The auditor’s report must accompany the financial statements when issued to the intended recipients. The main purpose of a financial statement audit is to add credibility to a business’s reported financial position and performance. The Securities and Exchange Commission requires that all publicly held entities 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 because of 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.
Definition of Financial Statement Audit
A financial statement audit examines an entity’s financial statements and accompanying disclosures by an independent auditor. The result is a report by the auditor attesting to the fairness of the presentation of the financial statements and related disclosures.
Need or Importance 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 an actual or potential conflict of interest between themselves and the reporting entity’s management.
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.
Consequence
Published financial statements are the only information source for users to make 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.
Complexity
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.
Remoteness
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 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 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. The independent auditors assure this relevance.
- 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 independent auditors report meeting their needs.
- Errors and frauds are located at an early date, and in the future, no attempts 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.
- Suppose the business is to be sold as a going concern. In that case, 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 accept the profit and loss account that a qualified auditor has prepared and 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 uniformly, one year’s accounts 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.
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. The audit must be at a reasonable cost and within a reasonable length of time to be useful.
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 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 preparing 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.
