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Financial Audits

Financial Audits

Financial Audits an objective examination of financial statements to provide an opinion on whether financial statements are stated in accordance with GAAP. This article explains what an audit is, but we do not provide any attestation services.

Financial audits are conducted to provide an opinion

Financial audits are conducted to provide an opinion on whether “financial statements” (the information being verified) are stated in accordance with specified criteria. Normally, the criteria are Generally Accepted Accounting Principles (GAAP), although auditors may conduct audits of financial statements prepared using the cash basis or some other basis of accounting appropriate for the organization. In providing an opinion on whether financial statements are fairly stated in accordance with accounting standards, the accountant gathers evidence to determine whether the statements contain material errors or other misstatements.

The audit opinion is intended to provide reasonable assurance, but not absolute assurance, that the financial statements are presented fairly, in all material respects, and/or give a true and fair view in accordance with the financial reporting framework. The purpose of an audit is to provide an objective independent examination of the financial statements, which increases the value and credibility of the financial statements produced by management, thus increase user confidence in the financial statement, reduce investor risk and consequently reduce the cost of capital of the preparer of the financial statements.

In accordance with the US GAAP, auditors must release an opinion of the overall financial statements in the auditor’s report. Auditors can release three types of statements other than an unqualified/unmodified opinion. An unqualified auditor’s opinion is the opinion that the financial statements are presented fairly. A qualified opinion is that the financial statements are presented fairly in all material respects in accordance with US GAAP, except for a material misstatement that does not however pervasively affect the user’s ability to rely on the financial statements. A qualified opinion can also be issued for a scope limitation that is of limited significance. Further, the auditor can instead issue a disclaimer because there is insufficient and appropriate evidence to form an opinion or because of a lack of independence. In a disclaimer, the auditor explains the reasons for withholding an opinion and explicitly indicates that no opinion is expressed. Finally, an adverse audit opinion is issued when the financial statements do not present fairly due to departure from US GAAP and the departure materially affects the financial statements overall. In an adverse auditor’s report, the auditor must explain the nature and size of the misstatement and must state the opinion that the financial statements do not present fairly in accordance with US GAAP.

Financial audits are typically performed by accounting firms

Financial audits are typically performed by accounting firms of practicing accountants who are experts in financial reporting. The financial audit is one of many assurance functions provided by accounting firms. Many organizations separately employ or hire internal auditors, who do not attest to financial reports but focus mainly on the internal controls of the organization. External auditors may choose to place limited reliance on the work of internal auditors. Auditing promotes transparency and accuracy in the financial disclosures made by an organization, therefore would likely reduce such a corporation’s concealment of unscrupulous dealings.

Internationally, the International Standards on Auditing (ISA) issued by the International Auditing and Assurance Standards Board (IAASB) is considered as the benchmark for the audit process. Almost all jurisdictions require auditors to follow the ISA or a local variation of the ISA.

Financial audits exist to add credibility to the implied assertion by an organization’s management that its financial statements fairly represent the organization’s position and performance to the firm’s stakeholders. The principal stakeholders of a company are typically its shareholders, but other parties such as tax authorities, banks, regulators, suppliers, customers, and employees may also have an interest in knowing that the financial statements are presented fairly, in all material aspects. An audit is not designed to provide absolute assurance, being based on sampling and not the testing of all transactions and balances; rather it is designed to reduce the risk of a material financial statement misstatement whether caused by fraud or error. A misstatement is defined in ISA 450 as an error, omitted disclosure, or inappropriate accounting policy. “Material” is an error or omission that would affect the user’s decision. Audits exist because they add value through easing the cost of information asymmetry and reducing information risk, not because they are required by law (note: audits are obligatory in many EU-member states and many jurisdictions are obligatory for companies listed on public stock exchanges). For collection and accumulation of audit evidence, certain methods and means generally adopted by auditors are:

  • Posting checking
  • Testing the existence and effectiveness of management controls that prevent financial statement misstatement.
  • Casting checking
  • Physical examination and count
  • Confirmation
  • Inquiry
  • Observation
  • inspection
  • Year-end scrutiny
  • Re-computation
  • Tracing in a subsequent period
  • Bank reconciliation
  • Vouching
  • Verification of existence, ownership, title, and value of assets and determination of the extent and nature of liabilities
Financial audits costs can vary greatly

Financial audit costs can vary greatly dependent on the nature of the entity, its transactions, industry, the condition of the financial records and financial statements, and the fee rates of the CPA firm. A commercial decision such as the setting of audit fees is handled by companies and their auditors. Directors are responsible for setting the overall fee as well as the audit committee. The fees are set at a level that could not lead to audit quality being compromised. The scarcity of staff and the lower audit fee lead to very low billing realization rates. As a result, accounting firms have started to use AI tools. Research has found that annual reports that convey an optimistic tone are associated with lower audit fees, suggesting that annual report tone reflects factors that auditors consider in assessing audit risk.

Responsibilities of an auditor under Corporations Act 2001 requires the auditor to:

  • Gives a true and fair view about whether the financial report complies with the accounting standards
  • Conduct their audit in accordance with auditing standards
  • Give the directors and auditor’s independence declaration and meet independence requirements
  • Report certainly suspected contraventions to ASIC

One of the major issues faced by private auditing firms is the need to provide independent auditing services while maintaining a business relationship with the audited company.

The auditing firm responsibility to check and confirm the reliability of financial statements

The auditing firm’s responsibility to check and confirm the reliability of financial statements may be limited by pressure from the audited company, which pays the auditing firm for the service. The auditing firm’s need to maintain a viable business through auditing revenue may be weighed against its duty to examine and verify the accuracy, relevancy, and completeness of the company’s financial statements. This is done by the auditor.

Numerous proposals are made to revise the current financial audits system to provide better economic incentives to auditors to perform the auditing function without having their commercial interests compromised by client relationships. Examples are more direct incentive compensation awards and financial statement insurance approaches. See, respectively, Incentive Systems to Promote Capital Market Gatekeeper Effectiveness and Financial Statement Insurance.

Financial Audits an objective examination of financial statements

Financial Audits an objective examination of financial statements to provide an opinion on whether financial statements are stated in accordance with GAAP
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