John Evans FCA
Bradley Sears LLP
10, Crown Road
Welsh Seafood Ltd
15th January 2018
Dear Jim Hanson,
It was great to hear from you. It seems like you are quite confused about the types of audit and their benefits.
First of all, let me start by explaining what an external audit is, how it works and why it is essential for any organization. External audit is conducted on an annual basis under international auditing standards by qualified accountants (independent of the organization) who examines the financials prepared by the organization. They analyze whether proper accounting records have been maintained or not. These auditors were appointed by the shareholders of the company and therefore they reports back to them on their audit opinion, whether the financial statements give a ‘true and fair’ view of the company or not.
In large companies, both ownership and control is separated. Shareholders appoint directors to run the business on behalf of them and this is where the need for external audit arises. These directors report the financial performance of the company and position where as shareholders on the other hand, need to validate the financial statements provided by them before relying on them. So, the main purpose of external audit is to provide reasonable assurance to the shareholders that the financials presented by the directors of the company are free from material misstatements.
However, small companies are not legally obliged to provide an external review of the company and especially because it is costly, many owners find it pointless to conduct one nevertheless, I would still recommend it to all my clients since there are several advantages you could consider before dismissing an audit.
Firstly, external audit determines the weaknesses with in the internal controls of the business. External auditors assess the transaction processes and verifies whether authority checks and authorizations were in place and working well before recording the transactions. Moreover, they confirm whether the computer systems work properly (not IT functions) by checking controls in the system and ensures that only the authorized ones accessed and performed specific tasks which then reduces the chance of misreporting and frauds. Therefore, after completing the audit, auditors will explain issues regarding the controls and advice on improving internal controls to enhance the performance and efficiency of the company.
Secondly, external audit provides credibility, which is vital for small businesses especially in their early years when they try to build a positive reputation. If an external auditor evaluated the financials of the company and validated them, their approval is considered more credible compared to an internal auditor since they are ought to be unbiased as they do not work directly for the company. This gives lenders, potential investors and clients some sort of security as the financials are free of error and would increase the chance of working with you.
Thirdly, external auditors are specifically trained to improve business processes and risks associated with misreporting financial data. They do not bring personal likes and dislikes to the job and works single minded.
Now, as you have mentioned about listing Welsh Seafood Ltd in the near future, I assume that you are aware of the prime requirements that you must comply with in order to list your company in the London stock exchange market. One of the main requirements include auditing your companies accounts and publish or file them for at least a three year period, which means you need to perform an external audit of your company before listing your company. Moreover, this is not only beneficial for the company for the reasons explained earlier, but because it is a legal requirement you must follow it.
However, if you change your mind on listing the company, please note that even though all companies are required to conduct external audit for statutory purposes, you can always claim audit exemption for the financial year under Companies Act. There are three conditions and at least two of them needs to be satisfied for claiming audit exemption. That is; company’s annual turnover not exceeding 10.2 million, assets value less than 5.1 million and if the number of employees are less than 50. So, Welsh Seafood Ltd does not require an audit as they meet the external audit exemption threshold and is considered as a small company.
Internal audit provide assurance over the organizations effectiveness of the internal control processes, risk management, governance processes. These audits are intended to identify whether risks associated with the business are managed well and precise processes are in place while the right procedures are being followed. Internal audits can perceive areas where innovations could be made for more efficiency and are based on the strategic needs of the company. In contrast to external audit, they look beyond financial risks and consider factors that could affect the accomplishment of organizational objectives.
Internal auditors report to the senior management through the audit committee and provide independent views on the level of success and advice on weak areas for improvement. There are a number of reasons why companies need to audit internally. Firstly, proper accounting systems are introduced. This comprises of a chain of activities within the organization by which transactions are processed and recorded in financial statements. Internal auditors can also detect weak areas and address them to the management of the company. This could not only improve the management processes but also help achieve organizational goals.
Division of labor is another factor that internal auditors can help the organization with. Auditors observe the activities of the employees (division of work) especially the management and evaluate employee performance and fix responsibilities of those with poor performance. These people can be held responsible for low work standards and action will be taken against them. Division of work also means less errors as different people are appointed for different tasks and this could possibly help protect accounting records from errors. After the audit is completed auditors will suggest the ways in which the company could improve their business performance.
Internal auditing helps the external auditors as the audit procedure is quite the same. External auditors usually refer the internal audit of the company before starting their audit work but are however responsible for the external audit.
The prime purpose of audit is to provide shareholders with independent expert opinion regarding the annual accounts of the company, whether they give a true and fair view of the company and if they can be relied up on as mentioned earlier. However, it is the auditor’s independence that demonstrates the objectivity while performing his task.
Auditors must be independent from the client company since any relationship between them could affect the audit opinion. On the other hand, auditors are expected to give honest and unbiased professional views on financials though, there are concerns regarding their independence. Sometimes, due to the lack of corporate governance measures these opinions are heavily influenced by auditors who intend to keep good relations with the client company. At this point, shareholders can no longer depend on them for their opinion as they are no longer independent. Furthermore, audit firms set audit fees below market rate and provide non-audit services to companies which then result in firm having commercial interests to protect. When conflicts between auditor’s interest to protect the shareholder and his commercial interest arises, concerns are raised.
There are several different types of threats that can affect auditor independence and objectivity. For the above reasons, I cannot take part in the audit since it would be considered as a self-interest threat as we have been mates for years. Self-interest threats may arise due to financial or other interests of family members or people you have a close relationship with. However my firm could still audit Welsh Seafood Ltd if I do not take part in the audit and the firm considers that there is no threat to the audit independence.
Auditors use their skill and experience to reach an opinion on financial statements. The terms such as ‘true and fair’ and auditors ‘opinion’ were chosen deliberately to ensure that even though a judgement was involved, the auditor’s report is rather a reflection and not a guarantee of the financials being accurate. These judgements are meant to be professional and are based on audit related work done by them in accordance with the standards established by the accountancy bodies. However, auditors can never give absolute assurance over the financials being free from error or material misstatements as there are audit limitations.
First of all, auditors apply the sampling technique. Hundreds and thousands of transactions are made in big companies and not every one of them can be checked with the limited time and resources at hand so they take random samples and check the transactions and balances. Therefore, it is unlikely that the auditors could detect any material misstatements since the testing was very limited. On the other hand, audit evidence is usually provided by the management. Audit involves use of professional judgement while identifying audit risks, selecting the right procedures and interpreting evidence. Even though guidelines are provided by the auditing standards, misjudgments may cause the auditor to not notice a misstatement in the financials.
I hope I have answered all your questions and feel free to call our firm if you have any doubts.