Financial Audit & Reporting: Definitions & Requirements

Finance Leadership

Financial statements are created through detail-oriented processes that rely on accurate data entry. A financial audit offers a layer of credibility to said documentation for shareholders, investors, lenders and the like. The importance of auditing cannot go unnoticed in any type of business, so we will touch on all the aspects of what an audit entails and why they are necessary. 

What is an Audit? Meanings & Definitions

A financial audit is performed by an independent third party or internal employees within an organisation. Third party auditors are certified public accountants (CPAs). Whether your organisation undergoes an internal audit or external audit, an auditor will review a company’s financial statements to ensure that the records are accurate and reflect the actual transactions that occurred. 

Audits result in an auditor’s opinion which reflect the overall accuracy of records. On a scale of clean to error-prone, the auditor’s opinions can be: unqualified, qualified, adverse or disclaimer of opinion. 

It’s possible to perform audits manually or utilise a software tool to help expedite the process. 

Understanding Audits & Why is it Necessary?

Generally, companies will receive at least an annual audit that reviews  its income statement, balance sheet and cash flow statement. It places the statements against the Generally Accepted Accounting Principles (GAAP) to make sure that they are “true and fair.” 

Audits are utilised for a variety of reasons. In 2002, the Sarbanes-Oxley Act stipulated that publicly traded companies need to receive evaluations to ensure their internal controls are effective. For publicly traded companies, it’s extremely important to maintain accurate financial records to reduce compliance risk. As such, audits can highlight areas where management may need to enhance their processes or boost their controls. 

Stakeholders have the opportunity to review audits to have an understanding of how the business is operating. Investors can look to audits when making their decisions. Lenders can gauge a company’s financial standing and use an audit to inform its lending offerings. 

What are the Types of Audits?

Most audits deal with the credibility of an organisation’s financial statements, but there are additional types of audits that are used for other purposes. Let’s take a look at the types of audits that exist: 

External Audits

External audits are performed by independent third parties, or CPAs. Since they are conducted by someone outside of the organisation, they have the feature of being unbiased, at least in theory. External audits are highly regarded by stakeholders because the nature of the relationship being independent. The auditor’s opinion will then play a role in the company’s fate by either showing as favourable or unfavourable. 

Internal Audits

Companies have the ability to perform their own audits whenever they so choose. An internal audit is performed by an employee of the organisation and then given to the management team and board of directors for review. 

It’s also possible for a company to hire an auditor consultant, who although is not part of the organisation, will be instructed to conduct the audit according to the organisation’s accounting principles. This type of audit provides insight for management to see if there’s any need for process improvement. Another benefit is that it offers a sort of test run before an external audit. 

Internal Revenue Service Audit 

The Internal Revenue Service (IRS) will routinely perform audits on taxpayer’s returns. The IRS has the power to audit either a business or an individual. It’s a myth that an IRS audit is representative of wrongdoing. An IRS audit can happen to anyone at any time and doesn’t necessarily indicate that something is wrong. They’re conducted on a statistically random basis by analysing a taxpayer’s return and comparing it to similar returns. 

As a result of an IRS audit, there can be three possible outcomes: no change to the return, a change that the taxpayer accepts and makes (while possibly paying a penalty), or a change that is not agreed upon by which a process follows for appeal and/or mediation. 

Forensic Audits

A forensic audit is a type of audit that can be used in court or legal proceedings as an investigative measure. It’s a specialised form of an audit, and so, most big accounting firms will have a dedicated department for forensic auditing. It can be used to prosecute for embezzlement, fraud or financial crimes. It could also be used in business closures, bankruptcy filings and even divorces. 

Operational Audits

It’s a best practice for an organisation to regularly review its own processes by way of finding errors or making enhancements. As part of this practice, an operational audit can be used to review procedures, systems, internal controls and key processes. 

The purpose is to add value to the business. Internal auditors or external firms can conduct an operational audit. It’s also possible to leverage automation software tools to provide insight as to how well a process is or is not working for your business. 

What are the Procedures of Financial Audits? 

Both internal and external audits follow a set of audit procedures. Performed manually or with automation software, these phases are as follows: 

Planning

At the start, there is a plan that will outline how data is to be collected and what will be used as the basis of the auditor’s opinion. Then, the auditor will review the financial statements from the agreed upon time period for review. 

Internal Controls

Next up, the auditor will want to take a look at the internal controls of an organisation. This involves checking the records and witnessing the financial processes in action. This is an imperative step for the auditor to be able to provide his or her opinion.

Testing

To see if the organisation’s internal controls are working or not, an auditor performs a test. The evidence gleaned from seeing the processes in action allow the auditor to determine whether or not the organisation is acting in line with GAAP. 

Reporting

The last step of the audit results in a report, which is a conclusion of whether or not the organisation is in adherence with GAAP. The auditor concludes with: an unqualified opinion, qualified opinion, disclaimer or adverse finding. The best case scenario is to receive an unqualified opinion, which is basically just an approval that all is being done properly. 

Financial Audit vs. Review

When hiring out for a financial audit, it’s important to note that CPA firms can perform different types of services. Organisations can choose from:

  • Compilation: A compilation is simply the preparation of an organisation’s financial documents. 
  • Review: A review provides “limited assurance,” in which a less comprehensive version of an audit is performed. This is a more cost effective choice to perform than a full scale audit. The review will report on the financial statements’ plausibility. 
  • Audit: An audit is the top-of-the-line legal requirement which provides an organisation with “reasonable assurance.” The audit can pinpoint material misstatements and can be used to identify fraud. 

Financial Audit Checklist

Financial audits don’t have to be stress-inducing. With the right amount of preparation, you can get through it without hassle. Review this checklist before getting started on your next audit:

  • Accounting Practices: The most integral thing you can do to ensure that financial audits run smoothly is to implement proper accounting standards and processes within your organisation, year-round. By doing this and also checking processes on a regular basis, it becomes easier to identify areas for improvement and nip potential issues in the bud. 
  • Financial Information Review: When an external auditor is hired to review statements, it’s helpful if your team is involved to help clear up questions or address potential mistakes. Automation software can make this a seamless process by providing audit trails and storing all data in a centralised location for easy review. 
  • Compile Documents: Before the audit begins, work like a French chef and have everything prepared in advance. By compiling all documentation, it makes the auditing process more efficient as everything will be easily traceable. 

Wrap Up 

Financial audits are an inherent aspect of running a business. Given the fact that finance teams have a lot to manage, an audit shouldn’t be a point of concern. When processes are in place, the right technology is being used, and there’s internal control, an audit can become an opportunity for improvement rather than a cause for concern.