Financial Statements

FRAUDULENT FINANCIAL REPORTING

Fraudulent financial reporting is defined as intentional or reckless reporting, whether by act or by omission, that results in materially misleading financial statements. Fraudulent financial reporting can usually be traced to the existence of conditions in either the internal environment of the firm (e.g., inadequate internal control), or in the external environment (e.g., poor industry or overall business conditions). Excessive pressure on management, such as unrealistic profit or other performance goals, can also lead to fraudulent financial reporting.

The legal requirements for a publicly traded company when it comes to financial reporting are, not surprisingly, much more rigorous than for privately held firms. And they became even more rigorous in 2002 with the passage of the Sarbanes-Oxley Act. This legislation was passed in the wake of the stunning bankruptcy filing in 2001 by Enron, and subsequent revelations about fraudulent accounting practices within the company. Enron was only the first in a string of high-profile bankruptcies. Serious allegations of accounting fraud followed and extended beyond the bankrupt firms to their accounting firms. The legislature acted quickly to fortify financial reporting requirements and stem the decline in confidence that resulted from the wave of bankruptcies. Without confidence in the financial reports of publicly traded firms, no stock exchange can exist for long.

The Sarbanes-Oxley Act is a complex law that imposes heavy reporting requirements on all publicly traded companies. Meeting the requirements of this law has increased the workload of auditing firms. In particular, Section 404 of the Sarbanes-Oxley Act requires that a company's financial statements and annual report include an official write-up by management about the effectiveness of the company's internal controls. This section also requires that outside auditors attest to management's report on internal controls. An external audit is required in order to attest to the management report.

Private companies are not covered by the Sarbanes-Oxley Act. However, analysts suggest that even private firms should be aware of the law as it has influenced accounting practices and business expectations generally.

AUDITING

The preparation and presentation of a company's financial statements are the responsibility of the management of the company. Published financial statements may be audited by an independent certified public accountant. In the case of publicly traded firms, an audit is required by law. For private firms it is not, although banks and other lenders often require such an independent check as a part of lending agreements.

During an audit, the auditor conducts an examination of the accounting system, records, internal controls, and financial statements in accordance with generally accepted auditing standards. The auditor then expresses an opinion concerning the fairness of the financial statements in conformity with generally accepted accounting principles. Four standard opinions are possible:

1. Unqualified opinion—This opinion means that all materials were made available, found to be in order, and met all auditing requirements. This is the most favorable opinion that can be rendered by an external auditor about a company's operations and records. In some cases, a company may receive an unqualified opinion with explanatory language added. Circumstances may require that the auditor add an explanatory paragraph to his or her report. When this is done the opinion is prefaced with the term, "explanatory language added."
2. Qualified opinion—This type of opinion is used for instances in which most of the company's financial materials were in order, with the exception of a certain account or transaction.
3. Adverse opinion—An adverse opinion states that the financial statements do not accurately or completely represent the company's financial position, results of operations, or cash flows in conformity with generally accepted accounting principles. Such an opinion is obviously not good news for the business being audited.
4. Disclaimer of opinion—A disclaimer of opinion states that the auditor does not express an opinion on the financial statements, generally because he or she feels that the company did not present sufficient information. Again, this opinion casts an unfavorable light on the business being audited.

The auditor's standard opinion typically includes the following statements, among others:

The financial statements are the responsibility of the company's management; the audit was conducted according to generally accepted auditing standards; the audit was planned and performed to obtain reasonable assurance that the statements are free of material misstatements, and the audit provided a reasonable basis for an expression of an opinion concerning the fair presentation of the audit. The audit report is then signed by the auditor and a principal of the firm and dated.