A firm’s management is primarily responsible for preparing its financial statements. Yet the financial statements can be viewed as a report on the performance of management. The conflict of interest in this situation is apparent. As a result, the financial statements of all corporations reporting to the SEC must be audited. Audits are required because they enhance the credibility of the financial statements. The financial statements of many privately held businesses are also subject to an audit. Banks, for example, require many loan applicants to submit audited financial statements so that lending decisions can be based on credible financial information.
One of the most important auditing relationships, which are depicted in Figure, is the role of the independent certified public accountant (CPA) who conducts the audit. CPAs are licensed by the individual states by meeting specified educational and experience requirements and passing the uniform CPA exam, which takes two days to complete. CPAs are also required to attend continuing professional education classes and participate in a peer review process, whereby one CPA firm reviews and critiquesthe work of another firm.
The wording has been carefully chosen by the accounting profession to communicate precisely what an audit does and does not do. The first paragraph identifies the company, the specific financial statements that were audited, and the years of the audit. Management’s responsibility for the financial statements is also acknowledged.
The second paragraph states that the audit has been conducted in accordance with generally accepted auditing standards (GAAS). These standards have been developed by the accounting profession to provide guidance in the performance of an audit, which consists of an examination of evidence supporting the financial statements. Because audits are costly, auditors cannot retrace the accounting for every transaction. Accordingly, only a sample of a corporation’s many transactions are reviewed. Based on the results of these tests, the auditor draws an inference about the fairness of the financial statements.
The second paragraph also notes that audits provide reasonable (not absolute) assurance that financial statements are free of material error. The lesser standard of reasonable assurance is employed for two reasons. First, auditors do not examine every transaction and thus they are unable to state conclusions in too strong a fashion. Second, even if auditors were to examine every transaction, collusion between two parties could make the detection of an error virtually impossible.
The third paragraph contains the auditor’s opinion. The opinion reflects the auditor’s professional judgment regarding whether the financial statements are fairly presented in accordance with GAAP. Some readers mistakenly assume that auditors “certify” the financial statements. Auditors do not provide financial statement readers with that level of assurance. Auditors do not guarantee the correctness of the financial statements. Auditors merely express an educated professional judgment based on audit tests conducted according to acceptable professional standards.
An analogy can be drawn to a medical doctor diagnosing a patient. Based on a series of appropriate tests, the doctor develops a diagnosis. In many cases, the doctor cannot be absolutely certain of the diagnosis. This is why, for example, exploratory surgery is sometimes necessary. Doctors do not issue guarantees, and neither do auditors.
The report that appears in Figure is an unqualified opinion, indicating that Arthur Andersen has no reservations about the reasonableness of Merck’s financial statements. However, a variety of concerns may arise that would cause the auditor to qualify the opinion or to include additional explanatory material. We know, for example, that there are several acceptable methods of accounting for inventory. If a company were to change its inventory method from one year to the next, the comparability of the financial statements for those years would be impaired, and financial statement readers would certainly want to be aware of such a situation. Because of this, changes in accounting methods are noted in the auditor’s report.