Opinion ID: 1348772
Heading Depth: 1
Heading Rank: 3

Heading: The Audit Function in Public Accounting

Text: Although certified public accountants (CPA's) perform a variety of services for their clients, their primary function, which is the one that most frequently generates lawsuits against them by third persons, is financial auditing. (Hagen, Certified Public Accountant's Liability for Malpractice: Effect of Compliance with GAAP and GAAS (1987) 13 J. Contemp. Law 65, 66 [hereafter Hagen]; Siliciano, Negligent Accounting and the Limits of Instrumental Tort Reform (1988) 86 Mich.L.Rev. 1929, 1931 [hereafter Siliciano].) (1) An audit is a verification of the financial statements of an entity through an examination of the underlying accounting records and supporting evidence. (Hagen, supra, 13 J. Contemp. Law at p. 66.) In an audit engagement, an accountant reviews financial statements prepared by a client and issues an opinion stating whether such statements fairly represent the financial status of the audited entity. (Siliciano, supra, 86 Mich.L.Rev. at p. 1931.) In a typical audit, a CPA firm may verify the existence of tangible assets, observe business activities, and confirm account balances and mathematical computations. It might also examine sample transactions or records to ascertain the accuracy of the client company's financial and accounting systems. For example, auditors often select transactions recorded in the company's books to determine whether the recorded entries are supported by underlying data (vouching). Or, approaching the problem from the opposite perspective, an auditor might choose particular items of data to trace through the client's accounting and bookkeeping process to determine whether the data have been properly recorded and accounted for (tracing). (Hagen, supra, 13 J. Contemp. Law at pp. 66-67, fn. 15.) For practical reasons of time and cost, an audit rarely, if ever, examines every accounting transaction in the records of a business. The planning and execution of an audit therefore require a high degree of professional skill and judgment. Initially, the CPA firm plans the audit by surveying the client's business operations and accounting systems and making preliminary decisions as to the scope of the audit and what methods and procedures will be used. The firm then evaluates the internal financial control systems of the client and performs compliance tests to determine whether they are functioning properly. Transactions and data are sampled, vouched for, and traced. Throughout the audit process, results are examined and procedures are reevaluated and modified to reflect discoveries made by the auditors. (Hagen, supra, 13 J. Contemp. Law at pp. 67-68.) For example, if the auditor discovers weaknesses in the internal control system of the client, the auditor must plan additional audit procedures which will satisfy himself that the internal control weaknesses have not caused any material misrepresentations in the financial statements. ( Ibid. ) The end product of an audit is the audit report or opinion. The report is generally expressed in a letter addressed to the client. The body of the report refers to the specific client-prepared financial statements which are attached. In the case of the so-called unqualified report (of which Arthur Young's report on the company's 1982 financial statements is an example), two paragraphs are relatively standard. In a scope paragraph, the CPA firm asserts that it has examined the accompanying financial statements in accordance with GAAS. GAAS are promulgated by the American Institute of Certified Public Accountants (AICPA), a national professional organization of CPA's, whose membership is open to persons holding certified public accountant certificates issued by state boards of accountancy. (Hagen, supra, 13 J. Contemp. Law at pp. 72-73.) The GAAS include 10 broadly phrased sets of standards and general principles that guide the audit function. They are classified as general standards, standards for fieldwork, and standards of reporting. General Standard No. 1 provides: The examination is to be performed by a person or persons having adequate technical training as ... auditor[s]. General Standard No. 3 provides: Due professional care is to be exercised in the performance of the examination and the preparation of the report. Standard of Fieldwork No. 2 provides: A sufficient understanding of the internal control structure is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed. The generality of these statements is somewhat mitigated by the Statements on Auditing Standards (SAS), which are periodic interpretations of the standards issued by the Auditing Standards Board of the AICPA. (Miller & Bailey, Comprehensive GAAS Guide (1991) pp. 5.03, 5.11, 6.07 [hereafter GAAS Guide].) For example, SAS-55, which relates to internal financial control structure, includes steps to be followed in understanding and testing accounting control systems in relation to information provided in financial statements. (GAAS Guide at p. 7.03 et seq.) The GAAS Guide, a commonly used summary of GAAS, that purports to integrate and comprehensively restate pertinent auditing standards, includes 140 major sections and more than 1,000 pages. In an opinion paragraph, the audit report generally states the CPA firm's opinion that the audited financial statements, taken as a whole, are in conformity with GAAP and present fairly in all material respects the financial position, results of operations, and changes in financial position of the client in the relevant periods. (GAAS Guide at p. 11.03; Hagen, supra, 13 J. Contemp. Law at pp. 74-76.) [3] The GAAP are an amalgam of statements issued by the AICPA through the successive groups it has established to promulgate accounting principles: the Committee on Accounting Procedure, the Accounting Principles Board, and the Financial Accounting Standards Board. Like GAAS, GAAP include broad statements of accounting principles amounting to aspirational norms as well as more specific guidelines and illustrations. The lack of an official compilation allows for some debate over whether particular announcements are encompassed within GAAP. (Hagen, supra, 13 J. Contemp. Law at pp. 74-76.) One standard text purporting to comprehensively restate GAAP includes 90 major sections and more than 500 pages. (M. Miller, GAAP Guide (1991).) In addition to or in place of the standardized statements in an audit report, the auditing CPA firm may also qualify its opinion, noting exceptions or matters in the financial statements not in conformity with GAAP or significant uncertainties which might affect a fair evaluation of the statements. The report may also contain a disclaimer stating the accountant's inability to express any opinion about the statements or an adverse opinion that the statements do not fairly present the financial position of the client in conformity with GAAP. (Hagen, supra, 13 J. Contemp. Law at pp. 69-72.) Arthur Young correctly observes that audits may be commissioned by clients for different purposes. Nonetheless, audits of financial statements and the resulting audit reports are very frequently (if not almost universally) used by businesses to establish the financial credibility of their enterprises in the perceptions of outside persons, e.g., existing and prospective investors, financial institutions, and others who extend credit to an enterprise or make risk-oriented decisions based on its economic viability. The unqualified audit report of a CPA firm, particularly one of the Big Six, is often an admission ticket to venture capital markets â a necessary condition precedent to attracting the kind and level of outside funds essential to the client's financial growth and survival. As one commentator summarizes: In the first instance, this unqualified opinion serves as an assurance to the client that its own perception of its financial health is valid and that its accounting systems are reliable. The audit, however, frequently plays a second major role: it assists the client in convincing third parties that it is safe to extend credit or invest in the client. (Siliciano, supra, 86 Mich.L.Rev. at p. 1932.) The GAAP acknowledge that financial audit reporting is a principal means of communicating accounting information to those outside an enterprise. (Statement of Financial Accounting Concepts of the Financial Accounting Standards Board of the AICPA No. 1, ś 6, p. 7.) As the AICPA recently stated: The independent audit, through the process of examining evidence underlying the financial statements, adds credibility to management's representations in the statements. In turn, the audit provides investors, bankers, creditors, and others with reasonable assurance that the financial statements are free of material misstatement. (AICPA, Understanding Audits and the Auditor's Report, A Guide for Financial Statement Users (1989) p. 36; see also Bus. & Prof. Code, § 5051, subd. (d) [practice of accountancy includes preparation of reports on audits for purpose of obtaining credit or filing documents with government agencies]; Cal. Code Regs., tit. 16, § 58.3 [accountant may not issue report on unaudited financial statements to client or others without complying with professional standards].) The AICPA's professional standards refer to the public responsibility of auditors: A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession's public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on certified public accountants. (2 AICPA Professional Standards (CCH 1988) § 53.01.) The United States Supreme Court had also recognized the public function of the CPA auditor as a reason to deny work product protection to the auditor's work papers. Distinguishing CPA firms from lawyers and other professionals who perform services for clients, the high court stated: By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This `public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. ( United States v. Arthur Young & Co. (1984) 465 U.S. 805, 817-818 [79 L.Ed.2d 826, 835-837, 104 S.Ct. 1495].)