PART ONE: Understanding Audit Reports and Auditor’s Opinion
Why is the audit report important? Essentially, management is responsible for designing an accounting information system that will capture all of its business transactions and compile the financial statements. However, anyone outside the company, such as a current or potential investor or creditor, may be concerned about whether management has put the financial statements together without bias.
Could management have intentionally or even unknowingly presented some events more optimistically than is warranted? Absolutely! And, worse, could management have intentionally included some fictitious revenues, omitted some actual expenses, or performed some other accounting trick so that the company’s financial results would appear better than in fact they are? Yes, if management is so inclined.
An independent auditor’s report is designed to alleviate that concern and give the public assurance that the financial statements can be relied on. Assurance is a key word: In fact, it is common in the accounting profession to refer to auditing as an assurance service or attest service because the auditors are providing assurance or attesting (vouching for) to the fairness of the presentation of the information on the financial statements.
The purpose of the audit report is to give the public confidence that it can rely on the financial statements prepared by management. However, what assurance does the public have that it can rely on what the auditors have to say? To enhance the public’s confidence in the audit report, auditors are required to be independent with respect to the client (the company whose financial statements are being audited). Independence is a critical aspect of auditing. It is so important that if for some reason a public accounting firm discovers during an audit that the firm is not independent with respect to its client, it is required to stop auditing and issue a very short (one sentence) report stating that the public accounting firm is not independent and therefore it cannot and is not issuing any kind of opinion on the financial statements.
To underscore its independence, the public accounting firm is required to include the word independent in the title of its audit report. The rules for determining whether a firm is or is not independent are fairly complex but are in place essentially to help ensure that auditors are able to conduct their audits in an objective, unbiased, and impartial manner. In fact, the auditing profession defines independence as the ability to conduct an audit in an unbiased and objective manner. This definition does not imply that auditors automatically assume that management is dishonest, but they also should not assume that management is honest; professional skepticism is to be exercised during the conduct of an audit.
To help ensure independence, there are rules forbidding an auditor’s direct financial interest of any amount in a client (even owning one share of stock in a client is prohibited), as well as rules pertaining to the type of employment that an auditor’s dependents and other relatives may have with a client. The accounting profession traditionally has been concerned with auditors being not only independent in fact – truly independent with respect to their clients – but also independent in appearance because perception is as important as reality. Thus, some of the independence rules may appear harsh, but the auditing profession believes the public’s confidence in their work is worth it.
Reasonable Assurance versus Absolute Assurance
An audit report provides reasonable assurance that the financial statements are free of material misstatements, not absolute assurance. In fact, the term reasonable assurance must be used in the audit report. However, reasonable assurance is never defined precisely in the professional auditing standards. Auditors understand that the term refers to the fact that audits cannot provide 100 percent guarantees that there are no material misstatements in the financial statements, although this is a concept that the public frequently misunderstands. When auditors have obtained reasonable assurance is a matter left to the auditor’s judgment.
Look for Part Two next week, when the discussion of “Understanding Audit Reports and Auditor’s Opinion” continues.
This information has been excerpted from Accounting Financial Tax. Copyright ©2012. All rights reserved.
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