6.3 Reading

The Basics of Auditing

A financial audit is the examination by an independent third party of the financial statements of a company or any other legal entity (including governments), resulting in the publication of an independent opinion on whether or not those financial statements are relevant, accurate, complete, and fairly presented. Financial audits are typically performed by firms of practising accountants. The principal stakeholders of a company are typically shareholders, but other parties such as tax authorities, banks, regulators, suppliers, customers and employees may also have an interest in ensuring that the financial statements are accurate. The audit is designed to reduce the possibility of material misstatement. A misstatement is defined as false or missing information, whether caused by fraud or error. Material is very broadly defined as being large enough to cause stakeholders to alter their decisions. The exact ‘audit opinion’ will vary between countries, firms and audited organizations. The CPA firm provides written assurance that financial reports are ‘fairly presented in conformity with generally accepted accounting principles (GAAP)’. The measure for ‘fairly presented’ is that there is less than 5% chance that the financial statements are ‘materially misstated’.

Types of auditors There are three types of auditors: internal, governmental, and external (i.e., independent auditors or certified public accountants). Internal auditors are employees of the organization whose activities are being examined and evaluated during an independent audit. The primary purposes of internal auditing are to review and assess a company's policies, procedures, and records and to review and assess a company's performance given its plans, policies, and procedures. Therefore, internal auditors review financial records and accounting systems, assess compliance with company policies, evaluate the efficiency of company operations, and assess the attainment of company goals. Governmental auditors include accountants employed by the U.S. General Accounting Office (GAO). The GAO serves as the accounting and auditing branch of Congress. These governmental accountants perform accounting and auditing tasks for the entire federal government. In addition, most states have their own accounting and auditing agencies, which resemble the GAO.

In contrast, the independent auditor is not an employee of the organization being audited or an employee of the government. He or she performs an examination with the objective of issuing a report containing an opinion on a client's financial statements. The attest function of external auditing refers to the auditor's expression of an opinion on a company's financial statements. Generally, the criteria for judging an auditor's financial statements are generally accepted accounting principles. The typical independent audit leads to an attestation regarding the fairness and dependability of the statements. This is communicated to the officials of the audited entity in the form of a written report accompanying the statements.

Types of audit Major types of audits conducted by external auditors include the financial statements audit, the operational audit, and the compliance audit. A financial statement audit (or attest audit) examines financial statements, records, and related operations to ascertain adherence to generally accepted accounting principles, meaning that the audit determines whether companies have followed the financial reporting standards given by various sanctioning boards such as the Financial Accounting Standards Board. An operational audit examines an organization's activities in order to assess performances and develop recommendations for improved use of business resources. A compliance audit has as its objective the determination of whether an organization is following established procedures or rules. Auditors also perform statutory audits, which are performed to comply with the requirements of a governing body, such as a federal, state, or city government or agency.

Audit reports The independent audit report sets forth the independent auditor's opinion regarding the financial statements. The auditor's opinion indicates whether the financial statements are fairly presented in conformity with generally accepted accounting principles, and applied on a basis consistent with that of the preceding year (or in conformity with some other comprehensive basis of accounting that is appropriate for the entity).

The auditor's unqualified report contains three paragraphs. The introductory paragraph identifies the financial statements audited, states that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The scope paragraph describes what the auditor has done and specifically states that the auditor has examined the financial statements in accordance with generally accepted auditing standards and has performed appropriate tests. The opinion paragraph expresses the auditor's opinion on whether the statements are in accordance with generally accepted accounting principles.

Various audit opinions are defined by the AICPA's Auditing Standards Board as follows:

1. Unqualified opinion: An unqualified opinion states that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the business in conformity with generally accepted accounting principles.

2. Explanatory language added to the auditor's standard report: Circumstances may require that the auditor add an explanatory paragraph (or other explanatory language) to the report.

3. Qualified opinion: A qualified opinion states that, except for the effects of the matter(s) to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the business in conformity with generally accepted accounting principles.

4. Adverse opinion: An adverse opinion states that the financial statements do not represent fairly the financial position, results of operations, or cash flows of the business in conformity with generally accepted accounting principles.

5. Disclaimer of opinion: A disclaimer of opinion states that the auditor does not express an opinion on the financial statements.

In contrast to the standardized report of external auditors, internal and governmental auditors prepare a variety of reports that serve a variety of purposes, depending on the auditing assignment and goals.

Legal Responsibilities The legal responsibilities of the auditor are determined primarily by the following:

1. Specific contractual obligations undertaken.

2. Statutes and common law governing the conduct and responsibilities of public accountants.

3. Rules and regulations of voluntary professional organizations.