The Financial Audit Process

Introduction

This paper seeks to analyze and discuss the financial audit process by analyzing the concept and implication of the financial audit process in business, its history and evolution, it objectives, the responsibilities of the independent auditor. The paper will also discuss the reports usually prepared by the auditors on the financial statements and the internal control. Further discussions include the evolution of accounting frauds in relation with accounting standards and the changes for financial audit under Sarbanes-Oxley Act of 2002.  Such changes deal on the powers of the auditor to require from management evaluation of internal control, the importance of ethics in accounting and financial decision making and how Sarbanes-Oxley Act affects the same, the cost implications, the manner of change, the joint responsibility auditor and management for the audit and needed CPA preparations for the changes. The later part deals on a special discussion for the need for ethical integrity in organizations in relation to better internal control.

What is financial audit process or financial auditing?

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Financial auditing as understood in theory and practice, is an accounting process in business that uses an independent body to examine a business financial transactions and statements for the ultimate purpose presenting an accurate account of a company’s financial business transactions.  The information as result should become reliable to decisions makers in making sure that the company being audited is trading financially, and that the accounts they are presenting to the public or shareholders are accurate and justified.

Thus, it is expected that the results of financial auditing procedures be presented to shareholders, banks and anyone else with an interest in the company with one main reason of ensuring that the trading company is not practicing any deception. Thus, there is requirement of independence from the party conducting the financial audit so that the opinion or findings made should be free from bias. This is reason that the financial audit is sometimes called an independent or external audit.

The audit is normally made different from the internal or operation audit which is usually done by employees on and employer where there is absence of independence because of the employer-employee relationship.

History of Financial Audit

Financial auditing has been practiced since about 1914.  However, before 1934 corporations or businesses were not legally required to be audited. It was therefore in 1934, that the United States Securities Exchange Act made financial audit legal requirement for all public trading companies. It is for this reason that the US SEC has put a department to deal specifically with this financial audit requirement.  During the early times, it was customary for the SEC to comply with the accounting industry as to the latter standards. The present status of the law on audit is for SEC to require compliance with standards passes by Financial Accounting Standard  Board (FASB), thus it could be deduced that much has changed from the initial practice of financial audit. Through time, there are regulations that affected financial audit and one of the latest and most controversial is the Sarbanes-Oxley Act of 2002.

Learn which of the following circumstances usually comes before a period of economic contraction?

The financial auditing process usually is done at least once a year, most commonly at the end of the financial year.  Companies may end their accounting period using calendar year which is every December 31 or any end of any month during the year under a fiscal year.  As the same financial audit was focused on the financial statements, all financial aspects of the company inspected for a given would essentially followed-up in a subsequent audit, thus annual comparison of audited data is normal part of the process. One of the great issues or difficult tasks on financial audit of company is the need to maintain objectivity for the auditor because of fact that the said auditor gets paid by the company that they audit.

Generally, a financial audit is usually a completed after an engagement and its normal to see unqualified opinion by auditors as companies would need to be declared that their financial statements are reliable for use in decision making because of the audit done by independent auditors. Auditors can however issue qualified opinion should they find material misstatement in the accounts or in some cases an adverse opinion if they determine that clients’ submission does not conform with the requirement of the generally accepted accounting principles (GAAP) as issued  by the FASB in the case of the US companies and even foreign companies whose stocks are listed in the US stock exchange. Thus, it could be asserted that in some cases, failures occur in financial audit. The Enron scandal not too long ago was a case in point, since the said company was found to have failed to disclose  important facts and figures to its stakeholders and other users of financial information particularly the investors  Enron was reported to have filed for bankruptcy, and its auditor Arthur Anderson which was one of the largest accounting firms in the world, had lost the right to audit because of the violation of some rules in financial audit.  In fact, the auditor was sued criminally but was eventually acquitted.

The financial audit could therefore could be considered a power and responsibility on the part of auditors and the magnitude of such responsibility produced major incidents such as the Enron Scandal and the WorldCom that forced government to create tighter and stricter regulations in the conduct of the financial audit process. Many innocent people had thousands of dollars and life savings lost and taken advantage by unscrupulous companies such as what happened in the case Enron and WorldCom. A number of stricter audit regulations usually comes late since legislation is political and therefore most of the time they are reactionary to situations which include scandals and histories involving accounting and financial frauds.  Before that time comes, many people will have lost large amounts of money. Financial audit is a serious matter that could help or bring down investors savings and money.

Objectives of the Financial Statement Audit

A financial audit involves a process of accumulating and evaluating evidence by an auditor made competent by law. Said auditor must be independent person about quantifiable information of an economic entity which are called their clients for the purpose of determining and reporting based on criteria particularly the accounting standards issued by the FASB.  The financial audit process involves submission of financial statements prepared by the entity client which will be subjected to an examination for the purpose of expressing an opinion.

Auditor Responsibilities

The auditors are made responsible for planning, supervising, and completing their audit procedures which they need to complete the audit in accordance with the generally accepted auditing standards (GAAS) in the United States of America.  When the application of audit procedures are completed, the auditors would be required to issue a combined audit report that includes their opinion on the financial statements and the result of their consideration of the internal controls.

Opinion of the auditor on the financial statements

The auditor’s opinion would be the product of the audit conducted on the financial statements after determination of conformity on the overall all in accordance with Generally Accepted Accounting Principles (GAAP). The opinion could be unqualified in the absence of material misstatement in what is being audited or evaluated. Otherwise, the following opinions could be issued: qualified, adverse or disclaimer of opinion.

Report on Internal Control by the auditor

The auditors are required to obtain understanding of the client’s internal control.  They need also to test the design of the controls, and if the same are found to have been designed properly, these auditors must test the operating effectiveness of the controls and report their findings.

 Evolution of accounting fraud in relation to accounting rules or standards

Financial audit evolves with accounting standards and accounting standards through time. In this part, emphasis is given on accounting standards which are related with evolution of accounting fraud. The evolution of accounting fraud may indeed be described to have started with the failure of some assumptions which are used to keep the entire accounting profession functioning well until a fresh accounting rule would have to be made to address new kinds of fraud. These assumptions would include the required independence of external auditors and responsiveness of accounting rules to address accounting problems.  It is indisputable though that the increasing complexities of business could be causative as well.  Accounting frauds may have grown over the years in terms of magnitude of persons involved and the increased ways of committing fraud, which may latter explain changes in rules affecting financial audit.  Some examples of accounting frauds committed by firms that have been involved in fraud scandals are worth determining if there is basis ascribe a relationship of the frauds and whether new standards on financial audit or financial reporting would be justified as result.

Accounting frauds are believed to have risen and fallen with times as innovations and ultimate corrections come. There is reason to believe that the practice of fraud may have started a long time ago since the start of accounting as part of doing business.  For the purpose of this paper,  it would be sufficient to assert that it has started prior to 1930. During said year, non-existent inventory was reported as a possibility and this resulted to requiring external auditors to verify the conduct physical count of inventory on hand. The event was later called McKesson Scandal when non-existing inventory appeared in the books. Since then, many frauds  may have been committed but were not published. The trend then is to have new accounting rules come out to respond to such corporate ploys in committing fraud.  The more recent and controversial ones include those WorldCom and Enron which are discussed in this paper.

Before going on further, there is need to state that accounting fraud presupposes the use of knowledge in accounting practices and principles to achieve financial gain illegally against the rightful claimants or owners of resources and the related benefits of claims or ownership. Accounting fraud is therefore done only if the people committing the same have at least some knowledge of accounting practices and principles.  The cases of WorldCom and Enron were believed to have happened because of failure of financial audit and the some parts of this paper will attempt to investigate on the nature of frauds committed and whether the fraud could have been averted if a good financial audit was made.

Some firms may have been involved in accounting scandals and the frauds appear to have been caused partly by the laxity of the accounting of accounting rules, behavior of CPA firms or auditor and greed of investors and investment bankers and incentives given to executives. The case of WorldCom and Enron are two specific examples, which got involved in fraud scandals. As analyzed, it could not be asserted that the first fraud influenced the other directly or directly.

In fact, the nature of fraud committed by Enron, which is failure to disclosure off balance sheet items, is different from the understatement of line expenses and deliberate overstatement of reported revenues. To argue however, that fraud has grown over the years may be true only if the ways by which fraud committed have expanded because of the increasing complexity of business and ever changing accounting rules based on this paper. The other dimensions of fraud require further investigations.  Accounting fraud however is just a means to an end for the perpetrators --- as quick-fix strategies to become rich in whatever way possible.   Fraud  commissions have happened even  before these Enron and WorldCom scandals in many different ways without actually calling them as necessarily as accounting fraud.   Knowing the causes as stated above would also be leading this paper look for deeper causes of fraud such as moral decay.  This may also be caused by the practice of rewarding short-term behavior as may be deduced into the day to day monitoring of stock prices in Wall Street especially by speculators. Another cause could be the failure of accounting education to educate people about the proper rules of accounting to be followed either by perpetrators and the regulators.

Since solutions must at least be prescribed to address ever changing kinds of fraud in the accounting and auditing industry, there are new developments in the field of accounting and auditing that would surely affect the financial audit process. One is the Sarbanes Oxley Act of 2002, which is believed to have made changes as discussed next.

Big changes for financial audit under Sarbanes-Oxley

Both auditors and the companies they audit, need to adjust for the new legal developments under the Sarbanes-Oxley.  One of the changes found in the law is the requirement to certify a company’s internal controls and the use of certain common audit strategies will just be then things of the past. But  management faces the same problem as internal control is still its responsibility and for which reason it must bear the increased cost of implementing the new rules under the new law. This is the reason why so many are not agreeable with the Sarbanes Oxley Act of 2002. There are even fears that same could drive investments outside US since additional cost of doing business could mean less profits.

The Exposure Draft of the New Statement of Auditing Standards (SAS) contains requirement that CPAs must understand the internal control of client companies and it is no longer enough to express opinion on financial statement.

The power of auditors to require from management evaluation of internal control

Before proceeding, there is reason to know first what is internal control. Internal control includes all the plans and procedures adopted by an organization which are designed to provide reasonable assurance of reliable financial information, compliance with applicable law and regulations, and efficient and effective operations. It is a set of policies that provides financial management checks and balance. It should therefore minimize the possibilities of errors and misuse of funds, provide clear audit trail and provide clear detection of errors or irregularities and therefore enhance promotion of accountability from officers and employees in relation to their functions.

The new role of the auditor under the Sarbanes would require auditors to use standards issued by the Public Company Accounting Oversight Board (PCAOB). Part of that standard is the power of the auditor to require management of to identify, document and evaluate significant internal controls. It would be interesting to ask whether the client can refuse or just delegate the task of evaluation of said internal control.  It may be explained that the if the client will refuse, it would amount to admitting of no audit since if the company management will refuse to do it, the auditor cannot proceed with evaluation. If such will happen, there would cancellation of the audit engagement and there would be no compliance of the company as far as the SEC requirement for filing of audited financial statements.  If this happens, the situation would be subjected to penalties or a ground to deny by the SEC to issue permits or registration that the company may need as public company.  Another consequence is that failure to file audited financial statements would literally deny the company to source funds from the stock market since they company’s management would lose their credibility which is a very important factor in any business.

Cost implications on increased requirements for financial audit

Financial audit may seek to attain credibility of financial statements and internal control as a basis for reliance in making a decision about a company. However, in every advantage or benefits desired, there is a corresponding cost, hence it could not simply be assumed that financial audit should just be fully strict to attain the objectives mentioned. There is also a need to balance with the cost of doing the same under stricter conditions.

How audits will change under the Sarbanes Oxley Act?

The Exposure Drafts  from the Auditing Standards Board (ASB) requires a public company audit to be under an integrated activity consisting of an audit of the financial statements and of internal controls.  CPAs conducting the audit should perform procedures to obtain sufficient evidence as basis for expressing an opinion on both the financial statements and internal control.  An opinion on internal controls by  the auditor would be whether the entity maintained an effective internal control over financial reporting in all material respects. Like the traditional audit of the financial statements, the audit will have to formalize its finding on the audit of internal control.  The auditor would be guided by the control criteria as defined and outlined in the Internal Control-Integrated Framework, which was issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Under the framework the there are five related components that must appear before for an entity may be declared to have achieved effective internal controls. These are the control environment, risk assessment, control activities, information and communication and monitoring.

The Joint Responsibility of Auditor and Management for the Audit

The financial audit takes the nature of the joint responsibility of the auditor and management. The auditor under the rule is required to attest to management’s assessment of the effectiveness of its internal controls of the client management using standards of attestation as issued by PCAOB. It appears that the evaluation control could not start until the management of the client company does its part. The responsibilities of management include accepting responsibility for the effectives of its internal controls. For management to comply with this requirement, it is not  enough that management present a manual of the present internal control. Management is also required to evaluate the effectiveness of the internal control criteria. As could be seen management is given a responsibility that is not ordinary.  Thus the evaluation of management must be supported  evaluation with sufficient evidence. This means that the evidence must be convincing for otherwise it could amount to no evaluation at all. As an evidence of the evaluation conducted by management, the latter is required under the rules to present a written assertion about their effectiveness. Management can accomplish this in either in a separate report accompanying the auditor’s report or a representation letter to the auditor.

What Should Certified Public Accountants (CPAs) need to Prepare For the Latest Developments in Financial Audit?

First, the external auditors must be prepared for the significant changes Sarbanes-Oxley and two related SASs from the ASB on their audit of public companies. The new developments now require these auditors to test controls in all transaction cycles and to prepare comprehensive reports on the effectiveness of their clients’ internal control over financial reporting. They would have to put a mix of existing procedures as cycle rotation would no longer will be an acceptable technique in their public audits.

Second, these auditors should inform their clients to be prepared to have a comprehensive system of internal controls, where most probably a project team should report directly to the CEO or CFO to accomplish the purpose. The personnel of the said team must from personnel from accounting, finance operations, legal, internal audit, information systems, and human resources.

Third, in preparing or gathering information upon direction of management of their client to document internal control pursuant to evaluation information control,  auditors should be always be reminded to protect their independence and objectify. The moment independence is affected, they would most likely be no longer objective in their audits and everything regarding the audit would become doubtful as to reliability.

Fourth, auditor’s opinion on the effectives of entity internal controls, although it may consider the results of management’s test of the operating effectiveness of controls, should be still be  based on the control criteria and purely relying on client results as principal evidence would not be acceptable. The client results as indicated here would include the tests performed by the internal auditor who are still the employees of management and their independence could still be presumed to be in question. The need to reperform test of controls should be a guide that must be followed by external auditors. It must be remembered that auditors are evaluating the works of management’s evaluation of their own internal control and their results need not be the same.

Fifth, auditors are required to take into consideration all test results and identified deficiencies in the control, as they give opinions on the effectiveness about the design and operation of their client’s internal controls. Unqualified opinion could not be justified in case of material weakness on said internal control.  If clients have failed to obtain sufficient evidence or to provide adequate client documentation as support for their own internal control evaluation, the same should be deemed material weakness as may be appropriate under the circumstance and  would serve as warning about the impropriety of giving unqualified or clean opinion.  Although it would be possible for an auditor to issue a clean opinion on their client’s financial statements, while qualifying their opinion of the effectiveness of internal controls, the users of information should be informed about the findings for each separate coverage of the audit of clients financial statements and internal control.

The need for ethical integrity in relation to internal control

The need to have ethical integrity in business organizations must be above other requirements in business if business organizations are to have effective internal control and even to  sustain their lives under a capitalistic economic system. This part of paper argues for the importance of ethical integrity in organizations by appreciating its effects in relation to requirement of a successful financial audit. Examining practical, ethical/social obligations of some known corporations, which have been violated ethical requirement in business organizations including the people who have failed to practice what are consistent with ethical integrity,  could suggest appropriate actions that may help in enhancing optimal and ethical decision-making process that would help business organizations a lot in ensuring successful financial audit.

It is important at this point to know the meaning of ethical integrity.  Integrity implied being whole in words and in action and ethics refer to the morality of an act. Thus to combine the two terms under ethical integrity would mean doing what is right under all circumstances both in words and in actions.  When the concept is applied in business, such business organizations must be governed by a code of ethics that should the guide behavior of all the members of the organization in the attainment of the latter is goal and objectives.  The code of ethics must therefore be understood by the people before they will accept the same and upon acceptable they must be responsible enough to suffer the consequences when they commit violations of their code of ethics. Stating the ethical integrity in code must come with the willingness of those bound under the code to practice the same because they believe in the benefits that it will provide the organization. If corporate officers obey their code ethics, the same is believed to strengthen internal control.  The presence of code of ethics of the client organization would be a plus factor that would determine effectiveness of such control.

Conclusion

This paper has found that financial audit process is not as simple as the auditor having complied with all the rules of audit. As a professional, the existing law on auditing has left to the auditor very wide latitude to decide what are material misstatements that would give the CPA a basis to issue an opinion other than an unqualified opinion. The law on auditing and accounting have actually evolved over the years and has created more responsibilities on the part of the auditor and management.

The role performed by auditor assumes great significance in making the economy to run well. It is in fact one of the contentions of European countries that the solution to present global recession is on improved regulation on companies, that is making them accountable to decisions they are making to shareholders.  The financial audit could be assumed as part of the regulation implemented by the states through certified public accountants (CPA) to lend credibility to financial statements.

The financial audit process on public companies covers auditing the financial statements and the internal control of the client. This could mean that the audit of internal control should reduce the risks of attestation. It could be observed that more emphasis is given to the audit of internal control to have great effect on the reliability of the financial statements.

It must be however emphasized that there are many factors that should be considered in ensuring the credibility of the financial statements that would come because of the financial audit. One is the independence of the auditor, which must not be compromised. The auditor must have several qualities for the person to be declared competent and eligible to practice as auditors. Through the years, the financial audit was found to have evolved in relation to the amount or degree of fraud that has happened to investors.  The primary purpose of the audit is to protect the investors. However, no matter how good the process may appear and how qualified the auditors may be, it is another thing if the investors commits errors of judgment in making investments.

Financial audit is set to evolve further in the light of new kinds of frauds being committed.  The case of Madoff involving $50-billion fraud had been in the headlines for many times as governments are looking for people who could have been responsible for the present recession.  It is simply surprising to see how had the auditing firms issued clean bills of financial health for Madoff’s firms and yet fraud was still there.

References

1. BBC News (2009), Fund boss held 'for $50bn fraud'  {www document} URL, http://news.bbc.co.uk/2/hi/business/7779442.stm, Accessed April 7, 2009
2. Gandel, S. (2008), The Madoff Fraud: How Culpable Were the Auditors?, www document} URL, http://www.time.com/time/business/article/0,8599,1867092,00.html, Accessed April 7, 2009
3. Jensen, B. History of Fraud in America,  2008 {www document} URL, http://www.trinity.edu/rjensen/415wp/AmericanHistoryOfFraud.htm, Accessed April 9, 2009
4. McConnell,D.  and  Banks, G. How Sarbanes-Oxley Will Change the Audit Process, September 2003, {www document} URL,  http://www.journalofaccountancy.com/Issues/2003/Sep/HowSarbanesOxleyWillChangeTheAuditProcess.htm , Accessed April 7, 2009
5. Office of Financial Management, U.S. Department of the Interior (2003),  FY2003 Financial Statement Preparation Guidance, CH-15.1, Chapter 15, {www document} URL http://www.doi.gov/pfm/fs_guidance/chapter15.pdf, Accessed April 7, 2009
6. Whittington  & Pany, Principles of Auditing , IRWIN, Chicago, USA, 1995
7. Office of Financial Management, U.S. Department of the Interior (2003),  FY2003 Financial Statement Preparation Guidance, CH-15.1, Chapter 15, {www document} URL http://www.doi.gov/pfm/fs_guidance/chapter15.pdf, Accessed April 7, 2009
8. BBC News (2009), Fund boss held 'for $50bn fraud'  {www document} URL, http://news.bbc.co.uk/2/hi/business/7779442.stm, Accessed April 7, 2009
9. Gandel, S. (2008), The Madoff Fraud: How Culpable Were the Auditors?, www document} URL, http://www.time.com/time/business/article/0,8599,1867092,00.html, Accessed April 7, 2009

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