What Are Financial Statement Audits and Why Do We Perform Them?
Independent auditors conduct financial statement audits of a business to provide a picture of that business’ health. Examples of financial statements include balance sheets, income statements, statements of retained earnings and equity, and statements of cash flows. An auditor focuses on the amounts presented within these documents and any accompanying disclosures. Aside from this quantitative information, your auditor may also review the accuracy of the footnotes found in these sheets.
In compliance audits, standards dictate that the auditor report noncompliance with the applicable requirements, except where the noncompliance is negligible. The Securities and Exchange Commission (SEC) mandates that all publicly held entities must file annual audit reports with them. Many lenders also require audit reports from businesses that they lend funds. In addition, some suppliers and grantors require audited financial statements prior to contracting or extending businesses trade credit.
Oversight of your audits can come from many entities. Certified Public Accountants (CPAs) perform independent auditing of financial statements. To become a CPA, you must pass the Certified Public Accountant Exam and have a license to perform public agency auditing according to a specific state’s standard in the U.S. Additional oversight may come from a company’s audit committee, which helps the board of directors assure they fulfill their responsibilities of oversight and governance.
Different countries may have rules and regulations that delineate auditing responsibilities and practice. For example, the European Union (EU) audit reform legislation specifies certain rules for public interest entities in the European Union around audits and auditing practices.
The time it takes to complete an audit depends on the size of your company and the quality of your record keeping. Companies that specialize in auditing say that an audit can take anywhere from three weeks to three months to complete.
Technology and Audits
Many companies use continuous auditing and data monitoring to recognize the risks and anomalies of their internal systems. Data and analytics help external auditors improve their audits by giving them a better grasp of their clients’ overall financial health. This is due to the availability of full data sets (as opposed to sample sets), and the abilities to identify trends and outliers and perform a comprehensive audit.
Innovations are driving improved audit quality, including using predictive analytics and artificial intelligence (AI). Predictive analytics uses data analysis techniques to make predictions about the future. For auditing, it brings data-driven processes into the standard auditing practice, while AI spots patterns in financial transactions. This enables risk-sensing, almost continuous monitoring of client data, and cognitive analysis. These innovations encourage auditors to use risk-based methodologies while auditing. Risk-based methods allow them to capture high-risk areas more quickly, so that the company has more time to answer concerns during the audit and the auditor can focus more on the outliers and exceptions. Further, these innovations can enable auditors to focus on processes within the company and direct auditors to areas where accounting is inconsistent.
What Do You Mean By Financial Statement?
Financial statements are the formal accounts of a business’s financial activities. There are many different types of financial statements. However, when you view three main financial statements together, they consolidate the information and show the financial position of not only the parent organization, but also its subsidiaries. These are the separate statements:
- Income Statements: Also called statements of comprehensive income, statements of revenue or expense, or profit and loss (P&L) reports, income statements show how much revenue your company earned, and its costs and expenses (typically over the course of one year). Additionally, income statements include a report on earnings per share (EPS). Shareholders receive EPS if the company decided to distribute all of their net earnings for that period, instead of reinvesting them.
- Balance Sheets: Balance sheets, also called statements of financial position, show your company’s assets, liabilities, and shareholder equity. Assets are items of value that your company owns, and can include tangible and intangible property, such as products or patents. Liabilities are what your company owes to others. These include everything from promised payments to future product deliveries. Finally, shareholder equity is your capital or net worth. If you sold off all your assets and paid off your liabilities, your shareholder equity would remain (to be distributed).
- Statements of Cash Flows: A statement of cash flow reports your company’s cash in and out. It tells you whether your business generated cash with the net increase or decrease for a period. This cash flows statement comes from your operating activities, financing activities, and investment activities. Your operating activities are those that bring in money from your regular business, such as your goods or services. Operating activities do not include long-term investments or capital. Your financing activities are the cash flow generated from doing things like selling off stock or investments. Finally, your investment activities are the cash flow from performing activites such as purchases or sales of long-term assets from the investment portfolio.
The Purpose of Financial Statement Audits
The purpose of an audit is to provide an independent opinion to your stakeholders about the truth and usefulness of your financial statements. One reason an audit is necessary is that often, company owners do not prepare the financial documents. In this way, an audit ensures that shareholders such as tax authorities, management, and financial institutions can rely on these documents to be accurate.
Any type of business, whether public, private, or nonprofit can undergo an audit. After reviewing all the appropriate documentation, an auditor forms an opinion about whether the financial statements “present fairly in all material respects” the company’s financial position, operational results, cash flow, or other pertinent standards of accounting. Financial statement auditing lends credibility to your reported financial position and your business’ performance. An audit assures anyone that they can use your financial statements to make decisions about your company. According to industry experts, all aspects of business are beginning to expect this concept of assurance.
However, since the process of auditing can be expensive and time-consuming, some private companies can choose not to have their financial statements audited. The law does not specify auditing for privately held companies; instead, these organizations can have an accountant produce a financial statement report to use for internal reporting without the rigor of an audit.
What Does an Audit Cost?
The cost of an audit depends on the type and size of your business, the audit’s complexity, your company’s related risk, and the audit firm you hire. The larger your organization, the more audit effort is necessary to verify your transactions and balances, which results in more audit hours and therefore, more fees. The more complex your fees and business are, the more time auditors will need to untangle and review your business picture. Your related risk is a two-factor identification of the risk exposure of your company for the auditor. When an auditor agrees to audit your company, they assume a risk of litigation, which is determined by the financial viability of your company and the effectiveness of its internal controls. Additional factors that can affect your audit time and price include whether your Chief Financial Officer (CFO) is a CPA and how long they have worked for your company, whether your Chief Executive Officer (CEO) is dominant in your business, and whether your company had the auditors bid for services or just hired a company outright.
Publicly traded business audits require the greatest number of hours to complete and cost the most. According to Financial Executives International’s Annual Fee Survey Report, in 2015, the average number of hours for an audit of a publicly traded company was 22,539 at a cost of $268 per hour. The median number of hours was 13,200 at a cost of $193 per hour. For privately held companies, the average number of hours for an audit was 1,898 with a cost of $184 per hour. The median was 1,000 hours with a cost of $195 per hour. For non-profit companies, the average number of hours was 1,935 with a coat of $197 per hour. The median number of hours was 1,400 with a cost of $173 per hour.
Fees can increase annually due to inflation, a company acquiring your business, or changes to laws that elevate the complexity of auditing procedures. Although experts consider the last decade of audit fees as relatively flat with respect to cost increases, the average increases in audit fees since 2015 have been anywhere from three to five percent for businesses that otherwise remained relatively unchanged. To keep costs down, your company can improve its internal controls before an audit. Although you cannot control mergers, acquisitions, and inflation, you can increase your internal financial efficiency and decrease audit fees so that you minimize your overall administrative costs. In one study, companies that cited ineffective internal controls had an almost a 5.1 percent median increase in their audit costs. Your choice of audit firm can also drive your costs. The Big Four accounting firms (see below for more details) audit the vast majority of publicly held companies, but small audit firms dominate the nonprofit audit market. According to an article in Accounting Today, there are about 41,600 small firms in the United States. These are firms that employ less than five people and have revenue less than $600,000.
An Overview of How to Audit Financial Statements
The process of auditing is fairly consistent across companies and industries. Examples of financial documents that can be audited include transaction entries, general ledgers, invoices, cash deposit records, bank statements, inventory spreadsheets, copies of loans, leases, and material contracts, lists of asset purchases with invoices, depreciation schedules, board minutes, payroll reports, stock subscriptions, merger agreements, and any articles of incorporation. You should have any documentation available that your auditor requests, should they pose an inquiry. Each audit generally follows specific steps, regardless of the type of company or the audit requirements:
- Engagement Acceptance: Before an auditor gets started, they should review your company to identify any risks or special circumstances associated with it and decide whether or not to accept your company as a client. The auditor reviews things such as your managerial integrity, any pending lawsuits, accounting policies, and business practices, as well as anything else that defines how your business should be or is operating. After some initial planning, the auditor determines how many personnel are necessary to complete the audit, as well as the time period and costs. The auditor uses this information to prepare an engagement letter that outlines this in detail.
- Planning and Risk Assessment: The size and complexity of your business determines the amount of planning an auditor will perform. During this stage, the auditor, who should have knowledge and understanding of your industry, performs trend and ratio analyses, documents internal control processes, and determines the risks associated with financial statement issues.
- Internal Controls and Substantive Testing: While the auditor(s) visits your business, they are executing a variety of tests on your financial data. They test control data and transaction data. The control tests indicate the effectiveness of your internal controls. If they determine your internal controls are effective, their work on the audit could be less substantive. If they determine your internal controls are weak, they will perform more substantive tests. Auditors consider the testing of transaction data to be substantive testing, which is the verification of the monetary amounts in your transactions. For example, they will trace random samples of disbursements to determine if payments and invoices match up to vendors and that the vendors actually exist. They are also looking to ensure that your company can explain unexpected monetary movements. Auditors often perform control and substantive testing simultaneously or in concert with each other.
- Analysis: During this process, your auditors want to ensure that both your documentation and their analysis support your account balances. The auditor also reviews the results of the substantive testing in detail during this process, along with any responses to their inquiries. The auditor documents large changes in your accounts, and looks to the generally accepted accounting principles (GAAP) or the International Financial Reporting Standards (IFRS) if there are discrepancies or process unknowns.
- The Auditor’s Report: Your CPA issues their opinion of whether your financial statements are in accordance with GAAP or IFRS in the form of the Auditor’s Report. This report is a fairly presented disclaimer, or a statement, and includes the scope of a claim, and whether someone can use your financial documents to make decisions and provide assurance. This is the subjective opinion of the auditor. The CPA also issues a report on the weaknesses of your company’s internal control process and includes notes for management to consider. A completed audit allows the company to publish this report alongside their financial statements.
- Summation: Your auditor is responsible for keeping the pertinent documentation from the audit and acquiring the signatures of management to verify they understand the information reported. The auditor keeps this information for future analyses, and in case litigation arises concerning the amounts reported.
Why Would a Business Owner Request an Audit?
An audit of your business can be time-consuming, expensive, and even a bit intimidating. You may be asking why a company would voluntarily go through this process. Aside from compliance reasons and the bank’s request, you may want to conduct an audit because it can tell you a few things:
- Whether someone is stealing from your company
- If your accounting department is doing things the right way
- What your finances look like at a certain point in time
Even though you understand why you would want an audit performed, you should share your reasons with others in your company. Experts cite some of the following as the most common misconceptions employees have about why their company is auditing:
- To make sure your company has money to pay the bills
- So your company can pay payroll on time
- Because the auditor wants to look at every penny received or spent
Why You Would Want to Use a Certified Public Accountant?
A CPA is an accountant who is schooled in the principles of business finance and operations. Accounting provides decision makers with information about the business’ financial activity in the past and forecasting for the future. An accountant is not necessarily a CPA. You can become a CPA — a challenging credential to earn — if you have enough experience and education, and can pass a certifying exam. A CPA must conduct the audit if your company is public. All auditors are required to do the following:
- Give a fair and true estimation if the financial report complies with accounting standards.
- Perform the audit in accordance with auditing standards.
- Meet the independence requirements.
- Report any illegal activities that they discover to the proper authorities.
Auditors are independent from your company. Therefore, they are not responsible for the financial statements that they use to form their opinion. Your company’s management is solely responsible for creating the financial statements. Even though your company pays the auditor for their services, they still need to maintain independence so their rendered opinion is credible. Experts say that at this time, the industry is looking to revamp policies to ensure this independence in the future.
Accountants may also perform reviews or compilations of your financial statements, which is a lower level of service offering. The audit is the highest level of service a CPA can provide. Audits provide the highest level of assurance that you need when sharing your financial statements with governing bodies, stakeholders, or potential investors.
The History of Audits
Some historical references state that the earliest recorded audit was performed in England in 1314. Queen Elizabeth I established the Auditors of Imprest in 1559 to audit government firms. Now, in the United Kingdom, the National Audit Office performs auditing of government expenditures, while in Australia, the Australian National Audit Office conducts all government financial statement audits. In the United States, the Government Accountability Office (GAO) performs auditing for government organizations, including the U.S. Congress.
Auditing initially existed for the oversight of government accounting. Governments hired auditors to ensure that offices kept accurate records. In the early 1800s, the intent of auditing became fraud detection because companies grew so large that their owners could not completely oversee all their operations — so, they had to hire others to do so. Owners conducted company audits as a way to monitor their business and to prevent fraud.
In the 1900s, auditor testing methods and reports became standardized. Instead of looking at every transaction, auditors were able to develop a system that could ferret out discrepancies so that their audits became quicker and less costly. This led to the advent of the “Independent Auditor’s Report” that accompanies a company’s financial statements.
Today, the way auditors works is “risk-based.” When they sample transactions of your business, they can determine whether a more comprehensive audit is necessary. Starting with an assessment of the need for an audit, an auditor reviews your financial statements and if they detect suspicious activity, they may move to a more large-scale audit. Auditing is not only a way to assure your financial statements, but also give your firm insights on its own activities so you can improve your processes and avoid future financial misreporting.
What Are The Big Four?
The Big Four refers to the four largest accounting firms in the world: Deloitte Touche Tohmatsu Limited (Deloitte), PricewaterhouseCoopers (PwC), Ernst & Young (E&Y), and Klynveld Peat Marwick Goerdeler (KPMG). Many people consider these firms elite in the world of accounting and auditing. The firms provide services such as auditing, assurance, taxation, consultancy, legal, and risk assessment and control worldwide. Almost all of the publicly traded companies, as well as many privately held firms, are audited by one of these four auditing firms.
Although, in theory, these four firms are unique companies, they are actually a network of firms owned and operated independently. They share the common name, branding, and adhere to the same quality standards. Each of the Big Four firms have their own coordinating body that doles out the work to each of the networked firms, but does not perform their services. The Big Four came into existence after a series of mergers and dissolutions took them from the Big Eight. For example, Ernst & Whinney merged with Arthur Young in 1989 to become Ernst & Young. The Arthur Andersen firm was one of the Big Eight, but was dissolved in 2002 after the company’s part in the Enron scandal was revealed.
Governance and Oversight in Auditing
A public company is one whose ownership is dispersed among the general public as shares of stock. The stock exchange allows these shares to be traded freely, which allows companies to raise money and capital through the sale of their stock shares. The U.S. Congress created the SEC through the Securities Act of 1933 as a response to the Great Depression. Congress charged the SEC with protecting investors, maintaining fair markets, and helping to form capital. As such, the SEC sets rules and regulations on public firms, requiring them to file their financial statements, which includes an audit conducted by an independent auditor, with the SEC quarterly. The UK and Australia have similar organizations that set forth laws for public companies.
Although private firms avoid the SEC, they must abide by certain regulations. Private companies still have to provide audit results, are restricted by fiduciary duty laws, and are bound by shareholder remedy statutes. Private businesses are not required to audit so they can attach results to their financial statements, but auditing is just as important for them so they can provide assurance to their shareholders and lenders.
Generally accepted auditing standards (GAAS), a combination of standards set by policy boards and ways of recording and reporting information that are commonly recognized, are set through the accounting industry. Many countries have organizations that are on top of developing and maintaining these standards. Even the SEC defers to these because they are essentially on the front lines of the financial industry and are constantly making improvements. In the U.S., the Financial Accounting Standards Board (FASB) sets the GAAP for U.S. companies. The international substitute to GAAP is the IFRS, which is set by the International Accounting Standards Board (IASB). Since 2002, the IASB and the FASB have been working to converge GAAP and IFRS. This is important because many professionals feel that standards should be consistent worldwide. Further, GAAP evolution is overwhelmingly important, especially in light of high profile cases of fraudulent reporting by major companies.
What Are Financial Statement Assertions?
Your auditor evaluates your financial records based upon assertions rooted in your financial statements. These are the claims and representations from your company’s management on your financial picture. Your auditors rely on these assertions about your business, and test the validity of the assertions when they conduct their audit testing. There are three main categories of assertions (there is a certain amount of duplicity across the categories, as they are intended for specific portions of the financial statements):
- Transaction-Level Assertions: For the income statement, transaction-level assertions promise accuracy, classification, completeness, cutoff, and occurrence.
- Account Balance Assertions: For the balance sheet, account balance assertions pledge completeness, existence, rights and obligations, and valuation.
- Presentation and Disclosure Assertions: For the accompanying disclosures, these assertions vow accuracy, completeness, occurrence, rights and obligations, and understandability.
Without these assertions from your management, your auditor will not proceed with auditing your company. One reason for this is that the lack of management assertions is a red flag for fraud.
What Comes Out of an Audit?
Your audit delivers not only the assurance that your investors require, but also knowledge about your business that can help produce positive business results. However, many businesses pay for audits, but flounder the results.
The by-products of an audit process, according to a study performed by Deloitte, are opportunities to improve business performance, insights about the business, and growth in the company in the three to five years following the audit.
An audit can also bring additional insights that help you to do the following:
- Identify internal management issues.
- Learn about new developments in your industry and market.
- Discover your policy and process shortcomings.
- Identify your risks and inefficiencies.
How to Get the Maximum Value from Your Audit
Audits provide extremely valuable information to a company. However, some never use the important insights they produce. If you are going to spend the time and money on an audit, you should maximize the usefulness of the results. These tactics can give you the maximum amount of return for your audit:
Good Communication: Your management, audit committees, and auditors should be communicating frequently during and after the process to ensure the company understands what the auditor finds and what steps they can perform to improve their business. Auditors should follow up to verify the company is clear on the meaning of their recommendations.
Get Auditors Trained on Good Judgment and Communication: Before hiring an auditing company, look for auditors with certain traits. You want an auditor that uses analytics and innovation and is able to figure out what is reasonable to share with your company.
We asked a professional for further advice on getting the most out of your audit.
At Optum Care, they end up building many financial statement documents from scratch (i.e. In Microsoft Excel), which requires intimacy with information and accounting. As a result, Chiazzese has developed strong relationships with accounting. “I have had to work hard on these relationships because our accounting is based elsewhere, so it is critical that I am able to meet with people and share documents from a distance,” he says.
“In my opinion, when you have the Big Four-type companies coming in to perform an audit, it always seems like there is a struggle to give the right amount of information. By this, I mean that they should be auditing information that is helpful, but you do not want to bog them down by giving them too much information. These are expensive, and you want the value, but you do not want them going too far into the weeds of your documents. There is a balance between fixing what needs fixing and showing that you have a competent finance department.
“I do not see the higher-level management discussions, but I do have auditors coming to me and asking for information. I am there performing the back and forth: getting information for them and explaining it on behalf of my company. As long as I know what and why I am doing something, the audits go smoothly. This is an important point for your staff: When they do not understand why they are doing something, an audit can get difficult and harried,” says Chiazzese.
Chiazzese believes the key to performing a successful audit is to ensure that if you leave tomorrow, those who come after you will understand where the information they need comes from. “As long as you are confident in your people, there should be nothing to worry about. You should be looking forward to your audit, and be confident when you are opening your books. There should not be any reason to be nervous. Your documentation will change for the better because of audits,” he says.
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