www.pwc.

com

Understanding a
financial statement audit
May 2017

Understanding a financial statement audit | 1

Preface
Role of audit
The need for companies’ financial statements1 to be audited by an independent external auditor has been a
cornerstone of confidence in the world’s financial systems.

The benefit of an audit is that it provides assurance that management has presented a ‘true and fair’ view of a
company’s financial performance and position. An audit underpins the trust and obligation of stewardship
between those who manage a company and those who own it or otherwise have a need for a ‘true and fair’ view,
the stakeholders.

Given the importance of its role, queries are often raised about the audit, the auditors and the stakeholders
they serve. This publication aims to provide useful background information on what a financial statement audit is
and the role of the auditor.

Definition of an audit
In general, an audit consists of evaluation of a subject matter with a view to express an opinion on whether the
subject matter is fairly presented. There are different types of audits that can be performed depending on the
subject matter under consideration, for example:
 Audit of financial statements
 Audit of internal control over financial reporting
 Compliance audit

This publication only focuses on audits of financial statements, which are undertaken to form an independent
opinion on the financial statements of a company.

Companies prepare their financial statements in accordance with a framework of generally accepted accounting
principles (GAAP) relevant to their country, also referred to broadly as accounting standards or financial reporting
standards. The fair presentation of those financial statements is evaluated by independent auditors using a
framework of generally accepted auditing standards (GAAS) which set out requirements and guidance on how to
conduct an audit, also referred to simply as auditing standards.

This publication focuses in particular on financial statement audits of public companies (listed companies, whose
shares are typically traded on a stock exchange)—what most people have in mind when discussing ‘audit'. Whilst
care has been taken to keep explanations broadly applicable to most public company audits, requirements and
practices will vary from country to country, and jurisdiction to jurisdiction. Descriptions are based on the current
broad form and scope of audit, the future of which is currently under debate around the world and is open to
change. This publication does not provide detailed explanation of all aspects of a financial statement audit and
readers should refer to other sources for further information.

1 See ‘Glossary of terms’ from page 13 onwards for more definitions.

2 | PwC
 Benefits of an audit
Overview Auditors are generally and ultimately appointed by
the shareholders and report to them directly or via
the audit committee (or its equivalent) and others
charged with governance.

However, some companies’ audited financial

Purpose of a financial statements, and particularly public companies, are on
statement audit public record. For large public companies, they may
Companies produce financial statements that provide also be used by other parties for varying purposes
information about their financial position and (see the chart below). In addition to shareholders,
performance. This information is used by a wide these may include, for example, potential investors
range of stakeholders (e.g., investors) in making considering buying the company’s shares and
economic decisions. Typically, those that own a suppliers or lenders who are considering doing
company, the shareholders, are not those that business with it. A rigorous audit process will, almost
manage it. Therefore, the owners of these companies invariably, also identify insights about some areas
(as well as other stakeholders, such as banks, where management may improve their controls or
suppliers and customers) take comfort from processes. In certain circumstances the auditor may
independent assurance that the financial statements be required to communicate control deficiencies to
fairly present, in all material respects, the company’s management and those charged with governance.
financial position and performance. These communications add value to the company and
enhance the overall quality of business processes.
To enhance the degree of confidence in the financial
statements, a qualified external party (an auditor) is
engaged to examine the financial statements,
including related disclosures produced by
management, to give their professional opinion on
Shareholders
whether they fairly reflect, in all material respects,
the company’s financial performance over a given
Others Banks
period(s) (an income statement) and financial
position as of a particular date(s) (a balance sheet) in
accordance with relevant GAAP. In many cases this is
Audited
required by law.
financial
statements
Investors Suppliers

Oversight
Customers
bodies

3 | PwC
Public vs. private companies In undertaking an audit, auditors apply relevant
GAAS that provides specific requirements and
While companies of all sizes produce financial
guidance on performing audit engagements. Auditing
statements, the number of stakeholders interested in
standards may be set by national or international
them would normally be larger for public companies
organizations, such as the International Auditing and
and larger private companies, due to the number of
Assurance Standards Board (IAASB) and adopted by
individuals, businesses and organisations that
national regulatory bodies.
interact with and are affected by them. Also, public
companies’ financial statements are typically
available to a larger number of users. In most
jurisdictions, for public companies, there are
additional requirements to comply with when
preparing their financial statements. Larger public Oversight
bodies
company audits are typically more complex and also
used by even more market participants.

Audit environment
Multi-location Legal
The changing economic and legal environment has audit matters environment

Audit
significant implications for a company’s operations
and financial reporting, and changes in the business,
economy and laws and regulations generally increase
the level of risks affecting the business and require
adequate response and disclosure in the financial
statements. This also affects the way an audit is
Auditing Accounting
conducted, since the auditor’s work needs to be standards standards
scaled to address increased risks of material (GAAS) (GAAP)
misstatement of the financial statements.

In the current environment, auditors have to take

into account various evolving factors that may result
in additional challenges (see the chart opposite).
When a company is comprised of multiple entities
there are additional complexities that need to be
addressed. These considerations are likely to
complicate matters further when the company has
locations in different countries and therefore may
span different regulatory requirements (see ‘multi-
location audits’ below).

4 | PwC
 Modified audit opinion
Reporting An audit opinion that is not considered ‘clean’ is one
that has been modified. Auditors issue a modified
audit opinion if they disagree with management
about the financial statements. In practice this may
be unusual as the company will typically make the
necessary amendments to the financial statements
Audit opinion
and disclosures rather than receive a modified
The management of a company is responsible for opinion. The auditors will also issue a modified
preparing the financial statements. The auditor is opinion if they have not been able to carry out all the
responsible for expressing an opinion indicating that work they feel is necessary, or if they have been
reasonable assurance has been obtained that the unable to gather all the evidence they need.
financial statements as a whole are free from material
misstatement, whether due to fraud or error, and that Auditors can also modify the audit report without
they are fairly presented in accordance with the modifying the opinion by adding additional
relevant accounting standards (e.g., International paragraphs to draw users’ attention to specific
Financial Reporting Standards). significant matters. For example, if the auditors
believe that there is some aspect of the financial
There are clear frameworks from independent statements that is subject to a material degree of
auditing standard setters which provide rules and uncertainty—even if fully disclosed—then they may
guidelines for how an audit should be carried out and draw attention to and emphasise this in the audit
the level of assurance obtained. It is the auditor’s report. This is widely known as an emphasis of matter
responsibility to plan and conduct the audit in such a paragraph.
way that it meets the applicable auditing standards
and sufficient appropriate evidence is obtained to Going concern assumption
support the audit opinion. However, what constitutes
Under the going concern assumption, a company is
sufficient appropriate evidence is ultimately a matter
viewed as continuing in business for the foreseeable
of professional judgement. The auditor considers a
future. Financial statements are prepared on a going
number of factors in determining whether financial
concern basis, unless management either intends to
statements are free of material misstatement, and in
liquidate the company or to cease operations, or has
evaluating any misstatements identified. These
no realistic alternative but to do so. When the use of
factors require professional judgement, where
the going concern assumption is appropriate, assets
auditors use their skill and experience to form a view
and liabilities are recorded on the basis that the
based upon the evidence gathered on the financial
company will be able to realise its assets and
statements taken as a whole.
discharge its liabilities in the normal course
of business.
The audit opinion is clearly stated as a separate
paragraph in the audit report. The auditor issues a
If management considers that the company will not
‘clean’ opinion when it concludes that the financial
continue to operate for the foreseeable future, the
statements are free from material misstatement.
financial statements must be prepared on a
‘liquidation’ (or ‘break-up’) basis—meaning that the
value of their assets must take account of potential
forced sales which will likely be significantly lower
and their liabilities may be significantly higher.

Understanding a financial statement audit | 5

Whether or not the going concern assumption is The annual report
appropriate is therefore fundamental to the values at
A company’s annual report is typically made up of the
which the assets and liabilities are recognised in the
audited financial statements and a narrative,
company’s balance sheet. Thus, going concern refers
containing management’s description of the
to the basis on which the financial statements are
company’s performance and activities. The narrative
prepared. It is not a guarantee of the company’s
part of the annual report is not normally audited.
solvency.
However, the auditors read the narrative statements
in the annual report to identify any material
In order to determine whether the going concern
inconsistencies with the audited information in the
assumption is appropriate, management must
financial statements. If they find any such
consider the prospects for the business in the light of
inconsistencies and these are not resolved, the
what the foreseeable future might bring. This
auditors report this in the audit report.
requires significant judgement as no statement about
the future can be guaranteed.
The financial statements, annual report and other
documents all enable shareholders to understand how
It is management’s responsibility to make a
management has performed over the
judgement on going concern. It is the auditor’s
periods presented.
responsibility to consider whether there are any
material uncertainties affecting management’s
Other reports
assessment and whether or not management's
judgement is appropriate. These judgements can be In most jurisdictions, financial statements form only
made only on the basis of what is known at the time, one part of the financial information that a public
and facts and circumstances can quickly change in company prepares. In addition to publishing full
the current business and economic environment. financial statements every year, public companies
What may be a reasonable assumption today, typically also need to issue less detailed financial
particularly in a fast-changing environment, may no information at other points throughout the year. In
longer be so a short time later. most cases, auditors review this financial information,
but this review is not an audit. Instead, the auditors
The most common recent form of such uncertainty is make inquiries, apply analytical and other review
where additional financing is needed to continue to procedures, and communicate whether anything has
develop a company’s business and fully fund its come to their attention that suggests the financial
working capital. While management may be information is not prepared, in all material respects,
confident of obtaining additional funding in order to in accordance with the relevant GAAP.
meet these needs, if there is no firm agreement with A review does not involve testing or other
potential suppliers of finance, there is inherent corroborative procedures.
uncertainty as to whether such funding will be raised.
Before the audited financial statements are published,
If the auditors consider that there are any material a public company will frequently make a preliminary
uncertainties, even if clearly disclosed in the financial announcement of its results for the year. These
statements, then they must include an emphasis of announcements are typically unaudited because the
audit report on the financial statements has usually
matter paragraph in their audit report. If the auditors
not been issued by that time. However, the company
disagree with management’s assessment that the
will generally ask its auditors to read the
going concern assumption is appropriate for the announcement prior to its release and inform them of
company’s financial statements or if adequate any material inconsistencies which have come to their
disclosure of material uncertainties is not made, then attention.
their audit opinion will be modified.

6 | PwC
 Auditing standards also require auditors to maintain
The audit process professional scepticism—an attitude that includes a
questioning mind and a critical assessment of audit
evidence. The ability to think in a critical manner
about how the current economic environment may
affect the company’s financial statements, to identify
significant risks of material misstatement, to develop
Professional judgement and appropriate audit responses, to obtain and assess the
scepticism sufficiency and appropriateness of audit evidence and
to reach well-informed professional judgements is
In undertaking an audit, the auditors consider the
integral to performing a quality audit.
mandatory and detailed GAAP that set out how a
company should account for and disclose even the
Inherent limitations of an audit
most complex transactions. However, many of the
issues that arise in an audit—particularly those An opinion is not a guarantee of an outcome, but
involving valuations or assumptions about the rather a statement of professional judgement. The
future—involve estimates to which the auditor must auditor cannot obtain absolute assurance that
bring their professional judgement and experience to financial statements are free from material
bear. misstatement because of the inherent limitations of
an audit. These are caused by a number of factors.
Indeed, many accounting measures can only ever be For example, many financial statement items involve
estimates that are inevitably based on imperfect subjective decisions or a degree of uncertainty (e.g.,
knowledge or dependent upon future events. For accounting estimates). Consequently, such items are
example, if a company was involved in legal action, it subject to an inherent level of uncertainty which
would need to estimate the amount at which the case cannot be eliminated by the application of
would be resolved; or if it was planning to sell an auditing procedures.
office building it owns, it would have to estimate the
sale price. It should not be assumed that every single fact and
detail in a set of audited financial statements has
In such cases, the auditor may determine the been checked and verified by the auditors, and is
reasonable range of possible values, and consider therefore guaranteed to be 100 percent accurate.
whether the company’s estimates lie within that The auditor obtains reasonable assurance by
range. The uncertainties that affect this judgement gathering evidence through selective testing of
need to be disclosed and—if they could have a financial records.
material effect—the auditors may include an
emphasis of matter paragraph in their report. Fraud
Fraud has a corrosive effect on the trust necessary for
These are areas where the auditors must use their companies to do business. Management is
experience and skill to reach an opinion on the responsible for running the company and preventing
financial statements. The words ‘opinion’ and ‘true and detecting fraud. Preventing and detecting fraud
and fair’ are deliberately chosen to make clear that is difficult because fraud is intentionally hidden and
judgement is involved. They underline the fact that may involve collusion by multiple participants.
the auditor’s report is not a guarantee but rather
reflects the auditor’s professional judgement Even though audits are properly performed in
based on work performed in accordance with accordance with relevant GAAS, they may not detect
established standards. material fraud. However, auditors are responsible for
obtaining reasonable assurance that the financial
statements are not materially misstated as a result of
fraud.

Understanding a financial statement audit | 7

Importantly however, if the auditors form suspicions Audit strategy and plan—Once the risks have
of fraud in the course of their work a number of been assessed, auditors develop an overall audit
things will change, including their risk assessment strategy and a detailed audit plan to address the risks
(see below), the nature and extent of communications of material misstatement in the financial statements.
with those charged with governance, the nature and Among other things, this includes designing a testing
extent of audit procedures, and the evaluation of the approach to various financial statement items,
effectiveness of the relevant internal controls and deciding whether and how much to rely on the
processes. The knowledge that an independent company’s internal controls, developing a detailed
external audit will be conducted generally has a timetable, and allocating tasks to the audit
deterrent effect against fraud. team members. The audit strategy and plan is
continually reassessed throughout the audit and
The five phases of an audit adjusted to respond to new information obtained
Broadly, the audit process can be summarised in about the business and its environment.
five phases:
Gathering evidence—Auditors apply professional
1 2 3 4 5 scepticism and judgement when gathering and
Audit
evaluating evidence through a combination of testing
Risk Gathering
Planning
assessment
strategy
evidence
Finalisation the company’s internal controls, tracing the amounts
and plan
and disclosures included in the financial statements
to the company’s supporting books and records, and
obtaining external third party documentation. This
Planning—Initial planning activities include formal
includes testing management’s material
acceptance of the client by the audit firm, verifying
representations and the assumptions they used in
compliance with independence requirements,
preparing their financial statements. Independent
building the audit team and performing other
confirmation may be sought for certain material
procedures to determine the nature, timing and
balances such as cash.
extent of procedures to be performed in order to
conduct the audit in an effective manner.
Controls testing
Risk assessment—Auditors use their knowledge of
the business, the industry and the environment in As businesses have grown more complex and
sophisticated, and the costs of labour have risen,
which the company operates to identify and assess
automated systems and processes have necessarily
the risks that could lead to a material misstatement in become much more prevalent. A well-run business
the financial statements. Those risks often involve a will have its own systems and controls in place to
high degree of judgement and require a significant operate efficiently, safeguard its assets, and to
level of knowledge and experience by the auditor, provide reasonable assurance that its transactions
particularly on large and complex engagements. This are properly reported and that its financial statements
requires a good understanding of the business and its are complete and accurate. The auditors assess the
risks, which is typically built up over a number of effectiveness of these controls in preventing and
mitigating the possible risk of material misstatement
years as part of the audit firm’s and auditor's
in those areas where the auditor plans to use such
knowledge. It also means that the auditors need to be controls to adjust the nature, timing and extent of
well informed about the industry and wider their testing. If they believe the controls are effective,
environment in which the company operates, and and they have tested that they operated reliably
about what its competitors, customers, suppliers throughout the year, then the level of substantive
and—where relevant—regulators are doing. audit evidence needed to give an opinion may be
reduced. Even if the controls are reliable, varying
degrees of substantive audit evidence will still always
need to be gathered.

8 | PwC
 The audit committee (or equivalent)
Substantive testing
In public companies, it is generally the
In addition to testing controls, the auditor is required shareholders who ultimately approve the auditor’s
to perform further procedures to gather evidence appointment, and the auditors are primarily
from substantive procedures (substantive audit
responsible to and overseen by those representing
evidence), which can include a combination of the
following: the shareholders’ interests with regards to financial
reporting and internal controls.
 Physically observing or inspecting assets (such
as inventory or property, plant and equipment); Typically an audit committee (or its equivalent),
 Examining records to support balances acting as a largely independent body, will be charged
and transactions; with representing the shareholders’ interests.
Companies may not necessarily have an audit
 Obtaining confirmations from third parties the committee and this interchange may be dealt with
company does business with (such as its less formally but in an equivalent manner. The audit
suppliers, customers and in particular the banks committee is a sub-committee of those charged with
it uses); governance, and is typically made up of a majority of
 Checking elements of the financial statements non-executive directors who are the shareholders’
by comparison to relevant external information representatives in relation to the external audit. They
and investigating any differences (for example, are usually responsible for overseeing the audit and
using an external market index to check pricing evaluating the independence and performance of the
and valuations); and auditors.

 Checking calculations. An important role of the audit committee is to assess

and recommend the appointment or reappointment
of the audit firm. The audit committee also provides a
forum for the auditors to escalate and discuss any
Finalisation—Finally, the auditors exercise significant concerns they may have about any aspect
professional judgement and form their overall of the financial statements prepared by management.
conclusion, based on the tests they have carried out,
the evidence they have obtained and the other work The chair of the audit committee has a vital role to
they have done. This conclusion forms the basis of play in assessing management’s tone from the top
the audit opinion. with respect to the company’s financial reporting.

Auditors interact with the company during all the As well as their public report on the financial
phases of the audit process listed above. There will be statements, the auditors will typically have more
continuing discussions and meetings with detailed communications with the audit committee.
management, both at operational and senior These communications may include a description of
executive levels, and with those charged with how the audit was carried out, the audit plan, the
governance. Using their professional scepticism and auditor’s views about the company’s accounting
judgement, auditors challenge management’s practices (including accounting policies, estimates
assertions regarding the numbers and disclosures in and disclosures), how the auditors satisfied
the financial statements. themselves on the key issues that arose, and
significant difficulties, if any, encountered during the
audit. The auditors may also comment to the audit
committee on their insights in areas such as the
strength of the organisation’s internal
control systems.

Understanding a financial statement audit | 9

Auditor independence Auditor appointment
Shareholders need to have confidence that the The auditor’s appointment is generally and ultimately
auditors have assessed relevant information approved by the shareholders but the auditors are
objectively, and that they have scrutinised evidence paid by the company itself. The audit committee
critically and independently. Shareholders also want takes responsibility for overseeing the auditor's
to be sure that the auditors have undertaken their independence and performance, and for
work and made their judgements free from any bias, recommending to the company’s highest governing
and without being influenced unduly by management body (typically the board) whether their
who prepared the financial statements. reappointment should be put to the shareholders at
an annual general meeting. The audit committee also
There are many detailed regulations and professional reviews the audit fee to satisfy itself that it is
standards to which audit firms and all their staff must competitive yet sufficient to ensure a proper quality
adhere, and which support both the fact and audit can be performed.
perception of auditor independence. In simple terms,
auditors may not do anything that should be the role If a company is considering changing its auditors, the
of management or that creates a mutual interest. audit committee will take the central role,
recommending to those charged with governance
Specific requirements vary around the world, but whether the auditor's appointment should be
generally include: reassessed, and if so, which other firm(s) should be
considered for the role. This is typically conducted
 Prohibiting the auditors from holding an interest through a competitive tender process with multiple
in (whether financial or through close relationship firms being considered.
with) the company they are auditing;
In addition to the audit committee responsibility for
 Prohibiting the auditors from providing the
company with certain services (such as reviewing the auditor's performance, there are a
implementation of accounting IT systems or hiring number of bodies such as regulators and standard
setters who play a key role in the oversight of the
employees) that could compromise their
objectivity; and audit profession and the monitoring of audit quality.

 Requiring key personnel on the audit to be Auditor appointment is more complicated in the case
changed from to time to time, so that fresh pairs of of multi-location audits (see 'multi-location audits'
eyes are brought to bear including regular rotation below), as in this situation the group auditor will
of the lead audit partner. need to perform and/or coordinate audits of
components of the group (subsidiaries, etc.) to
The most important factor underpinning auditor
independence is the attitude of mind that is instilled support the group audit opinion. The component
audits may be performed by the lead audit firm (i.e.
through audit training, practice, and the culture of
the firm providing an opinion on the group’s
the audit firm, and which auditors exhibit through
professional scepticism in their work. The discipline consolidated financial information), by another audit
firm in the lead auditor’s network, or by another
of independence is core to an auditor’s approach
unconnected audit firm. The auditors of those
and mindset.
components report to the lead auditor of the group
for the purpose of the consolidated group financial
statements. The lead auditor typically has sole
responsibility for the audit opinion on the
consolidated financial statements.

10 | PwC
Auditor qualifications and skills Multi-location audits
Auditors are generally qualified accountants who are In many cases, a business comprises several legal
members of a professional institute in their respective entities (which may be located in different countries),
countries. Although this varies between countries, whose results are consolidated into a single set of
qualified accountants normally must meet certain financial statements that present the financial
educational requirements, take several years of position and performance of the consolidated group.
studying and professional exams and have sufficient Large companies may have dozens or even hundreds
practical experience. of entities. Audits of such clients normally involve
audit teams from audit firms around the world
Becoming an auditor is a challenging process that performing work in different locations.
requires a combination of significant academic study
and a large amount of learning on-the-job. This The lead auditor responsible for issuing the opinion
means the people who qualify as auditors benefit on the consolidated group financial statements
both from an understanding of the principles of develops the audit strategy and defines the scope of
auditing, accounting, finance, law, business work to be performed at each component (location,
management, among other topics, and hands- entity, etc.) of the group. The lead auditor
on experience. communicates with the audit firms responsible for
component audits and typically reviews component
In addition to the technical knowledge, auditors need auditor's work in order to obtain evidence to
to have good analytical skills to be able to effectively support an opinion on the group consolidated
analyse the company’s information, properly financial statements.
interpret the analysis, apply professional judgement
and arrive at appropriate conclusions. Auditors must As a result, multi-location audits entail more complex
also possess broad communication skills (both verbal considerations regarding audit strategy, planning,
and written). As auditors communicate to the execution and communication.
company’s senior management and those charged
with governance, it is very important that they do so
in a clear and professional manner. Multi-location audit considerations
 Required procedures to obtain understanding of the
Auditors possess the analytical and logical skills component auditors by the lead auditor (e.g.,
needed to evaluate the relevance and reliability of the evaluating their professional competence, etc.);
systems and processes responsible for recording and
 Different regulatory requirements, e.g. different
summarising financial information. These skills
laws, regulations and accounting standards (which
enable auditors to understand how to gather and
would need to be converted to a consistent set of
assess evidence to evaluate representations made
standards for group accounts);
by others.
 Language and cultural differences;
Throughout their careers all auditors must undertake  Emerging markets considerations (e.g., evolving
continuing professional development to maintain laws and regulations, corporate governance
their qualifications. Most audit firms invest practices, potentially higher business risks, etc.);
significant resources in training and professional  Site visits of the company’s locations by the lead
development of their staff which go beyond the auditor around the world;
requirements of the territory professional
 Additional procedures to support timely, accurate
regulations. Overall, the training that auditors receive
two-way communications between the lead auditor
provides them with a significant array of skills, which
and component auditors; and
form the foundation for a wide range of careers in
various fields and contribute to the overall  Review of the audit procedures performed by the
recognition and high regard for audit professionals. component auditor(s).

Understanding a financial statement audit | 11

Glossary of terms

1 Accounting standards, also known as financial reporting

standards or General Accepted Accounting Principles (GAAP)
Accounting standards set out the requirements for the recognition, measurement,
presentation and disclosure of transactions and events that are important to the financial
statements. For example, International Financial Reporting Standards (IFRS) are issued
by the International Accounting Standards Board (IASB).

2 Annual general meeting

An annual general meeting (commonly referred to as an AGM) is a formal meeting held
once a year by a company, required by law, to which shareholders are invited.

3 Annual report
The annual report is a report issued by a company detailing its activities and financial
performance during the preceding year. It includes the financial statements and may
generally also include reports from those charged with governance (for example the
chairman of the board of directors), a review of the company’s strategy and performance,
information on risk management and governance, information for the shareholders and
other information such as a corporate and social responsibility statement.

4 Assurance
Assurance refers to enhancing the user’s confidence in the information that is being
reported. In a financial statement audit, the auditor obtains reasonable assurance about
whether the financial statements are free of material misstatement.

5 Audit committee
The audit committee is a committee of those charged with governance, responsible for the
oversight of a company’s financial reporting and accounting, financial regulatory
compliance, financial risk management processes, and the engagement of and interaction
with the company’s external auditor on behalf of the company’s shareholders. It is
typically comprised of a majority of independent non-executive directors.

6 Audit report and audit opinion

The audit opinion is a key part of the audit report that accompanies the company’s
financial statements in the annual report. It states the auditor’s conclusion on whether the
financial statements, including disclosures are presented fairly in all material respects in
accordance with the applicable financial reporting standards. The audit report and audit
opinion can be ‘unmodified’ or ‘modified’.

Understanding a financial statement audit | 13

 7 Auditing standards, also known as Generally Accepted
Auditing Standards (GAAS)
Auditing standards provide requirements and guidance for auditors regarding performing
audit engagements. Auditing standards may be set by national or international
organizations, such as the International Auditing and Assurance Standards Board
(IAASB) and adopted by national regulatory bodies. Auditing standards enhance quality
and consistency of audit engagements and strengthen public confidence in the auditing
profession.

8 Balance sheet
A financial statement that presents a company’s financial position as of a specified date. It
is also often referred to as ‘statement of financial position.’

9 Break-up basis
The break-up basis is used for preparing the financial statements of a company where
management is unable to confirm that it is a going concern (see below). On this basis,
assets and liabilities are included at the net value that would be realisable in the event of a
forced sale or liquidation.

10 Disclosures
Disclosures are the inclusion of information in the financial statements, such as further
analysis of the primary financial statements, a statement of principal accounting policies
applied, or key assumptions relating to accounting estimates, including information
required by law, financial reporting standards or other regulations. These are an integral
part of the financial statements.

11 Emphasis of matter
A paragraph included in the auditor’s report that refers to a matter appropriately
presented or disclosed in the financial statements that, in the auditor’s judgement, is of
such importance that it is fundamental to users’ understanding of the financial
statements. An emphasis of matter does not affect the audit opinion but modifies the audit
report to draw attention to specific matters disclosed in the financial statements.

12 Financial reporting standards

See accounting standards above.

14 | PwC
13 Financial statements
What specifically must be in the financial statements is governed by local law and
regulation and standards such as international financial reporting standards, however
generally they must include a balance sheet (showing assets, liabilities and equity),
income statement, cash flow statement and equity statement (showing changes in
equity). These are typically also referred to as the primary statements. Usually financial
statements are accompanied by additional disclosures (see the disclosures definition
above).

14 Generally Accepted Accounting Principles (GAAP)

See accounting standards above.

15 Generally Accepted Auditing Standards (GAAS)

See auditing standards above.

16 Going concern
Management’s assumption that the company will continue to operate for the foreseeable
future. Financial statements are prepared on a going concern basis, unless management
either intends to liquidate the company or to cease operations, or has no realistic
alternative but to do so. In these cases, the break-up basis is used (see above). The going
concern basis is one in which the assets and liabilities of the business are realised and
settled in the normal course of its activities.

17 Income statement
A financial statement that measures a company’s financial performance over a specific
accounting period.

18 Internal control systems

The processes designed, implemented and maintained by those charged with
governance, management and other personnel to provide reasonable assurance about
the achievement of an entity’s objectives with regard to reliability of financial
reporting, effectiveness and efficiency of operations, and compliance with applicable
laws and regulations.

19 Listed company
A listed company is a company whose shares can be bought and sold by the general
public and are listed on a stock exchange, such as the London Stock Exchange.

Understanding a financial statement audit | 15

 20 Material/materiality
Materiality is a concept used by both preparers and auditors of financial statements to
help determine what information is important, what information should be disclosed in
the financial statements, and to evaluate misstatements.

Information is material if its omission or misstatement could influence the economic

decisions of users taken on the basis of the financial statements. Materiality depends on
the size and nature of the item or error judged in the particular circumstances of its
omission or misstatement.

When determining whether a matter is material, the auditor also evaluates qualitative
considerations, such as the impact of misstatements on debt covenants, key ratios, etc.

21 Misstated/misstatement
A misstatement is a difference—arising from an error or fraud—between the amount,
classification, presentation or disclosure of an item in the financial statements, and the
amount, classification, presentation or disclosure that is required for that item to be in
accordance with the applicable financial reporting standards.

22 Modified/modifications
An audit opinion is modified when the auditor concludes that the financial statements
are materially misstated, or the auditor has been unable to obtain sufficient appropriate
audit evidence to reach a conclusion. A modified opinion could be:

A qualified opinion—the auditor concludes that, except for specific matters explained
in the audit report, the financial statements give a true and fair view;

An adverse opinion—the auditor concludes that the financial statements do not give
a true and fair view;

A disclaimer of opinion—the auditor concludes that the extent of their inability to

obtain sufficient appropriate audit evidence is such that it is not possible to form an
opinion on the financial statements.

The audit report can also be modified through an emphasis of matter paragraph without
altering the audit opinion (see the emphasis of matter definition above).

16 | PwC
23 Narrative statements
Management’s narrative statements comprise information included in the annual
report, outside the financial statements, on matters such as the company’s strategy,
risks, activities and performance for the year.

24 Primary statements
See financial statements above.

25 Reasonable assurance
In the context of an audit of financial statements, a high, but not absolute, level
of assurance.

26 Regulatory bodies
These are bodies which, among other things, have responsibility in relation to the
qualification and supervision of auditors. Other bodies have responsibility for:

Accounting and financial reporting standard setting: for example, the International
Accounting Standards Board (IASB).

Auditing standard setting: for example, the International Auditing and Assurance
Standards Board (IAASB).

27 Substantive audit evidence

Audit evidence obtained through substantive audit testing procedures, including for
example:
 Physical observation or inspection of assets (such as inventory or property, plant
and equipment);
 Examination of records to support balances and transactions;
 Obtaining confirmations from third parties (for example the banks it uses);
 Checking elements of the financial statements by comparison to relevant external
third party information; and
 Checking calculations.

28 True and fair

‘True and fair’ is a concept in relation to a set of financial statements that has no precise
definition. It takes into account the inherent judgements required in preparing (and
auditing) financial statements. Financial statements will not be ‘true and fair’ unless the
information they contain is sufficient in terms of both quality and quantity to satisfy the
reasonable expectations of users of the financial statements.

29 Working capital
A financial metric that measures the resources available to a company to finance its day-
to-day operations. It is typically calculated by deducting current liabilities from
current assets.

Understanding a financial statement audit | 17

 www.pwc.com
At PwC, our purpose is to build trust in society and solve important
problems. We’re a network of firms in 158 countries with more than
236,000 people who are committed to delivering quality in assurance,
advisory and tax services. Find out more and tell us what matters to
you by visiting us at www.pwc.com.
© 2017 PwC. All rights reserved. Not for further distribution without the
permission of PwC. "PwC" refers to the PwC network and/or one or more
of its member firms, each of which is a separate legal entity. Please see
www.pwc.com/structure for further details.

© 2012 PwC. All rights reserved. Not f or f urther distribution without the permission of PwC. “PwC” refers to the network of member firms of
PricewaterhouseCoopers International Limited (PwCIL), or, as the context requires, individual member firms of the PwC network.
18 | PwC