Definitions

Financial audit

Financial audit

A financial audit, or more accurately, an audit of financial statements, 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 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.

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 reduce the possibility of a material misstatement. 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.

The exact 'audit opinion' will vary between countries, firms and audited organisations.

In the US, 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 (5% audit risk) that the financial statements are 'materially misstated'.

History

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) 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.

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:

Planning and risk assessment

Timing: before year-end

Purpose:

  • to understand the business of the company and the environment in which it operates.
  • 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.

Internal controls testing

Timing: before and/or after year-end

Purpose:

  • to assess the internal control procedures (e.g. by checking computer security, account reconciliations, segregation of duties). If internal controls are assessed as strong, 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.

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 31st December, the hard close may provide the auditors with figures as at 30th November. The auditors would audit income/expense movements between 1st January and 30th 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.

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.

Significant audit firms

These firms are the 'Big 4' multinational accountancy firms which audit the majority of large quoted/listed companies. In addition to providing audits, they also provide other services including tax advice and IT consultancy.

Firm 2007 global revenue (US dollars)
PricewaterhouseCoopers (corporate website) 25.2bn
Deloitte (corporate website) 23.1bn
Ernst & Young (corporate website) 21.1bn
KPMG (corporate website) 19.8bn

Other significant audit firms are listed here:

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

Related qualifications

See also

References

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