What Is an Audit and Why Are They Necessary?

(Last Updated On: April 24, 2019)
What Is an Audit?

Every April, millions of people around the country are filled with dread as we enter the last month of tax season. It is do or die time – or in this case, it is more like do or get fined and possibly sent to jail time. But just because you end up filing your taxes, that doesn’t mean you’re automatically safe from any sort of repercussions. Even after submitting taxes, millions of people still wait with bated breath to see whether or not they are going to end up getting audited. But what exactly is an audit in the first place?

What Is an Audit?

Despite what many people think, audits are not just an excuse for the Internal Revenue Service (IRS) to find people to give fines to and arrest. They are actually an objective analysis of a person’s or group’s accounting records in order to confirm that the records are an accurate representation of the person’s or company’s financial situation.

These audits can be done internally or externally. Although the IRS does do a lot of audits every year, most of the country’s audits are done by private third companies. Having an external audit done at least once per year is part of every publicly traded company’s legal obligation.

Reasons to Have an Audit Done

When a company’s financial records are looked over by someone outside of the company, it can help to put the shareholders’ minds at ease. Other companies take this a step further and have monthly audits done all throughout the year to make sure that their records are continually accurate.

Companies that deal largely with cash will often complete daily audits in order to ensure that they have the proper amount of money on hand. Without these regular audits, it would be impossible to tell whether or not all of the money is where it is supposed to be.

When it comes to an individual’s own personal taxes, the IRS will conduct audits to minimize the “tax gap”. This is essentially the difference between what the IRS is owed, and what they actually receive. IRS audits can come at random, or they might select certain taxpayers based on any past suspicious activity.

The Types of Audits

As previously mentioned, audits can be done either internally or externally. Within each of these categories are subcategories of audits that determine exactly what the auditing process will look like.

For external audits, the auditor can either be a statutory auditor or an external cost auditor. Statutory auditors look at the financial reporting, and try to find any inconsistencies or mistakes. External cost auditors are tasked with looking at cost statements and sheets to determine whether or not there are any mistakes listed on them. Regardless of which type of auditor has been hired to do the work, external auditors follow their own set of standards that are completely independent of what the company’s standards are.

For internal auditors, there is technically only one category. However, consultant auditors can be seen as another possible type of internal auditor. Internal auditors are directly hired by the company that they are tasked with auditing, and works within their standards. They relay any information that they find to the company’s managers, board members, and stakeholders.

Consultant auditors are not actually doing their work internally, but they do use the company’s set of standards while doing their job. A company will generally hire a consultant auditor when they feel like they do not have the time or resources to audit certain parts of their operation.

Types of Audit Standards

There has been a lot of mention of standards so far, but no explanation of where these standards come from. Here is where we will break down the governing bodies responsible for establishing these standards.

As previously mentioned, internal audits follow the standards which are set by the companies themselves. Unless, of course, the company is public. In which case, the standards are set and enforced by the Public Company Accounting Oversight Board.

For external audits, standards can come from two different places. They will either be set by the American Institute of Certified Public Accountants (AICPA) or the International Auditing and Assurance Board (IAAB). National audits are done using the Generally Accepted Auditing Standards set out by the AICPA, whereas international audits are done using the International Standards on Auditing set out by the IAAB.

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