Audit Preparation Series: Understanding Reasonable Assurance
In our previous “Audit Preparation Series: Audit Basics article”, we covered the basic definitions of what an audit is, the types of opinions that can be issued, when an audit is required, and other types of assurance products that can be provided besides an audit. The article left you by stating that the goal of an audit is to obtain reasonable assurance the financial statements are free from material misstatement. This article will focus on explaining what reasonable assurance is.
So what does obtaining reasonable assurance mean? It might best help to first highlight what reasonable assurance DOES NOT mean in relation to your audit opinion.
- Reasonable assurance does not mean every single transaction was recorded correctly.
- Reasonable assurance does not mean every balance presented on the financials is 100% accurate.
- Reasonable assurance does not mean the financials include every possible disclosure required.
- Reasonable assurance does not mean fraud did not occur or is not actively occurring.
- Reasonable assurance does not mean the auditor will perform bookkeeping services.
It is fairly common for a client to assume that we, as auditors, have looked at every single transaction, to assume their audit opinion means there are no errors and that the auditors have determined fraud did not occur. An audit simply can never guarantee every single transaction is free from fraud or error. There are several factors that limit this. Primarily, it is due to the fact it is simply not practical, or cost effective for that matter, to examine every single transaction of an Organization. Even if every transaction was examined, the potential of intentional fraud or concealment of information would still limit an auditor’s ability to guarantee your financial statements are free of error. Lastly, the nature of financial reporting limits our ability to guarantee the financials are 100% accurate given the fact that certain elements of financial statements involve subjective judgement by management which could be subject to some degree of uncertainty.
So what is reasonable assurance? Reasonable assurance is a high, BUT NOT ABSOLUTE, level of assurance that the financial statements are fairly stated in all material respects. A high degree of careful preparation and planning is performed on our end, as auditors, in order to go about the actual process of auditing and arriving at this level of assurance.
- Planning our audit procedures to provide sufficient level of assurance
- Obtaining knowledge of the organization we are auditing, the industry in which they are involved in, any accounting standards applicable to the organization and having appropriate employee and supervisors for such work
- Determining what we consider to be material amounts relevant to your Organization
- Assessing risks of any material misstatement whether due to error or fraud
- Obtaining appropriate and sufficient audit evidence in order to make conclusions as whether certain financial statement elements are overall fairly stated.
Of the above mentioned processes, the concept of materiality is the area in which I get the most questions. By definition, materiality is the amount of error or omission that would affect the judgement of a reasonable person. Every auditor performs judgement as to the amount and function to determine materiality. For example, let’s say your Organization’s primary emphasis is taking in contributions from donors as the amount of contributions determines the amount of benefits you can provide in the community to individuals in need. Annually, your contribution revenue hovers around $1M. At the same time, you have a $5M building in which you conduct your operations in. An auditor would probably say contribution revenue is the basis for our materiality calculation. Based on a series of statistical calculations combined with factors of judgement as to the level of risk a certain organization has of errors existing, a dollar amount is then populated as your level of materiality. Let’s say the materiality amount in this example is $20,000. An auditor could go through the entire audit and find one error that caused a certain balance to be understated by $18,000 and still issue an opinion stating the financial statements are fairly stated in all material respects. We may also perform very limited procedures on certain account balances given materiality amounts and certain disbursements may not be looked at given the amount not being material. The audit procedures we will perform will be those which will detect material misstatements and provide you with reasonable assurance the financials are stated fairly in all material respects.
While we do not examine every account balance or transaction, as a client you can certainly always request additional emphasis in a certain area, even if it is not material. Maybe you would like the auditor to look into travel expenses and select few more transactions? Perhaps you would like the auditor to examine a certain number of accounts receivable write offs and see if appropriate supervisor sign offs are in place? Maybe you had a bad year with inventory losses, and despite it being an overall small amount, you want the auditor to perform an observation at year end? Certainly these are all possible procedures to have your auditor perform, and while they might not be integral or necessary in order to obtain an unmodified audit opinion, they might encounter an error or fraud which would have normally not been detected in the course of “normal” procedures performed by the auditor. It is very important to have discussions with your auditor prior to the audit, and discuss any areas of concern or emphasis.
With the understanding of what assurance you are receiving from your audit, and perhaps more certainty regarding what an audit will not do for your organization, it is time to think through the controls you have in place in your organization. What processes and procedures might be necessary to ensure a higher degree of certainty that your financial statements are accurate and fraud free? An audit will help provide a higher degree of certainty, but it can never replace having proper controls in place and accounting staff capable of providing accurate financial reporting. An auditor being able to obtain proper assurance is partially dependent upon you, as a client, providing appropriate and sufficient evidence. This leads us into our next topic of discussion in the Audit Preparation Series: How to Prepare for Your Audit.