What is an Audit?

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Definition:

Audits are an official investigation of a person’s or company’s financial statements to ensure they are accurate.

🤔 Understanding audits

In finance, an audit is an official investigation designed to discover if financial statements are accurate. Both individuals and companies can be audited. Internal audits are conducted by employees to inform upper management about a company’s performance. Outside companies and professionals perform independent external audits to ensure compliance with tax and reporting rules. In the US, the Internal Revenue Service audits people and businesses to make sure they’re paying taxes in full. After an IRS audit, delinquent taxpayers may need to pay back taxes and possibly penalties.

Example

Fraudulent accounting played a vital role in the Enron scandal of 2001. Key executives at the energy company manipulated financial statements to hide bad deals. Enron’s auditor, Arthur Andersen LLP, was convicted of destroying and falsifying records related to its audits.

Rigorous audits can ensure proper accounting takes place, which assures the public that a company’s announced financial performance is accurate. Enron went bankrupt, and Arthur Anderson, once one of the largest accounting firms in the world, was forced to dissolve as a result of bad accounting practices.

Takeaway

Audits are like having a tutor look at your work before turning it in. . .

The goal is still to do everything right on your own, but the tutor makes sure your work is correct before you turn in your assignment. Likewise, auditors help companies confirm their financial reporting is accurate, which helps them avoid penalties and maintain the public’s trust.

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What is an audit?

An audit is an official investigative process that examines financial records. Audits determine if financial records are accurate and represent the company’s true financial condition. Both people and companies can be subject to audits.

Auditing also ensures that financial information is presented in the correct format. In the US, for example, there are rules and guidelines around how to format financial statements such as balance sheets and income statements. Most companies and organizations must adhere to some set of guidelines around the creation, recording, and distribution of financial information.

Publicly traded companies must adhere to the Generally Accepted Accounting Principles (GAAP), which include:

  • Consistency: Financial reporting follows set standards.
  • Prudence: All financial information must be factual and reasonable.
  • Good faith: Everyone involved in financial reporting must act truthfully and in good faith.
  • Periodicity: Entities must report on their finances on a typical schedule, such as quarterly or annually.

GAAP also sets forth standards about how financial statements should be formatted, how costs and revenues should be presented, and what information must be disclosed. Audits of public companies evaluate their “books” (general ledger and financial records) against these standards to make sure nothing is incorrect or misleading.

Other companies may choose to follow GAAP, even if they are not required to by law. For instance, a small private company may be told it needs to have GAAP-compliant and audited financial statements before a bank will approve a loan.

Government bodies typically have their own standards to follow, set out by the Government Accountability Office (GAO) for the federal government and the Government Accounting Standards Board (GASB) for state and local governments.

It’s an auditor’s job to know which guidelines must be followed and to ensure the organization is in compliance.

What are the types of audits?

There are three main types of audits:

Internal

Businesses generally undertake internal audits to inform upper management about financial conditions and risk. Internal audits also ensure that internal controls comply with federal law. They are also sometimes used for developing company policy and strategy. Internal auditors may be employees of the company or outside consultants — They’re not required to be impartial and independent in the way an external auditor must be.

There’s typically a lot of leeway in how companies conduct internal audits. For instance:

  • While the auditor should be familiar with the business’s accounting standards, he or she doesn’t need specific training or designations.
  • Internal audits can happen whenever the company chooses — The frequency, length of time, and method of reporting are all up to the business.
  • Internal auditors are ideally objective and free from the influence of others in the company, but they ultimately report to the higher-ups.

External

When a company wants a more objective evaluation of its finances, it commissions an external audit. External audits are far more independent than internal ones, since they’re done by autonomous professionals rather than employees.

External auditors must follow Generally Accepted Auditing Standards (GAAS). External audits generally happen once a year, typically in the months before taxes are due. Most external audits are conducted by Certified Public Accountants who have expertise in the field and work for an audit firm.

At the end of an external audit, auditors offer one of the following four opinions:

  • Unqualified Opinion: Also known as a clean opinion, this states there are no issues with a company’s financial statements.
  • Qualified Opinion: An auditor issues this opinion if the financial statements look fine, except for one specific issue. Often this is because the auditor wasn’t able to get enough information to verify aspects of the financial reports or because the statements don’t conform to the Generally Accepted Accounting Principles (GAAP).
  • Adverse Opinion: This means the auditor concluded that the company didn’t adhere to GAAP and seriously misstated its financial position in its reports. Adverse opinions are likely indicators of fraud. Public companies that receive adverse opinions must correct their books and submit to another audit.
  • Disclaimer of Opinion: Sometimes, management is uncooperative in providing financial records, or financial records are missing. When this happens, an auditor can report a “disclaimer of opinion,” which means he or she can’t make any statement about the company’s records and financial health.

Internal Revenue Service

The Internal Revenue Service, the US tax authority, audits individuals and businesses. The IRS begins an audit if it finds discrepancies in financial reporting or if a statistical formula suggests an anomaly. Having a family member or business partner who was audited can also trigger an audit. The IRS conducts the audit either by mail or through an in-person interview and review of records. IRS audits can result in no change to a person’s or company’s tax bill or in the payment of additional taxes and fines.

Why are audits important?

The goal of an audit is to verify that reported financial information is both accurate and fair. Accuracy is essential because the reported income or loss dictates taxes. If information is inaccurate, the company may need to pay back taxes and possibly fines.

Publicly traded companies must regularly release audited financial reports. If these weren’t fair and accurate, companies could manipulate information to mislead investors, which could have disastrous consequences.

But audits aren’t just important for public companies and those who pay taxes. Internal audits ensure the accuracy of financial information and verify the integrity of the process used to produce the reporting. This provides upper management in a company with accurate information about finances, business practices, and risk on which to base their decisions.

In all cases, audits are useful for preventing and detecting fraud. Fraud is the act of intentionally deceiving others for personal gain. The mere knowledge that audits will take place can reduce financial fraud, since audits are one of the best ways of detecting it.

Sometimes, lenders or investors will require audited financial records before they issue a loan.

How does an audit work?

Internal, external, and Internal Revenue Service audits have some differences, but the majority of audits follow the same pattern.

First, you collect all the financial information you have. Records the IRS may request can include:

  • Bills
  • Receipts
  • Legal documents
  • Medical and dental records
  • Employment records
  • Records of charitable donations

Next, the auditor examines all of your documentation, looking for discrepancies. If the IRS finds any issues, you may be asked to pay additional taxes and penalties. However, the IRS typically gives you a 30-day window to appeal the decision if you think the auditor made an error. If the appeals officer denies your appeal, you have an additional 90 days to escalate the issue to tax court.

If an internal audit of a company unearths issues, it may recommend that managers correct these, but whether to do so is generally up to them. With external audits, mistakes in documentation can result in a qualified or adverse opinion. The company may be required to redo its books and submit to a second audit.

What does an auditor do?

What an auditor does varies based on the kind of audit they’re performing.

Internal auditors evaluate financial statements and the effectiveness of a company’s internal controls. They can also evaluate business processes and operations, including whether different branches of a company are working towards the company’s overall goals. Or they may be tasked with legal compliance, which involves researching laws and ensuring the company follows them.

External auditors are generally hired by the owners or shareholders of a company, but they work independently. They examine its financial records and then deliver an opinion on their accuracy and fairness. External auditors must follow Generally Accepted Auditing Standards (GAAS). They also determine if the company’s financial records follow Generally Accepted Accounting Principles (GAAP).

Internal Revenue Service auditors review business and personal tax returns. They look for discrepancies or statistically unlikely financial scenarios. However, being selected for an audit isn’t proof that a business or individual has done something wrong. When the IRS begins an audit, it mails requests for more documentation or schedules a face-to-face interview.

IRS auditors then determine if a person or business owes additional taxes. If not, the auditors record “no change,” and the case is closed. If they recommend changes, individuals and businesses have the opportunity to agree with the changes and pay any owed back taxes and penalties. The IRS can issue penalties for inaccurate, incomplete, or late tax filings, as well as late payments or failure to pay altogether. If the taxpayer or business disagrees with the findings, he or she can appeal the ruling.

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