The Auditor’s Opinion

Audited financial statements are a cornerstone of the financial markets. They are used to assist in raising money or obtaining loans. Without some form of independent assurance, capital acquisition would be delayed, made more cumbersome, and there would be added due diligence costs.

Tonight I will conduct my second Auditing class session of this semester at Fairleigh Dickinson University, and I will be teaching what the auditor’s opinion means and what auditors do to arrive at their opinion. By way of illustration, you can pick any Company’s annual report and follow along with its Auditor’s Report. That is what my students will be doing, each using a different company’s report.

All publicly owned companies must have audited financial statements that contain a report of the registered independent accounting firm performing the audit. Privately owned company audits also need to contain an auditor’s report, but except for the references to PCAOB and some other descriptions, it is not substantially different [the differences will not be covered here].

The Report of the independent registered public accounting firm provides their opinion that the financial statements were in conformity with U.S. generally accepted accounting principles [GAAP], that the company maintained effective internal controls, that the audits were conducted in accordance with standards of the U.S. Public Company Accounting Oversight Board [PCAOB] and some other things and that their audits provided a reasonable basis for their opinion; and that the internal control may not prevent or detect fraud.

The independent registered public accounting firm’s report is the only thing the firm does. It does not prepare the report, write the notes or any other work except what the report says it did. Note that the financial statements have the report as one of its seven elements, and besides being an integral part of the statements, it creates the validity of the statements based on what is said in the auditor’s report. All auditor’s reports are substantially similar in wording. Following are some descriptions of the audit report.

Accounting firm: Only registered accounting firms can perform an audit of a publicly owned company. They must be registered with the PCAOB. Certified public accountants can also audit nonpublic companies and other entities and do not need to be specially registered. However, all firms must have their quality control practices reviewed either by the PCAOB, or a state oversight authorized peer reviewer, as the case may be.

Independence: All auditors must be independent. There are strict rules to ensure this, and violations are treated seriously by the PCAOB or the state oversight committee. “Independent” means the firm, its partners, and certain family members can have no investment, creditor, management or other involvement in the company being audited. The independence requirements are provided by federal securities laws and applicable rules and regulations of the SEC and the PCAOB.

What the auditor did: They audited the Company’s statements that are specifically mentioned. Their responsibility was to express an opinion on the financial statements based on their audits. Besides auditing the financial statements, they also audit the system of internal controls over the financial reporting.

Expressing their opinion: The auditor provides their opinion similar to the following brief excerpt:

In our opinion, the consolidated financial statements [which are listed] present fairly, in all material respects, the financial position of the Company as of December 31, 2022, and 2021, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2022, in conformity with accounting principles generally accepted in the United States of America. 

The opinion is not based on anything else that wasn’t required under the criteria they followed. There are other methods of financial reporting, but only the one that they followed is what the opinion is based on. A common method for smaller nonpublic companies is the tax basis which follows the tax rules rather than GAAP. When reviewing a financial statement, always determine the basis of reporting before starting.

Internal control: There is a second opinion about the internal control over financial reporting and under what criteria they issued that opinion. So, the auditor tells what they did and that their opinion is based on what they did. The opinion is not based on anything other than what these criteria require. Here is a brief excerpt:

Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control – Integrated Framework (2013) issued by the COSO.

Basis for opinion: The reports point out that the financial statements, maintenance of internal controls, and assessment of its effectiveness are the responsibility of the Company’s management. Excerpt:

The Company’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting.

Accountant’s responsibility: They tell the reader what they are responsible for based on what they did, i.e., their audits.

Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company’s internal control over financial reporting based on our audits.

Affirmation of independence: They state they are required to be independent, and here is how it is usually written:

We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

Audit standards they followed: The accountant followed the audit standards of the PCAOB what those standards require.

We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.

How the audit was done: This is the big picture description of what they did. They did not perform any procedures to determine exactness. The amounts referred to were the numbers that appeared in the financial statements. The disclosures refer mainly to the notes to financial statements, which is the more voluminous part of the seven elements. The “disclosures” refer not only to the accounting principles used but the choices within them and how they were applied. For example, business equipment is not deducted when acquired but is deducted over a period of time, and this process is called depreciation. Within the depreciation “principle” are different methods and choices companies can adopt, and they can adopt different methods for different classes of equipment.

Our audits of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements.

They also evaluated the accounting principles used, significant estimates made by the Company’s management, as well as the overall presentation of the financial statements. Most of the numbers on the financial statement are estimates. I know it is shocking to find out that estimates are used and not exact numbers. One example is the accounts receivable balance, which is comprised of amounts customers owe for products or services they purchased. Well, accounting principles require an estimate to be made of a portion of the accounts receivable that would not be collected. No one knows what this will be, and only time will reveal the exact amount, but an estimate needs to be made as of the balance sheet date of what won’t be collected, and that estimate is treated as an expense and a reduction of the accounts receivable amounts reflected on the balance sheet. One might suggest that there is a scientific method of determining this estimate, but in reality, it is an educated guess after calculations are made to document how the estimate was determined. Further, in most situations, these estimates are not material, so they do not garner much attention. If there is a major egregious error, i.e., one that should have been foreseen or understood to be likely to occur, then there might be a problem with the financial report causing harm to an investor or other person relying on it, but these do not happen too often…hopefully. Also, “significant estimates” sounds like a subjective evaluation. What is significant to one person might not be significant to another.

Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements.

Here is what the auditor did with respect to the internal control.

Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.

Other procedures by the auditor: Our audits also included performing such other procedures as we considered necessary in the circumstances.

Purpose of what accountants do: The accounting firm’s opinion is not a definitive opinion, but one where they have a reasonable basis for the opinion based on what they say they did by following the rules they say they followed.

We believe that our audits provide a reasonable basis for our opinions.

Quid est internal control: The auditor defines and describes internal controls over financial reporting and its limitations in its report. Read the following carefully. It is important and provides the context of what was done.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i)pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii)provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii)provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any effectiveness evaluation to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.

Signature: The firm signs the report, names the firm’s office, date of report and the year they started as the Company’s auditors.

Almost all reports have the above wording. Some combine the Internal Control report with the Audit report, but that is a matter of style, and the proper wording is in those reports.

My students will learn this tonight in greater detail, but the above should serve as a good indication of those two important reports. Note that the accountant’s report is subject to periodic changes, so the above is meant to provide an overview and not the exact wording.

There are other uses of audited reports, and I have these described in a previous blog.

Enjoy!