What is an Audit?
Before we get to explaining an Auditor’s Report, what exactly is an Audit?
An audit generally refers to a financial audit. This constitutes an examination and verification of the facts and figures published in the financial statements of a company. This audit is performed to benefit the investors of the company by making sure that the financial statements actually match the underlying financial assets and transactions that the company claims that they represent.
Internal Audit versus External Audit
If an audit is be conducted internally by employees of the company, it is called an Internal Audit. If it is conducted by external auditors from an accounting firm, it’s called and External Audit.
Obviously, investors prefer an external audit over an internal audit because employees have a vested interest in the financial statements that they are auditing. As such, internal audits may produce a biased non-objective auditor’s report.
Internal Audits
An internal audit is performed by employees or consultants of the company that is being audited. Consultant auditors may be used by a company that does not have professionals on its payroll that are qualified to conduct such an audit.
Generally, an internal audit is aimed at improving certain internal processes and systems in the company. The results of an internal audit may recommend that the company make changes to its internal controls to comply with applicable laws, improve its financial metrics, or increase the effectiveness of its operations. It can also identify internal problems before it is reviewed by external auditors.
External Audits
An external audit seeks to produce an unbiased review and report of the financial statements of a company. These statements include the Income Statement, Balance Sheet, and Cash Flow Statement.
External auditors normally publish an auditor’s opinion that can be relied on by investors , lenders, and stakeholders to be accurate and credible.
Are Audits Mandatory?
Every company that is publicly-listed on a reputable exchange must be audited annually by a licensed Certified Public Accounting firm. Even a company that is not listed publicly but that sells registered securities to investors is also required to be audited annually. This is to protect investors of registered securities from receiving inaccurate financial information from the company.
Lenders to public companies also require an external auditor’s report to be submitted to the lender as a condition to the lender lending money to the company.
Audit Standards
Public companies are required by law to establish strong and adequate accounting internal controls to prevent fraud. And the audit is conducted from these internal controls. The law that governs these controls is the Sarbanes-Oxley Act (SOX) of 2002.
Audit standards are set out in generally accepted auditing standards (GAAS), are set out by Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA). Additional rules for the audits of publicly traded companies are made by the Public Company Accounting Oversight Board (PCAOB). Standards are set for international companies in the International Standards on Auditing (ISA) set up by the International Auditing and Assurance Standards Board (IAASB).
The Dreaded Tax Audit
Tax authorities such as the Internal Revenue Service (IRS) in the United States, Canada Revenue Agency (CRA) in Canada, and Her Majesty’s Revenue & Customs (HMRC) in the United Kingdom also perform audits of individual and corporate taxpayers in their tax jurisdictions to verify the accuracy of a tax return that the taxpayer filed with the tax authority.
Generally, despite the negative connotation attached to a tax audit, most tax authorities select audit candidates randomly. A taxpayer may also be selected for an audit if they had any financial dealings with another individual or company that was found to have errors in their tax return filed with the tax authority.
There are 3 possible tax audit outcomes available:
– No change to the tax return
– A change that is accepted by the taxpayer. If the change is accepted, the taxpayer may have to pay additional taxes.
– A change that the taxpayer disagrees with. If the taxpayer disagrees, the taxpayer may appeal the result.
What Is an Audit Committee?
Every public company must have an audit committee. This is a committee comprised of select directors from the company’s board of directors. The audit committee is responsible for overseeing the financial reporting and disclosure of the company, monitoring its accounting policies, working with the external auditors, ensuring regulatory compliance and assessing risk management strategies.
Public companies must have a qualified audit committee made up of independent outside directors to ensure it is independent, objective, and unbiased.
The audit committee works with the company’s auditors, CFO, and Controller to ensure that company’s financial statements are accurate. Some stock exchanges require that the audit committee include at least one financial expert such as a professional with an investment, banking or accounting background.
Most audit committees should meet each quarter to study the quarter’s financial statements and audit. If the audit committee deems that there is an issue with the company’s financial statements or audit, it can initiate a further special investigation.
Committee members change from time to time.. Members are generally paid annual compensation in cash or company stock. Directors are also paid for each audit committee meeting that they attend.
What Is an Auditor?
Now that we understand the internal workings of the audit process in a company, let’s look at the auditor.
An auditor is a licensed professional that is hired to to review and verify the accuracy of financial statements of a company. An auditor can identify errors in the financial statements and business fraud.
An Auditor Follows the Money
Auditor follows the money by following the company’s cash to verify that the funds are properly accounted for.
An auditor determines whether the company’s financial statements followed Generally Accepted Accounting Principles (GAAP). Each auditor takes detailed notes as he works in an audit trail. Once the audit is complete, the auditor presents his findings in an Auditor’s Report that accompanies the company’s financial statements.
Securities agencies such as the Securities and Exchange Commission (SEC) require that all public companies employ external auditors to produce Auditor’s Reports for the companies. The official procedures are established by the International Auditing and Assurance Standards Board (IAASB), a committee of the International Federation of Accountants (IFAC).
Unqualified Opinion
Auditor reports are accompanied by an unqualified opinion. These statements confirm that the company’s financial statements conform to GAAP, without providing judgment or an interpretation.
Qualified Opinion
If an auditor cannot give an unqualified opinion, he will publish a qualified opinion. This report states that the information provided for his audit was limited in scope. Or that the company does not abide by GAAP accounting principles.
Other Types of Auditors
Government Auditors maintain and examine records of government agencies and of private businesses or individuals performing activities subject to government regulations or taxation. Auditors employed through the government ensure revenues are received and spent according to laws and regulations.
Forensic Auditors specialize in crime and are used by law enforcement organizations to identify criminal financial crimes such as money laundering.
Qualifications of an Auditor
External auditors are required to have a Certified Public Accountant (CPA) license or its equivalent in their jurisdiction. The CPA license is a professional certification awarded by the American Institute of Certified Public Accountants.
Internal auditors do not need to have a CPA license. Often, a bachelor’s degree in subjects such as finance or accounting is sufficient as a minimum requirement to be an internal auditor.
Auditor’s Report
An auditor’s report is a written letter from the auditor containing their opinion on whether a company’s financial statements comply with GAAP and are free from material misrepresentation.
For public companies, the auditor’s report accompanies the company’s annual report and financial statements. The auditor’s report is required to be filed with a public company’s financial statements filed with the SEC via the EDGAR filing system.
An auditor’s report does not include investment research or analysis. It does not tell an investor whether a company is a good or bad investment. It simply tells the investor whether the financials that are published can be trusted.
Auditor’s Report Outline
The auditor’s letter follows a standard format, as established by generally accepted auditing standards (GAAS). It usually consists of 3 paragraphs.
– Paragraph 1 – the responsibilities of the auditor and directors
– Paragraph 2 – the scope of the audit
– Paragraph 3 – the auditor’s opinion
Clean or Unqualified Report means that the company’s financial records are free from material misstatement and conform to the guidelines set by GAAP.
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.
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.
Disclaimer of Opinion means that 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 could be both material and pervasive.
Example of an Auditor’s Report
Partially republished (in Bold Italics below) from the Report of Independent Registered Public Accounting Firm section of Meta Platforms, Inc. (formerly Facebook Inc.) SEC Filing 10-K Annual Report for the fiscal year ending Friday, December 31, 2021.
The following paragraphs provide a good example of the components of the Auditor’s Report of a large-cap public company.
Opinion on the Financial Statements
We have audited the accompanying consolidated balance sheets of Meta Platforms, Inc. (the Company) as of December 31, 2021 and 2020, the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2021, and the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2021 and 2020, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2021, in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the 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.