After your first year in business, you need reliable financial statements—especially if you plan to seek a loan or outside investment. To certify those statements were prepared correctly, you’ll undergo a financial audit that confirms the accuracy of your records.
Here is everything you need to know about financial audits and how they may apply to your business.
What is a financial audit?
A financial audit is a systematic examination by external or internal accountants or analysts of a company’s financial statements and records, as well as its accounting procedures and how it collects and records financial data. The purpose of a financial audit is to verify the business’s financial data so that outside parties—investors, lenders, suppliers, regulators, and other internal and external stakeholders— can trust the audited financial statements when dealing with the company.
During an audit, the auditor reviews internal controls, such as how financial duties are divided, to check for errors or fraud. For example, an audit might look for changes in accounting estimates or suspicious requests for payment. These reviews help ensure a business’s financial statements are reliable and comply with regulatory requirements.
A close examination of a company’s financial statements can also reveal opportunities to become more cost efficient or unlock resources for growth.
A financial statement audit may overlap with an IT (information technology) audit, which examines how the business’s financial data is stored and secured. An IT audit can include an examination of the cloud computing services the business uses, reassuring stakeholders that vital information is protected from hackers and employee misuse. Failure to safeguard data can lead to regulatory penalties and litigation after a breach.
Types of financial audits
Businesses may use different types of audits, depending on their needs, circumstances, and who will be reading the audit report:
External audit
An external audit is performed by independent CPAs who have no other connection to the audited business. This unbiased examination avoids conflicts of interest and gives the opinion credibility—something lenders, shareholders, and suppliers require.
US public companies must undergo an external audit annually so regulators and outsiders have an accurate picture of their condition. A company’s board of directors, not its executives, hires the external auditor.
Private companies may need to conduct external audits to raise capital or qualify for government-backed financing, such as SBA loans. For example, the SBA requires companies in its 8(a) Business Development program with more than $20 million in annual revenue to provide externally audited statements. Those between $7.5 million and $20 million may submit statements prepared by an independent CPA, while smaller companies may use internally prepared statements reviewed by a senior executive.
Internal audit
An internal audit is performed by the company's accounting team or its regular outside firm and is for internal consumption. It evaluates the effectiveness of financial reporting processes and the delegation of financial duties and responsibilities among employees, known as internal controls. Internal audit teams flag problems before they become material issues in an external audit.
Tax audit
A tax audit, conducted by the Internal Revenue Service (IRS) or state and local tax authorities, checks whether a company’s records accurately reflect its tax liability. An IRS audit ensures financial data is correct according to tax laws and that a business is paying all due taxes.
Forensic audit
Forensic audits are ordered when fraud, theft, or other malfeasance is suspected. They dive into specific transactions and often support legal cases or internal investigations.
What does a financial audit review?
- Founding documents
- Financial statements
- Account balances
- Internal documents
- Sampling of transactions
- Tax records
To complete a thorough audit, the auditor reviews data from multiple sources, including:
Founding documents
These include charters or articles of incorporation for corporations and operating agreements for partnerships and limited liability companies (LLCs). Auditors use them to understand a company’s operations, structure, and managerial responsibilities. They also examine loans, leases, contracts, employee benefits, and contingent liabilities, such as lawsuits or warranty obligations.
Financial statements
A company’s financial statements are typically the core focus of the financial audit and include the balance sheet, income statement, and cash flow statement. Analyzed together, financial statements provide a complete picture of the business’s financial condition.
Account balances
An auditor reviews a business’s general ledger for bookkeeping practices and examines the reconciliations between the ledger and bank account balances, looking for missing entries or differences in the timing of recorded transactions.
Internal documents
The auditor can also review a business’s contracts, invoices, receipts, and other records to confirm that revenue and expenses are based on real transactions.
Sampling of transactions
Examining every single transaction is impractical, so auditors select samples of transactions, randomly or using statistical analysis, to verify against other business records.
Tax records
Auditors examine federal and local tax returns and any IRS correspondence about exemptions or disputes.
Financial audit standards
Certified public accountants (CPAs) perform audits according to these principles:
Generally Accepted Auditing Standards (GAAS)
The American Institute of Certified Public Accountants (AICPA) developed Generally Accepted Auditing Standards (GAAS), which outlines how auditors must demonstrate competence in explaining the scope of an audit, procedures for collecting and examining financial data, and how to report findings. Just as generally accepted accounting principles (GAAP) guide financial statement preparation, GAAS guides auditors in evaluating those statements.
Public Company Accounting Oversight Board (PCAOB)
This independent regulator was created by Congress in 2002 to safeguard shareholders against financial fraud by publicly traded companies. The Public Company Accounting Oversight Board (PCAOB) oversees financial audits of such companies and inspects accounting firms to ensure compliance with GAAS. It was created after the failure of several big companies stemming from accounting fraud, including energy trading company Enron and telecom provider WorldCom.
International Standards on Auditing (ISA)
These rules are used in many countries outside the US. They were developed by the International Auditing and Assurance Standards Board, allowing cross-border comparisons of audit results for multinational corporations and international investors.
Outcomes of financial audits
At the end of the audit process, particularly an external audit, the auditor gives a formal opinion on the company’s financial statements, accounting procedures, and controls:
Unqualified opinion
Also called a clean opinion, this is the best outcome. An unqualified opinion states that the financial statements fairly represent the company’s financial position and comply with GAAP.
Qualified opinion
A qualified opinion is generally positive but notes exceptions. For example, one item in the financial statements may deviate from GAAP but isn’t important enough to make the statements misleading. Or scope limitations may have prevented the auditor from conducting part of the examination.
Adverse opinion
If statements are materially incorrect or don’t conform to GAAP, the auditor issues an adverse opinion—a red flag that prompts stakeholders to distrust the statements.
Disclaimer of opinion
When an auditor lacks sufficient evidence or doubts the company’s financial health and its ability to survive, they issue a disclaimer—essentially no opinion at all.
Financial audit FAQ
What happens during a financial audit?
An external audit by an independent auditor starts with a review of financial statements and internal records, and includes a review of its accounting procedures and delegation of financial duties among staff. External auditors may also inspect facilities and interview staff. Internal audits are generally less extensive and involve a review of internal controls for processing and storing financial data.
What does a financial statement audit show?
A financial audit of a business indicates whether financial statements are fair and accurate and whether accounting follows government regulations and professional accounting standards.
How is auditing different from accounting?
Accounting is the organization of a company’s financial data into periodic reports and financial statements. Auditing checks a business’s accounting to ensure accuracy and credibility.
