Comprehensive Guide to What to Audit When Doing Financial Audits : Key Areas and Calculations Demystified
A financial audit is an independent examination of a company’s financial statements. Financial audits are like detailed check-ups for a company’s financial health, which are like its financial report card, are accurate and follow the right rules.
The auditor’s goal is to determine whether the financial statements are fairly presented in accordance with generally accepted accounting principles (GAAP) or IFRS. The auditor will also assess the company’s internal controls over financial reporting.
GAAP means “common rules for money reports in the U.S.” IFRS is “global rules for money reports used worldwide”.
Let’s say an auditor is testing a company’s revenue recognition process. The auditor may select a sample of sales transactions and test the following:
- Whether the company has accurately recorded the quantity of goods or services sold.
- If the company has accurately recorded the selling price of the goods or services sold.
- Whether the company has only recognized revenue when it is earned and realized.
The auditor would then compare the calculated revenue to the revenue reported by the company in its financial statements. If there is a significant difference, the auditor would investigate further.
The goal to do financial audits
The goal is to give confidence to the company’s owners, investors, and others that the financial information is trustworthy. Think of it as a way to make sure everything adds up and there are no surprises hiding in the books.
The audit aims to verify that the financial information gives a true and fair view of the company’s financial position and performance.
Additionally, it helps identify any material misstatements or irregularities, providing confidence in the company’s financial health and transparency. Ultimately, the goal is to enhance trust and credibility in the financial reporting of the audited entity.
What to audit when conducting finance auditing?
Auditors typically focus on the following areas when conducting financial audits and use a variety of formulas and calculations to test the company’s financial statements and internal controls:
Revenue is the money a company earns from its primary activities, like selling products or providing services. It’s the income generated from the company’s core operations. In simple terms, revenue is the money that flows into the company from its customers. Auditors will test the company’s revenue recognition process to ensure that revenue is only recognized when it is earned and realized. This involves examining how revenue is recorded and recognized in the financial statements. When conducting finance auditing, there are several key areas to focus on. Here are some of the main aspects to audit, along with example formulas and calculations for each:
Example of revenue
- Sales Revenue: Money earned from selling products or services to customers.
- Service Fees: Income from providing services, like consulting, repairs, or professional advice.
- Subscription Fees: Revenue from customers who pay a regular fee for access to a service or product.
- Rental Income: Money received from leasing out property, equipment, or other assets.
- Licensing Fees: Revenue from allowing others to use the company’s intellectual property, like patents or trademarks.
- Interest Income: Money earned from investments or loans.
- Commission Income: Revenue earned by brokers or agents for facilitating transactions.
- Royalty Income: Payments received for the use of copyrighted material, like books, music, or software.
- Advertising Revenue: Income generated from displaying advertisements on a platform, like a website or app.
- Franchise Fees: Revenue from granting others the right to operate under the company’s brand and business model.
- Donations or Grants: Money received from individuals, organizations, or governments for specific purposes.
- Consulting Fees: Income from providing specialized knowledge or expertise to clients.
Formula Revenue recognation = Quantity sold x Selling price
Revenue = Quantity sold x Selling price
Imagine a company, ABC Electronics, sells 100 smartphones at $500 each during a particular month. They record this sale in their books.
Quantity Sold = 100 smartphones
Selling Price = $500 each
Using the formula:
Revenue = 100 × $500 = $50,000
So, ABC Electronics should recognize $50,000 as revenue for the month.
A company sells 100 widgets for $10 each. The total revenue for the sale of the widgets is $1,000 (100 widgets x $10/widget = $1,000).
Example Calculation: Suppose a company sold 200 units of a product at $50 each. Revenue=200×$50=$10,000
Expenses are the costs a company incurs to run its operations and generate revenue. They cover things like employee wages, rent, utilities, and other necessary payments. In simple terms, expenses are the money a company spends to keep its business going. Auditors will test the company’s expense recognition process to ensure that expenses are incurred and properly classified.
Examples of expenses
- Wages and Salaries: Payments to employees for their work.
- Rent or Lease Payments: Cost of using office space, retail space, or equipment.
- Utilities: Expenses for electricity, water, gas, and other essential services.
- Supplies: Costs for office supplies, materials, and consumables used in day-to-day operations.
- Insurance Premiums: Payments to insure the company against various risks.
- Advertising and Marketing Costs: Expenses for promoting the company’s products or services.
- Interest Expenses: Payments made on loans or credit lines.
- Depreciation and Amortization: Allocation of the cost of long-term assets over their useful life.
- Maintenance and Repairs: Costs to keep equipment and facilities in working order.
- Taxes: Various taxes such as property tax, sales tax, and income tax.
- Professional Fees: Payments to consultants, lawyers, or accountants for their services.
- Travel and Entertainment: Costs associated with business-related travel and client entertainment.
Formula Expense recognition
Expense = Quantity used x Cost per unit
A company uses 100 gallons of gasoline for its delivery trucks. The cost of the gasoline is $2 per gallon. The total expense for the gasoline is $200 (100 gallons x $2/gallon = $200).
2nd Expense Formula
Example Calculation: If a company used 500 units of a resource, and each unit cost $10, Expense=500×$10=$5,000
Assets are valuable things a company owns. They can be physical, like buildings or machines, or less tangible, like money owed to the company (accounts receivable) or ideas that can make money (patents). In simple terms, assets are what a company has that hold value. Auditors will test the company’s asset valuation process to ensure that assets are valued at fair value. This includes not only tangible assets like equipment and property but also the company’s inventory or stock.
Examples of assets
- Cash: Physical currency, as well as balances in bank accounts.
- Accounts Receivable: Money that is owed to the company by customers for goods or services provided.
- Inventory: Physical goods held for sale, like products on store shelves.
- Property, Plant, and Equipment (PP&E): Physical assets like buildings, machinery, and vehicles used in the business.
- Investments: Stocks, bonds, or other financial instruments that the company owns.
- Intangible Assets: Non-physical assets like patents, copyrights, trademarks, and goodwill.
- Prepaid Expenses: Payments made in advance for services or goods the company will receive in the future.
- Land: Physical property or space owned by the company.
- Accounts Prepaid: Money received in advance from customers for goods or services the company will provide.
Formula of Asset valuation
Asset value = Fair market value
A company owns a building that has a fair market value of $1 million. The asset value of the building is $1 million.
Example Calculation: If a piece of equipment is worth $15,000 according to market value, Asset Value=$15,000
Formula and calculation for Inventory Valuation
Inventory Value = Quantity of Items × Unit Cost
For example, if a company has 100 units of a product in stock, and each unit cost $10 to produce or purchase:
Inventory Value=100 units×$10 per unit=$1,000
So, the company’s inventory is valued at $1,000.
Formula and calculation for Inventory turnover
Inventory turnover = Cost of goods sold / Average inventory
A company has cost of goods sold of $1 million and average inventory of $500,000. The inventory turnover is 2 ($1 million / $500,000 = 2).
Formula and calculation for Days in inventory
Days in inventory = 365 / Inventory turnover
A company has an inventory turnover of 2. The days in inventory is 182.5 days (365 / 2 = 182.5).
Liabilities are things a company owes, like debts and obligations to pay money or provide services in the future. They’re like the company’s financial responsibilities. Auditors will test the company’s liability valuation process to ensure that liabilities are valued at fair value.
Some examples of liabilities:
- Bank Loans: Money borrowed from a bank that needs to be paid back with interest.
- Accounts Payable: Bills or invoices from suppliers or vendors that the company needs to pay.
- Salaries Payable: Amounts owed to employees for work performed that haven’t been paid yet.
- Unearned Revenue: Money received in advance for goods or services that haven’t been delivered yet.
- Accrued Expenses: Costs that have been incurred but not yet paid, like utilities or taxes.
- Long-Term Debt: Debts that are payable over an extended period, often years.
- Mortgages: Loans taken out to purchase property or real estate.
- Deferred Tax Liability: Taxes that the company will owe in the future but haven’t been paid yet.
- Warranty Liabilities: Amounts set aside to cover potential future warranty claims on products sold.
Liability valuation’s formula
Liability value = Present value of future cash flows
A company has a bond that pays $100 per year for 10 years. The interest rate is 5%. The present value of the future cash flows from the bond is $100,000 (PVIFA 5%, 10 years x $100/year = $100,000).
Example Calculation: If a company expects to pay $20,000 in future liabilities, and considering the present value, it’s worth $18,000, Liability Value=$18,000
In simple terms, equity is what’s left for the owners or shareholders after all debts and obligations are settled. It’s like the portion of the company that belongs to its owners. In financial audits, the auditors will test the company’s equity accounts to ensure that they are accurately stated.
Examples of equity:
- Common Stock: This represents the ownership shares that have been issued to investors.
- Preferred Stock: These are shares with special rights, often offered to certain investors.
- Retained Earnings: Profits that the company has earned and retained for future use rather than distributing them to shareholders.
- Additional Paid-In Capital: The amount investors paid for their shares above the par value (if applicable).
- Treasury Stock: Shares that the company has bought back from shareholders.
- Accumulated Other Comprehensive Income: Unrealized gains or losses that are not included in net income.
- Contributed Capital: Capital contributed by owners, which includes both common and preferred stock.
- Owner’s Equity: The residual interest of the owners in the assets after deducting liabilities.
Formula of equity control
Equity = Assets – Liabilities
A company has assets of $1 million and liabilities of $500,000. The company’s equity is $500,000 ($1 million – $500,000 = $500,000).
6. Internal controls
Internal controls in finance auditing are like the safeguards a company puts in place to make sure its financial information is accurate and secure. They’re rules, checks, and procedures that help prevent mistakes, fraud, or mismanagement. Think of them as the company’s security system for its money and financial data. Auditors will assess the company’s internal controls over financial reporting to determine whether they are effective in preventing and detecting material misstatements.
They will consider the following factors:
- The design of the company’s internal controls
- The effectiveness of the company’s internal controls in practice
- The company’s control environment
Formula of Committee of Sponsoring Organizations (COSO)
COSO framework = Control environment + Risk assessment + Control activities + Information and communication + Monitoring
The COSO framework is a framework for internal controls developed by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The framework consists of five components:
- Control environment: Use: Assesses the overall atmosphere of control consciousness within an organization.
Purpose: Ensures there’s a foundation of good control practices and ethical values.
- Risk assessment: Use: Identifies and evaluates potential risks that could impact financial reporting.
Purpose: Helps in prioritizing audit procedures and focusing on high-risk areas.
- Control activities: Use: Examines the policies and procedures implemented to mitigate identified risks.
Purpose: Ensures that the controls in place effectively prevent or detect material misstatements.
- Information and communication: Use: Reviews how financial information is captured, processed, and shared within the organization.
Purpose: Verifies that relevant financial information is accurately communicated to the appropriate parties.
- Monitoring: Use: Evaluates the ongoing assessment of controls and their effectiveness over time.
Purpose: Ensures that controls are continually updated and adjusted to address changes in the business environment.
Auditors will assess the company’s internal controls against the COSO framework to determine whether they are effective.
During an audit, while auditors may review bank reconciliations to gain an understanding of the company’s internal controls, the primary focus is on the company’s financial statements and the related assertions (e.g., existence, completeness, accuracy, etc.).
- Test the company’s bank reconciliation policy: Auditors may review the company’s bank reconciliation policy to ensure that it is comprehensive and that it covers all aspects of the bank reconciliation process.
- Test the timeliness of the bank reconciliations: Auditors may review the dates of the bank reconciliations to ensure that they are reconciled on a timely basis.
- Test the accuracy of the bank reconciliations: Auditors may reconcile the company’s bank account records to the bank statements to identify any discrepancies.
- Investigate discrepancies: Auditors will investigate any discrepancies that are identified during the bank reconciliation process to determine the cause of the discrepancy and to ensure that it has been properly corrected.
A company has a strong control environment, including a code of ethics and a board of directors that is actively involved in overseeing management. The company also has a risk assessment process in place to identify and assess risks to its financial reporting. The company’s control activities include approval procedures for significant transactions and physical controls over assets. The company also has a communication system in place to provide information to management about internal controls and to report any deficiencies. The company’s monitoring process includes internal audits and management reviews of internal controls.
The auditor would likely conclude that the company’s internal controls over financial reporting are effective.
Example of Internal controls (in finance auditing)
- Segregation of Duties: Ensuring that different individuals are responsible for different parts of a financial transaction. For example, the person who approves a purchase should not be the same person who pays the invoice.
- Authorization Procedures: Requiring proper approval and authorization before certain financial transactions can take place. For example, a manager must approve large expenses before they are incurred.
- Physical Controls: Safeguarding physical assets and sensitive financial information. This can include locked storage, restricted access, and surveillance systems.
- Reconciliation Processes: Regularly comparing different sets of financial records (such as bank statements and internal accounting records) to ensure they align.
- Documentation and Record Keeping: Maintaining detailed and accurate records of financial transactions. This ensures transparency and accountability.
- Internal Audits: Conducting periodic internal audits to review financial processes and controls, identifying any weaknesses or areas for improvement.
- IT Controls: Implementing measures to protect digital financial data, including password protection, firewalls, and encryption.
- Budgetary Controls: Monitoring actual financial performance against budgeted amounts to ensure spending stays within approved limits.
- Training and Education: Providing employees with proper training on financial policies and procedures to ensure they understand and follow the controls in place.
- Whistleblower Policies: Establishing a process for employees to report concerns about financial misconduct or fraud without fear of retaliation.
Financial audits are an important part of the financial reporting process. Auditors play a vital role in ensuring that financial statements are fairly presented and that companies are in compliance with GAAP.
Simple explanation of formulas and calculations
- Revenue recognition formula: This formula simply calculates the total revenue by multiplying the quantity sold by the selling price.
- Expense recognition formula: This formula calculates the total expense by multiplying the quantity used by the cost per unit.
- Asset valuation formula: This formula values an asset at its fair market value, which is the price that a willing buyer would pay to a willing seller.
- Liability valuation formula: This formula calculates the value of a liability by considering its future cash flows.
We hope this article has been helpful in providing you with a clearer understanding of financial audits. Please let me know if you have any other questions. If you need further information or assistance regarding financial audits, feel free to ask!