Introduction to auditing

Decisions to purchase or sell securities, lend money, extend commercial credit, enter into employment agreements, and other kinds of economic decisions depend in large part on financial information. Financial decision makers (users of financial information) demand reliable information, and accountants help satisfy that demand.

Financial decision makers usually obtain their accounting information from companies that want to secure loans or sell stock. This source of information creates a potential conflict of interest, which is a condition that creates society’s demand for audit services. Users need more than just information; they need reliable information. Thus they depend on professional auditors to serve as objective intermediaries who will lend some credibility to financial information. This “lending of credibility” is known as attestation, and independent auditing of financial statements is described as attestfunction.

Reliable financial information helps make capital markets efficient and helps people know the consequences of a wide variety of economic decisions. However, independent auditors practicing the attest function are not the only auditors at work in the economy. Bank examiners, IRS auditors, state regulatory agency auditors (e.g., auditors in the state’s insurance department), internal auditors employed by company, and federal government agency auditors all practice auditing in one form or another.

Let’s begin our acquaintance with auditing by learning definition. The most general definition is from a committee of the American Accounting Association. Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between the assertions and established criteria and communicating these results to interested users.

This definition contains several ideas important in a wide variety of auditing practices. Auditing is a systematic process. It is purposeful and logical and is based on discipline of a structured approach to decision making. It is not haphazard, unplanned, or unstructured.

The process involves obtaining and evaluating evidence. Evidence consists of all the influences that ultimately guide auditor’s decisions. The evidence relates to assertions about economic actions and events. When beginning an audit engagement, an independent auditor of financial statements is given financial statements and other disclosures by management and thus obtains management explicit assertion about economic actions and events.

The purpose of obtaining and evaluating evidence is to ascertain the degree of correspondence between the assertions and established criteria. Auditors will ultimately communicate their findings to interested users. In order to communicate in an efficient and understandable manner, a common basis for measuring and describing financial information should exist. Such a basis constitutes the established criteria essential for effective communication. These criteria largely consist of generally accepted accounting principles. All auditors rely to some extend on exclusive criteria of general truth and fairness.

The American Institute of Certified Public Accountants has not defined the audit but it gives the main objective of financial audit in Statement on Auditing Standards.

The objective of the ordinary examination of financial statements by the independent auditor is the expression of an opinion on the fairness with which they present financial position, results of operations, and changes in financial position in conformity with generally accepted accounting principles. The auditor’s report is a medium through which he expresses his opinion or, if circumstances require, disclaims an opinion. In either case, he states whether his examination has been made with generally accepted auditing standards.

The practical audit method. Inherent in the definition and objectives of auditing is a central emphasis on making decision. The important aspect of audit decision making is the method of approaching and solving an audit problem. An inquiring “audit attitude” is very important. A practical approach to problems can help us develop such an attitude.

The practical method is both an attitude and an organized procedure for reaching logical and supportable conclusions. Auditors must possess the inquiring mentality of a problem solver. For the auditor, the ever-present question is: “What economic action or event is being asserted?” Following closely is the next question: “Is it so?”

Use of the practical method in auditing involves a three-step process:

1. Problem recognition. Recognize the information being asserted by management – financial numbers, disclosures, and control effectiveness.

2. Evidence collection. Plan and perform procedures designed to produce evidence related to the information being asserted.

3. Evidence evaluation. Determine whether you have enough good evidence to make a justifiable decision about the problem. “Justifiable” means your decision will pass the test of review and criticism by someone else.

The most important step is the first one – recognizing the information being asserted. The “problem” is always the question: “Is it so?” Audit problems requiring decision are numerous, ranging from questions of the actual existence of things (assets, liabilities) and the actual occurrence of events (sales, cash receipts) to the proper accounting treatment for reporting purposes (classification, disclosure).

The second step in the practical audit method is the technical-procedural aspect of auditing. By collecting evidence, auditors build the basis for justifying a decision about the asserted information.

The third step is decision making. The auditor must decide whether the evidence shows anything wrong; for example, the evidence may show that the recorded value of accounts receivable is materially misstated or the contract terms are being violated. The assertions of accurate accounts receivable numbers and conformity with contract terms must be assessed in light of available evidence.

Consequently, the practical method applied in audit decisions is completed with this step: Formulate a judgment on the conformity of the asserted information with reality as the auditor perceives reality at the time the evidence is evaluated. This final statement of the decision-making method incorporates the concept of the careful, prudent practitioner – one who is not omniscient but who is professionally competent, careful, and knowledgeable.