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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 practicing 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 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. Auditing promotes transparency and accuracy in the financial disclosures made by an organization, therefore would likely to reduce of such corporations to conceal unscrupulous dealings.
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.
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 knowing that the financial statements are presented fairly, in all material aspects. An audit is not designed to provide assurance of 100% accuracy; rather it 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 asymmetry and reducing information risk, not because they are required by law (note: audits are obligatory in many EU-member states and in many jurisdictions are obligatory for companies listed on public stock exchanges).
Audit Process and Techniques
For collection and accumulation of audit evidence, certain methods and means generally adopted by auditors are:
- Posting checking
- Casting checking
- Physical examination and count
- Year-end scrutiny
- Tracing in subsequent period
- Bank reconciliation
- Verification of existence, ownership, title and value of assets and determination of the extent and nature of liabilities
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 issuance 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.
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, 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[update]) 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 papers).
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-end
- 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-end
- To assess the operating effectiveness of internal controls (e.g. authorisation of transactions, account reconciliations, segregation of duties) including IT General Controls. 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).
- 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.
Timing: after year-end (see note regarding hard/fast close below)
- 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.
- 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)
- 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.
Timing: at the end of the audit
- 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.
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.
- There are several related professional qualifications in the field of financial audit including Certified General Accountant, Chartered Certified Accountant, Chartered Accountant and Certified Public Accountant.