Why is reasonable assurance not absolute assurance?

What is Reasonable Assurance?

The AICPA defines reasonable assurance as a high, but not absolute, level of assurance. In an audit, that means perfection is not the goal because absolute assurance is not obtainable. Instead, auditors use reasonable assurance in their testing to come to a practical conclusion about the details of your organization’s security controls. At KirkpatrickPrice, our Information Security Specialists provide expert audits that focus on accuracy, attention to detail, and skilled efforts to meet standards of reasonable assurance.

During the audit process, our senior-level auditors use three guiding practices to ensure a thorough audit is performed: interview, observe, review. These practices enable our auditors to gain a certain quantity and quality of data in an effort to reach a level of reasonable assurance.

Interview

During the many stages of an audit, the Information Security Specialist designated to an organization will engage in direct discussion through weekly conference calls, our Online Audit Manager, and face-to-face conversations. These discussions focus on gaining understanding of an organization’s internal controls already in place and who is responsible for those controls. The interview portion of an audit allows auditors to gain enough information to form conclusions and gain reasonable assurance.

Observe

When an auditor makes an onsite visit, they walk through internal processes and confirm an organization is implementing the controls gathered by the auditor in previous discussions. The Information Security Specialist observes the practices, physical security safeguards, and personnel procedures that are applied within an organization. The auditor observes a number of controls that allow for a decision to be made on whether the processes meet compliance standards. By observing large quantities of internal controls during an audit, auditors can provide reasonable assurance that their conclusions are accurate and thorough.

Review

Information Security Specialists also analyze documentation provided by an organization during the audit process. This review of policies, procedures, and other physical documentation is an opportunity for an auditor to understand particular processes that are written into an organization’s frameworks. When reviewing, auditors pay close attention to consistencies in policies as well as physical procedures. These detailed reviews help to foster a higher level of assurance. Once an auditor determines a level of reasonable assurance can be met, they can provide proper education and help clients on the road to compliance success.

Transcript

Whenever you hire a CPA firm to conduct an audit for you, the threshold that we’re trying to meet is something called reasonable assurance. You can’t have absolute assurance in an audit because, in order for something to be absolute, everything would have to be perfect. We would have to see everything at all times. It’s just not practical and no one wants to spend the money it would take to reach absolute assurance, if that’s even possible. Reasonable assurance means that we have met a level of reasonableness in the testing that we performed. Would someone who has equivalent skills and expertise come to the same conclusions that we did? Did we do enough testing in order to gain that level of reasonable assurance? Is our level of effort that we’re asking you to participate in reasonable under the circumstances when you consider the risk that is involved? This is something to really understand when you go into your audit – that you auditor is going to be trying to reach that level that we call reasonable assurance.

Learning Objectives

At the end of this section, students should be able to meet the following objectives:

1. Describe the goal of an auditor in examining an account balance.
2. List audit tests that might be performed on an account receivable total.
3. Understand the reason that an independent auditor only provides reasonable assurance and not absolute assurance.

Question: A company is preparing a set of financial statements for the most recent year. It has hired an independent firm of CPAs to audit those statements and provide a report that will be attached to them. Perhaps this action is required of the company by the SEC or maybe by a local bank or other lender. What work does an independent auditor perform in examining a set of financial statements? The audit firm seeks to provide reasonable assurance to decision makers that these statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP. How is the auditor able to gain the evidence needed to make that assertion?

Answer: An independent audit is an elaborate and complicated activity that often requires scores of experienced CPAs many months to complete. A basic understanding of the audit process is best achieved through one or more upper-level college courses as well as years of practical experience. Thus, coverage here must, by necessity, be rather superficial.

The numbers found on a set of financial statements do not appear by magic. For example, if receivables are disclosed on a balance sheet as $12.7 million, a legitimate reason has to exist for reporting that particular figure. In preparing statements, company accountants should document how each balance was derived and why it is considered appropriate according to U.S. GAAP. The statements are the representation of the company; thus, the burden of proof is on that organization and its officials. The independent auditors then examine the available evidence to determine whether reliance on the reported information is advised.

As a simple illustration, assume that a business presents a list of one thousand customers and claims that the total amount due from them is $12.7 million. This figure is reported for “accounts receivable” under the asset section of the company’s year-end balance sheet. The independent audit firm seeks to accumulate sufficient, competent evidence to substantiate that this balance is not materially misstated in accordance with U.S. GAAP.

For these receivables, the auditor could carry out several testing procedures to gain the assurance needed. Such techniques might include the following:

• Add the individual account balances to ascertain that the total really is $12.7 million.
• Examine sales documents for a sample of individual customers to determine that the amounts sold are equal to the figures listed within the receivable. For example, if the sales document indicates that Mr. A bought goods at a price of $1,544 is that same dollar amount found in the company’s receivable balance?
• Examine cash receipts documents for a sample of customers to ensure that no unrecorded payments were collected prior to the end of the year. If Mr. A paid cash of $1, 544 on December 30, was the corresponding receivable balance reduced by that amount prior to the end of the year?
• Contact a sample of the customers directly to confirm that the balance shown is, indeed, appropriate. “Mr. A: Company records show that you owe $1,544. Is that amount correct?”

Through these and other testing procedures, the auditor hopes to ascertain that $12.7 million is a fairly presented amount for this asset account. All other reported balances are also examined during the independent audit. The quantity and type of audit testing varies considerably based on the nature of the account. Looking at $12.7 million in receivables requires different steps than investigating a building bought for that same amount. Not surprisingly, large balances often require especially extensive testing. In addition, certain accounts (such as cash or inventory) where the risk of misstatement is particularly high draw particular attention from the independent auditors.

If the auditor eventually concludes that sufficient evidence has been obtained to reduce the risk of a material misstatement in the financial statements to an acceptably low level, an audit report can be issued with that opinion. Assuming no problems were encountered, reasonable assurance is provided by the independent auditor to decision makers that the statements are presented fairly and, thus, contain no material misstatements according to U.S. GAAP.

As mentioned, the independent auditor’s report is then attached to the financial statements. Upon reading this report, investors and creditors should feel confident relying on the information provided by those statements to make financial decisions about the organization.

Question: One aspect of the audit process seems particularly puzzling. The independent auditor merely provides reasonable assurance. The risk that a material misstatement is included in the accompanying financial statements is only reduced to a low level and not to zero. Why do decision makers who may be risking significant amounts of money not insist on absolute and complete assurance? Because of the potential for financial loss, decision makers surely must want every possibility of incorrect reporting to be eliminated by the work of the independent auditor. Is reasonable assurance that no material misstatements are present truly adequate for decision makers who must rely on a set of financial statements for information?

Answer: Independent auditors provide reasonable assurance but not absolute assurance that financial statements are presented fairly because they contain no material misstatements according to U.S. GAAP. A number of practical reasons exist as to why the assurance level is limited in this manner.

First, many of the figures found on any set of financial statements are no more than estimations. Auditors do not possess reliable crystal balls that allow them to predict the future. The uncertainty inherent in these estimations immediately eliminates the possibility for absolute assurance. For example, reporting the amount of cash that will be collected from a large group of accounts receivable is simply a carefully considered guess. It is presented according to U.S. GAAP but it is still an estimate.

Second, organizations often take part in so many transactions during a period that uncovering every potential problem or issue is impossible. Usually, in analyzing most account balances, the auditor only has time to test a sample of the entries and adjustments. Without examining every individual event, absolute assurance is not possible. Material misstatements can always be missed if less than 100 percent of the transactions are tested.

Third, an independent auditor visits a company for a few weeks or months each year to carry out testing procedures. Company officials who want to hide financial problems are sometimes successful at concealment. Auditors can never be completely certain that they have not been victimized by an elaborate camouflage scheme perpetrated by management. Thus, they are not comfortable providing absolute assurance.

Fourth, informed decision makers should understand that independent auditors can only provide reasonable assurance. Through appropriate testing procedures, risk of a material misstatement is reduced to an acceptably low level but not eliminated entirely. Investors and creditors need to take that limitation into consideration when assessing the financial health and future well being of an organization presented through a set of financial statements. Although the risk is small, their decisions should factor in the level of uncertainty that is always present.

Key Takeaway

Financial statements are the product of company management. An independent auditing firm performs extensive testing of the balances and disclosure reported. Auditors seek to obtain sufficient evidence that the statements are presented fairly because no material misstatements are present according to U.S. GAAP. When the risk of a material misstatement has been reduced to an acceptably low level, reasonable assurance can be provided. Thus, decision makers can feel safe using the information. Absolute assurance is not humanly possible because all statements contain many estimations and the auditors do not have time (or the need) to examine every transaction. Management can, in some cases, also conceal problems from the auditors. Thus, decision makers need to understand that only reasonable assurance of no material misstatements is possible when examining a set of financial statements.

Why is reasonable assurance not absolute?

What is meant by the term reasonable assurance and how does that differ from absolute assurance?

What is absolute assurance?

Why do audits not provide absolute assurance that financial statements are presented fairly according to GAAP?