Few words in business inspire quite as much quiet dread as audit — which is simultaneously precisely the point and utterly unnecessary. While many see the audit as an inherently antagonistic process, it is in fact crucial to the success of an organisation. An audit is, to put it simply, an organised process of checking whether things are as good as everyone claims — a question that is occasionally unwelcome but more often surprisingly useful. After all, trust is an admirable quality in personal relationships, but, in business and finance, it tends to work better with documentation.
The Watchdog Within – What is an Internal Audit
The two main types of audits are differentiated by who is conducting the audit – someone from within the organisation or an external auditor. Beyond what is obvious from the name, they actually differ in quite a number of aspects. Firstly, an internal audit is a control process conducted on an ongoing basis by company employees for the benefit of the management. Let’s break this definition down.
Internal audits have the objective of making sure that everything in an organisation runs efficiently and correctly. And by “everything” I do mean everything; at least potentially. An internal audit may focus on a specific aspect of an organisation’s functioning, such as risk management, governance, financial management, efficiency, or compliance, but in most cases its spectrum of interest is broad and flexible, encompassing many of these aspects, as needed. The auditors in this case are either specialised company employees or an external subcontractor hired specifically for this purpose. In either case, the reports land on the management’s desks and are used to improve processes within the company. Internal audits are conducted on a continuous basis rather than being a limited one-time effort.
The Stranger With a Clipboard – What is an External Audit
By contrast, an external audit is not just the same process as the internal audit, just conducted by a third party. That would still be an internal audit, albeit one entrusted to a subcontractor. Rather, it is an independent assessment of an organisation’s financial statements, performed for the benefits of other stakeholders. In the case of publicly traded companies, these would be the shareholders; in other cases it might be the state (representing public interest) or, for instance, a charity’s donors that want to make sure their money is being spent well. Since its primary purpose is to provide an objective opinion on whether financial statements present a true and fair view, it must naturally be conducted by a neutral third party. External audits are typically conducted annually and follow a structured, standardised process. The findings are communicated to the relevant stakeholders and, unlike those of an internal audit, are not proprietary; in fact, in many cases they are made public.
Same Name, Different Game – Key Differences Internal vs External Audit
To sum up the key differences:
- Internal audits serve the management; external ones are for other stakeholders
- Internal auditors work for the company; external ones are a neutral third party
- Thus, internal auditors are semi-independent within the company; for external auditors, independence is a necessary precondition
- External audits focus primarily on finances; internal ones have a broader and more flexible scope
- An external audit is a one-time event (usually an annual one); an internal audit is an ongoing process
Audits, What are They Actually There for?
Both types of audits contribute to the accountability and transparency of an organisation and, ultimately, to improved functioning. However, their specific objectives differ. Internal audits aim to provide managers with reliable information about operational effectiveness and weaknesses in internal processes. This can be used for strategic decision-making and for making improvements. External audits, on the other hand, aim to provide independent assurance to stakeholders that financial information is accurate, complete, and compliant with standards.
Who Tells What to Whom? – Reporting and Stakeholders
Because of their different aims, internal and external audits also differ in the form and addressees of reporting. Internal audit reports are typically received by senior management, the board of directors, or an audit committee. They are confidential and designed for internal use only. They tend to be detail-oriented and focus on operational issues.
External audit reports are meant for an external audience – the shareholders, regulators, or even the public. They are published alongside the organisation’s annual financial statement and in many jurisdictions are publicly available. They are very formalised and follow a standardised form.
Playing by the Rules – Standards and Regulations
Both types of audits follow commonly accepted standards. However, the enforcement of compliance with these rules differs. The primary body setting out rules for internal audits is the Institute of Internal Auditors (IIA). Following its guidance is not only a good idea, as it makes the audit more reliable, but might also be required by the company charter. What is more, during an external audit, the auditors will not want to rely on internal audit documentation if it does not follow standards, making the process longer and more expensive. Finally, in highly regulated industries, such as banking or insurance, compliance with IIA standards is often a legal requirement.
In the case of external audits, adherence to standards (such as the International Standards on Auditing – ISA) is a legal requirement and failure to do so exposes the auditor to severe consequences. For instance, the European Union’s Audit Directive legally enforces the use of ISAs for all statutory audits in member states. Not only is adherence to standards mandatory, but the law might also dictate the specific rules for reporting (like IFRS or US GAAP). Finally, in many countries, external auditors must be certified or licensed and registered with a professional body (such as ACCA, ICAEW, or a national equivalent)
When You Don’t Get to Choose – When Is an External Audit Required?
External audits themselves are also often mandatory. In most jurisdictions, they are legally required for publicly listed companies, as well as large private companies above a certain size. Non-profit, charitable, and public sector organisations are also often subject to mandatory external audits, in the interest of public trust. Organisations in especially sensitive industries, such as healthcare, and financial institutions, are likewise typically required to perform annual external audits.
Better Together – How Audits Complement Each Other
Despite their differences, the two types of audits complement each other in a number of ways. Most obviously, internal audits may reveal and allow a company to correct weaknesses that would come up in an external audit. Conversely, internal audit findings can alert external auditors to areas of higher risk that warrant closer scrutiny. Furthermore, if the internal audit is done correctly, in full compliance with standards, external auditors will often rely on its findings, rather than duplicate the work of internal auditors. This will improve the efficiency of the external audit, limit its scope, and shorten duration, thus reducing its cost. Together, the two types of audits create a layered system of assurance that strengthens governance and accountability.
Why Bother? Benefits for Business
To many, being audited might seem like a daunting prospect, potentially leading to negative consequences. In reality, however, both internal and external audits are a crucial tool for risk management and building credibility. First of all, both allow an organisation to identify potential risks and weak points before they escalate to cause serious damage. A well-structured internal audit framework allows companies to make better decisions, weed out inefficiencies, and improve risk management. Whereas external audits enhance its credibility with investors, lenders, and business partners. Finally, both types of audits help an organisation to withstand regulatory scrutiny and respond to crises.
Myths, Mix-Ups, and Misunderstandings – Common Misconceptions
- An internal audit is just a trial run for an external audit. In fact, it has much broader functions and serves other purposes.
- External audits cover all aspects of an organisation. In reality, it focuses almost exclusively on financial statements.
- Internal auditors are disciplinarians; there to find your mistakes and punish you. Actually, their role is advisory, meant to help you improve your processes.
- A clean external audit if proof of good management. In fact, it is usually just proof of good (i.e. accurate and transparent) accounting.
- Having an external audit removes the need for internal audit. In practice, the two functions are complementary, not interchangeable.
The Short Version – Summary of Differences
In short, an internal audit is an ongoing internal process in an organisation, while an external one is a one-time third-party opinion. The external audit is there for the benefit of stakeholders; the internal one serves the management. Internal audits are broad in scope and ongoing, while the external one is periodic and focused on financial statements. External audit reports are often made public; internal ones serve the company and are confidential. However, both are equally essential for a sound governance framework and neither replaces the other.
