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What is a Financial Statement Audit

(Original Article posted to, Steven Bragg)

A financial statement audit is the examination of an entity's financial statements and accompanying disclosures by an independent auditor. The result of this examination is a report by the auditor, attesting to the fairness of presentation of the financial statements and related disclosures. The auditor's report must accompany the financial statements when they are issued to the intended recipients.

What is the purpose of a Financial Statement Audit?

The purpose of a financial statement audit is to add credibility to the reported financial position and performance of a business. The Trinidad and Tobago Stock Exchange and/or the Trinidad and Tobago Securities and Exchange Commission requires that all entities that are publicly held must file annual reports with it that are audited. Similarly, lenders (banks and financial institutions) typically require an audit of the financial statements of any entity to which they lend funds. Suppliers may also require audited financial statements before they will be willing to extend trade credit (though usually only when the amount of requested credit is substantial).

Financial Statement Audits may also be required for submission with tendering documentation and other types of financial proposals. Financial Statement Audits are more common for member/shareholder reporting and may also be required for submission with the entities annual tax return to the Board of Inland Revenue.

What does an Audit entail?

Audits have become increasingly common as the complexity of the two primary accounting frameworks, Generally Accepted Accounting Principles and International Financial Reporting Standards, have increased, and because there have been an ongoing series of disclosures of fraudulent reporting by major companies.

What are the stages of an Audit?

The primary stages of an audit are:

Planning and risk assessment - Involves gaining an understanding of the business and the business environment in which it operates, and using this information to assess whether there may be risks that could impact the financial statements.

Internal controls testing - Involves the assessment of the effectiveness of an entity's suite of controls, concentrating on such areas as proper authorization, the safeguarding of assets, and the segregation of duties. This can involve an array of tests conducted on a sampling of transactions to determine the degree of control effectiveness. A high level of effectiveness allows the auditors to scale back some of their later audit procedures. If the controls are ineffective (i.e., there is a high risk of material misstatement), then the auditors must use other procedures to examine the financial statements. There are a variety of risk assessment questionnaires available that can assist with internal controls testing.

Substantive procedures - Involves a broad array of procedures, of which a small sampling are:

  1. Analysis - Conduct a ratio comparison with historical, forecasted, and industry results to spot anomalies.

  2. Cash - Review bank reconciliation, count on-hand cash, confirm restrictions on bank balances, issue bank confirmations.

  3. Marketable securities - Confirm securities, review subsequent transactions and verify market value.

  4. Accounts receivable - Confirm account balances, investigate subsequent collections, test year-end sales and cut-off procedures.

  5. Inventory - Observe the physical inventory count, obtain confirmation of inventories held at other locations, test shipping and receiving cut-off procedures, examine paid supplier invoices, test the computation of allocated overhead, review current production costs, trace compiled inventory costs to the general ledger.

  6. Fixed assets - Observe assets, review purchase and disposal authorizations, review lease documents, examine appraisal reports, recalculate depreciation and amortization.

  7. Accounts payable - Confirm accounts, test year-end cut-off.

  8. Accrued expenses - Examine subsequent payments, compare balances to prior years, recompute accruals.

  9. Debt - Confirm with lenders, review lease agreements, review references in board of directors minutes.

  10. Revenue - Examine documents supporting a selection of sales, review subsequent transactions, recalculate percentage of completion computations, review the history of sales returns and allowances.

  11. Expenses - Examine documents supporting a selection of expenses, review subsequent transactions, confirm unusual items with suppliers.

Why is an audit costly?

An audit is the most expensive of all the types of examination of financial statements. The least expensive is a compilation, followed by a review. Due to its cost, many companies attempt to downgrade to a review or compilation, though this is only an option if it is acceptable to the report recipients. Publicly held entities must have their quarterly financial statements reviewed, in addition to the annual audit.

Audits are more expensive since Auditors must adhere to the strict audit standards as adopted by the Institute of Chartered Accountants of Trinidad and Tobago (ICATT) and/or the Association of Chartered Certified Accountants (ACCA) or other regulatory body. These standards include; International Standards on Auditing (ISA’s), International Standard on Quality Control (ISQC) and the International Federation of Accountant’s (IFAC) Code of Ethics amongst others.

In addition to performing Audits in accordance with the aforementioned quality standards, Auditors are subjected to periodical monitoring reviews conducted by the respective regulatory bodies aimed at ensuring that both compliance and quality is maintained in each and every audit. This may include the inspection and review of all audit files and working papers forming the basis of the Audit Report issued by an Auditor.

Auditors may be disciplined for any deficiencies identified by way of these monitoring reviews and risk having their Practicing Certificates (or Auditing Licenses) revoked should the conduct of their audit work not meet the quality standards of the regulatory bodies.

The cost of an audit is usually time based and depends on the complexity of the engagement, staffing requirements and the level of skill and knowledge involved. Clients who are higher risk (based on the Auditor’s assessment of controls and/or accounting system and state of documentation/records) are likely to incur higher audit fees since the Auditor must expand his/her audit testing in order to obtain the necessary assurances and to reduce the audit risk to an acceptable level.

Auditors in Trinidad and Tobago must be certified as a Member in Practice by the Institute of Chartered Accountants of Trinidad and Tobago (ICATT) and must maintain this certification by way of mandatory continuing professional development amongst other mandatory requirements.

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