Notes

An external audit of financial statements occurs when an auditor examines the financial records of a company to ensure compliance with Generally Accepted Accounting Principles (GAAP). Learn about external audits, auditors, and the importance of audits for maintaining legally compliant businesses.
To Trust or Not to Trust
Jed owns a coffee shop. Business has been incredible in the first two years, and he wants to expand into other markets. He decides to have a meeting with his friend Sophie, and see how he can raise funds to branch out by offering stock options in his company.

Sophie, who is an accountant, tells him that there are several things that he must do before he can even offer stock for sale. 'The most important thing,' she says, 'is to be sure that he has an external audit done of his company's financial statements. Without that, investors may not trust that the financial statements are accurate.'

'An external audit,' Jed asks. 'What's that?'

Sophie shakes her head, realizing that Jed has a lot to learn. 'Ok, Jed,' Sophie replies. 'It looks like we have a lot to talk about.' Sophie sits back and begins to explain the concept of an external audit to Jed.

The Audit and the Auditor
An external audit is an examination of a company's financial records by someone that is not an employee of the company itself. This person, known as an auditor, looks over the financial records of the company. The auditor has two main jobs.

His or her first job, and the most important, is to make sure that the financial statements of a company are in compliance with GAAP guidelines. GAAP guidelines are the generally accepted accounting principles that are established by the Financial Accounting Standards Board (FASB), which is the judge and jury in the accounting world.

The second job that an auditor has is to attest to the truth and accuracy of information on the financial statements in both the notes to the financial statements and in audit reports.

The FASB has developed rules for auditors to follow too; they are called GAAS or Generally Accepted Auditing Standards. They help ensure the accuracy, consistency and verifiability of the auditors reports. They specify the procedures that auditors must follow.

Why an Audit?
'So, you've told me what an audit is,' Jed says, 'and you've told me what an auditor is and who reigns over this type of thing, but what you haven't told me is why I need to have one done.'

'I was getting to that part, Jed. Just be patient,' Sophie replies. She continues on.

'There are three main groups of people that depend on financial statement audits. The first group is the investors. The investors are the people who have invested money into a company, as well as those who are considering making an investment into the company. They need to feel confident that the information on the financial statements is reliable.

The second group of people that depend on the financial statement audits is called regulators. Regulators are groups of people who spend their time reviewing practices of a company that are outlined in audit reports. The main goal of regulators is to ensure that company practices are legally compliant.

The third group of people that depend on financial statement audits are company leaders. Company leaders are those people in management that direct the actions taken by the company. Audits and audit reports allow company leaders to see how well their business is doing. They also tell company leaders where there may be room for improvement and where problem areas are.

Now, let's get to the burning question: Why have an audit done on company financial records? The answer is pretty simple. Investors, or those folks that you want to give you money to expand your business, need to know that you have taken every possible step to ensure the accuracy of the financial information that you have given them and that they have an auditor's opinion on the overall practices of the company. Having all that information makes it much easier for them to open their wallets to you. When they open their wallets, you expand your business. Do you see where this is going?'

Lesson Summary
'I do believe that I am getting a clearer picture of this whole auditing thing,' Jed says with a shake of his head. 'What you've told me, Sophie, is that an external audit is an examination of company financial records by someone outside of the company. You're also telling me that an auditor is the person who does the financial audit and that he must be a skilled Accountant. Am I right so far?'

'You are, my friend,' Sophie says with a smile. 'Keep going.'

'An auditor has two main jobs. One is to make sure that the financial statements follow GAAP guidelines. GAAP stands for generally accepted accounting principles, and they're established by the Financial Accounting Standards Board. The FASB is the judge and jury for the accounting world because what they say goes. Auditors also have another group of people that guide them in the protocol of an audit. That group of people is called the Public Company Accounting Oversight Board (PCAOB).' Along with the FASB, they have developed GAAS or generally accepted auditing standards. They specify the procedures that auditors must follow.

'You were listening, Jed! What else have you learned in my crash course on audits and auditors?' Sophie asks.

'I learned that there are three groups of people that are interested in what an audit has to say. Investors are interested because they're the people that are thinking about putting some of their own money into the company. Regulators are groups of people that review auditor's reports to see if the company is compliant with laws. Company leaders rely on audits and audit reports to let them know how well the company is doing and if there are any problem areas.

The most important thing that I learned today is that I need to make sure to have an external audit done of my company financial statements so that I can have someone else's opinion on how the company is doing. And so I can have everything ready to present to potential investors, and hopefully, I can get the ball rolling to expand the company!'

'Well Jed,' Sophie says, 'I do believe you have learned something today!'