A lot of companies have one or more accountants who are responsible for recording money that the company earns and spends.
But who’s to say that the numbers they record are accurate?
What is a financial audit?
A financial audit, also referred to as a financial statement audit or simply an audit, occurs when an examination of financial statements of a company is done to ensure that records are accurate. Financial audits can be done internally by an accountant within the company or externally by a firm.
Financial audits are done to provide an unbiased examination of a company’s financial statements. Essentially, they’re the process of double-checking financial information that was prepared by someone else.
Increasing the confidence in the company and reducing the risk of investors isn’t necessarily optional; The Securities and Exchange Commission (SEC) requires that all publicly held businesses must file a report with them that has been audited. Additionally, lenders often require an audit of financial statements to ensure that the funds loaned to that business are being spent accurately.
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Financial audit types
There are two types of audits that companies should be familiar with: internal and external audits.
Internal financial audits
Internal audits are done by someone employed by the company or organization that needs the audit.
A company often has a set of standards that they use to audit their financial statements. If an organization doesn’t have someone who is capable of performing an audit in-house, a consultant may be hired, but will use the company’s standards to perform that audit.
External financial audits
External audits involve a company hiring a third-party auditor to do a financial audit. By doing this, all bias is removed while reviewing the company’s financials and allow another, outside set of eyes to see the financial statements being reviewed, which can be helpful when searching for mistakes. Making the decision to do an external audit can often provide additional confidence for the parties using the financial statements that those statements are truly accurate.
An external auditor is completely independent from the company that they’re auditing, allowing for opinions on statements to be expressed candidly and openly with executives without feeling like they’re risking their own career or relationships.
If a company is public, the Securities and Exchange Commission requires that an audit be done by a third party.
Financial audit standards
Financial audits aren’t a free-for-all. Surprise.
The Generally Accepted Auditing Standards (GAAS) are a set of guidelines used by auditors when they conduct a financial audit, so that no matter who is conducting the audit and no matter the business being audited, reports can result in a somewhat similar fashion based off of these guidelines.
In short, the GAAS helps ensure the consistency and accuracy of the auditors actions and reports. The GAAS contains three sections: general standards, standards of field work, and the standards of reporting.
Stages of a financial audit
When someone says they’re performing a financial audit, it’s difficult to understand what that really means. Below, we’ll go into the phases of a typical financial audit.
Before an auditor dives in and crunches numbers, there are quite a few things that have to be done in order to prepare for that process.
1. Plan audit approach
Before any evaluation of financial statements takes place, the auditor should take the time to understand the business that they are auditing as well as the environment it operates in. By using this information, an auditor can determine whether or not any risks are present that could impact the financial statements.
2. Perform risk assessment
The second stage of a financial audit involves determining the effectiveness of a business’s management of financial information. This means having a concentration on the authorization process, how well assets are protected, and even how responsibilities are delegated.
To determine this, several tests can be conducted on sample transactions to determine a control group of effectiveness.
If the control group of transactions is determined to be effective, that means that there is a low risk of misstatement, and some of the procedures that would take place during the actual audit can scale back. However, if determined ineffective, meaning that there is a high risk of misstatement, auditors must use all procedures in order to spot all mistakes.
3. Identify financial audit objectives
After determining the risks of a financial audit, objectives can be identified. While it is obvious that the objective of a financial audit is to complete it, having sub-objectives that make up that entire objective are crucial so that managers understand where the information is coming from.
4. Choose your method
The methods you choose will depend on the goals you’re trying to reach during your financial audit. Each objective should (and likely will be) paired with a method that will provide strong evidence. Methods could include sampling parts of the books and comparing to how they should look, interviewing accountants regarding their processes, and observing those processes being carried out.
5. Pair method with a cost
Before performing any procedures, the auditor must determine the budget so that the business being audited has an idea of how much the process will cost them.
6. Finalize audit plan
The final step before the actual auditing is to confirm the plan that they have with the business requiring an audit. Once a company confirms that the plan is acceptable and something they are comfortable with, the actual audit may begin.
Now that all of the preparation work has taken place and the plan that has been developed is confirmed with the company requiring an audit, the audit may take place.
Internal or external, the auditor or team of auditors will be on-site and finalize the process with the company’s relevant team members, who will need to assist the auditor(s) in gathering records and explaining the process of keeping them.
Reviews that may take place involve the review of the accounting system, review of internal control policies, and review of how taxes are filed.
The results of these reviews should be documented and then a comprehensive review of that documentation is to be performed. Once performed, financial auditors can write up a report regarding what their findings were after analysis. The report serves as the conclusion in regards to how well the business follows accounting standards.
Gathering evidence for this report can be done in several different ways. Below are some of the ways in which this can be done:
Analytical procedures involve comparing your client’s books to what would be expected to appear on the books.
Confirmations involve asking for verification and assurance from independent employees that support decisions made by management.
Inspection of records involves asking the company for relevant documents that support what management asks for from the accounting department.
Recalculation involves confirming the mathematical accuracy of the department’s calculations.
Reperformance involves performing the business’s accounting procedure to ensure that the company is following their own guidelines.
Results of a financial audit
After a financial audit has been performed, a report is provided to the business that requested the audit. This report gives the business an opinion of its financial statements and may be eye-opening for managers. If a financial audit has been done by a CPA, there are four results that may come of that report:
1. Unqualified approval
This is probably the results your business is hoping for – it’s synonymous for an “all clear”. No issues were detected during the audit. You can breathe easy.
2. Qualified approval
If this result is reported, the auditor has found one of two things.
The first scenario is that one of the GAAS rules has been broken. The second is a scope limitation, which occurs when an auditor cannot perform a test due to the system of the business being dysfunctional.
The auditor will explain the reasoning behind this particular result, but it is up to the business to decide whether or not those inconsistencies affect the accuracy of the financial statements being produced.
3. Disclaimer of opinion
This result occurs when the auditor does not have any opinion regarding the inner workings of the business’s accounting department, due to the limit of the examinations that were done.
4. Adverse findings
This is the result a business should not be hoping for. When an auditor concludes the report with this result, it essentially means that the financial statements of a company are unreliable and do not follow the GAAS.
In other words, alarm bells should be going off in the managers’ heads, investors will not stay in place, and stock prices can plummet. If an adverse finding is reported, the SEC does not allow public business to trade.
Check yourself before you wreck yourself
We never said financial audits were fun. While it might be a lot of work, making sure financial records are accurate is all part of an accountant’s job. An auditor’s job is to double-check the accuracy. The least you can do is make it easy for them.
Wondering whose idea it was to audit in the first place? Take a deep dive into the history of accounting.
Daniella Alscher is a Brand Designer for G2. When she's not reading or writing, she's spending time with her dog, watching a true crime documentary on Netflix, or trying to learn something completely new. (she/her/hers)