Why Is it Important for a Company to Have an External or Internal Audit System?

Internal controls are vital for protecting a company’s financial and physical assets. Auditing is a method of testing the effectiveness of internal business controls and is itself a control mechanism. Formal and random internal audits work to uncover instances of fraud, errors and actions that can damage a company’s reputation and put its future at risk. External audits not only provide another layer of control, but also create transparency and enhance a company’s public image.

Business owners delegate much of the work involved in running a business. Although it is important to trust that employees will fulfill the duties of their role with honesty and integrity, a “trust but verify” attitude is essential. Internal and external audits are a fraud prevention measure. A company that institutes strong internal controls and conducts both random and regular audits sends an important message to employees. Knowing the company cares about and is actively working to safeguard company assets can effectively deter an employee or an outside vendor from considering theft or actions that constitute fraud.

Internal audit procedures can be effective for verifying the accuracy of randomly selected financial transactions. Spot checking starts by selecting a source document such as an invoice, receipt or purchase order, traces it through the accounting cycle and ends with adjusting entries to ledger accounts. This allows management to create an audit trail that reveals exactly how a transaction progressed. Audit trails that reconstruct electronic transactions can be even more useful as they provide a date and time stamp for each consecutive action.

Regularly scheduled internal audits often follow an established, step-by-step procedure. The focus is on reviewing, comparing and analyzing monthly and annual financial statements. Regular internal audits compare previous to current year financial statements and forecast prediction reports to final numbers reported in financial statements. Analysis involves studying the relationship between two financial statements. Procedures look to uncover changes in accounts that occur suddenly or slowly over time and assess whether any differences appear reasonable or require further investigation.

External audits are an objective, independent, third-party review of the controls and reporting procedures of a public or private company. External auditors conduct a review similar to an internal audit. Their focus, however, is less on uncovering errors and inconsistencies and more on evaluating the overall effectiveness of internal controls and on ensuring the company is in compliance with any applicable federal regulations. Public companies have a legal obligation to provide external audit results to shareholders and the U.S. Securities and Exchange Commission. Private companies often conduct an annual external audit by choice and publish the results in an annual statement.