Legal Importance of an Audit

What is the Legal Importance of an Audit?

The legal importance of an audit is to uphold the reliability of financial statements for all external users.

Auditors face civil and criminal liability in performing their duties and ensuring they uphold the transparency, usability, and reliability of financial information provided by reporting entities.

Audit Explained

Auditing refers to the examination of financial transactions and records of an entity to ensure that the financial information provided reflects the entity’s economic position and operations.

Audits are performed by internal, external, and governmental parties, and are used for a variety of reasons. Audits performed by external and governmental parties are important in establishing the validity of financial statements since they are not subject to conflicts of interest.

Importance of Auditing

Audits are needed to determine whether transactions shown by an entity fairly represent that entity’s economic state and operations.

Financial records are created internally and are subject to manipulation or fraudulent behavior from insiders. Internal parties may have personal incentives to manipulate these records, and auditing is important to ensure that the records are not misstated due to error or fraud.

Accounting Fraud

Accounting fraud refers to when an entity, such as a company, deliberately falsifies its financial records. Fraudulent behavior is difficult to define within accounting since most representations of financials are based on estimates.

For example, if a company decides to make an estimate that ends up being revised at a later date, this is not considered fraudulent behavior, as long as the company made the estimation in good faith by using all relevant information at the time of estimation.

However, if a company deliberately misstates its revenues to make itself appear more profitable or overstating assets to make itself seem more financially healthy, that is considered accounting fraud.

Punishment of Accounting Fraud

Accounting fraud is illegal and punishable, both in civil and criminal courts. In the United States, the Securities and Exchange Commission (SEC) is an independent agency that is responsible for protecting investors and maintaining fair, orderly, and efficient markets. This is mainly to ensure the public trust that underlies the financial system.

Accounting fraud undermines the trust that is required for a market economy. If a user of financial statements, such as an investor, cannot trust the company’s reported financial statements, it is very unlikely that the investor will be willing to invest their capital with that company.

However, if there are legal protections in place that confirm the accuracy of financial statements, then the investor is more likely to invest their funds, even if they do not know anyone from that company personally.

Auditors are held to the same level of trust. Investors need to know that they can trust the opinion of auditors and that the auditors will provide an unbiased opinion. Otherwise, it will undermine the financial system.

Therefore, to have an efficient and transparent market economy, three elements need to be present:

1. Rules (accounting standards)
2. Verifiers (auditors)
3. Enforcers (government agencies and laws)

Legal Liability of Auditors

Auditors can face civil and criminal liabilities in the performance of their duties. They are held to a professional code of conduct that ensures that they take due care when performing their duties.

Due care implies four aspects:

1. Possessing requisite skills to evaluate accounting records
2. The duty to employ skills with reasonable care and due diligence
3. Undertaking tasks with good faith and integrity
4. Liability for negligence, bad faith, and dishonesty

Auditors are responsible to the users of financial statements, and the foreseeable users who may rely on the financial statements that they issue an opinion on. Users of financial statements include:

• Shareholders
• Creditors
• Suppliers
• Customers
• Management
• Regulating entities

Foreseeable users of financial statements are determined by personal judgment. For example, there are new investors and potential creditors that may arise in the future; however, they do not currently have a vested interest in the specific company.

Even though the auditor does not know the users yet, the auditor still has an obligation to them.

Related Readings

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Legal Liability of Auditors
• Accounting Policies
• Audit Legal Implications
• Evidence in an Audit
• See all accounting resources