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What does an audit report contain?

Most audit reports on financial statements give the business a clean bill of health, or a clean opinion. At the other end of the spectrum, the auditor may state that the financial statements are misleading and should not be relied upon. This negative audit report is called an adverse opinion. That’s the big stick that auditors carry.

Auditors have the power to give an adverse opinion and no business wants that. The threat of an adverse opinion almost always motivates a business to give way to the auditor and change its accounting or disclosure practices in order to avoid getting the kiss of death of an adverse opinion.

An adverse audit opinion says that the financial statements of the business are misleading. The SEC does not tolerate adverse opinions by auditors of public businesses; it would suspend trading in a company’s stock share if the company received an adverse opinion from its CPA auditor.

One modification to an auditor’s report is very serious – when the CPA firm says that it has substantial doubts about the capability of the business to continue as a going concern. A going concern is a business that has sufficient financial wherewithal and momentum to continue its normal operations into the foreseeable future and would be able to absorb a bad turn of events without having to default on its liabilities.

A going concern does not face an imminent financial crisis or any pressing financial emergency. A business could be under some financial distress but overall still be judged a going concern. Unless there is evidence to the contrary, the CPA auditor assumes that the business is a going concern. If an auditor has serious concerns about whether the business is a going concern, these doubts are spelled out in the auditor’s report.

Is there any wonder as to why business owners petrified by the dreaded audit? Both SEC and IRS are vested with tremendous power over your public or private business; and a report or ruling by one or the other is enough to render any business – that is the subject of one of their audits – non-existent, if that business fails to conform with certain acceptable accounting principles.


Taking a Look at the Income Statement – Part Three


While some lines of an income statement depend on estimates or forecasts, the interest expense line is a basic equation. When accounting for income tax expense, however, a business can use different accounting methods for some of its expenses than those which it uses for calculating its taxable income. The hypothetical amount of taxable income, if the accounting methods used were used in the tax return is calculated.

Then the income tax based on this hypothetical taxable income is figured. This is the income tax expense reported in the income statement. This amount is reconciled with the actual amount of income tax owed based on the accounting methods used for income tax purposes.

A reconciliation of the two different income tax figures is then provided in a footnote on the income statement. Under the same scenario, net income is like earnings before interest and tax (EBIT) and can vary considerably depending on which accounting methods are used to report sales revenue and expenses. This is where profit smoothing can come into play to manipulate earnings.

Profit smoothing crosses the line from choosing acceptable accounting methods from the list of GAAP and implementing these methods in a reasonable manner, into the gray area of earnings management that involves accounting manipulation. It’s incumbent on managers and business owners to be involved in the decisions about which accounting methods are used to measure profit and how those methods are actually implemented.

A manager can be requires to answer questions about the company’s financial reports on many occasions. It’s therefore critical that any officer or manager in a company be thoroughly familiar with how the company’s financial statements are prepared. Accounting methods and how they’re implemented vary from business to business. A company’s methods can fall anywhere on a continuum that’s either left or right of center of GAAP.