Audits can take many forms, but they generally follow time-tested accounting practices. At the onset, auditors look at a company's records to identify problem areas where a potential exists for material misstatements of the financial statements. The auditors test management's assertions by using a number of auditing procedures.
TL;DR (Too Long; Didn't Read)
Audit procedures include vouching, tracing, observation, inspection of tangible assets, confirmation, recalculation and use of analytical procedures.
What Is the Purpose of an Audit?
The purpose of an audit is to provide an independent opinion about the accuracy and fairness of a company's financial statements, processes and procedures. It confirms that records are prepared in accordance with proper accounting procedures, such as generally accepted accounting principles, and reports any exceptions.
An objective analysis of the financial statements enables management, investors, creditors and lenders to have more confidence in the truthfulness and reliability of the company's reports.
The end result is to give an unbiased opinion as to the validity of the company's financial statements and to provide reasonable assurance that the financial statements do not contain any material misstatements.
What Are the Audit Objectives?
The primary objectives of an audit are as follows:
- Investigate the accuracy of internal controls.
- Verify the mathematical correctness of accounts and balances.
- Validate the authenticity of transactions.
- Assure the proper classification of capital and revenues.
- Check the existence and valuation of assets and liabilities.
- Confirm that the company is in compliance with all rules and regulations.
Secondary objectives of an audit are the following:
- Examine and create systems to prevent errors. These include errors of omission, deliberate errors and errors in application of accounting principles.
- Focus on ways to detect and prevent fraud. Construct systems to deter theft of cash or goods and falsifications of accounts.
- Determine over- or under-valuation of stock.
- Provide correct information to tax authorities.
What Are the Different Types of Audit?
The different types of audit are as follows:
Compliance: Compliance determines if the company is complying with relevant government regulations and company policies, for example, ensuring that the firm is in compliance with the indenture terms of a bond and verifying that the calculations and payments for a royalty agreement are correct and being met on time. Other concerns include: Is pay for workers' compensation being properly recorded? Is the business meeting EPA regulations required for proper waste disposal?
Construction: Construction reviews aspects of a project to ensure they are following the terms of the contract. Construction costs have a tendency to spiral out of control. Audits keep watch on costs and enforce controls and verify that project managers are doing their jobs properly. It makes sure that time lines and completion dates are being met and reviews safety procedures for employees.
Financial: Financial focuses on the accounting and reporting of financial transactions and examines receipts and disbursements of funds. Is the information correct and entered according to the appropriate accounting principles? Do adequate controls exist for cash accounts and other liquid assets?
Information: Information analyzes a company's computer systems, networks and databases and looks for potential internal and external security threats. The company's backup systems and ability to recover from computer viruses, power outages and natural disasters are also checked.
Investigative: Investigative checks for evidence of criminal activities such as fraud, money laundering, bribery or misuse of assets and anything that could lead to civil lawsuits or criminal charges. Auditors sometimes conduct covert operations to hide their investigations from the targets suspected of wrongdoing.
Operational: Operational audits analyze a company's planning processes, operating procedures and goals. The objective is to determine if the company's operations are in line with its goals and if they are accomplishing its objectives. The results could have recommendations for improvement.
Tax: The analysis of tax returns makes sure that the information is correct and the tax paid is fair. Tax audits are usually triggered when tax returns show unusually low tax payments.
What Is the Process of an Audit?
Assertions are claims made by management about the various aspects of a business. They fall into three areas: transactions, account balances and presentations and disclosures. Auditors verify the accuracy of these assertions by carrying out a series of auditing procedures.
Occurrence: Occurrence verifies that all the transactions that the company claims to have occurred actually did occur. For example, if a company is claiming a sale, auditors look for supporting documents that show the customer actually ordered the merchandise and that the shipment was made.
Existence: Do the assets exist? Auditors physically locate an asset to confirm its existence or watch employees taking inventory counts to verify that inventory exists.
Accuracy: Are transactions being recorded in the full and correct amounts without errors?
Valuation: Are the assets and liabilities recorded at the proper valuations? Valuation considers an example of marketable securities, checks current market prices and compares with values recorded on the company's books.
Completeness: Completeness makes sure that all transactions are recorded and nothing is missing, for example, looking through the bank statements to see if any payments to suppliers were not recorded. Are all cash receipts from customers recorded? Also, managers and third parties may be interviewed to find out if the company has made additional commitments in contracts and liabilities that are not recorded.
Cut-off: Cut-off checks to see if all transactions are recorded in the correct reporting period, for example, reviewing shipping documents to see if shipments made on the last day of the month are recorded in the correct period. Another example involves goods and materials delivered in a sale before the end of the fiscal year that should be recorded as an expense in cost of goods sold and not remain in inventory. Recording a sale in one period but reporting the related expense in the next period will overstate income.
Rights and obligations: Does the company legitimately own its assets? For example, does the company own its inventory or is it on consignment and owned by a third party?
Classification: Classification determines whether transactions are classified correctly. For example, the purchase records for fixed assets are reviewed to find out if they were recorded in the appropriate fixed asset account. Also, is revenue recognized as current income and not deferred sales?
Presentation and disclosure: All components on the financial statements must be properly described, classified and disclosed. For example, the method of inventory valuation, LIFO or FIFO, must be disclosed in the notes. Loans to related parties, like employees, must be stated separately and not buried in accounts receivable. Contingent liabilities should be explained since these are debt obligations that are not included in liabilities.
What Is an Audit Procedure?
Auditors have procedures that they use to determine the integrity of the financial reports and assertions made by their clients. The specific procedures used are different for each client. The choice of procedures depends on the nature of the business and the assertions that the auditors need to validate. Audit procedures include:
Vouching: Vouching is an inspection of supporting documents, such as copies of invoices to customers, shipping documents, bank statements, purchase orders, vendor invoices and receiving reports. Auditors' concerns are an overstatement of assets or exaggeration of revenues. Vouch down from financial statements to confirm existence.
Tracing: Tracing is different from vouching. This procedure arises from an auditor's concerns that some liabilities may be understated or that certain expenses have not been recorded on the income statement. Trace upward from the source documents to confirm completeness on financial statements. Auditors take source documents and trace them up to make sure the items are recorded on the financial statements.
Inspection of tangible assets: A physical examination of tangible assets is taken to confirm their existence.
Observation: Auditors observe staff taking inventory and the methods of counting and notice if the employees are conducting the counts accurately.
Inquiries of personnel: Not all investigations involve documents. Take the collection of accounts receivable, for example. The auditor discusses the likelihood of collecting the accounts receivable with the credit managers. There are no documents to record this probability. Opinion of collectability is based on the results of those discussions.
Confirmation: The auditor confirms account balances, such as accounts receivable and cash, with an examination of documents and contacts customers to get their acknowledgement of the debt. They also confirm amounts of liabilities and terms of repayment with third-party lenders.
Recalculation: The auditor recalculates certain transactions to find out if any differences exist between the client's work and the results from the audit. An example would be to recalculate the depreciation expense. Another example is to recalculate the monthly salaries of employees and make sure the net amount paid to each person is correct.
Reperformance: This is a testing of internal controls, for example, going through the process of recording a sale, posting an invoice to sales and accounts receivable or removing materials from inventory to account for cost of goods sold. The auditor compares his work with the process used by employees and looks for any discrepancies.
Analytical procedures: The auditor compares one period to another and looks for changes. Analytical procedures are used during the planning stage to identify areas for risk assessment. At the planning stage, the auditor is looking for those areas where there is the possibility of misstatements. For example, if the auditor notices that sales are going down but accounts receivable is going up, that is not a normal relationship. This anomaly should be investigated. The company could have a collectability problem with accounts receivable.
Audit Procedures Examples
Audit procedures are applied to test and validate management assertions, as shown in the following examples.
Existence: Auditors can verify the existence of inventory by taking an independent physical count, or they could observe company staff taking inventory. Vouching can be used to match inventory to purchase documents. An analytical calculation could be done to compare inventory turnover to cost of goods sold and see if the ratio makes sense.
Valuation: A physical inspection could be performed to look for old and obsolete inventory that should be written off. A recalculation would reveal the accuracy of product costing methods. Is the company using activity-based costing or plant-wide allocation of overhead costing? Employees could be asked how they do product costing to arrive at a valuation. An analytical procedure could be used to identify slow-moving stock by calculating inventory turnover.
Completeness: Is every piece of inventory in the warehouse recorded in the financial statements? The most common approach here is tracing, not vouching. For the completeness assertion, analytical procedures are used and comparisons are made between how much should be in inventory and how much is actually in inventory. Inventory items are traced to inventory records.
Rights and obligations: Does the company actually own the inventory? Raw materials are checked. Who owns raw materials? Talk to the purchase manager and employees involved in production, and send positive confirmations by mail to the suppliers. When does the company own the merchandise: at the time of shipment or after payment? The audit may vouch inventory items to documentation showing when goods were delivered to the company and examine supplier contracts to determine when the buyer takes ownership of the delivery.
Allocation: Allocation examines current assets and noncurrent assets, making sure that everything is a current asset for inventory and is not old and obsolete. Either tracing or vouching procedures can be used to classify assets for allocation.
Presentation and disclosure: Disclosures must be in accordance with accounting standards. The financial statement disclosures are reviewed, and personnel are asked how they make policy choices. The disclosures are compared with the financial standards required by normal accounting procedures.
It's not necessary to test all assertions, but the audit must have appropriate evidence to cover all relevant assertions.
James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company's operational, financial and business management issues. James has been writing business and finance related topics for National Funding, bizfluent.com, FastCapital360, Kapitus, Smallbusiness.chron.com and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.