Accounting statements, especially in large and complex organizations, can contain unintentional errors as well as misrepresentations. To avoid such inaccuracies, internal as well as external experts periodically audit the books of large organizations. This independent verification reassures both investors and management that the accounting statements are accurate, and allows key stakeholders to make better decisions about the firm.
Definition of Auditing
Auditing is the process of independently verifying the accounting entries and resulting financial statements of a business or other organization. Both for-profit corporations and non-profit organizations are subject to audits. Accountants may devote their entire careers to becoming experts in auditing, tending to specialize in specific industries. Auditing is dependent on industry as the errors that can creep into financial statements of an organization relate to the types of activities in which it specializes. For example, a petroleum refiner and supermarket chain require different approaches, as their inventory and sales practices are different. A specialized body known as the U.S. Government Accountability Office audits governmental agencies.
When auditing an organization, the auditor works with random samples. For example, in a supermarket chain with 100 stores, it is impossible to check if every store's records accurate reflect inventory levels. Instead, the auditor may visit a particular store, without revealing the precise outlet until the last moment. The auditor, or team of auditors for large outlets, may spend days counting inventory levels and checking them against the most recent records to ensure that the accounting records accurately indicate such information as total amount of inventory, expired products and the speed of inventory turnover.
Internal vs. External
An auditor can be an employee of the audited organization or an outsider. Internal auditors will usually have slightly different priorities than external auditors. In addition to ensuring the accuracy of financial statements, an internal auditor will assess other issues such as the quality control practices of the firm. The internal auditors of a supermarket chain, for example, may also check if the warehouse manager is doing everything he is supposed to in order to minimize spoilage. An external auditor, on the other hand, may not examine such details as long the books accurately reflect such information as the amount of expired products. Internal auditors usually adhere to strict ethical standards and operate fully independently of the accountants of the firm.
Audited financial statements allow managers to make confident business decisions. When the sales department marks down prices to move a significant amount of product in a short time, it wants to be sure that the warehouse actually has as many units as it has stated in the weekly report. Investors also can make better decisions about the firm when they have faith in the profit and loss statements. Especially in highly competitive industries, poorly audited firms could misrepresent figures to look better than they actually are. Finally, the auditing of governmental bodies minimizes the loss of taxpayers' money through mismanagement and allows policymakers to make optimum use of public funds.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.