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 assets from theft.
One key control is an audit, specifically an internal audit. Use this discussion to understand what an audit is, and why creating an internal audit function is important for your business.
Table of Contents:
What Is an Audit?
The results of an audit are reported in a written audit opinion, and the language in the opinion defines an audit.
During audits, CPAs analyze your accounting records and study the documentation for your transactions. After finishing this research, the CPA issues an opinion. If he likes what he sees, he’ll give you an unqualified opinion. This means that he believes that 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. In this context, the word “material” means an error or missing information that is large enough to impact the reader’s opinion of the financial statements. 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 states that the financial statements were prepared in accordance with these rules.
- Internal controls: Finally, 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 assets from theft. If these 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. An audit is performed to provide a higher level of financial assurance to stakeholders.
Important Differences Between Audits
It’s important to understand the difference between external and internal auditors, because they each serve a different purpose.
A CPA firm performs an external audit, and the accounting firm must be independent of the business under audit. Independence means that the only compensation that the CPA firm receives is the fee for the audit, and the CPAs 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.
An internal auditor, on the other hand, is a company employee, and these auditors are not independent. Internal auditors perform many of the same procedures that external auditors complete. In fact a CPA firm may rely on some of the work performed by internal auditors.
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.
To illustrate now an internal audit is performed, assume that Treeline Furniture is performing audit procedures on its $5 million inventory balance as of May 31st. Treeline manufactures furniture and stores finished goods in a warehouse.
Financial Statement Connections
Broadly speaking, and auditor performs test work on each account in the balance sheet. The balance sheet includes assets, liabilities, and equity, and each account has a unique set of procedures.
By auditing the balance sheet, the auditor also covers accounts in 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).
Why Assertions Are Important
The goal of an audit is to fully address audit assertions, which are claims made by management. Here are the five types of audit assertions, and how each assertion relates to Treeline’s inventory balance:
- Existence: Management is asserting that the $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 rights assertion applies to inventory. Treeline asserts that it owns all $5 million in inventory. Specifically, Treeline purchased all of the raw materials used to manufacture the furniture, and none of the items in inventory have been sold. Obligations, on the other hand, apply to liability accounts.
- 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.
Do You Use a Checklist?
The internal auditor will use an audit program to audit inventory, and you can find examples of audit programs online. The program takes each audit assertion and lists the procedures that should be performed to address the assertion. You can 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. The auditors will print the detail 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 completed, 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 procedures that auditors perform:
- 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 rights assertion.
- 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. The board is responsible for hiring and evaluating the performance of senior management.
This structure ensures that management is held accountable for any financial statements errors or internal control weaknesses, and that the auditors don’t report to management.
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 their 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 can write checks and also reconciles the checkbook, you 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 statements accuracy, improve your internal controls, and reduce the time spent with external auditors.