Auditor's Report - Explained
What is an Auditor's Report?
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Table of ContentsWhat is an Auditor's Report?How is an Auditor's Reports Used?Objective of an Audit Reporting Types of Auditors Opinion Unqualified/Clean OpinionQualified OpinionAdverse Opinion Disclaimer OpinionImportance of the Auditors Report Limitation of an Auditors ReportAcademic Research for Auditors Report
What is an Auditor's Report?
An auditors report refers to a written letter by an auditor/accountant after conducting an accounting audit process that opines whether a company's financial statements as presented comply with the generally accepted accounting principles (GAAP). Generally, an auditors report will be part of a company's annual report (Form 10-K) primarily to express a non-binding opinion on the company's financial position to stakeholders.
How is an Auditor's Reports Used?
An auditor is an accountant who is authorized to review and verify whether a company's financial records are fair and accurate representations of transactions within a given period. Financial records refers to all the original documentation and books including records of assets and liabilities, monetary transactions, ledgers, journals, checks and invoices involved in the preparation of financial statements. Financial statements prepared from a company's financial records include the balance sheet, income statement, the statement of changes in equity and cash flow statement. Therefore, an auditor will examine and evaluate a company's financial records and resulting financial statements using a set of systematic guidelines termed the generally accepted auditing standards (GAAS). The process is what is referred to as auditing. In a nutshell, an auditors report is the report resulting from auditors conducting an audit following GAAS guidelines created by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Also, importantly, after checking whether the financial statements as presented comply with GAAP guidelines which are the reporting standards for American companies recognized by the Securities and Exchange Commission (SEC). GAAP is issued by the Financial Accounting Standards Board (FASB). An auditors report was not always a statutory requirement for public listed companies in the United States. However, following the boiler room operation of the 1920s and subsequently the stock market crash of 1929 there was a need to safeguard investors. It prompted the enacted of the U.S. securities laws, that is, the Securities Act of 1933 and the Securities Exchange Act of 1934 which require companies to publish an annual report that provide public disclosure of a company's audited financial statements. Despite, the attempt to safeguard investors by enacted of the U.S. securities laws another scandal rocked the securities market in 2002; a corporate accounting scandal. It seemed public disclosure did not deter internal corruption and company's management cleverly connived with auditors to provide fraudulent financial statements. Many companies collapsed including Tyco International, Adelphia, Enron, Peregrine Systems, and WorldCom among others costing investors billions of dollars. Consequently, Senator Paul Sarbanes and House Representative Michael G. Oxley sponsored a bill which came to be known as the Sarbanes-Oxley Act that was signed into law on July 29, 2002.The Act set out strict standards for financial reporting by public companies, and extended criminal and civil liability to the management, boards of directors, and public accounting firms tasked with auditing for failure to comply with the stipulated regulations. Additionally, the act requires additional public disclosure of a company's internal control mechanism. Therefore, from the foregoing, it should be understood that currently an auditors report opines on two issues; the financial statements presented and the internal control mechanism of a company following an integrated audit. The auditor's report is modified to include all necessary disclosures by either presenting the internal control mechanism report subsequent to the financial statements report, or simply combining both reports into one auditor's report.
Objective of an Audit Reporting
Both the U.S. securities laws as well as the Sarbanes-Oxley Act have made it a statutory requirement for publicly listed companies to have external auditors conduct an audit and disclose their findings publicly in the auditors report. The auditors objective prior to presenting a report includes the following;
- To examine the company's internal check measures in place.
- To verify the arithmetic computation and balancing of books of accounts and supporting documents.
- Verifying the authenticity and validity of transactions posted for the past twelve months
- Verify whether there is a proper distinction between capital and revenue nature of transactions.
- Determine the true value of existing asset as well as stated liabilities.
- Verifying whether all the accounting statutory requirements are fulfilled by the company's in-house accounts/finance department.
- Ensure that there is truth and fairness in the operating results presented by income statement as well as the financial position presented by balance sheet.
- Detection and prevention of errors of principle, omission, commission as well as executive Compensation errors.
- Detection and prevention of frauds such as misappropriation of cash and company's goods, manipulation of accounts or falsification of accounts without any misappropriation, and under or over valuation of stock.
- External auditors usually collaborate with government agencies to provide information to the tax authority.
It is after all the above objectives have been achieved, and then can the auditor express a reasonable opinion on the financial status of the company. The type of opinion given will therefore be influenced by each of the item listed above.
Types of Auditors Opinion
A standard auditors report has got three parts or paragraphs. The auditors opinion is stated in the third paragraph. The first/ introductory paragraph states the work done and the responsibilities of the auditing firm and the audited company management, whereas the second paragraph is the scope; states the set of accounting standard practices referenced to for guidelines. The auditors opinion on a company's internal controls and accounting records can either be unqualified/clean, qualified, adverse, or a disclaimer opinion:
Most Auditors report expresses an unqualified opinion. However, the opinion is not a judgment but rather a non-binding opinion that a company's financial statements are fairly and appropriately presented. Though, regarded also as a clean Opinion, it cannot conclusively be stated to be a clean bill of health on the company's financial integrity but rather a reasonable assurance of compliance regarding the Financial Statements as presented without any notable exceptions. An Unqualified Opinion assumes that the generally accepted accounting principle (GAAP) have been consistently applied in presenting or preparing the financial statements. Also, that the relevant statement as presented by the company's in house accountants or internal auditors are in compliance with relevant statutory and regulatory requirements and an assurance on the internal control mechanism. Additionally, an unqualified opinion indicates that the management provided adequate disclosure of all the original documentation and books relevant to the proper preparation of the financial statements. Finally, it also may means that any deviation from GAAP guidelines and the resulting effects have been properly identified and the same disclosed in the Final Statements.
A qualified opinion is similar to an unqualified opinion, that is, a company's financial statements are fairly and appropriately presented. However, there are notable exceptions in specific area in contrast to an unqualified auditors report. Nevertheless, a qualified opinion bears no binding reflection on the operational efficiency or financial integrity of the company but rather it infers non-compliance regarding the Financial Statements as presented due to notable exceptions. Some of those notable exceptions that may force an auditor to render a qualified opinion include;
- Accounting procedures used by the company do not conform fully to Generally Accepted Accounting Principles (GAAP), that is, there were some notable deviations.
- Probably the financial records as presented by the company's in house accountants or internal auditors are not in full compliance with relevant statutory and regulatory requirements.
- The management did not provide adequate disclosure of all the original documentation and books relevant to the proper preparation of the financial statements therefore limiting the auditors scope.
- Where there were disclosures, some items were irrelevant to the resulting financial statements due to estimation uncertainty and misstatements in a particular account balance or class of transaction.
If the above mentioned exceptions do not have pervasive effect on the companys financial statements then a qualified audit opinion is reported. The format of a qualified report is very similar to the unqualified opinion. Except, an explanatory paragraph is added just after the scope paragraph to explain the reasons for the qualification then followed by the opinion paragraph which now gives the qualification.
This is the complete opposite of an unqualified opinion. The deviation noticed in terms of non-compliance with accounting standards cannot be considered exceptions but rather wrong doing. An adverse opinion is reported, if the financial records as audited are found to be misrepresented, misstated and when considered as a whole does not conform to GAAP and therefore has a pervasive effect on the financial statements presented. An adverse opinion, has literally an adverse effect on a company. It is a red flag to current and potential investors and can cause the company's stock prices to plummet. Although such an opinion is rare for a public listed company due to strict regulations, nevertheless, an occurrence can result in de-listing of a company's stock from the securities exchange. A company with an adverse opinion will most likely have their financial statements rejected by stakeholders be it Investors, lending institutions, or government agencies among others; since they have been reported to be not a fair and true representation of a company's financial position. In such a scenario the audited company will be required to correct the recommendation and obtain another auditor report thereafter. The wording of an adverse report is very similar to the qualified opinion report with an explanatory paragraph added to explain the reasons for the adverse opinion after the scope paragraph but before the opinion paragraph. However, the only deviation is that in the opinion paragraph the auditor categorically states that the financial statements presented are unreliable and pervasively differ from GAAP.
A disclaimer opinion should not be confused to be an actual opinion on the financial records, but rather a disclaimer that no opinion over the financial statements was able to be determined by the auditors. In short, no auditing work was done on the company's financial records as well as internal controls. Consequently, the auditors refused to present an opinion on the company's financial statements as presented. Some of the circumstances that may hinder auditors from carrying on with the auditing process include;
- A lack of independence by the external auditor due to existence of conflict of interest between the auditors and the company in question.
- The company's management has intentionally restricted access to all the original documentation and books relevant to the proper preparation of the financial statements therefore hindering the auditor's work.
- The company is facing significant legal investigations from government agencies as well as ongoing litigation which the outcome is uncertain.
- There is a substantial doubt about the company's ability to continue as a going concern, that is, continue operating into the near future, usually in the next twelve months.
The format for a disclaimer report is significantly modified. Understandably, the scope paragraph is entirely removed since in such a situation the management did not render any cooperation on their part and the audit could not be realized. An explanatory paragraph added to explain the reasons for not issuing an opinion. Finally, in the opinion paragraph, the auditors clearly states that an opinion could not be formed.
Importance of the Auditors Report
An auditors report is used by several stakeholders and provides reasonable assurance of a company's ability to continue as a growing concern among others which may include:
- Provides shareholders with an assurance that the financial statements presented are true and not cooked figures and therefore a basis for further investment into the company.
- Prove the integrity of the company's management to shareholders and relevant government agencies.
- The disclosures of financial information are used by tax authority to confirm as well as verify compliance with all statutory and regulatory requirements by the company.
- The auditors report presents financial information in a simple manner that could be understood by stakeholders with limited financial knowledge to have a basic understanding of the company's activities.
- Can be used by the company to acquire a facility from a financial institution with less strict requirements as the financial institution is assured of a probability of no default by the company.
- Boost confidence level in creditors who gain a sense of assurance that goods and services provided will be paid for comfortably by the company.
- Most importantly audit report requirement is meant to ensure that a company operates free from fraudulent activities and that errors are detection and correction made appropriately.
Limitation of an Auditors Report
- The work of auditors is usually limited by time constraints since they are required to provide an extensive audit within a short time therefore not much due diligence may be given to the books of accounts.
- The scope of the audit may not be comprehensive due to in access to confidential information which the management may not be willing to avail to the auditors due to ethical issues which are of concern by the management.
- Auditors are human being and there is a possibility of audit failure due to lack of independence and unbiased, therefore, resulting in an unqualified opinion whereas in reality the company is insolvent. An example of audit failure is the case of Arthur Andersen giving Enron an unqualified audit opinion prior to filing for bankruptcy.
- External auditors do not have the scope that allows them to trace posting to the source and therefore, inherent risks and fraud risks apparent to the company might not be detected during the audit review process.
- An audit report is a non-binding opinion, meaning it is not the entire truth due to the foregoing limitations and therefore subject to change in case of new material disclosure that may have a pervasive effect on the entire audit process.
- Most companies cannot afford the big four auditing firm to do their audit and may hire other firms with limited resources in terms of qualified personnel and therefore bringing to question the quality of the audit.
- Complexity of businesses and their system could sometime limit auditors from having a complete review on the company's key internal controls. Also, they may not be able to perform the correct risks assessment as a result.