Financial Auditing in Firms in United States

We precociously consume the risk we reduce. Just as advanced automotive safety technology makes for worse drivers*, the prevalence of government mandated auditors in the financial system has allowed us as investors to engage in riskier behavior than we would dare do otherwise.

After all, apart from the few of us who are formally schooled in finance, who really glances at a 10-K Earnings Statement? Who reads the Fund Flyers? Who really has any idea where the money in the financial system goes when you decide to take $10,000 out of a brokerage account and use it to acquire stock in an IPO of say, a hot new social media startup? The idea we have in America is that you can ask your financial advisor, who in turn is going to reference the Prospectus, which has been carefully audited and attested to by a group of highly knowledgeable and licensed accounting professionals.

The idea of audit probably needs some clarification, owing to the confusion created by the IRS.

When an individual is audited, it refers to an audit done by the Internal Revenue Service, and there is a requirement that they must be able to produce all supporting documentation for the previous seven years, outlining proof for every representation (or claim) they made on government tax forms. When a business is audited, by which I mean, audited by a public accounting firm that they have hired according to SEC requirements, it is not typically held to this strict requirement. Instead, a “reasonable level of assurance” is made using a certain percentage of documents that are requested from different departments in the company.

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Examining these and the business processes in place are used to “test” the claims by management and support that the documentation is in fact truthful.

That is a very crude simplification, but works for our argument.

So why do we audit? It comes from the idea that an individual will behave differently when they believe they are being observed. With a statistical chance that an indiscretion (read: lie) will be caught, an individual is less likely to try to deceive. For example: If I have to submit every receipt over $25, I’m less likely to create phony charges. This, combined with harsh penalties from being caught, (such as being fired, like in my case) is likely to deter a number of would be deceivers in the business world, and in turn lower the overall risk of fraud faced by investors. In theory then, paying to have a company audited makes it less likely for individuals to loose money to fraud. So what do we do?

We engage in riskier financial behavior. Knowing we have the safety net of the accounting profession, we are more willing to purchase $10 and $20 shares of virtually unknown companies on the assurance that they are truthful in their financial representations.

Another phenomenon occurs. Those intent on committing fraud work harder to evade being caught. The methods of moving money, and hiding these transactions in turn become more sophisticated as the benefits outweigh the penalties imposed and the means for charging them.

This is hardly intended to be a case against auditors. Far from it. If anything, we should pay closer attention to their statements, and look beyond them, to see what their statements are base on. Instead of waiting for a serious offense to arouse suspicions, we as investors should be more willing to do as advisers like Jim Cramer advocate, and dig deep and ask probing questions before putting our money just anywhere.

In the end, additional regulation will only make us so safe. You can change the game by requiring more mandatory oversight, and impose stiffer penalties. In the end, someone has to be willing to ask the basic questions such as “is my bank financially sound?” or “Is this company actually making money?”.

Leaving the detection of sophisticated fraud schemes to the auditors, we can still avoid a healthy portion of risk by thinking critically and steering clear of the too-good-to-be-true Bernie Maddoffs. Or at least we should try.