[Analysis] External Confirmation in Audits – Reliable Evidence for Financial Accuracy

External confirmation in audits refers to audit evidence obtained directly from a third party in response to the auditor's request. This type of confirmation is used to verify the accuracy of specific financial information, such as account balances, transactions, and legal matters, as represented in a company's financial statements. Due to its independence and objectivity, external confirmation is considered one of the most reliable forms of audit evidence, enhancing the credibility of the audit and reducing the risk of errors or misstatements.

Table of Contents 

1. Introduction
2. What Constitutes Audit Evidence?
3. Case Study – Audit Evidence Failure and Its Consequences
4. Importance of Complying with Audit Standards
5. Understanding External Confirmation in Audits
6. Why External Confirmation is a Valuable Audit Tool?
7. Different Types of External Confirmation
8. Challenges in Obtaining Reliable External Confirmation
9. Audit Standards for External Confirmation
10. Case Example – External Confirmation in Action
11. Conclusion – Enhancing Audit Quality with Audit Evidence

1. Introduction

The integrity of a financial statement audit is built upon the foundation of audit evidence. It is the information used by auditors to form an opinion on whether the financial statements of an entity are free from material misstatement. Externalconfirmation  stands out as a particularly valuable and reliable source among the various types of evidence gathered during an audit. This article delves into the role of audit evidence in financial audits, focusing on using external confirmations to gather reliable and relevant evidence.

2. What Constitutes Audit Evidence?

As per SA 505, “Audit Evidence” is the information used by the auditor in arriving at the conclusions on which the auditor’s opinion is based. Audit evidence includes information in the accounting records underlying the financial statements and information obtained from other sources.

Thus, the auditor must obtain sufficient and appropriate evidence to support their opinion on the financial statements. The reliability of the evidence depends on the source and nature, with direct evidence, such as external confirmation, generally being more reliable than indirect evidence, such as client representations. Audit evidence comes from a variety of sources and can be classified into different types:

• Physical Evidence – Tangible items that can be inspected (e.g., inventory count).
• Documentary Evidence – Written or electronic records substantiating transactions (e.g., invoices, contracts).
• Testimonial Evidence – Information gathered from discussions with management or staff.
• Analytical Evidence – Data obtained through analytical procedures, such as ratios or trend analysis.
• External Evidence – Information from independent third parties, such as banks, customers, or suppliers.

3. Case Study – Audit Evidence Failure and Its Consequences

An order from the NFRA emphasises the need to obtain sufficient and appropriate audit evidence. In the said case, the auditor failed to obtain sufficient appropriate audit evidence relating to trade receivables even though 100% of the trade receivables were unsecured without any provision for doubtful debts and formed a material part of the Balance Sheet (52.89%).

Following a detailed investigation, the NFRA found that the auditor failed to exercise due diligence while performing the audit of financial statements, particularly in relation to the audit of trade receivables. This failure was substantiated by the non-creation of the provision of doubtful debts, which showed that the audit procedures were not performed in accordance with the prescribed standards of the Institute of Chartered Accountants of India (ICAI). As a consequence of the violations, the regulatory body imposed the following penalties and actions:

• A monetary fine of ₹5,00,000 for non-compliance with auditing standards.
• A one-year suspension of the engagement partner from serving as an auditor or internal auditor or from conducting audits of financial statements or internal audits for any company or body corporate.

4. Importance of Complying with Audit Standards

The penalties and corrective actions imposed in this case remind all professionals in the field to comply with the established guidelines and safeguard the interests of stakeholders relying on accurate and truthful financial statements. Obtaining audit evidence is crucial because it enables the auditor to form an accurate opinion, ensures compliance with professional standards, helps detect material misstatements or fraud, and strengthens the overall quality and credibility of the audit process. The audit’s integrity and value would be significantly compromised without sufficient and appropriate audit evidence.

Continuing with the sources of audit evidence, external confirmation is a particularly reliable method, as it offers independent verification from third parties, thereby reinforcing the authenticity and objectivity of the evidence. The article’s next section will explore how audit evidence can be gathered through external confirmation.

5. Understanding External Confirmation in Audits

As per SA 505, “External Confirmations” is defined as audit evidence obtained by the auditor from a third party in response to a direct request. It is used to verify the accuracy of information presented in financial statements, such as balances, transactions, or other specific financial data. External confirmations are considered one of the most reliable sources of audit evidence, as they provide independent, external validation of the assertions made by the client. The confirmation may be in written responses, electronic communications, or other documented forms from the third party. External confirmations are most commonly used to verify:

• Account Balances – Confirming the balances of third parties’ receivables, payables, or cash.
• Transactions – Verifying specific transactions with customers or suppliers, such as sales or purchases.
• Legal Matters – Confirming ongoing or potential litigation details with the company’s legal advisors.
• Debt Agreements – Verifying terms of loan agreements with lenders or financial institutions.

6. Why External Confirmation is a Valuable Audit Tool?

External confirmation is highly regarded in audits because it comes from an independent source, making it more trustworthy than internal documents that could be influenced or altered. The reliability of the third-party provider, whether a bank, customer, or supplier, adds credibility to the confirmed information, ensuring that it is more objective and accurate.

External confirmations are especially useful when auditing high-risk areas where management may have incentives to misstate financial information. For example, confirming the accuracy of accounts receivable balances helps auditors assess whether the company’s reported assets are valid and whether customers are likely to pay their debts.

7. Different Types of External Confirmation

External confirmation can take various forms, and auditors typically choose the method based on the nature of the information being confirmed and the level of assurance required.

• Positive Confirmation – These require the recipient to respond to confirm the information. Positive confirmations are particularly useful when there is a high risk of error or fraud, e.g. account receivable confirmation.
• Negative Confirmation – In contrast, negative confirmations request the recipient to only respond if they disagree with the information provided. These are generally used when the risk of misstatement is lower, for example, when confirming accounts payable.
• Blank Confirmation – These are a variation of positive confirmations where the third party is asked to provide the balance or other information rather than confirming what has been sent by the auditor.

8. Challenges in Obtaining Reliable External Confirmation

Although external confirmation is highly valuable, it comes with certain challenges and limitations, including:

• Non-responses – A lack of response from third parties can undermine the effectiveness of external confirmation. This is particularly problematic when confirmations are used to verify significant balances.
• Misstatements or Errors in Responses – While third-party confirmations are generally reliable, they may still contain errors or be incomplete. Auditors need to critically assess the reliability of the responses.
• Cost and Time – External confirmation can be time-consuming and costly, especially when dealing with large numbers of third parties. It may also involve delays in receiving responses, which can impact the audit timeline.
• International Considerations – When auditing entities with international operations, auditors may encounter difficulties obtaining external confirmations from foreign parties due to language barriers, different legal systems, or time zone differences.

 9. Audit Standards for External Confirmation

• International Standards on Auditing (ISA 505) – Under ISA 505, External Confirmations auditors must send external confirmations to obtain sufficient and appropriate audit evidence. The standard highlights the importance of using external confirmation procedures when they effectively obtain evidence.
• PCAOB –In the United States, the PCAOB (Public Company Accounting Oversight Board) also provide guidelines in Auditing Standard (AS) 2301, AS 2310, and AS 2410 on using external confirmation as part of the audit process. The PCAOB’s guidance on external confirmation stresses the importance of obtaining sufficient, reliable, and appropriate audit evidence to support the auditor’s opinion. The auditor must consider the nature and risk of the accounts being confirmed, select appropriate procedures, assess the reliability of responses, and document all steps in the process. Failure to do so may lead to a misstatement or failure to detect fraud, which could result in a modified audit opinion.

10. Case Example – External Confirmation in Action

An order from the NFRA emphasises the importance of obtaining appropriate audit evidence through external confirmation. In this case, the auditor failed to obtain sufficient appropriate audit evidence relating to trade receivables, trade payables and supplier advances. The auditor obtained no external confirmations of bank balances and third-party balance confirmations.

During its investigation, the NFRA determined that the auditor had committed professional misconduct and, exercising its authority, imposed the following penalty:-

• Monetary penalty of Rs. 2,00,000/- (Two Lakhs Rupees) on the engagement partner
• Debared the engagement partner and the auditor firm for two years from being appointed as an auditor or internal auditor or from undertaking any financial statements or internal audit of the functions and activities of any company or body corporate.

11. Conclusion – Enhancing Audit Quality with Audit Evidence

In conclusion, an audit’s integrity and quality heavily rely on the sufficiency and appropriateness of audit evidence. Audit evidence not only supports the auditor’s opinion but also ensures compliance with professional standards, aids in detecting misstatements or fraud, and enhances the credibility of the audit process. Among the various sources of audit evidence, external confirmation stands out as a particularly reliable method. By obtaining independent verification from third parties, external confirmation reinforces the objectivity and authenticity of the information, reducing the risk of errors and fraud. However, its effectiveness depends on careful planning, execution, and overcoming potential challenges such as non-responses or errors in the confirmation process. When used effectively, external confirmation significantly strengthens the audit process, ensuring auditors can provide stakeholders with a more accurate, transparent, and trustworthy financial picture.