Do investors understand the limitations of audit ?

Both global and Indian accounting/audit standards seek to serve the information needs of investors because as paragraph 10 of the “Framework for the Preparation and Presentation of Financial Statements,” issued by the Institute of Chartered Accountants of India (ICAI) in July 2000, indicates, for a profit-oriented entity that “as providers of risk capital to the enterprise, investor need more comprehensive information than other users. The provision of financial statements that meet their needs will also meet most of the needs of other users that financial statements can satisfy”.

Auditing Standard SA-320(Audit Materiality) also states that In this context, it is reasonable for the auditor to assume that users:

(a) Have a reasonable knowledge of business and economic activities and accounting and a willingness to study the information in the financial statements with reasonable diligence:- With economic activities getting more and more complex, which investor will really comprehend business well? And even for the value investors, financial statements and disclosures are getting so complex that even reading it takes hours to get past the boilerplate. In this impatience economy where we want everything NOW, the reasonable diligence assumption is getting diluted. 

(b) Understand that financial statements are prepared, presented and audited to levels of materiality; In other terms, there is an unstated confidence interval even for financial numbers. But unlike science and statistics where the confidence interval is publicly stated, auditors must decide that confidence interval(materiality) for themselves, but  

(c) Recognize the uncertainties inherent in the measurement of amounts based on the use of estimates, judgment and the consideration of future events; Investors still assume that accounting numbers are precise, because many non accountants are exposed to accounting only as a single compulsory business elective, where the complexity and earnings management aspects are not brought out in most courses. Hence, most MBA/CFA students still exit with an impression of accounting as a bunch of weird ledgers. The imprecision is not discussed much in academic settings, as setting papers/quizzes needs precision for ease of checking. 

(d) Make reasonable economic decisions:-This assumes that investors are rational but as behavioral finance repeatedly proves, investors are anything but rational. Therefore, focus on anchoring(investors look more to earnings than to cash flow), presenting proforma unaudited information etc is much more important 

So what should investors realize(and auditors consider disclosing)?

1.Accounting profit is not a point estimate, it is more like a range

2.Neither accounting or auditing will ever reach ‘100% accuracy’-assuming any such thing exists

3.There is a confidence interval which you do not know for that information

4.Audit does not guarantee that the entity will continue(just look at Kingfisher/SKS) nor does it promise about legal compliance/regulatory favour.

[The article has been written by Anandh Sundar Tripuri. He is a student of IIM Ahmedabad 2010-12 batch and a ranker in CA/CS/CWA exams. ]

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Do investors understand the limitations of audit ?

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