Role of an External Auditor in Corporate Governance

Formal presentations will show the four pillars of corporate governance to include the board of directors, internal auditors, management, and external auditors. And after the introduction of federal legislation under the Sarbanes-Oxley Act, tightening up the expectations on external auditors, the role of external auditors in governance is more important than ever.

The concept of corporate governance represents the collection of activities, rules, processes and guidelines that make sure the company is using its resources, strategies and directions in the best possible way consistent with its mission and stated goals. This is important because shareholders and stakeholders depend on this maxim to measure company progress toward these goals.

Without corporate governance, shareholders putting their trust in management to do what’s best for their investment may be poorly served. Since management by nature is geared to move the company toward more profit, this may be to the detriment of the overall life of the company and the shareholder’s investment stake. On the other hand, decisions made just to please shareholders can drive a company into bankruptcy. Corporate governance keeps the balance between what may be two opposing forces.

Public companies, those that have shared their ownership with shareholders on public markets in return for investment, are required to have independent, third-party validation of their financial reports and progress. This is to make sure the company management is not pulling the wool over the eyes of affected investors. External auditors function in this third-party role as certified examiners who are licensed to perform such validations.

External auditors are usually public accounting firm employees brought in under contract to review the accounting and financial books of a company. This task is performed quarterly and annually, consistent with the reporting cycle for public investment companies. The external auditor is under the fiduciary burden to make sure that the public and shareholders can be comfortable with the reports issued by the subject company. The external auditor’s third-party opinion is critical for successful or failed validation.

External auditors promote corporate governance by making sure the subject company’s reports are accurate, true and an appropriately fair reflection of the company’s status. In the process, if anything is discovered that looks fraudulent, then it is directed to management. The external auditor should seriously consider stepping away from the review if management ignores the issue or tries to cover it up. But it is not the external auditor’s role to be the fraud investigator per se.

The external auditor will examine the subject company to make sure its automated systems, particularly the financial ones, follow internal controls. Issues or questions raised by outside regulatory agencies over the subject company are also fair game for review. Specifically related to publicly-invested companies listed on public markets like the NASDAQ or the Dow, the Sarbanes-Oxley Act spells out specific requirements that external auditors must meet when preparing their review reports and validating company reports.

Since the external auditor’s reports are the key to measuring the performance of publicly-invested companies, the federal government felt it necessary to protect the independence of external auditors. With the 2002 passage of the Sarbanes-Oxley Act, each affected company has to have an internal audit committee separate from management to be in charge of retaining external auditors. This breaks the direct report and pay relationship with management of a company and the hired auditor.