What is an audit?

Definition

An audit is an independent examination of financial statements that ends in an opinion on whether those statements are fairly stated. On the books this is not an account; it is outside work done after the close, when a CPA gathers evidence and then reports on the package as a whole.

The opinion is the point of the service. A review offers limited assurance from questions and analytics, and a compilation presents numbers with no assurance; an audit is the examination that gives an opinion.

The company's own close still has to happen first. The auditor does not take over the ledger.

Where it shows up

Balance Sheet: Related to an independent opinion on whether the statement is fairly stated.

P&L: Related to an independent opinion on whether the statement is fairly stated.

Cash flow: Related to an independent opinion on whether the statement is fairly stated.

See also: Review Engagement · Internal Controls · Year-End Close

When you look at your Balance Sheet, an audit does not add a new line. The same assets, liabilities, and equity sit there; the auditor's letter rides with the statements, not on them.

The Income Statement is the same. Revenue and expenses stay as management recorded them; the opinion is about whether those amounts, taken together, are fairly stated.

The auditor works on a Financial Statement Package. That bundle is what a lender or an owner actually receives after the year-end close.

A clean close makes the exam faster. A messy close means more testing, more questions, and more time before an opinion can be issued.

How it works

Management finishes the close and gives the auditor the statements plus a Trial Balance. The auditor does not take over the general ledger; the company still owns every number.

The auditor plans the work and looks at internal controls. Those procedures help the auditor decide how much testing is needed; the opinion is still on the statements, not a separate grade on the procedures.

Testing follows. The auditor traces reported amounts back along the audit trail to a source document, confirms balances with outside parties, and may watch a physical inventory count.

Unusual journal entry activity gets extra attention. So do estimates, cutoff, and accounts that moved in ways that do not match the business.

The auditor uses a size threshold for what is big enough to matter to a reader. Small slips can be noted; slips above that size have to be fixed or they affect the opinion.

If the statements need a change, management is asked to post it. The opinion is issued only after the auditor has enough evidence, and it says whether the statements are fairly stated under the common US rules.

Segregation of duties can reduce the testing in an area. Weak separation can increase it; either way the opinion is still about the statements.

The fee for this work is a professional cost on the P&L. It is the price of the opinion, not a new statement line the exam creates.

If the auditor cannot get enough evidence, the opinion is modified or withheld. An unmodified opinion is given only when the examination was completed and the statements are fairly stated.

Example

Ridgeway Machine, a machine shop, closes December 31 with $1,200,000 of revenue and $180,000 of steel on the floor. The lender that funds a $250,000 equipment line requires an independent opinion on those statements.

The auditor watches the year-end count of steel and traces a sample of jobs to invoices and shipping records. The auditor also confirms a large receivable with a customer and reads the bank reconciliation against the December bank activity.

One adjusting journal entry booked $22,000 of revenue for a job that had not shipped. Management reverses it, and revenue falls by $22,000.

The auditor finishes the remaining tests. The opinion says the December 31 statements are fairly stated.

The lender receives the package plus that letter. Ridgeway paid for an examination with evidence, not a review based only on questions and analytics.

Common mix-ups

An audit is not a review engagement. A review is limited assurance from inquiry and analytics; an audit examines evidence and gives an opinion.

An audit is not a compilation. A compilation presents the statements with no assurance; an audit does not stop at presentation.

An audit is not the same as the audit trail. The trail is the chain from a reported number back to its source; the audit is the independent exam that uses that chain.

Related terms

• Review Engagement: A limited-assurance engagement based mostly on inquiry and analytics.
• Compilation: An accountant's lowest level of service, presenting statements without assurance.
• Internal Controls: The procedures that keep the books accurate and assets protected.
• Audit Trail: The traceable chain from a reported number back to its source document.
• Reconciliation Workpaper: The documented support showing how a reconciled balance was proven.
• Materiality: The threshold at which an error or item is big enough to matter to a reader.
• Year-End Close: The heavier close at fiscal year end, including closing entries and audit preparation.
• Generally Accepted Accounting Principles: The common US rules for how financial statements are prepared.