Role of an external auditor in corporate governance

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Role of an external auditor in corporate governance
An external auditor examines the company's accounting practices in depth. (John Foxx/Stockbyte/Getty Images)

Corporate governance in a business, or any type of organisation, ensures that the company operates in the best interests of its stakeholders, which includes everyone involved in the business, from shareholders to the community. Corporate governance oversees a company's practices and processes and provides a framework for achieving business objectives. In the field of business finance, the relationship between corporate governance and external auditors is critical for financial transparency.

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The audit committee

It is essential to understand the role of an audit committee in corporate governance because this clarifies the purpose of an external auditor. An audit committee aims to ensure the integrity of a business's financial reporting, in the internal and publicly published reports, and that the internal accounting procedures and practices are followed. Members of the audit committee should be independent non-executive directors and at least one of them should have "recent and relevant" financial experience, according to corporate law experts Pinsent Mason. Larger companies need to have at least three members, whilst companies outside the FTSE 350 only need two members. None of the company's own finance or internal audit staff are allowed to be on the audit committee. In addition, the company has to justify its choice of audit committee members in its annual report.

Audit committee and auditors

The UK Corporate Governance Code stipulates the role of the audit committee in section C3. Apart from monitoring the integrity of financial reporting, reviewing internal financial controls and risk management systems, it also has responsibility for appointing the external auditor. Keeping the appointment within the control of the audit committee is one way of maintaining the independence of the external auditor's report. The audit committee also has responsibility for reviewing the external auditor's work and deciding whether it is effective. The committee may decide to appoint a new external auditor if, for example, it finds evidence that the auditor is less than objective in his reports. This might arise if the auditor gets too close to the company's management.

The external auditor

An external auditor has to provide an opinion on the quality of a company's financial statements. If you study a company's published annual report, you will see that the accounts are signed off by an accountancy firm as being a "true and fair" statement of the company's financial state. The external auditor also needs to be satisfied that the accounts are prepared according to legal accounting practices. The external auditor has a wide-ranging set of tasks that supplement these broad outlines of the role. These include the selection of accounts for random testing, conducting departmental reviews and the interviewing of finance officers about accounting practices. The auditor may want to ensure that the business is getting value for money from its suppliers and it is also a part of the job to notice signs of financial fraud.

Maintaining independence

The corporate governance code places responsibility for additional, non-audit functions with the audit committee. This means that an external auditor must not undertake any non-audit jobs for the company. An example of this might be providing a consultancy service to the company on a specific project. This would compromise the independence of the external auditor, and therefore the effectiveness of the corporate governance system.

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