Financial Auditing Concepts

Learning Objectives

• Explain the purpose of financial statement auditing
• Identify the people responsible for preparing financial statements and preventing fraud
• Explain the external auditor's responsibility for fraud risks
• Distinguish between fraud arising from fraudulent financial reporting and misappropriation of assets

Who is Exempted from Statutory Audit?

• Small company: Private company meeting at least two of three criteria for the past two financial years:
  • Total annual revenue less than S$10 million
  • Total assets less than S$10 million
  • Number of employees less than 50
• Exempt private company: Annual revenue less than S$5 million and fewer than 20 members, none of whom is a corporation
• Dormant unlisted company: Total assets within the financial year must not exceed S$500,000 and dormant from formation date or end of previous financial year

Basic Types of Audit & Assurance Engagements

• Financial Statement Audit: Complete scope of work done, reasonable assurance, accurate and complete to a certain extent, true and fair view with no material misstatements, positive assurance on assertion(s) - statutory audit
• Review: Limited scope of work done, moderate/limited assurance, no evidence that it is not true and fair, no material modifications required, negative assurance on assertion(s) - quarterly reporting or as-needed.
• Agreed Upon Procedures (AUP): Specific procedures to be performed, no assurance, as per agreed upon criteria

Purpose of a Financial Statement Audit

• Enhance intended users' confidence in financial statements
• Achieved by the auditor expressing an opinion on whether the statements are prepared in accordance with an applicable reporting framework
  • In the case of most general-purpose frameworks, the opinion is on whether the statements give a true and fair view

Why Do We Need Audits?

• Agency Theory: Independence, trust, biases and motives of financial providers, misalignment of interests of owners and management
• Information Risk: Technical competence, distance, remoteness of information, complexity of transactions

Origins of Modern Audit

• Modern audit originates from failures in the 19th century (e.g., City of Glasgow Bank) revealing the need for independent annual audits, now mandatory for listed and large companies.
• Aims to provide assurance to shareholders about the true and fair view of a company's assets, liabilities, financial position, and profit/loss.
• Crucial for maintaining investor confidence and market stability, as it impacts employees, customers, suppliers, and pensioners.

Purpose of a Financial Statement Audit (SSA200.36)

• Enhance the degree of confidence of intended users about the financial statements, by expressing an opinion on whether statements are prepared in accordance with an applicable financial reporting framework.
• An audit conducted in accordance with SSAs and relevant ethical requirements enables the auditor to form the opinion.

Users of Audited Financial Statements

• Users and the types of decisions they make
  • Management: review of performance, operational decisions, and reporting, buying or selling
  • Stockholders/bondholders: determining financial position for buying or selling; Evaluating loan factors
  • Financial institutions: evaluating loan decisions; considering interest rates
  • Taxing authorities: determining taxable income, and complying tax due
• Provides assurance to these users

Level of Assurance & Expectations Gap

• Audit reports provide reasonable, high level assurance but there is still an expectations gap.
• Expectations gap is the difference between public perception and the responsibilities of auditors regarding the reliability of audited financial statements guaranteeing the entity remains in existence.
• Auditors are not responsible for guaranteeing future performance
• Auditors cover the type and extent of financial statement items tested, not all errors are uncovered during the audit.
• Auditors provide reasonable assurance, but not absolute assurance, regarding accuracy of statements' figures.

Who Is Responsible for the Preparation of Financial Statements?

• Management is responsible for the preparation of financial statements in accordance with applicable financial reporting framework
• Management is responsible for establishing internal control relevant to the preparation of financial statements

Which Items are Responsibilities of Management?

• Everything except the Independent Auditors Report

Management Versus Auditor Responsibilities

• Management: Maintaining internal controls, preparing and reporting (financial statements and disclaimers).
• Internal audit function: provides independent assurance on internal controls and reports.
• Audit committee: provides oversight on the reporting process.
• External auditor: conducts independent audit of internal controls and financial statements.

Independent Auditors' Report

• Auditors' opinion on the financial statements of a company in accordance with the Companies Act 1967 and Singapore Financial Reporting Standards(International).
• Statements provide a true and fair view of the consolidated financial position and financial performance.

Who is Primarily Responsible for Preventing Fraud?

• Primarily the management and board of directors.
• Internal audit's assessment and recommendation of controls to limit risk of fraud within the company.

SSA Definition of Fraud

• Fraud: An intentional act by one or more individuals involving deception to gain an unfair advantage. -Fraud risk factors: Conditions that indicate an incentive or pressure to commit fraud, involving management, those charged with governance, employees, or third parties.
• FRAUD TRIANGLE (Pressure, Opportunity, Rationalization) : A framework for spotting high-risk situations. -Prevention & Detection of Fraud: Primary responsibility of management and governance.

How is Occupational Fraud Initially Detected?

• Internal audit
• Management review
• Document examination
• Accident / reconciliation
• Automated transaction / data monitoring

Who Reports Occupational Fraud?

• Employees
• Customers
• Anonymous sources
• Vendors
• Shareholders / owners
• Competitors

External Auditor's Responsibility Regarding Fraud & Error

• Auditors identify and assess risks of material misstatement due to fraud
• Auditors obtain sufficient evidence for assessing fraud risks in financial reports
• Auditors respond appropriately to identified fraud risk during audits

Limitations of an External Audit on Fraud Detection

• Auditors obtain reasonable assurance, but not absolute assurance, about the absence of material misstatement.
• Inherent limitations of an audit means that some material misstatements may not be detected regardless of procedural compliance
• Risk of not detecting management fraud is greater than that of employee fraud.

Fraud Risk Response Towards Management Override of Controls

• Selecting journal entries for testing (SSA 240.32(a))
• Reviewing accounting estimates (SSA 240.32(b))
• Introduce unpredictability / Modify timing, nature and extent of audit

Professional Scepticism

• Ongoing questioning about information and audit evidence
• Acknowledging the integrity of management but maintaining a critical stance towards potential inconsistencies
• Evaluating records and documents, and investigating discrepancies.

Professional Scepticism - Alertness to..

• Contradictions in audit evidence
• Questionable reliability of documents and responses
• Conditions suggesting fraud
• The need for additional audit procedures

What are the Two Common Fraudulent Misstatements?

• Fraudulent financial reporting: Perpetrated by those who have vested interest or accountability in the performance of the entity.
• Misappropriation of Assets: Theft by employees usually for small amounts.

Fraudulent Financial Reporting (FFR) Examples

• Revenue recognition: Early recognition, fictitious sales
• Accounting estimates: Intentional misstatement (e.g., sales returns, provisions, accruals)
• Complex/unusual transactions: Transactions outside regular business processes involving related parties

Misappropriation of Assets (MA) Examples

• Embezzlement: Diverting receipts to personal accounts
• Theft of assets: Stealing inventory or scrap
• Inappropriate payments: Payments to fictitious vendors or employees
• Kickbacks: Payments to purchasing agents in exchange for inflated prices

Drivers of Fraud

• Pressure: Incentive from external or internal sources to reach unrealistic financial goals
• Opportunity: Percieved chance to commit fraud.
• Rationalization: Ability to justify fraudulent actions

Applying the Fraud Triangle to Local Fraud Cases

• Summary of the case
• Type of fraudulent misstatement
• Examination of Fraud Triangle factors (pressure, opportunity, rationalization)
• Proposed internal control to prevent fraud

Key Concepts Summary

• Overview of key auditing concepts covered in the provided material.