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.
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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
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