Audit

What is an Audit?

Definition: Audit is an analysis or study of an accounting system that summarizes its finding with an opinion on the accuracy of the system and its reports. In other words, an audit is an examination of the processes and procedures put in place by management to ensure that accounting information is recorded accurately and the financial statements are free from material misstatements.

The term audit usually refers to a financial statement audit. A financial audit is an objective examination and evaluation of the financial statements of an organization to make sure that the financial records are a fair and accurate representation of the transactions they claim to represent. The audit can be conducted internally by employees of the organization or externally by an outside Certified Public Accountant (CPA) firm.

Audit is the examination or inspection of various books of accounts by an auditor followed by physical checking of inventory to make sure that all departments are following documented system of recording transactions. It is done to ascertain the accuracy of financial statements provided by the organisation.

What Does Audit Mean?

An audit is the examination of the financial report of an organisation – as presented in the annual report – by someone independent of that organisation. The financial report includes a balance sheet, an income statement, a statement of changes in equity, a cash flow statement, and notes comprising a summary of significant accounting policies and other explanatory notes.

The purpose of an audit is to form a view on whether the information presented in the financial report, taken as a whole, reflects the financial position of the organisation at a given date, for example:

  • Are details of what is owned and what the organisation owes properly recorded in the balance sheet?
  • Are profits or losses properly assessed?

When examining the financial report, auditors must follow auditing standards which are set by a government body. Once auditors have completed their work, they write an audit report, explaining what they have done and giving an opinion drawn from their work. Generally, all listed companies and limited liability companies are subject to an audit each year. Other organisations may require or request an audit depending on their structure and ownership.

Audit can be done internally by employees or heads of a particular department and externally by an outside firm or an independent auditor. The idea is to check and verify the accounts by an independent authority to ensure that all books of accounts are done in a fair manner and there is no misrepresentation or fraud that is being conducted.

All the public listed firms have to get their accounts audited by an independent auditor before they declare their results for any quarter.

Example

Public companies are required by the SEC to have the financial statements, internal controls, and a few other processes audited by an independent auditor from a public accounting firm. The auditor or audit team’s main job is to examine the books, records, and documentation to assure that there are no obvious errors and accounting processes were running appropriately. They are also in charge of evaluating the financial statements to assure external users that they are free of material errors that could mislead their judgment. In other words, CPAs are in charge of examining the business and making sure the financial statements accurately represent its financial activities for the period.

The dreaded IRS audit is another type of examination. In this case, the Internal Revenue Service reviews a taxpayer’s income tax return and supporting documentation to ensure all of the income was properly reported and the deductions that were claimed were legitimate. Since the tax laws and income tax returns are fairly complicated, many people have difficulties filing their taxes themselves. The IRS audits taxpayers to keep them honest and make sure they are following the tax code even if they don’t understand it.

The Three Different Types of Audits

ISO 19011:2018 defines an audit as a “systematic, independent and documented process for obtaining audit evidence [records, statements of fact or other information which are relevant and verifiable] and evaluating it objectively to determine the extent to which the audit criteria [a set of policies, procedures or requirements] are fulfilled.” There are three main types of audits:

  1. Process audit: This type of audit verifies that processes are working within established limits. It evaluates an operation or method against predetermined instructions or standards to measure conformance to these standards and the effectiveness of the instructions. A process audit may:
    • Check conformance to defined requirements such as time, accuracy, temperature, pressure, composition, responsiveness, amperage, and component mixture.
    • Examine the resources (equipment, materials, people) applied to transform the inputs into outputs, the environment, the methods (procedures, instructions) followed, and the measures collected to determine process performance.
    • Check the adequacy and effectiveness of the process controls established by procedures, work instructions, flowcharts, and training and process specifications.
  2. Product audit: This type of audit is an examination of a particular product or service, such as hardware, processed material, or software, to evaluate whether it conforms to requirements (i.e., specifications, performance standards, and customer requirements).
  3. System audit: An audit conducted on a management system. It can be described as a documented activity performed to verify, by examination and evaluation of objective evidence, that applicable elements of the system are appropriate and effective and have been developed, documented, and implemented in accordance and in conjunction with specified requirements.
    • A quality management system audit evaluates an existing quality management program to determine its conformance to company policies, contract commitments, and regulatory requirements.
    • Similarly, an environmental system audit examines an environmental management system, a food safety system audit examines a food safety management system, and safety system audits examine the safety management system.

What are the Four Phases of an Audit Cycle?

  1. Audit planning and preparation: Audit preparation consists of planning everything that is done in advance by interested parties, such as the auditor, the lead auditor, the client, and the audit program manager, to ensure that the audit complies with the client’s objective. This stage of an audit begins with the decision to conduct the audit and ends when the audit itself begins.
  2. Audit execution: The execution phase of an audit is often called the fieldwork. It is the data-gathering portion of the audit and covers the time period from arrival at the audit location up to the exit meeting. It consists of multiple activities including on-site audit management, meeting with the auditee, understanding the process and system controls and verifying that these controls work, communicating among team members, and communicating with the auditee.
  3. Audit reporting: The purpose of the audit report is to communicate the results of the investigation. The report should provide correct and clear data that will be effective as a management aid in addressing important organizational issues. The audit process may end when the report is issued by the lead auditor or after follow-up actions are completed.
  4. Audit follow-up and closure: According to ISO 19011, clause 6.6, “The audit is completed when all the planned audit activities have been carried out, or otherwise agreed with the audit client.” Clause 6.7 of ISO 19011 continues by stating that verification of follow-up actions may be part of a subsequent audit.

Types of Audits

External Audits

Audits performed by outside parties can be extremely helpful in removing any bias in reviewing the state of a company’s financials. Financial audits seek to identify if 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 both accurate and complete. External audits, therefore, allow stakeholders to make better, more informed decisions related to the company being audited.

External auditors follow a set of standards different from that of the company or organization hiring them to do the work. The biggest difference between an internal and external audit is the concept of independence of the external auditor. When audits are performed by third parties, the resulting auditor’s opinion expressed on items being audited (a company’s financials, internal controls, or a system) can be candid and honest without it affecting daily work relationships within the company.

Internal Audits

Internal auditors are employed by the company or organization for whom they are performing an audit, and the resulting audit report is given directly to management and the board of directors. Consultant auditors, while not employed internally, use the standards of the company they are auditing as opposed to a separate set of standards. These types of auditors are used when an organization doesn’t have the in-house resources to audit certain parts of their own operations.

The results of the internal audit are used to make managerial changes and improvements to internal controls. The purpose of an internal audit is to ensure compliance with laws and regulations and to help maintain accurate and timely financial reporting and data collection. It also provides a benefit to management by identifying flaws in internal control or financial reporting prior to its review by external auditors.

Internal Revenue Service (IRS) Audits

The Internal Revenue Service (IRS) also routinely performs audits to verify the accuracy of a taxpayer’s return and specific transactions. When the IRS audits a person or company, it usually carries a negative connotation and is seen as evidence of some type of wrongdoing by the taxpayer. However, being selected for an audit is not necessarily indicative 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: no change to the tax return, a change that is accepted by the taxpayer, or a change that the taxpayer disagrees with. If the change is accepted, the taxpayer may owe additional taxes or penalties. If the taxpayer disagrees, there is a process to follow that may include mediation or an appeal.