Are Audited Financial Statements of Value Anymore?
Auditors will surely do a lot of head scratching in the coming months as they decide which of their clients’ books are prepared as:
- going concerns
- breakup basis
- going concern but with an expression of doubt as to the firm’s future
I’ve looked at the last audited statement for Bear Stearns and the audit was essentially unqualified and yet Bear Stearns failed. I don’t have time to examine the annual reports for Circuit City, General Motors, Tweeter, Wachovia, Citi, Mervyns and many other firms that have struggled in 2008 but I bet a number of them had audits that were prepared on a going concern basis.
This question is at the heart of some concern as to the role of auditors. Are auditors really taking a close look at all of the forces that are impacting the viability of a firm or are they concerned mostly with the historical financial statements? The latter is acceptable if an accountant is making no judgment call re: the immediate viability of a firm. But, if employees, shareholders and other constituents are relying on auditors to perform a thorough assessment of a firm’s situation, then auditors must do more.
Specifically, auditors should and must opine on the following:
- Audit clients that buy, sell, trade or originate ‘opaque’ financial instruments (e.g., collateralized debt obligations of sub-prime mortgages) are by their nature trying to hide the true nature of the product they are selling. Logically, one cannot render an opinion on the viability of a business that sells opaque products as one cannot understand the risks, liabilities or future obligations these products may manifest.
- Audit clients that utilize off-balance sheet financing or special purpose entities (SPE) are firms that are intentionally hiding material risks from auditors and shareholders. Again, logic would require that these techniques immediately render an audit pointless. A colleague of mine and I were comparing potential stock investment lists when she noticed that she had GE and I didn’t. I told her that GE Capital is a big user of SPEs and that is a red flag for me. I also had concerns that Warren Buffet’s infusion of capital into the company at terms regular investors could not receive was another sign of concern.
- Relationships between audit clients and their banks are highly fluid today but appear to be mending. Retailers are one group that have faced a really tough time getting the capital they need to finance merchandise purchases. Access to working capital is a key determinant in whether many firms can continue to operate. Auditors would be correct to flag highly leveraged firms as doubtful. Firms that are backed by or controlled by private equity and venture capital may also be doubtful if they rely on these deep pockets to fund expansion or operations. Moreover, if these capital backers are prone to sell off the business’ best assets, load up their portfolio firms with debt and/or pay themselves out-sized dividends, performance bonuses or other compensation even when the company isn’t growing, then these firms should be flagged as doubtful concerns.
What investors may need auditors to provide is something other than a set of polished financial statements. We need a clear checklist completed by the auditor that addresses a number of potential viability risks. This checklist could contain items such as:
- the company consistently generates cash in excess of operational needs
- the firm has enough cash on hand to fund operational needs for 12 months
- the firm does not use off balance sheet mechanisms or in the case of equipment leases, these amount to less than 2% of total revenue
- the firm owns the property its operations are based out of
Bottom line: The accounting models Luca Pacioli dreamed up over 500 years ago need updating. The audit industry needs to recognize how antiquated traditional reports are, the chronic need for change and the lack of relevancy their output is in the modern world. To regain relevance, audit firms need to move at the speed of modern business and re-connect with their real core value.