Audit: Meaning in Finance and Accounting and 3 Main Types

What Is an Audit?

An audit is a formal review of a person or company's financial records by professional accountants. Audits can be conducted internally, by employees of the organization, or externally, by an outside certified public accountant (CPA) firm.

Lenders and underwriters may require an audit in order to evaluate a company's financial health. Tax authorities also conduct audits to ensure that a taxpayer has correctly reported their income.

Understanding Audits

An audit is the review or inspection of a company or individual's accounts by an independent body. Auditors may be hired internally by the company or work for an external third-party firm. Almost all companies conduct a yearly audit of their financial statements. This includes the review of statements such as the income statement, balance sheet, and cash flow statement.

Lenders often require the results of an external audit annually as part of their debt covenants. Audits are a legal requirement for some companies due to compelling incentives to intentionally misstate financial information in an attempt to commit fraud. Publicly traded companies must also receive an evaluation of the effectiveness of their internal controls as a result of the Sarbanes-Oxley Act (SOX) of 2002.

In the United States, external audits follow the generally accepted auditing standards (GAAS). They're set out by the Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA).

Additional rules for the audits of publicly traded companies are made by the Public Company Accounting Oversight Board (PCAOB) that was established as a result of SOX in 2002. A separate set of international standards is known as the International Standards on Auditing. They were set up by the International Auditing and Assurance Standards Board.

Importance of Audits

Audits are a necessary and important part of the financial world because a company's financial health and well-being can't be upheld without proper accounting. Routine audits ensure that companies are following reporting standards and that they're being truthful and honest about their financial position. Audits are particularly important for shareholders and lenders as well as consumers and suppliers.

The process of auditing also helps companies in other ways, including:

• Finding inefficiencies
• Improving production and operations
• Meeting compliance requirements
• Establishing procedures for monitoring
• Fraud prevention
  

Types of Audits

Audits can involve financial accounts of companies or individuals. They can be conducted by external or internal auditors and they may also be completed by tax agencies like the Internal Revenue Service (IRS).

External Audits

Audits performed by outside parties can help remove bias in reviewing the state of a company's financials. These audits seek to identify whether there are any material misstatements in the financial statements.

An unqualified or clean auditor's opinion provides financial statement users with confidence that the financials are presented fairly in all material respects. External audits allow stakeholders to make better, more informed decisions related to the company being audited.

External auditors follow a set of standards that are different from those of the company or organization hiring them to do the work. The resulting auditor's opinion expressed on items being audited (a company's financials, internal controls, or a system) can be candid and honest when audits are performed by third parties. They won't affect daily work relationships within the company.

Internal Audits

Internal auditors are employed by the company or organization for whom they're performing an audit. The resulting audit report is given directly to management and the board of directors.

They're not employed internally but consultant auditors use the standards of the company they're auditing rather than a separate set of standards. Internal auditors are typically used when an organization doesn’t have the in-house resources to audit certain parts of its operations.

The results of an internal audit are used to make managerial changes and improvements to internal controls. The purpose is to ensure compliance with laws and regulations and to help maintain accurate and timely financial reporting and data collection.

Ongoing audits also provide benefits to management by identifying flaws in internal control or financial reporting before its review by external auditors.

Internal Revenue Service (IRS) Audits

The IRS routinely performs audits to verify the accuracy of taxpayers’ returns and specific transactions. It usually carries a negative connotation when the IRS audits a person or company and is seen as evidence of some type of wrongdoing by the taxpayer but being selected for an audit isn't necessarily a sign of any wrongdoing.

IRS audit selection is usually made by random statistical formulas that analyze a taxpayer's return and compare it to similar returns. A taxpayer may also be selected for an audit if they have any dealings with another person or company who was found to have tax errors on their audit.

There are three possible IRS audit outcomes available:

1. No change to the tax return
2. A change that is accepted by the taxpayer
3. A change with which the taxpayer disagrees

The taxpayer may owe additional taxes or penalties if the change is accepted. There's a process to follow that may include mediation or an appeal if the taxpayer disagrees.

The Bottom Line

The idea of an audit can make people very nervous but audits aren't entirely bad despite the negative connotation. Individuals who are audited by tax agencies are commonly chosen at random. Corporate audits are routinely conducted to make sure financial statements are in line with accounting standards. You'll know that the companies in which you have an interest are being honest about their financial position if you're an investor.