• Sat. Apr 20th, 2024

What It Means in Finance and Accounting, 3 Main Types

What Is an Audit?

The term audit usually refers to the financial audit or review of financial statements. 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.

Key Takeaways

  • There are three main types of audits: external audits, internal audits, and Internal Revenue Service audits.
  • External audits are commonly performed by Certified Public Accounting firms and result in an auditor’s opinion which is included in the audit report.
  • An unqualified, or clean, audit opinion means that the auditor has not identified any material misstatement as a result of his or her review of the financial statements.
  • External audits can include a review of both financial statements and a company’s internal controls.
  • Internal audits serve as a managerial tool to make improvements to processes and internal controls.

Investopedia / Daniel Fishel


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 receive a yearly audit of their financial statements. This includes the review of statements like 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. For some companies, audits are a legal requirement due to the compelling incentives to intentionally misstate financial information in an attempt to commit fraud. As a result of the Sarbanes-Oxley Act (SOX) of 2002, publicly traded companies must also receive an evaluation of the effectiveness of their internal controls.

Standards for external audits performed in the United States, called the generally accepted auditing standards (GAAS), are 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), which was established as a result of SOX in 2002. A separate set of international standards, which are called the International Standards on Auditing, was set up by the International Auditing and Assurance Standards Board.

Importance of Audits

Audits are a necessary and important part of the financial world. That’s 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, more importantly, that they are 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 may also be completed by taxation agencies like the Internal Revenue Service (IRS).

External Audits

Unqualified 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 that are different from those of the company or organization hiring them to do the work. 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 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. Internal auditors are used when an organization doesn’t have the in-house resources to audit certain parts of its 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.

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

The biggest difference between an internal and external audit is the concept of independence of the external auditor.

Internal Revenue Service (IRS) Audits

The IRS 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:

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

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.

What’s the Purpose of an Audit?

Audits are generally meant to ensure that businesses and individuals are being honest and accurate about their financial positions. But, the purpose of an audit depends entirely on the type of review in question.

For instance, corporations are routinely audited to ensure they are compliant and are following accounting standards. Audits also ensure that businesses are representing their financial well-being accurately.

Tax agencies conduct routine audits at random or may do so if someone’s tax return is flagged. Things that may trigger an audit include specific tax credits and deductions, or certain types of income.

Are Audits a Bad Thing?

The term audit conjures up negative feelings for a lot of people because they’re usually associated with tax agencies that want to review tax returns. People often believe they’ll be responsible for a hefty tax bill after an audit.

Being audited isn’t necessarily a bad thing. Most agencies just want to ensure that you’re following the law and taking tax credits and deductions that you’re entitled to claim.

In the corporate world, audits help companies remain compliant by reviewing financial statements to ensure that they accurately represent their financial positions.

How Do I Prepare for an IRS Audit?

Although it may seem daunting, an IRS audit shouldn’t worry you. The agency routinely conducts audits for corporations and individuals—some randomly while others are flagged because of certain types of income, credits, and deductions. The best way to prepare for an audit is to keep your tax records, including any receipts and tax documents, in a location that’s easily accessible for up to three years.

The Bottom Line

The idea of an audit can make people very nervous. Despite the negative connotation, audits aren’t entirely bad. 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. If you’re an investor, you’ll know that the companies in which you have an interest are being honest about their financial position.

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