18 December 2011Corporate Governance and EthicsRequirement 1According to Collins and Schultz (1995), external audit refers to an evaluation of the firm’s operations, financial reporting, governance and internal controls. The main purpose of an external audit is the provision of independent assessment of internal governance and financial health of the firm without bias. An independent and external auditor is concerned with the assessment of the fairness of the financial statements of the firm. There are several purposes of having independent and external audits. Increasing the confidence of investors- Investors rely on audit reports prepared by independent and external auditors when making their investment decisions.
Investors expect the independent and external auditor to make a verification of the internal control procedures, which are put in place by the company, verify the accounting methods and procedures used by the company’s accountants in the preparation of financial statements and provide an opinion on the operations of the company. In addition, investors might use independent and external auditor’s report to make an assessment of how the senior managers of the firm perform and the extent to which their actions impacts on the profitability, competitiveness and reputation of the firm. Providing an assurance to industry regulators- Industry regulators usually review independent and external audit reports when evaluating whether a company has adhered to the standards and principles of the industry.
This can best be established by a party which is distinct from the company. An independent and external auditor is likely to provide audit reports that are free from bias hence a good measure that can be used by industry regulators. Helping the Government agencies to regulate- Government agencies often use reports prepared by an independent and external auditor to have a clear understanding of the operations of the firm and its adherence to laws that are applicable in their area of operations.
They can also use external auditor reports as a basis for their investigations or enquiries. For example, the audit report information might be used by, say, the US Securities and Exchange Commission to commence an insider trading enquiry at a firm. Help to supplement internal audits- A company has its own internal control systems put in place.
The senior managers can use external audit reports to measure the adequacy and effectiveness of the internal controls of the company. External audit report may be relied on by the internal audit department in planning, reviewing and executing annual audit programs. For example, it may allocate more resources to areas pointed as risky by external auditors. Independent and external audits support good corporate governance and ethical decision making in various ways especially by overcoming the limitations of internal control systems and procedures. This is because of the fact that there is no system which is entirely foolproof since employees in collusion can override the best controls.
Notice that a critical aspect of an internal control system is the separation of duties. Individual who have the physical responsibility for assets should not also have access to accounting records (Ward and Deck, 1993). However, since these individuals are within the organization and know each other and their roles, they can agree to commit a fraudulent activity and interfere with the accounting records of the company. This can take long to be identified since they are the same individuals who are in custody of these financial records.
This has the effect of defeating the overall purpose of internal control systems. An independent and external auditor is; however, distinct from the company and does his work as an independent entity. This means that eventually the external auditors’ reports will reveal the fraudulent activities of the employees of the company. Therefore, it is worth noting that the employees of the company will avoid fraudulent activities for the fear of being exposed by the external auditor. This ensures that they practice good corporate governance and uphold ethics in all their decision making processes and actions.
In addition, external audits resolve the issue of cost versus benefit tradeoff. Before a decision is made to establish an internal control system, the senior managers need to satisfy themselves that the matter to be ruled on represent a significant problem and that the system will not impose cost on the many for which the benefits are few. Putting in place an internal control system is an additional cost to the company whilst the same services can be contracted to an external audit at a lower cost.
Minimizing the cost to the company is a critical means of maximizing the wealth of the shareholders of the company through achieving possible value of the company.