CHAPTER ONE
INTRODUCTION
1.1 INTRODUCTION
Modern financial accounting is based on a double entry system. Described simply, double entry bookkeeping allows firms to maintain records that reflect what the firm owns and owes and also what the firm has earned and spent over any given period of time. Double entry bookkeeping revolutionized the field of financial accounting during the Renaissance period. Whereas simple ledgers had long been the standard for record keeping for merchants, the church and state treasuries, the growth of long distance trade and creation of the first joint stock companies resulted in firms whose records were too voluminous and complicated to provide any assurance of accuracy to their users. The double entry system solved the problem of managers knowing whether they could trust their own books.
However, these same companies were now expected to share their records with outside stakeholders, such as investors, lenders and the state. This created the problem of how outsiders could trust the company’s books. Thus came the independent public auditor, whose role was (and is) to serve as an independent guarantor of financial information. Stakeholders placed their trust not in a firm’s management, who had a vested interest in presenting the rosiest of pictures to all who cared to ask, but in the auditors retained by management to vouch for them. It doesn’t take an attorney to see how a problem of agency is created by this arrangement. Do auditors work for the managers who hire and pay them or for the public that relies on their integrity in order to make decisions? Financial statements are inherently representative of certain assertions by a firm’s management to the users of those financial statements. Among these are: 1. Existence. That the assets and liabilities reflected on the balance sheet are true and accurate as of the balance sheet date. 2. Completeness.
That the financial statements represent all of the firm’s activities during the time period in question. 3. Valuation. That the amounts on which the financial statements are based are correct or reasonable under the circumstances. 4. Rights and Obligations. That what is owned and owed as reflected by the balance sheet is true and correct.
Presentation and Disclosure. That the items in the financial statements are valued and described in the proper way. Each of the preceding assertions is basically a problem of trust, which audits are designed to resolve. As an accountant, I am disappointed to admit that, all too oen of late, my colleagues have failed in this respect. Not only have auditors failed to manage public expectations by honestly and openly communicating the limitations of assurance work, but in many cases they have also, through collusion, corruption, incompetence, or simple laziness, failed to properly do their jobs. This problem is even worse outside the US and EU member states, where lax enforcement of existing regulations creates opportunities for easy manipulation of financial statements. If a firm’s management is willing to issue inaccurate financial statements and capable of organizing a conspiracy to support them, then it is very likely that auditors will fail to detect the associated misstatements (assuming that the firm’s auditors were not colluding with the firm outright).
Production of bogus financial statements is a delicate affair. Merely falsifying revenue or recording it early doesn’t work on its own, because it throws the books out of balance. For example, a credit to the sales revenue account must be matched with a debit to an asset account (usually cash or accounts receivable). For fraudulent accounting records to stand up to any kind of scrutiny, they usually must be backed by a “legend” consisting of altered or falsified documentation. Bearing this in mind, Generally Accepted Auditing Standards require testing of all aspects of the financial statements and also that auditors obtain “sufficient, appropriate” evidence to support them. As one can imagine, the cost of completing the work ranges from obscene to astronomical. It is not uncommon for the cost an annual audit of a moderately sized company to run into the tens of thousands of dollars. However, the cost to the public of relying on faulty financials can be many times more.
