 Hello, Arlene. What is it and why do we need it? Support Accounting Instruction by clicking the link below, giving you a free month membership to all of the content on our website, broken out by category, further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files, and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. At the end of this, we will be able to explain the need for audits, understand what independence means in the context of an audit, define assurance services, and explain what financial reporting framework is and how it is used as well as list and defined types of test engagements. Alright, so why do we need audits? So why do we need an audit? Basically for trust. Trust is going to be the main service that we're going to have for the audit. For example, if we think about a company and who they're going to do business with, they're going to have transactions with could be end users, end users like investors. If you're talking about a publicly traded company, more and more that's going to be just normal people are investing and they're putting their money into the company. The company wants those investments, of course. If we talk about banks, we can think about banks in terms of a company possibly could need a loan and they're going to want the transaction. The bank, of course, wants to provide the loan because they're going to make interest on that. The government, government, the company may not want to do business, but they have to do business in terms of taxes in some way, and the government, of course, is going to have a need for that as well. So when we want to have these transactions happen, but notice what happens often is that what will limit a transaction is if there's no trust. If the investor wants to invest in the company, but they don't know if the company is going to be profitable, then the investor doesn't doesn't know if they're going to put the money in there. If the banks don't think that the company will be able to pay back the loan plus the interest, which is why they're given the loan in the first place, then they're less likely to give the loan. So what can the company do to give more trust? Well, the investors, the bank, the government are going to ask for, of course, financial statements. They're going to say, hey, why don't you give us some financial statements, tell us what your profitability is, tell us how you're doing, and then we're more likely to give you what we want. We can do business then. The investors can then put in money and invest. The banks could give the loan. The government can process their taxes. But still, we still might have a problem because the investors, the users might be saying, hey, the company has an incentive to maybe not provide financial statements that are correct or they might provide financial statements that are not correct in terms of what the end users are thinking in terms of the procedures or how it was created, was it made in accordance to some standards? There could be errors on it. So the end users still may not fully trust the financial statements. And that's of course where the CPA firm comes in with the audit. And the audit then should give some level of assurance that the financial statements which are created and the responsibility of the company are correct in accordance with some agreed upon standards. So that's going to be the idea that financial statements are then go to the CPA firm, which then could go to the end users with some more type of verification as to the reliability of the financial statements in some way. Now, of course, there's pros and cons to this type of transaction because that trust, that added trust is the benefit. That's hopefully going to say, okay, now we can have more transactions happening because there's more transparency. The end users are more confident in what the company is providing and therefore, that's going to facilitate more transactions. That's huge. We want to have openness and transparency in order to have more transactions. Of course, the downside of that is that it's going to cost more money in order to do this. In order to have the CPA firm go in, if you're talking about audits of publicly traded companies, that's a lot of money to process those audits. So there's a pro and a con of that, but the idea of it is to facilitate the transactions to provide the trust needed for people to do business and that's going to be the concept of the audits. So why would we trust the audit, you might ask? What is it about an audit that makes the audit process a more trustworthy process? Well, the idea of independence and a third party, independent third party is a key component of why we would trust an audit. For example, if we have the company and the end users, they're doing business, they want to do business, A and B are doing business, C over here is not involved in the immediate transaction between A and B. So if we were to do business, if you had two people doing business and you had a third party, possibly someone who's a friend of both of you or someone that both of you do not even know, then you might say, hey, this person has no relation to the transaction we're doing. Therefore, their opinion is objective. And let's rely on their opinion then. And of course, in this case, we're relying on a third party who is a professional in one that they should have the knowledge in terms of whether something is correct or not. And they should have the standards in this case being a CPA regulated by the regulations to act independently. So that's kind of the reason we would trust the third party. So independence becomes a huge thing. Now note, you might be thinking, well, how does the CPA firm get paid by the company? It's right. So you're going to have, you might be thinking, well, there's a kind of a problem that is a problem. That's why independence becomes so important. Because you know, we need to have some regulations, some standards to regulate the CPA firm profession in order to remain independent. So if we had other problems, if you know, the people that were doing the audit were also part of the board of directors, or were part of management of the company, then clearly, they would not be independent. And we'll take a look at a lot more kind of rules in terms of what makes someone independent, what makes someone not independent. And we want to be independent, both in appearance and in actuality, so that we can be someone that both parties can rely on in this transaction. What are assurance services? So categories could include provide reliability, or we can have organizing information into certain form or context. We're going to be focusing on the providing of reliability. That's the most common idea of the assurance when we think about the financial statements. We're usually having the confidence in the financial statements. What does it mean to provide reliability? So a test services are subset of assurance services. So we're going to talk about a test engagements. We want to provide assurance as to something's reliability. So that's going to be the basic idea from the broad sense. We're providing assurance as to something's reliability, usually financial statements is what most people think of some kind of review of subject matter that is the responsibility of another is another way to put it. So again, we usually think about the financial statements, the financial statements being a responsibility of the company and the assurance, the reliability, the reliability, the assurance, the attestation engagement is to give some type of reliability on those financial statements, which are the responsibility of another. We could give some kind of assurance on another stuff like internal controls and other types of things as well. What type of subject matter can be reviewed? So it could include financial forecast, it could include internal controls, which is a huge one these days, it couldn't control compliance with laws and regulations. So there's a lot of things that besides the financial statements that we could actually have reviewed and given an opinion on in this way or give some kind of assurance in what type of standard should a review be based on. So generally established by groups of experts. So when we think about the standards, when we think about if we're taking a look at something, for example, the financial statements, then we of course need to compare that to something. We need to say, okay, how is this thing going to relate? How do we know? How can we give assurance? Well, usually we're going to find some standard standards that we're going to take a look at. Standards usually being created by experts. If we're talking about financial statement audits, standards set by financial reporting framework. So if we're talking about financial statement audits, usually the thing we look at when we're looking at audits, we're looking at some kind of framework, the financial reporting framework to go by. Normally, that's generally accepted accounting principles gap. So normally in a normal audit, we would say, hey, here's the financial statements, we're going to dig down on them and see if they are in accordance with the rules that generally accepted accounting principles, do they adhere to the generally accepted accounting principles? Now note, if we could have other standards though, financial reporting frameworks that we're looking at. So for example, if you're getting a loan from the bank and the bank is willing to accept a cash basis or willing to accept financial statements that are in accordance with the tax code, then that might be good enough. We might be saying, okay, now we're reviewing this in relation to the financial reporting framework of the IRS tax code or a cash basis. So how is financial reporting framework used? So CPA firm performs an audit in order to gather evidence to issue an opinion on whether financial statements follow the financial reporting framework. So when we think about, if we're thinking about gap as the financial reporting framework, then of course what we're going to do is say, okay, how can we prove that the financial statements are in accordance with gap? Well, we're going to go and we're going to try to gather evidence. We're going to basically make a case for it. And then we're going to give an opinion as to whether they do conform or they don't conform based on the evidence that we're going to draw. So what type of a test engagements are there? There's going to be examinations, there's reviews, there's agreed upon procedures, these are going to be the most common items. What's an examination? Usually that's an audit, an audit when involving historical financial statements. So when we think about examinations, we're generally thinking the audit and that's the highest assurance CPA can offer. So that's when we think about an audit, that's the highest assurance. Now note, we're not talking about IRS audits, tax audits usually. When we talk about financial statements, we're talking about the assurance of the CPA assurance of the financial statements generally, that's going to be the context of the audits in this case. So what's in a review then? It's much less in scope of procedure than an examination. So an audit is going to be the highest examination that we can have. A review is going to be much less. So we're going to do a lot more digging. We may not go out to the company's site as much. It's probably involved a lot more testing that are in-house ratio analysis things we can do in the office. And therefore it provides only limited assurance. So sometimes that might be all you need. If you're talking to the bank and you're looking for a loan or what not, a company needs a loan, maybe they don't need an audit. Maybe they just need an assurance. Maybe they don't need us digging into a full audit. That would cost a lot more money. If the bank only wants a reasonable assurance with a review, then that may be appropriate in those cases. Of course, a publicly traded company is required to have audits non-publicly traded companies. They may have many types of situations where a review would be a good way to go. Let's take a look at a chart here. So if we had an examination, we're saying the assurance level is high. So we're going to say we're given high assurance that the financial statements that we're talking about in audits are correct. That means that the risk of a material misstatement is low. So if we look at the financial statements and you say, what are the odds that there's a big misstatement on the financial statements, well if it's been audited, the risk of a material misstatement, a misstatement that would be relevant to decision making is low. It doesn't mean there's not in material misstatements, but if it's in material, it shouldn't affect decision making. So assurance report. We're going to issue a report for these things and usually if we're talking about an audit somewhere in the standard report that we'll take a look at later, it's going to say in our opinion. So that's going to be, it's going to be in our opinion. It's going to be part of the report. Procedures. We're going to choose from all available procedures in any combination that can limit risk to a low level. So we're going to do a lot more procedures in the audit. We're going to do the analytical procedures. We're also going to pick from procedures that we think can lower the risk and that could include going out to the actual site and digging through things like invoices and whatnot and actually observing things and whatnot. And then we have the review and remember that a review is a lot less. So we're going to have the assurance level is only moderate. It's not as high a level of assurance if we're doing a review as opposed to an audit. Therefore, the risk of material misstatement is moderate. So if we're looking at the financial statement, what's the risk that there's a material misstatement? Well, it's moderate. You know, there's a higher risk than if we did a full audit and an examination. If we do a report, our report would say something like, we are not aware of any material modifications that should be made. So you can see that that's a lot more kind of lawyering and not giving a full assurance there in that. So we're given a reviewed opinion there. And notice, we're never going to say in the report that we guarantee anything because that's legally not a smart thing to do because it could expose to liability. So in this case, we're saying we are not aware of any material modifications. All right. So often limited to inquiry and analytical procedures. So what are we going to do in a review? Usually it's going to be more of the stuff we can do in the office. We're going to do, you know, ratio analysis probably and compare the numbers from last year to this year. We're going to do some some ratio analysis in there and see if there's unusual circumstances, unusual information. We're probably going to do a lot less of going out to the company and digging through and doing more observations and that type of thing in the review process as compared to the audit.