The Audit Process – a Journey from Appointment to Opinion

The audit process is a highly structured journey that moves from “getting to know you” to “signing on the dotted line.” It is designed to ensure the auditor remains independent and the financial statements are reliable.

Pre-Engagement (Before Appointment)

Before a firm accepts a client, they must perform “due diligence” to ensure they aren’t walking into a disaster or a conflict of interest.

• Ethical Check: The firm ensures they are independent (e.g., no one on the audit team owns stock in the client).
• Risk Assessment: They look at the client’s reputation. Is the management honest? Is the company on the verge of bankruptcy?
• Professional Clearance: The new auditor contacts the previous auditor to ask if there are any professional reasons why they shouldn’t take the job.
• The Engagement Letter: Once satisfied, both parties sign this contract. It defines the scope, fees, and responsibilities of both management and the auditor.

Planning & Risk Assessment

This is the “mapping” phase. You don’t just start counting pennies; you look for where the big mistakes are likely to happen.

• Materiality: The auditor determines a “threshold” (e.g., $50,000). Errors below this might be ignored; errors above it must be fixed.
• Understanding the Business: Learning about the industry, regulations, and how the company makes money.
• Internal Control Evaluation: Does the company have good “checks and balances”? If their IT systems and accounting rules are strong, the auditor can do less manual testing.

Execution (Fieldwork)

This is the “boots on the ground” phase where the assertions we discussed earlier are actually tested. It usually involves two types of tests:

• Tests of Controls: Checking if the company’s own rules work (e.g., “Does a manager actually sign off on every $10,000 check?”).
• Substantive Procedures: * Analytical Procedures: Looking at trends (e.g., “Why did travel expenses double when everyone stayed home?”).
• Tests of Detail: Physically counting inventory, calling banks to confirm balances, or inspecting invoices.

Review & Completion

The “wrap-up” phase where all the evidence is gathered and synthesized.

• Subsequent Events: Checking if anything happened after the year-end but before the report is signed (like a major lawsuit or a warehouse fire).
• Going Concern: Assessing if the company will stay in business for at least the next 12 months.
• Management Representation Letter: A signed letter where management takes final responsibility for the numbers and confirms they didn’t hide anything.

Reporting

The final product. The auditor issues an Audit Opinion, which is usually one of four types:

1. Unmodified (Clean): The “Gold Standard.” Everything looks good.
2. Qualified: “Everything is fine, except for this one specific issue.”
3. Adverse: The records are a mess or misleading. Do not trust them.
4. Disclaimer: The auditor couldn’t get enough info to form an opinion at all.

To give you a “real-world” feel, let’s follow a fictional company, Apex Electronics, a mid-sized retailer, through a full audit cycle.

Phase 1: Pre-Engagement & Acceptance

The Real-Life Scenario: Apex Electronics wants to switch auditors because their previous firm was too expensive. They approach “City Audit LLP.”

• Integrity Check: City Audit looks at Apex’s board. They find the CFO was once investigated for aggressive tax manoeuvres. must the auditors decide: Is this a client we want to risk our reputation on?
• Independence Check: One of the audit partners realises her husband owns 5% of Apex. She must be removed from the project entirely to maintain Independence.
• The Engagement Letter: This is the contract. It says, “We will audit you for $100,000. It is your job to provide the receipts; it is our job to tell the public if they are true.”

Phase 2: Risk Assessment & Planning

The Real-Life Scenario: The auditors sit down in a conference room at Apex HQ to “map the minefield.”

• Identifying High-Risk Areas: They notice Apex started selling online this year. Risk: The website might not be recording sales tax correctly, or revenue might be recognized before the product ships (Cut-off assertion).
• Setting Materiality: The auditors look at Apex’s $10M profit. They decide Materiality is $500,000.
• Real-world impact: If they find a $5,000 error in office supplies, they note it but don’t obsess. If they find a $600,000 error in “Cash,” the audit stops until it’s fixed.
• Walkthroughs: The auditor follows one single laptop sale from the moment a customer clicks “Buy” to the moment the cash hits the bank. They are looking for Internal Controls (e.g., “Does the system automatically generate an invoice?”).

Phase 3: Fieldwork (The “Nitty-Gritty”)

This is where auditors spend weeks in “the audit room” (usually a cramped back office) looking at evidence.

A. Substantive Testing of Assets (Existence)

• Inventory Count: On December 31st, the auditor goes to the Apex warehouse. They pick 50 boxes of “Premium Headphones” from the spreadsheet and say, “Show me these boxes.” This tests Existence. Then they find 10 boxes on the floor and say, “Show me these on the spreadsheet.” This tests Completeness.
• Bank Confirmations: The auditor doesn’t just look at a bank statement (which can be Photoshopped). They send a formal letter directly to Apex’s bank. The bank mails back a secret confirmation of the balance.

B. Testing Revenue (Occurrence & Accuracy)

• Vouching: The auditor picks a random $50,000 sale from the ledger. They “vouch” it back to the shipping document and the customer’s signed delivery receipt.
• Real-life catch: If there is no shipping document, that “sale” might be fake (a “ghost” sale to inflate profits).

C. Search for Unrecorded Liabilities (Completeness)

• The auditor looks at bank statements after the year-end (January). They see a $200,000 payment to a supplier. They check if that debt was listed on the December 31st balance sheet. If not, Apex was “hiding” debt to look healthier.

Phase 4: Review & Finalization

The Real-Life Scenario: The audit team finds that Apex’s “Old Inventory” (unsold flip phones) is still listed at full price.

• Proposed Adjustments: The auditor tells the CFO, “You need to write down the value of these phones by $300,000 because they are obsolete.” If the CFO refuses, the auditor threatens a Qualified Opinion.
• Going Concern Review: The auditor notices Apex is losing its biggest contract. They must ask: “Will this company even exist in 12 months?” If the answer is “maybe not,” they must add a scary warning paragraph to the audit report.
• Management Rep Letter: The CEO signs a document saying, “To the best of our knowledge, we haven’t committed any fraud.” (This protects the auditor legally).

Phase 5: Issuing the Report

The auditor signs the Independent Auditor’s Report. This goes into the company’s Annual Report (10-K).

• Example: For Apex, they issue a Clean (Unmodified) Opinion. Investors now feel safe buying Apex stock because a third party has “vouched” for the numbers.