Financial Statement Producers, Users and Auditors

Financial statements are one of the most relied-upon sets of documents that investors utilize in order to make investment decisions. There is an entire industry dedicated to providing assurance on financial statements produced by a companies’ management. When auditors are working closely with several tiers of management to provide assurance on information that is used by widely dispersed, almost anonymous, shareholders represented by a mostly absent board of directors…who should the auditors consider their client? And why does it even matter?

Warren Buffett once brought up the issue in one of his letters to his shareholders. The following is an excerpt from the book “The Essays of Warren Buffett: Lessons for Corporate America“, which is a compilation of Warren Buffett’s letters to his shareholders.

“Audit committees can’t audit. Only a company’s outside auditor can determine whether the earnings that a management purports to have made are suspect. Reforms that ignore this reality and instead focus on the structure and charter of the audit committee will accomplish little. The key job of the audit committee is simply to get the auditors to divulge what they know.

To do this job, the committee must make sure that the auditors worry more about misleading its members than about offending management. In recent years auditors have not felt that way. They have instead generally view the CEO, rather than the shareholders or directors, as their client. That has been a natural result of day-to-day working relationships and also of the auditors’ understanding that, no matter what the book says, the CEO and CFO pay their fees and determine whether they are retained for both auditing and other work.”

Buffett, Warren. Essays of Warren Buffett: Lessons for Corporate America. 2nd ed. The Cunningham Group, 2008. 74-75. Print.

Simplified Example

With publicly traded companies, that have thousands of widely dispersed shareholders and several tiers of management, the auditor-client relationship often becomes a bit clouded. Let’s take a look at the most simplified example to help illustrate.

Imagine a business with one owner, who is not involved in the business whatsoever and one manager who handles everything from day-to-day operations, financials, marketing, etc. The manager produces the annual financial statements (as he possess all the relevant information to do so) which is used, by the owner, to assess the manager’s performance and determine the manager’s annual bonus. The owner also uses the annual financial statements to assess future profitability and determine whether he will retain ownership of the business or whether he will sell the business to someone else.

In this scenario, who will likely pay for and subsequently benefit the most from, an independent firm conducting an audit of the financial statement that management has produced? The answer at this point should be obvious…the owner. The owner, who has no direct control of the production of the financial statements and uses the financial statements to make key decisions, will want an independent firm to audit the financial statements. The owner is the sole user of the financial statements and this means that the auditor would consider the owner the client and not the manager.

Underlying issue

So why does it matter so much who the auditor considers the client to be?

Audit firms are running a service business, and just like any other service business, they look to act in the best interests of their clients. In preparing financial statements, the management must use several assumptions and estimates. Management possesses the ability to selectively choose accounting policies based on their judgement and the resulting financial statements produced, if the auditors considered management their client, could be drastically different than if the auditors considered the owners their client. The “net income” figure, often seen as a hard fact by many people, is actually somewhere between being just an opinion and being a hard fact.

In the example above, the interests of the manager can be different from the interests of the owner. The manager will mainly be concerned about the performance metrics that his bonus will be based on (whether it is net income, revenue, assets, etc.) and will have an inherent bias to choose accounting policies, estimates and assumptions that maximize those performance metrics. This could ultimately conflict with the owner’s best interest, as the owner has to use the financial statements to properly assess future profitability and decide whether to retain ownership of the business or not.

As mentioned in the example above, the owner is not involved in the business whatsoever, this includes assisting the auditors. The audit would be conducted at the manager level (as opposed to the owner level) because the manager, who is involved in the operations of the business, possesses the relevant knowledge and information that the auditor will need, in order to provide assurance on the financial statements the manager produces. All audit discussions, audit inquiries, audit procedures and information gathering is done with the manager. The manager would even be the one who signs the check to pay for the audit fees, but despite this close working relationship that the auditor has with the manager, at the end of the day the audit fees are coming out of the owner’s pocket and the owner is the one benefiting from the audit being conducted. Therefore, the auditor must keep in mind that the client is the owner and should act to serve the owner’s best interest.

Large publicly traded companies

In theory, applying the logic in the above example to large publicly traded companies with several tiers of management and thousands of shareholders would be as simple as replacing “manager” with “senior management (CEO, CFO etc.)” and replacing “owner” with “shareholders (represented by the board of directors)”. But obviously in practice, it is a bit more complicated.

As mentioned, the auditor should ideally be seeking to serve the owners’ (shareholders’) best interests as they are the users of the financial statements. But even within the “shareholder” group for large publicly traded companies, interests can be widely varying. For example, long-term shareholders’ interests may differ from short-term shareholders’ interests, which both could differ from activist shareholders’ interests and so on. The board of directors do their best to represent the shareholders, but with such varying interests, the consensus will be imperfect and hard for auditors to conclusively rely on.

So if serving the management’s best interest is inappropriate and serving the shareholders’ best interests is impractical, who should the auditors consider their client?…

The entity.

The separate legal entity that is characterized by the underlying business. The entity’s primary concern is the business it houses. Auditors should seek to serve the interests of the entity, and this would mean providing assurance that the financial statements represent the true economics of the underlying business that the entity houses. Rather than asking themselves “which accounting policy/estimate/assumption would be more useful/relevant to the shareholders(users of the financial statements)?”, auditors should be asking themselves “which accounting policy/estimate/assumption would better reflect the true economics of the business?”. Interests of some shareholders (most likely long-term shareholders) will perfectly align with the interests of the entity, as these shareholders would want the financial statements reported in a way that reflects the true economics of the business.

Conclusion

Defining the client is critical for the auditor in order to outline the guiding light for whose interests they should be seeking to serve. Working closely with management to provide assurance on information that is used by widely dispersed shareholders, defining the client may be a bit more complicated than theory suggests. However, when in doubt as to what may be more useful/relevant to the user, the auditors’ best bet is to consider the entity as their client and do their best to reflect the true economics of the underlying business in the financial statements.

Jathu Vasantharajah

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