Audit Trail

By  ADAM HAYES

 Reviewed by 

MICHAEL J BOYLE

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.

KEY TAKEAWAYS

 An audit trail is a sequential record detailing the history and events

related to a specific transaction or ledger entry.
 Maintaining an audit trail is often a regulatory requirement in many
financial domains, as well as an accounting best practice.
 Order audit trails provide evidence and information for regulators in
cases of suspected fraud or illegal financial activity.
 The use of audit trails helps to stabilize the overall economy by
confirming the information corporations release to the public.
 Regulatory institutions such as the SEC and the NYSE will use audit
trails for the explicit reconstruction of trades when there are
questions as to the validity or accuracy of trade data.

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.
Pros
 Encourages user accountability and compliance
 Helps maintain a well-functioning economy
 Protects against fraud
 Improves security
Cons
 Costliness in terms of time and money
 Can slow business operations
 Requirements may be too rigid

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 2015.1 In
2016 he pleaded guilty to spoofing and wire fraud.2
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.

Auditing FAQs
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."3

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.

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