Financial statement audit procedure

An audit of financial statement consists mainly in procedures aimed at obtaining audit evidence for amounts and disclosures presented in the financial statements. The auditor's primary task is to confirm, based on the gathered evidence, whether the audited financial statements give a true and fair view of an entity’s net worth, financial position and profit (loss). The auditor also confirms the compliance of the financial statements with the applicable laws and the adopted accounting principles (policy) as well as the correctness of the books of account based on which those financial statements were prepared. The auditor decides on the selection of audit procedures to be applied.

Acceptance of audit engagement

An audit of financial statements is a complex process. In the first step the audit firm accepts the engagement. For that purpose, the audit firm must first consider whether it will be able to maintain independence and meet competence and ethical requirements related to the audit, verify the client’s integrity and appoint the auditing team. If all of the above criteria can be met, the audit firm accepts the engagement and, in the next step, signs a contract for audit and evaluation of financial statements with the client's manager. The client concludes the contract for audit of financial statements based on the resolution on selecting an auditor, adopted by the body approving the client’s financial statements.

Overall and partial materiality

After signing the contract, the auditor can start work. His first main task is to obtain information about the audited entity and its environment, with particular regard to the entity’s internal control system. This knowledge must be sufficient for the auditor to identify and assess the risk of material misstatements, whether due to fraud or error, in the financial statements. Next, the auditor plans the audit, that is, designs procedures enabling him to collect adequate audit evidence and significantly reducing the identified risks.

A very important aspect of audit planning is determining the “overall materiality”, i.e. the maximum allowable misstatement value in the financial statements which does not affect business decisions to be made by the financial statement users. The starting point for determining materiality may be the analysis of some financial statement figures on which the financial statement users place a particular focus when assessing the entity’s performance (e.g. gross profit, revenues, balance sheet total or equity components). Depending on the assumed calculation base, materiality is determined as 0.5-7% of that base. In order to appropriately limit the risk that the aggregated unadjusted and undetected misstatements will exceed the overall materiality level set for the financial statements, the auditor also determines “partial materiality” at 60-75% of the overall materiality. In addition, the auditor may set a “threshold” – a percentage ratio below which the detected misstatements are regarded as immaterial and not requiring adjustments to the financial statements.

Tests of controls

The next step is conducting the tests of controls to check the entity's accounting system and the existence and functioning of its internal control system. The main purpose of the tests of controls is to obtain assurance that the entity’s controls ensure that business transactions are recognised in the books of account completely and in accordance with the entity’s accounting policy and that any irregularities in those controls are detected. The auditing team starts the tests of controls with interviewing the entity’s employees and management on the functioning of selected processes. Based on their answers the auditor describes a given process and compares the process description with the relevant source documents to see if he can identify any irregularities in the internal control system. Based on the test results the auditor can assess the system’s strengths and weaknesses and appropriately plan the main audit procedures so as to minimise the risk of irregularities.

The results of the tests of controls are taken into account in planning substantive tests. Substantive tests aim to verify the earlier assertions and are based on the tests of controls. If the auditor obtains sufficient assurance that the entity’s internal controls and accounting system work properly, he may limit the scope of substantive testing. The stronger the trust in the systems, the smaller the size of the substantive testing sample.

Agreeing the version of the financial statements  

In the final ste p of the audit, the auditor agrees the final version of the financial statements with the entity's management. The auditor describes and discusses the detected material misstatements with the entity’s management during the audit summary meeting, which is usually held after the preliminary and main audit. The results of the  auditor’s work are presented in the report on audit of financial statements.