Independent Auditor

An independent auditor is a licensed certified public accountant or accounting firm hired by a company to examine its financial statements and issue a professional opinion on whether they are fairly presented according to generally accepted accounting principles. The auditor is independent because they are not an employee of the company being examined. That separation is the entire source of their credibility.

The US Securities and Exchange Commission requires all publicly held companies to have their financial statements audited by an independent auditor before filing annual reports. The US Supreme Court stated in US v. Arthur Young that the SEC requires audited financial statements to reduce investor reliance on potentially inaccurate information.

Management Prepares the Statements; the Auditor Examines Them

The financial statements belong to management. Management designs the systems that capture transactions, selects accounting policies, and makes the judgments that produce the numbers. The auditor's job is to gather enough evidence to form an independent opinion on whether those numbers fairly represent reality.

The Public Company Accounting Oversight Board is explicit on this boundary: the auditor's knowledge of transactions is limited to what they observe during the audit. They cannot require management to do anything. If management refuses access, the auditor's only remedy is to modify or disclaim their opinion.

The Four Audit Opinions Signal Very Different Things to Investors

• Unqualified opinion: The financial statements are fairly presented in all material respects. This is the standard clean result most audits produce.
• Qualified opinion: The statements are fairly stated except for one or two specific departures from accounting standards. It signals a limited problem, not a crisis.
• Adverse opinion: The statements do not fairly present the company's financial position and contain material misstatements. This is a serious red flag for any lender or investor.
• Disclaimer of opinion: The auditor could not gather enough evidence to form any opinion and refuses to issue one. This signals that something prevented a proper audit.

The PCAOB Sets the Rules for Public Company Audits

The Public Company Accounting Oversight Board was created by the Sarbanes-Oxley Act of 2002 following the Enron and WorldCom accounting scandals. It sets auditing standards for firms that audit public companies and conducts inspections to ensure compliance. The American Institute of CPAs Auditing Standards Board sets equivalent rules for private company audits.

Statement on Auditing Standards 134, effective December 2021, overhauled the format of the auditor's report and introduced Critical Audit Matters. CAMs require auditors to disclose the most complex and significant issues identified during the audit directly in the report, giving financial statement users more context about where high judgment or difficulty existed.

Audited Statements Reduce Borrowing Costs for Companies That Are Not Required to Audit

Many private companies that are not legally required to have audits choose to do so anyway. Research cited in financial accounting textbooks consistently shows that audited companies obtain bank loans at lower interest rates than comparable unaudited companies.

Banks view an independent auditor's opinion as a signal that reduces information asymmetry between borrower and lender. Even a small business seeking a $500,000 loan can improve its terms by paying for an audit that gives the bank greater confidence in the numbers it is reviewing.

Sources

• US Securities and Exchange Commission – https://www.sec.gov/about/reports-publications/investorpubsaboutauditorshtm
• Public Company Accounting Oversight Board – https://pcaobus.org/oversight/standards/archived-standards/pre-reorganized-auditing-standards-interpretations/details/AU110
• PCAOB Auditing Standard AS 3101 – https://pcaobus.org/oversight/standards/auditing-standards/details/AS3101
• National Council of Nonprofits – https://www.councilofnonprofits.org/running-nonprofit/nonprofit-audit-guidec/what-independent-audit
• GRF CPAs and Advisors – https://www.grfcpa.com/resource/auditor-responsibilities/