Financial audit

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(December 2010)

Accountancy

Key concepts

Accountant · Bookkeeping · Cash and accrual basis ·

Constant Item Purchasing Power Accounting · Cost of goods
sold · Debits and credits · Double-entry system · Fair value
accounting · FIFO & LIFO · GAAP / International Financial
Reporting Standards · General ledger · Historical cost ·
Matching principle · Revenue recognition · Trial balance

Fields of accounting

Cost · Financial · Forensic · Fund · Management · Tax

Financial statements

Statement of Financial Position · Statement of cash flows ·

Statement of changes in equity · Statement of comprehensive
income · Notes · MD&A

Auditing

Auditor's report · Financial audit · GAAS / ISA · Internal

audit · Sarbanes–Oxley Act

Accounting qualifications

CA · CGA · CMA · CPA

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A financial audit, or more accurately, an audit of financial statements, is the review of the
financial statements of a company or any other legal entity (including governments), resulting in
the publication of an independent opinion on whether those financial statements are relevant,
accurate, complete, and fairly presented. Financial audits are typically performed by firms of
practicing accountants due to the specialist financial reporting knowledge they require. The
financial audit is one of many assurance or attestation functions provided by accounting and
auditing firms, whereby the firm provides an independent opinion on published information.
Many organisations 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.

Contents
[hide]
• 1 Purpose
• 2 History
○ 2.1 Audit of government expenditure
• 3 Governance and Oversight
• 4 Stages of an audit
○ 4.1 Planning and risk assessment
○ 4.2 Internal controls testing
○ 4.3 Substantive procedures
○ 4.4 Finalization
• 5 Commercial relationships versus objectivity
• 6 Related qualifications
• 7 See also
• 8 References

[edit] Purpose
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 (interested parties). 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 ensuring that the financial statements are accurate.
The audit is designed to increase the possibility that a material misstatement is not detected by
audit procedures. A misstatement is defined as false or missing information, whether caused by
fraud (including deliberate misstatement) or error. "Material" is very broadly defined as being
large enough or important enough to cause stakeholders to alter their decisions.
Audits exist because they add value through easing the cost of information asymmetry, not
because they are required by law. For example, a privately-held company that does an issue
securities on a public exchange might engage a firm to audit its financial statements in order to
obtain more desirable loan terms from a financial institution or trade accounts with its customers.
Without the audit, the lending party would not have assurance as to whether or not the company's
financial position is accurate. In turn, the lender could price protect against this information
asymmetry.
The exact form and content of the "audit opinion" will vary between countries, firms and audited
organizations.
In the US, the CPA firm provides written assurance that financial reports are fairly presented, in
all material respects, in conformity with generally accepted accounting principles (GAAP),
where the threshold for materiality is determined via auditor's judgment.
[edit] History
[edit] Audit of government expenditure
The earliest surviving mention of a public official charged with auditing government expenditure
is a reference to the Auditor of the Exchequer in England in 1314. The Auditors of the Imprest
were established under Queen Elizabeth I in 1559 with formal responsibility for auditing
Exchequer payments. This system gradually lapsed and in 1780, Commissioners for Auditing the
Public Accounts were appointed by statute. From 1834, the Commissioners worked in tandem
with the Comptroller of the Exchequer, who was charged with controlling the issue of funds to
the government.
As Chancellor of the Exchequer, William Ewart Gladstone initiated major reforms of public
finance and Parliamentary accountability. His 1866 Exchequer and Audit Departments Act
required all departments, for the first time, to produce annual accounts, known as appropriation
accounts. The Act also established the position of Comptroller and Auditor General (C&AG) and
an Exchequer and Audit Department (E&AD) to provide supporting staff from within the civil
service. The C&AG was given two main functions – to authorise the issue of public money to
government from the Bank of England, having satisfied himself that this was within the limits
Parliament had voted – and to audit the accounts of all Government departments and report to
Parliament accordingly.
Auditing of UK government expenditure is now carried out by the National Audit Office. Sing
industry (acting through various organisations throughout the years) as to the accounting
standards for financial reporting, and the U.S. Congress has deferred to the SEC.
This is also typically the case in other developed economies. In the UK, auditing guidelines are
set by the institutes (including ACCA, ICAEW, ICAS and ICAI) of which auditing firms and
individual auditors are members.
Accordingly, financial auditing standards and methods have tended to change significantly only
after auditing failures. The most recent and familiar case is that of Enron. The company
succeeded in hiding some important facts, such as off-book liabilities, from banks and
shareholders. Eventually, Enron filed for bankruptcy, and (as of 2006[update]) is in the process of
being dissolved. One result of this scandal was that Arthur Andersen, then one of the five largest
accountancy firms worldwide, lost their ability to audit public companies, essentially killing off
the firm.
A recent trend in audits (spurred on by such accounting scandals as Enron and Worldcom) has
been an increased focus on internal control procedures, which aim to ensure the completeness,
accuracy and validity of items in the accounts, and restricted access to financial systems. This
emphasis on the internal control environment is now a mandatory part of the audit of SEC-listed
companies, under the auditing standards of the Public Company Accounting Oversight Board
(PCAOB) set up by the Sarbanes-Oxley Act.
[edit] Governance and Oversight
Many countries have government sponsored or mandated organizations who develop and
maintain auditing standards, commonly referred to generally accepted auditing standards or
GAAS. These standards prescribe different aspects of auditing such as the opinion, stages of an
audit, and controls over work product (i.e., working papers).
Some oversight organizations require auditors and audit firms to undergo a third-party quality
review periodically to ensure the applicable GAAS is followed.
[edit] Stages of an audit
A financial audit is performed before the release of the financial statements (typically on an
annual basis), and will overlap the year-end (the date which the financial statements relate to).
The following are the stages of a typical audit:[citation needed]
[edit] Planning and risk assessment
Timing: before year-end
Purpose:...
• To understand the business of the company and the environment in which it operates.
○ What should auditors understand?[1]
 The relevant industry, regulatory, and other external factors including the
applicable financial reporting framework
 The nature of the entity
 The entity’s selection and application of accounting policies
 The entity’s objectives and strategies, and the related business risks that
may result in material misstatement of the financial statements
 The measurement and review of the entity’s financial performance
 Internal control relevant to the audit
• To determine the major audit risks (i.e. the chance that the auditor will issue the wrong
opinion). For example, if sales representatives stand to gain bonuses based on their sales,
and they account for the sales they generate, they have both the incentive and the ability
to overstate their sales figures, thus leading to overstated revenue. In response, the auditor
would typically plan to increase the rigour of their procedures for checking the sales
figures.
[edit] Internal controls testing
Timing: before and/or after year-end
Purpose:
• To assess the operating effectiveness of internal controls (e.g. authorisation of
transactions, account reconciliations, segregation of duties) including IT General
Controls. If internal controls are assessed as effective, this will reduce (but not entirely
eliminate) the amount of 'substantive' work the auditor needs to do (see below).
Notes:
• In some cases an auditor may not perform any internal controls testing, because he/she
does not expect internal controls to be reliable. When no internal controls testing is
performed, the audit is said to follow a substantive approach.
• This test determines the amount of work to be performed i.e. substantive testing or test of
details.[citation needed]
[edit] Substantive procedures
Timing: after year-end (see note regarding hard/fast close below)
Purpose:
• to collect audit evidence that the management assertions (actual figures and disclosures)
made in the Financial Statements are reliable and in accordance with required standards
and legislation.
Methods:
• where internal controls are strong, auditors typically rely more on Substantive
Analytical Procedures (the comparison of sets of financial information, and financial
with non-financial information, to see if the numbers 'make sense' and that unexpected
movements can be explained)
• where internal controls are weak, auditors typically rely more on Substantive Tests of
Detail (selecting a sample of items from the major account balances, and finding hard
evidence (e.g. invoices, bank statements) for those items)
Notes:
• Some audits involve a 'hard close' or 'fast close' whereby certain substantive procedures
can be performed before year-end. For example, if the year-end is 31 December, the hard
close may provide the auditors with figures as at 30 November. The auditors would audit
income/expense movements between 1 January and 30 November, so that after year end,
it is only necessary for them to audit the December income/expense movements and the
31st December balance sheet. In some countries and accountancy firms these are known
as 'rollforward' procedures.
[edit] Finalization
Timing: at the end of the audit
Purpose:
• To compile a report to management regarding any important matters that came to the
auditor's attention during performance of the audit,
• To evaluate and review the audit evidence obtained, ensuring sufficient appropriate
evidence was obtained for every material assertion and
 • To consider the type of audit opinion that should be reported based on the audit evidence
obtained.
[edit] Commercial relationships versus objectivity
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's responsibility to check and confirm the reliability of financial statements may
be limited by pressure from the audited company, who 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.
Numerous proposals are made to revise the current 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.
[edit] Related qualifications
• There are several related professional qualifications in the field of financial audit
including Certified General Accountant , Chartered Certified Accountant, Chartered
Accountant and Certified Public Accountant.
[edit] See also
• Auditor's report • Forensic Accounting
• Center for Audit Quality (CAQ) • International Standards on Auditing (ISA)
• Comfort letter • List of accounting topics
• Comparison of accounting software
• Computer Assisted Audit Tools

[edit] References
1. ^ International Standard on Auditing 315 Understanding the Entity and its Environment and
Assessing the Risks of Misstatement
Retrieved from "http://en.wikipedia.org/wiki/Financial_audit"
Categories: Auditing | Finance
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