The objective of external audit is for the auditor to express an opinion on the truth and fairness of financial statements.
The main necessity for conducting the audit of financial statements stems from the fact that the persons responsible for the preparation of financial statements are often different from the owners of large corporations.
Whereas in small owner managed companies, the owners have first hand knowledge of the affairs of their business, management and ownership is normally separate in the case of large companies that often have thousands of shareholders. In large corporations, shareholders appoint directors to run the enterprise on their behalf. This separation of ownership and control creates the need for external audit.
Financial statements are the main source of accountability of management performance by the shareholders. However, as the management is responsible for the preparation of financial statements, shareholders have to rely on external verification by auditors in order to gain reasonable assurance that the accounts are free from material misstatements and can therefore be relied upon to be presenting true and fair view of the affairs of the company.
Apart from the needs of owners, other users of financial statements may need to place reliance on the financial statements. External audit is a means of providing a reasonable basis for the users to place reliance on financial statements.
Examples of stakeholders (other than shareholders) that rely on audited financial statements include the following:
Tax authorities rely on audited financial statements to determine the accuracy of tax returns filed by the companies.
Financial institutions require audited accounts of prospective borrowers for assessing the credit risk by analyzing their liquidity and financial position.
Management uses the audit exercise to re-evaluate the company’s risk management processes and internal control system by considering the feedback given by external auditors during the course of the audit in this regard.
Financial audit is intended to provide a ‘reasonable’ assurance over the accuracy of financial statements. It therefore does not provide absolute assurance that the financial statements are free from all misstatements. The purpose of audit is confined to provide reasonable assurance in order to avoid excessive time and cost in the performance of the audit that may outweigh any benefit that may be derived from the enhanced assurance. Absolute assurance is also impossible to guarantee in most cases due to the inherent limitations of audit.