What is an Audit of Records?
Have you ever pulled up your personal finances, only to find that something doesn’t add up? As you go back through and check each individual transaction to find the mistake, you’re actually performing an audit of records. For larger companies, the process is much the same. An audit is an examination and evaluation of an organization’s financial records and statements, to inspect and verify transaction accuracy.
Audit has a bad connotation attached to it because it’s associated with the Internal Revenue Service (IRS). Most companies “under audit” by the IRS have a reason to be—a red flag went up somewhere in their accounting. That said, an audit isn’t a bad thing. In fact, it’s a good practice that can set mistakes right and save individuals and companies a lot of financial headaches down the line.
The Practice of Auditing
Audits are an objective process. In some cases, they’re performed because there’s a problem with the books, but the origin of the problem isn’t known. In other cases, auditing is proactive—the means to prevent future accounting errors. Nevertheless, the mission is the same: to ensure all records are fair and accurate representations of the transactions they represent.
On a fundamental level, auditing is a systematic review of ledger transactions. For companies following double-entry accounting standards, it means verifying the presence of both entries as funds flow through the company’s books. If transactions match up on both sides of the ledger, they’re verifiable. If there’s only a single entry or the entry falls off, it’s the purpose of the auditor to catch and remedy it.
At the end of an audit, the auditor should be able to verify that the records are complete and accurate. If that’s not the case, the company needs to remediate its books—usually with the help of the auditor or an independent accountant.
Three Types of Audits
Audits can take different forms, depending on the scope of the evaluation or the nature of the situation. We’ve already mentioned IRS audits, and there’s also external and internal audits to consider.
- IRS audits. The implication of an IRS audit isn’t just that there are inaccuracies in the accounting, but that they might be the result of willful ignorance or, worse, fraud. For companies, IRS audits signal impropriety, which is why these audits are such a big deal.
- External audits. Public companies need to have their books audited once per year by an external, independent accounting firm. This ensures accuracy and propriety for all reported financials. For large companies, audits are ongoing.
- Internal audits. Internal audits are self-checks by a company to ensure accounting best practices in day-to-day operations. These audits also cover operational practices, such as dispersing petty cash or handling inventory.
The purpose of these audits is the same: to certify the accuracy of financial transactions and records.
Who Performs an Audit?
The person or entity performing the audit depends entirely on what kind of audit it is. For example, forensic accountants will typically perform an IRS audit because of the implication of obfuscated accounting. External audits need to happen via a third party. As a result, many public companies keep an accounting firm on retainer to handle the consistent and ongoing auditing demands of the organization. A company may have internal auditors as well, such as a CPA or controller. These individuals are capable of reviewing the ledger for routine audits.
When it comes to public financial statements, independent auditors will usually include their opinion with an audit report. There are four different types of audit reports that investors should pay attention to:
- Unqualified. If the opinion is clean, it means the auditor hasn’t found anything suspect or misstated during their review of the company’s financials.
- Qualified. These opinions tend to mean that some aspect of a company’s accounting isn’t GAAP-compliant, but doesn’t appear to offer any misrepresentations.
- Adverse. If an auditor finds gross misrepresentation of financial statements during an audit, they’ll issue an adverse opinion. It’s an indicator of fraud.
- Disclaimer. In the absence of complete financial records, auditors may issue a disclaimer. This doesn’t indicate wrongdoing—rather, an incomplete audit.
Most audit opinions for public companies are unqualified or, occasionally, qualified. Adverse audits tend to follow news of an IRS investigation.
What are Audits Used For?
The clear and present purpose of an audit is to identify mistakes in a company’s financial records and correct them accordingly. But while this is the core function, it’s not the only thing they’re used for.
Internally, audits help companies to correct processes and procedures that led to the mistake. Audits identify where controls failed and help companies institute new ones. It’s also an opportunity for the company to practice good housekeeping of its financial records before handing them over to third-party auditors.
Externally, audits are proof of the accuracy of reported figures. For investors, an audit verifies the company’s financial claims as true, which allows them to make informed decisions about whether to invest in that company. It’s why the Securities and Exchange Commission requires external audits.
Where to Find an Auditor’s Report
Interested in reviewing the most recent audit for a company you’re thinking of investing in? You’ll find the auditor’s report in the company’s Form 10-K (Section 8). Moreover, when a company decides to hire an auditor or switch firms, it must announce this information in Form 8-K (Item 4). These are the first places investors should check for auditor information. They’ll yield valuable credence to the financials you’ll inevitably look at to judge a company’s investment potential.
In fact, this is vital to making sure you are investing in assets that meet your specific goals to building wealth. For more daily investing analysis and insights, sign up for the Liberty Through Wealth e-letter below.