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 its 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, such as 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.
- 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.
Understanding the 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.
For example, cost of goods sold (COGS) is an expense item subtracted from gross revenue used when calculating net earnings. The cost of goods sold figure would be double-checked by verifying the transactions and data sources that went into calculating 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.
How Audit Trails are Used
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 as to the validity or accuracy of trade data. This is 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. For example, if it is believed 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.
Example of an Order Audit Trail: OATS
The Order Audit Trail System (OATS - now called CATS) is an automated trade entry system established by the Financial Industry Regulatory Authority (FINRA) used to record information relating to orders, quotes, and other related trade data from all equities traded on the National Market System (NMS). This system simplifies an order's progression from the initial receipt of the order to its eventual execution or cancellation, for easy tracking or auditing purposes.
One of the purposes of OATS is to monitor for suspicious behavior and provide an audit trail for investigators. Because of the data that is recorded, the people undertaking the suspicious activity are 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 on that day. In 2015 the man responsible, a London resident, was caught and arrested. 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 being filled on them but rather for the sole purpose of manipulating the market in his preferred direction.