External Audit: Its objective, purpose and importance

The primary purpose of an external audit is to enhance the credibility of a business by attesting to its financial health; for listed companies external auditing drives up its share price as investors are convinced that a healthy report by a neutral party means the company is doing well and expected to maintain the momentum in coming times. To put it in layman terms, an external audit refers to the examination or scrutiny of financial statements of an organization by an independent body i.e the body operates independently of the entity being audited. As far as external audit is concerned, it is important to note that it is done for statuary purposes i.e. it is required by law. External audit reports are generally of interest to stakeholders, investors, government agencies, financial institutions, shareholders, etc who treat unbiased and unhampered report by an independent body to be the real marker of an organization’s performance and its financial health.

1. How the organization is working i.e. its state of affairs
2. Operations during the concerned period

Appointment of the auditor for External Audit

An external audit is carried out either as part of the annual review of accounts or the audit may be necessitated by a request for special review by a donor agency. External audit is carried out by registered and recognized professional accountancy bodies with accountants who have known and recognized professional qualifications, such as CPA, ACA or ACCA. The report of the audit carried out by external auditors are generally addressed to the shareholders of a company. In the United States external audit can be conducted by non-governmental external auditors only if they are certified public accountants. They are eligible to carry out external review of the financial statements of a corporation and submit the report for public review. In the UK, and other countries, external auditing and report submission is carried out by Chartered Accountants and Certified General Accountants.

In the United States, companies that are listed on stock exchanges, external audit is conducted in accordance with the Sarbanes-Oxley Act (SOX), which has promulgated rigorous requirements on external auditors who carry out assessment of financial statements of a corporation. In many countries external auditors conducting external audit of government run corporations are appointed by an independent government body such as the Comptroller and Auditor General. Securities and Exchange Commissions also have the power to impose stringent rules and regulations on external auditors to maintain the fairness and transparency of audit.

Purpose of appointing an external auditor

The primary purpose of external audit is to ensure that the financial statements provided by an organization are up to date, accurate and trustworthy and paints the right picture with respect to financial health of a company. External audit also ensures that the corporation is utilizing funds as per the existing rules and regulations. An important thing to note here is that the primary job of an external auditor is not to detect fraud, though a mismatch in the financial details provided by the corporation and those found by auditor is a clear cut case of mismanagement and financial misdemeanor. External auditors as such are generally described as ‘watch dogs’ and not ferocious bloodhounds who are constantly on the trail for hunt.

What is involved?

It is very important to note that auditors do not have the luxury of finishing their work at their own time and leisure. They have a very limited time in which they have to complete their work and submit the report. As such they direct their energy and effort on testing the genuineness of a sample of transactions and results instead of delving deep to check everything with a fine comb. External audit is undertaken to attest to the veracity of the financial reporting of a corporation and as such it is of paramount importance that their independence and authority is respected in all circumstances. However, since they are investing their time and efforts going through the report, it is only but natural that they will demand compensation for their hard work.

As mentioned above, auditors are watch dogs and not bloodhounds let loose to catch acts of omission and commission by a corporation, it is therefore of paramount importance that all audits should be treated as a positive experience by companies and not something that inspire fear and trepidation. External auditing is a true chance for a corporation to properly assess its strengths and weaknesses and rectify them at the earliest to maintain competitive growth in the marketplace. Corporations should treat the report as something that could aid them in improving their overall accounting system. Also, corporation should insist that the external auditors submit a Management Letter which lists the summary of the finding, highlights loopholes and contains genuine suggestions about overcoming the weaknesses.

The audit report

The result of any external audit is an ‘audit opinion’ which states whether the financial statements handed over by the corporation give a ‘true and fair’ view about how the organization is conducted its operations for the given period.

True: It attests to the veracity of the transaction and existence of an asset.

Fair: It attests to the veracity of the value of the transaction as well as that assets and liabilities are fairly stated.

If the external auditors believe that the financial statements do not give a ‘true and fair’ value, they are at liberty to give various other opinions which are listed as following:

Adverse: The statements contain so many glaring errors and misstatements that they are overall wrong.

Qualified – disagreement: There is a certain degree of misstatements such as incorrect accounting policy, bad debts, undisclosed frauds, etc.

Qualified - limited scope: There is certain degree of ambiguity involved, few documents have not been made available for review, some internal inconsistencies are present, which may lead to non-recording of income, etc.

About the author

Sumit Agarwal
Sumit Agarwal (ACMA ACA India), the Managing partner of dns accountants is a highly respected accountant with expertise in helping owner-managed businesses.