Auditing: Definition, Types, and Importance

The purpose of auditing is to perform an objective examination and evaluation of the financial statements of an organization or an individual. Audits ensure that the statements are a fair and accurate representation of the entity’s financial position and economic performance. They function as a method of ensuring regulatory compliance and financial transparency while generating stakeholder trust.

The IRS (Internal Revenue Service) performs audits to verify the accuracy of an individual taxpayer’s federal returns or other transactions. IRS audits usually carry a negative connotation and are seen as evidence that the taxpayer did something wrong, even though an audit can be selected randomly.

Key Takeaways 

• Audits happen to individual taxpayers and businesses.
• An audit can benefit the overall financial health of a business.
• Audits ensure financial statements are compliant and processes are efficient.
• The 3 main types of audits are internal, external, and IRS.
• Audits typically follow a 5-stage process.

Table of Contents

• What Is Auditing?
• What Is the Main Purpose of Auditing?
• Why Auditing Is Important?
• Types of Audits
• Audit Process
• Conclusion
• Frequently Asked Questions

What Is Auditing?

Auditing is defined as a review of financial records to confirm accuracy and compliance, or find errors. These records include bank and financial statements and tax returns. Business audits also include a review of payroll and inventory records and source documents, such as invoices, purchase orders, and other relevant information.

What Is the Main Purpose of Auditing?

The main purpose of an audit is to confirm the accuracy of an individual or business’s financial statements and records. Accounting audits verify an entity’s compliance with tax laws and applicable financial reporting frameworks like GAAP and IFRS and financial statements’ accuracy and trustworthiness. Typically, auditing in accounting is carried out by a third party to provide an objective and independent examination.

Why Auditing Is Important?

Auditing is important for several reasons. A review of a company’s operations and records can help uncover inefficiencies, including accounting and reporting. A business or individual may then improve their processes, production, and operations.

To remain compliant, publicly traded companies must also establish procedures for monitoring their records and examine their internal controls for efficiency. Some companies perform regular financial audits because of the potential for misstated financial information, either due to fraud or errors. This is especially true for businesses that need more effective internal controls.

The resulting findings of an auditor can enhance the credibility of the financial statements with users such as lenders, creditors, and investors. Financial statements with a favorable audit opinion are more likely to provide credit and funding for a business.

Types of Audits

Financial audits of individuals and companies share similarities, though there are a few differences. Typically, they can take 3 forms—internal audits, external audits, and IRS audits. 

Internal Audits

In internal audits, a company employee or team performs the review. If a company does not have someone to perform the internal audit, they hire a consultant auditor. 

Internal auditors or consultant auditors use company standards to evaluate various processes within the company, including accounting and corporate governance. Assuming the company adheres to generally accepted accounting principles and auditing standards. They look for accurate data collection, regulatory compliance, and transparency in financial reporting.

The results of internal audits serve to notify the management and board of directors of performance and compliance. The data informs changes to staff, processes, and internal controls. It also acts as an opportunity to make corrections before an external audit. 

External Audits

External audits are independent reviews performed by third parties or external auditors, resulting in an unbiased report. External auditors examine the effectiveness of a company’s processes, their compliance with rules and laws, and the accuracy of their financial reporting. They also identify material misstatements in the financial records.

An external audit offers an unqualified, or clean, auditor opinion and can inform stakeholders about risk management in decision-making related to the audited company. 

IRS Audits

The Internal Revenue Service performs external audits on businesses and individual taxpayers. They can be random, based on a statistical formula that compares one return to the norm. They can also happen if a taxpayer has been associated with or dealt with another company that had errors in their tax return. 

Even though the IRS performs audits often, they are the least desirable type of audit because there is an inference that an infraction has occurred. If proper procedures aren’t in place, the process can be grueling. 

IRS audits examine the tax returns and transactions for accuracy and report one of two outcomes:

• No changes to the return
• Changes are necessary

If changes are necessary, a person can either agree with the findings and make the adjustments, which may change their tax liability, or dispute the findings. To dispute the findings means to undergo an appeal process or mediation.

Audit Process

Audits usually follow a standard process, and many audits include the following 5 stages:

Stage 1: Selection

The first stage of any audit is selection. Selection refers to the process of selecting an entity for an audit based on established criteria and risk factors. As mentioned above, the IRS has a selection process based on specific formulas. These formulae make the selection process more or less randomized unless there are obvious 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 company selected for audit. 

Stage 3: Execution

After determining an audit’s plans, it’s time to execute the audit. Executing a financial audit involves inquiring about, reviewing, and validating a company’s financial records and operations. 

Financial audits also examine a business’ measures that are in place for internal controls. Good internal controls indicate a well-governed financial process and typically will produce more accurate, verifiable financial data. An auditor can easily compare their observations to an organization’s expected standards, providing objective evidence regarding employee actions. An audit can also provide insight into the overall efficiency of the process.

Stage 4: Reporting

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

• Audit events
• Observations
• Conclusions and auditor’s opinion
• 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. This follow-up serves to verify any necessary changes to the audit. In this way, the company can ensure they are operating efficiently and legally.

Conclusion

Audits can help a business or individual taxpayer limit their financial risk, increase borrowing capacity, and improve stakeholders’ trust. Biannual and annual audits can also help an organization identify areas for improvement and inform changes throughout the company. 

FAQs About Auditing

FreshBooks reviewed the most frequently asked questions and compiled a list with the answers for your review and convenience. Have a look.

What is an example of auditing?

An example of an audit is a cost/benefit review of a client’s billables. A business can examine the hours spent on a particular client and any expenses incurred and compare them to the amount of revenue that the client generates for the company.

Can anyone perform an audit?

Yes and no. While anyone can review the financial statements and processes of their business for discrepancies and inefficiencies, only a CPA can perform a mandatory audit. Legally required audits must be performed by a CPA who adheres to specific standards in compliance with regulatory and government bodies. 

What is the difference between accounting and auditing?

Accounting is the act of recording, tracking, and reconciling financial data. Auditing is the action of reviewing those documents for accuracy and compliance. Strong accounting practices encourage better data tracking and recording, improve fiscal accountability, and make auditing in accounting less labor-intensive.

What is a partial audit?

A partial audit reviews a portion of a company’s financial statements or processes. The auditor does not examine the whole account but instead scrutinizes a specific aspect of the system. The auditing method is the same as a complete audit.

What is the interim audit?

An interim audit happens sometime before the end of the fiscal year, usually after 6 or 9 months. They determine the profit for a period, inform about dividend disbursements and financing, and reveal fraud and employee compliance. They can also help to spread out the workload of a yearly audit.

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