Table of Contents What Is an Audit Trail? Understanding an Audit Trail Types of Audit Trails Audit Trails Pros and Cons Examples of an Audit Trail Pros Encourages user accountability and compliance Helps maintain a well-functioning economy Protects against fraud Improves security Costliness in terms of time and money Can slow business operations Requirements may be too rigid The Order Audit Trail System (OATS) is an automated trade entry system established by the Financial Industry Regulatory Authority (FINRA) that is used to record information relating to orders, quotes, and other trade-related data from all equities traded on the National Market System (NMS). Audit trails also force entities to maintain a thorough and updated audit log and trail system, which further cuts down on fraud and other types of financial crime. Without the use of audit trails to confirm financial information, there would be no reason to believe in the legitimacy of a company's financial reports. Auditing FAQs An audit trail is a step-by-step record by which accounting, trade details, or other financial data can be traced to their source.
What Is an Audit Trail?
An audit trail is a step-by-step record by which accounting, trade details, or other financial data can be traced to their source. Audit trails are used to verify and track many types of transactions, including accounting transactions and trades in brokerage accounts.
An audit trail is most often utilized when the accuracy of an item needs to be verified, as it might be in the case of an audit. Audit trails can be useful tools when determining the validity of an accounting entry, source of funds, or trade.
Understanding an Audit Trail
Audit trails can be used in accounting when an auditor or examiner needs to verify figures such as revenue, net earnings, or earnings per share (EPS). Transactions that are involved in computing a company's revenue, net earnings, or earnings per share are reviewed and the calculations may be redone if figures were incorrectly classified.
The cost of goods sold (COGS), for example, is an expense item subtracted from gross revenue that's used when calculating net earnings. The COGS figure would be double-checked by verifying the transactions and data sources that went into calculating the cost of goods sold. All elements of the final numbers are double-checked along the audit trail to verify the final figure.
All public companies undergo a financial audit as part of their reporting responsibilities.
Types of Audit Trails
Audit trails, or rather the process of following an audit trail, are found in many different areas of finance. When buying a home, for example, a mortgage lender may utilize an audit trail to determine the source of funds for a down payment. They may ask to see a bank statement showing the deposit of funds into the account and ask for additional verification regarding the source of the deposit.
The Securities and Exchange Commission (SEC) and NYSE will use audit trails for the explicit reconstruction of trades when there are questions about the validity or accuracy of trade data. This is done to ensure that the trades taking place on major exchanges are in compliance with current regulations.
Of course, audit trails can also be used to track improper market activity. If it is believed, for example, that a particular entity is trading large volumes of a thinly traded stock for the purpose of manipulating the share price, a regulator can utilize an audit trail to help identify the culprit.
A regulator will then document and analyze all houses and brokers involved in specific trades for the offending security to determine whose activity is abnormal and who might be the manipulator. Depending on the complexity of the trading scheme being used, reconstructing the trade history may require forensic accounting in addition to audit trail data.
Advantages and Disadvantages of Audit Trails
Audit trails are a vital tool used by accountants to hold corporations accountable for their actions. Without the use of audit trails to confirm financial information, there would be no reason to believe in the legitimacy of a company's financial reports. In this way, audit trails not only protect consumers from fraudulent reporting, they also help to stabilize the overall economy.
Audit trails also force entities to maintain a thorough and updated audit log and trail system, which further cuts down on fraud and other types of financial crime. In industries such as healthcare, the meticulous keeping of audit logs helps ensure that sensitive information, such as HIPAA-protected data, can only be accessed by the appropriate parties.
While audit trails provide financial information that is absolutely necessary for the smooth flow of business, there are challenges to maintaining and implementing the practice.
The biggest issue faced by corporations is the time and money it takes to maintain a sufficiently compliant audit log, especially when the audit log is automated. Logs also may be difficult to navigate and store as they increase in size. Furthermore, access may be too broad, which can compromise the integrity of the data.
Finally, as in the case of banks looking to approve loans to their members, sometimes the requirements of audit trails are unnecessarily rigid. If, for example, a consumer fails to keep appropriate financial records, they may be unfairly rejected for loans for which they would otherwise be approved.
Examples of an Audit Trail
The Order Audit Trail System (OATS) is an automated trade entry system established by the Financial Industry Regulatory Authority (FINRA) that is used to record information relating to orders, quotes, and other trade-related data from all equities traded on the National Market System (NMS). This system simplifies an order's progression from its initial receipt to its eventual execution or cancellation, for easy tracking or auditing purposes.
One of the purposes of OATS is monitoring for suspicious behavior and providing an audit trail for investigators. Because of the data that is recorded, anyone involved in suspicious activity is easier to find.
A significant case occurred on May 6, 2010, when a day trader "spoofed" the S&P 500 E-mini market. He used an automated program that started a domino effect of sell orders which led to a flash crash that day. The man responsible, a London resident, was caught and arrested in 2015. In 2016 he pleaded guilty to spoofing and wire fraud.
While a number of parties were involved in providing testimony and evidence, and this case involved futures, not stocks, it shows the importance of order audit trails and financial oversight. The regulators were able to see that Navinder Singh Sarao, the man responsible, put out hundreds of huge orders with no intention of filling them, but rather for the sole purpose of manipulating the market in his preferred direction.
Another famous example of fraud discovered by auditing practices in recent years was the case of Enron. In the late 1990s, Enron was praised for its innovation and was one of the darlings of Wall Street. However, the company had significant exposure to some of the hardest-hit sectors of the dotcom bubble crash in 2000. Instead of eating its losses and moving forward honestly, the company hid its losses from investors and inflated profits in other sectors to appease shareholders.
The firm tasked with auditing the company, the now-defunct Arthur Andersen, signed off on Enron's reports even though they knew the documents were fraudulent. Eventually, the losses were too big to hide and Enron was forced to file for bankruptcy.
Even though Arthur Andersen's CEO ordered auditors to destroy all Enron documents that revealed fraud, eventually the truth came out and employees at both Enron and Arthur Andersen were charged criminally.
The Enron case presents one of the most convincing arguments of the need for accurate and thorough audit logs.
In response to the Enron scandal, President George W. Bush signed into law the Sarbanes-Oxley Act. The Act heightened the consequences for destroying, altering, or fabricating financial statements and trying to defraud shareholders.
What Are Auditing Standards in the United States?
Companies in the United States are required to abide by generally accepted accounting principles (GAAP).
What Is Internal Auditing?
Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. This report provides management with the tools necessary to attain operational efficiency by identifying problems and correcting lapses before they are discovered in an external audit.
What Is Materiality in Auditing?
According to the U.S. GAAP, materiality is described in this way: "The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item."
How Will I Know If the IRS Is Auditing Me?
If you are being audited by the IRS, you will be notified by mail. The IRS does not notify individuals via telephone. For more information, consult the IRS website on audits.
What Should a General Ledger Audit Trail Include?
A general ledger audit trail should record all of a company's transactions and all of the documents — whether paper or electronic — related to those transactions. This could include invoices, purchase orders, and expense reports, as well as any other information that can confirm the source and contents of the transaction.
What Documents Are Included in a Payroll Audit Trail?
A payroll auditing trail should include all employees' identification information, expense reports, tax documents, and any documentation related to changes in their salary as well as to bonuses or additional compensation.
The Andersen Effect is a reference to auditors performing more careful due diligence when auditing companies in order to prevent accounting errors. read more
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