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Do You Trust Audited Financial Statements?

Prior to the Enron financial scandal, most people didn’t stop to question the validity of corporate financial statements. Most of us, programmed early on to trust authority, accepted that the big-name auditing firms who “independently” examined and certified the financial statements were squeaky clean and above reproach.

That was then; this is now. As we approach the 10th anniversary of the Enron fiasco—the big financial wake up call—we know now that not all financial statements are created equal, or with 100-percent integrity. We know now that supposedly independent and objective auditing firms serve clients in other capacities. And we know now that some audit firms are tempted to look the other way when corporations tweak the numbers to make earnings look better.

You’ll recall that in the wake of the Enron scandal, it took nearly five years of back-and-forth political bickering before Congress finally passed the Sarbanes-Oxley Act and imposed much stricter guidelines on auditing firms. Since then the Financial Accounting Standards Board (FASB) has implemented risk-based auditing rules that require auditors to zero in on high-risk areas subject to fraud when conducting an audit engagement. And the SEC stands ready to reward any whistleblower with the guts to step up and point to skulduggery.

Yet today some auditing firms still continue to earn substantial profits from corporate clients by performing big-ticket consulting assignments and other work unrelated to annual audits. Which makes one wonder just how independent and objective those audits really are.

That puts the burden of due diligence and scrutiny squarely on the shoulders of investors or their advisors, and further reminds us to pay heed to the old caveat, “Buyer Beware!”

An annual report can be a powerful and informative tool for defining a company’s financial position. To the savvy reader, it can offer a good glimpse into where the company is headed in the future. But to the untrained eye, these documents are fraught with complex numbers, fluffy text, and glossy full color photos accompanied by a positive and upbeat “Message from the CEO.”

The complexity presents a dilemma for the average person who is just trying to make sense of it all. What do those numbers really mean? How can they trust that the numbers haven’t been manipulated? This uncertain situation is exactly what motivated us to write our book: The Truth Behind the Numbers in Financial Statements: A Step-by-Step Guide to Investigating Before You Invest. Our mission: To guide you past the corporate PR machine and get you right to the heart and the meaning behind the math.

Financial statements are expected to be straightforward summaries of what actually took place in a corporation. But in our book we explain that there is no one single “right” outcome for financial statements. That’s because auditors and accountants have a variety of choices allowable within the GAAP guidelines that relate to how certain transactions, reserves, and the timing of recognizing those transactions are handled.

Footnotes provide details beyond the numbers and explain the accounting assumptions used in the report.  But the footnotes can sometimes be highly technical and difficult to understand. When something doesn’t sound right, we urge you dig a little deeper and to trust your instincts.

And even after you have read our book and have a better understanding of financial statements, never base your investment decisions on a single year of financial results. Don’t rely on a snapshot; watch the whole movie by reviewing information that’s been reported over several years. You’ll want to check five or even 10 years worth of results to get a better picture of a company’s competitive position, financial strength and earnings potential.

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