Financial Audit: Overview, and Best Practices

Internal Audit 101: This series explores the foundations of internal audit by industry, including basic definitions and concepts relative to auditors in specific sectors. 

What Is a Financial Audit?

A financial audit typically refers to the annual audit of an organization’s financial statements to ensure its records are a fair and accurate representation of the organization’s financial transactions. The financial statement audit looks to understand the financial performance of an organization to provide reasonable assurance of the future performance of a company.

Often based on GAAP standards, the audited financial statements are reviewed yearly by independent auditors and include the income statement, balance sheet, and cash flow statement. GAAP stands for the generally accepted accounting principles and determines the set rules and accounting standards for presenting financial information to stakeholders.

A financial audit can also include an audit of the organization’s internal control over financial reporting, which is commonly integrated with an audit of financial statements. 

Both internal auditors and external auditors can conduct financial audits. The biggest difference between external and internal audits is the objectivity and independence of the external audit firm’s opinion on the financial statements and internal controls audited.

Financial Audit versus IT Audit

While financial and IT audits both strive to enhance company transparency, their scopes are distinctly unique. A financial audit serves as a magnifying glass for financial statements, scrutinizing each detail for alignment with accounting laws and standards. It’s like taking a company’s financial pulse, making sure every heartbeat, or in this case, every transaction, is healthy and legitimate.

On the flip side, an IT audit takes a deep dive into the company’s technological veins. It assesses the infrastructure, policies, and operational aspects of the company’s information technology. It’s akin to a cyber check-up, ensuring the safety and effectiveness of the systems that process and safeguard the company’s crucial financial data.

The spotlight here is on data security, IT governance, IT infrastructure, and most importantly, the integrity of systems that crunch financial data. This demonstrates that while the realms of financial audits and IT audits may appear separate, they are intricately connected. They intersect at the critical juncture where financial data is processed, emphasizing the symbiotic relationship that exists between them in maintaining corporate health and transparency.

The History of the Financial Audit

Most companies receive a yearly audit of their financial statements to satisfy debt covenants to lenders. For publicly traded companies, financial audits are a legal requirement under the Sarbanes-Oxley Act (SOX) of 2002. In addition to requiring an audit of the company’s financial statements, SOX also requires public companies to receive an audit of management’s assessment of the effectiveness of the company’s internal control over financial reporting. SOX established the Public Company Accounting Oversight Board (PCAOB) to oversee the rules and standards for such audits. SOX audit programs can vary in maturity and status based on when the organization has gone public and whether or not the organization has undergone any updates to its SOX program since it was initially required in the early 2000s. Organizations planning for an initial public offering (IPO) will usually perform audit readiness activities to ensure they can meet SOX compliance once required.

The Backbone of Financial Audits: Generally Accepted Auditing Standards (GAAS)

When it comes to the bedrock of financial audits, Generally Accepted Auditing Standards, or GAAS, stand tall. GAAS equates to the minimum set of standards that auditors must turn to when conducting a financial audit. This vital set of guidelines applies to how financial statements are audited by CPA. Its well-defined structure and rigidity instill consistency and uniformity into the auditing process.

GAAS provides the path to follow to ensure an audit is carried out with the highest degree of professionalism. It fosters a culture of integrity and objectivity, which is paramount in establishing the credibility of financial audits.

GAAS focuses on the principles that govern the audit process, which include a comprehensive understanding of the company’s internal controls, a meticulous examination of the evidence supporting financial statements, and an objective review of the entire financial report and disclosures.

By following GAAS, auditors can dig into the details while keeping the big picture in mind, ultimately bolstering the reliability of financial statement audits. The result? Enhanced corporate transparency and strengthened investor confidence. 

Types of Financial Audits

While the purpose of all financial audits remains the same, there are three primary types that stakeholders should be aware of.

External Financial Audit

External financial audits are usually conducted by employees of an independent certified public accountant (CPA) firm and include an audit of both financial statements, accounting policies, and internal controls over financial reporting. External audits seek to identify if there are any material misstatements in the financial statements, as well as evaluate the effectiveness of existing accounting practices. An external auditor’s findings result in an auditor’s opinion, included in the financial audit report. This opinion is a crucial accompaniment to the financial statements in helping analysts and investors gain comfort in an organization’s financial condition and performance as stated by management.

Internal Financial Audit

Internal financial audits are conducted by employees of the organization known as internal auditors to provide management with an assessment of the effectiveness of financial reporting processes and internal controls over financial reporting. Internal audit teams may complement the work of external auditors to understand the firm’s accounting system based on a pre-agreed plan and meetings. Internal audits help an organization improve its processes and internal controls by performing projects and controls assessments to identify any areas of improvement or deficiencies in the controls and reporting process, allowing the opportunity to remediate those issues before they become a material error (under generally accepted auditing standards, misstatements and omissions are considered material if they could “influence the judgment made by a reasonable user based on the financial statements.”) The results of an internal audit, along with the internal audit team’s recommendations for improvement, are recorded in a financial audit report provided to the organization’s management and board of directors.

Internal Revenue Service (IRS) Audit

An IRS audit is a review of an individual’s or organization’s accounts and financial information to ensure information is reported correctly according to tax laws and to verify the amount of tax reported is accurate.

Here are the possible outcomes of the IRS Audit

1. No Change: The auditor finds everything in order and makes no changes.
2. Agreement: The auditor proposes changes, and the taxpayer understands and agrees with these changes.
3. Disagreement: The auditor proposes changes, but the taxpayer disagrees. In this case, the taxpayer can request a conference with an IRS manager, file an appeal if eligible, or seek mediation. To effectively prepare for an IRS audit, it’s crucial first to understand the scope of the audit, as the IRS will inform you whether it’s a correspondence, office, or field audit. Organizing all relevant documentation is key, including receipts, bills, employment documents, business logs, and legal papers, to support your case. Before the audit, thoroughly review the tax return(s) in question to understand every item and how it was calculated. Being aware of your rights as a taxpayer is essential, including the right to professional representation and the right to appeal the IRS‘s decision.

During the audit, answer all questions truthfully but avoid volunteering unsolicited information. Ensure to keep copies of all documents you provide to the IRS. Finally, once the audit is complete, make sure you understand the outcome and any subsequent expectations. If the audit reveals any mistakes, correct these in future tax returns to avoid similar issues.

Defining the Financial Audit Procedures

Substantive procedures are the procedures performed to support financial audits. A substantive procedure may be a process, step, or test that creates conclusive evidence regarding the completeness, existence, disclosure, rights, or valuation (the five audit assertions) of the financial statements. To qualify as a substantive procedure, enough documentation must be collected so another qualified auditor can conduct the same procedure on the same documents and come to the same conclusion.

Financial audit procedures are built around the five audit assertions at the account or asset level. They are as follows:

• Preparation
• Designating the team
• Communication and execution
• Forming the audit opinion
• Creating an action plan

Planning for a financial audit involves performing scoping and risk assessments before the audit project to understand areas that are material to the organization as well as evaluate areas of significant risk. External auditors will usually determine their level of reliance on the work of the internal audit function in obtaining audit evidence ahead of the audit. External auditors will evaluate the extent of their reliance on requirements set forth by the American Institute of Certified Public Accountants (AICPA).

What’s Audited? An Overview of Financial Statements

The financial audit primarily involves a microscopic examination of the four cornerstones of a company’s financial health: the balance sheet, income statement, statement of cash flows, and statement of changes in equity.

Imagine the balance sheet as a snapshot in time, a still frame capturing a company’s financial state at a particular moment. It records the company’s assets, liabilities, and shareholders’ equity. By analyzing this, auditors get a sense of the company’s net worth and how it is financed, whether it’s from debts, shareholders’ contributions, or earnings.

Moving onto the income statement, picture it as a video playing the company’s income and expenses over some time. It tells the story of a company’s profitability, demonstrating whether the company’s operations are bringing in more money than it’s spending.

The statement of cash flows, on the other hand, is like a company’s financial diary, documenting the tale of the company’s cash inflow and outflow. It’s a lens through which auditors see how a company is generating and spending its cash, breaking it down into activities like operating, investing, and financing.

Lastly, the statement of changes in equity. This is the tale of the company’s retained earnings, shareholder investments, and any dividends paid out. It’s like the company’s financial biography, narrating how its equity has evolved.

Together, these financial statements weave a comprehensive story of a company’s financial standing, performance, and cash management. It’s an auditors’ job to scrutinize these stories in depth, validating their truthfulness, and ensuring they abide by the established accounting principles. Each number, each figure, and each disclosure undergoes a thorough examination to confirm its accuracy and authenticity.

The process is detailed, diligent, and quite frankly, crucial. Because at the end of the day, it’s these audited financial statements that shape the company’s reputation, guide investors’ decisions, and influence the financial world’s trust in the company.

Financial Statement Review: The Complete Checklist

While there is variance across industries, the generic work steps of a typical financial statement review would include:

• Audit Planning: Risk Assessment and Scoping
  • For financial scoping, a determination of materiality in light of the financial review process is required. Any accounts identified over that benchmark individually would be considered. Additionally, the remaining accounts should be assessed in the aggregate to determine the appropriateness of coverage. Teams should confirm the remaining balance of accounts not tested is below the materiality threshold determined by the team.
• Fieldwork
  • Reconciliation: Compare the sub-ledger balances received to the general ledger balance.
  • Subledger analysis: Analyze all of the detailed transactions from the sub-ledger, and ensure the sum of all transactions agrees with the reconciliation. The sub-ledger should be at the lowest level of detail.
  • Sampling of transactions: Select a sample of transactions, typically using statistical analysis, to obtain comprehensive evidence ofthe execution of the transaction. Samples should involve one transaction – if more than one transaction rolls up into the sample, consider whether you’ve selected a sample of a sample. 
    • Within the sampling of transactions, consider the coverage obtained from controls in place and the potential reduction of testing procedures based on control activities performed.
  • Performance of account-specific procedures: Such as comparing transactions to the source invoice and confirming the completeness, accuracy, and validity of the transaction. 
• Issue Management and Follow-up
  • Errors identified should be analyzed and extrapolated to determine the impact on the organization.
  • Remediation plans should be developed to remediate the current issue and to prevent it from happening again in the future.
• Prepare for the Formal External Audit
  • Hold conversations with the External Audit team to discuss findings, and be prepared to share documentation of testing procedures performed.
• Leverage Technology to Streamline the Process

Some of these steps can be reduced if control coverage is identified to be sufficient; for example, for a fully automated transaction type.

The Different Roles: Independent Auditors versus Internal and External Auditors

There are distinct roles for the characters each has a unique role when it comes to the financial audit – namely those of the independent auditors, internal auditors, and external auditors. While they all follow the script of GAAS, their roles in the narrative are diverse.

Independent auditors come from external entities, typically from reputable auditing firms, with no ties to the company they’re auditing. This gives them an impartial perspective, allowing them to assess the company’s financial statements with uncolored glasses. Independent auditors bring a fresh set of eyes, lending credibility and authenticity to the audit results.

Next are the internal auditors. These are the employees of the company, working tirelessly behind the scenes. Their prime focus is on the efficacy of internal control systems, which are crucial in maintaining financial accuracy and integrity. They’re like the company’s financial immune system, constantly monitoring and strengthening internal processes to prevent errors and fraud.

Last but not least, we have external auditors. Now, these aren’t to be confused with independent auditors. External auditors are also company insiders, but they’re engaged in a very specific mission. Their role is to conduct an audit of the company’s financial statements, primarily for regulatory bodies or stakeholders. They’re like the company’s financial press corps, communicating the company’s financial standing to the outside world with precision and clarity.

So, despite the apparent similarities in their names, the roles of independent, internal, and external auditors are nuanced and distinct. They’re different characters in the same play, working in harmony to bring the financial truth to light. Remember, in the grand narrative of a financial audit, each role is vital, and each character brings something unique to the audit. Together, they help craft a financial audit that is thorough, accurate, and credible.

Optimizing Financial Audits Using Technology

Performing a financial audit without technology can lead to breakdowns over version control, team communication, and comparisons to the prior year. For organizations performing financial audits not related to SOX, leveraging internal audit management software can help streamline the entire financial audit process and create automated workflows to promote efficiency and effectiveness throughout the end-to-end audit lifecycle. SOX-compliant organizations can easily link between controls testing and financial audit testing to identify efficiencies. 

Research performed over the last decade by global consulting firm Protiviti consistently reveals rising key control counts, increased hours spent on compliance, increased internal and external costs, and the continued inefficiency of manual processes specific to SOX. Organizations that have successfully implemented audit management software report time savings of 33% to 50% on administrative audit work performed during testing and documentation, time savings that can ultimately convert into more value-added projects for the business. 

This ongoing research points to one conclusion: the time has never been better to embrace SOX and audit automation software. First-rate audit management software can not only help strengthen internal controls but also seamlessly link together controls and substantive testing, which can reduce the amount of financial audit testing auditors need to perform to accomplish audit goals.

To learn how AuditBoard can help you streamline your financial audits and SOX audits, fill out the form below.

FAQs

What are the three types of audits?

There are three primary types of financial audits, these include, the external financial audit, the internal financial audit, and the IRS audit.

What is the purpose of a financial audit?

The purpose of a financial audit is to ensure an organization’s financial statements are a fair and accurate representation of its financial transactions. The process involves reviewing the income statement, balance sheet, and cash flow statement.

What does the financial auditor look for?

A financial auditor looks for misrepresented information within the financial records and evaluates the effectiveness of internal controls over financial reporting. They perform substantive procedures to support audit assertions about the completeness, existence, disclosure, rights, or valuation of the financial statements, and aim to provide an auditor’s opinion on the financial condition and performance of the organization.