Study: Explain the role of management, the internal auditor and the external auditor in preparing and issuing the annual financial statements

 

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Explain the role of management, the internal auditor and the external auditor in preparing and issuing the annual financial statements.

As you will notice, I have organized this particular learning objective a little differently.  I do not have one single overriding video with the related video transcript provided below, but rather I have provided textual content, interspersed with videos from other authors and hyperlinks to various sites that will help you learn about the role of management, the internal auditors and the external auditors in preparing and issuing the company's annual report and related financial statements.

The Role of Management

To start off, let's learn about management's four key roles of Planning, Organizing, Leading and Controlling as described by VEA New Zealand in the video below. 

Management Roles:  Planning, Organising, Leading, Controlling (2m:32s) Links to an external site.Although all four roles of Planning, Organizing, Leading and Controlling are very important to management and their organization, you will notice that in order to prepare the annual financial statements, management must put a significant amount of effort into the "Controlling" role which has the primary responsibility to ensure that the company has good internal controls which are defined as "...a process, effected by an entity's board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting and compliance." (Internal Control - Integrated Framework (2013) Executive Summary, COSO, pg. 3 Links to an external site.).  The preparation of the company's annual financial statements and related reports are part of this "reporting" objective and "reporting" falls within management's role of "controlling".

The management team of a corporation, as hired by the shareholder-elected board of directors Links to an external site., should carry out its management roles in a manner that increases shareholder value.  In addition, some industry observers believe that management should not only focus on running the company to increase shareholder value, but to also increase stakeholder value. 

Stakeholders Links to an external site.are effectively anyone impacted by the decisions made by the company.  This would include all the company employees, the company's customers, the company's shareholders, as well as anyone else affected by management decisions.  For example, a management team that focuses only on increasing shareholder Links to an external site.value might choose to reduce its expenses and increase its profits by dumping toxic manufacturing waste into a local stream.  However, although saving money by dumping the waste in a local stream may increase the company's profits and even lift its stock price, thus benefiting its shareholders, it is likely to harm countless local stakeholders (i.e. the people who want to swim, fish, and obtain clean water from the local stream).  A management team focusing not only on increasing shareholder, but also stakeholder value, would likely choose dispose of the waste properly even if that decision reduces the corporation's profits in the short-term.

The corporation's Board of Directors uses various reports and meetings to hold the management team responsible for its stewardship.  Many of the reports that management must submit are required by law.  The following list includes key reports that the management of publicly-traded companies must submit to their shareholders or to the Securities and Exchange Commission (SEC) Links to an external site. which then makes them very easy for the public to obtain through its freely available, and easy-to-navigate EDGAR website.  Why don't you try out the EDGAR website by searching for a public company's Form 10-K report for the most recent year? If you are really stuck, here is a short video (2m:46s) to show you how to use EDGAR find a Form 10-K for Microsoft.How to use the EDGAR search feature (2m:46s) Links to an external site.

The key reports or certifications that management must prepare and submit annually are as follows:

1)      The Annual Report to Shareholders
2)      The annual report on Form 10-K which includes the:

a. Annual Report to Shareholders
b. Financial statements and related footnotes
c. Management certifications
d. Report of Management on Internal Control over Financial Reporting
e. Auditors’ reports on the financial statements and on the effectiveness of internal controls Links to an external site. over financial reporting (this is prepared by the auditor, but is submitted by management)

Although the Form 10-K includes additional items, we will only focus on those listed above.

1)      The Annual Report to Shareholders

The Annual Report to Shareholders “... is usually a state-of-the-company report, including an opening letter from the Chief Executive Officer, financial data, results of continuing operations, market segment information, new product plans, subsidiary activities, and research and development activities on future programs.”

The Annual Report to Shareholders does not necessarily include the financial statements and the auditors’ report.  Some companies have chosen to keep their financial statements Links to an external site. and auditors' report separate from their “Annual Report to Shareholders” so that they can use their annual report more like a marketing brochure to encourage potential and existing shareholders to invest in or stay invested in the company.

2)      The annual report on Form 10-K

The annual report on Form 10-K is a regulatory filing that, depending on the size of the company, must be submitted to the SEC within 75 to 90 days of the end of the company’s fiscal year.  In the northern hemisphere, many companies' fiscal year ends are December 31st, but when companies incorporate they are allowed to choose any day in the year as their "fiscal year end".

 “The annual report on Form 10-K provides a comprehensive overview of the company's business and financial condition and includes audited financial statements.”  —Form 10-K

If you would like to see a list of all the items included in the Form 10-K please go the Investor.gov Links to an external site. website.

2a) The Annual Report to Shareholders is the same report referred to 1) above.  If management has decided to create their annual report separately as described above, they can simply include a copy of it in their Form 10-K filing.

2b) Financial statements and related footnotes include the Balance Sheet, the Statement of Shareholders’ Equity, the Income Statement, the Statement of Cash Flows and many pages of additional “footnotes” that help provide supplementary information related to the amounts and disclosures included in the financial statements.  An example of a footnote would be for the total of a company's long-term assets as included in one lump-sum on the Balance Sheet to be broken out into its more specific categories of Land, Buildings, and Equipment in the footnote.

2c) Management certifications are signed statements by a company’s Chief Executive Officer (CEO) and Chief Financial Officer (CFO) in which they certify to the reliability of the company’s financial statements and to the internal controls that were put in place to help ensure the reliability of such statements.  Click here and here to see the two certifications that Microsoft’s CEO, Stephen A. Ballmer was required to submit as part of Microsoft’s Form 10-K.

2d) Report of Management on Internal Control over Financial Reporting is included in the Form 10-K to indicate that management recognizes its responsibility for internal controls over financial reporting and that it evaluated and concluded on their effectiveness.

2e) Auditors’ reports on the financial statements and on the effectiveness of internal controls over financial reporting will be described in more detail in the "The role of the auditors" discussion below.

The Role of the Internal Auditor
Internal auditors Links to an external site. play a significant role in helping management fulfill its roles and objectives. 

Internal auditors are employees of the corporations that they audit, therefore, they are not "independent".  However, internal auditors do perform work of such a sensitive and significant nature that they need to have some level of independence from the departments, employees and managers of the corporation that they are called upon to audit.  For example, in most corporations, the internal audit department does not report to the controller, the Chief Financial Officer (CFO), or even the Chief Executive Officer (CEO), but rather the chief internal auditor is required to report directly to the "Audit Committee" which committee is comprised of outside/independent members of the board of directors, with one of them needing to qualify as a "financial expert".

Internal auditors serve as internal consultants to company management to help them achieve good "Internal Control" particularly by improving operations, reporting and compliance.

Sometimes, under specified circumstances, internal auditors can even help the external auditors (as described below) perform auditing procedures that will provide the basis for the external auditors report on the financial statements and internal controls over financial reporting.

Internal auditors are not normally tasked with designing and implementing internal controls but rather with testing the design and implementation to see if they properly achieve good internal control.

Accountants with a good understanding of business, business processes and computer information systems, make great internal auditors.  Current research also indicates that internal auditors have new duties on their horizon such as providing business insights and strategic advise as described in the article titled New Duties on Horizon for Internal Auditors Links to an external site. from the CGMA magazine.

You can learn more about the role of internal auditors by visiting the Institute of Internal Auditors' home page Links to an external site..

The Role of the Independent Auditors

As noted above, the annual report on Form 10-K is not complete without the inclusion of the auditors’ reports on the company’s financial statements and on the effectiveness of the company’s internal controls over financial reporting.

Audits by independent accountants (Certified Public Accountants Links to an external site. "CPAs" in the United States) are required in order to provide existing and potential shareholders an independent opinion on the reliability of the financial statement information that management provides to them.

While working through an audit, an auditor may discover errors and misstatements in the financial statements provided by the management of the company being audited.  Such misstatements may indicate that management may have different motivations other than truly increasing shareholder value.  For example, management may be tempted to bias the financial statements, to the detriment of the shareholders, in order to achieve their own personal ambitions.  For example, if a CEO’s contract specifies that he will receive a $10 million performance bonus if the company’s reported Net Income Links to an external site. increases by 10%, the CEO might choose to manipulate the financial statements to make them appear that the 10% increase was actually achieved, when, in fact, it really wasn't.  This is called fraudulent financial reporting.  You might want to watch the following (1m:37s) that provides examples of common types of fraudulent financial reporting.fraudulent financial reporting. Links to an external site.In addition, a manager may choose to divert assets Links to an external site.from the company for personal use.  For example, the controller of one of my clients was caught using the corporate credit card to purchase personal clothing items and other technology items for her home.  This type of fraud is called misappropriation of assets Links to an external site..  Both fraudulent financial reporting and misappropriation of assets are illegal and have been known to create huge losses for shareholders.  An independent auditor may also come across instances of bribery and corruption in which individuals give money or other resources to persons in authority (often in influential governmental, supplier or customer positions) to obtain unfair advantages, favors or preferential treatment.  When auditors discover risk factors indicating that any of these situations exist, they will need to perform additional testing to determine the extent of such risks and their impact on their audit plan.

Because of this conflict of interest between a company’s management and its shareholders, external auditors are hired to provide an independent, second opinion on the fairness of the company’s financial statements and their related footnotes.  If the company is a publicly-traded company, the auditor will also be required to issue a report on the effectiveness of the company’s controls over financial reporting.

An audit of a company’s financial statements requires the auditor to plan the audit to obtain reasonable assurance that the financial statements and their related footnotes are not materially misstated.  One common misunderstanding is that auditors test every single number in the financial statements.  This is absolutely not the case.  Even if an auditor had the desire to test every single number for a company like Apple, s/he simply would not be able to finish the audit in his/her lifetime.  Some might say, get a larger team of auditors.  Although that might help, it is still unlikely that they could get the audit done in time to be submitted to the SEC within the 75-90 day reporting deadline.  Finally, the real question is, who would be willing to even pay for an audit at that level of detail?  Remember, we need to keep in mind the cost of the audit as compared to the benefit that the audit is likely to provide to those who rely on it.  Over the years, the market has indicated that it is unwilling to pay for a 100% audit of every single account in a company's financial statements.  It is clear that although a 100% audit would increase the reliability of the financial statements that companies provide, such increased reliability does not justify the additional costs to be born by the company, and indirectly by the creditors and investors.

In order to provide a reliable audit that factors in cost-benefit considerations, auditors use a risk-based audit approach in which they strive to focus their audit work on the items in the financial statements that are most likely to be incorrect and would most likely influence the decision of someone relying on them.  Such amounts are known as being "material", because they are significant enough in amount or nature to influence a reasonable decision-maker relying on the financial statements.  

Auditors actually use a variety of audit procedures that help them test the financial statements “enough” to provide an opinion on them.  These procedures include using statistics to select a sample of items to test and analytical procedures to recognize and test unusual trends.  They also include understanding and testing the proper operation of the company’s internal controls over financial reporting so that they can rely on the financial numbers that the reporting system produces. 

At the end of an audit, the auditor of a publicly-traded company will issue opinions on 1) the effectiveness of the company’s internal controls over financial reporting and 2) the fair presentation of the company’s financial statements, in all material respects, in accordance with US GAAP Links to an external site..

Some of you may already be considering a career as an auditor, so let’s take a moment to describe what it takes to become an auditor Links to an external site.. 

In the United States the only individuals licensed and certified to perform financial statement audits are Certified Public Accountants (CPAs).  Auditors in other countries are often known as Chartered Accountants (CAs).  US CPAs receive their licenses to perform audits from the state in which they choose to work.  Here are the four general requirements to become a CPA.  (Note:  I will not be testing you on these at this time):

1)      Education, minimum of 4 years, but usually 5 is required
2)      Experience, usually two years of audit work supervised by a CPA
3)      Examination, 4 exams totaling 14 hours, testing knowledge of auditing and attestation, financial accounting and reporting, regulation, and business environment and concepts
4)      Application, must be submitted to the state and pay the appropriate fee of a few hundred dollars

If you are interested in more details on the process of becoming a CPA feel free to click on the “Steps to Become a CPA” as provided by the American Institute of CPAs.  You can also visit the site of the American Institute of CPAs Links to an external site. to learn more about the profession in general.  Having said that, all I really expect you to know at this stage is that in order to become a CPA and perform audits of PRIVATELY-HELD companies, you must obtain a CPA license from your respective State Board of Accountancy.  A CPA license is similar in concept to a driver's license which allows the holder to legally drive a car.  Both licenses are issued and enforced by the state in which the licensee expects to perform audits or drive cars, currently states are working on a reciprocity agreement to allow licensees in one state to perform audits in other states thus increasing the mobility of CPAs.  You can read more about this initiative at:  What is mobility? Links to an external site. 

However, please note that state-licensed CPAs are ONLY allowed to perform audits of privately-held companies.  If a state-licensed CPA wants to perform audits publicly-traded companies that are subject to SEC regulations, the CPA must comply with additional rules and register with the Public Company Accounting Oversight Board (PCAOB) Links to an external site..  Because of these additional registration requirements, many smaller CPA firms do not perform audits of publicly-traded companies.

Here is a quick summary image of some of the key points discussed in this topic:

As you should notice in the image above, the green box represents employees of ABC Corp.  Because management and internal auditors are employees of the company they are not independent and therefore could potentially be biased when preparing and issuing ABC's financial statements, that is why the external auditors, which are required to be independent can not be employees or have any financial interest in ABC, or even have close relatives work in influential positions at ABC (such as CEO, CFO, Controller, etc.).

As a final note, please remember that management is responsible for preparing the financial statements and for setting up a reliable system of internal controls over financial reporting.  In the United States, auditors of publicly-traded companies are responsible for auditing their financial statements AND their internal controls over financial reporting.