What Is Auditing? Definition, Types & Importance

What Is Auditing? Definition, Types & Importance

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Table of Contents

Auditing originates from the Latin term “Audire”, which means “to hear,” - just as in ancient times auditors used to listen to officers and people of authority to confirm the validity of their words. Over the years, the role of auditing evolved to verifying written reports: specifically, the financial records of individuals and businesses.

By definition, auditing is an official inspection and verification of the credibility of financial reports. Audits can be conducted by either a business’s management as an internal control process or by the government, in case they notice suspicious financial activity.

In this guide, we’ll be explaining what auditing is, why it’s so important, the different types of audits, and everything else you need to know about auditing for your small business accounting.

Read along to learn about:

What Is Auditing?

Auditing, or a financial audit, is an official examination and verification of a business’s financial records.

The main goal of auditing is to make sure that a company’s financial statements are accurate and are following regulatory guidelines. Auditing also gives investors, creditors, and other stakeholders reasonable assurance that they can rely on a company and its integrity.

Now, it’s important to note that auditing doesn’t provide a complete guarantee that every digit recorded in a company’s financial reports is accurate. Auditors work within a specific, reasonable margin of error known as materiality. The volume of materiality depends on the size of the company and its reported revenue and expenses.

For small businesses, an accounting error of a few thousand dollars might be significant, but for a large corporation like Apple or Amazon, such a material mistake may be considered as a conventional mistake and not a cause for concern.

Want to learn how to correctly manage and prepare your financial reports? Head over to our guide on financial reporting for small businesses.

The Importance of Auditing

Credibility and Reliability

With an internal auditing system, your business can create accurate and reliable financial reports through which you can gain insights on which segments or product lines are performing best and how to properly allocate resources. Additionally, regular auditing will make your shareholders trust that your accounts are true and fair and that it’s safe to invest in your business.

Preventing Fraud

If the government audits your financial statements and finds that your business has been manipulating its financial health, or hiding revenue and losses, you’ll likely deal with severe fees and legal punishments. Your business will also acquire a bad reputation, and you will most likely lose reliability in the eyes of your customers and stakeholders.

Recurring internal audits by a professional auditor or accountant of the company play an important role in detecting these fraud cases before they become substantial and problematic. Having a rigorous auditing system set in place alone prevents and scares employees or vendors from attempting a scheme to defraud your business in the first place.

Main Types of Auditing

Depending on who performs financial audits, we categorize audits into three main categories: internal, external, and government audits.

1.  Internal Audits

An internal audit is an audit performed by a qualified auditor or accountant who is part of your company. This audit helps assure your business is in compliance with laws and regulations and is accurately recording financial information. Regularly performing these internal audits also ensures risk management and guards you against possible issues such as fraud, waste, or financial abuse.

You can conduct these audits on a weekly, monthly, or annual basis, depending on the circumstances and the agenda which best suits your business demands.

You have to identify which department you wish to audit first during these internal audits. Next, the chosen auditor will collect as much information on that department’s internal control process, and conduct fieldwork testing. Once the evaluation is completed, the auditor will prepare an official auditor’s report, follow up with management regarding any issues found, and suggest possible solutions.

2.  External Audits

An external audit is an audit of your financial statements made by an independent, third-party professional. These types of audits can be extremely helpful as they’re more unbiased and reliable than internal audits.

External auditors can be candid and honest about the issues found during the audit, without affecting daily work relationships within the business. Key responsibilities of an external auditor include planning and implementing audit procedures, examining accounts and financial statements, analyzing business risks, preparing an audit report, and discussing the end conclusion with the management department of their client.

3.  IRS Audits

Internal Revenue Service (IRS) audits, or tax audits, are government reviews conducted to a business to ensure that financial data has been reported in compliance with tax laws.

Sometimes, IRS audits are conducted randomly, but more often than not IRS selects businesses based on suspicious activity, such as unusual deductions or uncommon sources of income. If you’re selected, the audit will either be conducted by mail, at the IRS offices, or in your business field.

Mail audits are documentation requests from the IRS that you will receive and send via email. Office audits consist of in-depth, in-person interviews where IRS agents review your tax returns and examine all relevant information to legitimize your financial reporting. Field audits within your business premises are similar to office audits, but the IRS agents will also make assessments based upon your business place and the processes occurring there.

5+ Auditing Tips

  1. When conducting an internal audit, make sure that you have a clear goal about what you’re looking to achieve. Ask yourself why you’re conducting the audit, and what actions you’re going to take depending on the result.
  2. Internal auditing involves reviewing a huge pile of information. To avoid wasting time, prioritize processes that require immediate auditing, based on the audit’s goal.
  3. Make sure you’ve claimed valid business deductions. Keep all of your expense receipts, and don’t mix up your expenses as business deductibles.
  4. Know your accounting cycle. The accounting cycle is the multi-step process that analyses and records your financial data, and translates them into financial statements. By following it accordingly, you’re keeping accurate, up-to-date journal entries of your transactions, complying with federal regulations, and avoiding government audits.
  5. Use the right tools. A great way to do this is by streamlining your processes with cloud-based accounting software like Deskera. With Deskera, you can automate most of your accounting tasks like journalizing transactions, calculating payments, or generating financial statements. Say goodbye to most of your typical accounting errors, eliminate fraud, and fear nothing in case you’re ever audited by the government. Try the software out yourself right away, with our completely free trial.

Auditing FAQ

#1. What Does an Auditor Do?

Auditors are specialists who evaluate and review your company’s finances to make sure they’ve been kept accurately and comply with legal requirements. Auditors can also act as advisors and suggest risk management or cost-saving actions.

#2. What Triggers Tax Audits?

Some of the main reasons why the government conducts tax audits include math errors, failing to report a part of your income, claiming a lot of charitable donations, deducting too many business expenses, and more.

#3. What Happens During an IRS Audit?

There are three resolutions to an IRS audit: agreement, disagreement, or no change.

By agreeing, you confirm that changes need to be made and agree with the proposed amendments made by the IRS agents. By disagreeing, you do not accept the proposed amendments and as a result, you can either choose to file for an appeal or discuss a dispute mediation. In case there’s no change, your information is examined, reviewed, and confirmed, and nothing will happen.

Key Takeaways

And that’s a wrap!

Here’s a quick recap of the main points we’ve covered:

  • Auditing is the process of reviewing and confirming your financial reports.
  • Audits verify that you’ve created accurate and reliable financial reports and that no fraudulent activities are happening within the business.
  • There are three main types of audits: internal, external, and government or IRS audits.
  • Internal audits are made by qualified auditors within the business, external audits are conducted by external third parties, whereas government audits are tax reviews by the IRS.
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