Internal Audit: Definition, Types, & Process

For most people, the word audit brings to mind taxes and stress. While financial audits are probably the most common, both internal and external, there are many other types. Some types of external audits are legally required by regulatory bodies; internal audits are not a legal requirement. However, most companies regularly carry out internal audits in a variety of areas.

Internal audits provide a variety of benefits in terms of risk management, process control, and assessment of compliance, performance, and efficiency. They are also a great way to prepare for external audits and avoid nasty surprises in the form of fines or other types of disciplinary actions.

In this article, you will learn about internal audits and their purpose, as well as the different types available. You will also learn about the steps involved in the process and the 5Cs of internal audits.

What is an Internal Audit?

An internal audit comprises a series of procedures and checks that are designed to provide objective assurance regarding different aspects of the company's performance and operations.

The words “internal audit” are frequently used to refer to the process itself or the department responsible for its execution.

Internal audits are carried out voluntarily by the company itself, usually looking to improve in certain areas or preparing for an external audit or inspection. External audits, on the other hand, are required by entities external to the company. Unlike internal audits, which assess multiple aspects of the business, external audits usually focus on financial practices and reporting, as well as internal financial controls.

What is the Purpose of an Internal Audit?

Internal audits aim to provide an objective source of information on various aspects of the company. Among other things, internal audits can assess risks to the organization, the control environment, the effectiveness of operations, and compliance with laws and regulations.

If the company lacks the resources to carry out internal audits, an external company may be hired for this purpose. However, it would remain an internal audit, as it would be commissioned by the company itself. External audits are carried out by auditors that are external to the company - usually from CPA firms - and completely independent of it.

Unlike external audit results, which are reported to shareholders and people outside the company, internal audit results are usually reported to those responsible for internal management. Management uses these reports to improve operations or prepare for external audits or inspections.

What are the Different Internal Audit Types?

Below, you will find descriptions of specific types of internal audits that cover key aspects of your business.

Financial Audits

Internal financial audits focus on different aspects of the company’s finances, like accounting and reporting practices and standards. Financial audits can be carried out on the company as a whole or applied to specific projects or assets. These audits can also be used to verify the accuracy and validity of billing, expenses, or reimbursements.

Compliance Audits

Some audits are specifically concerned with ensuring compliance with applicable laws and regulations. These can cover a wide range of areas, including financial practices, data protection and privacy, handling and disposal of toxic or dangerous products or substances, and different aspects of sustainability policies.

IT System Audits

Regardless of the industry, most companies use at least basic systems based on information technologies. These systems need to be checked regularly, both in terms of the infrastructure and the accuracy and efficiency of policies and procedures. Depending on the nature of your business, these procedures can include security and access control, data management and recovery, as well as all software, hardware, and system backups and recovery procedures.

Operational Audits

An operational audit focuses on assessing whether the company’s current resources and procedures are sufficient to ensure it can run efficiently and meet its objectives. Operational audits are usually performed as a result of significant changes, such as changes in the company’s management or changes in key roles in different departments.

Performance Audits

Unlike operational audits, which focus on process, performance audits focus on results. Each company has its own set of performance goals and objectives that are evaluated using different metrics. Often, these metrics are used to decide whether employees receive incentives like bonuses or promotions. However, not all aspects of performance can be measured easily, and some simply cannot be quantified.

Special-Purpose Audits

Special purpose audits are those that respond to specific circumstances or events and are usually one-time events.

Internal Audit Process

Now that you know the different types of internal audits most frequently used, it’s time to learn the main steps involved in the process.

1. Planning

As usual, the first step is to plan the audit carefully, which includes defining the scope and objectives of the audit. The audit team needs to set specific requirements and review relevant documentation, including laws, regulations, industry standards, and company policies.

The audit team also reviews the results of previous audits and sets the budget and a timeline for the audit. Once the audit has been planned, and the checklist created, a meeting will be scheduled to launch the process.

2. Fieldwork

This step is where the auditing activities actually take place. Fieldwork comprises various activities, including interviews with employees in key roles, reviewing documents or artifacts that provide evidence of the execution of controls, testing the controls, and documenting the work performed.

3. Reporting

In addition to being objective, reports should be clear and precise to avoid misunderstandings. These reports also include recommendations and suggestions for improvements, together with the findings. A draft of the report is usually reviewed with management to ensure accuracy before distributing the final report.

4. Monitoring

This last step is crucial but sometimes overlooked. It’s important to continue monitoring after the final report has been issued. These reports often include actionable recommendations and suggestions, so it’s necessary to follow up and ensure they are implemented. Otherwise, the process audit could end up being an expensive but ultimately useless event.

What are the 5 C's of Internal Audits?

The 5Cs of internal audits refer to the reporting requirements of these audits. The full report should summarize the answers to questions relating to the criteria, condition, cause, consequence, and corrective actions.

Criteria

Why was the audit necessary? What was the specific focus of the audit? Is the aim to improve operations or prepare for an external audit?

Condition

What company expectations were not being met? What specific condition was not satisfied? Was the audit the result of a rule or regulation being broken?

Cause

What caused the issue? Why did it arise? Who was involved? What processes were involved? How could the issue have been avoided?

Consequence

What was the outcome of the problem that triggered the audit? What are the internal consequences of the problem? Are there potential external consequences?

Corrective Action

How can the problem be fixed? What are the specific steps necessary to resolve the problem? What kind of monitoring will be implemented to ensure corrective actions are applied?

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Conclusion

Although internal audits are not always a requirement for a business, they are highly recommended. In addition to helping you ensure compliance with the laws and regulations your company needs to follow, internal audits can serve to identify areas for improvement.

You now know what an internal audit is and how it differs from an external audit. You have descriptions of the most common types of internal audits, and you understand the steps involved in the internal audit process. Finally, you also know about the 5Cs of internal audits. To learn more about other types of internal controls, take a look at this article on The 3 Types of Internal Controls.