Audit: What It Means in Finance and Accounting, 3 Main Types

What Is an Audit?

The term audit usually refers to a financial statement audit. A financial audit is an objective examination and evaluation of the financial statements of an organization to make sure that the financial records are a fair and accurate representation of the transactions they claim to represent. The audit can be conducted internally by employees of the organization or externally by an outside Certified Public Accountant (CPA) firm. Key Takeaways

There are three main types of audits: external audits, internal audits, and Internal Revenue Service (IRS) audits.
External audits are commonly performed by Certified Public Accounting (CPA) firms and result in an auditor's opinion which is included in the audit report.
An unqualified, or clean, audit opinion means that the auditor has not identified any material misstatement as a result of his or her review of the financial statements.
External audits can include a review of both financial statements and a company's internal controls.
Internal audits serve as a managerial tool to make improvements to processes and internal controls.

Understanding Audits

Almost all companies receive a yearly audit of their financial statements, such as the income statement , balance sheet , and cash flow statement . Lenders often require the results of an external audit annually as part of their debt covenants. For some companies, audits are a legal requirement due to the compelling incentives to intentionally misstate financial information in an attempt to commit fraud. As a result of the Sarbanes-Oxley Act (SOX) of 2002, publicly traded companies must also receive an evaluation of the effectiveness of their internal controls . Standards for external audits performed in the United States, called the generally accepted auditing standards (GAAS) , are set out by Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA) . Additional rules for the audits of publicly traded companies are made by the Public Company Accounting Oversight Board (PCAOB) , which was established as a result of SOX in 2002. A separate set of international standards, called the International Standards on Auditing (ISA), were set up by the International Auditing and Assurance Standards Board (IAASB).

Types of Audits

External Audits

Unqualified audits performed by outside parties can be extremely helpful in removing any bias in reviewing the state of a company's financials. Financial audits seek to identify if there are any material misstatements in the financial statements. An unqualified, or clean, auditor's opinion provides financial statement users with confidence that the financials are both accurate and complete. External audits, therefore, allow stakeholders to make better, more informed decisions related to the company being audited. External auditors follow a set of standards different from that of the company or organization hiring them to do the work. The biggest difference between an internal and external audit is the concept of independence of the external auditor. When audits are performed by third parties, the resulting auditor's opinion expressed on items being audited (a company's financials, internal controls, or a system) can be candid and honest without it affecting daily work relationships within the company.

Internal Audits

Internal auditors are employed by the company or organization for whom they are performing an audit, and the resulting audit report is given directly to management and the board of directors. Consultant auditors, while not employed internally, use the standards of the company they are auditing as opposed to a separate set of standards. These types of auditors are used when an organization doesn’t have the in-house resources to audit certain parts of its own operations. The results of the internal audit are used to make managerial changes and improvements to internal controls. The purpose of an internal audit is to ensure compliance with laws and regulations and to help maintain accurate and timely financial reporting and data collection. Ongoing audits also provide benefits to management by identifying flaws in internal control or financial reporting prior to its review by external auditors.

Internal Revenue Service (IRS) Audits

The Internal Revenue Service (IRS) also routinely performs audits to verify the accuracy of a taxpayer’s return and specific transactions. When the IRS audits a person or company, it usually carries a negative connotation and is seen as evidence of some type of wrongdoing by the taxpayer. However, being selected for an audit is not necessarily indicative of any wrongdoing. IRS audit selection is usually made by random statistical formulas that analyze a taxpayer's return and compare it to similar returns. A taxpayer may also be selected for an audit if they have any dealings with another person or company who was found to have tax errors on their audit. There are three possible IRS audit outcomes available: no change to the tax return, a change that is accepted by the taxpayer, or a change that the taxpayer disagrees with. If the change is accepted, the taxpayer may owe additional taxes or penalties. If the taxpayer disagrees, there is a process to follow that may include mediation or an appeal. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Securities and Exchange Commission. " SEC Implements Internal Control Provisions of Sarbanes-Oxley Act; Adopts Investment Company R&D Safe Harbor ."

AICPA. " Generally Accepted Auditing Standards ," Page 1599.

Securities and Exchange Commission. " Public Company Accounting Oversight Board (PCAOB) ."

IAASB. " International Auditing and Assurance Standards Board ."

Internal Revenue Service. " IRS Audits ."

An internal audit checks a company’s internal controls, corporate governance, and accounting processes. The auditor's report contains the auditor's opinion on whether a company's financial statements comply with accounting standards. Accounting is the process of recording, summarizing, and reporting financial transactions to oversight agencies, regulators, and the IRS. A certification provided by the independent auditor of a company's financial records that accompanies and opines on the audited financial statements. Audit risk is the risk that financial statements are materially incorrect, even though the audit opinion states that there no material misstatements. An auditor is a person authorized to review and verify the accuracy of business records and ensure compliance with tax laws.