What is an audited financial statement?

An audited financial statement is a financial report that has been examined and verified by an independent certified public accountant (CPA). The purpose of an audit is to provide assurance that a company’s financial statements are free from material misstatements and presented fairly in accordance with generally accepted accounting principles (GAAP). Audited financial statements provide more credibility and reliability for decision makers than unaudited statements.

Why are audited financial statements required?

There are several reasons why audited financial statements are required for certain companies and entities:

Public companies – Publicly traded companies are required by securities regulators like the SEC to have their financial statements audited annually by an independent external auditor. This provides assurance to investors and shareholders that the financial statements can be relied upon.
Private companies – Banks and other lenders often require private companies to provide audited financial statements before they will approve financing. The audit provides assurance that the statements can be used in evaluating the company.
Nonprofit organizations – Nonprofit organizations that receive government grants are typically required to submit audited financial statements. This verifies that the funds are used properly and in compliance with grant requirements.
Regulatory compliance – Industries like financial services that are heavily regulated are required to have audited financial statements to meet compliance requirements and demonstrate financial responsibility.

In summary, audited financial statements are required to provide independent verification for stakeholders that the statements are free of material misstatement and comply with reporting standards.

What does an audit involve?

An audit of financial statements involves several steps carried out by a CPA firm:

Planning – The auditor will gain an understanding of the client’s business and processes and identify key risk areas to focus on.
Testing internal controls – The auditor will evaluate the effectiveness of internal accounting controls and test a sample.
Examining evidence – The auditor will request supporting documentation for a sample of transactions and account balances.
Confirmation – The auditor will independently confirm account balances like cash and debt with banks and creditors.
Analytical procedures – The auditor will analyze financial ratios and trends to check for inconsistencies or red flags.
Evaluating disclosures – The auditor will assess that financial statement disclosures are clear, complete, and compliant with reporting standards.
Issuing an audit opinion – The auditor will issue an opinion stating whether the financial statements are fairly stated and free of material misstatement.

This audit testing provides reasonable but not absolute assurance that the statements contain no material errors or fraudulent activities. The auditor then issues an audit report sharing their opinion on the financial statements.

What is included in audited financial statements?

A complete set of audited financial statements typically includes the following documents:

Independent Auditor’s Report – This letter communicates the auditor’s opinion on whether the statements are fairly presented.
Balance Sheet – The balance sheet presents a snapshot of assets, liabilities, and equity on the last day of the accounting period.
Income Statement – The income statement summarizes revenues earned and expenses incurred during the accounting period.
Statement of Cash Flows – The cash flow statement shows sources and uses of cash organized by operating, investing, and financing activities.
Statement of Changes in Equity – This statement reconciles the changes in retained earnings and additional paid-in capital from the beginning to end of the period.
Notes to Financial Statements – The notes provide important details and disclosures related to material account balances and company policies.

These core financial statements provide key information on the company’s financial position, operating performance, and cash flows. The notes provide critical details and disclosures required for fair presentation under GAAP.

What are the 4 types of audit opinions?

There are four main types of opinions an auditor can issue on audited financial statements:

Unqualified opinion – This is a clean opinion stating that the financial statements are fairly presented in accordance with GAAP. This is the standard opinion if the auditor found no issues.
Qualified opinion – A qualified opinion means that the statements are fairly presented except for an issue that is clearly described in the report. This indicates some departure from GAAP.
Adverse opinion – An adverse opinion states that the financial statements are not fairly presented and do not conform with GAAP. This indicates pervasive misstatement.
Disclaimer of opinion – Here the auditor does not express an opinion on the financial statements. This is issued when the auditor could not obtain sufficient evidence to form an opinion.

The type of opinion issued depends on the nature and extent of any discrepancies noted during the audit. An unqualified opinion provides the most assurance to users of the financial statements.

Who performs the audit?

Financial statement audits must be performed by qualified independent CPAs. Specifically:

The auditor cannot be employed by or affiliated with the company being audited. Independence is critical.
The auditor must be a licensed CPA and able to objectively evaluate the company’s statements.
The auditor may work for an accounting firm that is engaged to perform the audit under contract.
Larger companies typically use large international accounting firms like Deloitte, PwC, Ernst & Young, or KPMG to conduct their audits.
Small private companies often engage local or regional CPA firms to perform their audits.

Using an auditor who is truly independent and has no financial stake in the company provides credibility to the audit and reassurance that the opinion is objective.

Can financial statements be manipulated even if audited?

Yes, there is still a possibility that even audited financial statements could contain manipulated or fraudulent data. Here are some ways companies can distort their financials despite an audit:

Providing falsified documentation to the auditor to conceal fraudulent transactions or balances.
Timing transactions at year-end to improperly inflate revenue or earnings.
Omitting or obscuring important information through complex organizational structures or inadequate disclosures.
Colluding with the auditor to influence the audit opinion through bribery or deception.
Deliberately misapplying accounting standards, especially in more complex areas like revenue recognition or fair value accounting.

Auditors try to detect such activities through detailed testing and evaluation of internal controls during the audit. However, if company management is determined to commit financial statement fraud they may still be able to circumvent or deceive the auditors.

What are common financial ratios used in analysis of audited statements?

Here are some key financial ratios that analysts commonly calculate using audited financial statements:

Profitability ratios – Gross margin, operating margin, net margin, return on assets, return on equity
Liquidity ratios – Current ratio, quick ratio, operating cash flow ratio
Leverage ratios – Debt to equity, interest coverage ratio
Valuation ratios – Price to earnings, price to book value, price to sales
Efficiency ratios – Inventory turnover, days sales outstanding, fixed asset turnover

These ratios help assess the company’s profitability, liquidity, solvency, valuation, and efficiency. Audited statements provide more reliable figures to calculate key ratios used in financial analysis and modeling.

Examples of Common Financial Ratios

Here are examples of how some key financial ratios are calculated and interpreted:

Return on equity (ROE) = Net income / Average shareholders’ equity. ROE shows how much profit is generated on shareholder’s equity. Higher is better.
Current ratio = Current assets / Current liabilities. Shows short-term liquidity. A ratio under 1 may indicate solvency issues.
Debt to equity ratio = Total liabilities / Total shareholders’ equity. Indicates financial leverage. A high ratio means more debt financing relative to equity.
Inventory turnover = Cost of goods sold / Average inventory. Shows how efficiently inventory is managed. Low turnover may indicate excess or obsolete inventory.

What are the consequences of fraudulent financial reporting?

Intentionally issuing materially misstated or fraudulent financial statements can have serious legal and financial consequences, including:

Criminal charges of accounting fraud leading to substantial fines and jail time for executives.
Civil lawsuits by shareholders and other parties suffering losses from relying on the false statements.
Delisting from stock exchanges for public companies and loss of investor confidence.
Bankruptcy, liquidation, or being forced to restate financials due to the damage to the company’s reputation and finances.
Regulatory fines and penalties, such as from the SEC.
Loss of contracts, customers, and access to financing due to lack of trust.

In addition to severe organizational impacts, individuals involved in perpetrating financial statement fraud face steep personal consequences like prison, fines, disbarment, and job loss. The risks far outweigh potential rewards.

How can financial statement users detect fraudulent reporting?

Financial statement users should watch for certain red flags that may indicate potential manipulation or fraud:

Inconsistencies between the statements and footnotes.
Sudden unexplained changes in financial performance or trends.
Shifting auditor opinions, like from unqualified to qualified.
Unusually complex corporate structures or frequent restructuring.
Delays in issuing audited statements or providing requested information.
Aggressive revenue recognition or asset valuation policies.
Outsized compensation or frequent management turnover.
External news raising questions about the company or management integrity.

No single red flag definitely indicates fraud. But users should apply professional skepticism when reviewing statements and leverage tools like financial ratio analysis to detect anomalies.

How can auditors detect fraudulent financial reporting?

Auditors use various techniques to try to uncover intentional misstatements and fraud during the financial statement audit:

Evaluate internal controls and perform walkthroughs to understand risks.
Corroborate management responses to inquiries with documentation and external sources.
Expand testing of high-risk accounts like revenue and receivables.
Use analytical procedures to identify outliers from expectations.
Review journal entries for signs of potential earnings management.
Observe inventory counts and fixed asset audits.
Follow-up on whistleblower hotline allegations.
Assess if disclosures indicate anti-fraud programs and controls.

Auditors must balance procedures to detect fraud with efficiency. Collaboration between management, auditors, and audit committees helps enhance fraud prevention and detection.

How can technology help detect financial statement fraud?

Emerging technologies are enhancing external auditors’ capabilities to detect anomalies and signs of potential financial statement fraud, including:

Data analytics – Analyzing patterns in entire populations of transactions rather than small samples to identify high-risk areas.
Artificial intelligence – Using machine learning to model normal behavior and detect outliers suggestive of manipulation.
Digital audit trails – Leveraging distributed ledgers like blockchain to provide independent transaction verification.
Electronic confirmations – Obtaining real-time automated confirmations of balances and information from third parties.
Drones – Conducting physical inventory counts and audits more quickly and accurately using aerial drone technology.

New technologies allow auditors to analyze more data, identify anomalies faster, and directly access independent confirmation to enhance detection of potential misstatements.

How can audited financial statements be used for investment analysis?

Audited financial statements are critical for conducting detailed analysis to inform investment decisions:

Assess historical performance trends using common size analysis and financial ratios based on audited financial data.
Benchmark company metrics like margins, turns, and ROE against competitors and industry averages using audited figures.
Evaluate quality of earnings by analyzing sources and sustainability of profits and cash flows.
Forecast future financial performance through trend analysis, modeling, and valuation techniques.
Review auditor opinions and footnotes to identify risks, uncertainties, or red flags.
Assess transparency and integrity of management through clarity of disclosures.

The higher quality and reliability of audited statements enhances financial analysis to determine whether a company makes a sound investment at its current valuation.

What are limitations of relying solely on audited statements?

While audited financial statements provide vital information, investors should recognize certain limitations:

Statements present historical data and may not reflect current conditions.
Accounting rules allow flexibility in assumptions, estimates, and policies.
An audit provides reasonable but not absolute assurance of no material misstatement.
Statements may lack certain details required in more stringent regulatory filings.
Footnotes may be difficult for non-accountants to interpret.
Statements may omit intangibles and lack forward-looking disclosures.

To address these limitations, investors should supplement analysis of audited statements with other information like management commentary, industry data, economic factors, and direct queries to the company.

Conclusion

In summary, audited financial statements provide critical information to stakeholders, needing credibility that is verified by an independent auditor. The audit process assess whether statements conform with GAAP and contain no material misstatements. While not foolproof, a diligent audit protects against fraudulent financial reporting. Investors should analyze audited statements but also look beyond them by gathering supplemental forward-looking information to make fully informed decisions.