A financial audit consists of a review of the financial statements of a person or an institution, to determine their accuracy. In the United States, the word “audit” colloquially refers to a tax audit performed by the Internal Revenue Service (IRS). Taxpayers often go to great lengths to avoid being subjected to this type of audit, but a financial audit in the business world is a normal process in the course of year-to-year operations.
Businesses, churches, and governments are some of the institutions which undergo financial audits. In a typical financial audit, a certified public accountant (CPA) reviews and inspects the institution’s records of its accounting procedures. This is important, especially for publicly traded companies, because it establishes the credibility of the financial position of the company, as reported by its leaders.
The goal of a financial audit is to correct and eliminate what are known as material misstatements. These are any pieces of incorrect or missing information, that on their own are large enough to matter, in the sense that they may significantly change the outside perception of the institution’s financial condition. When there is less than a five percent risk that material misstatements remain in the accounting records, the financial audit has accomplished its task, and the records are released to any interested parties.
Most of the large, publicly traded companies in the world are audited by one of four accounting firms, known as the “Big Four.” These firms perform financial audits in addition to other common accounting tasks such as tax return preparation, among others. Numerous other accounting firms exist which provide auditing services as well.
In performing a financial audit, one of the potential obstacles faced by the auditing firm is the need to balance conflicting incentives. Specifically, the firm must correctly and scrupulously audit the records of its client, while maintaining a comfortable business relationship with the client. If the auditing firm finds many discrepancies and makes the auditing process a stressful one for the client, the client may be motivated to look elsewhere for auditing services next time. The accounting firm may face the incentive, in these situations, to be less than strictly honest in the audit, which may lead to a more pleasant experience for the client, who will then bring return business to the firm. These issues must be taken into account as part of the already complex auditing process.