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6.3 Performing an Audit

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

  1. Describe the goal of an auditor in examining an account balance.
  2. List the tests that might be performed in auditing a reported balance such as account receivable.
  3. Understand the reason that an independent auditor only provides reasonable assurance and not absolute or perfect assurance.

Auditing a Reported Balance

Question: A company creates a set of financial statements for the most recent year. It hires an independent firm of CPAs to audit those statements and prepare a report that will be attached to them. Perhaps this action is required of the company by the SEC or maybe by a local bank or other lender. What work does an independent auditor perform in examining a set of financial statements? The audit firm hopes to be able to provide reasonable assurance to decision makers that these statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP. How is the auditor able to gain sufficient evidence to make that assertion?

 

Answer: An independent audit is a complicated activity that often requires scores of experienced CPAs many months to complete. Serious knowledge of the audit process is best achieved by taking upper-level college courses as well as through years of practical experience. However, a general understanding of the process is important because of its relevance to almost all businesses as well as investors and creditors. For that reason, coverage here will include a limited overview of a financial audit.

The numbers found on a set of financial statements do not appear by magic. For example, if receivables are disclosed on a balance sheet as $12.7 million, a legitimate reason has to exist for reporting that particular figure. In preparing statements, company accountants should document the steps taken to arrive at each balance and the work performed to determine the appropriate method of reporting according to U.S. GAAP. The statements are the representation of the company; thus, the burden of proof is on that organization and its officials. The independent auditors then examine the available evidence to ascertain whether reliance on the reported information should be advised.

As an illustration, assume that a business presents a list of 1,000 customers and claims that the total amount due from them is $12.7 million. This figure is reported as “accounts receivable” under the asset section of the year-end balance sheet. The independent audit firm seeks to accumulate sufficient, competent evidence to substantiate that this reported balance is not materially misstated in accordance with U.S. GAAP.

For these receivables, the auditor carries out a number of possible testing procedures to gain the assurance needed. Such techniques might include the following:

  • Add the individual account balances to ensure that the total really is $12.7 million.
  • Examine sales documents for a sample of individual customers to determine that the amounts sold to them are equal to the figures listed within the receivable. For example, if the sales document indicates that Mr. A bought goods at a price of $1,544, is that same amount found in the company’s receivable balance?
  • Examine cash receipts documents for a sample of individual customers to ensure that no unrecorded payments were collected prior to the end of the year. If Mr. A paid cash of $1,544 on December 30, was the corresponding receivable balance reduced by that amount prior to the end of the year?
  • Contact a sample of the customers directly to confirm that the balance shown is, indeed, appropriate. “Mr. A: Company records show that you owe $1,544 as of December 31. Is that amount correct?”

Through these and other testing procedures, the auditor hopes to ascertain that $12.7 million is a fairly presented amount for this asset. All other reported balances are also examined in a similar manner during the independent audit. The actual quantity and type of testing varies considerably based on the nature of the account. Auditing $12.7 million in receivables requires different steps than investigating a building bought for that same amount. Not surprisingly, large monetary balances often require especially extensive testing. In addition, certain accounts (such as cash or inventory) where the risk of misstatement is particularly high will draw particular attention from the independent auditors.

If the auditor eventually concludes that sufficient evidence has been obtained to reduce the risk of a material misstatement in the financial statements to an acceptably low level, an audit report can be issued with that opinion. Assuming no problems were encountered, reasonable assurance is provided by the independent auditor that the statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP.

As mentioned, the independent auditor’s report is then attached to the financial statements. Upon reading this opinion, investors and creditors should feel confident relying on the information provided by those statements to make their financial decisions about the reporting organization.

Test Yourself

Question:

The Aberton Corporation has recently produced financial statements for Year One. The CPA firm of Nash and Hill has been hired by the company to perform an independent audit. The firm is concerned because the accounts receivable balance seems unreasonably high and might contain a material misstatement. Members of the audit team are least likely to watch for which of the following?

  1. The accounts receivable contain fake account balances.
  2. The company has failed to record cash amounts collected on its accounts receivable near the end of the year.
  3. Credit sales made in Year Two were erroneously recorded in Year One.
  4. A large collection received on January 2, Year Two, was recorded on December 30, Year One.

Answer:

The correct answer is choice d: A large collection received on January 2, Year Two, was recorded on December 30, Year One.

Explanation:

The auditor suspects that the accounts receivable balance is inflated. Fake accounts cause that problem and might be fraudulently created to increase reported assets and revenues. Failure to record cash collections also inflates the receivable total because reductions were omitted. Adding Year Two sales into Year One causes the figures for the first period to be overstated. However, recording a cash collection in advance reduces the receivable balance prematurely so that it is understated.

Reasonable Assurance and not Perfect Assurance

Question: One aspect of the audit process seems particularly puzzling. The independent auditor merely provides reasonable assurance. The risk that a material misstatement is included in the accompanying financial statements is only reduced to a low level and not to zero. Why do decision makers who may be risking significant amounts of money not insist on absolute and complete assurance? Because of the potential for financial loss, investors and creditors surely want every possibility of incorrect reporting to be eliminated by the work of the independent auditor. Is reasonable assurance that no material misstatements are present truly adequate for decision makers who must rely on a set of financial statements for information?

 

Answer: As has been stated, independent auditors provide reasonable assurance but not absolute assurance that financial statements are presented fairly because they contain no material misstatements according to U.S. GAAP. A number of practical reasons exist as to why the level of assurance is limited in this manner.

First, many of the figures found on any set of financial statements are no more than estimations. Auditors do not possess reliable crystal balls that allow them to predict the future. The uncertainty inherent in these estimations immediately eliminates the possibility for absolute assurance. For example, reporting the amount of cash that will be collected from a large group of accounts receivable is simply a carefully considered guess. It is presented according to the rules of U.S. GAAP, but it is still an estimate. No one can provide absolute assurance about any estimation.

Second, organizations often take part in so many transactions during a period (millions for many large companies) that uncovering every potential problem or issue during an audit is impossible. Usually, in analyzing most account balances, the independent auditor only has time to test a sample of the entries and adjustments. Without examining every individual event, absolute assurance is not possible. Even with extreme vigilance, material misstatements can always be missed if less than 100 percent of the transactions are tested.

Third, an independent auditor visits a company for a few weeks or months each year to carry out testing procedures. Company officials who want to hide financial problems are sometimes successful at concealment. Auditors can never be completely certain that they have not been victimized by an elaborate camouflage scheme perpetrated by management. Thus, they are not comfortable providing absolute assurance.

Fourth, informed decision makers should understand that independent auditors can only provide reasonable assurance. Through appropriate testing procedures, risk of a material misstatement is reduced to an acceptably low level but not eliminated entirely for the reasons that have been named. Investors and creditors need to take that limitation into consideration when assessing the financial health and future well being of an organization as presented through a set of financial statements. Although the risk is small, their decisions should factor in the level of uncertainty that is always present.

Test Yourself

Question:

The Osgood Company released its Year One financial statements after an audit by the independent audit firm of Hatley, Joyner, and Bostick. Subsequently, a material misstatement was found in these financial statements. If a proper audit was conducted, which of the following is least likely?

  1. A large transaction took place early in Year Two but was reported by the company in Year One.
  2. A large estimation was made in Year One that eventually proved to be materially incorrect.
  3. A large liability was hidden by the management of the company.
  4. The company eventually lost a large lawsuit that it had expected to win.

Answer:

The correct answer is choice a: A large transaction took place early in Year Two but was reported by the company in Year One.

Explanation:

Answers b and d relate to estimates. Auditors seek evidence that each estimate is reasonable, but absolute accuracy is impossible. In a proper audit, estimates can prove materially wrong. Answer c relates to the possibility that management can conceal events from the auditors. Auditors work to make sure they are not fooled, but again, absolute assurance is not possible. Answer a is correct; auditors should examine large transactions to determine proper reporting so that the timing error is found.

Key Takeaway

Financial statements are the product of company management. Independent auditors then seek to obtain sufficient evidence that these statements are presented fairly because no material misstatements are present according to U.S. GAAP. The auditing firm performs extensive testing of the balances and disclosures that are reported. When the risk of a material misstatement has been reduced to an acceptably low level, reasonable assurance can be provided. Thus, decision makers should feel safe using the information. Absolute assurance is not humanly possible because all statements contain numerous estimations and the auditors do not have time (or the need) to examine each individual transaction. Management can, in some cases, also conceal problems from the auditors. Thus, when examining a set of financial statements, decision makers need to understand that only reasonable assurance of no material misstatements is possible and take that into consideration.