Financial audit
Encyclopedia
A financial audit, or more accurately, an audit of financial statements, is the verification of the financial statements of a legal entity, with a view to express an audit opinion. The audit opinion is intended to provide reasonable 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 enhance the degree of confidence of intended users in the financial statements.
Financial audits are typically performed by firms of practising 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 audit
ors, 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.
Internationally, the International Standards on Auditing
(ISA) issued by the International Auditing and Assurance Standards Board
(IAASB) is considered as the benchmark for audit process. Almost all jurisdictions require auditors to follow the ISA or a local variation of the ISA.
, not because they are required by law (note: audits are obligatory in many EU-member states).
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
.
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 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.
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 paper
s).
Some oversight organizations require auditors and audit firms to undergo a third-party quality review periodically to ensure the applicable GAAS is followed.
The following are the stages of a typical audit:
Purpose:...
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Notes:
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Methods:
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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.
Financial audits are typically performed by firms of practising accountants who are experts in financial reporting. The financial audit is one of many assurance
Assurance services
Assurance service is an independent professional service, typically provided by CPAs, with the goal of improving the information or the context of the information so that decision makers can make more informed, and presumably better decisions...
functions provided by accounting
Accountancy
Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers. The communication is generally in the form of financial statements that show in money terms the economic resources under the control of management; the art lies in...
firms. Many organizations separately employ or hire internal audit
Internal audit
Internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk...
ors, who do not attest to financial reports but focus mainly on the internal controls of the organization. External auditors
External audit staff
An external auditor is an audit professional who performs an audit in accordance with specific laws or rules on the financial statements of a company, government entity, other legal entity or organization, and who is independent of the entity being audited...
may choose to place limited reliance on the work of internal auditors.
Internationally, the International Standards on Auditing
International Standards on Auditing
International Standards on Auditing are professional standards for the performance of financial audit of financial information. These standards are issued by International Federation of Accountants through the International Auditing and Assurance Standards Board .-Respective responsibilities:*ISA...
(ISA) issued by the International Auditing and Assurance Standards Board
International Auditing and Assurance Standards Board
The International Auditing and Assurance Standards Board is the independent standard setting body which issue auditing, review, other assurance related services and quality control standards to be applied by the global auditing profession...
(IAASB) is considered as the benchmark for audit process. Almost all jurisdictions require auditors to follow the ISA or a local variation of the ISA.
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. 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 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 asymmetryInformation asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
, not because they are required by law (note: audits are obligatory in many EU-member states).
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 IElizabeth I of England
Elizabeth I was queen regnant of England and Ireland from 17 November 1558 until her death. Sometimes called The Virgin Queen, Gloriana, or Good Queen Bess, Elizabeth was the fifth and last monarch of the Tudor dynasty...
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
Comptroller
A comptroller is a management level position responsible for supervising the quality of accounting and financial reporting of an organization.In British government, the Comptroller General or Comptroller and Auditor General is in most countries the external auditor of the budget execution of the...
of the Exchequer, who was charged with controlling the issue of funds to the government.
As Chancellor of the Exchequer
Chancellor of the Exchequer
The Chancellor of the Exchequer is the title held by the British Cabinet minister who is responsible for all economic and financial matters. Often simply called the Chancellor, the office-holder controls HM Treasury and plays a role akin to the posts of Minister of Finance or Secretary of the...
, William Ewart Gladstone
William Ewart Gladstone
William Ewart Gladstone FRS FSS was a British Liberal statesman. In a career lasting over sixty years, he served as Prime Minister four separate times , more than any other person. Gladstone was also Britain's oldest Prime Minister, 84 years old when he resigned for the last time...
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
National Audit Office (United Kingdom)
The National Audit Office is an independent Parliamentary body in the United Kingdom which is responsible for auditing central government departments, government agencies and non-departmental public bodies...
.
Governance and Oversight
In the United States, the SEC has generally deferred to the accounting 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
Association of Chartered Certified Accountants
Founded in 1904, the Association of Chartered Certified Accountants is the global body for professional accountants offering the Chartered Certified Accountant qualification . it is one of the largest and fastest-growing global accountancy bodies with 147,000 members and 424,000 students in 170...
, 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
Enron
Enron Corporation was an American energy, commodities, and services company based in Houston, Texas. Before its bankruptcy on December 2, 2001, Enron employed approximately 22,000 staff and was one of the world's leading electricity, natural gas, communications, and pulp and paper companies, with...
. The company succeeded in hiding some important facts, such as off-book liabilities, from banks and shareholders. Eventually, Enron filed for bankruptcy, and is in the process of being dissolved. One result of this scandal was that Arthur Andersen
Arthur Andersen
Arthur Andersen LLP, based in Chicago, was once one of the "Big Five" accounting firms among PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, providing auditing, tax, and consulting services to large corporations...
, 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
Accounting scandals
Accounting scandals, or corporate accounting scandals, are political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations...
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
Public Company Accounting Oversight Board
The Public Company Accounting Oversight Board is a private-sector, non-profit corporation created by the Sarbanes–Oxley Act, a 2002 United States federal law, to oversee the auditors of public companies. Its stated purpose is to 'protect the interests of investors and further the public interest...
(PCAOB) set up by the Sarbanes-Oxley Act.
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 paper
Working paper
A working paper or work paper or workpaper may refer to:*A preliminary scientific or technical paper. Often, authors will release working papers to share ideas about a topic or to elicit feedback before submitting to a peer reviewed conference or academic journal.* Sometimes the term working paper...
s).
Some oversight organizations require auditors and audit firms to undergo a third-party quality review periodically to ensure the applicable GAAS is followed.
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-endPurpose:...
- To understand the business of the company and the environment in which it operates.
- What should auditors understand?
- 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
- What should auditors understand?
- 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-endPurpose:
- To assess the operating effectiveness of internal controls (e.g. authorisation of transactions, account reconciliations, segregation of dutiesSeparation of dutiesSeparation of duties is the concept of having more than one person required to complete a task. In business the separation by sharing of more than one individual in one single task shall prevent from fraud and error. The concept is alternatively called segregation of duties or, in the political...
) including IT General ControlsITGCIT general controls are controls that apply to all systems components, processes, and data for a given organization or information technology environment...
. 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.
Substantive procedures
Timing: after year-end (see note regarding hard/fast close below)Purpose:
- to collect audit evidence that the management assertionsManagement assertionsIn a financial audit, management assertions or financial statement assertions is the set of information that the preparer of financial statements is providing to another party...
(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.
Finalization
Timing: at the end of the auditPurpose:
- To compile a reportAuditor's reportThe auditor's report is a formal opinion, or disclaimer thereof, issued by either an internal auditor or an independent external auditor as a result of an internal or external audit or evaluation performed on a legal entity or subdivision thereof...
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.
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
- There are several related professional qualifications in the field of financial audit including Certified General AccountantCertified General AccountantCertified General Accountant is the designation of professionals who are jointly members of the Certified General Accountants Association of Canada and a provincial or territorial CGA association, or a CGA association overseas...
, Chartered Certified AccountantChartered Certified AccountantChartered Certified Accountant was historically seen as a British qualified accountant designation awarded by the Association of Chartered Certified Accountants . However, although ACCA is UK based, it is a global body for professional accountants with 147,000 qualified members and 424,000...
, Chartered AccountantChartered AccountantChartered Accountants were the first accountants to form a professional body, initially established in Britain in 1854. The Edinburgh Society of Accountants , the Glasgow Institute of Accountants and Actuaries and the Aberdeen Society of Accountants were each granted a royal charter almost from...
and Certified Public AccountantCertified Public AccountantCertified Public Accountant is the statutory title of qualified accountants in the United States who have passed the Uniform Certified Public Accountant Examination and have met additional state education and experience requirements for certification as a CPA...
.
See also
- Auditor's reportAuditor's reportThe auditor's report is a formal opinion, or disclaimer thereof, issued by either an internal auditor or an independent external auditor as a result of an internal or external audit or evaluation performed on a legal entity or subdivision thereof...
- Center for Audit QualityCenter for Audit QualityThe Center for Audit Quality is an autonomous public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets...
(CAQ) - Comfort letterComfort LetterA comfort letter is a document prepared by an accounting firm assuring the financial soundness or backing of a company. The comfort letter can be issued by a CPA declaring no indication of false or misleading information in the financial statements and that the company's prospectus follows GAAP....
- Comparison of accounting softwareComparison of accounting softwareThe following comparison of accounting software documents the various features and differences between different professional accounting software and personal finance packages.- Free and open source software :- Proprietary software :...
- Computer Assisted Audit Tools
- Forensic AccountingForensic accountingForensic accounting is the specialty practice area of accountancy that describes engagements that result from actual or anticipated disputes or litigation. "Forensic" means "suitable for use in a court of law", and it is to that standard and potential outcome that forensic accountants generally...
- International Standards on AuditingInternational Standards on AuditingInternational Standards on Auditing are professional standards for the performance of financial audit of financial information. These standards are issued by International Federation of Accountants through the International Auditing and Assurance Standards Board .-Respective responsibilities:*ISA...
(ISA) - List of accounting topics