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Date: October 24, 2014 Vlad Morosan
Importance of an External Audit
Prepared by Vlad Morosan, /440132 @mail.muni.cz/
Purpose of the financial statement audit
Since its introduction, the need for certain companies’
financial statements to be audited by an independent external
auditor has been a cornerstone of confidence in the world’s
financial systems. The benefit of an audit is that it provides
assurance that management has presented a ‘true and fair’ view
of a company’s financial performance and position. By ‘True’ it is
meant that the information from the financial statement is
factual and conforms to reality (numbers based on genuine
transactions that have truly occurred) and by ‘Fair’ it is meant
that the information is free from discrimination and bias, and
complies with accounting standards and rules (estimates and
judgmental decisions made by the company are a fair
representation according to the accounting standards).
Users of a financial statement audit report
Companies produce financial statements that provide
information about their financial position and performance. This
information is used by a wide range of stakeholders
(e.g.,investors) in making economic decisions. Typically, those
that own a company, the shareholders, are not those that
manage it. Therefore, the owners of these companies (as well as
other stakeholders, such as banks, suppliers and customers) take
comfort from independent assurance that the financial
statements fairly present, in all material respects, the company’s
financial position and performance. To enhance the degree of
confidence in the financial statements, a qualified external party
(an auditor) is engaged to examine the financial statements,
including related disclosures produced by management, to give
their professional opinion on whether they fairly reflect, in all
material respects, the company’s financial performance over a
given period(s) (an income statement) and financial position as
of a particular date(s) (a balance sheet) in accordance with
relevant GAAP.
Auditor required qualifications and skills
Auditors are generally qualified accountants who are members
of a professional institute in their respective countries. Although
this varies between countries, qualified accountants normally
must meet certain educational requirements, take several years
of studying and professional exams (ex. ACCA) and have
sufficient practical experience.
Who is required to undertake an audit?
Public companies, private businesses, and nonprofits may all
be required under law to provide annual audited statements to
ensure compliance with regulations and to provide sufficient
financial disclosures. From one country to another, the
regulation regarding the necessity of a company to have its
financial statements audited differ, depending on the GAAP.
For instance, in the Czech Republic joint-stock companies are
required to have their financial statements audited by a
registered auditor if one or more of the following criteria are met
for both the current year and the preceding year:
 the net turnover exceeds CZK 80 .000.000 per annum
(approx. € 3.000.000);
 the total assets exceed CZK 40.000.000 (approximately €
1.500.000);
 the average number of employees exceeds 50
Auditors’ duties
The principal duty of the auditors to a company is to report to
the members of the company on the financial statements
examined by them. The auditors’ report must state whether, in
their opinion the company has maintained proper books of
account; the financial statements have been properly prepared
in accordance with the provisions of the regulation and give a
true and fair view of the company’s affairs and of its profit (or
loss); Where the auditors cannot report positively on any of the
above matters, they may find it necessary to ‘qualify’ their audit
report giving reasons for the qualification. A qualified audit
report can take three forms, namely:
 a ‘qualified opinion’, in which the auditors state that the
financial statements give a true and fair view, except for
certain matters which the auditor will specify in the report;
 a ‘disclaimer of opinion’, in which the auditors state that they
are unable to form an opinion as to whether the financial
statements give a true and fair view. A disclaimer of opinion
will arise where the scope of the auditors’ work has been
limited in some way e.g. they have been unable to gain access
to all of the books and records, or;
 an ‘adverse opinion’, in which the auditors state that the
financial statements do not give a true and fair view. An
adverse opinion will be given where the auditors are in
disagreement with the financial statements and the directors
are not prepared to amend them to reflect what the auditor
considers to be a true and fair view.
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Date: October 24, 2014 Vlad Morosan
Auditors’ rights
Auditors have the right of access at all reasonable times to the
books, accounts and vouchers of the company. They can require
from the company’s officers and employees such information
and explanations that are necessary for the performance of their
duties. A person who fails to comply with such a request within a
reasonable time, or who knowingly gives false information, is in
breach of the Law.
Auditors are entitled to attend any general meeting of the
company and to receive the same notices and communications
relating to meetings as the members. They also have the right to
be heard at all general meetings on any part of the meeting that
concerns them.
What powers do auditors have?
It is important to understand that auditors are not the ‘finance
police’. They are not in a position to dictate how an organization
should go about its business or directly punish organizations that
engage in risky, underhand or deceitful activities. In essence, the
auditor’s power lies in the fact that their opinion on an
organization’s financial position is seen as important by the
organization itself and by anyone with an interest in the health
of the organization – shareholders, suppliers, customers, tax
authorities to name just a few. This opinion is trusted enough to
affect the decisions these groups make about their own dealings
with the organization
Appointment of auditors
The first auditors of a company may be appointed by the
directors or by a general meeting of the company. After that, the
auditors are appointed by the members of the company in
annual general meeting and hold office until the next such
meeting.
Removal and non-reappointment
Auditors may be removed by resolution of a general meeting
or by way of resolution appointing someone else instead of
them.
Where such a course of action is proposed, auditors are
entitled to contest their proposed removal and to explain the
circumstances of their proposed removal to the members.
An auditor is permitted to resign from office before the expiry
of his or her term of appointment by serving notice in writing on
the company. Resigning auditors or auditors who are unwilling to
be reappointed must state in their notice of resignation the
circumstances connected with the resignation which they
consider ought to be brought to the notice of the members and
creditors or if there are none, that no such circumstances exist.
Audit stages
Exactly how an audit is carried out will depend on the nature
of the organization being audited. However, most auditors
follow a broadly similar process, working closely with their
clients’ senior management and guided by a set of ‘International
Standards’ – essentially these are designed to ensure that audits
are carried out in the same way the world over, whilst allowing
auditors to follow rules and regulations set out by individual
countries.
In general terms, an audit will cover:
 Planning and risk assessment: This is a process of getting to
know the organization being audited as well as any issues that
commonly affect similar organizations when it comes to
financial reporting. The auditor will also use this process to
identify any areas that may need special attention.
 Internal controls testing: This aspect of audit has become a lot
more important in recent years. It is about working out
whether the control systems in use are sufficiently robust and
reliable, and whether they comply with any regulations the
organization is subject to. The results of this work will
determine how the rest of the audit process is carried out
 Substantive procedures: This is the process of gathering the
evidence needed in order to assess whether an organization’s
claims about its financial position are fair and accurate. The
strength of the organization’s internal controls will go a long
way to determining how detailed this process is. Broadly, there
are two substantive procedures:
 Substantive Analytical Procedures: This process is used if
internal controls are deemed to be reliable and robust and is
essentially the comparison of sets of financial information to
see if the accounts 'make sense' when viewed from different
perspectives
 Substantive Tests of Detail: If internal controls are deemed to
be weak, absent, or have not been tested, then a ‘test of
detail’ approach will be taken. In essence, this is a process
of selecting a sample of items from the organization’s
accounts, then finding hard evidence (e.g. invoices, bank
statements) to check that they have been properly accounted
for.
 Finalization: With all this assessment work carried out, the
auditor will use the information gathered to write a final
report – which is an independent opinion of the organization’s
financial position. The auditor will also prepare a letter or
report for the organization’s management, setting out any
important issues that came to light whilst the audit was being
carried out.
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Date: October 24, 2014 Vlad Morosan
Ethical values and behavior
Ethics refers to the study of moral principles or values that
determine whether actions are right or wrong and outcomes are
good or bad. People rely on their ethical values to determine
“the right thing to do.”
Unfortunately an ongoing stream of incidents involving
corporate wrongdoing continues to raise serious questions about
the ethical values of many corporate leaders. Scandals at Enron,
Worldcom, Tyco, and other companies led to the Sarbanes-Oxley
Act in 2002, which put more controls on U.S. companies and
auditing firms to minimize conflict of interest and disclose
companies’ financial pictures more fully. This legislation might
reduce some unethical conduct, but wrongdoing is unlikely to
disappear completely.
Arthur Andersen Example:
Arthur Andersen is a real life example why in some cases even
though a court decision is not terminal the damage to the
Company‘s reputation will prevent it from returning as a viable
business, though it still nominally exists.
Arthur Andersen LLP, based in Chicago, is a holding company
and formerly one of the "Big Five" accounting firms among PWC,
Deloitte Touche Tohmatsu, EY and KPMG, providing auditing,
tax, and consulting services to large corporations.
In 2002, the firm voluntarily surrendered its licenses to
practice as Certified Public Accountants in the United States after
being found guilty of criminal charges relating to the firm's
handling of the auditing of Enron, an energy corporation based in
Texas, which starting with 1993 until 2001 had dubious energy
trading schemes and accounting practices. Enron’s complex and
dubious accounting schemes allowed Enron to reduce its tax
payments, to inflate its income and profits, inflate stock price
and credit rating, hide losses in off-balance sheet subsidiaries
and fraudulently misrepresent Enron’s financial condition in
public reports. At that time Arthur Andersen LLP was Enron’s
external auditor.
Following the 2001 scandal in which $100bn in revenue from
what it was considered an energy giant - Enron was found to
have sustained itself by means of institutional and systematic
accounting fraud, Andersen's performance and alleged
complicity as an auditor came under intense scrutiny. It is
important to mention that by that time the team auditing Enron
was not rotating (same audit team was performing audit of
Enron financial statements for the entire year); the fee received
from Enron in year 2000 was $52mln - and most of it for
consulting services and not audit, a fact that raised doubts about
Arthur Anderson independence;
Arthur Andersen was accused that it did not fulfill its
professional responsibilities in connection with its audits of
Enron's financial statements, or its obligation to bring to the
attention of Enron's Board (or the Audit and Compliance
Committee) concerns about Enron's internal contracts over the
related-party transactions. Andersen was convicted of
obstruction of justice for shredding documents related to its
audit of Enron. Since the U.S. Securities and Exchange
Commission cannot accept audits from convicted felons, the firm
agreed to surrender its CPA licenses and its right to practice
before the SEC on August 31, 2002—effectively putting the firm
out of business. The Supreme Court of the United States
unanimously reversed Andersen's conviction due to what it saw
as serious flaws in the jury instructions which theoretically left
Andersen free to resume operations. However the damage to
the Andersen name was so severe that it has not returned as a
viable business even on a limited scale. There are over 100 civil
suits pending against the firm related to its audits of Enron and
other companies.
As a conclusion I would say that unethical companies will
eventually get exposed: Witness Enron. Companies that live and
breathe their missions, by contrast, will get recognized by both
the retail and capital markets. Stock values, of course, are a
function of multiple factors. But solid principles are good for
business, and ultimately good for corporation valuations.
Auditor independence
With the above example I wanted to make clear how
important the auditor’s independence is. Shareholders need to
have confidence that the auditors have assessed relevant
information objectively, and that they have scrutinized evidence
critically and independently. Shareholders also want to be sure
that the auditors have undertaken their work and made their
judgments free from any bias, and without being influenced
unduly by management who prepared the financial statements.
Specific requirements vary around the world, but generally
include:
 Prohibiting the auditors from holding an interest in (whether
financial or through close relationship with) the company they
are auditing;
 Prohibiting the auditors from providing the company with
certain services (such as implementation of accounting IT
systems or hiring employees) that could compromise their
objectivity; and
 Requiring key personnel on the audit to be changed from to
time to time, so that fresh pairs of eyes are brought to bear
including regular rotation of the lead audit partner.
Bibliography
1. EY Library / http://www.ey.com/home/library
2. PWC Publications/ “Understanding a financial statement
audit” (January 2013)
3. McLean, Bethany; Peter Elkind (2003). The Smartest Guys
in the Room
4. Kaplan Publishing (2012). ACCA: Paper F4