Updated July 14, 2023
What is Financial Statement Audit?
The term “financial statement audit” refers to the process in which an independent auditor evaluates the financial statements of an entity along with the related disclosures.
The audit report is the outcome of this evaluation process, which attests to the fairness of the entity’s financial reporting. The audit report is an indispensable part of the financial statements of an entity.
Explanation of Financial Statement Audit
The financial statement audit indicates that an entity’s reported financial position and performance are genuine and trustworthy. As per the Securities and Exchange Commission (SEC), all publicly listed companies must file annual reports along with the audit report. Additionally, lenders, investors, and suppliers also draw comfort if the financial statements of any entity are audited.
Purpose of Financial Statement Audit
The key points defining the purpose of a financial statement audit are:
- To maintain an updated accounting system that finally goes into preparing the financial statements.
- To capture the auditor’s opinion on a fair and accurate representation of the financial position and performance of the subject entity.
- Add credibility to the financial statement to benefit lenders, investors, and regulators.
Phases of the Financial Statement Audit
The overall process of financial statement audit can broadly classify into six major phases that are briefly described below:
- Risk assessment: According to the American Institute of Certified Public Accountants (AICPA), an auditor should evaluate the risks associated with each engagement stage, which may arise from any particular circumstances, management’s integrity, pending lawsuits, etc.
- Engagement planning: An auditor has to prepare the complete plan for the entire engagement process, and the time requires is directly proportional to the size and complexity of the subject entity. Additionally, the auditor must evaluate the staffing requirement for the engagement process and ensure that each member maintains an independent viewpoint. In the audit process, the auditor must understand the subject entity’s business and industry, internal control, and the risk of misstatements in the financial statements. Based on all these, the auditor decides on the engagement plan, time duration, and audit cost.
- Audit testing: Once the fieldwork starts, the auditor performs random tests of the financial data to ensure that the reported amount is arithmetically correct, authentic, and classified appropriately. The decision on timing and various tests performed on the financial statements are part of the auditor’s planning process.
- Analysis of accounts: During the analysis of accounts, the auditor needs to check whether or not underlying documents back the account balances in the financial statements. The auditor must evaluate the audit test results, examine management’s responses to inquiries and record any adjusting journal entries. In case of material Y-o-Y change in any accounts, the auditor must record the reasons for the same and perform necessary research as per Generally Accepted Accounting Principles (GAAP).
- Reporting: The auditor issues the opinion on the financial statements stating whether or not the financial reporting has been done by the relevant accounting principles,i.e., GAAP in the case of the US. The auditor may also prepare the basic financial statements and the associated notes for the company’s management. The audit report may also capture any weaknesses identified in the organization’s internal control process.
- Documentation: The auditor usually maintains proper documentation about the audit process. The documents should have management signatures confirming that the information provided in the financial statements represents the entity’s financial position and performance. These documents may be helpful in case of lawsuits or other future account analyses.
Need for Financial Statement Audit
The need for a financial statement audit can attribute to the following:
- Conflict of interest: Many of the end-users of the financial statements are apprehensive that there is an inherent conflict of interest between the management and the stakeholders of the subject company. In such a scenario, an independent audit assures these stakeholders that financial reporting is accurate and not biased in the management’s favor.
- Conformity: Most investors, lenders, and other stakeholders use published financial statements as the only trustworthy source of information. Such an independent audit of the statements assures these users that the financial accounts and the disclosures have been prepared per the guidelines of the relevant accounting principles, e.g., GAAP.
- Complexity: The chances of misinterpretations and unintended errors increase with the increase in accounting complexity in the subject entity. Hence, an independent audit ensures that the risk of misunderstandings or mistakes reduces to a large extent.
Importance of Financial Statement Audit
The importance of a financial statement audit can on the following basis :
- The quality of financial reporting can improve significantly through a rigorous audit process.
- The audit process assures the investors that the amounts captured in the financial statements and accompanying notes are correct and unbiased.
- An unqualified opinion indicates that the financial statements are accurate and fair representation and in agreement with the applicable accounting principles.
Some of the significant advantages of a financial statement audit are as follows:
- It ensures that all the relevant financial information is captured in the financial statements or the accompanying notes and disclosures.
- It helps evaluate the quality of financial reporting of the subject entity.
- It makes the tax filing process much easier as the tax authorities usually accept the financial statements prepared by an independent auditor without much investigation.
Some of the significant limitations of financial statement audit are as follows:
- An auditor is ultimately humane and susceptible to committing mistakes and, as such, can’t ensure a guarantee of correctness.
- Limitations can adversely impact an audit process on time and cost.
So, it can be seen that an independent audit adds to the credibility of the subject entity’s financial statements. It helps shareholders, lenders, and other stakeholders make decisions about investments in it.
This is a guide to Financial Statement Audit. Here we also discuss the introduction and purpose of a financial statement audit, with its advantages and limitations. You may also have a look at the following articles to learn more –