Krax in Logic

Written by: Michael Kravshik.

As an accountant, my stories from work were never usually the topic of discussion at the dinner table. Nonetheless, the work that accountants do is extremely important and necessary. It’s drier characteristics aside; accounting affects most people in significant ways. It encompasses an extremely wide range of activities, and accountants handle many different types of important tasks. But when most people imagine accounting, the common vision is that of bookkeeping, which is the processes of recording the financial transactions and positions of a company. This includes the debits and credits that many are familiar with, but is really only a small part of the profession. When I decided to become a Chartered Accountant I knew a lot about bookkeeping, but almost nothing about audit. When I was offered an internship as an auditor I still had no idea what I’d be doing. I even had to take an introductory course on auditing before I started, and still had very little concept of what my days would be like. It’s my guess that there are many people who don’t really know what audit is, and that’s why I wrote this. The goal of this post is two-fold:

1)   Try to explain what exactly auditing is, why it’s important, and how it’s done (as briefly as possible to avoid boredom but provide insight).

2)   To help everyone (especially those who deal with auditors) understand that they are actually good people (most of the time) and not just doing the things they do to piss you off.

First, it is important to keep in mind that tax auditors and financial auditors are different. I will be focusing on financial audit, as most people have a better understanding of what tax auditors do. Financial audit is the processes of making sure a company’s financial statements accurately represent reality. Most auditors will cringe at this imperfect definition, but it will manage as a simplistic description to be expanded upon. Financial statements are quantitative reports that provide information about the performance or financial health of an organization including balance sheets, income statements, cash flow statements, etc…

Why is it important that financial statements are accurate? – Financial statements are used by many different stakeholders in the organization including, but not limited to, investors, banks, regulators, and management itself. These stakeholders will use the information in the statements to make important decisions regarding the organization, such as whether to invest, or whether to give them a loan. If the statements aren’t accurate, than decisions are based on false or misleading information.

Why wouldn’t the statements ‘accurately represent reality’? – Two ways; error or fraud. Errors are bound to occur, especially in companies that have thousands of daily transactions, but  these do not represent any ‘ill-will.’ Fraud of course, is quite the opposite. There is significant motivation for fraud to take place, since these figures are often used in the determination of management compensation (i.e. how big the bonuses are), but also because these numbers are used and speculated on by the markets. The result of fraudulent accounting can cause substantial ‘real-world’ impact on things like jobs, savings, pensions, etc… as Enron and others have taught us.

What does ‘accurately represent reality’ really mean? – When I say, “accurately represent reality,” you might think this is like a math problem, its either right or wrong. To some extent you’d be right, but auditing and accounting in general is not that cut and dry. A lot of accounting rules are based on estimations or expectations, and the ultimate decision of whether these are ‘right or wrong’ comes down to the professional judgment of the auditor.  In addition, if an auditor were to actually go through every single number and figure it would cost an unreasonable amount of money, and therefore a certain degree of ‘wrong’ is accepted. There is the constant trade-off between the value of an auditors ‘verification work’ and the cost of doing it.

So how do we know if something is ‘right-enough’? – This changes based on which rules are being followed and which type of information is being verified. However, when auditors have completed their work, they won’t say “these statements are correct,” but instead they will have “obtained reasonable assurance that the statements are free of material misstatement.” This seems like a mouthful but its actually quite simple. The deciding factor for something being ‘right-enough’ is what is called ‘material misstatement.’ A misstatement is ‘material’ if it is significant enough to influence one of the aforementioned stakeholders decisions. Said more simply, if its not a big deal or won’t change anyones mind, auditors don’t care.  In addition, the auditors don’t say they are 100% sure there are none of these misstatements. ‘Reasonable assurance’ can mean a lot of things and I won’t bore you with the slew of rules and guidelines created to determine what is reasonable in each situation. All I will say is that it is important to keep in mind that auditors cannot and do not find everything, and they are not expected to. As well, there are many different types of ‘assurance’ and they can result in different answers to what is considered ‘reasonable.’

How is it actually done? – Financial auditing uses many different tools and processes to do their work. Some things are quite easy to check such as a bank account. The auditor will simply mail or call your bank and confirm the amount deposited. Some transactions happen millions of times, and samples are selected using statistical tools to ensure they are covering enough of them for ‘reasonable assurance.’ Other times auditors have to physically count/inspect assets the company owns, giving us the complimentary title ‘bean-counter’. The most difficult of all are the estimations mentioned earlier. Auditors could use external experts (i.e. real estate appraiser), use historical information or may just review or re-produce the figures management has suggested to get ‘reasonable assurance’. In addition, there are a plethora of varying situations that could call for different measures being taken and difficult judgments being made. For many companies these estimates can end up being worth millions or billions of dollars.

In all cases, the professional judgment of the auditor is the final word. If management disagrees with the auditor than they can still choose to not comply. However, if they don’t, the auditors won’t give them the ‘perfect score’ (in audit terms, an ‘unqualified opinion’) on their audit, which is perceived poorly by the markets. If its really bad, they just won’t sign off at all. This is why it is important that auditors are ‘independent’ of the company, and ideally should have no motivation to skew the numbers any which way. To maintain this ‘independence,’ auditors have many rules placed on them such as not being able to accept gifts, not being able to invest in their clients, etc…

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Hopefully that provides a little bit of insight into what auditors do and why it’s important. Personally, I disagree with many of the specifics of the audit process, and perhaps even the way it is structured, but that is a topic for a different post. That being said, it is obvious that the work they do is important to maintain an international financial market that is built on the concept that information is reliable. So why does everyone hate auditors?

After a few years of working as an auditor, I can honestly say that it’s difficult to know that’s how you’re perceived before you even walk in the door. At the same time, I really do understand why clients feel that way. Auditors walk into your office, demand the work you’ve done all year (with all relevant back up), look through it and then tell you its wrong. To add insult to injury, most of the ‘work-horses’ of the audit industry are under 25 years old. So I can understand when a guy whose been doing his job for 35 years isn’t pleased about a 23 year old university grad second guessing his work. It must be annoying, and especially so if you don’t even know what the point of them doing it all is.

At this point I’d like to bring up the positive message of this post. Auditors are not your enemy, they are your friend. It wasn’t the auditor that decided you have to get an audit, it was the government and regulators and for good reason. The auditors’ goal is to obtain that ‘reasonable assurance’ at the least cost (financial, time-wise and psychologically) to the client. Usually (at least in Canada), audits are fixed fee projects, meaning that they do not get paid more for taking longer. The auditor wants to have as little impact on their clients’ life, while still getting the information they have to. If the auditor finds something ‘bad,’ yes it means more work for the client, but it also means a ton more work for the auditor. Auditors are not robots, and no matter how much you may think they enjoy sitting in a windowless room trying to find all your mistakes, they really don’t. They want to go home and enjoy life like the rest of humanity… most of them at least. The auditor and client are teammates in completing the job that regulators force them to do. If every client understood this and took it to heart, the audit process would be a lot less painful. And indeed this really is the case, as any auditor who has had this type of client can attest. It really has nothing to do with the actual character of the clients themself. They could be the nicest people in the world, but if they don’t understand why they are doing something annoying (and potentially staying late to do it), they will undoubtedly get pissed off.

So next time you see your auditor, comfort him or her with a warm embrace and repeat the following “I understand your plight, and I still think you are a good person.” Well maybe that’s a little too far, but I know that auditors appreciate when the clients understand where they are coming from. In the end, they are just trying to do their job and showing that little bit of compassion might even make your own audit adventure a little less painful.

I’ve heard of auditors being referred to as ‘financial policemen.’ Maybe that’s a bit sensationalist, but if the cop that gives you a speeding ticket can be a decent person, so can your auditor.

This is a short description of auditing. What can you add?

Audit stories encouraged.