Audit

What Is an Audit?

An audit is a formal review of a company's financial statements, carried out by an independent accountant who checks whether the reported numbers follow generally accepted accounting principles and present a true and fair picture of the business. The person or firm doing the work is called an auditor. At the end, the auditor issues a written report containing an opinion, which investors and lenders rely on when judging how trustworthy the financial information is.

Audits are not the same as bookkeeping or routine accounting. The auditor does not prepare the numbers. Instead, the auditor tests them, looking at supporting documents, confirming balances with banks and customers, observing inventory counts, and reviewing how revenue and expenses were recorded. The auditor must be independent of the company, meaning it cannot have a financial or management stake that would compromise its judgment.

How an Audit Works

Auditors usually begin by learning the business and its industry, then assessing where errors or fraud are most likely to occur. They select samples of transactions and account balances to test, rather than examining every entry. Because sampling is used, an audit provides reasonable assurance, not absolute certainty.

The auditor then concludes with one of several opinion types:

• An unmodified opinion, often called a clean opinion, means the statements are presented fairly in all material respects.
• A qualified opinion means most of the statements are fair but a specific issue is a problem.
• An adverse opinion means the statements are materially misstated.
• A disclaimer of opinion means the auditor could not gather enough evidence to form a view.

A going concern paragraph may be added if there is substantial doubt that the company can keep operating for the next year.

Why Audits Matter to Investors

For publicly traded companies in the United States, audits are required by law. The Sarbanes-Oxley Act of 2002 created an oversight board for auditors of public companies. Audits give investors an independent check on figures they cannot verify themselves, and they help the audit committee of a company's board oversee management's reporting.

Audits are distinct from internal audit functions, which are run by company employees to review controls and operations. An external audit provides a second, independent view.

Audits have limits. They cannot catch every error or fraud, and the quality of an audit depends on the auditor's skill and independence. The audit opinion and the accompanying notes to the financial statements are worth reading closely, since a clean opinion does not guarantee a company's financial health.