What is an External Audit: Roles, Responsibilities & Examples

Introduction

Regular and thorough audits are of utmost importance for businesses of all sizes, yet many of them struggle with operational inefficiency, compliance issues e, fraud, and financial records anomalies despite frequent internal audits. These issues not only impact the reliability of financial reporting but also lead to potential conflicts of interest.

This is where an external audit comes into play. An external audit makes financial reporting reliable, gives an accurate view of financial performance, and increases stakeholders’ confidence in financial records. An external auditor examines all the financial statements, records, commercial transactions, accounting practices, and internal controls of a business. But amid challenges like constantly changing regulatory requirements, global tax changes, and evolving financial breaches and frauds, how can external auditors ensure true and fair financial judgment?

This blog covers everything you need to know about external audit – external audit definition, external auditor duties and responsibilities, limitations or challenges of external auditing, and more.

What Is An External Audit?

An external audit is a financial review, where independent auditors examine and analyze a business’s financial records and statements. This process highlights misstatements in reporting due to errors and frauds, providing stakeholders a true and fair picture of the business’s financial position.

Here, a third-party audit team examines the accounting books, general ledgers, balance sheet, income statement items, and other financial reports. They validate the accuracy of a business’s financial statements and assess their operational efficiency.

In addition, an external audit also determines if a business is complying with the accounting standards such as GAAP and Sarbanes-Oxley Act (SOX) regulations and standards. Conducted within a set of predefined rules and regulations, external audit focuses on gathering all relevant financial information to give a transparent picture of the business’s financial position. External audit helps businesses increase the authenticity and credibility of their financial statements, which is important for investors and lenders.

Five Key Steps of External Audit Process

The external audit process starts with the planning and preparation of audit findings by gathering financial information and then analyzing a company’s internal control. Auditores then verify and analyze financial data to prepare a conclusive statement, which is communicated and reported to stakeholders.

1. Planning and preparation

In this step, the external audit team examines the company’s operations and evaluates the organizational structure and available financial records to define the overall scope of the external audit. They also identify potential areas of errors, anomalies, and risks. The audit team also revisits past audit findings to pinpoint and analyze the changes, set audit milestones, and maintain highly transparent communication with the company management.

2. Evaluating internal control

The audit team examines the internal control mechanism to explore the effectiveness and strength of a company’s operational procedures. For example, when evaluating a company’s operations, an auditor can consider looking into ways of safeguarding assets if their financial records are accurate and comply with the regulatory requirements, and so on. Any misstatements here can prompt the auditor to change their approach and move towards an in-depth substantive audit.

More importantly, evaluating internal control paves the way for integrated auditing, wherein the scope of audit extends beyond financial records and evaluates the effectiveness of operational and technological processes as well.

3. Validating the accuracy of financial records

This step is the crux of the entire external audit process. The audit team validates the accuracy of financial transactions and account balances, ensuring there are no accounting anomalies. External auditors adopt various techniques, like analyzing financial records against industry benchmarks and regulatory standards and testing the correctness of individual transactions across accounts.

4. Analysis and conclusion

After the critical accuracy check, the audit team will analyze the company’s financial statements (income statement and balance sheet) and conclude with their findings. Based on the available data and financial inferences, the auditor will highlight their findings as Qualified or Unqualified Opinions, Disclaimers, and Adverse Opinions to indicate discrepancies and provide a conclusive statement.

5. Reporting and communicating audit report

The final stage involves preparing a holistic audit report for the company’s board members, shareholders, investors, and lenders. This report details the audit procedures, findings, and the auditor’s opinion on the financial statements. The audit team can also discuss their findings and recommendations to address the financial issues highlighted in the report with the stakeholders.

External Audit Process Examples

Let’s take two examples to understand the external audit process.

• Example 1: External audit to prepare for the IPO and sale
  Suppose XYZ Ltd plans to go public and sell its shares. But first, the company needs to audit its financial statements through an external audit to expedite the due diligence process and provide investors and buyers with a fair picture of their financial position.

  External auditors will provide XYZ Ltd. with an independent assessment of its internal control over financial reporting. The audit team will evaluate processes such as cash handling, inventory management, and financial transaction recording to identify weaknesses or deficiencies. This will help the company reduce the risks of errors or fraud. The company will then implement the auditors recommendations to improve operational efficiency, safeguard assets, and ensure the accuracy of financial records before presenting the reports to stakeholders.

• Example 2: Detecting and preventing fraud
  Suppose ABC Ltd, a manufacturing company, needs to borrow funds from banks or financial institutions to expand their workshops to new areas. As part of the loan agreement the company has to get their financial statements audited,

  A third-party audit team thoroughly reviews the company’s financial statements to ensure accuracy in revenue, expenses, and asset valuation. They also evaluate the internal controls, compliance with accounting standards, and management representations for data integrity. In addition, the team also examines the financial ratios to assess the company’s liquidity position and its ability to repay. The audited report helped ABC Ltd. demonstrate transparency and accountability in its financial operations, assuring the bank while identifying areas for operational enhancements.

Who Is An External Auditor?

An external auditor is a public accountant who conducts independent evaluations of a company’s financial statements and disclosures. They ensure that the financial statements presented are error-free, don’t include any material misstatements, and are not influenced by fraudulent activities.

An external auditor is independent of the entity being evaluated and is responsible for giving an unbiased evaluation of financial statements and internal control systems. Their opinions and disclaimers are considered and highly valued by investors, lenders, and other stakeholders who need an impartial assessment of a company’s financial performance.

External Auditor Duties and Responsibilities

External auditor’s duties and responsibilities can be divided into three categories:

• Auditing duties: Planning the audit and preparing audit reports.
• Technical duties: Financial analysis and applying auditing standards
• Soft skills: Communication, problem-solving, and attention to detail

1. Auditing duties

Here are the key auditing responsibilities of an external auditor:

• Preparing for the audit
  External auditors must have a deep understanding of a business’s requirements when evaluating risks and errors. They should be able to apply their accounting to tasks that they are qualified to work on.
• Conducting audit procedures
  An external auditor must have the skills to identify material misstatements and highlight potential risks and breaches. They should be able to help companies minimize the impact of inaccurate or misleading financial records by applying audit procedures based on their findings.
• Recording and communicating audit results
  External auditors must know how to test controls and determine whether they are strong enough to mitigate risks and improve the accuracy of financial statements. As a next step, they would need to comprehend the audit results and provide a detailed report explaining their conclusions. These findings must be documented in financial reports, highlighting disclaimers, references, and recommendations.

2. Technical duties

There are four primary duties of an external auditor.

• Financial analysis
  
  This involves a detailed examination of financial statements to identify trends and risk factors. External auditors must know how to apply financial modeling and analysis skills to provide accurate reports on a business’s financial performance and stability. They must also recommend remedies for potential risks.
• Internal control analysis
  This is one of the most critical skills that an external auditor needs. They must be well-versed in common internal control mechanisms and assess their effectiveness for a business. Internal controls also help auditors spot unauthorized activities or transactions and evaluate their impact on the financial numbers.
• Auditing standards
  External audits must adhere to GAAP (Generally Accepted Accounting Principles) and other accounting standards. For example, according to the Sarbanes-Oxley Act of 2002, all public companies in the USA must comply with GAAP when preparing their financial statements and reports.
• Research skills
  External auditors must be adept at researching complex accounting issues and topics to support their audit findings. This includes researching the company’s financial statements and forming opinions on the financial statements’ accuracy.

3. Soft skills

The duties and responsibilities of an external auditor go beyond preparing audit reports and analyzing financial statements. It also includes soft skills like:

• Written and verbal communication
  External auditors must know how to communicate the audit findings and inferences in both written and verbal, to stakeholders and management. They must also know how to prepare documentation and summarize their findings, which could be used as a reference for the next audit.
• Problem-solving
  Problem-solving is a critical component of an external audit process. External auditors must sharpen their problem-solving skills to navigate complex financial issues and design audit processes that help mitigate these challenges.
• Attention to detail
  An accurate and efficient audit report requires a nuanced and careful review of every financial statements and other financial records. An external auditor must be proficient in identifying discrepancies and improving the accuracy and reliability of their reports. The review process includes screening documentation, interviewing management, and observing processes.

Importance Of External Audit Process

The external audit process primarily focuses on determining the completeness and accuracy of financial records and ensuring they follow accounting guidelines. Here’s why an external audit process is essential for businesses:

1. Improving credibility

An external audit helps companies verify their financial records and statements and boost transparency. The independent nature of the external audit gives room for true, accurate, and impartial presentation of financial information, thereby improving companies’ reputation and credibility.

2. Identify and mitigate business risks

External auditors are responsible for giving unbiased, independent evaluations of a company’s financial position and performance and identifying potential risks and anomalies. An external audit process helps a company collaborate with the third-party audit team, key managers, and supervisors, reducing the long-term impact of risks and allowing companies to troubleshoot them.

3. Ensure objectivity

An external auditor helps a company gain a comprehensive and objective view of their operations and financial performance. External auditors critically evaluate a company’s financial ventures and investments, shedding light on operational areas that could be improved. Auditors’ recommendations not only help improve profitability but also eliminate discrepancies in accounting procedures and make necessary corrections in financial records to remove ambiguity.

4. Improved decision-making

External audit reports are a lot more than mere reporting of financial statements. An external audit highlights the strengths and weaknesses of internal controls and gives a consolidated view of a company’s organizational structure. These deep insights help companies create strategies, make the best of the available resources, make necessary adjustments in the company structure, and boost efficiency in operations.

5. Helps in preparing a business budget

Audit reports play a critical role in preparing a business budget. An external audit report emphasizes unprofitable operations or investments. Auditors often also recommend investments that are small but yield better returns. The report also acts as a guide to reduce expenses and improve cash reserves.

Limitations of External Audit

While external audits are critical to maintaining transparency and accountability, they also pose numerous challenges, like restricted access to financial data, conflicts of interest, time constraints, and more.

1. Restricted access to financial data

External auditors often have difficulties accessing the complete financial information of a company. This could be due to reasons such as companies’ data protection rules and confidentiality agreements. This could lead to ambiguity in auditing reports and reduce the fairness of opinions.

2. Conflicts of interest

A lot of times, company management and external auditors have a conflict of interest that ends up compromising the integrity of the external audit process. For instance, a senior director may have a deep connection with the external auditors or may have a vested interest in audit results. In such cases, the directors’ objectivity may be called into question and undermine an audit report’s effectiveness.

3. The limited scope of the audit

External audits usually involve reviewing only a portion or sample of a company’s financial data to derive audit findings. There are high chances of such samples missing on relevant and critical transactions, operational risks, or small changes in general ledgers.This reduces the credibility and effectiveness of the audit report as it does not give total assurance of the financial statements and performance of the company.

4. Time shortage

External audits often face a lot of time constraints, which makes it difficult for both auditors and company management to gather relevant pieces of financial information for audit samples and prepare accurate conclusive statements. This could be especially difficult when the external auditor has other audit commitments, making the company compete for their attention and time.

How Does AI Help In Mitigating External Audit Challenges?

To navigate audit challenges, external auditors need timeliness and compliance with financial reporting, along with seamless and accurate detection of anomalies or errors. AI-driven solutions in auditing not only help enable efficient financial investigation but also enhance the overall reliability of audit reports. Here are two solutions, financial close management and anomaly management to the rescue.

Financial close management will help external auditors:

• Enhanced analysis and auditors’ productivity
  External auditors and companies can get a detailed trail of records that include information on transactions, ensuring that controllers and managers can manage the accountability and integrity of close. This will help ensure the timeliness of financial reporting while ensuring both the company and the audit team can access up-to-date financial information promptly.
• Automate data extraction
  Financial close management not only helps reduce the manual work of data extraction but also lets auditors and accountants use templated data processing to save time and utilize that for other critical tasks during peak load like audit preparedness, adjustments and reporting.
• Standardization and compliance
  Financial close management systems enforce standardized accounting policies and procedures, ensuring consistency in financial reporting across periods and entities. This standardization helps auditors verify compliance with accounting standards and regulatory requirements

Similarly, anomaly management will help external auditors

• Detect unusual activities
  AI-based identification of missed or incorrect general ledger (GL) postings leverages machine learning capabilities to not only generate alerts of potential incorrect GL postings but also highlight missed entries to ERP data. This proactive approach enables auditors to investigate and address potential issues promptly, reducing the risk of material misstatements in financial statements.
• Continuous monitoring
  AI solutions continuously track anomalies through the anomaly engine and make it available as a worklist for auditors or accountants to take action on. It also gives automated corrective suggestions to resolve and correct journal entries for some anomaly patterns to expedite the close process and make the data more reliable.
• Anomaly progress dashboard
  Dashboards help accountants and auditors use customizable out-of-the-box reports and dashboards to enable key stakeholders and get a bird’s eye view of potential misreporting in the source data. There are multiple box dashboard reports like anomaly count across periods, anomaly count based on class (omission or error), summary view across risk Category (based on amount thresholds), summary view based on anomaly status (open, ignored, closed). These dashboards can help users take proactive action on potential anomalies.

Improve Your Auditing Results With HighRadius’ Record to Report Solutions

An effective external audit involves numerous factors to consider, viz., accuracy detection and mitigation of anomalies, correct analysis of financial statements, checking the accuracy of financial records, and so on. With this in mind, HighRadius’ Record to Report solution brings together solutions like Anomaly Management, Financial Close and Account Reconciliation to help external auditors frame effective audit findings and build robust reports.

Our Account Reconciliation solution simplifies auditing with automated transaction logging and customizable workflows for seamless journal processing and reconciliation. It helps auditors and accountants make supported documents for auditing and reconciliation easy to access by automating transaction logging. Auditors and finance teams can easily track workflows and prepare, post, and process transactions in journals seamlessly with customizable journal workflows.

Next is our AI-powered Anomaly Detection solution, which uses state-of-the-art machine learning models to generate alerts every time an accountant posts a wrong general ledger entry in the ERP. The cherry on top are the customizable out-of-the-box reports and dashboards for anomalies based on class, risk category, and anomaly status that give a bird’s-eye view of potential misreporting in the source data and help take proactive actions to rectify them.

The last is the Financial Close solution that provides detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30% while providing a comprehensive audit trail. Task logs create an audit trail that shows all the changes made to each task in chronological order, along with details of the user account (accountant) from where the changes were made.This ensures a high degree of visibility to auditors while performing their tasks.

FAQs

1. What is an external audit report?

An external audit report refers to a document that summarizes the findings and conclusions drawn by an external auditor derived from evaluating a company’s financial statements, records, and transactions. The report is shared with a company’s management team, board of directors, and other stakeholders.

2. How much does an external audit cost?

Audit fees for publicly held companies saw a 4.6% hike, according to the Financial Education & Research Foundation (FERF). The average audit fees paid by over 6200 organizations were as high as $2.4 million, with large accelerated filers paying $5.6 million and smaller companies around $532,321.

3. How often should external audits be performed?

An external audit is usually conducted once a year. The frequency of external audits must align with the financial reporting cycles. Also, stakeholders must receive updated audit reports on time. However, where there are higher business risks, management can conduct interim external audits.

4. What is the goal of an external audit?

The primary goal of an external audit is to conduct comprehensive audits that include a systematic review of financial records, regulatory compliance, and internal controls. External audits are responsible for verifying the accuracy, fairness, and integrity of a business’s financial statements.

5. What is external auditing in accounting?

External auditing in accounting is a process where external auditors examine a company’s accounting records to find out whether their financial statements are prepared in a fair and accurate manner and if they comply with the requirements of accounting standards like GAAP or SOX.