What it means
Management prepares the financial statements, but readers need to know whether to trust them. An audit provides that assurance by having an independent professional test the figures and the processes behind them.
The auditor does not prepare the accounts and is not responsible for the company's day-to-day decisions, and must remain independent of the people whose work is being checked. The auditor starts by understanding the business and assessing where mistakes or fraud are most likely.
They then test samples of transactions, confirm balances with banks and customers, attend stock counts and review estimates such as provisions. Concepts such as materiality, which means the size of an error that could change a reader's decision, guide how much testing is needed.
At the end, the auditor issues a report. An unmodified or "clean" opinion says the statements fairly present the company's position, while a qualified opinion points to a specific problem.
In serious cases the auditor may disclaim an opinion or give an adverse opinion, which can alarm lenders and investors. There are different types, and an external audit is carried out by an independent firm, often required by law for larger companies, listed businesses and some others.
An internal audit is done by the company's own team to test controls and risks, and it reports to the audit committee. There are also tax audits by the authorities and specialised audits of areas such as IT systems and compliance.
An audit gives reasonable assurance, not a guarantee. It cannot guarantee that every error or fraud will be found, since it relies on sampling and judgement.
Even so, an audited set of accounts carries far more weight with banks and buyers than unaudited figures. Audits also create value beyond the opinion.
Auditors often issue a management letter that points out weaknesses in controls, such as poor segregation of duties or missing reconciliations. Acting on these recommendations reduces the risk of future errors and fraud, and many finance teams treat the letter as free advice.
In practice
Real-world examples
Example 1
A family-owned manufacturer applies for a $2,000,000 bank loan. The bank asks for audited accounts for the last three years, because it wants independent assurance on the profit and debt figures.
Example 2
A software company preparing to be listed on a stock exchange appoints an audit firm to review two years of records. The auditors find that revenue on multi-year contracts was recognised too early, and the company corrects it before publication.
Example 3
A retail group's internal audit team visits ten stores to test cash handling. It finds that two stores do not reconcile their daily takings, and the audit committee orders new procedures to be adopted across the chain, with the team returning three months later to confirm they work. The chain's finance director later reports the progress of those changes at each audit committee meeting.
Think of it
An audit is like a home inspection before buying a house. An independent expert reviews everything to make sure there are no hidden problems.
Case study
Seen in the real world
Northgate Furniture is an illustrative, fictional company that had grown quickly and asked its external auditors to examine the year-end accounts for the first time. Management expected a routine exercise.
During the stock count the auditors found that $400,000 of inventory had already been sold but was still on the books. They also noticed that a few large sales had been recorded in December although the goods shipped in January.
The accounts were corrected and profit fell by $250,000, which the lender noted before extending a new credit line. The management team had to explain the cut-off errors to the board, and the company hired a stock controller before the following year end. The illustrative story shows how an audit can catch errors that management, busy with growth, had not noticed. The finance director also acted on the auditors' management letter by introducing a monthly stock reconciliation, and the following audit finished two weeks earlier than before.
Watch out
Common mistakes
- Believing an audit guarantees the accounts are completely accurate, when it provides reasonable assurance based on testing and judgement.
- Assuming the auditor is responsible for preparing the accounts, when this is the duty of management and the directors.
- Confusing external and internal audit, when the first gives an opinion to outsiders and the second helps management improve controls.
Questions
People also ask
Does every company need an audit?
Not always, since the requirement depends on the country, the size of the business and whether it is listed or has outside investors, although many small businesses choose a voluntary audit to reassure lenders.
What does a qualified opinion mean?
It means the auditor found a specific problem or limitation, but the rest of the statements are otherwise fairly presented.
How long does an audit take?
It depends on size and complexity, from a few weeks for a small company to several months for a large group, and timing is usually agreed with management in an engagement plan before work starts.
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