Legal Importance of an Audit

What is the Legal Importance Of An Audit?

The legal importance of an audit lies in its role in upholding the reliability of financial statements for all external users.

An audit involves a meticulous examination of a party's financial accounts and statements, typically conducted by professionals known as auditors or by a certified public accounting (CPA) firm. The primary purpose of audits is to assess an organization’s financial health and adherence to government regulations. 

From a legal standpoint, audits serve vital functions. If an audit is performed incorrectly, the business and the auditor can face severe civil and criminal charges by the Securities and Exchange Commission (SEC).

The legal significance of audits cannot be measured. The inspection mechanism ensures the firm is held accountable, complies with accounting standards, has legitimate financial statements, protects its shareholders, and enhances its reputation.

All stakeholders, including investors, lenders, suppliers, owners, creditors, and shareholders, place great importance on the successful execution of audits. For businesses to maintain a strong market position, engaging auditors who uphold the highest accounting standards is crucial.

Audits strengthen a company’s public image and promote transparency and accountability. If a company gets audited and everything turns out good, its image gets boosted. People may invest in the company if it is responsible and practices healthy risk management.

What is Included in an Audit Report?

In an audit report, the auditor summarizes whatever they find. They assess an organization's financial statements, and then usually, there is a small expression of opinion about the information presented. This is known as an auditor’s opinion.

The main contents of an audit generally include:

• Overview of the procedures performed
• Risks that were identified
• Accounting policies that need to be amended, adopted, or removed
• Deficiencies that could pose a threat to the company

Audits need to be completed 100% factually.  There should be no bias reported other than in the author’s opinion. Every other section needs to be done objectively.

The organization must provide access to all necessary information and details the auditor deems necessary to complete the report. If any information is withheld, the organization can face severe legal consequences.

Legal Framework for an Audit

Audits are meant to be carried out in a specific manner. Auditors should follow standard practices. This strict system includes a legal framework that ensures the audit’s efficacy.

Sarbanes-Oxley Act (SOX)

The first federal act to go over is the Sarbanes-Oxley Act of 2002. The act protects investors concerning the factuality and historical accuracy of the financial disclosures made by companies.

Public Company Accounting Oversight Board (PCAOB)

The Sarbanes-Oxley Act created the Public Company Accounting Oversight Board. This committee ensures audits made by independent accounting professionals meet certain quality control standards.

The act clarifies that audit firms must be objective and completely transparent to their clients. All information must be communicated and not withheld. The Sarbanes-Oxley Act states that audit firms must be honest about all services.

You would think the act only spells it out for audits, but it says so for all services. The proper internal controls must also be carried out and maintained.

International Financial Reporting Standards (IFRS)

The next legal framework to go over is the International Financial Reporting Standards, commonly abbreviated as IFRS. IFRS provides a benchmark tool that the world, notably the European Union, uses to measure financial reporting as well as transparency of accounts.

Legal Importance Of An Audit: Role of Regulatory Bodies

Regulatory bodies play a crucial role in ensuring that companies and firms adhere to established regulations and maintain the highest ethical standards in the world of audits. We will go over two bodies in this article: the SEC and the FRC.

The U.S. Securities And Exchange Commission (SEC)

The SEC is a prominent regulatory authority, especially well-known within the cryptocurrency realm, owing to its involvement in recent cases such as the downfall of FTX. The agency charged the CEO, Sam Bankman-Fried, with defrauding equity.

The SEC oversees securities exchanges and works closely with the Public Company Accounting Oversight Board to ensure high-quality audit standards.

The Financial Reporting Council (FRC)

The FRC is the United Kingdom‘s regulator for reporting an audit. This council ensures ethical standards for UK auditors and auditing firms. The FRC also ensures that these firms and independent auditors comply with standards and punishes individuals if they do not conduct themselves well.

Internal Revenue Service (IRS)

While we are on the topic of oversight, it is interesting to note that all the information auditors report gets sent to the IRS, which is the Internal Revenue Service of the United States. 

This organization ensures tax records, and everything matches at the end of the fiscal year, and individuals and firms pay whatever they owe to the country. Whenever auditors send information to the IRS, there is an individual who verifies the information.

The main topic we keep hitting in this article is complying with the legal requirements. What exactly does compliance mean? When I say comply with legal requirements, auditors must ensure they are credible and act ethically.

Their audits mean a lot to stakeholders and potential investors, so auditors must perform their duties rightfully and do it in a way that is abiding by the regulations.

One important concept to know is Auditor Independence. Auditor independence has to do with the impartiality of an auditor. The auditor must be free from all bias when doing this financial reporting.

This reporting greatly impacts the economy as other stakeholders and the public have their confidence in these auditors.

To reiterate, it is key that these auditors uphold certain ethics as they are working professionally, so they must act according to their codes of conduct. 

The one reassuring thing for companies is that many committees and organizations oversee auditor interactions, so if there were to be anything wrong, it is very straightforward how to report this and potentially get that auditor’s license revoked.

Legal Importance Of An Audit: Consequences for Non-Compliant Organizations

Let's dive deep into the organization’s side of things. Some of the consequences are:

1. Penalties for Auditors: The auditor will be punished if organizations do not adhere to audit requirements. This can include a fine penalty or possibly revoking their license. These penalties are strict as they need to uphold a sense of credibility. Harsh penalties stop the auditor from repeating such irresponsible behavior.
2. Consequences for Organizations: Based on how the governing authority rules, the organization can face penalties or fines. These consequences will vary depending on the severity of the non-compliance. 
   • More often than not, organizations that do not comply take a hit in their reputation. As a result, the company may also lose stockholders.
3. Correcting False/Misleading Information: Suppose an auditor remarks that there is false or misleading information to the company. In that case, it is up to the organization to verify this error and then complete the statement to correct the published information.
4. Legal Action: If it is found that an auditor verified a false statement, then there can be legal action taken, such as a lawsuit. Then, this liability can reach anyone in the organization, namely the executives and Board of Directors, and will be taken to court. The company may face major costs and damage to its prestige.
5. Fraudulent Activities: The worst-case scenario for a company is engaging in fraud. Such actions come with severe punishments, and a company that commits fraud often struggles to recover. They stand to lose stakeholders and customer base.
   • Customers lose trust and confidence in the company, resulting in a decline in the existing customer base and making it increasingly challenging to attract new customers.

Legal Importance of Audits for Stakeholders

Let’s discuss the individuals who need the audit to go well - the stakeholders.

Stakeholders have put money into the company, so they expect a company to perform well and get returns. Any company's main stakeholders are suppliers, investors, and directors.

1. Providing important information: Stakeholders rely on these audited statements to make informed decisions. Since the auditors are supposed to have a fair and truthful view of the organization’s finances and performance, these stakeholders are fully trusting these auditors.
   • Auditors need to make mistake-free assessments and ensure there’s no misleading information in the reports. A company with auditors who assess financial performances is one step closer to transparency than a company that does not get audited.
2. Performing a key task for companies: A lot of companies do not have individuals trained in doing these auditing checks, so having a trained professional come in and do this work will allow the company to reap benefits in the long run.
   • Their chances of fraud are much slimmer, and the stakeholders will be more satisfied with their choices and decisions in investing with that company.
3. Tax Compliance: Audits provide stakeholders with an extra layer of security that the firm they are invested in has complied with tax procedures. Tax filings were done correctly. Enough proof is provided in audits about tax claims and tax defenses.
   • Audits do have a major role in stakeholders’ interests; they provide a sense of financial accuracy, promote transparency, mitigate the risk of fraud and other negative events, and ensure tax compliance.

Importance of Audits in Legal Proceedings

Audits are critical during legal proceedings. These proceedings are usually misconduct or fraud. The legal authorities rely on audits to verify claims and determine any violations. 

Verifying Claims

When regulatory bodies do conduct investigations, they often ask for the audit and documentation. Audit reports provide insight into the organization’s finances, and auditors may need to testify in court to verify claims.

Audit reports are very strong evidence in court because they are an objective view of a company and its finances. Since auditors are the experts, they can verify any claims, and the court values audits as a valuable source of information.

If auditors do find any irregularities or fraudulent activities during an audit, organizations may face penalties, injunctions, or criminal charges, depending on the severity of the case.

As mentioned before, if a company does not disclose any materials or there are deficiencies in internal controls, organizations may face fines and also need to implement new measures in the workplace.

Mitigation

Audits ensure liabilities are corrected and there is little chance of legal action and/or financial loss. 

Healthcare Standards

In industries like healthcare, firms must only produce goods that abide by safety and quality standards.

The firm can pull that product and/or release a recall if an audit catches that the good was incorrectly produced. This would reduce the risk of a legal proceeding or defect.

Environmental Regulations

Audits also ensure that firms have worked along with environmental regulations. Nowadays, the penalties for pollution or environmental damage can seriously set a company back.

Therefore, audits allow companies to verify everything before it becomes serious.

International Business

International business is a large part of the economy. Trade agreements must be made and followed.

There are specific duties the company must handle with customs and border protection agencies. Audits can prevent legal issues in international business.

Legal Importance of Audits for Internal Controls

Internal controls are the policies and processes an organization uses to verify whether its financial information is reliable and accurate. Audits assess how effective these internal controls are. These two work hand-in-hand.

Ensuring The Internal Controls Are Suitable

Audits make sure that the internal controls are designed and used correctly. Internal controls ensure that the audits work successfully and that there are few chances of irregularities and fraudulent behavior.

Some internal controls are segregating duties, establishing responsibilities, checks and balances, enabling the workplace to collaborate, and lifting everyone up.

Lower Chance Of Fraud

The chance of committing fraud decreases significantly if a company is audited. Auditors can also end up recommending what an organization should do or how to better their internal controls.

These auditors want to help a company, and they don’t want the company to end up in a lawsuit or with any fines, as that also tarnishes their record as an auditor. 

Compliance Programs

Audits and internal controls also work together through compliance programs, which ensure organizations follow regulations and standards.

If a company passes all the compliance programs, there is little to no risk of legal deficiencies and problems. The audit would then go smoothly.

Conclusion

Audits are extremely important and useful for organizations. They promote transparency, allow shareholders to get a look at a company’s finances, and can help the company steer away from any risks of fraud or misstatements.

Auditors need to work with a closely monitored legal framework that ensures the audits are up to regulations and assess a company in the most fair way possible.

These audits must comply with legal requirements; likewise, it’s even more important that the organizations follow these requirements to avoid lawsuits or legal trouble. 

Audits give stakeholders some confidence that the company they are invested in is acting the right way. These companies must have strong internal controls, auditors must remain independent, and accurate information must be shared through audit reports. 

Audits are a great way to verify information. Understandably, not every company has auditors working for them, so it’s important to reach out to auditing firms or independent auditors so that they can look at the finances.

If more companies were to adopt audits, there would be a lot more transparency in society and responsible financial management. 

It is recommended that organizations use audit processes to work with qualified auditors and ensure their internal controls and compliance programs are up to par. 

Audits are not supposed to be viewed as a way for companies to be put in their place or for wrongdoings to be recorded, but rather a way for organizations to work with their stakeholders’ interests, decrease the likelihood of a legal proceeding, and verify internal controls.

Researched and authored by Omkar Iyer | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Assertions in Auditing
• Audited Financial Statements
• Auditor Opinions
• Auditor's Report
• What Is An Audit