The purpose of an audit is to provide financial statement users with an opinion by the auditor on whether the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework. An audit also enhances the degree of confidence of intended users in the financial statements. Financial audits add credibility to the implied assertion by the management that the financial statements fairly represent the entity’s position and performance to its stakeholders like shareholders, tax authorities, banks, regulators, suppliers, customers, and employees.
Auditors strive to maintain a high level of independence to keep the confidence of users relying on their reports. When auditing accounting data, auditors focus on determining whether recorded information properly reflects the economic events that occurred during the accounting period. Information risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of the information risk is the possibility of inaccurate financial statements. Auditing has a significant effect on information risk.
The reduction of information risk can have a significant effect on the borrower’s ability to obtain capital at a reasonable cost. The most common way for users to obtain reliable information is to have an independent audit. External users, such as stockholders and lenders who rely on the financial statements to make business decisions, look to the auditor’s report as an indication of the statement’s reliability. They value the auditor’s assurance because of the auditor’s independence from the client and knowledge of financial statement reporting matters.
For example, a bank officer, while deciding to make or not a loan to a business, tries to be satisfied that there is minimal information risk because a borrower’s financial statements are audited, and hence the bank’s risk is substantially reduced and the overall interest rate to the borrower can be reduced. A system of internal control consists of policies and procedures designed to provide management with reasonable assurance that the company achieves its objectives and goals.
Auditors are primarily concerned about controls over reliability of financial reporting and controls over classes of transactions. Financial statements are not likely to correctly reflect GAAP or IFRS if internal controls over financial reporting are inadequate. Auditors emphasize internal control over classes of transactions rather than account balances because the accuracy of accounting system outputs depends heavily on the accuracy of inputs and processing.
For example, if products sold, units shipped or unit selling prices are wrong in billing customers for sales, both sales and account receivables will be misstated. Section 404(b) requires that auditor report, in case of public companies, on the effectiveness of internal control over financial reporting. If internal controls are assessed as effective, this will reduce the amount of substantive tests the auditor needs to do.