An audit is the examination or inspection of various books of accounts by an auditor followed by physical checking of inventory to make sure that all departments are following a documented system of recording transactions. It is done to ascertain the accuracy of the financial statements provided by the organization.
What is it Audit ? And why do we need Audit?
At the end of this blog, we will be able to explain the need for audits understand what independence means, in the context of an audit, define assurance services and explain what the financial reporting framework is and how it is used, as well as listed define the types of attest engagements.
why do we need an audit? So why do we need an audit, basically, for trust? Trust is going to be the main service that we’re going to have for the audit, for example, if we think about a company and who they’re going to do business with, they’re going to have transactions with could be end-users and users like investors,
if you’re talking about a publicly-traded company, more and more, that’s going to be just normal people are investing, and they’re putting their money into the company, the company wants those investments. Of course, if we talk about banks, we can think about banks in terms of a company possibly could need a loan, and they’re going to want that transaction, the bank, of course, wants to provide the loan because they’re going to make interest on that the government,
the company may not want to do business, but there have to do business in terms of taxes in some way. And the government, of course, is going to need that as well. So when we want to have these transactions happen, but notice what happens often is that what will limit a transaction is if there’s no trust
if the investor wants to invest in a company, but they don’t know if the company is going to be profitable, then the investor doesn’t know if they’re going to put the money in there.
If the banks don’t think that the company will be able to pay back the loan plus the interest, which is the way they’re why they’re given the loan in the first place, then they’re less likely to give the loan.
So what can the company do to give more trust? Well, the investors, the bank, the government are going to ask for, of course, financial statements, they’re going to say, Hey, why don’t you give us some financial statements, tell us what your profitability is, tell us how you’re doing. And then we’re more likely to give you what we want, we can do business, then the investors can then put in money and invest, the banks could give the loan, the government can process their taxes.
And But still, we might have a problem, because the investors, the users might be saying, hey, the company has an incentive to maybe not provide correct financial statements, or they might provide financial statements that are not correct in terms of what the end-users are thinking in terms of the procedures or how it was created was it made in accordance to some standards, there could be errors on it.
So the end, users still may not fully trust the financial statements. And that’s, of course, where the CPA firm comes in with the audit. And the audit then should give some level of assurance that the financial statements which are created and the responsibility of the company, are correct by some agreed-upon standards.
So that’s going to be the idea that financial statements are then going to the CPA firm, which then could go to the end-users with some more type of verification as to the reliability of the financial statements in some way. Now, of course, there’s pros and cons to this type of transaction, because that CPA for that trust, that added trust is the benefit, that’s hopefully going to say, Okay, now we can have more transactions happening, because there’s more transparency, the end-users are more confident in what the company is providing.
And therefore that’s going to facilitate more transactions, that’s huge. We want to have openness and transparency, to have more transactions. Of course, the downside of that is that it’s going to cost more money to do this, to have the CPA firm go in,
if you’re talking about audits of publicly traded companies, that’s a lot of money to process those audits. So there’s, there’s a pro and a con of that. But the idea of it is to facilitate the transactions to provide the trust needed for people to do business. And that’s going to be the concept of the audit. So why would we trust the audit?
You might ask what you know, what is it about an audit that makes the audit process a more trustworthy process? Well, the idea of independence and a third party independent third party is a key component of why we would trust an audit.
For example, if we have the company and the end-users, they’re doing business they want to do business, A and B are doing business. see over here is not involved in the immediate transaction between A and B. So if we were to do business, if you have two people doing business, and you had a third party, possibly someone who’s a friend of both you or someone that both of you do not even know, then you might say, hey, this person has no relation to the transaction we’re doing.
Therefore their opinion is objective. And let’s rely on their opinion then. And of course, in this case, we’re relying on a third party who is a professional in one that they should know in terms of whether something is correct or not. And they should have the standards in this case being a CPA regulated by the regulations to us act independently. So that’s kind of the reason we would trust the third party.
So independence becomes a huge thing. Now note, you might be thinking, well, how does the CPA firm gets paid by the company? Right? So you’re gonna have, you might be thinking, well, there’s a kind of a problem, that is a problem. That’s why independence becomes so important. Because, you know, we need to have some regulation, some standards, to regulate the CPA firm profession, to remain independent.
So if we had other problems, if you know, the people that were doing the audit, were also part of the board of directors or were part of the management of the company, then clearly, they will not be independent. And we’ll take a look at a lot more kind of rules in terms of what makes someone independent, what makes them not independent, and we want to be independent, both in appearance and in actuality, so that we can be someone that both parties can rely on in this transaction.
What are assurance services? So categories could include providing reliability, or we can have organizing information into a certain form or context, we’re going to be focusing on the providing of reliability. That’s the most common idea of assurance when we think about the financial statements, where usually having confidence in the financial statements.
What does it mean to provide live but reliability? So test services are a subset of assurance services. So we’re going to talk about test engagements, we want to assure as to something’s reliability. So that’s going to be the basic idea. From the broad sense, we’re assuring as to something’s reliability, usually, financial statements are what most people think of some kind of review of the subject matter. That is the responsibility of another is another way to put it.
So again, we usually think about the financial statements, the financial statements being a responsibility of the company, and the assurance, the reliability the assurance, the attestation engagement, is to give some type of reliability on those financial statements, which are the responsibility of another, we could give some kind of assurance on another stuff like internal controls and other types of things as well, what type of subject matter can be reviewed.
So it could include financial forecasts, it could include internal controls, which is a huge one these days, it couldn’t control, compliance with laws and regulations. So there’s a lot of things besides the financial statements that we could have a review and give an opinion on in this way, or give some kind of assurance in what type of standards should a review be based on? So generally established by groups of experts.
So when we think about the standards, when we think about if we’re taking a look at something, for example, the financial statements, then we, of course, need to compare that to something we knew to say, Okay, what how is this thing going to relate? How do we know how can we give assurance? Well, usually, we’re going to find some standards that we’re going to take a look at standards usually being created by experts if we’re talking about financial statement audits, standards set by financial reporting framework.
So if we’re talking about financial statements, audits, usually the thing we look at when we’re looking at audits, we’re looking at some kind of framework, the financial reporting framework to go by. Normally, that’s a Generally Accepted Accounting Principles Gap. So normally, in a normal audit, we would say, Hey, here’s the financial statements, we’re going to dig down on them and see if they are by the rules, the Generally Accepted Accounting Principles, do they adhere to the Generally Accepted Accounting Principles? Now, note, if we could have other standards, though, financial reporting frameworks that we’re looking at.
So for example, if you’re getting a loan from the bank, and the bank is willing to accept the cash basis, or willing to accept financial statements that are by the tax code, then that might be good enough, we might be saying, Okay, now we’re reviewing this to the financial reporting framework of the IRS tax code or a cash basis. So how is the financial reporting framework used?
Does a CPA firm perform an audit to gather evidence to issue an opinion on whether financial statements follow the financial reporting framework? So when we think about if we’re thinking about gap as the financial reporting framework, then of course, what we’re going to do is say, Okay, how can we prove that the financial statements are by gap?
Well, we’re going to go and we’re going to try to gather evidence, we’re going to make a case for it. And then we’re going to give an opinion as to whether they do conform, or they don’t conform, based on the evidence that we’re going to draw.
So what type of attest engagements are there? There are going to be examinations, there are reviews, there are agreed-upon procedures, these are going to be the most common items. What’s an examination? Usually, that’s an audit and audit when involved in historical financial statements. So when we think about examinations, we’re generally thinking, the audit and that’s the highest assurance CPA can offer.
So that’s when we think about an audit sets the highest assurance now, no, we’re not talking about IRS. IRS audits, tax audits, usually when we take When we’re talking about financial statements, we’re talking about the assurance of the CPA assurance of the financial statements generally, that’s going to be the context of the audit in this case.
So what’s in a review, then it’s much less in the scope of the procedure, then an examination. So an audit is going to be the highest examination that we can have a review is going to be much less. So we’re going to do a lot more digging, we may not, you know, go out to the company site as much, it’s gonna probably involve a lot more testings that are in house ratio analysis, things we can do in the office, and therefore it provides only limited assurance.
So sometimes that might be all you need. If you’re talking to the bank and you’re looking for a loan or whatnot, a company needs a loan, maybe they don’t need an audit, maybe they just need an assurance, maybe they don’t need us digging into a full audit, that would cost a lot more money. If the bank only wants a reasonable assurance with a review, then that may be appropriate. In those cases. Of course, a publicly-traded company is required to have audits and non publicly traded companies may have many types of situations where the review would be a good way to go.
So if we had an examination, we’re saying the assurance level is high. So we’re gonna say we’re giving high assurance that the fact that the financial statements, if we’re talking about an audit, are correct, that means that the the the risk of a material misstatement is low. So if we look at the financial statements, and you say, what are the odds that there’s a big misstatement on the financial statements?
Well, if it’s been audited, the risk of material misstatement that would be relevant to decision making is low. It doesn’t mean there are no material misstatements. But if it’s in material, it shouldn’t affect decision making. So assurance report, we’re going to issue a report for these things.
And usually, if we’re talking about an audit, somewhere in the standard report that we’ll take a look at later, it’s going to say, in our opinion, so that’s going to be it’s going to be in our opinion, it’s gonna be part of the report procedures, we’re going to choose from all available procedures, any combination, that can limit risk to a low level.
So we’re gonna do a lot more procedures in the audit, we’re gonna do the analytical procedures, we’re also going to pick from procedures that we think can lower the risk. And that could include you know, going out to the actual site and digging through things like invoices and whatnot, you know, observing things and whatnot.
And then we have the review. And remember, that review is a lot less so we’re gonna have the assurance level is only moderate, it’s not the as high level of assurance if we’re doing a review as opposed to an audit, therefore, the risk of material misstatement is moderate.
So if we’re looking at the financial statement, what’s the risk if there’s a material misstatement? Well, it’s moderate, you know, there’s a higher risk than if we did a full audit and an examination. If we do a report, our report would say something like, we are not aware of any material modifications that should be made.
So you can see that that’s a lot more kind of lawyer re and not giving a full assurance there, in that, so we’re given a reviewed opinion there. And notice, we’re never gonna say in the report that we guarantee anything because that’s legally not a smart thing to do. After all, it could expose to liability.
So in this case, we’re saying we are not aware of any material modifications. Alright, so often limited to inquiry and analytical procedures. So what are we going to do in a review usually is going to be more or less stuff we can do in the office, we’re going to do you know ratio analysis probably, and compare the numbers from last year this year.
We’re going to come to do some ratio analysis in there and see if there are unusual circumstances, unusual information, we’re probably going to do a lot less of going out to the company and digging through and doing more observations and that type of thing in the review process as compared to the audit.