1.5 Audit Defined

Certified Public Accountants (CPAs) perform several types of services that provide assurance to information users regarding the quality of that information. While the focus of this book is on auditing, we will briefly discuss both auditing and some other services commonly provided by CPAs.

According to the American Accounting Association’s Committee on Basic Auditing Concepts, auditing is defined as follows:

This definition contains several key elements that we will break down.

Systematic Process

Auditing is a systematic process. Auditing standards require that auditors go to great lengths to plan and prepare for the audit. Significant work is put into planning well in advance of performing any audit procedures. Auditors follow this detailed plan, which is called an audit program, as they carry out the audit procedures to obtain and evaluate evidence.

Objectively Obtaining and Evaluating

Auditors must be objective as they obtain and evaluate audit evidence. In order for the public to trust the auditor’s opinion regarding the fairness of the reported information, the auditor should not be biased in one direction or the other. Consider the used car purchase discussed earlier. If you discovered that the mechanic you asked to verify the seller’s information was the seller’s brother, you would probably be less assured by the mechanic’s opinion, regardless of how knowledgeable he was. Standard setters and lawmakers have created very detailed rules regarding the expectation for independence and objectivity of auditors as they carry out their audits.

Evidence

Note that the definition of auditing indicates that auditors obtain and evaluate evidence. The gathering and evaluation of this evidence is what allows auditors to form an opinion regarding the reliability of the company’s financial statements. Auditors are required to obtain sufficient appropriate evidence during the course of their audit before drawing any conclusions regarding the accuracy of the reported information.

Assertions

The evidence that auditors obtain relates to assertions made by management. These assertions are either explicit or implicit claims management makes in the preparation of the company’s financial statements. For example, by recording a net accounts receivable balance of $15 million on the balance sheet, management is implicitly asserting that those receivables are the result of legitimate sales transactions and that the amount is actually owed to the company (i.e., it hasn’t already been collected), is likely to be collected, is mathematically correct, and so forth. Auditors evaluate the reliability of each account in the financial statements by designing their tests to evaluate each of these assertions made by management.

Economic Actions and Events

An audit deals with economic actions and events. While other services provided by auditors can offer assurance regarding information that is not financial in nature, such as compliance with royalty contracts, audits deal exclusively with economic actions and events.

Established Criteria

In order to provide an opinion on the reliability of a company’s financial statements, the auditor needs a standard to compare the company’s financial statements to. For example, auditor’s opinions often include a phrase indicating that the company’s financial statements are fairly stated in accordance with Generally Accepted Accounting Principles (GAAP). Thus, GAAP is the established criteria or standard that auditors employ to evaluate a company’s set of financial statements.

The framework for quality internal controls issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) is the established criteria an auditor most commonly uses when performing an evaluation of a company’s internal control.

Communicating the Results to Interested Users

The purpose of an audit, according to auditing standards, is to “enhance the degree of confidence of intended users in the financial statement” (ISA 200). This is done by issuing a written report to users of the financial statements that provides information regarding the auditor’s findings and her opinion regarding the fair presentation of the financial statements. When an auditor believes the financial statements are fairly stated in all material respects, she issues a report containing an unmodified audit opinion (also referred to as an “unqualified audit opinion”). This opinion is attached to the company’s financial statements and effectively reduces the information asymmetry that exists between management and those who rely on the company’s financial information.