If you’ve ever known an accountant, then you’ve probably familiar with the term “audit,” but you may not understand exactly what it means. You probably know it involves finances, but it’s important to understand the different types of audits and how they could affect not only your business but also your own personal finances.
An audit is a process through which a company’s financial statements are examined objectively. Usually, the audit is performed by an external party such as a firm or the Internal Revenue Service; however, internal audits — or audits performed by someone within the organization itself — can help companies ensure transparency and preparedness.
The purpose of an audit is to ensure that all organizations are honest about their financial status. Many companies or organizations hire auditing services to perform audits because a third party audit is typically more reliable; internal audits run the risk of showing bias toward their own companies.
There are three different types of audits, and each is easily distinguishable from the others. Though they aim for the same general objective, each reaches the objective in a unique way. This can alter not only the reliability of the audit report but also the meaning of the results.
An internal audit occurs when a company asks one of its own employees to conduct an audit of that company. Since the person initiating the audit is part of the company instead of a third party organization, these audits tend to be viewed in a slightly different light. Rather than being a source of stress, these audits are more casual, as they will only be used for internal purposes. Information obtained in an internal audit goes directly to management — or, depending on the type of organization, a board of directors — so companies have direct control over who sees the results of the audit and what they choose to do with that information.
The purpose of an internal audit is, therefore, quite different from that of an external or government audit. Internal audits allow companies to ensure that they’re adhering to all standards and regulations. They force companies to reckon with any financial irregularities and maintain absolute transparency. Besides being a wise financial decision, this is an excellent way for companies to prepare for external and government audits. They can identify any flaws or inconsistencies within their companies and processes before a third party identifies them for them.
External audits are performed by third parties and do not primarily serve the company being audited. Instead, they objectively analyze a company’s financial statements for errors. Unlike internal audits, the results lack all potential bias and are therefore more useful to those, like stakeholders, who rely on businesses to have accurate financial statements.
Bias can work multiple ways, though. While some internal auditors show bias towards their own companies, some internal auditors who found questionable results were then met with an awkward situation: how to tell their peers that their financial documents weren’t up to par. External audits remove that potential bias, allowing a third party to more easily explain the sometimes harsh truth.
External audits provide a kind of confidence and security that is not provided by internal audits. Many rely on this information to make major financial decisions and therefore turn to external audits for more accurate answers.
When determining crucial data, such as an organization’s taxable income, the government takes control of audits. This information is often public, as taxpayers want to see that their time and money are going toward a worthy cause. For example, in the United States, the Internal Revenue Service (IRS) can conduct audits of all tax-generating entities. They examine tax returns and other financial documents for intentional or unintentional signs of fraud.
Just because a government entity can conduct audits, however, doesn’t mean it will conduct them. For this reason, audits tend to carry with them an aura of fear and stress. People and businesses often feel that if they are being audited, it is because they have done something wrong or the government believes they have done something wrong. This could not be further from the truth, as audits often occur as part of a routine audit lottery. This means the audits occur at random, with no link to actual or perceived wrongdoing. It is merely a safeguard to keep all businesses and entities honest and transparent.
Nevertheless, there are a few things that will catch the government’s attention and increase the chances of an audit, such as the following:
- Inexplicably high income
- Larger and more frequent donation amounts
- Higher number of claimed deductions
The results of a government audit primarily affect tax returns, but this does not have to be a cause for concern. Usually, entities with irregular financial statements are asked to adjust their tax returns to reflect inconsistencies found by the government, and this is sufficient action to address the error. This is obviously not always the case; intentional fraud, particularly, can leave bigger scars. Yet the average person has nothing to fear when it comes to a routine government audit.
Understanding the definition and purpose of auditing is important to any tax-paying entity. The three different types — internal, external, and government — each serve a different purpose. While internal audits help an organization improve its internal operations, external and government audits help identify financial inconsistencies and expose them for correction. Knowing this information can defuse the tension that surrounds the auditing process.