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

What does Audit mean?

The word "Audit" comes from the Latin word "Audrey", which means "to hear". In early times, businesses used to have small sizes; transactions were also very small and typically stored in physical registers. But today, companies have changed a lot, and computers are used in enterprises for keeping records of transactions.

By auditing, all business transactions are checked to determine whether the transactions made comply with the rules and regulations of accounting or not.

These transactions are inspected on the basis of vouchers and information. It includes the inspection of Account Books, P&L (Profit/Loss) Accounts, Balance Sheets, and other related vouchers with bills and invoices.

In simple terms, "Auditing means the systematic and independent examination of books, vouchers, and other financial and legal records in order to verify and report upon the facts regarding the financial condition disclosed by the Balance Sheet and Net Income revealed by the Profit and Loss Account".

An audit is done to check whether the Balance Sheet has been made correctly or not and whether it shows the true nature of the business. It is also called a financial or company audit, and according to the law, it is a must for companies to get the Audit done.

Respective Terms

• Books of accounts: include Journal or subsidiary books like Cash Books, Purchase Books, and Sales Books. Ledger and Trial Balance also come under the head Books of accounts.
• Financial statements: include Trading Account (Gross Profit and Gross Loss), a Profit and Loss Account (Net Profit and Net Loss), and a Balance Sheet (shows the company's accurate and fair view).

Objectives of Audit

Primary Objective

• Examination of Accounts books- The main objective of auditing is to inspect the accounts book of the organization.
• Verification of financial statements- After verifying the accuracy of books of accounts, the auditor gives his expert opinion about the accuracy and truthfulness of the financial statements. The profit and loss shown in the Profit and Loss Account are also checked.

Secondary or Subsidiary Objective

• Detection and prevention of errors
• Detection and prevention of fraud
• Advice to the manager

Types of Audits

There are mainly three different types of Audits, such as Internal Audit, Continuous / External Audit and IRS (Internal Revenue Service) Audit. Internal Audits and External Audits are widely used practices; however, IRS audits are also seen in use. Let us discuss each in detail:

1. Internal Audit

When the accounts book of a company is inspected and checked by the senior accountant of the same company or staff, then it is called an Internal Audit.

Many big companies are following this kind of Audit, and they assign this work of Audit to such person or employee of the company who is honest, trustworthy, and has experience in the area of auditing. Such a person or employee is appointed by the management team of the same company. The person appointed to do internal audit checks and verifies all the activity of the company. He or she also ensures whether every transaction made by the company is being appropriately recorded or not.

It ultimately reduces the chances of fraud and errors which could possibly happen in the company. Regular internal audits in the company help the auditor and the company when the yearly Audit is done, which an external auditor does. This is done to increase the efficiency of the employees of the company so that they can work in a more proper manner with confidence and trust in the respective company.

No special qualification is required to do a company's internal Audit. The persons doing the internal audit act like an auditor only, but they do not give an audit report but only provide valuable suggestions or advice to the owner or management team of the company, which helps the company in the running smoothly.

The internal auditor examines the rules and regulations, plans and procedures and verifies whether they are being followed properly.

The basic definition of the Internal Audit is "Internal auditing is an independent objective assurance and consulting activity, which is designed to and/ or add value to and/ or improve an organization's operations".

Advantages of Internal Audit

• Detects errors and frauds: By doing an internal audit of a company, the accounts book of the company regularly gets checked, and frauds or errors can be detected. The employees also get careful about it and do not commit any fraud or mistakes because they know that they will get caught by the internal auditor during the internal auditing process.
• Operational Improvement: The operational process of a company also gets checked from time to time, and the work that needs to be done regularly can also be improved, leading to more profit for the company.
• Determination of work standard: It means that the working standard of the employees is also set by doing the internal Audit. For example, what work should be done and within what time? The company gets the idea by internal auditing that the work assigned to the employees is done according to the standard set or not.
• Helpful in the determination of policies: Internal Audit helps the company in determining the different policies of the company. Through the internal Audit, the problems and difficulties in the company's current plan are determined, and such projects are analyzed so that the complications can be removed. The internal auditor collects these problems and suggests solutions to the management of the company to solve those problems so that the company does not face loss in the future.
• Protection of Assets: Internal Audit also helps in utilizing the assets of the company properly, and the depreciation in the value of the assets is also calculated through this. Internal Audit increases the safety of the assets by assigning an authorized person to take care of the assets, which reduces the chances of the assets being misused.
• Relation to the customer: Through the Internal Audit, the relationship between the customer and the organization also gets improves. Having a good relationship with the customers is very important for any organization. Suppose the internal auditor checks the bills carefully. In that case, it can be checked whether the customer has been charged a higher price or not and whether the bills are appropriately made or not; if any customer has returned the product, then what is the reason behind it? All this information can be extracted by doing an Internal Audit.

2. Continuous Audit or External Audit

The continuous Audit is for big businesses and organizations where transactions are done in huge numbers, and it is also costly to conduct.

Continuous Audit is done by an auditor who has practice and experience in the field of accounts and finance. When a company needs to conduct an ongoing audit, a CA (Chartered Accountant) is called in. But CAs usually do not come and audit themselves on a regular basis. Instead, they send their junior employees to visit the company and check the daily transactions of the company.

The Chartered accountant, i.e., the auditor, also visits the company from time to time to get updates, and if any problem occurs, then he suggests the management of the company regarding that or solves the problem by himself.

Additionally, this process of Audit is done throughout the whole year. In the end, after the completion of the Audit, the principal auditor (often the CA) submits his report to the management of the company, and this is what we call a continuous audit.

Let's see the definition of Continuous Audit:

"When the audit of a company is done by a professional auditor or in the guidance of the auditor throughout the whole year, then it is called a continuous audit".

Advantages of Continuous Audit

• Intensive checking of books and accounts: The Company's books of accounts are appropriately checked while doing the continuous Audit. Auditor gets a lot of time to check all the books of accounts of a company as the constant audit process continues throughout the year.
  All the reports do not come altogether for the auditors and their staff, which makes it easy for the auditor and the staff to check the information in parts. The benefit of this is that if any fraud has been committed in the books of accounts or anywhere in the transactions of the company, then it can be easily identified by the auditor and/ or his staff.
• Quick discovery of errors and frauds: Errors and frauds can be identified very quickly by performing continuous audits because the entries are checked just after the listing. The benefit of this is that the company employees do not get time to commit fraud or error in the books of accounts again in the future.
• Detection of errors at the very beginning: As all the books of accounts are checked regularly, errors can be identified at the very beginning, and they can be avoided from happening again.
• The moral effect on the employees: If a continuous audit is done in any company, it also affects the employees' morale as they do their work more carefully to avoid errors.
• Quick improvement in the accounting system: Because of continuous auditing, the auditors know the errors very quickly. Then the auditor gives the information about errors to the company's management and offers suggestions to correct or improve. Because of this, the mistakes which could happen in the accounting system during the financial year can be easily fixed.
• Early presentation of final accounts: As the work of continuous Audit is performed throughout the whole year, the process of accounting also runs together with it. Because of this, all the accounts also get maintained, and the final accounts are made ready at the end of the year.
• Help in the declaration of interim dividends: This can create problems when a company pays interim dividends to its shareholders and if the accounts still need to be audited. However, continuous auditing removes all such issues as the accounts get already maintained during the ongoing audit process. Also, the managers get the knowledge of how much profit the company is going to make and share.

3. Internal Revenue Service (IRS) Audits

The third type of Audit is the Internal Revenue Service audit, in which the IRS conducts the Audit to check the transactions made by the company or a person and the accuracy of the taxpayer's return.

When an IRS conducts this type of auditing, there is a high chance that the person or company did something wrong in filing the return. Also, if someone is dealing with someone who has committed fraud or an error in paying taxes or is found to have made an error while doing an audit, the IRS can also audit the person dealing with that wrongdoer.

In case of errors or fraud detected in this Audit, heavy IRS audit penalties and interest are imposed on the concerned individual or company. In more extreme cases, the penalty can also cost you thousands of dollars or even a prison sentence.

Difference between Internal and External Audit