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Warren Buffett on the essence of audit

Feb 19, 2009

The Satyam issue has made many an investor and analyst wake up to the importance of the role of auditors in a firm. Satyam was a blatant case of fraud and embezzlement of funds. But it also throws up many equally important issues regarding financial reporting such as:

  1. The pressure on managements to meet forecasted numbers,

  2. The cover up of indications of a deterioration in the quality of earnings such as increased receivable days and

  3. The masking of cash flows to and fro between group companies.
The need for better disclosure for investors cannot be emphasised enough. Due to the lack of access to the transactions within a company and a thorough knowledge of accounting, it is usually the investors of a company that end up bearing the brunt of ill intentioned managements. But this is not a new problem. The investing community has been grappling with the issue since the time corporations were first formed. So what is the solution?

One of the world's greatest investors Warren Buffett seems to have a clear cut solution in hand. His first step is to make clear the practical role of the audit committee in the corporate setup. His next step is to understand the dynamics of its relationship with the external auditor, and how this relationship should be used for the best possible advantage to the investor.

He suggests that since audit committees can't really audit, and only a company's outside auditor can determine whether the earnings that a management purports to have made are suspect, the key job of the audit committee is simply to get the auditors to divulge what they know. Thus the committee must make sure that the auditors worry more about misleading the members of the audit committee than about offending the management. It may be noted that auditors generally end up viewing the CEO, rather than the shareholders or directors, as their client. The only way to break through the fortress of this cozy relationship is that audit committees should unequivocally put auditors on the spot. And how does Mr. Buffett propose that that this be done?

In his opinion, audit committees can accomplish this goal by asking four questions of auditors, the answers to which should be recorded and reported to shareholders. These questions are:

  1. If the auditor were solely responsible for preparation of the company's financial statements, would they have in any way been prepared differently from the manner selected by management? This question should cover both material and nonmaterial differences. If the auditor would have done something differently, both management's argument and the auditor's response should be disclosed. The audit committee should then evaluate the facts.

  2. If the auditor were an investor, would he have received - in plain English - the information essential to his understanding the company's financial performance during the reporting period?

  3. Is the company following the same internal audit procedure that would be followed if the auditor himself were CEO? If not, what are the differences and why?

  4. Is the auditor aware of any actions - either accounting or operational - that have had the purpose and effect of moving revenues or expenses from one reporting period to another?

The essence of this solution is auditors be put in a spot where there remains no room for ambiguity, which is usually the favored tool used by management to cover up any kind of gaps. Breaking down the abstruse details of accounting will bring more clarity for the average investor.

Buffett strongly feels that when auditors are put on the spot, they will do their duty. If they are not put on the spot, it leaves enough room for the deception to remain hidden and concealed forever. And as always, investors will continue to be the ones at the receiving end.

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