This article provides a practical explanation of an audit and the concept of auditing. After reading, you’ll understand the basics of this powerful financial management tool.
What is an audit and what is auditing?
An audit is a systematic and independent inspection of an organisation’s books, accounts, legally required record keeping, documents, or vouchers in order to determine to what extent financial and non-financial documents offer an accurate account of reality.
Auditing is defined as the act of verification that is conducted by auditors, such as an inspection or investigation, to ensure that the requirements for the above-mentioned matters are being met. An audit can be conducted for an entire organisation, but also for a certain position, process, or subprocess. Audits can have several administrative purposes, such as composing inspection documents, risk reports, and performance evaluations. Auditing also checks whether organisations have taken corrective action.
The word audit comes from the Latin word audire, meaning hearing. Audits were being carried out as early as the Middle Ages. Moyer posited that an auditor’s most important task was exposing fraud.
What’s the primary purpose of auditing?
The term auditing usually refers to an audit of a financial statement. Other forms of auditing, such as operational audits and strategic audits are explained later in this article. Any form of auditing is conducted to determine if the target of that audit complies with applicable principles, as well as organisational and statutory requirements. Conforming to legal standards and rules has traditionally been the main reason for inspecting the financial statements of organisations.
Audits offer external stakeholders assurances that an audited aspect doesn’t contain any discrepancies or conflicts of interest. The audit is an objective evaluation, usually of financial statements, resulting in an assessment that answers the question whether the information provided is on the level and in accordance with the applied accounting framework, such as GAAP or IFRS. The assessment of the reliability of the information increases the credibility of the statements for the parties that use them, such as creditors and investors. For instance, if the assessment is positive, the likelihood of credit and financing being made available increases.
The difference between internal and external audits
What are external audits?
Audits that are administered by external parties can be very useful to alleviate suspicions of possible bias when assessing the status of a business, unit, or process. A clean accounting bill of health gives users of the overviews the confidence that the data is both accurate and complete. External audits therefore enable stakeholders to make better decisions regarding the business that has been audited. Another advantage of external auditors compared to internal ones is that they can be open and honest without having to worry about it impacting their day-to-day professional relationships at work.
External auditors use standards that are different from the ones employed by the company itself.
What are internal audits?
Internal auditors work for the company or organisation for which they conduct the audit. The audit report will be presented directly to the management or shareholders. Usually financial statements are first audited internally before an external auditor looks into them. The advantage of this is that management gets a chance to identify and resolve shortcomings in the statements before external auditors see them.
What different types of audits are there?
Generally speaking, an audit is an investigation into an existing system, report, or entity. There are several types of audits that can be administered, including the following:
1. Compliance audits
This form of auditing is focused on policy and the procedures of an organisation or department to check whether they are in accordance with both internal and statutory standards and regulations. This form of auditing is used in regulated industries or education.
2. Construction audits
A construction audit is an analysis of the costs of a specific building project. The activities in a construction audit include analysis of the contracts offered to the contractors, invoices paid, overhead, change orders, and whether things are completed on time. The goal of a construction audit is to show that the costs of a particular project are reasonable and acceptable.
3. Financial audits
A financial audit is an analysis of information that shows whether the financial statements of an organisation meet the specified criteria. Usually these criteria are international standards, for instance for annual financial statements. In order to make an assessment whether the financial statements contain material errors or other inaccuracies, the auditor will collect as much information as possible.
4. Operational audits
Operational auditing is an extensive analysis of the objectives, plans, procedures, and results of the activities of a company. The audit can be conducted internally or by an external entity. The result is an assessment of the activities, often with a recommendation for optimisation.
5. Tax audits
This is an analysis of tax returns that have been submitted by an individual or a business unit in order to determine if the tax information and resulting tax payments are correct. These audits are often aimed at tax returns that result in too low tax payments, in order to determine if an additional assessment can be made.
Example of the auditing process
This article has discussed several types of auditing. Each type of audit is tailored to the organisation’s needs, and different audit subjects require different approaches. However, the general approach for a successful audit remains the same and is explained below. This example is based on an audit of financial statements.
Sisters Daniela and Laura together own a chain of three shops in Amsterdam selling sports attire. Their retail chain is called SportsNeeds and has the best sales performance of all the sports attire stores in the region. The chain is growing fast, and both sisters hope to expand it once again. Opening new shops also means a new round of investing. Laura tells Daniela that she wants to make sure that their financial records are in order and that she doesn’t want to run the risk of getting caught because of errors or omissions. They need an audit of those financial records to generate trust among investors. The audit process is a way to make sure that all statements by the business are in accordance with relevant bookkeeping principles.
The audit process for the sisters Daniela and Laura consists of the following steps:
Phase 1: planning and design
Daniela contacts an accountancy firm and discusses the necessity of an audit. The firm wants to know what they need exactly, so that they can come up with a plan for the scope of the audit. The sisters communicate that they want to make sure the financial statements are in order. They want accountants to check if the figures on the profit and loss statement and the financial statements are accurate.
The auditor is then sent a complete description of the chain, also containing an overview of all positions, branches, and managers. After determining the strategy and the scope of the audit, the accounting firm sends a formal letter to the sisters detailing the strategy and start date of the audit.
Phase 2: tests
The accounting firm wants assurances that they have access to all internal auditing processes, store locations, warehouses, and the book-keeping system. They also want to know how all sales transactions are recorded, and how the purchasing process from suppliers is set up (procurement). Additionally, they require information about the cash management system, and who has access to the financial records, to complete the audit.
Phase 3: conducting analytical procedures
When the auditors arrive, they start planning interviews with employees and the sisters. At the introductory meeting, they were informed about how SportsNeeds is set up. Now they want to know from employees how they carry out their work, and whether they comply with the procedures laid out by the management to start the audit. Auditors will observe and record what is said in these meetings. If they find that the procedures aren’t being observed or at least not very accurately, they will perform an additional audit of the company records.
Next, the sales figures are checked to see if they match the data in the financial statements. A physical count will also be made in the warehouses and shops to determine if that data was accurate. In addition, procurement invoices will be studied, and they will determine whether all orders have been received. The auditors will likely also contact customers in order to verify whether the accounts receivables are correct.
Phase 4: completion and creating the audit report
All data that was collected will be checked, based on which an audit-report is created. The audit report contains a summary of all findings, and it’s forwarded to the management. The report also includes issues that will have to be resolved.
Phase 5: following up on recommendations
The final step in the audit process is about taking corrective action. This step is taken to ensure that any issues that were identified are resolved in time. The management of the audited company will work with the accountants and communicate when all agreed actions have been completed. When these have been carried out and no other audit actions are required, the financial statements of the sisters Laura and Daniela will be deemed accurate and reliable.
Now it’s your turn
What do you think? Do you recognise this explanation of auditing? Are financial statements in your organisation audited internally or externally? What other business units in your work environment deal with audits? Do you have any tips or additional comments?
Share your experience and knowledge in the comments box below.
- Arens, A. A., Loebbecke, J. K., Elder, R. J., Beasley, M. S., & American Institute of Certified Public Accountants. (2000). Auditing: An integrated approach (Vol. 8). Upper Saddle River, NJ: Prentice Hall.
- Boynton, W. C., Kell, W. G., Johnson, R. N., & Wheeler, S. W. (2001). Modern auditing. J. Wiley & Sons.
- Carmichael, D. R., Willingham, J. J., & Schaller, C. A. (1989). Auditing concepts and methods. New York, NY: McGraw-Hill.
- Kok, C. (1989). The Court of Auditors of the European Communities:” The Other European Court in Luxembourg”. Common Market Law Review, 26(3), 345-367.
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