Fundamental Concepts in Conducting a Financial Statement Audit
An Overview of the Financial Statement Auditing ProcessF I G U R E 1 – 3
Terms of Engagement
Implements internal controls
Conducts transactions
Accumulates transactions into account balances
Prepares financial statements
Issues financial statements to users
Obtains evidence
Tests management assertions against criteria
(GAAP)
Determines overall fairness of financial statements
Issues audit report to accompany
financial statements
Management Auditor
Evid enc
e
As se
rtio ns
Com mun
icatio n
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reports EPS of $4.52. This very small difference is unlikely to affect an investor’s decisions in any significant way. Thus, the auditor will likely consider the difference to be immaterial.
One of the auditor’s first tasks in planning an audit is to make a judgment about just how big a misstatement would have to be before it would significantly affect users’ judgments. The concept of materiality is important because it simply isn’t practical or cost beneficial for auditors to ensure that financial statements are completely free of any small misstatements.
The Financial Accounting Standards Board has provided the following definition of materiality:
Information is material if omitting it or misstating it could influence decisions that users make on the basis of the financial information of a specific reporting entity.6
The focus of this definition is on the users of the financial statements. In planning the engagement, the auditor assesses the magnitude of a misstatement that may affect users’ deci- sions. This materiality assessment helps the auditor determine the nature, timing, and extent of audit procedures used to collect audit evidence. Let’s relate the concept of materiality to our house inspector analogy—we would not be willing to pay a house inspector to validate the remaining life on lightbulbs or thoroughly test every cabinet hinge. These items are not material to the buyer’s decision.
While other factors must be considered in determining materiality, a common rule of thumb is that total (aggregated) misstatements of more than about 3 to 5 percent of income before tax would cause the financial statements to be materially misstated. Suppose the audi- tor decides that the financial statements of a client with $8 million in net income would be materially misstated if total misstatements exceed 5 percent of income, or $400,000. The auditor would design audit procedures precise enough to detect misstatements that, either by themselves or in combination with other misstatements, might exceed the materiality thresh- old of $400,000. When testing is complete for all accounts, the auditor will evaluate the audit results and ask the company to adjust its financial records for identified misstatements. The auditor will issue a clean audit opinion if the auditor’s estimate of remaining, unadjusted mis- statements in all the accounts add up to less than overall materiality of $400,000. This is why the wording of the standard auditor’s report indicates that the financial statements “present fairly in all material respects . . .” As we will explain next, in connection with the concept of audit risk, there can be no guarantee that the auditor will uncover all material misstatements. In fact, the auditor provides no assurance that immaterial misstatements will be detected.
Audit Risk The second major concept involved in auditing is audit risk, which is the risk that the auditor may mistakenly give a “clean” opinion on financial statements that are materially misstated.
Audit risk is the risk that the auditor mistakenly expresses a clean audit opinion when the financial statements are materially misstated.7
The auditor’s standard report states that the audit provides “reasonable assurance” that the financial statements do not contain material misstatements. The phrase “reasonable assurance” implies that even when the auditor does a good job, there is some risk that a mate- rial misstatement could be present in the financial statements and the auditor will fail to detect it. The auditor plans and conducts the audit to achieve an acceptably low level of audit risk. The auditor controls the level of audit risk through the effectiveness and extent of the audit work conducted. The more effective and extensive the audit work (and thus the type and amount of audit evidence collected), the lower the risk that a misstatement will go undetected and that the auditor will issue an inappropriate report. But it is important to understand that the concept of reasonable assurance means that an auditor could conduct an audit completely in accordance with professional auditing standards and fail to detect material misstatements. A
6Financial Accounting Standards Board, Statement of Financial Accounting Concepts No. 8, Chapter 3: “Qualitative Characteristics of Useful Accounting Information.” 7AU 320, Materiality in Planning and Performing an Audit.
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house inspector cannot absolutely guarantee the absence of any significant problems without taking apart a house board by board, which of course is simply not practical. Similarly, due to cost constraints and the sheer impossibility of investigating every item reflected in an entity’s financial statements, the risk that an auditor will mistakenly issue a clean opinion on materially misstated financial statements should be low, but it cannot be driven to zero. Even careful and competent auditors can only offer reasonable, rather than absolute, assurance.
Audit Evidence Regarding Management Assertions The third major concept involved in auditing is evidence regarding management’s assertions, or, more simply, audit evidence. Most of the auditor’s work in arriving at an opinion on the financial statements consists of obtaining and evaluating audit evidence relating to manage- ment’s assertions. Audit evidence consists of the underlying accounting data and any addi- tional information available to the auditor, whether originating from the client or externally.
As illustrated earlier in our discussion about EarthWear, management’s assertions are used as a framework to guide the collection of audit evidence. The assertions, in conjunction with the assessment of materiality and audit risk, are used by the auditor to determine the nature, timing, and extent of evidence to be gathered. Once the auditor has obtained sufficient appropriate evidence that the management assertions can be relied upon for each significant account and disclosure, the auditor has reasonable assurance that the financial statements are fairly presented. Note the two key descriptors of audit evidence: sufficient and appropriate.
The sufficiency of audit evidence simply refers to the quantity of evidence the auditor obtains—does the auditor have enough evidence to justify a conclusion as to whether manage- ment’s assertions are fairly stated? The appropriateness of audit evidence refers to whether the evidence is relevant and reliable. Relevance refers to whether the evidence relates to the specific management assertion being tested. Reliability refers to the diagnosticity of the evi- dence. In other words, can a particular type of evidence be relied upon to signal the true state of the account balance or assertion being examined? Using the house inspection example, inspecting the foundation of a house may not give us relevant evidence about whether the roof leaks. Likewise, evidence about the roof that is obtained by standing on the ground and look- ing up likely would not be as reliable as evidence obtained by climbing up on the roof or by inspecting the attic space.
While the auditor has a professional responsibility to obtain “sufficient appropriate evi- dence,” the auditor seldom has the luxury of obtaining completely convincing evidence about the true state of a particular management assertion. In most situations, the auditor is able to obtain only persuasive evidence that the assertion is fairly stated.
You might ask why the auditor relies on concepts such as materiality and audit risk in design- ing an audit. Why not test all account balances and all transactions that occurred during the period so that audit risk can be driven to zero, even for immaterial misstatements? The main reason is the cost and infeasibility of such an audit. In a very small business, the auditor might be able to examine all transactions that occurred during the period and all the accounts that exist at the end of the period and still issue the audit report in a reasonable amount of time. However, it is unlikely that the owner of the business could afford to pay for such an extensive audit. For a large organization, the sheer volume of transactions, which might well reach into the millions, prevents the auditor from examining every transaction. Similarly, ending account balances can reflect millions of individual items (e.g., individual inventory items making up the ending inventory account). Thus, just as with a house inspection, there is a trade-off between the exactness or precision of the audit and its cost.
To deal with the problem of not being able to examine every transaction and account, the auditor selects a subset of transactions and accounts to examine. Many times the a
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