Anatomy of an audit: purpose, meaning and importance

December 2024  |  COVER STORY | FINANCE & ACCOUNTING

Financier Worldwide Magazine

December 2024 Issue

Keeping one’s financial house in order is sound advice in any line of business, but the adage is particularly applicable to companies subject to stringent financial reporting requirements.

At regular intervals in its lifespan, a company of whatever size, whether public or private, needs to furnish external parties, such as shareholders, investors and lenders, with assurances that its financial statements are a fair representation of its results and financial position.

Chief among the means of determining the financial health of a company is a comprehensive review of its reporting and accounting procedures and related operations, conducted both internally and externally – commonly known as an audit.

Originating from the Latin term ‘audire’, which means to hear, an audit, as defined by the American Society for Quality, is an on-site verification activity, such as an inspection or examination, of a process or quality system to ensure compliance to requirements. An audit can apply to an entire company or may be specific to a function, process or production step. Some audits have special administrative purposes, such as auditing documents, risk or performance, or following up on completed corrective actions.

In some circumstances, an audit is a statutory requirement that must be conducted in accordance with relevant legislation. In others, it is non-statutory, thus not required by legislation and generally conducted at the behest of directors, trustees or shareholders.

“An audit is equivalent to an annual physical health examination,” says Angela Veal, a partner at Eisner Advisory Group LLC. “It is always good for a company to obtain a health check even if it is not mandatory,” she asserts. “This keeps the company on its toes and helps ensure accountability to various stakeholders. It can also uncover unexpected issues or areas of improvement.”

In the view of Anthony Pugliese, president and chief executive of the Institute of Internal Auditors (IIA), an audit is a critical driver of both functional optimisation and value creation within companies. It can anticipate and identify potential risks, as well as provide strategic advisory support to boards and leadership, ensuring that relevant threats are effectively addressed.

“A robust audit function ensures that internal controls and risk management practices are firmly in place across key operational areas, including financial and sustainability reporting, consumer protection, legal and compliance and much more,” continues Mr Pugliese. “However, the value of an audit extends beyond these standard requirements toward driving meaningful organisational change.”

Types of audit

Although often confused or conflated, external and internal audits serve different purposes. Both are important, and companies need to understand the role each performs.

The primary role of the internal audit function is to help a company’s decision makers safeguard organisational assets while supporting operational sustainability and scalability. An audit provides assurance that a company’s risk management, governance and internal control processes are operating effectively. It also helps to maintain operational efficiency by identifying problems and correcting lapses in internal controls.

An external audit, in comparison, confirms the accuracy of financial statements, controls and compliance within governing laws and regulations. It is an independent opinion which can support a company’s efforts to secure external financing from lenders and investors while establishing stakeholder confidence. The final audit report is provided to the company’s management team, board of directors and other stakeholders.

In some cases, an internal audit is conducted prior to an external audit to help companies identify any inconsistencies or areas for improvement, allowing corrections to be made before the involvement of a third-party auditor.

Key differences

While internal and external audits are broadly similar in intent and are undertaken – statutorily or otherwise – for the betterment of the company under review, each is distinct in scope and assessment involved.

In its analysis of the differences between the two, PwC identifies three key points, as outlined below.

First is the level of independence. An external audit is conducted by an independent third party, while an internal audit is conducted by the company’s own employees or internal audit department who provide objective, independent assurance by typically reporting directly to the board. This means that an external audit provides a more objective assessment of a company’s financial information and operations, while normally an internal audit is more subjective.

Second is the scope of the assessment. External audits are focused on financial information and records, and they are usually limited to a specific period of time, such as a year. Internal audits are focused on the company’s overall operations and processes, and they can cover a wide range of topics, such as compliance, risk management, technology and systems and human resources.

Third is the level of detail in the assessment. External audits are usually more detailed and in-depth than internal audits, as they are required to provide assurance to stakeholders that the company’s financial statements are accurate and in compliance with relevant laws and regulations. Internal audits are more focused on identifying potential risks and opportunities for improvement in the company’s operations.

Benefits of audit

Providing complementary functions and essential effective governance, internal and external audit helps companies to improve their operations on the inside while providing an accurate representation on the outside.

In its 2024 analysis ‘The Benefits of Auditing Your Business’, Williamson & Croft notes that an audit has seven key benefits (whether it is a legal obligation or commissioned specifically by the company) that can assist in navigating audit thresholds, as outlined below.

First, it helps influence budgetary decisions. When a company has a definitive financial picture, it is much easier to forecast its liquidity and allocate it accordingly. That way, priority can be given to investing in the areas that will have the most impact. Audited financial statements provide reliable data for making informed budgetary choices, allowing a company to optimise resource allocation and strategic decisions.

Second, it increases shareholder confidence. When a company undergoes an audit, it demonstrates a commitment to transparency and financial integrity. This, in turn, reassures shareholders that their investments are being managed responsibly – for instance, by updating shareholders with the latest, accurate business valuation.

Third, it reveals underperforming and overperforming areas. With a clear understanding of which areas of the business are performing profitably and which are not returning on spend, a company can make data-backed decisions about what to optimise. As an audit is an unbiased and complete assessment of all financial data, a company will be able to see exactly how products, segments and divisions are performing with absolute clarity.

Fourth, it give confidence in anti-fraud measures. Getting an independent review of its finances means that a company knows exactly what it is spending and where. No stone is left unturned in an audit, so any unauthorised transactions or suspicious activities will be detected. This provides peace of mind and demonstrates to stakeholders that the company takes its financial integrity seriously and has robust measures in place to prevent and detect any fraudulent activities.

Fifth, it confers credibility in a company. If a company needs a business loan from a bank, an audit is usually required as audited financial statements demonstrate transparency and adherence to accounting standards. This enhances the company’s credibility in the eyes of lenders, investors and other stakeholders. A detailed independent audit instils confidence, making it easier to secure funding, attract investors, and establish trust with both customers and partners.

Sixth, it paints a clear financial picture for the C-suite to review. An audit consolidates all financial data into a clear, standardised format, making it easier for the C-suite to understand the company’s financial position. This way, senior executives can make informed strategic decisions based on accurate and up to date information.

Lastly, it can be tailored more specifically to the business. While a tax audit or statutory audit must conform to certain legal requirements and standards, one of the benefits of auditing electively is that it can then be tailored to meet the unique needs of the company’s business. By working with experienced auditing accountants, a company can design an audit that focuses on areas of particular concern or importance.

Overall, suggests Ms Veal, companies need to ensure the audit amounts to more than just a box-ticking exercise. “This requires all-around buy-in from leadership and stakeholders on the importance of audit, a well-defined audit scope, proper client and audit team training, and a robust audit post-mortem process that helps management and audit committees identify, correct and prevent future issues,” she adds.

Challenges and strategies

As with any assurance improvement process, benefits are accompanied by challenges. In its ‘Exploring Audit Challenges Facing Firms Today’ report, DataSnipper highlights key issues modern companies face when their business is audited, as outlined below.

First, the rapid progression of technology has completely transformed the way businesses operate and introduced new complexities for auditors. With the emergence of digital processes, auditors need to stay up to date with technology, including understanding cyber security risks, ensuring data integrity and identifying system vulnerabilities.

Second, the ever-evolving regulatory landscape presents a significant challenge for companies. Compliance requirements are continuously being updated and auditors must stay informed about these changes to ensure that companies adhere to the latest standards. Failure to do so can result in financial penalties and damage to a company’s reputation.

Third, where a company has global operations, it means it has audit teams that come from all over the world, each with their own unique backgrounds. So, companies need to ensure these multinational audit teams work together smoothly, making allowances for time zone differences and differing work cultures.

Lastly, the way things work within a company can either make audits easier or harder to pull off successfully. When a company has an organisational culture that puts a premium on honesty, doing things right and being open, it sets the stage for audits to go more smoothly. However, if the culture is not big on being upfront and holding people accountable, it can create more problems and risks.

Additional challenges highlighted by DataSnipper include maintaining impartiality when auditing areas with close ties or vested interests, and the need to operate within limited budgets given that staffing and timing issues have the capacity to hinder comprehensive audits and risk management.

“Auditors must gather insights from key departments, leadership, and the company’s board of directors and audit committee to create a comprehensive map of its staffing and operations,” adds Mr Pugliese. “This approach enables the identification of areas for improvement. Effective communication between audit functions and other departments is crucial during this process and can present challenges.

“To navigate these complexities, it is essential for internal audit functions to establish systems for frequent communication with boards and relevant departments,” he continues. “Educating stakeholders on the broader mission and value of internal audit can improve efficiency of the audit, foster effective collaboration and ensure alignment.”

Different animal

Undoubtedly, the audit of tomorrow will be a very different animal from the audit of today. In a world characterised by uncertainty, auditors need to embrace new technologies, engage in continuous learning and adapt to changes in methodologies and practices. Doing so means they can meet evolving demands and maintain the profession’s reputation for integrity and reliability.

“I foresee the use of technology for big data sets and a lot more cross-border audits,” says Ms Veal. “Disruptive trends include a diverse audit team not just focusing on audit compliance procedures, but a team with a wide array of subject matter expertise.

“It is important to demystify overall misconceptions about audits throughout the industry – that it is not just a compliance activity,” she continues. “When done right with focused objectives, an audit can be very valuable to a company and the general public.”

For Mr Pugliese, it is initiatives such as the IIAA’s ‘Vision 2035 Project’ – a venture designed to create a comprehensive and integrated vision of the future of the audit profession – that will provide discoveries that offer a distinctive viewpoint on auditing’s current state and its future aspirations.

“The impact of technology on the profession is a recurring theme in our research,” says Mr Pugliese. “Our findings highlighted the potential of artificial intelligence (AI) to disrupt and enhance internal audit. From increasing data and threat complexity to improving the quality of recommendations and insights, AI presents challenges and opportunities.

“And as the risk landscape evolves and new regulations and potential threats emerge, audit functions are increasingly assuming a more strategic role within companies,” he adds. “Thus, it is essential for companies to recognise the audit function as both critical support for compliance and assurance and a strategic partner and advisory body, aligned with the overarching goal of driving value.”

© Financier Worldwide

BY

Fraser Tennant