You are biased, and therefore not to be trusted.
Okay, that was a bit cruel and perhaps not entirely true in your particular case (I hope!). But when talking about a company’s management or officers and financial reporting it is a rule to live by. Hence, the need for annual audits and the resulting audited financial statements and auditor’s opinions.
First, let’s take a step back. As part of running your business, you need to provide financial information to all variety of third parties. That might include your investors, the Board of Directors, potential investors, the tax authority, a bank and so on. Now, you can provide financial statements that you put together yourself, but there is a significant problem: you are biased. You have an interest in the financial statements appearing a certain way. Here are some examples:
- It is good for you if investors and Board of Directors think that you are running the company well. It is less good for you if they see that payroll expenses have jumped 50% in the last six months because you gave yourself a random, massive raise.
- It is good for you if potential investors think that revenues are climbing like a rocket. It is less good for you if those revenues are instead split up between revenues and deferred revenues (a liability—services you will have to provide later even though you got the money now).
- It is good for you if you are showing the tax authority very low net income so your taxes will be lower. It is less good for you if you have a healthy net income—taxes galore!
- It is good for you if the bank sees that you have solid balances of cash and receivables (amounts owed to you) in relation to your liabilities (amounts you owe). It is less good for you if half of that cash balance is listed as “restricted”, because it is already serving as security for a loan at another bank, or if your receivables are reduced by 20% because a lot of them are probably not collectible.
In short, you have a vested interest in things appearing a certain way. Because of that interest, you might be tempted to class payroll expenses as office costs, to record deferred revenues as revenues, to inflate your expenses or to ignore the fact that some of your cash is locked up as security for debt or some of your invoices aren’t collectible.
Or, in other words, honestly, you just cannot be trusted.
This is where “audited financial statements” come in. Audited financial statements are financial statements which have been carefully checked or “audited”, by an independent auditor (see more on this below). In addition to checking out the numbers themselves, the auditor will also make sure that everything is classed properly and in accordance with the local rules. The auditor will also get an understanding of the overall state of the company and generally check out the company’s processes—the better the processes, the less likely it is that someone recorded something fraudulently or in error. The goal of all of this is to ensure that the financial statements that the auditor signs off on are fair and not misleading.
Now, the matter of an “independent” auditor? You could use John from accounting to do the audit, but he has the same problem that you do: he has a vested interest in the results. That is why the person doing the audit has to be independent. Independent means that, the auditor has no interest in how the audit comes out. They just don’t care. Whatever comes out, good or bad, they are going to report. They do not work for the company. They do not manage the company. They are going to call it as they see it because, hey, it’s your funeral, not theirs. In addition, the auditor needs to be a certified public accountant or an accountant with official professional certification where you are (e.g. in the UK and Canada, that would be a chartered accountant).
On the completion of the audit, the auditor performing the audit (often a firm though it can be a lone accountant) will write and sign off on a report called an audit opinion. This report is included with the financial statements. The report covers (1) what the auditor was asked to do (2) how they did it and (3) what they found and what their opinion is, together with a collection of disclaimers (we are independent, if there are errors, don’t even look at us, blame management).
If the auditor believes that the financial statements are reasonably correct and fair, they will issue an “unqualified” (clean) opinion. If that is not the case, they will give a “qualified” opinion, together with a description of why they aren’t giving a clean opinion (“management are a bunch of lying crooks”).