Understanding the Auditing Process: What General Counsel Need to Know
Auditing is the process of evaluating a company’s financial statements according to set standards. While a company’s auditors have primary responsibility over auditing financial reports, lawyers regularly need to work alongside auditors and understand how to interpret audit reports. It is therefore critical for lawyers, particularly in-house corporate counsel, to have a basic understanding of the principles underlying the preparation of financial statements and the major rules governing the auditing process.
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Purpose of Auditing
Companies prepare financial statements on a regular basis to keep investors informed of their recent financial performance and future outlook. Financial statements are also assessed by a company’s current and prospective creditors, providing information about whether to loan money to the company.
For U.S. public companies, a company’s audited financial statements must be filed with the Securities and Exchange Commission (SEC) every year as part of its annual 10-K report.
A company’s accounting department maintains a system for financial recordkeeping. The auditor’s job is to ensure that the company’s accounting records are an accurate and fair reflection of the company’s financial performance.
The auditors assess a company’s financial statements in accordance with uniform auditing standards while factoring in the company’s unique circumstances. At the conclusion of the audit process, the auditors issue an opinion about the financial statements as a whole. The audit opinion provides assurances that the auditors have reviewed the company’s financial statement and formed an opinion as to their accuracy.
Auditing and Financial Reporting Standards
In the United States, a company’s financial reports must be prepared in accordance with the U.S. generally accepted accounting principles, or U.S. GAAP. These accounting principles have been established by the Financial Accounting Standards Board (FASB), an independent standard-setting body.
For foreign companies, sometimes referred to as foreign private issuers (FPIs), different accounting principles are applied. The International Financial Reporting Standards (IFRS) have been adopted by many companies outside of the United States. The IFRS accounting principles have been established by the International Accounting Standards Board (IASB), an independent standard-setting organization.
The auditing process can involve a number of steps beyond just looking at the company’s written accounting records. These steps may include:
- Conducting interviews of employees both within and outside of the company’s accounting department
- Asking the company’s business counterparties for more information about their dealings with the company
- Visiting a company’s facilities and assessing its inventory levels
- Obtaining representation letters from the company’s chief financial officer or senior management with respect to certain financial statements made
At the end of the audit process, the auditors will issue an audit opinion. The form and content of the audit opinion is governed by standards set by the Public Company Accounting Oversight Board (PCAOB). This audit opinion, which comes in the form of a letter, is addressed to the company, its board of directors, or stockholders.
Most audit opinions are unqualified, meaning that the auditors have concluded that the company’s financial statements present fairly the financial position, results of operations, and cash flows in accordance with standard accounting principles.
Sometimes unqualified opinions are issued with an explanatory note. For example, the audit opinion may include special going concern disclosures. This is often the case when the auditors determine that there is a significant likelihood that a given company will run into major operational or liquidity issues in the foreseeable future.
If the auditors determine that a company’s financial statements generally are presented fairly with a caveat, they may issue a qualified opinion. This could arise if there was a limitation on the scope of the audit and the auditor was unable to perform all standard audit procedures to support its opinion.
In certain circumstances, the auditors may have to issue an adverse opinion concluding that the company’s financial statements do not fairly present the company’s financial position. In practice, adverse opinions are rare.
There are strict auditor independence rules set forth by both the SEC and the PCAOB. Many of the SEC rules regarding auditor independence are in Section 10A of the Securities and Exchange Act of 1934.
The general independence rules contained in Regulation S-X outlines a number of circumstances that will disqualify an auditor from being considered independent. These circumstances include:
- The auditor has certain business relationships with the company outside of the ordinary course of business
- The auditor is compensated by the company on a contingency or commission basis
- The auditor or a related party has certain types of investments in the company
In addition to understanding the SEC rules governing auditor independence, in-house lawyers should keep themselves informed of the auditor independence requirements of the Sarbanes-Oxley Act. Enacted in 2002, the Sarbanes Oxley Act also implemented a number of requirements for companies regarding their internal controls over financial reporting.