Internal and External Auditing.

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Since Lehman Brothers announced its collapse last September, the financial crisis has spread all over the world. Almost all the capital markets have suffered from it. Even many companies, especially finance related companies, bankrupted due to the economic depression. This essay aims to focus on the current economic situation and the collapse of several finance related companies, and then evaluate the role and importance of internal and external auditing.

The current economic situation and several bankrupt financial companies

Most developed countries, emerging countries and low income countries are still in a period of economic downturn, even though the global financial system has survived from the brink of meltdown. This economic crisis began after a loss of confidence by investors concerning the value of securitized mortgages in the USA resulting in a liquidity crisis that prompted a substantial injection of capital into the financial markets by the United States Federal Reserve, the Bank of England and the European Central Bank. Following this, in September 2008, the crisis deepened, and a great number of banks, mortgage lenders and insurance companies suffered heavily. For instance, Lehman Brothers, as the first bankrupt company and the symbol of the crashed capital markets worldwide, was the direct victim of the highly risky financial derivative, subprime mortgage. Also, Fannie Mae and Freddie Mac which owed or guaranteed a great deal of the US's mortgage market, were highly susceptible to the subprime mortgage crisis, and finally were taken over by the U.S. government. As the market confidence was dramatically destroyed, investors who were extremely pessimistic preferred saving money to investing. This led to many finance related companies going bankrupt.

In general, the financial crisis was directly caused by high risk mortgages and the pessimistic market. However, internal and external auditing still play pivotal roles in a financial crisis, which can be seen from the roles of internal and external auditing.

The role and importance of internal auditing

Internal auditing has been defined by the Institute of Internal auditors Inc. as follows:

‘internal auditing is an independent, objective assurance and consulting activity designed to add value and improve an organization's operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance.'(Cascarino & Esch, 2007:5)

According to the definition, roles of internal auditing could be classified in three types, risk management, control, and governance.

1. Role in control

An effective control means having mechanisms in place to prevent, to detect and if possible mitigate threats to achievement of the company's objectives (Porter, Simon & Hatherly, 2004:503). One of the core mechanisms of control is mutual restraint. This means that job design should be based on each job being restricted by another job, meanwhile overseen by supervisors. The method could avoid personnel using companies' resources to make profit for themselves. In addition, feedback mechanisms, as another pivotal mechanism of control, could ensure that managers can obtain complete and true reports from their subordinates who may not report a failure on their part to managers because of the desire to make performance better. Thus, the role of internal auditing in control is to review the company's control to make sure that: controls are effective to prevent and detect the occurrence of potentially damaging event; and feedback mechanism is effective so that relevant levels of management are informed completely and truly.'

2. Role in risk management

Based on the COSO description, risk management relates to how an organization sets goals, and then identifies, analyzes, and responds to those risks that could potentially affect its ability to achieve its goals. It has become increasing important due to the high business risks caused by frequent changes of environment and intensive competition. In finance related companies, especially, most of their products have inherent risks because of the characters of financial products. Risk management could prevent those risks from exerting a detrimental influence on business. While internal auditing requires monitoring and evaluating the effectiveness of the organization's risk management, more specifically, an internal auditor can advise the management and the board regarding strategies, marketing, operation, capital planning and other aspects concerning risks through assessing the activities implemented by managers and personnel.

3. Role in corporate governance

As for corporate governance, internal auditing is generally about participation in meetings and discussions with members of the board, which may include reporting the control situation, informing the board on the capabilities of key managers, suggesting questions for risk management, assessing the performance of departments, ensuring the board receive effective information.

The importance of internal auditing

According to the roles above, it is evident that internal auditing plays a crucial role in maintaining a company's healthy development. Without effective internal auditing, risk management, control, and governance could not be implemented effectively. As a result, the company would probably encounter threats that may destroy the business from both outside and inside.

The role and importance of external auditing

The external audit is an audit performed for parties external to the auditee. Experts, independent of the auditee and its personnel, conduct these audits in accordance with requirements which are defined by or on behalf of the parties for whose benefit the audit is conducted (Porter, Simon & Hatherly, 2004:7). External auditing could be divided into two types based on governmental auditing and independent auditing. This essay mainly discusses independent auditing that the auditors are assigned by accounting or auditing firms because of the situations described above.

1. Role of expressing an opinion

The primarily role of external auditing is to express an opinion on whether the auditee entity's financial statements are free of material misstatements. This means that the external auditor should gather and evaluate evidence relating to assertions about the information contained in these financial statements to ascertain the degree of correspondence between those assertions and established criteria, GAAP, and communicate the results to financial statement users outside the entit . External auditing ensures that the financial statements are truly and fairly represented by the management rather than detecting fraud. If external auditors find any error or fraud relating to the information contained in the financial statements during the audit process, it is their responsibility of suggest management to correct, or they would report to financial statements users.

2. Role of supervisor

External auditing, as an outside supervisor, oversee the companies, especially listed companies, in order to preventing them from material misstatement, because of the separation between the ownership and management functions, the potential conflict of interest between preparers and users of financial statements, and the knowledge limitation of financial statement users to distinguish the information for themselves. Not only does it add the quality of financial statements, but it also gives the credibility to the financial information provided by the management of companies. This enhances the safety of investment for outside users.

The importance of external auditing

Actually, the importance of external auditing has emerged in the discussion of its roles. Differing from the internal auditing which is importance to companies themselves, the importance of external auditing is mainly for external financial statement users. If these is not external auditing or the external auditing is not effective, external financial statement users would be misled by the untrue and unfair financial statements and make an improper decision which may cause them bankruptcy. Moreover, it would lead to confusion in the capital market. In another words, the financial crisis may be partly controlled, if the external auditing is extremely effective, because the crisis in many countries is mainly caused by stock sell-off due to the market pessimistic sentiment.


The above describes the current economic situation and takes some collapsed finance related companies as examples. Though the financial crisis did not directly stem from the non-effective internal and external auditing, I believe them could avoid the deterioration of the economic.

References List

Cascarino, R. & Esch, S.V. (2007) Internal Auditing: An Integrated Approach (2nd edition). South Africa, Juta and Co Ltd.

Porter B., Simon, J. & Hatherly, D. (2004) Principles of external auditing((2nd edition). England, John Wiley & Sons Ltd.

Brink, V.Z.(1972) The Internal Auditor's Review of Organizational Control, Florida, The Institute of Internal Auditors,Inc.

The Institute of Internal Auditors.(2004)The Role of Internal Auditing in Enterprise-wide Risk Management. London, Institute of Internal Auditors-UK and Ireland Ltd.