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 is an attestation of 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 is an indication that an entity’s reported financial position and performance is genuine and trustworthy. As per the Securities and Exchange Commission (SEC), all publicly listed companies are required to file their 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 financial statement audit are:
- To maintain an updated accounting system that finally goes into the preparation of the financial statements.
- To capture the auditor’s opinion on a fair and true representation of the financial position and performance of the subject entity.
- To add credibility to the financial statement for the benefit of lenders, investors, and regulators.
Phases of the Financial Statement Audit
The overall process of financial statement audit can be broadly classified 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 stage of engagement, which may arise out of any special 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 required for the same is directly proportional to the size and complexity of the subject entity. Additionally, the auditor also needs to evaluate the staffing requirement for the engagement process and ensure that each member maintains an independent viewpoint during the process. In the audit process, the auditor needs to understand the subject entity’s business and industry, its 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 cost of the audit.
- Audit testing: Once the fieldwork work starts, the auditor performs random tests of the financial data to ensure that the reported amount is arithmetically correct as well as authentic and classified appropriately. The decision of timing and variety of tests performed on the financial statements is 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 is required to 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 is required to 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 in accordance with the relevant accounting principles,i.e. GAAP in the case of the US. The auditor may also prepare the basic financial statements along with the associated notes for the subject 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 pertaining to the process of audit. The documents should have management signatures confirming that the information provided in the financial statements is a true representation of the entity’s financial position and performance. These documents may prove useful in case of lawsuits or other future account analysis.
Need for Financial Statement Audit
The need for a financial statement audit can be attributed 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 true and not biased in the management’s favour.
- Conformity: Most investors, lenders, and other stakeholders use the published financial statements as the sole trust worthy source of information. Such an independent audit of the statements assures these users that the financial accounts along with the disclosures have been prepared as 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 misinterpretations or errors is reduced to a large extent.
Importance of Financial Statement Audit
The importance of a financial statement audit can be assessed based on the following:
- The quality of financial reporting can be improved 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 true and fair representation and in agreement with the applicable accounting principles.
Some of the major advantages of a financial statement audit are as follows:
- It ensures that all the relevant financial information is either captured in the financial statements or in the accompanying notes and disclosures.
- It helps in the evaluation of the quality of financial reporting of the subject entity.
- It makes the process of tax filing much easier as the tax authorities usually accept the financial statements prepared by an independent auditor without much investigation.
Some of the major limitations of financial statement audit are as follows:
- An auditor is ultimately humane who is susceptible to committing mistakes and, as such can’t ensure absolute guarantee of correctness.
- An audit process can be adversely impacted by limitations pertaining to 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’ stakeholders take decisions pertaining to investments in it.
This is a guide to Financial Statement Audit. Here we also discuss the introduction and purpose of financial statement audit along with advantages and limitations. You may also have a look at the following articles to learn more –