External audit is the process of independent evaluation of the company’s financial statements by a qualified independent third party, the external auditor. In this case, auditors review the transactions and balances of the company’s accounting records to determine whether they are complete and accurate.
As a result, auditors express their opinion in the audit report, whether the company’s financial statements present fairly, in all material respects, in accordance with the applicable accounting standards and regulations.
For the external audit, auditors are usually appointed by shareholders at the annual general meeting of the company. Likewise, external auditors are usually chosen based on their skills, experiences, qualifications, and reputations.
Objectives of External Audit
- To have an objective assessment of financial statements whether they give a true and fair view, in all material respects
- To review whether financial statement have been prepared in accordance with applicable accounting standards, such as US GAAP, IFRS, or local GAAP
- To enhance the overall quality of the company’s financial statements so that the users, such as shareholders, lenders, suppliers, and other stakeholders, gain more confidence in having a business relationship with the company.
- To comply with applicable laws and regulations that required the company to have its accounts audited by an independent third party. This usually happens to listed companies and other public interest entities (PIE), such as banks and insurance companies, which are usually required by stock market regulations and country’s laws to have their accounts audited by an independent external audit firm.
Process of External Audit
The process of external audit usually follows three stages including planning stage, evidence gathering stage and completion stage.
|Process of External Audit|
The external audit process usually starts after auditors are appointed for the audit of the company. In general, audit activities start with the planning of an overall audit, include accepting clients by signing engagement letter after agreeing on the terms, forming an audit team, determining the time and scope of the audit.
Another important of audit planning of external audit is the risk assessment that auditors perform in order to assess the risks of material misstatements that could occur in financial statements due to the business environment.
The final phase of the audit plan is developing the overall audit strategy in order to ensure that the audit process is performed in an efficient and effective manner and all the risks of material misstatements have been properly addressed. This stage of external audit includes designing overall audit programs and procedures and allocating audit tasks to various team members based on their skills and experiences.
Evidence Gathering Stage
This is the second stage of external audit which auditors need to obtain sufficient and appropriate audit evidence before they can form an opinion on financial statements. Hence, they need to perform audit tests including tests of controls and substantive tests in order to gather the audit evidence.
In this stage of external audit, before performing substantive tests, auditors usually perform tests of controls to obtain evidence to support the effectiveness of the controls so that they can rely on control, hence reduce some of the work they need to perform in substantive tests. However, auditors only perform the test of controls on those controls that they believe can reduce the risk of material misstatements in financial statements.
After that, auditors need to perform substantive tests including both substantive analytical procedures and tests of details. Substantive analytical procedures are performed by looking at trends, ratios, and relationships between data, including both financial and non-financial information.
Tests of details are performed by examining supporting documents on transactions and balances, physical inspection on fixed assets, and recalculation on the work done by the client, etc.
In general, auditors need to test all relevant financial statement assertions, including occurrence, existence, completeness, accuracy, cutoff, and classification, etc. in the external audit to obtain sufficient and appropriate audit evidence to form the basis of opinion.
Completion stage is the final stage of the external audit process where auditors make their conclusion on the client’s financial statements whether they present fairly, in all material respects. In this case, external auditors make an overall conclusion by exercising their professional judgment and based on evidence they obtained during their audit work.
As a result, they produce audit report expressing an opinion on financial statements which most of the time says “In our opinion, the financial statements present fairly…” or “In our opinion, the financial statements give a true and fair view…” This is the case of unmodified or unqualified audit opinion which is also referred to as “clean opinion”.
However, sometimes external auditors also give a modified audit opinion which could be qualified opinion, adverse opinion or disclaimer of opinion. In this case, it would mean financial statements have the problem, either due to material misstatements or due to auditors couldn’t obtain sufficient and appropriate audit evidence to form the basis of opinion.
Independence of External Auditors
Independence is very important and external auditors need to be independent both in fact and in appearance. This is so that shareholders have confidence that external auditors will perform their work and make their judgment free from any bias.
While performing their work, either examining supporting documents or making a professional judgment on any area of the audit work, auditors should always maintain objectivity. They should never let any personal or business relationship to influence and compromise their objectivity.
This is why many restrictions are placed on the external auditors, in which they are not allowed to:
- Have financial interest in client
- Have family and close personal relationships with client
- Have close business relationships with client
- Have long association with senior management of the client
- Accept any gift or hospitality that can bring independence, both in fact and in appearance, into question, etc.