What is External Audit?
External Audit is defined as the audit of the financial records of the company in which independent auditors perform the task of examining the validity of financial records of the company carefully in order to find out if there is any misstatement in the records due to fraud, error or embezzlement and then reporting the same to the stakeholders of the company.
The objective of an external audit report includes the determination of the completeness and accuracy of the accounting records of the client, ensuring that the records of the clients are prepared as per the accounting framework which applies to them, and ensuring that the financial statements of the client present the true and fair results and the financial position.
Table of contents
- The term “external audit” refers to an examination of a company’s financial records by independent auditors tasked with determining the records’ accuracy.
- They are focused on identifying any misstatements that may have resulted from fraud, error, or embezzlement before informing the relevant parties.
- It aids in establishing the true picture of the company’s financial and market status, which further serves as the foundation for managerial decisions.
- Auditors examine the accounting books, purchase records, inventories, and other financial information to ensure that the business operates properly. They arrange their audits and base their work on them. They assess the company’s compliance with GAAP as well.
External Audit Explained
External audit is the process of examination and analysis of the company’s financial documents by an auditor or a team of auditors, external to the company. These audits are conducted to ensure there are no cases of fraud, embezzlement, or genuine errors from individuals within the company.
Auditors examine the accounting books, purchasing records, inventory, and other financial reportsFinancial ReportsFinancial reporting is a systematic process of recording and representing a company’s financial data. The reports reflect a firm’s financial health and performance in a given period. Management, investors, shareholders, financiers, government, and regulatory agencies rely on financial reports for decision-making. to check that the company is functioning in the right manner. They conduct the external audit process based on these parameters.
Moreover, They also determine whether the company following GAAP standards or not. They perform the test and then submit a detailed report to the authorities. It conducted with the purpose to gather different information so that the auditors can give their opinion on the true and fair view of the company’s financial position as on the balance sheet date. External audit increases the authenticity and credibility of financial statementsFinancial StatementsFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. as the financial statements of the company are being verified by an independent external party.
Let us understand the external audit process with the help of a couple of examples as discussed below.
XYZ ltd manufactures garments and is listed as a publicly-traded companyPublicly-traded CompanyPublicly Traded Companies, also called Publicly Listed Companies, are the Companies which list their shares on the public stock exchange allowing the trading of shares to the common public. It means that anybody can sell or buy these companies’ shares from the open market., i.e., sell their shares to the public. The company wants to know whether they are liable to get its financial statements audited by an external auditor or not.
As per the law, all the company publicly traded businesses or corporations which sell their shares to the public are legally required to get their financial statements audited by an external auditor. The objective includes the determination of the completeness and accuracy of the accounting records of the client, ensuring that the records of the clients are prepared as per the accounting framework and ensuring that the financial statements of the client present the true and fair financial position. Hence, the company will appoint an auditor who will conduct the external audit of the company and give its audit report in writing, which will be based on the various evidence and information gathered on the true and fair view of the financial statements provided to him to the concerned parties.
Gold Resource Corporation reported the results of its yearly operations in December 2022. In the report, they declared net losses of $6.3 million and EBITDA of $19.5 million.
They also clarified that their external audit firm, BDO USA, LLP was yet to finish their audit. Once their external audit report was procured, they would be able to confirm the net results of the company’s performance.
Roles & Responsibilities
Let us understand the roles and responsibilities of an external audit process through the discussion below.
- The main responsibility is to verify the company’s general ledger and make all other essential inquiries from the company’s management. It helps to determine the real picture of the company’s market and financial situation, which further provides the basis for managerial decisions.
- Examine the validity of financial records to find out if there is any misstatement in the company’s record because of fraud, error, or embezzlementEmbezzlementEmbezzlement refers to the act of secretly taking, withholding, or misappropriating money or other asset that is kept, maintained, or placed under an individual's responsibility by the company for which he or she works.. So, it increases the authenticity and credibility of financial statements as the financial statements of the company.
- If there are errors in the accountingErrors In The AccountingAccounting errors refer to the typical mistakes made unintentionally while recording and posting accounting entries. These mistakes should not be considered fraudulent behaviour first-hand as this can happen with anyone and by anyone. process of the company, then it may prohibit the owner of the company is taking the decisions which are best for the company. An audit helps in overcoming this problem to a great extent as the procedures in the audit are designed in such a way that they help in detecting the errors in the system and the other fraudulent activity. The audits also ensure the recording of accounting transactions as per the generally accepted accounting principleGenerally Accepted Accounting PrincipleGAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting.. It helps the owner of the business to cover themselves when it comes to following the different rules and regulations which the registered entity needs to follow.
Even though an external audit report increases the credibility of a company’s financials, there are a few factors that prove to be a hassle. Let us understand them through the explanation below.
- The audit is conducted by reviewing the sample data of the company, which the auditor thinks is material for his examination. An auditor does not assess and review all the transactions which occurred in the company. Thus, he merely expresses his audit opinion on the financial statements and data based on the sample data provided to him. Therefore, this does not give total assurance about the financial position of the company.
- Expenses involved in conducting an audit may be very high.
- In all stages of accounting, from preparation to finalizing the financial statements and expressing the audit opinion, there is the involvement of humans and thus making it prone to error. Also, if there is a lack of knowledge or experience of an auditorAuditorAn auditor is a professional appointed by an enterprise for an independent analysis of their accounting records and financial statements. An auditor issues a report about the accuracy and reliability of financial statements based on the country's local operating laws. in the relevant field, then the purpose of the audit will not solve.
Let us understand the importance of an external audit process through the discussion below.
- The main purpose for which the external audit is conducted includes the determination of the completeness and accuracy of the accounting records of the client, to ensure that the records of the clients are prepared as per the accounting framework which applies to them and to ensure that the financial statements of the client present the true and fair results and the financial position. A statutory auditorA Statutory AuditorOne of the most common types of audits is the statutory or financial audit. Its main purpose is to gather all relevant information so that the auditor may provide an accurate and unbiased assessment of the company's financial position. can ask for the company’s financial books, records, or information in relation to that for which the management cannot deny him.
- After conducting the audit and gathering necessary information, the external auditor is supposed to give its audit reportAudit ReportAn audit report is a document prepared by an external auditor at the end of the auditing process that consolidates all of his findings and observations about a company's financial statements. in writing, which will be based on the various evidence and data collected on the true and fair view of the financial statements provided to him to the concerned parties.
- Most commonly, an external audit is intended to get the certification of financial statements of the company. Certain investors and the lenders require this certification for their analysis. Also, all publicly traded businesses or the corporations which sell their shares to the public are legally required to get their financial statements audited and get this certification.
Frequently Asked Questions (FAQs)
An unbiased analysis of the financial accounts can show shareholders that the business is being operated in their best interests and can draw their attention to any problems that may not have been brought to their attention.
An external audit of financial statements aims to determine whether, in the auditor’s judgment, they present information about the company’s financial status honestly and fairly in all material ways.
An external audit allows the government and the company to examine the organization’s financial operations. An external audit guarantees that the company’s financial statements are substantially accurate and fair to investors, lenders, and other stakeholders.
This article has been a guide to what is External Audit. Here we explain the roles, responsibilities, examples, importance, and limitations. You can learn more about accounting from following articles –