We’ve received the following question from one of our readers:
- How do you test if a company’s financial reports are accurate? I was wondering for when we verify the accounts, how do we determine that they’re accurate and reliable when we usually don’t go and check it in their stores/outlets. — Anon
- Hi Anon, thanks for your question. It’s certainly a very important topic to discuss, as it is vital for investors to be able to trust the information in a company’s financial report in order to make informed investment decisions. So let’s get started!
While there are many ways to evaluate how reliable or “accurate” an accounting statement is, two common methods are review of internal controls and independent audits says Paul Haarman.
One of the best ways to determine how accurate a company’s financial report is to evaluate the internal controls that are used during the preparation process. The concept behind reviewing these internal controls is that if strong, well-designed and sufficient internal controls exist, then inaccuracies or fraud should be minimized or non-existent. Internal control reviews focus on several areas within a company including: segregation of duties, documentation, authorization, reliance and physical security. Segregation of duties refers to having different people responsible for different tasks. For example, one person should prepare journal entries while another has responsibility for review and approval before they are posted.
Documentation requires that all transactions must be properly document before being enter into an accounting system. Authorization means that anyone preparing or authorizing accounting transactions must be properly train. Reliance refers to documenting who has access to sensitive information in the company’s systems. Finally, physical security means that only authorized people have access to certain keys, passwords and other tools used in data processing systems.
To perform a control review, companies use an “internal control questionnaire”, which is a list of questions design to encourage management to document their internal controls related to preparation of financial statements. The auditors may also ask management some supplementary questions on areas they feel need more clarification or detail during the audit process itself.
You can see an example of such a questionnaire below:
Control Questionnaire (in PDF Format)
An independent audit provides assurance (or guarantees) that a company’s financial statement is an accurate reflection of reality says Paul Haarman. Independent audits are perform by licensed and/or certified public accountants (referred to as CPAs). And they include both the audit of a company’s financial statements as well as other assurance services such as review of internal controls, statutory audits or special investigations related to transactions outside of normal operations. A CPA firm will issue an “unqualified opinion” on a company’s financial report if it believes the statements fairly represent what is actually occurring in the business.
If the CPA determines that certain aspects of a company’s financial statements are incorrect or misleading. They will indicate this with a phrase called “modified opinion”. Which includes a description of their findings along with recommended course corrections for future periods. A CPA may also issue a “disclaimer” of opinion. Which means they were not able to complete their review for some reason. Disclaimers of opinions are usually issue if the company refuses to provide sufficient access or materials. That would allow the auditor to complete their job.
Independent audits exist as both mandatory and voluntary services. They are mandatory only when banks will lend money, stock is trade publicly on exchanges. Issuers file periodic reports with the SEC (such as 10-Ks and 10-Qs), or there is litigation involve. When audits become compulsory, it is refer to as statutory audit. And must be perform by a CPA firm register in the U.S., regardless of. Whether the business is domestic or international
After discussing what a financial audit is, we look at the most common types of audits performed by CPAs. And the order in which they are typically perform explains Paul Haarman. We also discussed internal control reviews and how they relate to external auditing. Finally, we provided some basic information about independent audits, including when they are compulsory and voluntary services.