Internal Vs External Audit: A Beginners Guide for Small Business Owners

Life is a continuous audit, and integrity is the key to passing it

Whether you are a small business or a large corporation, an audit is an integral part of financial operations. Both internal and external audits offer their own set of values to the company. In this blog, we will cover the key differences between the two and how to ensure success in both scenarios.

Internal or External Audit: What Do They Mean for Your Business?

The internal audit, as the name suggests, is carried out by an inhouse team that may not necessarily be certified CPAs. However, in the long run, auditors do get associated and certified by well-known professional bodies (e.g., the Institute of Internal Auditors) that offer audit training and education. The main goal of an internal audit is to ensure that the organization is better prepared to address any potential risks or gain better visibility of the company’s processes and controls.

External audits, on the other hand, are carried out by an external auditor who possesses accounting (CPA) and compliance-related qualifications. They are primarily hired by shareholders and don’t directly work for the company. The main goal of an external audit is to ensure that all the financial records and statements are accurate and instill confidence in external stakeholders, like investors, creditors, regulators, etc., about the company’s financial well-being.

Internal Audit Vs External Audit: Key Differences

Even though both audit processes strive to promote transparency and efficiency for the company, there are some fundamental differences when we look at these two audits from the scope, purpose, cost and other relevant metrics.

Let’s take a closer look.

Scope: The internal audits provide insights and risk mitigation steps while the external audit is more of a legal and regulatory compliance requirement that should occur every year without fail.

Audit Focus: The internal audit team, with a focus on the future, checks the business health of the company and identifies any risks that can be prevented from occurring again. While the external audit team assesses the past financial records and compliance proofs to ensure that the company is financially sound and compliant.

Purpose: An internal audit’s purpose is to ensure that company management gets a clear picture of its processes and controls, which then allows them to make decisions to improve their future management strategy. The purpose of external audits is to follow a standard procedure prescribed by the law based on which they can independently examine and verify the company’s financial statement.

Auditor Profile: In the case of internal auditors, they are an in-house team hired by the company to tackle internal auditing tasks. External auditors are certified independent auditors who are hired by the shareholders of the company to carry out the external audit.

End-user: The internal auditors work and submit their audit reports to the company management and may even report it to the internal audits committee. On the other hand, external auditors share their audit reports with company shareholders. The findings made in the internal audit remain confidential to the company, whereas the external audit reports are made available in the public domain in the form of financial statements.

Timeline: Generally, internal audits can be scheduled anytime during the year and are subject to the company’s audit policy. External audits happen once a year unless there are specific statutes that require more audits within a year.

Internal Audit Vs External Audit: Advantages and Disadvantages

Let’s first do a side-by-side comparison of the advantages and disadvantages of Internal audit to illustrate how internal audit plays a crucial role.

Internal Audit

Advantages	Disadvantages
Better decision-making The audit reveals insightful data and highlights key areas of improvement that otherwise could be easily overlooked by the management. This paves the way for the company management to make strategic calls for the future, based on their audit findings.	Expensive According to a research study done by cfo.com (Refer graph) the median expense of conducting an internal audit comes to around 73 cents per $1000 revenue. And some of the most efficient internal audit teams cost only 13 cents per $1000 revenue whereas some of the most expensive internal audits can cost $3.06 per $1000 revenue. This clearly shows that internal audit is a resource intensive process and any company undertaking internal audits has to be very efficient to keep the audit expense low.
Improved Business Operations As a result of internal audits, a company can get rid of systemic hurdles and operational challenges. In due course of time, the company can gauge if the suggested plan of action in the audit findings is working or not and if they need a new strategy altogether.	Workplace disruption regular audits can become a hurdle in day-to-day work. Since audits require involvement of multiple stakeholders in the company, they tend to disrupt work at multiple levels within the company, which in turn can negatively affect the bottom line of the company.
Reduced Risks One of the key benefits of internal audits is that they reveal potential risks to the decision-makers of the company and how well-prepared the company is to face these risks. Once these risks are revealed, the company can mitigate the risks and also take steps towards dealing with incidents in case of any eventuality.	Employee Resistance As pointed out above, audits are often seen as disruptive and hence can easily face resistance from employees. From their point of view, audit can bring forth negative aspects of work which can highlight a team’s or an individual’s inefficiencies.
Higher External Audit Success A company that has internalized the culture of internal audits has a higher probability of successfully meeting external audit criteria. This allows the company to easily avoid any compliance-related penalties and punishments in future.	Time-Consuming If a company relies on manual way of operating things, then the entire audit process is bound to be tedious owing to the manual nature of work culture and can often lead to mistakes owing to human errors.

External Audit

Advantages	Disadvantages
Better Transparency The ability to undergo an external audit shows that a company is open to external scrutinization and ready to take the next step to ensure transparency in their systems and accounting practices.	Expensive The expense incurred in conducting an external audit depends on the size and complexity of its financial data. In a research study done by the Financial Education and Research Foundation, it was found that the average cost of auditing a publicly traded company was $2.52 million. In a separate study done by the National Council for Nonprofits, it was found that the non-profits can manage their external budget in the range of $10000 and $20000.
Robust Internal Processes When a company decides to hire an external auditor, they often set up internal processes, policies, accounting and bookkeeping practices that increase the probability of a successful external audit.	Performance Pressure A company facing an impending external audit is often under a lot of pressure. The company decision-makers worry about missing out on any crucial finance data or a missed compliance issue that could lead to a negative audit outcome.
Better Public Perception By letting an outside entity go through your books, a company not only instills confidence in the shareholders, but also helps create a positive public perception. This shows that your company follows honest and compliant processes.	Negative Publicity The company always faces the risk of losing its face publicly if the results of the external audits are not as per expectations. A negative result leads to shareholder loss and leads to negative media coverage in the business circles, which is not good from the long-term perspective.

Also Read: Insights on FQHC Accounting, Single Audit (A-133) and Grant Reporting

How to Decide the Type of Audit Your Company Needs?

Both types of audits serve very specific goals. Let’s first take the case of internal audits. Internal audits are meant for a company or key decision-makers who are looking to address operational inefficiencies, risk mitigation, or even build stronger internal controls. Internal audit helps a company build solid groundwork for effective decision-making. Having said this, internal audits also prepare companies to get ready for an external audit.

External audits, on the other hand, are meant for publicly traded companies, rapidly growing private companies, companies with banking requirements, etc. The main objective of having external audits is to assure company shareholders, government or regulatory entities, or even the general public that the company is following all the required legal and compliance laws.

Generally, any company that invests in a long-term business vision aspires to undertake internal as well as external audits as they both offer business benefits.

What is the auditor looking for?

Now that we have discussed auditing as a process, let’s take a closer look at what are the expectations of an internal and external auditor. It goes without saying that if you are able to better meet the auditor’s expectations, the chances of a desirable audit outcome are going to be much better.

Internal Auditor

Effectiveness of internal process: Check for opportunities where the operational inefficiencies can be addressed and result in maximum desired output.

Enhanced internal controls: Assess if all the company controls are working at a desirable level and to identify if there are any areas of improvement.

Financial transparency: Ensure all the financial data is accurate and depicts the correct business picture.

Fraudulence detection: Evaluate the risk of fraud and how well-equipped the company is to deal with fraud.

Compliance fulfilment: Ensuring the company meets all the compliance requirements and standards.

External Auditor

Financial statement accuracy: Ensure that all the financial data and statements are accurate, complete and follow the accounting standards properly.

Risk assessment: Assess the risk mitigation policies and ensure that they are effective in preventing risks.

Compliance fulfilment: To ensure that all company financial information complies with regulatory requirements and laws.

Internal controls effectiveness: To see if company internal controls are performing efficiently with desired effectiveness.

Audits: The cornerstone of financial resilience

For any company that aims to bring financial transparency and integrate financial regularity into its accounting culture, an audit is one of the key ingredients. Even though external and internal audits play a complementary role, they are crucial for developing a strong and positive financial picture of a company.

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Author

John Bugh

John Bugh is the Chief Revenue Officer for Pacific Accounting and Business Services (PABS), responsible for the strategic direction, planning, vision, growth, and performance of the company’s marketing, branding, and revenue streams.

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