Financial audits review accuracy of financial statements. Certified public accountants inspect accounting records to establish credibility. Objective is to correct material errors. Large publicly traded companies are audited by the “Big Four” accounting firms. Audit firms must balance conflicting incentives.
A financial audit consists of a review of the financial statements of a person or institution, to determine their accuracy. In the United States, the word “audit” colloquially refers to a tax audit conducted 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 annual operations.
Businesses, churches, and governments are some of the institutions that 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, as it establishes the credibility of the company’s financial position, as reported by its leaders.
The objective of a financial audit is to correct and eliminate what are known as material errors. These are pieces of incorrect or missing information that alone are large enough to matter, in the sense that they can 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 disclosed to interested parties.
Most of the world’s large publicly traded companies are audited by one of four accounting firms, known as the “Big Four.” These companies perform financial audits in addition to other common accounting tasks such as preparing tax returns, among others. There are many other accounting firms that also provide auditing services.
When performing a financial audit, one of the potential obstacles facing the audit firm is the need to balance conflicting incentives. Specifically, the company must properly and scrupulously audit its client’s records, while maintaining a comfortable business relationship with the client. If the audit firm finds many discrepancies and makes the audit process stressful for the client, the client may be motivated to seek audit services elsewhere next time. The accounting firm may face the incentive, in these situations, to be less than strictly honest in the audit, which can lead to a more pleasant experience for the client, which will then bring business back to the firm. These issues must be considered as part of the already complex audit process.
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