AUDIT
The course in auditing is different from other courses in the accounting curriculum. The other financial and managerial accounting courses are aimed at conveying financial or managerial accounting principles and concepts and how they are applied in preparing and using financial information. The approach to these financial and managerial courses has been as a member of the organization’s management team, and the finished product—the financial statements—was used either by management for decision making or reporting the financial activities to stockholders, investors, lenders, or interested third parties.
It is also possible to approach a course in auditing from the standpoint of a member of the organization, whose audits are performed by internal auditors. However, here we will discuss the role of the external auditor, the auditor who is not an employee of the organization. This approach requires the student to alter the orientation he or she has assumed in other accounting courses. The new role is that of an outsider, or an independent public accountant, hired not to prepare financial statements, but to give an opinion on the fairness of the financial statements prepared by the internal company accountants. This role will require a different approach to learning than previously encountered in accounting courses and will demand unique skills that enable the auditor to make decisions regarding the accuracy of an organization’s financial statements. The first skill is the ability to approach and solve audit problems. In addition, the auditor must possess an inquiring audit attitude to uncover problems and discrepancies when they exist. Some have suggested that auditing cannot be learned in the classroom, and that it is a subject that can only be learned by actual hands-on experience. While it is difficult to duplicate or simulate the actual practice environment in the classroom, it is possible to learn about auditing in the classroom. For those not intending to become professional auditors, this course will illuminate the process of auditing, as well as the role played by auditors in financial reporting. As potential users of independent audits, students will find it valuable to know not only what an audit represents, but also its limitations.
Auditors are valued because of their technical knowledge and independence in providing assurances, as well as their competence and experience in assiting companies to improve operations. Auditors often make and help implement recommendations that improve profitability by enahncing revenue or reducing costs, including the reduction of errors and fraud, and by improving operational controls.
Assurance Services
Assurance services are independent professional services that improve the quality of information for decision makers. Individiuals who are responsible for making business decisions seek assurance services to help improve the reliability and relevance of the information used as the basis for their decisions. Assurance services are valued because the assurance provider is independent and perceived as being unbiased with respect to the information examined.
Assurance services can be performed by certified public accountants (CPAs) or by a variety of other professionals. The need for assurance is not new. CPAs have provided many assurance services for years, particularly assurances about historical financial statement information.CPA firms have also performed assurance services related to lotteries and contents to provide assurance that winners were determined in an unbiased fashion in accordance with contest rules. More recently, CPAs have been expanding the types of assurance services they perform to include engagements that provide assurance about other types of information, such as assurance about company financial forecasts and assurance about Web site controls. The demand for assurance services is expected to grow as the demand for forward-looking information increases and as more real-time information becomes available through the Internet.
Attestation Services
The source of accounting information for financial decision makers creates a potential conflict of interest which is a condition that creates society’s demand for audit services. Users need reliable information and this creates the need for professional auditors to lend credibility to financial information. The lending of credibility is known as attestation, and the independent auditing of financial statements is described as the attestfunction.
One category of assurance services provided by CPAs is attestation services. An attestation service is a type of assurance service in which the CPA firm issues a report about the reliability of an assertion that is the responsibility of another party.
There are three categories of attestation services: audit of historical financial statements, review of historical financial statements, and other attestation services that may be applied to a broad range of subject matter.
1. Audit of Historical Financial Statements:
An audit of historical financial statements is a form of attestation service in which the auditor issues a written report expressing an opinion about whether the financial statements are in material conformity with generally accepted accounting principles.
Audits represent the predominant form of assurance performed by CPA firms.
Auditing does not include financial report production. Auditors obtain evidence to determine whether financial statements information prepared by management is reliable. Auditors express an opinion that the company’s financial statements are in conformity with generally accepted accounting principles. Independent auditors work for clients. A client retains the auditor and pays their fee. An auditee is the entity being audited. The client and the auditee are typically the same entity, but can be different.
When representing information in the form of financial statements, the client makes various assertions about its financial condition and results of operations. External users who rely on those financial statements to make business decisions look to the auditor's report as an indication of the statements' reliability. They value the auditor's assurance because of the auditor's independence from the client and knowledge of financial statement reporting matters.
2. Review of Historical Financial Statements:
A review of historical financial statements is another type of attestation service performed by CPAs. Many nonpublic companies want to provide assurance on their financial statements, without incurring the cost of an audit. Whereas an audit provides a high level of assurance, a review service provides a moderate amount of assurance on the financial statements, and less evidence is necessary to support this level of assurance. A review is often adequate to meet users' needs and can be provided by the CPA firm at a much lower fee than an audit.
3. Other Attestation Services:
CPAs provide numerous other attestation services. Many of these services are a natural extension of the audit of historical financial statements, as users seek independent assurances about other types of information. For example, banks often require debtors to engage CPAs to provide assurance about the debtor's compliance with certain financial covenant provisions stated in the loan agreement. CPAs also provide assurance about the effectiveness of a client's internal controls over financial reporting. The information about internal controls is closely related to the financial statements, but it is also forward-looking because effective internal controls reduce the likelihood of future misstatements in the financial statements. CPAs also can attest to the information in a client's forecasted financial statements, which are often used to obtain financing.
Other Assurance Services:
Most of the other assurance services that CPAs provide do not meet the formal definition of attestation services. They are similar to attestation services in that the CPA must be independent and must provide assurance about information used by decision makers. They differ in that the CPA is not required to issue a written report, and the assurance does not have to be about the reliability of another party's written assertion about compliance with specified criteria. Rather, in these other assurance services engagements, the assurance is about the reliability and relevance of information, which may or may not have been asserted by another party. The common feature of all assurance services, including audits and attestation services, is the focus on improving the quality of information used by decision makers.
The demand for assurance on other types of information is expected to grow substantially with new types of risks faced by businesses and increases in the amount of available information sources.
Assurance Services on Information Technology:
One of the major factors affecting the demand for other assurance services is the growth of the Internet and electronic commerce. As transactions and information are shared online and in real time, there is even greater demand for assurances about computer controls surrounding information transacted electronically and the security of the information related to the transactions. CPAs can help provide assurance about these functions. Two examples of assurance services related to information technology are assurances over Web site controls and assurances about information system reliability.
Assurance Services on Other Types of Information:
CPA Performance View: Businesses need success factors other than financial information to manage their business. Examples include customer satisfaction and product quality. CPAs can help management identify and measure critical success factors.
CPA Risk Advisory Services: To succeed in the economy, businesses must be successful in taking and managing risk. For example, a company expanding globally may face risks from changes in exchange rates or political upheaval in other countries. CPAs providing this service help their clients identify and manage risks.
There are almost no limits to the types of services that CPAs can provide.
Nonassurance Servives Provided by CPAs:
CPA firms perform numerous other services that generally fall outside the scope of assurance services. Three specific examples of nonassurance services CPAs often provide include accounting and bookkeeping services, tax services, and management consulting services.
The common feature of all assurance services, including audits and attestation services, is the focus on improving the quality of information used by decision makers.
Economic Demand for Auditing
To illustrate the need for auditing, consider the decision of a bank manager in making a loan to a business. This decision will be based on such factors as previous financial relationships with the business and the financial condition of the business as reflected by its financial statements. If the bank makes the loan, it will charge a rate of interest determined primarily by three factors:
a) Risk-free interest rate: This is approximately the rate the bank could earn by investing in government treasury notes for the same length of time as the business loan.
b) Business risk for the customer: This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions such as a recession, poor management decisions, or unexpected competition in the industry.
c) Information risk: Information risk affects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements.
Auditing has no effect on either the risk-free interest rate or business risk, but it can have a significant effect on information risk. If the bank manager is satisfied that there is minimal information risk because a borrower's financial statements are audited, the risk is substantially reduced and the overall interest rate to the borrower can be reduced. The reduction of information risk can have a significant effect on the borrower's ability to obtain capital at a reasonable cost.
Nature of Auditing
So far, we have discussed the importance of audits of financial statements and their relation to other attestation and assurance services offered by CPA firms. We now examine auditing more specifically using the following definition:
"Auditing is the accumulation and evaluation of evidence about information to determine and report on the degree of correspondence between the information and established criteria.” Auditing should be done by a competent, independent person.
Kinds of Audits
1. External Auditing
External auditors are certified public accountants who are independent of the organizations whose assertions or representations are being audited. These independent auditors offer their audit services on a contractual basis. The majority of audits performed by external auditors are financial statement audits.
2. Operational / Internal Auditing
Internal auditing is practices by auditors employed by an organization. Internal auditing activity is known as operational auditing, performance auditing, or management auditing. Operational auditing refers to the study of business operations for the purpose of making recommendations about the economic and efficient use of resources, effective achievement of business objectives, and compliance with company policies. The goal of operational auditing is to help managers discharge their management responsibilities and improve profitability. Internal auditors can perform audits of financial reports for internal use.
3. Governmental Auditing
Members of local, state and federal government units audit various organizational functions for a variety of reasons such as the following:
Local and state government units audit businesses to determine whether sales taxes have been collected and remitted according to stipulated laws or regulations (a type of compliance audit).
The Internal Revenue Service audits corporate and individual income tax returns to determine whether income taxes have been calculated according to the applicable laws or interpretations of these laws (another type of compliance audit).
Governmental audits also includes:
- Financial audits that determine whether;
- Financial information is presented in accordance with established criteria
- The entity has adhered to the financial compliance requirements, and
- The entity’s internal control is suitably designed and implemented.
- Performance audits (a type of operational audit), that review for efficiency and economy in the use of resources.
But as we have told before, we will commonly be interested in the external auditing.
Accumulating and Evaluating Evidence
Evidence is any information used by the auditor to determine whether the information being audited is stated in accordance with the established criteria. Evidence takes many different forms, including oral testimony of the auditee (client), written communication with outsiders, observations by the auditor, and electronic data about transactions. It is important to obtain a sufficient quality and volume of evidence to satisfy the purpose of the audit. Determining the types and amount of evidence necessary and evaluating whether the information corresponds to the established criteria is a critical part of every audit.
Sufficient Competent Evidence in Auditing
Competency of Evidence: To be considered competent, evidence must be valid, relevant, and unbiased. The relative competence and persuasive power of different kinds of evidence would be determined by the following hierarchy of evidential matter, from highest to lowest.
1.Auditors direct, personal knowledge obtained through physical observation, or mathematical computation
2.Documentary evidence obtained directly from independent external sources (external evidence).
3.Documentary evidence that has originated outside clients system, but which has been received and processed by the client (external-internal evidence).
4.Internal evidence consisting of documents that are produced, circulated, and stored within the clients system (internal evidence).
5.Verbal and written representations by the client’s officers, directors, owners, and employees.
Sufficiency
The auditor can rarely be certain of the validity of the financial statements. However, he needs to obtain sufficient, relevant and reliable evidence to form a reasonable basis for his opinion thereon.
Sufficiency of Evidence: Sufficiency, a question of how much competent evidence is enough, a matter of auditor’s professional judgment.
Relevance
The relevance of the audit evidence should be considered in relation to the overall auditing objectives of forming an opinion and reporting on the financial statements.
To achieve these objectives, the auditor needs to obtain evidence to enable him to draw reasonable conclusions in answering the questions such as:
a) Balance Sheet
1. Have all of the assets and liabilities been recorded?
2. Are the assets owned by the enterprise and are the liabilities properly those of the enterprise?
3. Have the amounts attributed to the assets and liabilities been arrived at in accordance with the stated accounting policies on an acceptable and consistent basis?
4. Have the assets, liabilities and capital and reserves been properly disclosed?
5. Do the recorded assets and liabilities exist?
b)Profit and loss account
1. Have all income and expenses been recorded?
2. Did the recorded income and expense transactions in fact occur?
3. Have the income and expenses been measured in accordance with the stated accounting policies, on an acceptable and consistent basis?
4. Have income and expenses been properly disclosed where appropriate?
Reliability
Although the reliability of audit evidence is dependent upon the particular circumstances, the following general presumptions may be found helpful:
1. Documentary evidence is more reliable than oral evidence.
2. Evidence obtained from independent sources outside the enterprise is more reliable than that secured solely from within the enterprise.
3. Evidence originated by the auditor by such means as analysis and physical inspection is more reliable than evidence obtained from others.
Audit Evidence
The auditor should obtain relevant and reliable audit evidence sufficient to enable him to draw reasonable conclusion from the following items:
- Main accounting evidence from accounting system: balance sheet, profit and loss account, ledger, daily book, cashbook, trial balance sheet are main accounting evidence.
- Evidence in support of the overall audit opinion: invoices, receipts, checks, bank drafts and other documents.
The auditor will obtain evidence from several sources, which, together, will provide him with the necessary assurance.
Competent, Independent Person:
The auditor must be qualified to understand the criteria used and must be competent to know the types and amount of evidence to accumulate to reach the proper conclusion after the evidence has been examined. The auditor must also have an independent mental attitude.