Understanding Financial Statement Audits: A Comprehensive Guide

Overview and Purpose of Financial Statement Audits

Purpose of a Financial Statement Audit

Organizations produce financial statements that provide information about their financial position and performance. This information is used by a wide range of stakeholders (e.g., investors) in making financial decisions. Often, those who own an organization (the shareholders) are not those who manage it. Therefore, the owners of these organizations (as well as other stakeholders such as banks, suppliers, and customers) take comfort from independent assurance that the financial statements fairly present, in all material respects, the company's financial position and performance.

To enhance the level of confidence in the financial statements, a qualified external auditor is engaged to examine the financial statements, including related disclosures prepared by management, to provide their professional opinion on whether they fairly reflect, in all material respects, the organization's financial performance over a given period(s) (an income statement) and financial position as at a specific date(s) (a balance sheet) in accordance with applicable GAAP. In most cases, this is legally required.

Public vs. Private Companies

While organizations of all sizes produce financial statements, the number of stakeholders interested in them would typically be larger for public organizations and larger private companies, due to the number of individuals, organizations, and institutions that interact with and are affected by them. Also, public organizations' financial statements are typically available to a larger number of users. In many jurisdictions, for public companies, there are additional requirements to comply with when preparing their financial statements. Large public company audits are typically more complex and also used by many more market participants.

Audit Environment

The changing economic and regulatory environment has significant implications for an organization's operations and financial reporting. Changes in the business, economy, and laws and regulations generally increase the level of risks affecting the business and require adequate response and disclosure in the financial statements. This also affects the way an audit is conducted, since the auditor's work must be scaled to address increased risks of material misstatement of the financial statements.

In the current environment, auditors need to consider various evolving factors that may result in additional challenges. When an organization consists of multiple entities, there are additional complexities that must be addressed. These considerations are likely to complicate matters further when the organization has operations in various countries and therefore spans different regulatory requirements.

Audit Reporting and Opinions

Audit Opinion

The management of a company is responsible for preparing the financial statements. The auditor is responsible for expressing an opinion indicating that reasonable assurance has been obtained that the financial statements as a whole are free from material misstatement, whether due to fraud or error, and that they are fairly presented in accordance with the applicable accounting standards (e.g., International Financial Reporting Standards).

There are clear frameworks from independent auditing standard setters which provide rules and guidance on how an audit should be carried out and the level of assurance obtained. It is the auditor's responsibility to plan and conduct the audit so that it meets the applicable audit standards and sufficient appropriate evidence is obtained to support the audit opinion. However, what constitutes sufficient appropriate evidence is ultimately a matter of professional judgment.

The audit opinion is clearly stated as a separate paragraph in the audit report. The auditor provides a 'clean' opinion when they conclude that the financial statements are free from material misstatement.

Modified Audit Opinions

Auditors can also modify the audit report without changing the opinion by adding additional paragraphs to draw users' attention to specific significant matters. For instance, if the auditors believe that there is some aspect of the financial statements that is subject to a material level of uncertainty—whether or not fully disclosed—then they may draw attention to and emphasize this in the audit report. This is widely known as an emphasis of matter paragraph.

Going Concern Assumptions

Under the going concern assumption, an organization is viewed as continuing in business for the foreseeable future. Financial statements are prepared on a going concern basis, unless management either intends to liquidate the organization or to cease operations, or has no realistic alternative but to do so.

When the use of the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the organization will be able to realize its assets and discharge its liabilities in the ordinary course of business.

If management considers that the organization will not continue to operate for the foreseeable future, the financial statements must be prepared on a 'liquidation' (or 'break-up') basis—meaning that the valuation of their assets must consider potential forced sales which will likely be substantially lower, and their liabilities may be substantially higher.

The Annual Report

An organization's annual report is typically comprised of the audited financial statements and a narrative, containing management's description of the organization's performance and activities. The narrative portion of the annual report is not typically audited. However, the auditors read the narrative statements in the annual report to identify any material inconsistencies with the audited information in the financial statements.

Other Reports

In many jurisdictions, financial statements form only one piece of the financial information that a public company prepares. In addition to publishing full financial statements annually, public companies typically also need to provide less detailed financial information at various points throughout the year. In most cases, auditors review this financial information, but this review is not an audit. Rather, the auditors make inquiries, apply analytical and other review procedures, and communicate whether anything has come to their attention that suggests the financial information is not prepared, in all material respects, in accordance with the applicable GAAP.

The Audit Process

Professional Judgment and Skepticism

In undertaking an audit, the auditors consider the mandatory and detailed GAAP that set out how an organization should account for and disclose even the most complex transactions. However, many of the issues that arise in an audit—especially those involving valuations or assumptions about the future—involve estimates to which the auditor must bring their professional judgment and experience to bear.

Indeed, many accounting measures can only ever be estimates that are inevitably based on imperfect information or dependent upon future events. For example, if an organization was involved in legal proceedings, it would need to estimate the amount at which the case would be settled; or if it was planning to sell a property it owns, it would need to estimate the sale price.

Auditing standards also require auditors to maintain professional skepticism—an attitude that includes a questioning mind and a critical assessment of audit evidence. The ability to think critically about how the current economic environment may affect the organization's financial statements, to identify significant risks of material misstatement, to develop appropriate audit responses, to obtain and evaluate the sufficiency and appropriateness of audit evidence, and to reach well-informed professional conclusions is essential to performing a quality audit.

Inherent Limitations of an Audit

An opinion is not a guarantee of an outcome, but rather a statement of professional judgment. The auditor cannot obtain absolute assurance that financial statements are free from material misstatement because of the inherent limitations of an audit. These are caused by various factors. For instance, many financial statement items involve subjective decisions or a degree of uncertainty (e.g., accounting estimates). As a result, such items are subject to an inherent degree of uncertainty which cannot be eliminated by the application of auditing procedures.

Fraud Considerations

Fraud has a corrosive effect on the trust fundamental for organizations to conduct business. Management is responsible for running the organization and preventing and detecting fraud. Preventing and detecting fraud is difficult because fraud is intentionally concealed and may involve collusion by multiple parties.

Although audits are properly conducted in accordance with applicable GAAS, they may not detect material fraud. However, auditors are responsible for obtaining reasonable assurance that the financial statements are not materially misstated due to fraud.

The Five Phases of an Audit

Broadly, the audit process can be summarized in five phases:

Auditors interact with the organization during all phases of the audit process listed above. There will be ongoing discussions and meetings with management, both at operational and senior executive levels, and with those charged with governance. Using their professional skepticism and judgment, auditors challenge management's assertions regarding the numbers and disclosures in the financial statements.

The Audit Committee and Governance

In public companies, shareholders ultimately approve the auditor's appointment, and the auditors are primarily responsible to and overseen by those representing the shareholders' interests with respect to financial reporting and internal controls.

Typically, an audit committee (or its equivalent), acting as a largely independent body, will be charged with representing the shareholders' interests. Organizations may not necessarily have an audit committee, and this interaction may be managed less formally but in a similar manner. The audit committee is a sub-committee of those charged with governance and is typically comprised of a majority of non-executive directors who are the shareholders' representatives with respect to the external audit.

The chair of the audit committee has a fundamental role to play in assessing management's tone from the top with respect to the organization's financial reporting.

In addition to their public report on the financial statements, the auditors will typically have more detailed communications with the audit committee. These communications may include a description of how the audit was performed, the audit approach, the auditor's views about the organization's accounting practices (including accounting policies, estimates, and disclosures), how the auditors satisfied themselves on the key issues that arose, and significant challenges, if any, encountered during the audit.

Auditor Independence and Qualifications

Auditor Independence

Shareholders need to have confidence that the auditors have assessed relevant information objectively, and that they have examined evidence critically and independently. Investors also need to be certain that the auditors have undertaken their work and made their conclusions free from any bias, and without being influenced unduly by the management who prepared the financial statements.

There are many detailed rules and professional standards to which audit firms and all their staff must adhere, and which support both the fact and appearance of auditor independence. In simple terms, auditors may do nothing that should be the role of management or that creates a mutual interest.

The most important factor supporting auditor independence is the state of mind that is instilled through audit training, practice, and the culture of the audit firm, and which auditors exhibit through professional skepticism in their work. The discipline of independence is core to an auditor's approach and attitude.

Auditor Appointment

The auditor's appointment is generally and ultimately approved by the shareholders, but the auditors are paid by the organization itself. The audit committee assumes responsibility for overseeing the auditor's independence and performance, and for recommending to the organization's highest governing body (typically the board) whether their reappointment should be put to the shareholders at an annual general meeting.

If an organization is considering changing its auditors, the audit committee will play the central role, recommending to those charged with governance whether the auditor's appointment should be reconsidered, and if so, which other firm(s) should be considered for the role. This is typically conducted through a competitive tender process with multiple firms being considered.

Auditor Qualifications and Skills

Auditors are typically qualified accountants who are members of a professional body in their respective countries. Although this varies between countries, qualified accountants typically must meet certain educational requirements, take several years of training and professional examinations, and have sufficient practical experience.

Becoming an auditor is a challenging process that requires a combination of significant academic study and a large amount of learning on-the-job. This means the people who qualify as auditors benefit both from an understanding of the principles of auditing, accounting, finance, law, business management, among other topics, and hands-on experience.

Throughout their careers, all auditors must undertake continuing professional development to maintain their qualifications. Most audit firms invest significant resources in training and professional development of their staff which go beyond the requirements of the local professional regulations.

Multi-Location Audits

In many cases, a business comprises several legal entities (which may be located in different countries), whose results are consolidated into a single set of financial statements that present the financial position and performance of the consolidated group. Large companies may have dozens or even hundreds of entities. Audits of such clients normally involve audit teams from audit firms around the world performing work in different locations.

The lead auditor responsible for issuing the opinion on the consolidated group financial statements develops the audit strategy and defines the scope of work to be performed at each component (location, entity, etc.) of the group. The lead auditor communicates with the audit firms responsible for component audits and typically reviews component auditor's work in order to obtain evidence to support an opinion on the group consolidated financial statements.

As a result, multi-location audits entail more complex considerations regarding audit strategy, planning, execution, and communication. The lead auditor must ensure that sufficient appropriate audit evidence is obtained from all significant components to support the group audit opinion.