Auditing: What It Is & Why It’s Done
The Importance of Auditing
Auditing typically refers to an objective review of a company’s financial statements, which consist of the cash flow statement, the income statement, and the balance sheet. Audits are evaluations that analyze the level of accuracy that the business has characterized in its financial records. The process looks at how a business documents investing, financing, and operating ventures.
Depending on the type of audit and what it aims to accomplish, it can be conducted by internal employees or independent, third-party examiners, like a Certified Public Accountant (CPA) firm or a government agency such as the Internal Revenue Service. When it comes to the United States, the Generally Accepted Accounting Principles (GAAP) are what auditors look to when analyzing financial statement preparation. External audits are guided by the American Institute of Certified Public Accountants’ (AICPA) Auditing Standards Board (ASB). The AICPA requires that the generally accepted auditing standards (GAAS) are followed by external auditors to ensure proper protocol is followed.
When it comes to regulations, the Sarbanes-Oxley Act of 2002 requires publicly traded companies to have their internal controls’ impacts reviewed. It also states that companies that do not implement and enforce their internal controls may be subject to criminal charges.
Defining Internal Controls
Internal controls can be thought of as how businesses manage operations by regulating permissions, documentation, congruency, protection/safety, and partitioning of responsibilities for business processes. These are broken into preventative and detective activities.
Sometimes referred to as protective activities, responsibilities are compartmentalized and distributed among different individuals to dissuade mistakes or deceit from occurring.
It also integrates highly detailed written procedures and validation procedures for further cautionary measures. It’s meant to verify that no sole person is able to approve, document, or be responsible for monetary transactions and final products. Permitting invoices and validation of expenses are examples of internal controls. Only permitting appropriate access to the fewest employees necessary and the fewest required business equipment is one way to implement this type of internal control.
Detective Controls Defined
Detective controsl are redundant systems that are put in place to intercept issues that might have fallen through the initial round of quality control measures. Looking at reconciliation procedures, which match the data in question against known accurate data sets, it’s used to fix discrepancies.
Internal audits are usually conducted by a business’ employees, primarily performed as a way to evaluate internal operations and internal controls. They look to identify any deficiencies or weaknesses in the business’ operations, often occurring before an external auditor reviews its financial statements. This type of audit is also meant to review and identify any legal or regulatory compliance issues.
An external audit occurs when an independent auditor, such as a third-party CPA firm, assesses a business’ internal controls and financial statements. It is performed to provide an objective opinion that an audit conducted by the business itself cannot. With a “clean opinion” or “unqualified opinion” provided by the independent auditor, businesses can provide those looking at financial statements confidence that such financial statements are reliable. It enables the outside entity to focus on the financials, the business’s internal controls, etc. by providing a conflict-of-interest-free perspective.
Government audits are done to ensure that businesses have accurately reported their taxable income to respective government agencies. This can include federal agencies such as the Internal Revenue Service (IRS) and Canada Revenue Agency (CRA), which are the U.S. and Canada’s respective tax collection agencies.
When an IRS audit has concluded its review, there may be a few different preliminary results and resulting paths. The tax return may see no modification. There may be a modification the taxpayer agrees to, which could result in additional money being owed. The third result occurs when the filer doesn’t agree with the change, and it is worked out through an appeal process.
Whether it’s an investor for a publicly traded company or a business looking for creditors for help with money, materials, etc., having audited financial statements provide confidence that they’ll see a return on their investment or a high likelihood of their debts being satisfied in the future.