Assurance and Financial Statement Auditing
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significantly reducing the cost of capital. In fact, studies indicate that audits save companies billions of dollars in costs of obtaining capital; for example, by getting lower interest rates on loans and selling stock at higher prices.
Given that the seller of stocks and bonds typically hires the auditor, consider just how crucial a strong reputation is to an independent auditor. Four large, international accounting firms dominate the audits of large publicly traded companies, auditing over 95 percent of the revenue produced by all such companies in the United States. One reason these firms domi- nate the audits of large companies is because they have well-known names and strong reputa- tions. Entities who buy assurance from these firms know that potential investors and creditors will recognize the auditing firm’s name and reputation and feel assured that they therefore face reduced information risk.
The fact that the entity being audited typically hires and pays the auditor also highlights just how important auditor objectivity and independence are to the investing public. In fact, Arthur Andersen, the once highly regarded member of the former “Big 5” international accounting firms, failed in 2002 at least in part because the firm lost its reputation as a high- quality, objective auditor whose opinion could be relied upon by investors and creditors. Later in the book we will discuss some changes enacted over the past several years to strengthen the independence of financial statement auditors, including prohibiting auditors from providing many kinds of consulting services to their public audit clients.
Management Assertions and Financial Statements We’ve seen that home sellers make a number of different assertions about which a home buyer might want independent assurance. What assertions does a company that is selling its stocks or bonds make? Some of the most important assertions entities make to investors are implicit in the entities’ financial statements. Immediately after this chapter you will find a set of financial statements for EarthWear, a hypothetical seller of high-quality outdoor cloth- ing. We’ll use EarthWear examples and exercises throughout the book to illustrate important audit concepts and techniques. Let’s consider what assertions EarthWear makes to potential investors when it publishes its financial statements. For example, EarthWear lists the asset account “Cash” on its balance sheet and indicates that the account’s year-end balance was $48.9 million.
Stop and Think: Consider for a moment what assertions the company is making about cash.
An obvious answer is that EarthWear’s management is asserting that the cash is really there—that it “exists.” They are also implicitly asserting that all the cash that the company owns is included in the records—in other words, the financial records are “complete” with respect to the company’s cash. Finally, management is asserting that the cash amount is fairly and accurately recorded, and that no other parties have valid claims to the cash. Such asser- tions are implicit for each account in the financial statements.
Financial statement assertions are management’s expressed or implied claims about information reflected in the financial statements. Assertions are central to auditing because they are the focus of the auditor’s evidence collection efforts. In other words, much of what auditors do revolves around collecting and evaluating evidence about management’s financial statement assertions.
One of the main tasks of the auditor is to collect sufficient appropriate evidence that management’s assertions regarding the financial statements are correct. If you were to audit EarthWear, how would you go about collecting evidence for the cash account? The process is really quite logical and intuitive. First, you would carefully consider the most important asser- tions the company is making about the account, and then you would decide what evidence you would need to substantiate the truthfulness of each important assertion. For example, to ensure the cash exists, you might examine bank statements or send a letter to the bank
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requesting confirmation of the balance. To ensure the cash hasn’t been pledged or restricted, you might review the minutes of key management meetings to look for discussions or agree- ments on this issue.
We will discuss management assertions in greater depth in Chapter 5, but for now take a look at Table 1–2, which lists all of the management assertions that auditors focus on in an audit. This presentation divides management assertions into three aspects of information reflected in the financial statements: transactions, account balances, and presentation and dis- closure. For example, EarthWear’s management asserts, among other things, that transactions relating to inventory actually occurred, that they are complete (i.e., no valid transactions were left out), that they are classified properly (e.g., as an asset rather than an expense), and that they are recorded accurately and in the correct period. Similarly, management asserts that the inventory represented in the inventory account balance exists, that the entity owns the inven- tory, that the balance is complete, and that the inventory is properly valued. Finally, manage- ment asserts that the financial statements properly present the inventory (e.g., inventory is appropriately listed as a current asset on the balance sheet) and that all required disclosures having to do with inventory (e.g., a footnote indicating that the company uses the FIFO inventory method) are complete, accurate, and understandable. Understanding the assertions in terms of transactions, account balances, and presentation and disclosure is helpful because the three categories help the auditor focus on the different types of audit procedures needed to test the assertions in the three different categories. Chapter 5 discusses the types of proce- dures available to the auditor in more detail.
Once you have finished auditing the important assertions relating to each account included in the company’s financial statements, you will need to report your findings to the company’s shareholders and to the investing public because EarthWear is publicly traded.
Now, instead of EarthWear’s auditor, imagine you are a prospective investor in Earth- Wear. As an investor, would the reputation of the company’s auditor matter to you? Would you want to know that the audit firm used an appropriate, well-recognized audit approach to gather sufficient, appropriate evidence? What form of report would you expect? What if the lead partner on the audit were a close relative of EarthWear’s president? Considering these questions makes it easy to see that the desired characteristics of auditors and audit services are similar to those relating to house inspectors and house inspection services.