A financial statement risk is inherent in both external and internal audit activities. It refers to the possibility that auditors may fail to detect significant errors in an accounting report following an in-depth review. A financial statement risk results from five management "assertions" or assumptions—presentation and disclosure, existence or occurrence, rights and obligations, completeness and valuation or allocation.
Top management's assertions about "presentation and disclosure" in corporate financial statements are important. "Presentation" indicates the order in which an accountant lists financial statement items. Generally accepted accounting principles (GAAP) in the U.S., and international financial reporting standards (IFRS), recommend specific presentation models for each financial statement. For instance, a statement of cash flows must indicate (in this order): cash flows from operating activities, cash flows from investing activities and cash flows from investing activities. "Disclosure" relates to important information that management may omit in financial statements, and which may cause a firm to incur losses resulting from litigation or regulatory fines.
The "existence or occurrence" assertion relates to operating transactions. Simply put, senior management asserts, or confirms to an auditor, that financial-statement items exist. Senior management also confirm that the transactions and journal entries which make up account balances actually occurred. To illustrate, presume Company A's balance sheet shows $10 million in cash. An external auditor verifies the "existence" assertion by receiving written confirmation from the bank about the Company A's account balance.
"Rights and obligations" assertions relate to assets and liabilities, respectively. An asset is an economic resource that a company owns or on which it can have ownership rights in the future. An auditor ensures that a firm has actual ownership rights on assets, in accordance with legal requirements. A liability refers either to a debt the company must repay when due, or a financial obligation it must honor on time. The auditor also ensures that corporate financial obligations are accurate.
An auditor verifies the "completeness" assertion by ensuring that financial statements, taken as a whole, are complete. A complete set of financial statements includes a balance sheet (or statement of financial position), a statement of profit and loss (otherwise known as a statement of income), a statement of cash flows, and a statement of retained earnings. The auditor also ensures that each financial statement displays all relevant items: for example, verifying expenses, revenues, losses and gains in the statement of profit and loss.
Senior management's assertions about "valuation or allocation" relate primarily to asset-depreciation assumptions. In accounting parlance, depreciating an asset means spreading its cost over several years. A firm may report inaccurate financial data if department heads assume wrong depreciation rates. This is due to the fact that depreciation journal entries are expenses that affect a corporation's statement of income.