The External Auditor

It can be seen from the brief description of disclosure requirements for fixed assets and inventories in a company’s financial statements that management’s freedom to select accounting methods and to portray results and financial posi-tion is strictly limited. Another major force which controls the acposi-tions of man-agement is the annual external audit. The remainder of this module describes briefly the role of external auditors, the methods they employ and the report which they submit.

5.18.1 The Role of the Auditor

The Companies Act requires that all limited companies have their accounts audited by independent persons who hold an accounting qualification recognised by the Department of Trade and Industry. The auditors are normally drawn from firms engaged in public practice; they are appointed by the shareholders in general meeting and are eligible to be reappointed each year. There are safeguards which protect the auditors from being dismissed by an unscrupulous or vindictive management.

The auditors are required to make a report to the shareholders on the accounts examined by them. This report forms part of the published financial statements.

The report shall state whether, in the auditors’ opinion, a true and fair view is given of the profit (or loss) for the year and of the financial position at year-end. MBA’s auditors’ report is reproduced on p. 5/28 of its accounts and their responsibilities are set out on the previous page.

5.18.2 Audit Methodology

To enable them to make a report, the auditors must ensure that the books, records and internal controls have been satisfactorily maintained during the accounting period. The principal aspects of their work include:

(a) an examination of the system of bookkeeping, accounting and internal control to ascertain whether it is appropriate for the business and properly records all transactions. This is followed by such tests and enquiries as are considered necessary to ascertain whether the system is being properly carried out. Both these steps are necessary to form a basis for the preparation of the accounts;

(b) comparison of the balance sheet and profit and loss account and other statements with the underlying records in order to see that they are in accordance therewith;

(c) verification of the title, existence and value of the assets appearing in the balance sheet;

(d) verification of the amount of the liabilities appearing in the balance sheet;

(e) verification that the results shown by the profit and loss account are fairly stated; and

(f) confirmation that the statutory requirements have been complied with and that the relevant accounting standards have been applied correctly.

5.18.3 Internal Control

Note that the auditors are not required to satisfy themselves about every single transaction of the company during the accounting period. Provided they have ensured that the system of internal control is secure, they can rely on that system to produce adequate records from which the financial statements will be drawn.

Auditors are spending an increasing proportion of their time today examining

and testing internal control, which they see as a fundamental basis for later, and more widespread, audit tests.

Internal control is a term used to describe all the various measures taken by the owners and managers of a company to direct and control their employees.

Because any employee, or manager for that matter, might be or become dishon-est, incompetent, careless or lazy, it is necessary to establish procedures designed to make them directly accountable for their behaviour and to encourage them to avoid such irregularities and shortcomings. A simple but effective method of examining internal control is for the auditor to draw a flow chart of each major system in the company, purchases, sales, inventory control, cash responsibilities, and so on. Such flow charts will highlight weaknesses in the system where, for example, too much authority and executive action resides in one official. The auditors will then concentrate their attention and tests on this person’s activities ensuring that the official has not abused, either deliberately or accidentally, the power vested in him or her by the company. The auditor will also bring this type of shortcoming in internal control to the attention of management in the end-of-audit letter which the auditor sends to the board of directors.

5.18.4 Internal Control Surrounding Additions to Fixed Assets

The nature of internal control can best be grasped by an example drawn from the audit tests surrounding the additions to a company’s fixed assets. The auditor would look at the following points during assessment of the system of internal control.

1 All capital expenditure should be authorised, whether such expenditure consists of purchases from third parties or the company’s own labour and materials, and rules should be laid down for the regular reporting of actual expenditure against authorisations.

2 The authorisation should normally be given by means of board minutes, or, where the amounts involved do not warrant a board minute, by a senior official of the company.

3 In the case of large capital projects the system should provide for progressing the project and authorising the necessary payments up to completion.

4 Expenditure capitalised should be for additional assets and not for replace-ments (unless the asset or part replaced has been written off) and should be limited to the cost of work done or supplied by outside contractors, plus the company’s expenditure on direct materials and labour.

5 If capital expenditure is extensive, only a percentage of additions need be verified, but this test should include all items over a stated amount.

The items selected should be verified by inspecting agreements, architects’

certificates, suppliers’ invoices and other documentary evidence in respect of purchases from third parties or by an examination of stores requisitions and wages sheets as regards the company’s own materials and labour. The percentage added for overheads should be checked and it should be seen that these are restricted to shop or factory overheads as are appropriate.

6 The items selected for test should be properly authorised, either by the board or by a responsible official. (This point is of special importance where

any of the directors or senior executives are remunerated by commission on profits, as the figure upon which commission is calculated will be inflated if revenue expenditure properly accounted for in the profit and loss account is incorrectly allocated to capital in the balance sheet.)

7 Any substantial capital additions which have been made during the year under audit should be inspected to satisfy the auditor that expenditure which has been capitalised is properly represented by some tangible asset.

If auditors are satisfied with the accuracy, authorisation and treatment of the small number of transactions tested, they can place reliance on the system of internal control surrounding the additions of fixed assets and, therefore, on the figures produced for them by the company, and concentrate their attention on other sensitive areas of the company’s accounting system.

5.18.5 Materiality

An auditor’s task is made more difficult by the volume of transactions entered into by a company during the course of a year. Clearly auditors cannot check every transaction nor can they expect every one to be exactly in accordance with stated procedures. Mistakes occur; shortcuts are taken. They therefore set a limit, usually expressed in monetary terms, below which they will not examine in depth. Equally, should mistakes emerge in the low-value transactions, they will not insist on these being put right before signing their audit report. This limit, which they alone set, is called the level of materiality.

Example

A brewery company spends about £25 million per annum on repairs and refurbish-ments of its pubs. The decision on whether each individual item of expenditure should be capitalised or written off is one which is taken by the company. But, because the decision affects the level of reported profits (that is, capitalised expen-diture boosts the fixed assets and therefore is not a charge to this year’s profit and loss account), the auditor examines these decisions. But since the £25 million comprises many thousands of individual programmes of repairs and refurbishments, he will set a limit of materiality of, say, £50 000. He will examine individual items of expenditure above the amount and if he is broadly in agreement with the man-agerial decisions taken on these, he will assume the smaller items are also correct.

And even if they are wrong, the magnitude of the mistake is not going to make a material difference to the reported results of the company.

5.18.6 The Audit Report

The aim of the audit is to enable the auditor to report to the shareholders of the company on the following matters:

(a) whether the accounts give the information required by the Companies Act 1985 in the manner required by this Act;

(b) whether the balance sheet gives a true and fair view of the state of the company’s affairs as at the end of year;

(c) whether the profit and loss account gives a true and fair view of the profit or loss for the year;

(d) in the case of a holding company submitting group accounts, whether the group accounts have been properly prepared so as to give a true and fair view of the state of affairs and profit and loss of the company and its subsidiaries so far as concerns members of the company.

In addition, auditors must state in their reports if they are unable to satisfy themselves as to the following matters:

(a) that they have obtained all the information and explanations which they require;

(b) that proper books of account have been kept;

(c) that proper returns adequate for the purpose of their audits have been received from branches or subsidiaries not visited;

(d) that the accounts are in agreement with the books.

The absence of any comment in the audit report is equivalent to a positive statement by the auditors that they have satisfied themselves on the above matters.

The auditors’ report is usually unqualified, meaning that they have found nothing in the audit to detract from the opinion that the accounts show a true and fair view of the state of affairs of the company. The MBA audit report is unqualified.

If the auditor qualifies a report it is important that the qualification should state specifically and positively the reason why, and the extent to which, the auditor is not satisfied. It should also state the effect on the accounts and, wherever possible, the amounts involved. The objective of the auditor should be to convey information, not to arouse enquiry. There are many possible causes for auditors to qualify their reports. For example, they may be unhappy about the provision for bad and doubtful debts, believing that the company should have provided more than it did in the profit and loss account. The report would read as follows:

In our opinion, the provision which has been made by the company for losses in respect of bad and doubtful is insufficient by £6 million. With this reservation in our opinion the accounts set out on pages X to Y give a true and fair view. . .

5.19 Summary

Managers are constrained by three sets of rules when constructing corporate financial statements:

(a) company legislation passed by the government of the country in which the company is registered;

(b) the accounting standards set by the accounting profession or its regulators;

and

(c) the listing requirements of the Stock Exchange.

Few companies disclose any information not required by the above set of rules.

Groups of companies consolidate their results at the end of the financial year into a group profit and loss account and a group balance sheet; in addition the parent company must publish its own balance sheet.

These financial statements are subject to audit. An auditor is required to report to the shareholders of a company on whether or not the accounts reflect a true and fair view of the company’s affairs. To do this he or she undertakes a series of checks and examinations of the company’s books and internal controls.