Why the role of the external auditor is important to users of financial statements?

Definition of External Audit

External Audit is an independent examination of the financial records maintained by the company done by a third person (who is appointed by the shareholders of the company in the general meeting) and provide an opinion whether the financial statements as a whole give a true & fair view of the state of affairs of the entity, of the profit/loss of the company & of the cash flows of the company for the year ended.

Explanation

• Audit means an examination of the financial records of the entity.
• Such an examination has to be done in a systematic manner & independent from the entity. An audit may also be applicable to a non-profit-oriented entity.
• Now, an external audit is generally called a financial audit or statutory audit (since the same is mandated by the statute or law governing the entity).
• The external audit is done by a CPA (Certified Public Accountant) in the United States of America & by CA (Chartered Accountant) in India. Such persons are known as auditors of the entity.
• The end purpose is to a given opinion on the financial statements.
• The opinion is provided in the audit report. The opinion can be any of as follows:
  • Clean Report: It means there are no material misstatements in the financial statements.
  • Qualified Report: It means such financial statements have some sort of identifiable material misstatement.
  • Adverse Report: Such an opinion is dangerous for the financial health of the company & creates many doubts in the eyes of regulatory authorities. The adverse opinion means the financial statements are materially misstated & the effects are found everywhere in the financial statements.
  • Disclaimer of Opinion: Such opinion reflects the weak internal policies of the company since the auditor is not provided with proper information to form an opinion.

Purpose of External Audit

The main purpose of an external audit is as follows:

• Verification of the accounts of the entity.
• Ensuring whether the company is compliant in respect of laws & regulations.
• Ensuring whether the financial statements give a true & fair view of the company.
• Ensure that all relevant accounting standards, as applicable, are followed by the entity.
• The purpose is also to increase the confidence of stakeholders about the financial status of the company.

Objectives of External Audit

• The main objective is to provide an opinion on whether the financial statements as a whole give a true & fair view in all material respects of the state of the affairs of the company and are free from material misstatements whether arising due to fraud or error.
• Also, the auditor needs to confirm whether the entity is presenting the financial statements in accordance with the applicable financial reporting framework.
• For the purpose of achieving the said objectives, the auditor needs to follow audit procedures & guidelines as provided by the governing body of the auditors.
• The external audit also ensures about the completeness, accuracy, consistency of the financial records of the entity.
• The audit engagement letter specifies the objectives as well as the scope of the audit. The audit engagement letter works as a contract with the client since it has clear details about the rights & responsibilities of the auditor as well as the management, scope, timing & extent of audit procedures, fees to be charged, etc.
• Auditor has to report a number of things as per the requirement of the statute. Hence, the auditor also has the objective to gather evidence for the purpose of reporting.
• However, one should note the fact that the auditor is not appointed with the objective to detect fraud within the entity. Detection of fraud is altogether a different type of assignment & cannot be merged with the normal statutory audit. But, if during the normal course of procedures of the audit, the auditor identifies any fraud, then he/it should report the same to those charged with governance.

External Audit Process

The typical external audit process goes as follows:

Step 1: Appointment of the Auditor

• Here, the shareholders need to ensure that the person is independent from the affairs of the company in all respects.
• A firm or an individual is recommended by the audit committee of the company on the basis of various factors filtered by the committee.
• Such a recommendation is placed by the board of directors of the company in front of the shareholders for their approval in the annual general meeting.
• Once the majority votes are received, the appointment is approved

Step 2: Confirmation by Auditor

• After appointment by the company, the auditor ensures his independence at his end.
• He/she checks whether the said appointment can be accepted.
• If everything is fine, he provides confirmation to the company.
• The company needs to inform the said appointment of the governing body.

Step 3: Audit Engagement

• A formal engagement contract is made between the company & the auditor.
• Such a contract enumerates the audit objectives, independence of the auditor, responsibilities of each party, audit fees to be paid, etc. such that everything is clear between the two parties.
• The engagement letter also ensures the scope of work to be done.

Step 4: Audit Planning & Execution

• Here the main task of the auditor starts. He needs to prepare an audit plan first, containing the deadlines for each area & the overall deadline for completion of the audit.
• Once the plan is in place, the auditor prepares audit programs for the execution of the audit.
• He also assesses the significant risks in the financial statements of the entity, through his normal audit procedure.

Step 5: Collection of Evidences

• As per the audit program, the auditor needs to collect evidence to support his opinion in the audit report.
• Such evidence needs to be corroborative in nature i.e. convincing evidence.

Step 6: Audit Report

• The signing of the audit report is the last step in the external audit process.
• Here, the process for the said year gets completed in its entirety.
• Auditor gives his opinion as per his judgments about the financial statements.

Example of External Audit

ABC Inc is a public limited company with effect from January 1, 2020. It was earlier a private limited company. It has its own audit department ensuring the compliances & also have an internal audit department of its own. ABC Inc is of the view that the internal owned departments are very strict in the compliances & have knowledge of the entire business. Thus, it is of the contention that no external audit should be required. Also, it contends that the internal department can work independently & can issue an audit report. Is the view stated by ABC Inc appropriate & valid in law?

Solution:

The contention is not valid due to the following reasons:

• The audit departments owned by the entity cannot be said to be independent since they are under employment by the company.
• They cannot sign the audit report.
• Even if it has strong internal policies, it has to be checked by an independent person altogether.
• Analysts will never rely on internally generated audit reports since the same is subject to any sort of manipulations.
• It is mandatory for publicly listed companies, to get the accounts audited by an independent individual or a firm of such individuals.

Scope of External Audit

• The scope of the external audit includes checking the compliances of the relevant laws & regulations governing the entity.
• The auditor needs to ensure the validity & authenticity of the financial records.
• Reporting of fraud by or on the company, if the auditor identifies during the normal procedure of audit program.
• Early detection of errors is also included within the scope of external audit.

Importance of External Audit

• The external auditor is appointed by the shareholders of the entity. Thus, it is important for the auditor to report to the shareholders about the compliance well-being of the entity.
• Audit report ensures the shareholders & management about the effectiveness & efficiency of the internal controls of the organization.
• The hidden fraudulent mechanism of the entity is stopped due to the audit process in place.
• The management becomes answerable to the qualifications or adverse opinions of the auditor. This has serious implications on the management of the entity.
• Investors rely only on audited financial statements. Thus, an examination by an independent person enhances the reliance of potential investors.

Conclusion

The external audit is all about giving an opinion on the financial statements of the company. It is the most important audit for the entity, amongst the other audits. The opinion para of the audit report is the most important area in the whole audit report. The management has to answer the shareholders, in its meeting, about the qualifications or concerns raised by the auditor. The external auditor also provides information about the critical audit matters of the entity. This para helps the readers understand the critical area in the whole financial statements of the company. In some cases, the company needs to change its auditors after a certain set of years are completed. This further ensures the independence part of the auditor.

Recommended Articles

This is a guide to External Audit. Here we also discuss the definition and objectives of external audit along with scope and importance. You may also have a look at the following articles to learn more –

1. Inventory Audit
2. Audit Assertions
3. Audit Risk
4. Statutory Audit