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Unit 10: Audit of Financial Statements

guidelines and accounting principles to verify that they adhere to regulatory procedures and Notes
standards generally accepted in firms’ industries. These specialists may work in internal audit
departments or at public accounting firms.
10.2.1 Risk Assessment

Auditors analyze entities’ operations and transactions to appraise business risks, control
weaknesses and segment profiles. They may focus on financial risks or operational exposures.
Financial risks may be market and credit risks. Market risk originates from fluctuations in
securities’ prices; it is calculated by complex math tools such as VaR, which stands for value at
risk, or Monte Carlo simulation methods that use various projections to arrive at a likely value.
Credit risk is the risk of loss from business partner defaults; it is measured by internal rating
models. Operational exposures—also called operating risks—originate from human actions or
systems. They may relate to litigation, technology systems or regulatory actions. Auditors
assign ratings—high, medium, low— to areas reviewed and allocate resources based on
risk severity.

Example: An audit manager might assign more auditors to an area deemed “high-risk”.

10.2.2 Internal Controls Testing

Auditors review and internal controls related to financial recording and reporting processes.
They assess policies, procedures and guidelines existing in revenue-producing areas and verify
that such procedures are operating correctly. Auditors tests two criteria: design and operating
effectiveness. Controls are adequately designed if procedures are clearly stated, responsibilities
are defined, and there are consequences for control breaches. Controls are operating effectively
if they remedy deficiencies or internal weaknesses for which they are designed.

Example: An auditor might review the cash disbursement process to verify that duties
are segregated between inventory receipt, warehouse management, vendor checks’ scheduling,
treasury activities and bank statements’ reconciliation.

Notes Auditors who review firms’ financial statements focus on internal controls and
processes, operating guidelines, business risks and policies in financial reporting programs.

10.2.3 Analytical Procedures

Auditors apply analytical procedures in areas where adequate controls and processes are noted.
Analytical procedures refer to comparisons between historical and current-year data, evaluations
of key ratios and appraisals of financial trends. Audit specialists also verify that financial
statements—balance sheet, income statement, owners’ equity statement and statement of cash
flows—are prepared and presented in accordance with accounting principles generally accepted
in the industry.

Example: An auditor might review salespeople’s commissions for five years and check
whether increases in such figures are consistent with increases in revenues.

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