What it means
Financial statements are prepared by the people who run the company, who have every incentive to present results favourably. Shareholders, lenders, regulators and the public need assurance that the numbers can be relied on.
The external audit provides that assurance. The auditor does not prepare the accounts and does not guarantee that every figure is exactly right; the auditor gathers enough evidence to conclude, with reasonable assurance, that the statements are free from material misstatement, whether caused by error or fraud.
The work follows a defined process. The auditor first understands the business and its risks, then assesses the company's internal controls, then tests transactions and balances: confirming bank balances and receivables directly with third parties, attending inventory counts, examining contracts and invoices, recalculating estimates such as depreciation and provisions, and reviewing events after the year end.
The result is an audit report attached to the financial statements. An unqualified (or "clean") opinion says the statements are fairly presented.
A qualified opinion says they are fairly presented except for a specified matter. An adverse opinion says they are not fairly presented.
A disclaimer says the auditor could not obtain enough evidence to form a view. Anything other than a clean opinion is a serious matter for lenders and investors.
Auditors also report to management on weaknesses they find in controls, usually in a management letter, and for listed companies they may be required to report on internal control over financial reporting itself. Internal audit goes further into operations, testing whether procurement, payroll, IT security and compliance processes work as designed, and reports to the audit committee of the board.
Audits cost money and management time, and small companies are often exempt. But an audit disciplines the finance function, reassures lenders, supports a sale or fundraising, and catches errors and fraud that would otherwise compound.
Many private companies choose to be audited even when the law does not require it.
In practice
Real-world examples.
Example
A listed retailer's annual report includes an audit report from a registered firm giving an unqualified opinion, plus a description of the key audit matters such as inventory valuation and store impairment.
Example
A charity above the statutory threshold is audited each year, and the auditor reports to the trustees that restricted funds have been correctly applied.
Example
A private company preparing for sale commissions its first audit so that buyers can rely on three years of audited accounts.
Think of it
“An audit is like a home inspection before buying a house. An independent expert reviews everything to make sure there are no hidden problems.
Formula
Calculation
Audits do not use a single formula, but materiality, the threshold below which misstatements are unlikely to affect a reader's decisions, is calculated at the planning stage and drives the whole approach.
Worked example. A company has revenue of $40 million, profit before tax of $3 million and total assets of $25 million. The auditor sets overall materiality using a benchmark; for a profit-oriented company, 5% of profit before tax is common.
- Overall materiality = 5% x $3,000,000 = $150,000
- Performance materiality (a lower threshold used when planning tests, to allow for undetected errors) = 75% x $150,000 = $112,500
- Clearly trivial threshold (below which errors are not even accumulated) = 5% x $150,000 = $7,500
What this means: the auditor designs tests to detect misstatements above $112,500 in any account. If the audit finds errors totalling $60,000 that management declines to correct, the auditor concludes the statements are still fairly presented because the uncorrected total is below $150,000. If the errors total $200,000, management must correct them or the opinion will be qualified.
Sample sizing example: to test $8 million of receivables, the auditor might confirm the 15 largest balances (covering $5.2 million) directly with customers and select a statistical sample of 40 from the remainder, extrapolating any errors found to the untested population.Case study
Seen in the real world.
A regional wholesaler with $60 million of revenue had been audited by the same small firm for twenty years and received a clean opinion every time. When it sought a larger credit facility, the new bank required an audit by a firm with greater resources. The new auditors attended the year-end inventory count for the first time in the company's history and found that stock recorded at $4.5 million physically amounted to about $3.6 million; the difference had built up over years through unrecorded write-offs and a warehouse system that was never reconciled to the ledger.
They also found that a long-serving credit controller had been writing off receivables from certain customers in exchange for payments to a personal account. The restated accounts showed profit $1.2 million lower than reported, the credit controller was dismissed and prosecuted, and the bank facility was approved only after the company implemented cycle counting, a stock-to-ledger reconciliation and separation of duties in credit control. The owner's comment afterwards was that twenty years of clean opinions had told him nothing, because nobody had ever looked.
Watch out
Common mistakes.
- Believing an audit guarantees the accounts are correct or that no fraud has occurred. It provides reasonable, not absolute, assurance and is designed around materiality.
- Treating the audit as a compliance cost only. The management letter is often the most useful review a business gets all year.
- Keeping the same auditor for decades without any rotation or challenge. Fresh eyes find what familiar ones miss.
Questions
People also ask.
What is the difference between an audit and a review?
A review provides limited assurance based mainly on inquiry and analysis; an audit provides reasonable assurance based on detailed testing and evidence.
Who appoints the auditor?
Shareholders, on the recommendation of the board or its audit committee. The auditor must be independent of management.
What happens if the auditor finds a problem?
Management is asked to correct it. If they refuse and the matter is material, the auditor qualifies the opinion, which is disclosed to everyone who reads the accounts.
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