Tracy John A. Accounting for Dummies

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Chapter 15

Audits and Accounting Fraud

In This Chapter

 Trying to prevent misleading financial reports

 Interpreting the auditor’s report

 Dealing with managers who massage the numbers

 Coping with fraud (if you can find it)

 Auditing the auditors

uppose you’re one of the external shareowners of a business or one of its

lenders. You depend on its financial reports for the information you need

about your stake in the business. How can you be sure that its accounting

methods conform with established standards? How do you know whether the

business makes adequate disclosure in its financial reports? Is the business

playing by the rules in measuring its profit and in releasing financial informa-

tion? You trust the managers, or you wouldn’t have put your money in the

business. But you still have these nagging questions. Well, in business, as in

politics, the answer is: Trust, but verify.

Many businesses hire an independent CPA (certified public accountant) to

audit their financial reports. An audit provides assurance that the financial

report of the business is correct and not misleading. The CPA examines the

evidence and renders a report. The auditor’s report says that the business

uses proper accounting methods and its financial report provides adequate

disclosure. Or not. Things get messy when the auditor finds fault with the

accounting or financial disclosure of the business. But it’s better to be

warned than to continue on your merry way and be unaware of the deficien-

cies in the business’s financial report.

A financial report can be wrong and misleading because of innocent, uninten-

tional errors, or because of deliberate cold-blooded fraud. Errors can happen

because of incompetence and carelessness. Fraud happens when the company’s

accountants and managers are crooks. The CPA auditor should definitely catch

all significant errors. The auditor’s responsibility for discovering fraud is not as

clear-cut. You may think catching fraud is the purpose of an audit, but I’m sorry

to tell you it’s not as simple as that.

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Exploring the Need for Audits

One reason for audits — especially for smaller private companies that do not

employ professionally qualified accountants — is to have a second set of

eyes look over the business’s accounting methods and financial reports. The

investors and lenders of a business are more comfortable having an audit.

Indeed, they may demand an annual audit as a condition of putting their money

in the business. After all, there’s the possibility that not everything is on the

up-and-up in the business and in its financial report.

I hope I’m not the first person to point this out to you, but the business world

is not like Sunday school. Not everything is pure and straight. A business could

deliberately deceive its investors and lenders with false or misleading numbers

in its financial report. That’s where audits come in. Audits are one means of

keeping misleading financial reporting to a minimum.

In a sense, CPA auditors are like highway patrol officers who enforce traffic

laws and issue tickets to keep speeding to a minimum. Or, if you prefer another

analogy, a business having an independent accounting professional come in

once a year to check up on its accounting is like a person getting a physical

exam once a year. The audit exam may uncover problems that the business

was not aware of, and knowing that the auditors come in once a year to take a

close look at things keeps the business on its toes.

After completing an audit examination, the CPA prepares a short report stat-

ing whether the business has prepared its financial report according to the

appropriate U.S. or international accounting and reporting standards (which I

explain in Chapter 2). In this way, audits are an effective means of enforcing

accounting standards. The auditors hold the feet of managers to the fire, or

at least that’s how it should work.

Businesses whose ownership and debt securities (stock shares and bonds)

are traded in public markets in the United States are required to have annual

audits by an independent CPA firm. (The federal securities laws of 1933 and

1934 require audits.) For a publicly traded company, the cost of an annual

audit is the price the company pays for going into public markets for its capi-

tal and for having its securities traded in a public marketplace — which pro-

vides liquidity for its securities, of course.

Although federal law doesn’t require audits for private businesses, banks and

other lenders to private businesses may insist on audited financial statements.

If lenders don’t require audited statements, a business’s shareowners have to

decide whether an audit is a good investment. Of course, audits aren’t cheap.

It’s hard to do an audit of even a small business in less than 100 hours. At $100

per hour (which is probably too low an estimate), the audit fee would be

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$10,000. Owners and investors in a private business should balance the cost

of an audit (which they bear) against the benefit of getting more reliable

financial statements from the business.

Instead of a full-fledged audit, which they can’t realistically afford, many smaller

businesses have a CPA come in regularly to look over their accounting methods

and give advice on their financial reporting. Unless a CPA has done a complete

audit, she has to be very careful not to express an opinion of the company’s

financial statements. Without a careful examination of the evidence supporting

the amounts reported in the financial statements, the CPA is in no position to

give an opinion on the financial statements prepared from the accounts of the

business.

What’s in an Auditor’s Report

The large majority of financial statement audit reports give the business a clean

bill of health, or what’s called a clean opinion. (The technical term for this opin-

ion is an unqualified opinion, which means that the auditor does not qualify or

restrict his opinion regarding any significant matter.) At the other end of the

spectrum, the auditor may state that the financial statements are misleading

and should not be relied upon. This negative, disapproving audit report is called

an adverse opinion. That’s the big stick that auditors carry: They have the

power to give a company’s financial statements an adverse opinion, and no

business wants that.

The threat of an adverse opinion almost always motivates a business to give

way to the auditor and change its accounting or disclosure in order to avoid

getting the kiss of death of an adverse opinion. An adverse audit opinion says

that the financial statements of the business are misleading. The Securities and

Exchange Commission (SEC) does not tolerate adverse opinions by auditors of

public businesses; it would suspend trading in a company’s securities if the

company received an adverse opinion from its CPA auditor.

The clean (unqualified) opinion

If the auditor finds no serious problems, the CPA firm gives the business’s

financial statements an unqualified or clean opinion. However, I should warn

you that the standard audit report has enough defensive, legalistic language

to make even a seasoned accountant blush. If you have any doubts, go to the

Web site of any public corporation and look at its most recent financial state-

ments, in particular the auditor’s report.

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The following summary cuts through the jargon and explains what the audit

report really says:

Standard Audit Report (Unqualified or Clean Opinion)

1st paragraph We did an audit, but the financial statements

are the responsibility of management; we just

express an opinion of them.

2nd paragraph We carried out audit procedures that provide

us a reasonable basis for expressing our opin-

ion, but we don’t necessarily catch everything.

3rd paragraph The company’s financial statements conform

to accounting and financial reporting standards

and are not misleading.

For large public companies (those with over $75 million market cap at the

time of this writing), the auditor’s report must contain a paragraph explaining

that the CPA audited the company’s internal controls over financial reporting,

which expresses an opinion on the effectiveness of these controls. This

extension of the auditor’s report concerning internal controls is the outgrowth

of the financial reporting fraud scandals over the last decade (does Enron ring

a bell?). Top management of the business must also include a statement in the

annual financial report giving their opinion on the company’s financial reporting

internal controls.

Other kinds of audit opinions

An audit report that does not give a clean opinion may look very similar to a

clean-opinion audit report to the untrained eye. Some investors see the name

of a CPA firm next to the financial statements and assume that everything is

okay — after all, if the auditor had seen a problem, the Feds would have pounced

on the business and put everyone in jail, right? Well, not exactly. How do you

know when an auditor’s report may be something other than a straightforward,

no-reservations clean opinion? Look for more language than just the standard three

paragraphs — that’s the key.

Additional language in an audit report is important to look for — it’s never good

news. For example, the auditor’s report may point out a flaw in the company’s

financial statements but not a fatal flaw that would require an adverse opinion.

In this situation, the CPA issues a qualified opinion. The auditor includes a short

explanation of the reasons for the qualification. You don’t see qualified audit

opinions that often, but you should read the auditor’s report to be sure.

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One modification to an auditor’s report is very serious — when the CPA

expresses substantial doubts about the capability of the business to continue as

a going concern. A going concern is a business that has sufficient financial where-

withal and momentum to continue its normal operations into the foreseeable

future and would be able to absorb a bad turn of events without having to default

on its liabilities. A going concern does not face an imminent financial crisis or

any pressing financial emergency. A business could be under some financial

distress but overall still be judged a going concern. Unless there is evidence to

the contrary, the CPA auditor assumes that the business is a going concern.

But in some cases, the auditor may see unmistakable signs that a business is in

deep financial waters and may not be able to convince its creditors and lenders

to give it time to work itself out of its present financial difficulties. The creditors

and lenders may force the business into involuntary bankruptcy, or the business

may make a preemptive move and take itself into voluntary bankruptcy. The

equity owners (stockholders of a corporation) may end up holding an empty bag

after the bankruptcy proceedings have concluded. (This is one of the risks that

stockholders take.) If an auditor has serious concerns about whether the busi-

ness is a going concern, these doubts are spelled out in the auditor’s report.

Who’s Who in the World of Audits

Some CPAs operate as sole practitioners, but many CPAs form partnerships

(also called firms). A CPA firm has to be large enough to assign enough staff

auditors to a client so that all audit work can be completed in a relatively short

period — financial reports are generally released about four to six weeks after

the close of the fiscal year. Large businesses need large CPA firms, and very

large global business organizations need very large international CPA firms.

The public accounting profession consists of four very large international

firms; several good-sized second-tier national firms; and many regional firms,

small local firms, and sole practitioners.

The Big Four international CPA firms are household names in the business world:

 Ernst & Young

 PricewaterhouseCoopers (all one word with the C capitalized — the

result of the merger of two firms)

 Deloitte Touche Tohmatsu

 KPMG (the PM in the name derives from an earlier time when Peat

Marwick was part of the firm’s name)

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These four firms and other large CPA partnerships are legally organized as

limited liability partnerships, and you see LLP after their names. The Big Four

audit the large majority of the public corporations in the United States. The

Big Four are international in scope and employ a large number of people. For

example, Ernst & Young has about 130,000 employees worldwide. In contrast,

browse through the CPA section in the business listings of your local phone

book; you’ll find many sole practitioners and small CPA firms.

Many CPAs do not do auditing. In fact, they wouldn’t touch auditing with a

ten-foot pole. They provide income tax, financial advising, and business con-

sulting services — and they make a handsome income doing so. They avoid

auditing for several reasons. Perhaps the most important reason is the risk of

being sued for failing to discover fraud in financial statements on which the

CPA expressed a clean opinion. Auditors have a lot of trouble discovering

fraud, which I discuss in the later section “Discovering Fraud, or Not.”

Another reason many CPAs shy away from auditing is that businesses don’t

want to pay for the cost of a good audit; they want to buy an audit opinion on

the cheap. Generally, auditing is not as lucrative as income tax, advising, and

consulting services. Also, auditing is much more regulated as compared with

income tax and consulting. All in all, it’s a quieter life for CPAs without audit-

ing. Auditing is a high risk and high stress activity, but not a particularly high

income activity. Nevertheless, some small CPA firms do audits. Most mid-size

and larger regional CPA firms do audits; auditing is a sizeable part of their rev-

enue. Auditing is the mainstay of the Big Four and other national CPA firms.

Standing Firm When Companies

Massage the Numbers, or Not

I majored in accounting in college and, upon graduation, went to work for one

of the national CPA firms. I took great pride in my profession. I went on to get

my Ph.D. in accounting, and I taught at the University of California in Berkeley

and at the University of Colorado in Boulder for 40 years before retiring. I regu-

larly taught the auditing course, which introduces students to the audits of

financial statements by independent CPAs.

I always stressed that an auditor is duty-bound to exercise professional

skepticism. The auditor should have a mindset that challenges the accounting

methods and reporting practices of the client in order to make sure that its

financial statements conform with accounting standards and are not mislead-

ing. A good auditor should be tough on the accounting methods of the client.

An auditor should never be a weak, look-the-other-way, let’s-go-along-with-

management reviewer of a business’s accounting methods and financial

reporting practices. An auditor should be as mean as a junkyard guard dog —

a true enforcer of accounting and financial reporting standards.

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Ideally, a business should select the accounting methods that are best suited

to how it operates and stick with those methods over time; its managers should

never intervene in the accounting process. Well, it doesn’t always work this way.

I explain in Chapter 12 that business managers don’t always remain on the side-

lines regarding the accounting in their business. Sometimes managers, working

in cahoots with the controller, intervene and manipulate the timing for recording

sales revenue and expenses (and gains and losses in some situations). In these

situations, management overrides normal accounting procedures.

In many audits the CPA becomes aware of heavy-handed accounting manipu-

lation (also called massaging the numbers) for purposes such as smoothing

year-to-year profit, boosting profit for the year, or making the business appear

more solvent than it really is. Generally, managers have some ground to stand

on; there is some rationale for their accounting machinations. But both the

managers and the CPA auditor know what’s going on: The financial statements

are being tweaked.

What’s an auditor to do? The auditor is under pressure to go along with man-

agement, even though he may strongly disagree with the accounting manipu-

lations. He knows that better accounting should be used or that disclosure

should be more adequate. Too often, instead of holding his ground, the CPA

capitulates and does not force management to change. He allows the financial

statements to be manipulated. This is a harsh comment, and I don’t make it

lightly. If you could get frank answers from practicing CPA auditors on this

issue, you’d find that most agree with me.

Here’s my take on the situation: CPA auditors go along with management mas-

saging of the numbers (and “massaging” disclosure) if they think that the

financial statements are not seriously misleading. The CPA’s rationale is this:

Yes, the financial statements could be more correct and could provide better

disclosure, but all in all the financial statements are not seriously misleading.

I must acknowledge that in many situations CPA auditors do stand their

ground: They persuade the business not to manipulate its accounting num-

bers and to provide better disclosure. However, the CPA cannot brag about

this in the audit report, saying “We talked management out of manipulating

the accounting numbers.” CPA auditors deserve a lot of credit for working

behind the scenes to enforce accounting and financial reporting standards.

At the same time, many auditors could — and should — be tougher.

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Discovering Fraud, or Not

Massaging the numbers is one thing. Accounting and financial reporting fraud,

also called cooking the books, is another thing altogether. Accounting fraud

refers to such schemes as recording sales revenue for products and services

that have not been sold, not recording expenses that have been incurred,

recording gains that have not and probably will not be realized, and not recording

losses that have been sustained. Financial reporting fraud encompasses

accounting fraud; it also includes failing to disclose negative matters that

should be disclosed in a financial report or making deliberately misleading

disclosures in a financial report.

The track record of CPA auditors in discovering accounting and financial

reporting fraud is not very good. The number of well-known companies that

engaged in accounting and financial reporting fraud in recent years that was

not discovered by their CPA auditors is truly staggering. The best known of

these companies was Enron, but hundreds of companies committed account-

ing fraud. Enron is also infamous for the reason that its auditor, Arthur Andersen

& Company, was found guilty of obstruction of justice because its senior staff

persons on the audit destroyed audit evidence. Almost overnight this venerable

CPA firm ceased to exist. Over the years, I had attended several faculty work-

shops held by Arthur Andersen, and I had the highest regard for the firm. Quite

clearly, in the case of the Enron audit, something went seriously wrong.

Auditors have trouble discovering fraud for several reasons. The most impor-

tant reason, in my view, is that those managers who are willing to commit fraud

understand that they must do a good job of concealing it. Managers bent on

fraud are very clever in devising schemes that look legitimate, and they are

very good at generating false evidence to hide the fraud. These managers think

nothing of lying to their auditors. Also, they are aware of the standard audit

procedures used by CPAs and design their fraud schemes to avoid audit

scrutiny as much as possible.

Over the years, the auditing profession has taken somewhat of a wishy-washy

position on the issue of whether auditors are responsible for discovering

accounting and financial reporting fraud. The general public is confused

because CPAs seem to want to have it both ways. CPAs don’t mind giving the

impression to the general public that they catch fraud, or at least catch fraud

in most situations. However, when a CPA firm is sued because it didn’t catch

fraud, the CPA pleads that an audit conducted according to generally

accepted auditing standards does not necessarily discover fraud in all cases.

In the court of public opinion, it is clear that people think that auditors should

discover any material accounting fraud — and, for that matter, auditors should

discover any other material fraud against the business by its managers,

employees, vendors, or customers. CPAs refer to the difference between their

responsibility for fraud detection (as they define it) and the responsibility of

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auditors perceived by the general public as the “expectations gap.” CPAs want

to close the gap — not by taking on more responsibility for fraud detection,

but by lowering the expectations of the public regarding their responsibility.

You’d have to be a lawyer to understand in detail the case law on auditors’

legal liability for fraud detection, and I’m not a lawyer. But, quite clearly, CPAs

are liable for gross negligence in the conduct of an audit. If the judge or jury

concludes that gross negligence was the reason the CPA failed to discover

fraud, the CPA is held liable. (CPA firms have paid millions and millions of dol-

lars in malpractice lawsuit damages.)

In a nutshell, standard audit procedures do not always uncover fraud, except

when the perpetrators of the fraud are particularly inept at covering their

tracks. Using tough-minded forensic audit procedures would put auditors in

adversarial relationships with their clients, and CPA auditors want to main-

tain working relationships with clients that are cooperative and friendly. A

friendly auditor, some would argue, is an oxymoron.

One last point: In many accounting fraud cases that have been reported in

the financial press, the auditor knew about the accounting methods of the

client but did not object to the misleading accounting — you may call this an

audit judgment failure. In these cases, the auditor was overly tolerant of ques-

tionable accounting methods used by the client. Perhaps the auditor may

have had serious objections to the accounting methods, but the client per-

suaded the CPA to go along with the methods. In many respects, the failure to

object to bad accounting is more serious than the failure to discover account-

ing fraud, because it strikes at the integrity and backbone of the auditor.

Who Audits the Auditors?

One result from the plethora of Enron-type accounting fraud scandals was pas-

sage of the 2002 Sarbanes-Oxley Act, which was quickly signed into law by

President George W. Bush. The Act imposed new duties on corporate manage-

ment regarding their responsibilities over internal controls that are designed

to prevent financial reporting fraud. The act also established a new regulatory

board that has broad powers over CPA firms that audit public businesses: the

Public Company Accounting Oversight Board (PCAOB), which is within the

administrative structure of the Securities and Exchange Commission (SEC).

Prior to the passage of this act, the accounting profession policed itself

through entities of the national association of CPAs, the American Institute of

CPAs (AICPA): the Auditing Standards Board, the Ethics Committee, and the

peer review process. These entities are still in place, but now the AICPA has

jurisdiction only over private businesses that are not under the jurisdiction

of the federal securities laws and the SEC. CPA firms that audit both private

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