Many businesses don’t put much effort into keeping their accounting systems up to speed and they skimp on hiring competent accountants. In short, there is a risk that the financial statements of a business could be incorrect and seriously misleading.
Whether the financial statements are correct or not depends on the answers to two basic questions:
Does the business have a reliable accounting system in place and employ competent accountants?
Have its managers manipulated the business’s accounting methods or deliberately falsified the numbers?
To increase the credibility of their financial statements, many businesses hire independent CPA auditors to examine their accounting systems and records and to express opinions on whether the financial statements conform to established standards. In fact, some business lenders insist on an annual audit by an independent CPA firm as a condition of making the loan.
The outside, non-management investors in a privately owned business could vote to have annual CPA audits of the financial statements. Public companies have no choice; under federal securities laws, a public company is required to have annual audits by an independent CPA firm.
Two points: CPA audits are not cheap, and these audits are not always effective in rooting out financial reporting fraud by managers. Unfortunately, there have been many cases of CPA auditors not detecting serious financial fraud that had been going on for years right under their auditing noses.
Cleverly concealed fraud is very difficult to uncover unless you stumble over it by accident. CPAs are supposed to apply professional skepticism in doing their audits, but this doesn’t always lead to discovery of fraud.