Speaker 1: All right. In this lesson, we're going to talk a little bit about the financial statement auditing process. Now, before we really get started, I want to address this video with another lesson that we're going to be talking about because both of them are going to be very similar in nature. So, in this lesson, we're going to talk about how the financial statement audit process works when it comes to both management and auditors, and so we're going to talk a little bit about what management does and then how auditors fit in there and what they do. In another lesson, we're going to spend some time just talking about what the auditor does, and so in that lesson, you might watch that lesson and be totally confused, but what we're doing here is we're kind of giving you the 35,000-feet view of how management and auditors work together, and then we're going to give you the 20,000-foot view of how audits work, so both lessons are going to be important to understand, but I don't want you to get confused from this lesson and the other lesson because it's going to seem like, wait, didn't he kind of talk about that, but then he didn't really talk about that? This is really just focused on management's part and how auditors fit into the picture. The other lesson that we're going to go through just talks about the auditor's process for completing an audit. To kind of get us started, let's look at here what we have on this board, and what we have here is kind of what main tasks do the management and auditors have. Let's start with management. Management here, the first thing that they usually do is implement internal controls. Why would they implement internal controls? We learned in another accounting class that internal controls are controls that management puts in place to make sure that what they're requesting all of their subordinates to do is done in the fashion that management wants it. Remember in a very big organization, you've got the president, you've got some senior VPs at the top, and then the VPs, and then you might have managers, and so on, and so on. Above them, you've got the board of directors. I have this hierarchy right here. The board of directors are going to advise management or the president on how to operate the organization and what goals board of directors wants management to achieve. The president, as well as the senior VPs, are going to have to disseminate that information down to their subordinates. As they do that, we get something called loss in translation. We know what that means. Loss in translation means that what comes here by the time it gets to here is now different. Management puts in internal controls so that the upper management's goals are followed by those that are below it. An example of internal controls is that if a check is issued over $5,000, there must be two signatures on it. That's an internal control. No one person has the ability to write a check over $5,000. When a shipment comes in, before that shipment's put into inventory, it must be counted by the dock worker. The dock worker's not allowed to know how much we're receiving. When the dock worker counts, we take that number and match it against the invoice from the vendor to make sure that what they billed us for is what they shipped. Those are controlled to make sure all of our financial statements are done or financial information is done correctly. That's what we're most concerned with. Management's going to implement some internal controls, and then management, as well as the company itself, are going to conduct transactions. As they conduct transactions, those transactions will accumulate into balances. For instance, if we make a sale of $1,000, that is a transaction, so we will book a journal entry into the books. At the end of the year, we put all of those transactions, summarizes them into an account balance. Think of your bank account. Every day you're going to Starbucks or you're going to a coffee shop, you're buying your coffee, and then at the end of the month and at the end of the year, you're going to get a balance left in your bank account based on all your ins and outs. If we wanted to, we can throw all that information into a financial planning software, and it will spit out how much you spend at these coffee shops or Starbucks and whatnot. That's the summary balance. It's a listing of all the transactions. Same thing here. We conduct our transactions, and then we accumulate all those transactions into balances. Once we've done that, then we prepare some financial statements. In real life, once we've done all of our transactions for the year, we prepare an income tax return, and then we issue the financial statement. That's what management does from the financial accounting standpoint. What about auditors? What do auditors do? Again, 35,000 feet level, bird's eye view, this is what they do. Auditors will obtain evidence, test the assertions, determine the overall fairness of management assertions, and then issue an audit report. How does this interact with each other? The process is this. Management will hire auditors, usually at the direction of the upper management, but also of the direction of the board of directors. The board of directors or even the audit committee will decide who their auditors are going to be. Once that's done, there's some terms of engagement. The auditors will give an engagement letter to management saying, this is what we're willing to do, how long this audit will take, how much it will cost. That's the terms of engagement between management and the auditors. We have all of these things here that management's doing. They're implementing internal controls, they're conducting transactions, and they're accumulating transactions into balances. Us as auditors, our first job is to obtain evidence on all three things here. The first thing that we do is we look at internal control. We'll talk a lot about this later on, but we look at internal controls to see if we can rely on their controls. If we can rely on their controls, we might be able to get away with looking at less evidence. For instance, if they're following the controls that all checks over $5,000 are being signed by two people, then we're maybe not concerned when checks are issued for eight or 10,000. We may not have to look at that many checks in order to make sure that they're appropriate in value and appropriate in authorization. We're going to look at internal controls to give us an idea of how well internal controls are being used and being followed by the entire company. We'll obtain evidence, and from that evidence, we'll make some risk assessments based on the client, and then we will look at their transactions and obtain evidence on their transactions. Then we're going to look at their balances. We're going to find evidence of this stuff here in order to test management's assertions. We're going to test management's assertions. The way that we test management's assertions is we look at their financial statements. We look at their financial statements, and we say, okay, they're asserting they've got $5 million in cash. Then we go back to our evidence and see, can we rely on that number based on the evidence that we've obtained? If we can't, then we have a misstatement, and if we have a misstatement, either management fixed that misstatement, or we're going to issue a report saying what misstatements we see in the financial statement. We test management's assertions, and what assertions are we testing? We're testing the assertions that are on the financial statement. In a previous lesson, we talked about what assertions are. Then we take all of the evidence that we've gathered, and we take all of the information that we've gathered from testing management's assertions, and we determine the overall fairness of the financial statement. We haven't really talked a lot about this, but we did talk about it a little bit in a previous lesson in that we're not going to get absolute assurance that the financial statements are presented fairly. The reason why we're not going to get absolute assurance is because of cost versus benefit. In order to get absolute assurance, we're going to have to audit every single piece of transaction in the accounting book. The problem with that is if we have a large organization, we would have to look at millions and millions of transactions, and that's just not possible. The cost to do that would outweigh the actual benefit of providing an opinion to the users of a financial statement. What do we do? We provide reasonable assurance. When we look at determining overall fairness, we're looking for reasonable. Is it reasonable to say that their financial statements are properly prepared and properly done and properly shows the economic position of the organization? If it is, then we're going to issue a clean report. We call that an unqualified audit report, and we'll talk more about the types of audit reports in another lesson, but we'll issue a report. If they are not presented fairly, then we may decide to issue an audit report that says that these financial statements are not prepared fairly, or we may do something called a qualified opinion where everything is good except for this part that we've tested and reviewed. Once we've done that, once we issued an audit report, let's assume it's a clean report. We're doing all of the books the way that they should be based on U.S. GAAP. Then we're going to go ahead and give them the audit report, then they will attach that audit report to the issued financial statement, and then they'll issue the financial statement to the external users of those statements. So again, 35,000 foot view of what financial statement audit process looks like. We've got management doing this stuff, and then we have auditors doing this stuff with this information. Auditors are going to obtain evidence on the internal controls and the transactions and the transaction balances, and then we're going to test assertions based on using our evidence of the financial statement that we're given to prior to release. We'll determine the overall fairness based on the results of our management assertion test as well as the evidence that we received, and then we'll issue an audit report based on our determination of the fairness that will go into the issued financial statements and then subsequently give it out to external users of those financial statements. So again, 35,000 foot view. This is kind of the high level. This is what is happening on both sides of the fence, and this is what we're trying to do. Again, in the next lesson or in a future lesson, we're going to talk more about what auditor's job is. So now we're going to take away management side of things, and we're going to look straight at auditing and what that auditing process looks like, and we're going to expand this because obviously this is not just what we do. There's detail to this, and we're going to expand that. So hopefully you have a better understanding of the financial statement audit process from both the management side and from the auditor's side.