Eli5: What exactly is auditing in accounting?


I keep hearing this term from my accountant friend and have absolutely no idea what it means. I tried googling it but that just left me even more confused than I was.

In: 170

Auditing means the same in accounting as anywhere else.

Someone goes to check that there are records where they’re meant to be, whether those records match each other and reality, and if they do not, Investigate why.

Audits can be internal (done by the company on its own) or external (bringing a third party in), although accounting audits are done externally because you’re trying to convince others (clients, shareholders, potential investors) that there’s no funny business goin on, and someone going “yeah, I checked it myself and everything is great, you don’t need to see it” doesn’t convince anybody.

Companies produce a lot of different reports. They report their income and earnings to shareholders, they report their wages paid to the unemployment division of the state, they report their taxes paid to the state and federal revenue departments. They may also produce reports specific to their industry.

An audit is when another person or group of people are allowed to look at company data in order to verify if the report is accurate, complete, and correct.

So if a company reports that they had 45 full-time employees and paid all the unemployment insurance correctly, an audit would mean a person from the unemployment insurance agency could come in, and review their payroll records. If a company said it was worth $100 million, a financial auditor could look at their records of sales and purchases (their financial records) to verify how accurate that claim is. If a chemical company said it had 500 gallons of methylamine, an audit might involve someone physically counting the containers but also looking at records of sales and purchases.

**Mom:** Bright-Interest, did you finish your homework for tonight?

**Bright-Interest:** Yes mom! It’s all ready to hand in tomorrow at school!

**Mom:** Let me take a look at your homework, to check for any errors.

That’s auditing. Someone else checking to make sure that work was done properly.

Someone can audit your accountant, to make sure they did the math properly.

Someone can audit your taxes, to make sure you filled things out properly.

Auditing = fact checking. Auditors are independent third parties who are brought in to verify what a company is reporting is actually the case.

If there were not auditors, then companies could just make up financial information and we would just have to trust what managers are saying. It makes for poor market conditions and leads to economic uncertainty. Auditors step in between management and investors to validate what management is reporting.

Auditing is not perfect for a multitude of reasons. Due to the vast size and operations of many companies, it’s simply not feasible to verify every transaction that comes in and out of the company. Many accounting determinations are also subjective so the true value of an item can vary based on who made the determination, which in that case auditors would audit the valuation process to ensure that the logic is sound. Additionally, if management truly is intent on committing fraud, they are more likely to find/create a loophole that lets them hide it.

Auditing (like most things in our financial markets) is built on collective trust and “just go with it” mentality. Why does money have value? Because we all agree it does. Why is the share price of company ABC worth $10? Because enough market participants agree it does. Why is $1USD worth €.91EUR? Because enough people agree that it does. Why does an audit verify a company’s financials? Because enough people trust that the auditors did their work correctly to validate that the financials are materially consistent with the true operations

One very specific example:

Company: We spent a million dollars on office supplies.

Auditor: Checks receipts to make sure that they add up to a million dollars.