Audit: Definition, Types & Process

KEY TAKEAWAYS

• Audits are a normal part of business operations.
• When an internal or external audit is being performed, it means that stakeholders are looking for a way to improve the business.
• Almost any part of a business is subject to an audit.
• Processes get reviewed and refined through audits.
• Financial statements are also subject to audits, which leads to better budgetary decisions.

What Is an Audit?

In business terms, the definition of audit is essentially an objective review of a company’s financial statements. Audits serve to ensure that the information released by a business is fair and accurate. In businesses, there can be financial audits, as well as performance audits. We’ll cover the difference between those a bit later on.

Overall, an audit is a benefit to your company, so long as you’re doing things the way that you should. Audits make sure that all processes are running as intended, which protects your business.

Understanding Why Businesses Need Audits

A detailed audit is a necessary part of running any business. At the very least, businesses need to undergo a financial audit once a year. The point of these audits is to go over the financial statements that a company releases—a process with many steps. These include:

• Inquiry – Inquiry is the process of seeking information from people with knowledge of a company’s finances. This can be a formal, written inquiry, or a more informal oral conversation. 
• Confirmation – This is the step of confirming and verifying financial information with an unaffiliated third party. This step ensures that any financial assertions on the part of the company are factual. 
• Inspection – In addition to reports on the business being audited, auditors themselves must be subject to inspection. This is to ensure their work is conducted appropriately and is subjected to all necessary regulations. 
• Recalculation – Naturally, finance entails lots of math. Audits frequently recalculate sums previously done by the company, ensuring all the numbers match up. 
• Observations – When the audit is completed, the relevant organization will receive a report and analysis of the auditor’s observations. These will provide the full picture of a company’s finances, assets, liabilities, and overall operations. 

These steps all come together to help the auditor validate the accuracy and occurrence of a business’ financial data. This means reviewing all financial statements from the company, including its income statement, balance sheet, and cash flow statement.

The Different Types of Audits

There are typically three financial audits. There are internal audits, external audits, and IRS audits. Of the three, people tend to worry the most about IRS audits, naturally. We’re going to take a look at all three types of audits and explain them in depth.

Internal Audits

Internal audits are the first type of audit to consider for any business. An internal audit is an audit designed to evaluate various processes within a company. Included among these are corporate governance processes and accounting processes.

An internal audit team typically handles each internal compliance audit. These are performance audits that serve to determine whether operations are up to par.

External Audits

For the most part, external audits focus entirely on financial statements. However, external auditors can audit an entire organization and its processes if asked to do so. Plus, the effectiveness of risk management depends on the accuracy of the external auditor’s audit evidence.

IRS Audits

The least desirable audit is the IRS audit. Most business owners dread the idea of going through an audit because the process can be so tiresome. It is very important to remember that the Internal Revenue Service performs audits often.

As such, audits are a routine part of the department. They are only seeking to verify the accuracy of the taxpayer’s return and transactions. Audits may also occur because a taxpayer had documents that indicate they had dealings with someone who had tax errors, too.

When a company gets selected for an IRS audit, there are three general audit outcomes to expect:

• No changes to the return
• Changes are necessary

When the IRS determines the latter, there are two options:

• The taxpayer agrees with the audit adjustments
• The taxpayer disputes the changes

If the taxpayer accepts the audit adjustments, the result may change tax liability. Should the taxpayer dispute the changes, they will have to undergo mediation or an appeal process. Both of these actions take a lot of time.

Understanding the Audit Process

When you review audit processes within companies themselves, you’ll find that many include the following five stages:

Stage 1: Selection

The first stage of any audit is selection. Selection refers to selecting a process or a set of financial statements to review and audit. As mentioned previously, the IRS has a selection process based on specific formulas. This makes the selection process more or less randomized unless there are glaring errors.

Stage 2: Planning

The planning stage is the second stage of an audit. After the selection of an area for audit, auditors will begin to plan the audit itself. This includes gathering any relevant background information. It also includes initiating contact with the area under audit.

Stage 3: Execution

After determining an audit’s plans, it’s time to execute the audit. For financial audits, this involves inquiring about, reviewing, and validating all financial information provided alongside a business’ financial statements.

Financial adults also examine a business’ measures that have put in place for internal controls. Good internal controls indicate a well-governed financial process, and typically will produce more accurate, verifiable financial data. This means an auditor can easily compare their observations to an organization’s expected standard, providing objective evidence regarding employee actions. It can also provide insight on the overall efficiency of the process.

Stage 4: Reporting

Following the execution, the auditor reports all audit events and audit findings. Auditors will compile all of the information found throughout the audit and provide it to all relevant parties. An audit report will contain a large amount of information, including:

• Audit events
• Observations
• Conclusions
• Specific recommendations

Upon receiving the audit report, the subject of the audit should draft a response. The response itself should include an action plan related to any recommendations. It should also provide a general timeframe to make the appropriate changes.

Stage 5: Follow-Up

In the event of an internal audit, internal auditors should follow up on the audit within a specific period of time. This follow-up serves to verify any necessary changes to the audit. This is a way for the company to make sure that they are operating efficiently, as well as legal.

The Benefits of an Audit

While many business owners view audits as a negative thing in most cases, they provide great benefits to a business. Following an audit, a business can enjoy the following things:

Compliance with the Law: Audits help businesses maintain good legal standing.

Improvements: Businesses that conduct audits have more potential to improve and perform better.

Reputation: Any business that allows audits to take place seems more credible to all of its stakeholders.

Fraud Prevention: A financial statement audit helps businesses prevent internal fraud from occurring.

Better Budgeting: When financial records get reviewed, it provides better oversight of a company’s budget and provides an invaluable foundation for better budget building in the future.

Summary

It’s helpful to look at audits in a positive light. For one, the findings within audits can serve to be a real benefit to management. Audits can help you maintain compliance to requirements within your company.

What’s more, audits help you keep better track of your bookkeeping records. So whether you’re facing a formal audit or an informal audit (otherwise known as a review), use it to your company’s advantage.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

Written by Jami Gong, MPAcc, CPA

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.