Why you should be very skeptical of that auditor’s report

Welcome to annual report season! This is the yearly tradition dictated by the Securities and Exchange Commission that requires publicly held companies to file their annual 10-K forms anywhere between 60 and 90 days after the calendar year ends. Many banks, investors and other institutions place similar requirements on their clients. These reports include a company’s financial statements, which are audited by an outside accounting firm.

My advice? Be very skeptical of that auditor’s report.

As a CPA, a proud member of this great profession and a former manager at a big accounting firm, I’m not confident in an auditor’s report. Why? Have you read one lately? Like most investors you probably haven’t. But you should.

The industry-standard template provided by American Institute of Certified Public Accountants says that “management is responsible” for the company’s financial information and that the auditor is only giving “reasonable assurance about whether the financial statements are free from material misstatement.” What’s material? What’s significant? This is information not shared.

Those same executives are required to sign a “representation letter” that lays all the burden on them and makes it almost impossible to blame an outside accountant for any problem that may occur. This letter alone, with its heavy reliance on what management says and does, raises questions as to how ineffective today’s audit procedures are.

What about fraud? It’s no better. An audit report “expresses no opinion” on the effectiveness of a company’s internal controls. Translation: we’re not responsible for fraudulent activity.

As investor, these are not exactly comforting words. Basically, the accountant is saying to the world that all the information in the financial statements comes from management and that they’ve made efforts to verify that the financial statements are mostly right. But if the you-know-what hits the fan, their attorneys have plenty of cover (and insurance) for when the litigation starts.

“Over many decades, audits have become a standardized pass/fail test, focusing less on auditors’ judgment and more on checking boxes,” writes CPA Blake Oliver, who also co-hosts a popular accounting podcast. “Here’s the result: audit opinions have become commoditized. Auditors must compete on price, and therefore, salaries have stagnated. Audit quality has declined.”

Most investors don’t understand this. The public perception is that an accountant’s audit opinion gives a stamp of approval on the financial statements and that everything is kosher. But the reality is that the typical audit isn’t what the public perceives. This is not the profession’s fault. This is not bad accounting. It’s just the current rules. And they need to be looked at again. Because this is not a new problem.

“Virtually every audit opinion in the world says almost the same thing, with no details about the company being audited,” the New York Times reported all the way back in 2011. “Auditors are paid millions of dollars to produce a report that no one thinks is worth reading.”

Financial audits involve taking very small, targeted samples of transactional data and verifying them. They require a significant reliance on a company’s financial management team, who are oftentimes graduates of the very firms that are auditing them and know all the ins-and-outs of the process. These people are generally not corrupt. But let’s face it: They know how to play with the numbers without the auditor knowing. (Psst…it’s usually hidden in the inventory.)

During an audit, the lion’s share of critical work on the ground (inventory observations, cut-off testing, analytical reviews, receivables confirmation) is being done by children — yes, children — who are still hung over from their college graduations. I was once that person, and looking back, I am shocked by the responsibility I had, given my lack of experience at the time. The accounting profession’s desperation to find recruits has not only lowered the competence bar but also added more tasks on the shoulders of an already exhausted staff, to the point where reports are being delayed.

The relationships between accounting firms and their clients also raise flags. Partners are judged on their billings and are more motivated to avoid problems rather than look for them and upset a profitable revenue stream. Competition with other firms oftentimes results in fees that force cuts in auditing hours and procedures — and more outsourcing audit work overseas — in order to win the deal. Firms are allowed to sell additional tax and consulting services to their clients, which can challenge their independence. Their “peer reviews” to check on each other’s best practices are mostly a form-filling exercise designed to keep young staffers busy during the off season.

It’s a wonder that more frauds aren’t happening. But I think they are — it’s just that we don’t know about them. Big stock market crashes oftentimes reveal the seedier side of the audit game — the world’s Bernie Madoffs, WorldComs and Enrons. But I’m betting there are countless others that go undetected or unreported with the hopes that the passage of time will see to the problem.

So no, I don’t have much faith in the auditor’s opinion. But I know what would help.

What we need is more transparency. Auditing every transaction doesn’t make sense and is not cost justifiable. But shareholders should know the percentage of transactions tested in a typical audit so we can better understand just how little is being looked at. More details should be disclosed around the “management letters” issued to a company’s executive team that points out potentially significant lapses in internal controls. Perhaps the partner on the job should have their own representation letter — to shareholders.

And on the topic of partners, they and their managers need to cut down on the client lunches and instead get in the trenches. Like our annual continuing professional education requirements, the leaders of accounting firms should be professionally required to do a portion of staff work, like observing inventories, grilling the accounting managers on expenses or even checking bank reconciliations. Why? Because someone my age not only has more experience, they have a much different perspective on these things than a green 22-year-old. The devil’s in the details, people.

Audit fees should be publicly announced and fixed for all companies depending on multiple factors (revenues, transactions, employees, etc.) so the process is more standardized and corners don’t have to be cut. Auditing firms should be disallowed from providing any other service to a client other than their audits. Company management should be held criminally liable for any financial impropriety, regardless of amount. Peer reviews should be periodically done by financial regulators, not just other accounting firms.

Our accounting profession is professional, trustworthy and credible. But it’s time to take another look at how audits are done and how the results are communicated to the investing public. Until the above changes — and others — are made, my advice to shareholders reading the auditor’s report is to do what a good auditor does: trust, but verify.

Gene Marks is financial commentator and founder of the Marks Group, a small-business consulting firm.