Financial Reporting

Basic Concepts of Financial Statement Audit

Financial Statement Audit

Financial Statements Audit simply means the examination, inspection, or review of an entity’s financial statements[1]. The process of financial statement audit also analyzes the disclosures by an independent auditor in the financial statements. The purpose of conducting a financial statement audit is to ascertain the fairness of the financial statements and related disclosures. The phrases “give a true and fair view” and “present fairly” is usually used to describe the purpose of financial statement audit. Financial Statements Audit also shows whether the financial statements are prepared as per the financial reporting framework.

A financial statement audit adds credibility to the financial statements and shows the financial position and performance of a business. Audited financial statements enhance the confidence of the interested parties or the intended users. For e.g; all Public companies are required to file their audited financial reports with the Securities and Exchange Commission, all lenders are interested in the audited financial statements of a company to which they lend funds, suppliers are interested in the audited financial statements of a company to know if they can extend trade credit.

What are the major financial statements that require an audit?

  1. Balance Sheet
    The balance sheet provides a complete overview of a company’s financial performance. It provides details about the assets owned by the company, the amount of equity held by the shareholders, and the liabilities of the company.  A balance sheet usually provides details of one financial year. Further, it is the auditor’s responsibility to ensure that no asset or liability or share equity is missing from the balance sheet.
  2. Income Statement
    An income statement shows the incomes and expenses incurred in operating and non-operating activities and the profit or loss incurred during a period. Unlike a balance sheet, an income statement does not provide data for a specific accounting period rather it ranges over two to three accounting periods.
  3. Cash Flow Statement
    A Cash Flow Statement shows a company’s capacity to generate cash and pay its debt obligations. It is co-related with the balance sheet and income statement. Further, the cash flow statement of a company helps the investor or the intended user to understand the company’s operations and how the money circulates in and out of a company. A Cash Flow Statement is divided into three categories; a) the operating activities b) the investing activities and c) the financing activities.
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What are the phases of the Financial Statement Audit?

Financial Audit phrases can broadly be categorized into:

  1. Planning
    Planning includes the incoming of the client, verification of documents and requirements of the client, building an audit team, and performing various procedures to ensure the nature, duration, and extent of procedures to be performed to conduct the audit effectively.
  2. Risk Assessment
    The Auditors must use their experience and knowledge about the business, industry, and environment in which the company is operating to identify the risks which could lead to misstatements in the financial statement. Assessing the risks requires significant knowledge of large and complex engagements.
  3. Audit strategy and Plan
    After assessing the risks, the audit team plan and strategize to address the risk in the financial statements. Audit Plan and Strategy have to be reassessed from time to time depending on the changes in the business and environment.
  4. Gathering evidence
    Auditors gather and evaluate evidence by tracing the amounts and disclosures in the financial statements, arranging supporting books and records, and also obtain confirmation or documentation from the third party. Further, the auditors engage in discussions and meetings with the company to know their assertions regarding the disclosures in the financial statements.
  5. Finalization
    Auditors apply their professional minds to different evidence, principles, and standards and come to an overall conclusion. Based on this judgment they arrive at the audit opinion.

Principles of Financial Statement Audit

The basic principles of auditing are integrity, objectivity, independence, confidentiality, skills and competence, work performed by others, documentation, planning, audit evidence, accounting system & internal control & audit reporting. They are the basics of auditing that govern the professional responsibilities of an auditor and have been discussed in detail below:

  • Integrity, Objectivity, and Independence – The auditor’s work should depict his straightforwardness, honesty, and sincerity in his professional work. His work should be fair and must not be biased.
  • Confidentiality – An auditor gets an in-depth idea about the functioning of the company and also its trade secrets. Therefore, the auditor needs to maintain the confidentiality of information acquired during his work & not disclose any such information to a third party.
  • Skill and Competence – The auditor should perform his work with the utmost professional care. The auditor should possess adequate training, experience, and competence to perform the work.
  • Work Performed by others (Accountability) – The auditor may delegate work to assistants/use work performed by other auditors & experts but he will continue to be accountable for his opinion on financial information.
  • Documentation – The auditor should document every matter relating to the audit. The auditor must also check the accuracy of the books of accounts including double-checking the books’ arithmetical accuracy & verifying that the entries are properly posted.
  • Planning – The auditor’s plans should be based on knowledge of the client’s business. The auditor should plan his work to conduct an audit effectively & timely. 
  • Audit Evidence – The auditor must check that the capital & income transactions are properly differentiated. All financial transactions must fall into one of two categories: revenue/capital. All of the assets of the Company must be physically verified by the auditor. For that, all legal documents, certifications, official statements & other documents to know the ownership of all assets must also be examined. The auditor must also make certain that no entry is missing from the balance sheet. The auditor must go over all of the documents, letters, and certificates once again or seek confirmation directly from outside parties if necessary to ensure that no liabilities are missed. The auditor must also verify & check the accuracy of both income & expenditure items. A paper trail is left behind by every financial transaction. These supporting documents must be examined by the auditor to make sure that the transactions are valid and accurate. He should obtain sufficient and appropriate audit evidence by performing compliance and substantive procedures. Based on the evidence, the auditor will be able to draw reasonable conclusions.
  • Accounting System and Internal Control – All systems of accounting and financial operation should be thoroughly examined and assessed. It is the primary goal of any audit. Analyzing the system and its functionality before beginning the  final statements of accounts audit will serve as the foundation for the overall auditing process. Further, the extent of the audit will be find out by the efficacy of the organization’s internal control system. The auditor can totally rely on the system if the internal controls of the company are in place & very effective. If the internal control system is not up to the mark, the auditor should go over every minute detail properly and assess the control system according to the Companies (Auditor’s Report) Order (CARO), 2003.
    The purpose of an internal control system is to ensure that the accounting system is adequate and that all the accounting information has been duly recorded. The auditor should act in accordance with the accounting system and related internal controls.
  • Audit Conclusions and Reporting – Auditor must make sure that the accounts are compliant with the Companies Act 2003, the Income Tax (IT) Act 1961 & other relevant laws. The Auditor should review & assess the conclusions drawn from the audit evidence attained through the performance of procedures. The report of the audit should contain a clear written expression of opinion on the financial statements.
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The evaluation of a company’s financial performance is done based on the financial statements. Financial statements communicate the overall doing of a company over a specific period against its competitors as well as against the company’s past performance. It also facilitates future decision-making. Therefore, it is important to conduct a financial statement audit. A financial statement audit enhances the credibility of the financial statement and helps in gaining the confidence of the intended users.

Also Read: What is Financial Statement Analysis?

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