An independent auditor is a certified public accountant (CPA) or chartered accountant (CA) who examines the financial records and business transactions of a company with which they are not affiliated. An independent auditor is typically used to avoid conflicts of interest and to ensure the integrity of performing an audit.
Independent auditors are often used—or even mandated—to protect shareholders and potential investors from the occasional fraudulent or unrepresentative financial claims made by public companies. The use of independent auditors became more critical after the implosion of the dotcom bubble and the passage of the Sarbanes-Oxley Act (SOX) in 2002.
An auditor may perform various auditing, tax, and consulting services for individuals, corporations, nonprofit organizations, or government entities.
How Independent Auditors Work
An independent auditor either works for a public accounting firm or is self-employed. An auditor examines financial statements and related data, analyzes business operations and processes, and provides recommendations on achieving greater efficiency. They evaluate company assets for impairment and proper valuation and determine tax liability, ensuring compliance with tax code and laws.
The auditor develops an opinion asserting the reliability and fairness of clients' financial statements, then communicates the information to investors, creditors, and government organizations. Also, an auditor may perform other auditing, tax, and consulting services for individuals, corporations, nonprofit organizations, or government entities.
Procedures for an Independent Audit
An independent auditor asks questions of management and staff for a better understanding of the business, its operations, financial reporting, internal control system, and known fraud or error. They may perform analytical procedures on expected and unexpected variances in account balances or transaction classes, then test documentation supporting those variances. The auditor also observes the company’s physical inventory count and confirms accounts receivable (AR) and other third-party accounts.
The Sarbanes-Oxley Act (SOX)
The Sarbanes-Oxley Act of 2002 was passed after Enron, WorldCom, and several other technology companies collapsed due to accounting improprieties. The goal of SOX was to improve corporate governance and restore the faith of companies' investors. However, many in the business world are against SOX, seeing it as a politically motivated move leading to a loss of risk-taking and competitiveness.
Of concern to many is the mandate requiring that public companies obtain an independent audit of their internal control practices. The cost of the requirement is felt most acutely by companies with a market capitalization of $75 million or greater. The audit standards were modified in 2007, reducing costs for many firms by 25% or more annually.
Key Takeaways
- Independent auditors are certified public or chartered accountants who examine the financial records of companies and are not affiliated with the companies being audited.
- Independent auditors have a mandate to protect shareholders and potential investors from a public company’s possible fraud and accounting improprieties.
- Company managers can use the results of an independent audit to improve company processes.
- Independent audits provide a clear picture of a company's worth, which helps investors make an informed decision when considering whether to purchase a company’s shares.
Benefits of an Independent Auditor
Despite the high initial costs of the internal control mandate, companies can experience many benefits from the independent audit process. Managers can use the information to continually improve internal processes. Companies frequently find that over time the internal control testing becomes more cost-effective.
Additionally, markets use the information from the audit to assess businesses more effectively. Audits provide a clear picture of a company's worth, which helps investors make an informed decision when considering whether to purchase shares in a company. Financial analysts and brokerage companies also rely on an audit's results when making investment recommendations to their clients.
An auditor's report is a written letter from the auditor containing their opinion on whether a company's financial statements comply with generally accepted accounting principles (GAAP) and are free from material misstatement.
The independent and external audit report is typically published with the company's annual report. The auditor's report is important because banks and creditors require an audit of a company's financial statements before lending to them.
Key Takeaways
- The auditor's report is a document containing the auditor's opinion on whether a company's financial statements comply with GAAP and are free from material misstatement.
- The audit report is important because banks, creditors, and regulators require an audit of a company's financial statements.
- A clean audit report means a company followed accounting standards while an unqualified report means there might be errors.
- An adverse report means that the financial statements might have had discrepancies, misrepresentations, and didn't adhere to GAAP.
How an Auditor's Report Works
An auditor's report is a written letter attached to a company's financial statements that expresses its opinion on a company's compliance with standard accounting practices. The auditor's report is required to be filed with a public company's financial statements when reporting earnings to the Securities and Exchange Commission (SEC).
However, an auditor's report is not an evaluation of whether a company is a good investment. Also, the audit report is not an analysis of the company's earnings performance for the period. Instead, the report is merely a measure of the reliability of the financial statements.
The Components of an Auditor's Report
The auditor's letter follows a standard format, as established by generally accepted auditing standards (GAAS). A report usually consists of three paragraphs.
- The first paragraph states the responsibilities of the auditor and directors.
- The second paragraph contains the scope, stating that a set of standard accounting practices was the guide.
- The third paragraph contains the auditor's opinion.
An additional paragraph may inform the investor of the results of a separate audit on another function of the entity. The investor will key in on the third paragraph, where the opinion is stated.
The type of report issued will be dependent on the findings by the auditor. Below are the most common types of reports issued for companies.
Clean or Unqualified Report
A clean report means that the company's financial records are free from material misstatement and conform to the guidelines set by GAAP. A majority of audits end in unqualified, or clean, opinions.
Qualified Opinion
A qualified opinion may be issued in one of two situations: first, if the financial statements contain material misstatements that are not pervasive; or second, if the auditor is unable to obtain sufficient appropriate audit evidence on which to base an opinion, but the possible effects of any material misstatements are not pervasive. For example, a mistake might have been made in calculating operating expenses or profit. Auditors typically state the specific reasons and areas where the issues are present so that the company can fix them.
Adverse Opinion
An adverse opinion means that the auditor has obtained sufficient audit evidence and concludes that misstatements in the financial statements are both material and pervasive. An adverse opinion is the worst possible outcome for a company and can have a lasting impact and legal ramifications if not corrected.
Regulators and investors will reject a company's financial statements following an adverse opinion from an auditor. Also, if illegal activity exists, corporate officers might face criminal charges.
Disclaimer of Opinion
A disclaimer of opinion means that, for some reason, the auditor is unable to obtain sufficient audit evidence on which to base the opinion, and the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive. Examples can include when an auditor can't be impartial or wasn't allowed access to certain financial information.
Example of an Auditor's Report
Excerpts from the audit report by Deloitte & Touche LLP for Starbucks Corporation, dated Nov. 15, 2019, follow.
Paragraph 1: Opinion on the Financial Statements
"We have audited the accompanying consolidated balance sheets of Starbucks Corporation and subsidiaries (the 'Company') as of September 29, 2019, and September 30, 2018, the related consolidated statements of earnings, comprehensive income, equity, and cash flows, for each of the three years in the period ended September 29, 2019, and the related notes (collectively referred to as the 'financial statements').
In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of September 29, 2019, and September 30, 2018, and the results of its operations and its cash flows for each of the three years in the period ended September 29, 2019, in conformity with accounting principles generally accepted in the United States of America."
Paragraph 2: Basis for Opinion
"We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (PCAOB). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks.
Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion."