What is Financial Audit ?
Financial auditing refers to an accounting process applied in business. The process involves using an individual body for evaluating the financial transactions and statements of a business. The ultimate purpose of financial audit is presenting an accurate amount of the business transactions of a company. Besides, it ensures that the accounts presented to the public and shareholders are accurate and justified. The results of financial audit are useful for banks, shareholders, and anybody else with an interest in the company.
The financial audit is also referred to as an external or independent audit. A very basic definition for the financial audit states that it is an "audit of financial statements". The main objective of a financial audit is to determine whether the financial statements (including the balance sheet, income statement and cash flow statement) of an organisation provide a fair representation of the operations and financial condition of the organisation.
Financial audits are performed to obtain assurance as to whether an organization's financial statements are free of material misstatements. During a financial audit, an auditor reviews financial statements to provide a formal auditor's opinion. This opinion is attached to the front of the organization's financial statements to provide assurance that they are fairly presented in other words, that they meet generally accepted accounting principles and have been scrutinized by an independent auditor. Absolute assurance cannot be attained because of :
- Factors such as the use of judgment and the use of testing of the data underlying the financial statement.
- Inherent limitations of internal control.
- The audit evidence available to the auditor is persuasive rather than conclusive in nature.
Objectives of Financial Audit
The objectives of financial auditing may broadly be categorized as :
Primary Objectives
To determine and judge the reliability of the financial statement and the supporting accounting records of a particular financial period is the main purpose of the audit. As per the Indian Companies Act, 1956 it is mandatory for the organisations to appoint an auditor who, after the examination and verification of the books of account, disclose his opinion that whether the audited books of accounts, profit and loss account and balance sheet are showing the true and fair view of the state of affairs of the company's business. To get a true and fair view of the companies' affairs and express his opinion, he has to thoroughly check all the transactions and relevant documents of the company made during the audited period, which will help the auditor to report the financial condition and working result of the organisation.
While carrying out the process of audit, the auditor may come across certain errors and frauds. But detection of fraud or errors are not the primary objective of the audit. They are come under the secondary objectives of audit. Audit also discloses whether the accounting system adopted in the organisation is adequate and appropriate in recording the various transactions as well as the setbacks of the system.
Secondary Objectives
In order to report the financial condition of the business, auditor has to examine the books of accounts and the relevant documents. In that process he may come across with some errors and frauds. These errors and frauds may classify as below:
1) Detection and Prevention of Errors and Mistakes :
Following types of errors can be detected in the process of auditing :
i) Clerical Errors :
Due to wrong posting such errors may occur. Money received from "X company" credited to the "Y company" account is an example of clerical error. Even though the account was posted wrongly, the trial balance will agree. Clerical errors can classify as below:
a) Errors of Omission :
When there is no record of transactions in the books of original entry or omission of posting in the ledger could lead to such errors. Sales not recorded in the sales book or omissions to enter invoices in the purchase book are examples of errors of omission. Errors due to entire omission will not affect the trial balance. Errors due to partial omission will affect the trial balance and can be detected.
b) Errors of Commission :
These errors are errors caused due to wrong posting either wholly or partially of in the books of original entry or ledger accounts or wrong totaling, wrong calculations, wrong balancing and wrong casting of subsidiary books.
For example, Rs.5,000 is paid to Microsoft for the supply of windows programme and the same is recorded in the cash book. While posting the ledger the Microsoft's account is debited by Rs.500. It may be due to the carelessness of the accountant. Most of these errors of commission are reflected in the trial balance and can be identified by routine checking of the books.
c) Compensating Errors :
These are errors committed in such a way that the net result of these errors on the debit side and credit side would be nullify the net effect of the error.
For example, Ram's account which was to be debited for Rs.5,000 was credited for Rs.5,000 and similarly, Sita's Account which was to be credited for Rs.5,000 was debited for Rs.5,000. These two mistakes will nullify the effect of each other. Unless detailed investigation is undertaken such errors are difficult to locate as both the sides of the trial balance are equally affected.
ii) Errors of Principle :
While recording a transaction, the fundamental principles of accounting is not properly observed, these types of errors could occur. Over valuation of closing stock or incorrect allocation of expenditure or receipt between capital and revenue are some of the examples of such errors. Such errors will not affect the trial balance but will affect the profit and loss account. It may occur due to lack of knowledge of sound principles of accounting or can be committed deliberately to falsify the accounts. To detect such errors, the auditor has to do a careful examination of the books of account. Apart from the foregoing errors the following kinds of errors also fall in this category :
- Excess or inadequate provision for depreciation
- Excess or wrong provision for bad and doubtful debt
- Over-valuation or under-valuation of closing stock, etc.
2) Detection and Prevention of Frauds :
To get money illegally from the organisation or from the proprietor frauds are committed intentionally and deliberately. If it remains undetected, it could affect the opinion of the auditor on the financial condition and the working results of the organisation. Therefore, it is necessary for the auditor to exercise utmost care to detect such frauds. It can be committed by the top management or by the employees of the organisation. Frauds could be of the following types :
i) Misappropriation of Cash :
Since the owner has very limited control over the receipts and payments of cash, misappropriation or defalcation of cash is very common specially in large business organisations. Cash can be misappropriated by various ways as mentioned below :
- Recording fictitious payments
- Recording more amount than the actual amount of payment
- Suppressing receipts
- Recording less amount than the actual amount of payment
There should be strict control over receipts and payments of cash known as "Internal check system" to prevent such frauds. The auditor should check the Cash Book with original records, bills register, invoices, vouchers, counterfoils or receipt books, wage sheets, salesman's diary, bank statements, etc., in order to discover such frauds.
ii) Misappropriation of Goods :
Companies handling with high value goods are pray to this kind of misappropriation. Without proper records of stock inward and stock outward, it is difficult for the auditor to find out such fraud. Periodical and surprise checking of stock and maintaining the proper record of inward and outward movement of stock can reduce the possibility of such fraud.
iii) Falsification or Manipulation of Accounts :
In order to achieve certain specific objectives, accounts may be manipulated by those responsible persons who are in the top management of the organisation They prepare accounts such a manner that they disclosed only a fake picture not the true picture. Some of the ways used in manipulating the accounts are as follows :
- Inflating or deflating expenses and incomes
- Writing off of excess or less bad debts
- Over-valuation or under-valuation of closing stock
- Charging excess or less depreciation
- Charging capital expenditures to revenue and vice versa
- Providing for excess or less doubtful debts
- Suppressing sales and purchase or showing fictitious sales and purchases, etc.
iv) Window Dressing :
When accounts are prepared in such a manner that they seem to indicate a much better and sound financial position of the business enterprise, it is known as window dressing. The main objectives behind window dressing are as follows :
- To attract potential investors to subscribe for the shares in order to procure further capital
- To obtain further credit
- To enjoy better reputation in the market by showing more sound financial position than in actual term
- To win the confidence of shareholders
- To raise the price of shares in the market by paying higher dividends
v) Secret Reserves :
When accounts are prepared in such a manner that they seem to disclose worse financial position o n of the company than actual ones, it is known as 'secret reserves'. Thus the real picture of the business is concealed and a distorted picture is revealed. The main objectives behind showing less profit than actual ones are :
- To avoid or reduce income tax liability
- To buy back shares from the open market through reducing the price of shares by paying less or no dividend
- To conceal the true position of company's state of affairs from the competitors
On the basis of above discussion, it can be concluded that auditing has the principal objective of seeing whether or not the financial statements exhibit a true and fair view of state of affairs and of reporting accordingly. Detection of errors and frauds and making recommendations so as to prevent their re-occurrence is incidental and secondary objective of auditing but by no means less significant object as compared to former.
Specific Objectives
From the analysis of various definitions given by different authorities on the subject and latest developments in the field of auditing, it should be clear that the term audit should not be confined to financial audit alone. The area of operation of audit is quite wide and such other areas like review of cost, operations, efficiency. management, and tax liability, etc., fall under the purview of audit. Accordingly there would be specific objectives in respect of each type of such specified audit.
For example, in cost audit which is concerned with verification of cost records and examination of cost accounting procedures, the object of audit is to verify the truth, accuracy and fairness of costing data and to serve as an effective tool of cost control. Similarly, in a management audit, the aim of audit is to promote the efficiency of management functions and to enhance the operational efficiency besides identifying areas of weakness in internal control. Thus depending upon the nature and subject matter of specific audit, there would be specific and different objectives in respect of each specific audit.
Principles of Financial Audit
The principles of financial audit are as follows :
1) Prerequisites for conducting financial audits :
- Ethics and independence
- Quality control
- Engagement team management and skills
2) Principles related to basic audit concepts :
- Audit risk
- Professional judgement professional scepticism
- Materiality
- Communication
- Documentation
3) Principles related to the audit process :
- Agreeing the terms of the engagement
- Planning
- Understanding the audited entity
- Risk assessment
- Responses to assessed risks
- Considerations relating to fraud in an audit of financial statements.
- Going-concern considerations.
- Considerations relating to laws and regulations in an audit of financial statements.
- Audit evidence.
- Consideration of subsequent events.
- Evaluating misstatements.
- Forming an opinion and reporting on the financial statements.
- Form of opinion.
- Elements required in the auditor's report.
- Modifications to the opinion in the auditor's report.
- Determining the type of modification to the auditor's opinion.
- Emphasis of Matter paragraphs and Other Matters paragraphs in the auditor's report.
- Comparative information-corresponding figures and comparative financial statements.
- The auditor's responsibilities in relation to other information in documents containing audited financial statements.
- Special considerations audits of financial statements prepared in accordance with special-purpose frameworks.
- Special considerations - audits of single financial statements and specific elements, accounts or items of a financial statement.
- Considerations relevant to audits of group financial statements (including whole-of-government financial statements).
Basic Procedures for a Financial Audit
Generally, four key phases are outlined for financial audit process. These phases include planning the audit, determining the working of internal control, testing significant assertions about the data and evaluating compliance, and reporting the evaluations. These phases are explained below for your reference :
1) Planning :
The process of financial audit begins with a plan that involves the method of collecting data to form an opinion about the organization or company's financial status. A way is planned to collect a sample reflecting a point in time in the life of the company or organization. The financial transactions and documents are then looked at. It is noteworthy that the sample should show compliance with GAAP.
2) Internal Controls :
The next step involves giving a look at the internal controls. The auditor demands info look closely at the records, and watches financial procedures in action. Without these steps, the auditor cannot give a statement about the financial status of the organization.
3) Testing :
Testing implies checking whether the internal controls are working or not. An auditor requests more info, returns to the company for more inspections, and watches how financial procedures are being performed. If the evidence demonstrates GAAP compliance, the auditor determines that the company successfully detects and prevents the errors.
4) Reporting :
The final step in financial audit involves giving a conclusion on how the company adheres to accounting standards. The audit from a CPA gives the organization an unqualified approval, a qualified approval, a disclaimer, or an adverse finding The unqualified approval is considered as the best result and the adverse finding is considered to be the worst result.
Performance Evaluation of Financial Auditing for Non-Profit Organizations
Financial Audit includes the financial statements for performance evaluation :
- Profit and Loss Account
- Balance sheet
- Cash Flow statement
In case of large not-for-profit organisations, almost the same accounting system is followed as in the case of profit seeking organisations. In case of small not-for-profit organisations usually, the cash book is prepared and with the help of such a cash book, a Receipts and Payments Account is prepared and with the help of such account and additional information, an Income and Expenditure Account and a Balance Sheet are prepared.
Profit and Loss Account
The profit and loss account is an account, which is designed to highlight the net profit, earned or net loss incurred by the business entity arising from its transactions during an accounting period. It contains all the items of revenue gains, losses and operating expenses pertaining to the accounting period.
All the nominal accounts which are left after preparing a trading account are to be transferred to this account. This transfer, however, is to be made on the basis of double entry principle, i.e., all expenses and losses (i.e., office and administration, selling and distribution, all non-operating expenses, and abnormal losses) will appear on the debit side of this account and all incomes and gains (i.e, operating, non-operating, abnormal gains etc.) will appear on the credit side of this account with the amount of gross profit or gross loss. The income statement focuses on the :
- Inflows (or creation) of assets, cash, or accounts receivables that result from the sale of goods and services to customers or clients. These receivables are known as revenues.
- Outflows (or consumption) of resources that are required in order to generate revenues. These outflows are known as expenses.
Profit, net income, or net earnings is the amount by which revenues exceed expenses. If expenses exceed revenue, the amount of difference is known as loss or net loss.
Balance Sheet
A balance sheet is a statement of assets and liabilities of a business enterprise at a given date. It is prepared at the end of the accounting period after the trading account and profit and loss account have been prepared. It shows the financial position of the business at the end of the accounting period. It is called a balance sheet because it is a sheet of balances of ledger accounts, which are still open after the preparation of trading and profit and loss account.
According to Freeman, "A balance sheet is an item wise list of assets, liabilities and proprietorship of a business at a certain date".
According to American Institute of Certified Public Accountants, "Balance sheet is a list of balances in the assets and liability accounts. This list depicts the position of assets and liabilities of a specific business at a specific point of time".
Cash Flow Analysis/Statement
Cash plays a very important role in the entire economic life of a business. A firm needs cash to make payments to its suppliers, to incur day-to-day expenses and to pay salaries, wages, interest and dividends, etc. In fact, what blood is to a human body, cash is to a business enterprise. It is very essential for a business to maintain an adequate balance of cash.
But many a times, a concern operates profitably and yet it becomes very difficult to pay taxes and dividends. This may be because (i) although huge profits have been earned yet cash may not have been received or (ii) even if cash has been received; it may have drained out (used) for some other purposes. This movement of cash is of vital importance to the management.
A statement of changes in the financial position of firm on cash basis is called a cash flow analysis/statement. Such a analysis enumerates net effects of the various business transactions on cash and takes into account receipts and disbursements of cash. A cash flow analysis summarizes the causes of changes in cash position of a business enterprise between dates of two balance sheets. Cash flow analysis is a statement of changes of financial position in business due to inflow or outflow of cash and their analysis is required for short-range business premises.