As your company grows from a small operation into a larger business, you need to put more controls in place to monitor your finances and protect your assets from theft. One key control is an audit, specifically an internal audit. It’s time to understand what an audit is, learn why creating an internal audit function is important for your business, and pick up some best practices along the way.
What is an audit?
For starters, there are two types of audits: external audits and internal audits. External audits are performed by independent CPA firms, while internal audits are performed by company employees. Both external and internal audits use similar procedures.
In general, an audit is a set of accounting procedures used to determine whether or not the financial statements are free of any large errors, called “misstatements.”. The results of an audit are reported in a written audit opinion, and the language in the opinion defines the audit.
During audits, certified public accountants (CPAs) analyze your accounting records and study the documentation of your transactions. After finishing this research, the CPAs issue an opinion. If they like what they see, they’ll give you an unqualified opinion. This means that they believe your financial statements comply with generally accepted accounting principles in all material respects.
An auditor reports on several topics:
- Financial statements: An auditor reports whether or not the financial statements are free of material misstatement. An audit is designed to identify financial statement errors.
- Regulatory requirements: The financial statements must be prepared based on a set of accounting rules. For-profit businesses in the U.S. must use Generally Accepted Accounting Principles (GAAP), while governmental and not-for-profit firms use different sets of accounting rules. The audit opinion says that the financial statements were prepared in compliance with these rules.
- Internal controls: Most audits require an auditor to assess the effectiveness of internal controls. These controls are put in place so that the business can produce accurate financial statements and prevent the theft of assets. If there are weaknesses in any internal controls, the auditor must disclose the weaknesses.
Stakeholders, such as investors, creditors, and regulators, rely on the accuracy of the financial statements. Audits are performed to provide a higher level of financial assurance to stakeholders. Also, if you’re a business in the United States, an internal audit can help you in the event of a tax return audit from the Internal Revenue Service (IRS).
Important differences between audits
It’s important to understand the difference between external and internal auditors, as they each serve a different purpose.
A CPA firm performs an external audit, and the accounting firm must be independent of the business being audited. Independence means that the only compensation that the CPA firm receives is the fee your business pays them for the audit. The CPA firm cannot perform tax, consulting, or any other work for the audit client. No individual member of the CPA firm can be an employee or a consultant of the business being audited.
An internal auditor, on the other hand, is a company employee tasked with the audit procedures. These auditors are not independent like a CPA. For example, an internal audit at your business could be performed by you, or a dedicated specialist that is employed by you. An internal audit doesn’t have to be performed by a third party.
Internal auditors perform many of the same procedures that external auditors perform. In fact, a CPA firm may rely on some of the work performed by internal auditors during the external audit process, which the independent CPA must then explain in his or her audit report.
An audit opinion from an external auditor is considered more reliable than work performed by an internal auditor because the CPA firm must be independent to issue an opinion.
Financial statement connections
Broadly speaking, an auditor performs test work on each account in the balance sheet. The balance sheet includes assets, liabilities, and equity. Each account also has a unique set of procedures to ensure accurate financial reporting.
By auditing the balance sheet, the auditor also collects audit evidence for the income statement and other financial statements. When you audit fixed assets (a balance sheet account), the procedures you perform also address depreciation expense on the assets (an income statement account). This process allows the auditor to track the value of a fixed asset and the amount of depreciation expense recognized for the asset. For example, if your office has computers, those are assets that will lose value over time. The decline in value is posted to depreciation expense.
Why assertions are important
The goal of an audit is to fully address audit assertions, which are claims made by management. For clarity’s sake, let’s pretend there’s going to be an internal audit at the company Treeline Industries. Here are the five types of audit assertions, and how each assertion relates to Treeline’s inventory balance:
- Existence: Management is asserting that $5 million in inventory exists and is located in the warehouse as of May 31st.
- Completeness: The detailed inventory listing includes every physical inventory item that makes up the $5 million balance. The inventory listing must be complete.
- Rights and Obligations: Since inventory is an asset account, the obligation and rights assertion applies to inventory. Treeline asserts that it owns all $5 million in inventory, and that the company purchased all of the raw materials used to manufacture the furniture, and none of the items in inventory have been sold.
- Valuation: Treeline’s valuation of each inventory item is based on original cost. There are several methods used to value inventory, and original cost is the most frequently used method.
- Presentation and Disclosure: The company has disclosed the valuation method used to value inventory. Also, Treeline must disclose any obsolete inventory that has been written off as an expense. Since obsolete inventory cannot be sold, it must be reclassified into an expense account.
The internal auditors will design procedures to address each of the audit assertions.
How to verify assertions
External and internal auditors rely heavily on software to perform audit procedures. Assume, in this case, that an internal auditor is auditing the inventory balance. The program takes each audit assertion and lists the procedures to be performed by the business to address the assertion. Think of an audit program as a checklist.
For example, to audit the existence assertion for inventory, the internal auditor will perform a physical count of inventory items — preferably on May 31st if we’re going back to the example claim from earlier. The auditors will print the detailed inventory listing and verify that each physical item is in the warehouse. If the listing includes 30 maple dining room tables, for example, all 30 of the tables must be identified in the warehouse.
Once the physical count is complete, the auditor will review the inventory listing to ensure that each inventory item was located. Any items on the listing that were not found will be removed from the inventory records. The inventory count also addresses the completeness assertion, because the process ensures that the listing is complete.
Here are some other areas auditors check during an audit of the balance sheet and income statement:
- Cash: The auditor will review the bank statements and the bank reconciliation to verify that the ending balance in cash is correct as of May 31st.
- Fixed Assets: An auditor will review the title for large assets, such as machinery and equipment to ensure that the company owns assets. This procedure addresses the assertion of the right.
- Long-term debt: Auditors compare the loan balance, interest rate, and maturity date listed in the accounting records to the lender’s statement. This step confirms that the long-term debt balance is correct.
Once an internal auditor completes every step in each audit program, the audit is complete. The internal auditor provides the results of the audit work to the board of directors. To ensure independence, the external auditors report to the board, and not to company management. This structure ensures that management is held accountable for any financial statement errors or internal control weaknesses.
Creating an internal control department is time-consuming and expensive, but your business will realize some big benefits. Internal auditors can reduce the amount of time and money you must pay a CPA firm to complete an external audit. If your internal audit staff is well trained, the CPA firm can rely on their work and reduce the hours spent on your audit.
Internal auditors can also identify procedures that can be improved. If, for example, you generate invoices using an outdated software system, an auditor can point out flaws in the system and recommend a new system to increase accuracy.
Most importantly, internal auditors can test your procedures to prevent theft. If, for example, a single employee writes checks and also reconciles the checkbook, your firm is at risk for theft of cash. The internal auditor can recommend new procedures to separate those two duties and reduce the risk of theft.
Hiring internal auditors can help you increase financial statement accuracy, improve your internal controls, and reduce the time spent with external auditors. Internal auditors are there to help you, the business owner, so think of them as an investment and not a cost. Also, an experienced internal auditor can ensure you’re keeping all of your finances and expenses in order, which is especially helpful in the event of a tax return audit from the IRS.
Stay audit-proof all year
Audits seem daunting at first. The prospect of going through your entire inventory and combing through your finances is no small task. Still, the time and effort that goes into an audit pales in comparison to the cost of missing inventory. If possible, hire or train someone internal as your auditing specialist. Stay vigilant and always do your best to ensure inventory is being accurately tracked.
No matter the size of your business, audits are an essential element of success. Stress the importance of accurate inventory tracking to your employees, lead by example, and everything will work out just fine. Before too long, you and your business will be an audit-proof testament to the merits of accurate inventory. Now that’s a title to put on a name tag.