AuditingOne of the most common services provided by Certified Public Accountants (CPA’s) is the audit. In general, to audit means to conduct a thorough assessment. In accounting, to audit an entity means to thoroughly examinethe bookkeeping records, financial accounts, and the policies and procedures of that entity. An “entity” could be a partnership, corporation, trust, or governmental unit. Audited financial statements are the accepted manner in which companies report the status of their operations to interested parties outside the company. Preparation of the financial statements is the responsibility of the company being audited. It is the auditors’ job to express an opinion on the statements management has prepared.Any company whose stock is traded on a public exchange is required by the Securities & Exchange Commission (SEC) to have an annual audit. Other companies may also want or need an audit, possibly because of requirements of bankers or others who have invested in the company. Also, stockholders who are not involved in the operations of the business may want an audit to give them confidence in the company’s financial statements.In a corporation the stockholders elect the “board of directors”. The basic responsibility of the board of directors is to determine the mission and purpose of the organization. The Board hires the “chief executive officer (CEO)” as well as other top management and periodically reviews their performance. The Board sets policies for the organization. It is responsible for ensuring that the company has sufficient resources to operateand, when necessary to raise additional funds, decides how these resources should be raised. Overall it is the responsibility of the Board to represent the interest of the stockholders, who are often too distant from the company to do this for themselves.The type of audit covered in this course is called a “financial audit”. In a financial audit, the objective is to forman opinion on the financial statements produced by the management of the company. There are other types ofaudits that businesses may undergo, including operational audits, informational audits, investigative audits, taxaudits, and follow-up audits. This course focuses on audits performed by independent (or external) auditors. These auditors are qualified CPAs (Certified Public Accountants) who are not affiliated with the company being audited. The “independent” component of the external auditors is important because the public needs assurance that the auditors are separate and apart from management and do not have a vested interest in the outcome of the audit.Many companies also have internal auditors. These auditors are employed by the company, and they audit departments within the company. While internal auditors are not independent of the company, they typically report directly to top management as well as the audit committee, which is a subcommittee of the company’s Board of Directors. Because internal auditors have a voice with both top management and the audit committee, they have considerable power in the company. It is the internal auditor’s job to find any problems that the external auditors might come across and try to get these problems corrected before the external auditors arrive. One of the ways internal auditors do this is by creating and managing internal controls. Internal controls are covered in more detail later in this reading but 66basically these are the rules and procedures that help ensure that the employees comply with the policies of the company as well as those of outside regulators, which include the SEC, FASB, IRS, etc. In a financial audit the objective of the external auditors is to gather enough information so they are reasonably satisfied that the financial statements have no material misstatements. A material misstatement is an error significant enough that it would mislead the reader. To make this determination, the external auditors must gather and evaluate sufficient information, called audit evidence. The audit evidence needs to be of sufficient quantity and quality so the auditors are able to form an opinion based on the information they have evaluated. Notice that the auditors are not guaranteeing that the financial statements are absolutely correct. Instead they are stating that they have conducted sufficient tests to allow them to issue an opinion that the financial statements do not contain any material errors.When CPAs audit financial statements, their work must be in accordance with generally accepted auditing standards (GAAS). The purpose of these standards is to help insure that audits performed by various CPAs will be as uniform as possible. The standards were originally written in 1947 and were very broad. Since then, moredetailed interpretations have been added to give auditors more guidance.Even with the guidance provided by the American Institute of Certified Public Accountants (AICPA) and other organizations, professional judgment is still an important part of every audit, in part due to the concepts of materiality and audit risk. Materiality relates to the potential impact that a misstatement could have on the financial statements. The Financial Accounting Standards Board (FASB) defines a material error as:“… the magnitude of an omission or misstatement of accounting information that, in light of surrounding circumstances, makes it probable that the judgment of a reasonable person relying on the information would have been changed or influenced by the omission or misstatement.”Notice that whether or not an item is material is dependent on the auditors’ perceived needs of the readers of the financial statements. An omission or misstatement is more likely to be seen as material if it is large (especially in comparison to the company as a whole) or felt to be of significant importance to the users of the financial statements. Audit risk refers to the possibility that the auditors fail to realize that there is a material misstatement in the financial statements. This is the risk that the auditors indicate the financial statement give a true and fair picture of the status of the company when the statements are, in fact, misleading. Audit risk is a real concern in any audit because, to be feasible, audits must be conducted by examining only a portion of the transactions that occurred during the year and verifying only a portion of the company’s account balances.