPA auditors are required to plan their audit procedures to search for possible fraud and to identify weak internal controls that would allow fraud to go undetected. This is a side benefit of audits; but the main purpose of an audit is to express an opinion on the fairness of financial statements (including footnotes), and whether the financial statements adhere to generally accepted accounting principles.

Fraud would undermine the integrity of the financial statements, of course, so the CPA auditor has to be on the lookout for fraud of all types (as well as for accounting errors). But the CPA says nothing at all about fraud in the audit report. There is no statement such as "we looked for fraud but didn't find any." What the CPA auditor does say is discussed next.

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