A financial statement audit is the examination of an entity’s financial statements and accompanying disclosures by an independent auditor, with the result being a report by the auditor, attesting to the fairness of presentation of the financial statements and related disclosures.
The auditor’s report must accompany the financial statements when they are issued to the intended recipients.
The main purpose of a financial statement audit is to add credibility to the reported financial position and performance of a business. The Securities and Exchange Commission requires that all entities that are publicly held must file annual reports with it that are audited.
Similarly, lenders typically require an audit of the financial statements of any entity to which they lend funds.
Suppliers may also require audited financial statements before they will be willing to extend trade credit (though usually only when the amount of requested credit is substantial).
Audits have become increasingly common as the complexity of the two primary accounting frameworks, Generally Accepted Accounting Principles and International Financial Reporting Standards, have increased, and because there has been an ongoing series of disclosures of fraudulent reporting by major companies.
Before we proceed further, it is considered necessary that one should understand the relationship between accounting and auditing.
Need for Financial Statement Audits
Need for Financial Statement Audits
The need for independent audits of financial statements can be attributed to four conditions as follows:
Conflict of Interest
Many users of financial statements are concerned about ah actual or potential conflict of interest between themselves and the management of the reporting entity.
This apprehension extends to a fear that the financial statements and accompanying data prepared by management may be intentionally biased in management’s favor.
Thus, users seek assurance from outside independent auditors that the information is both;
- free from management bias, and
- neutral concerning the various user groups.
Published financial statements are the only source of information for users in making significant investments, lending and other decisions.
So statement users look to the independent auditor for assurance’ that the financial statements have been prepared in conformity with GAAP, including all the appropriate disclosures.
As the level of complexity of accounting increases, so does the risk of misinterpretations and unintentional errors. So to evaluate the quality of the financial statements, users rely on independent auditors.
Distance, time and cost make it impractical even for the most knowledgeable users of financial statements to seek direct access to the underlying accounting records to perform their verifications of the financial statement assertions. So users rely on the independent auditor’s report to meet their needs.
The present-day the need for independent audits of financial statements is increasing day by day.
On account of the following advantages people get their accounts audited:
- Conflicts of interest exist among the different classes of users of financial statements, such as creditors and stockholders. In this case, auditing helps the users by assuring from outside independent auditors that the information is both: (1) free from management bias and (2) neutral concerning the various user groups.
- Users want financial statements to contain as much relevant data as possible. This relevance is assured by the independent auditors.
- .Since the subject matter of accounting and the process of preparing financial statements have become increasingly complex, the risk of misinterpretations and unintentional errors is increasing. To evaluate the quality of the financial statements, users rely on independent auditors to access the quality of the information contained therein.
- Distance, time and cost make it impractical for the most knowledgeable users of financial statements to seek direct access to the underlying accounting records. So users rely on the independent auditors report meeting their needs.
- Errors and frauds are located at an early date and in future no attempt are made to commit such frauds or one is rather careful not to commit an error or a fraud as the accounts are subject to regular audit.
- The auditing of accounts keeps the accounts clerks regular and vigilant as they know that the auditors would complain against-them if the accounts -are not prepared up-to-date or if there is any irregularity.
- In case of fire, the insurance company may settle the claim based on the audited accounts of the previous years.
- Money can be borrowed easily based on the previous audited balance sheet.
- If the business is to be sold as a going concern, there will not be much difficulty regarding the valuation of assets and goodwill as the accounts have already been subject to audit by an independent person.
- Income tax authorities generally accepted the profit and loss account which has been prepared by a qualified auditor and they do not go into details of the accounts.
- The management may consult the auditor and seek his advice on certain technical points although it is not the duty of an auditor to give advice.
- If the accounts have been prepared on a uniform basis, accounts of one year can be compared with other years and if there is any discrepancy, the cause may be enquired into.
- Audited accounts are considered more or less correct by the sales tax authorities.
- It would facilitate the settlement of the accounts of a deceased partner.
- Auditing acts as an alternative to an internal control system.
Sole traders and partnerships are under no legal obligation to get their accounts audited but because of the advantages derived, they generally have their accounts audited.
Similarities between Accounting and Auditing
The similarities between both an accounting and an audit require a thorough knowledge of accounting procedures and are usually done by those with an accounting degree.
An auditor will generally be an accountant who is “knowledgeable about the organization’s auditing procedures and processes.
Another similarity; both processes aim to ensure the company’s records accurately reflect its financial position.
There are significant differences in the methods, objectives, and parties responsible for the accounting process by which the financial statements Jtre prepared and the audit of the statements.,
Accounting methods involve identifying the events and transactions that affect the entity.
Once identified, these items are measured, recorded, classified, and summarized in the accounting records. The result of this process is the preparation and distribution of financial statements that conform to generally accepted accounting principles (GAAP).
The ultimate objective of accounting is the communication of relevant and reliable financial data that will be useful for decision making.
An entity’s employees are involved in the accounting process, and ultimately responsibility for die financial statements lies with the entity’s management.
The typical audit of financial statements involves obtaining and evaluating evidence concerning management’s financial statements to enable the auditor to verify whether the statements are presented in conformity with GAAP.
The auditor is responsible for adhering to generally accepted auditing standards in gathering and evaluating the evidence and in issuing an audit report that contains the auditor’s conclusion expressed in the form of an opinion on the financial statements.
The primary objective of auditing is to add credibility to the financial statements prepared by management.
Differences between Accounting and Auditing
Accounting is related to the collection, recording; analysis and interpretation of financial transactions but auditing refers to the examination of books of accounts along with the evidential documents.
There are significant differences between auditing and accounting;
Accounting is the act of collecting, recording, analyzing and interpretation of financial transactions but auditing is the act of examination of books of accounts and evidential documents, to prove the true arid fair view of profitability and financial position.
Beginning of Work
Work of accounting begins when financial transactions take place but the work of auditing begins when the work of accounting ends.
Accounting prepares profit and loss account and balance sheet and other statements as per the instruction of auditor but auditor checks the books of accounts considering their fairness as well as complying with the provision of company act or not.
Nature of Work
Accounting keeps the record of financial transactions but auditor checks and verifies the books of accounts.
An accountant is a staff of an organization and draws the salary from the business but an auditor is an independent person who is appointed for a specific period and gets a sum of remuneration.
Preparation of Report
An accountant does not prepare a report after the completion of his task but he has to give information to the management when needed but the auditor needs to prepare and present a report after the completion of his work to the concerned authority.
An accountant remains responsible for the management but an auditor is responsible to the owners or shareholders.
Limitations of a Financial Statements Audit
A financial statement audit made by GAAS is subject to several inherent limitations.
One constraint is that the auditor works within fairly’ restrictive economic limits. To be useful, the audit must be at a reasonable cost and within a reasonable length of time.
The limitation on cost results in selective testing, or sampling, of the accounting records supporting data. The time constraint may affect the amount of evidence that can be obtained concerning events and transactions after the balance sheet date that may affect the financial statements.
Another significant limitation is the established accounting framework for the preparation of financial statements.
Alternative principles are often permitted under GAAP, estimates are an inherent part of the accounting process, and no one including auditors can foresee the outcome of uncertainties.
Despite these limitations, a financial statement audit adds credibility to the financial statements.