What it means
The two types do quite different jobs despite sharing a name. The external auditor gives an opinion on the annual financial statements for the benefit of shareholders and other outside users, working to a defined set of auditing standards.
The internal auditor works continuously across the organisation, reviewing controls, processes and risks, and reports to the audit committee rather than to the managers being reviewed. An external audit follows a familiar shape.
The auditor plans the work by assessing where a material misstatement is most likely, tests the controls and the transactions in those areas, evaluates the significant judgements management has made, and then forms an opinion. Fieldwork happens in bursts around the interim and year-end dates rather than continuously.
Auditors are accountable to the shareholders who appoint them, not to the finance team who deals with them day to day. Listed companies in most jurisdictions must put the audit out to tender periodically and rotate the audit firm or at least the lead partner after a set number of years.
Firms themselves are supervised by an audit regulator that inspects completed files and can impose sanctions. Independence is the whole basis of the role, so the rules around it are detailed.
Auditors cannot hold shares in the client, cannot audit systems or valuations they built themselves, and face limits on how much non-audit work they can bill alongside the audit. Where a cap applies it is usually expressed as a ratio of non-audit fees to audit fees over a rolling period.
It is just as important to know what an auditor is not. They are not there to guarantee that no fraud exists, they do not prepare the accounts, and a clean opinion is not a statement that the business is well run or financially healthy.
Their opinion covers whether the statements are free from material misstatement, which is a narrower question than most people assume. For a finance team the relationship works best when it is planned rather than endured.
Agreeing a timetable, a request list and a materiality level early, and flagging difficult judgements before fieldwork rather than during it, keeps the fee predictable. Auditors charge for surprises, and most surprises are avoidable.
In practice
Real-world examples.
Example
A furniture manufacturer's external auditor spends two weeks on site in January testing the year-end stock count, revenue cut-off and the warranty provision. The team challenges a $600,000 provision release that management had booked in December and asks for the supporting claims data. The provision is partly reinstated before the accounts are signed.
Example
An internal auditor at a mid-sized bank reviews expense approvals and finds that 14% of claims above the $5,000 threshold were approved by the claimant's direct report rather than their manager. The finding goes to the audit committee with a recommendation to enforce the hierarchy in the system. The control is fixed in the following quarter.
Example
A charity crosses the income threshold that requires a statutory audit rather than an independent examination. Its finance manager underestimates the difference, and the first audit takes twice as long as expected because grant conditions were never documented against the income recognised. The second year, with a proper grant register, runs smoothly.
Formula
Calculation
Non-Audit Fee Ratio = Non-Audit Fees / Audit Fees x 100
Audit Fee Intensity = Audit Fee / Revenue x 100
Worked example. Selby Marine Supplies pays its audit firm $420,000 for the statutory audit. In the same year it also pays the firm $120,000 for tax compliance work and $90,000 for financial due diligence on an acquisition, so non-audit fees total $120,000 + $90,000 = $210,000.
Non-audit fee ratio = $210,000 / $420,000 x 100 = 50%.
That sits comfortably under the 70% cap that applies in several regimes. If the company then asked the same firm to run a $180,000 systems implementation, non-audit fees would rise to $390,000 and the ratio to $390,000 / $420,000 x 100 = 92.9%, breaching the cap and forcing the work to another provider.
For context, Selby's revenue is $210,000,000, so the audit fee represents $420,000 / $210,000,000 x 100 = 0.2% of turnover, which is a typical order of magnitude for a company of that size.Case study
Seen in the real world.
Selby Marine Supplies is an illustrative, fictional ship chandlery group invented to show how the auditor relationship shapes cost and outcome. For six years it used the same firm for audit, tax, payroll advice and transaction support, and the finance director valued the convenience of a single point of contact. Nobody tracked the fee split.
When a new chair of the audit committee asked for a breakdown, non-audit fees had reached 118% of the audit fee, well beyond the threshold the committee considered acceptable for independence. The committee moved the payroll and transaction work to another provider, kept tax compliance with the audit firm, and brought the ratio down to 45% over two years.
The unexpected benefit in this fictional case was that the audit itself got sharper. With less other work at stake, the audit team pushed harder on the goodwill impairment model and on revenue cut-off at the two overseas depots, and the committee got the kind of challenge it had assumed it was already paying for.
Watch out
Common mistakes.
- Expecting the auditor to find all fraud. An audit is designed to detect material misstatement, and immaterial or well-concealed collusive fraud can pass through undetected.
- Asking the auditor to prepare the accounts they will then audit. That destroys independence, and in most regimes it is prohibited outright for public interest entities.
- Reading a clean opinion as a verdict on business performance. The opinion says the statements are fairly presented, not that the strategy is sound or the company is profitable.
Questions
People also ask.
What is the difference between an internal and an external auditor?
The external auditor is appointed by shareholders to opine on the annual accounts, while the internal auditor is an employee reviewing controls and processes for the board.
Who appoints the external auditor?
Shareholders formally appoint them, usually on the recommendation of the audit committee, which also negotiates the fee.
Why do audit firms have to rotate?
Long tenure risks the auditor becoming too comfortable with management, so rotation of the firm or the lead partner is required to preserve professional scepticism.
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