What is Auditing?
Auditing refers to financial statement audits or an objective examination and evaluation of a company’s financial statements – usually performed by an external third party.
Audits can be performed by internal parties also, as well as by a government entity such as the Internal Revenue Service (IRS).
Importance of Auditing
Audit is an important term used in accounting that describes the examination and verification of a company’s financial records. It is to ensure that transactions are represented fairly and accurately.
Also, audits are performed to ensure that financial statements are prepared in accordance with the relevant accounting standards. The three primary financial statements are:
- Income statement
- Balance sheet
- Cash flow statement
Financial statements are prepared internally following relevant accounting standards, such as International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP), and are developed to provide useful information to the following:
- Government entities
Financial statements capture the operating, investing, and financing activities of a company through various transactions that are recorded. Because the financial statements are developed internally, there is a high risk of fraudulent behavior by the preparers of the statements.
Without proper regulations and standards in place, preparers can easily misrepresent their financial positioning to make the company appear more profitable or successful than they actually are.
Auditing is crucial to ensure that companies represent their financial positioning fairly and accurately, and in accordance with accounting standards.
Types of Audits
There are three main types of audits:
1. Internal audits
Internal audits are performed by internal employees of a company or organization. The audits are not distributed outside the company. Instead, they are prepared for the use of management and other internal stakeholders.
Internal audits are used to improve decision-making within a company by providing managers with actionable items to improve internal controls. They also ensure compliance with laws and regulations and maintains timely, fair, and accurate financial reporting.
Management teams can also utilize internal audits to identify flaws or inefficiencies within the company before allowing financial statements to be reviewed by external auditors.
2. External audits
Performed by external organizations and parties, external audits provide an unbiased opinion that internal auditors might not be able to give. External financial audits are utilized to determine whether there are any material misstatements or errors in a company’s financial statements.
When an auditor provides an unqualified opinion or clean opinion, it reflects that the auditor provides confidence that the financial statements are represented with both accuracy and completeness.
External audits are important for allowing various stakeholders to confidently make decisions surrounding the company being audited.
The key difference between an external auditor and an internal auditor is that an external auditor is independent. It means that they represent a more honest opinion rather than an internal auditor who may be biased.
There are many well-established accounting firms that typically complete external audits for various corporations. The most well-known are the Big Four – Deloitte, KPMG, Ernst & Young (EY), and PricewaterhouseCoopers (PwC).
3. Government audits
Government audits are performed by entities that relate to ensuring that financial statements have been prepared accurately in order not to misrepresent the amount of taxable income of a company.
Within the U.S., the Internal Revenue Services (IRS) performs audits that verify the accuracy of a taxpayer’s tax returns and transactions. The IRS’s Canadian counterpart is known as the Canada Revenue Agency (CRA).
Audit selections are made to ensure that companies are not misrepresenting their taxable income. Misstating taxable income, whether intentional or not, is considered tax fraud. The IRS and CRA now use statistical formulas and machine learning to find taxpayers that are at high risk of committing tax fraud.
Performing a government audit may result in a conclusion that there is:
- No change in the tax return
- A change that is accepted by the taxpayer
- A change that is not accepted by the taxpayer
If a taxpayer ends up not accepting a change, the issue will go through a legal process of mediation or appeal.
CFI offers the Certified Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: