Audit (West's Encyclopedia of American Law)
A systematic examination of financial or accounting records by a specialized inspector, called an auditor, to verify their accuracy and truthfulness. A hearing during which financial data are investigated for purposes of authentication.
The INTERNAL REVENUE SERVICE (IRS) conducts two types of audits, called examination of taxpayer returns, and they are typically conducted using one of two types of procedures. The most common auditing procedure involves correspondence between the service and the taxpayer or interviews with the taxpayer in a local IRS office. A less common method involves field audits whereby IRS officials conduct the audit at the taxpayer's home or place of business. Treas. Reg. § 601.105(b)(1). The service determines which audit procedure should be followed in a particular case. During an audit, an IRS official may question the taxpayer about a particular transaction or transactions that appear on the taxpayer's return or may conduct a thorough investigation of the taxpayer's entire tax return.
Although many people fear audits by the IRS, the percentage of returns examined by the IRS is relatively low. For example, of 108,034,700 returns filed by taxpayers in 1997, the IRS examined 1,662,641, or about 1.5 percent of the total number of returns. Despite this low number, several...
(The entire section is 314 words.)
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Auditing (Encyclopedia of Business and Finance)
The objective of an audit is to provide assurance that an assertion corresponds with some established criteria. An audit involves gathering and evaluating evidence to support the assertions and preparing a communication indicating the work done by the auditor and his or her opinion regarding the degree of correspondence between the assertions and established criteria.
TYPES OF AUDITS
Two primary types of audits are financial audits and compliance audits. In a financial audit, the management of a business asserts that the financial statements are prepared in accordance with generally accepted accounting principles (GAAP), which are the applicable criteria. The financial statement auditor attests to the degree of correspondence between those financial statements and GAAP. In a compliance audit, an individual or business asserts that it is complying with specific laws, regulations, policies or procedures. The compliance auditor provides assurance that the entity is, in fact, complying with those applicable criteria. More details are provided below.
Audits are related to a wide range of criteria. Operational, or performance, audits evaluate the effectiveness and/or efficiency of an organization. For example, an auditor may determine whether or not a recipient of government funds is performing the funded services in a cost-efficient manner. The term "attestation engagement" includes audits and other services in which an auditor is engaged to issue a written communication that expresses a conclusion about the reliability of a written assertion that is the responsibility of another party. For example, an auditor may attest to the reliability of awards programs. The key components are an assertion made by one party with the expectation that a third party will rely on it and an attest or providing a written report on the assertion. Assurance services are independent professional services, including attestation services, that improve the quality of information or its context for decision makers. Developing areas for assurance services include Webtrust, which provides assurance regarding controls related to electronic commerce.
TYPES OF AUDITORS
The three broad groups of auditors are external, internal, and governmental. Certified public accountants (CPAs) are external, independent auditors who are licensed by individual states to provide auditing services. The public accounting profession has played an active role in developing and providing attestation services. The American Institute of Certified Public Accountants (AICPA), a voluntary national professional organization, represents the accounting profession in the United States in general and the public ac counting profession in particular. The AICPA publishes books, journals, and other materials, manages a Web site (www.aicpa.org), lobbies legislators, and sets professional standards. State professional societies, such as the New York State Society of CPAs, provide support on a local level. The United States Securities and Exchange Commission (SEC), in requiring publicly held companies to have annual audits, promoted the role of the CPA in providing services of this nature (i.e. independent, professional, external verification). SEC requirements are discussed below.
Internal auditors are employees of organizations. In publicly owned companies, internal au ditors typically report to senior management and the board of directors, through its audit commit tee. Internal auditors are primarily involved in compliance and operational audits. The Institute of Internal Auditors (IIA), an international organization, is the professional organization repre-senting the internal auditing profession. The IIA publishes materials, encourages local chapter activities, offers certification as a certified internal auditor (CIA), and provides general support for practicing internal auditors. (For more information, go to .)
Government auditors evaluate their own agencies and those for which they are responsible, including recipients of funds. These auditors exist on the national, state, and local levels. Internal Revenue Service (IRS) auditors and General Accounting Office (GAO) auditors are the most visible government auditors. IRS auditors examine tax returns. (For more information, go to http://www.irs.gov/.) The GAO is responsible for oversight, review, and evaluation of federal agencies and recipients of federal funds. The GAO reports to the U.S. Congress. (For more information, go to .)
The objective of a financial audit is to determine whether the financial statements are prepared in accordance with generally accepted accounting principles (GAAP). The management of an organization is responsible for preparing the financial statements. The auditor is responsible for rendering an opinion on the fairness of those financial statements based on his or her audit.
When preparing the financial statements, management must follow GAAP, which are the principles and practices that govern financial re porting. Formal Statements of Financial Ac counting Standards are issued by the Financial Accounting Standards Board (FASB), an independent standards-setting organization in the United States. (For more information, go to www.rutgers.edu/Accounting/raw/fasb/.) The Audit Committee of the company's board of directors acts as a liaison with the auditors who are per forming the financial statement audit.
SECURITIES AND EXCHANGE ACT OF 1934
The Securities and Exchange Act of 1934 requires publicly held companies to file Form 10-Ks with the Securities and Exchange Commission (SEC) within 90 days after the end of the fiscal year. This filing must include audited financial statements and an independent auditors report. The SEC was established to protect investors, and the requirement to publish audited annual financial statements plays a role in meeting that objective. (For more information, go to www.sec.gov.)
Nonpublic companies may have their financial statements audited for several reasons. The company may be planning to go public in the near future and will need audited financial statements for several years prior to an initial public offering. A bank or other creditor may require audited financial statements annually. A business may voluntarily hire an auditor to provide the owners with assurance that its financial statements are reliable.
Audited financial statements that will be submitted to the SEC or to others are audited by CPAs. These CPAs practice in public accounting firms, many of which are referred to as professional services firms. The largest firms are commonly referred to as "The Big Five." These five firms are: Arthur Andersen & Co. (http://www.arthurandersen.com/), Deloitte & Touche (), Ernst & Young (http://www.ey.com), KPMG Peat Marwick (http://www.kpmgcampus.com/), and Pricewaterhouse Cooper (). These companies, and many other public accounting firms, operate as limited liability partnerships (LLPs) and thus carry LLP designation in their names. In addition to accounting and auditing services, many CPA firms offer tax and consulting services. These consulting services include systems design, litigation support, pension and benefits consulting, and financial planning.
GENERALLY ACCEPTED AUDITING STANDARDS
The external, independent CPA must follow generally accepted auditing standards (GAAS) when performing the financial statement audit. These ten broad standards include three general requirements for the individual auditor, three standards for fieldwork, and four reporting standards. Authoritative guidance regarding the application of these ten general standards is provided in Statements on Auditing Standards (SASs), which are issued by the AICPA's Auditing Standards Board.
The general standards require the CPA to be proficient in accounting and auditing, to be independent from his or her client, and to exercise due professional care. Before accepting an audit client, the auditor must determine if he or she will be able to provide the necessary services on a timely basis and must have no financial or managerial relationship with the company whose financial statements are being audited.
The fieldwork standards address what is required when actually performing the audit work. The auditor must plan the engagement and supervise assistants. The auditor must obtain an understanding of the company's internal controls. The auditor must obtain sufficient competent evidence to support the financial statement assertions.
The reporting standards set requirements for the auditor's report. The report must explicitly refer to GAAP and must state an opinion on the financial statements as a whole. If there has been a change in accounting principles used by the company or inadequate disclosure of significant information, the auditor's report should address those issues.
TYPES OF AUDITOR'S REPORTS
The auditor can issue five types of reports on financial statements: unqualified opinion, unqualified opinion with explanatory language, qualified opinion, adverse opinion, or disclaimer of opinion.
If the financial statements present fairly, in all material respects, an entity's financial position (i.e., the balance sheet), results of operations (i.e., the income statement), and cash flows (i.e., the statement of cash flows) in conformity with GAAP, and if the audit is performed in accordance with GAAS, then a standard unqualified report can be issued. The standard unqualified report is as follows:
Independent Auditor's Report
We have audited the accompanying balance sheets of X company as of December 31, 20X2 and 20X1, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company's Management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of X Company as of [at] December 31, 20X2 and 20X1, and the results of its operations and its cash flows for the years then ended in conformity with generally accepted accounting principles.
Under certain circumstances, which are specified in the professional guidance, an auditor adds explanatory words or paragraph to a report in which an unqualified opinion is expressed. The unqualified opinion is not affected. There are nine situations in which such explanations are allowed. Among the most common are those instances in which there has been a change in accounting principle with which the auditor concurs. In such instances, the auditor adds a paragraph after the opinion paragraph. The additional paragraph identifies briefly the accounting change.
The auditor would issue a qualified opinion in situations where the auditor views a departure from GAAP as being material, but not pervasive or highly material relative to the entire set of financial statements; or when the auditor has not been able to obtain sufficient competent evidence pertaining to a material, but not pervasive or highly material, part of the financial statements. The auditor must add an explanatory paragraph before the opinion paragraph describing the reason for the qualification and then qualify the opinion paragraph. In the case of inadequate evidence, which is referred to as a scope limitation, the second paragraph of the report would also been modified.
If, in the auditor's judgment, pervasive or highly material deviation(s) from GAAP exist and the auditee cannot be persuaded to adjust the financial statements to the satisfaction of the auditor, then the auditor must express an adverse opinion. In this condition, the auditor expresses an opinion that the financial statements taken as a whole do not present fairly the financial position, results of operations, and cash flows of the company in accordance with GAAP.
A disclaimer of opinion, which basically means giving no opinion, is issued when the scope limitation (typically lack of evidence regarding financial statement assertions) is so pervasive or highly material that the auditor cannot draw conclusions as to the fairness of the financial statements, taken as a whole. A disclaimer is also issued when the auditor lacks independence from the auditee. Disclaiming an opinion is also permitted, but not required, in conditions of major uncertainty about the company's ability to continue as a going concern for a year following the date of the financial statements.
CODE OF PROFESSIONAL CONDUCT
The AICPA Code of Professional Conduct guides the CPA in the performance of professional services, including audits. The code consists of principles, rules, interpretations, and rulings, going from the very broad to the very specific.
The six ethical principles of professional conduct provide the basis for the rest of the code. CPAs are expected to exercise professional and moral judgments in all their activities. CPAs should act in the public interest. CPAs should perform all their work with the highest sense of integrity. CPAs should be free of conflicts of interest when performing professional services. CPAs should observe the profession's technical and ethical standards. CPAs in public practice should observe these principles of the Code of Professional Conduct in determining the scope and nature of services to be provided.
The rules address more specific ethical concerns. CPAs are required to be independent, to act with integrity and objectivity, and to follow and comply with applicable standards. When expressing an opinion on financial statements, the CPA must use GAAP as the criteria for evaluating fairness. Client information is confidential. Contingent fees, commissions, or referral fees are not acceptable when providing audit services. CPAs shall not commit discreditable acts, advertise in deceptive ways, or practice in a form of organization that is not permitted by state law.
The interpretations provide more detail regarding the rules. The independence rule has the most interpretations. Interpretations give guidance on issues such as financial and managerial relationships with the client, honorary directorships, loans, litigation, and firm and family relationships. Interpretations of other rules address issues such as conflicts of interest, competency, departures from promulgated GAAP, disclosure of confidential client information, sale of a practice, contingent fees in tax matters, client's records, governmental requirements in attest services, and CPAs operating a separate business.
Rulings are answers to specific questions. They provide guidance to CPAs regarding particular concerns that surface in providing professional services. Examples include whether or not a CPA can accept a gift from a client, when an individual can refer to him- or herself as a CPA, and the recruiting of personnel to fill a client position.
The objective of a compliance audit is to determine whether the auditee is following prescribed laws, regulations, policies, or procedures. These audits can be performed within a business organization for internal purposes or in response to requirements by outside groups, particularly government. Compliance audits can also be performed on individuals, for example, a compliance audit of an individual's tax return.
Typically, internal auditors are involved with compliance audits, within an organization, although independent CPAs perform this work as well. A compliance audit may focus on internal controls and whether or not the organization is following the internally prescribed policies and procedures. As part of the compliance audit, the auditor will obtain evidence supporting the assertion that the controls are being followed. Based on the auditor's evaluation of the evidence, he or she will usually write a report discussing the findings and making recommendations for improvement. A compliance audit could also look at external laws and regulations. The auditor would assess whether or not the organization, or the applicable part of the organization such as the marketing department, is adhering to specific laws and regulations, such as the Foreign Corrupt Practice Act of 1977. This law prohibits business entities from bribing officials of other governments in order to win business contracts.
Standards to be used when auditing federal government agencies and recipients of federal funds are found in "Government Auditing Standards," issued by the Comptroller General of the United States. This publication, which is referred to as the "Yellow Book," includes additional auditing standards that must be followed, in addition to GAAS. As part of any Yellow Book audit, the auditor must evaluate compliance with laws and regulations.
The auditor must perform several steps. First, the auditor must identify pertinent laws and regulations. Then, the auditor assesses the risks of material noncompliance; in so doing, the auditor must consider and assess internal controls. Next, the auditor designs steps and procedures to test compliance with laws and regulations to provide reasonable assurance that both unintentional and intentional instances of material noncompliance are detected. The auditor must issue a report on the tests of compliance in which all instances of noncompliance or illegal acts must be reported.
Messier, William F. Jr., (1997). Auditing: A Systematic Approach. New York: Irwin McGraw-Hill.
Auditing (Encyclopedia of Business)
The American Accounting Association defines auditing as a systematic process of objectively obtaining and evaluating the accounts or financial records of a governmental, business, or other entity based on established criteria. While auditing focuses largely on financial information, the process also may involve examination of nonfinancial documents that reveal information about a business's conduct. Handled by a trained accountant, an audit and the auditor's report provide additional assurance to users of financial statements that the information presented in financial statements is accurate, and can help companies assess their performance and their compliance with applicable regulations.
TYPES OF AUDITORS
There are three types of auditors: internal, governmental, and external (i.e., independent auditors or certified public accountants). Internal auditors are employees of the organization whose activities are being examined and evaluated during an independent audit. The primary purposes of internal auditing are to review and assess a company's policies, procedures, and records and to review and assess a company's performance given its plans, policies, and procedures. Therefore, internal auditors review financial records and accounting systems, assess compliance with company policies, evaluate the efficiency of company operations, and assess the attainment of company goals.
Governmental auditors include accountants employed by the U.S. General Accounting Office(GAO). The GAO serves as the accounting and auditing branch of Congress. These governmental accountants perform accounting and auditing tasks for the entire federal government. In addition, most states have their own accounting and auditing agencies, which resemble the GAO. Because the GAO and its state counterparts are separate agencies from the departments and agencies they audit, they are similar to external auditors. Consequently, federal and state departments and agencies often have their own internal auditors, who provide internal auditing services similar to those described above. Moreover, GAO auditing largely has the same focus as internal auditing: examining financial records, assessing compliance with laws and regulations, reviewing efficiency of operations, and evaluating the achievement of objectives.
In contrast, the independent auditor is not an employee of the organization being audited or an employee of the government. He or she performs an examination with the objective of issuing a report containing an opinion on a client's financial statements. The attest function of external auditing refers to the auditor's expression of an opinion on a company's financial statements. Generally, the criteria for judging an auditor's financial statements are generally accepted accounting principles. The typical independent audit leads to an attestation regarding the fairness and dependability of the statements. This is communicated to the officials of the audited entity in the form of a written report accompanying the statements.
Investors and lenders are the primary users of financial statements and they rely on financial statements to make decisions such as whether to buy stocks or bonds, lend money, and extend credit. By conducting audits, external auditors make financial statements consistent and meaningful. To assess a company's position accurately, investors and lenders need credible financial information on a company's sales, profits, debt, value, and so forth. Companies usually have their own accountants and managers prepare their financial information, which could bring about a conflict of interest. Hence, users of financial statements demand the services of independent auditors to verify the accuracy of company information and lend credibility to the financial information, which is called attestation. Since individual users cannot verify information contained in financial statements, auditing by external accountants reduces the number of mistakes in financial statements and prevents companies from issuing fraudulent statements. In addition, the Auditing Standards Board in 1997 issued its statement "Consideration of Fraud in a Financial Statement Audit," which requires greater effort on the part of external auditors to ensure that financial statements are free from fraud and misstatements.
TYPES OF AUDITS
Major types of audits conducted by external auditors include the financial statements audit, the operational audit, and the compliance audit. A financial statement audit (or attest audit) examines financial statements, records, and related operations to ascertain adherence to generally accepted accounting principles, meaning that the audit determines whether companies have followed the financial reporting standards given by various sanctioning boards such as the Financial Accounting Standards Board. An operational audit examines an organization's activities in order to assess performances and develop recommendations for improved use of business resources. A compliance audit has as its objective the determination of whether an organization is following established procedures or rules. Auditors also perform statutory audits, which are performed to comply with the requirements of a governing body, such as a federal, state, or city government or agency.
Internal auditors also perform financial statement audits, operational audits (which are also referred to as performance auditing and management auditing), and compliance audits, although their audits have a different scope and their reports a different purpose. Because of the potential for conflicts of interest, internal auditors perform financial statement audits for internal use only. Nevertheless, much of the work internal auditors do is similar to the work external auditors do, except that it is not intended for external use. In addition, an operational audit involves reviewing an organization's activities to evaluate performance, attainment of business goals, and efficient use of resources. Internal auditors also perform compliance audits to ensure conformity with company policies as well as with applicable government laws and regulations. Even though internal auditors are employees of the companies they audit, they nevertheless strive for independence insofar as possible.
The auditing process is based on standards, concepts, procedures, and reporting practices, primarily imposed by the American Institute of Certified Public Accountants (AICPA). While these standards and procedures constitute the foundation of auditing for all three types of auditors, other organizations such as the Institute of Internal Auditors and the General Accounting Office impose their own standards and procedures, which apply to internal auditing and governmental auditing, respectively. The auditing process relies on evidence, analysis, conventions, and informed professional judgment. General standards are brief statements relating to such matters as training, independence, and professional care. AICPA general standards are:
- The examination is to be performed by a person or persons having adequate technical training and proficiency as an auditor.
- In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors.
- Due professional care is to be exercised in the performance of the examination and the preparation of the report.
Standards of fieldwork provide basic planning standards to be followed during audits. AICPA standards of field work are:
- The work is to be adequately planned and assistants, if any, are to be properly supervised.
- There is to be a proper study and evaluation of the existing internal control as a basis for reliance thereon and for the determination of the resultant extent to which auditing procedures are to be restricted.
- Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmation to afford a reasonable basis for an opinion regarding the financial statements under examination.
Standards of reporting outline the required auditing standards relating to the audit report and its contents. AICPA standards of reporting are:
- The report shall state whether the financial statements are presented in accordance with generally accepted accounting principles.
- The report shall state whether such principles have been consistently observed in the current period in relation to the preceding period.
- Informative disclosures to the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.
- The report shall contain either an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons therefore should be stated. In all cases where an auditor's name is associated with financial statements, the report should contain a clear-cut indication of the character of the auditor's examination, if any, and the degree of responsibility he or she is taking.
THE AUDITING PROCESS
Auditors generally conduct audits following four general steps: planning, gathering evidence, evaluating evidence, and issuing a report.
In planning the audit, the auditor develops an audit program that identifies and schedules audit procedures that are to be performed to obtain the evidence. The auditor must be aware of potential problems involved in the auditing process, such as whether company property and debt actually exist or whether company transactions actually took place. In addition, the auditor usually formulates a hypothesis about company financial information at this step, such as "Company financial reports are accurate" or "Company financial reports are inaccurate." Audit evidence is proof obtained to support these hypotheses and ultimately the audit's conclusions.
After the planning is completed, the auditor must collect the evidence necessary to support the audit's conclusions. Evidence-gathering procedures include observation, confirmation, calculations, analysis, inquiry, inspection, and comparison. An audit trail is a chronological record of economic events or transactions that have been experienced by an organization. The audit trail enables an auditor to evaluate the strengths and weaknesses of internal controls, system designs, and company policies and procedures. The auditor must evaluate the initial hypothesis based on the evidence and accept or reject the hypothesis as a result. Finally, the auditor prepares a report based on the findings of the other steps, which involves making a decision about company records and claims and whether the actual evidence supports company records and claims.
The independent audit report sets forth the independent auditor's opinion regarding the financial statements. The auditor's opinion indicates whether the financial statements are fairly presented in conformity with generally accepted accounting principles, and applied on a basis consistent with that of the preceding year (or in conformity with some other comprehensive basis of accounting that is appropriate for the entity). A fair presentation of financial statements is generally understood by accountants to refer to whether:
- The accounting principles used in the statements have general acceptability.
- The accounting principles are appropriate in the circumstances.
- The financial statements are prepared so they can be used, understood, and interpreted.
- The information presented in the financial statements is classified and summarized in a reasonable manner.
- The financial statements reflect the underlying events and transactions in a way that presents the financial position, results of operations, and cash flows within reasonable and practical limits.
The auditor's unqualified report contains three paragraphs. The introductory paragraph identifies the financial statements audited, states that management is responsible for those statements, and asserts that the auditor is responsible for expressing an opinion on them. The scope paragraph describes what the auditor has done and specifically states that the auditor has examined the financial statements in accordance with generally accepted auditing standards and has performed appropriate tests. The opinion paragraph expresses the auditor's opinion on whether the statements are in accordance with generally accepted accounting principles.
Various audit opinions are defined by the AICPA's Auditing Standards Board as follows:
- Unqualified opinion: An unqualified opinion states that the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the business in conformity with generally accepted accounting principles.
- Explanatory language added to the auditor's standard report: Circumstances may require that the auditor add an explanatory paragraph (or other explanatory language) to the report.
- Qualified opinion: A qualified opinion states that, except for the effects of the matter(s) to which the qualification relates, the financial statements present fairly, in all material respects, the financial position, results of operations, and cash flows of the business in conformity with generally accepted accounting principles.
- Adverse opinion: An adverse opinion states that the financial statements do not represent fairly the financial position, results of operations, or cash flows of the business in conformity with generally accepted accounting principles.
- Disclaimer of opinion: A disclaimer of opinion states that the auditor does not express an opinion on the financial statements.
The fair presentation of financial statements does not mean that the statements are fraud-proof. The independent auditor has the responsibility to search for errors or irregularities within the recognized limitations of the auditing process. An auditor is subject to risks that material errors or irregularities, if they exist, will not be detected.
Investors should examine the auditor's report for citations of problems such as debt-agreement violations or unresolved lawsuits." Going concern"' references can suggest that the company may not be able to survive as a functioning operation. If an "except for" statement appears in the report the investor should understand that there are certain problems or departures from generally accepted accounting principles in the statements that question whether the statements present fairly the company's financial statements and that will require the company to resolve the problem or somehow make the accounting treatment acceptable.
In contrast to the standardized report of external auditors, internal and governmental auditors prepare a variety of reports that serve a variety of purposes, depending on the auditing assignment and goals. Both internal and governmental reports strive to communicate information clearly and concisely. Government reports tend to emphasize the efficient use of resources by the government departments being audited, whereas internal reports tend to vary greatly because of the plethora of interests and purposes companies may have for auditing.
The legal responsibilities of the auditor are determined primarily by the following:
- Specific contractual obligations undertaken.
- Statutes and common law governing the conduct and responsibilities of public accountants.
- Rules and regulations of voluntary professional organizations.
SEE ALSO: Balance Sheet; Compliance Auditing; Income Statement; Internal Auditing
updated by Karl Heil]
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Taylor, D. H., and G. W. Glazen. Auditing: Integrated Concepts and Procedures. 7th ed. New York: John Wiley & Sons, 1996.