Auditing for Financial Reporting

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Auditing for Financial Reporting Tatiana Antipova The Institute of Certified Specialists (ICS), Perm, NA, Russia Perm State University (PSU), Perm, NA, Russia

Synonyms Auditing for financial reporting = Financial statement audit in the public sector (for the purpose of this entry).

Definition The term “audit” possibly originates from the Latin “audire,” meaning “to listen”. In the ancient Rome practice, one official would compare records with another for a separation of duties and verification. Later this practice expanded to England that confirmed a quotation from Shakespeare’s piece: If you suspect my husbandry or falsehood, Call me before the exactest auditors And set me on the proof. (W. Shakespeare 1623)

Auditing: “A systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and

communicating the results to interested users.” (Hyytinen and Kallunki 2014) Government auditing: is essential to the government’s responsibility of accountability to the public. Government audits are intended to provide an independent, objective, nonpartisan assessment of the stewardship, performance, and cost of government policies, programs, and operations (GAO-06-729G Government Auditing Standards, 1.01, 1.02). Most often the government auditing is divided into financial statement audits and performance audits. So we can see that financial statement audit is a part of government auditing. Financial statement audit in the public sector: an assessment of the public sector organizations’ financial position and results of its operations, as a rule for the whole fiscal year. The primary purpose of a financial statement audit is to provide an opinion (or disclaim an opinion) about whether an entity’s financial statements are presented fairly in all material respects in conformity with generally accepted accounting principles (GAO-06-729G Government Auditing Standards, 1.25). The term “financial statements” refers to a presentation of financial data, including accompanying notes, derived from accounting records and intended to communicate an entity’s economic resources or obligations at a point in time or the changes for a period of time in conformity with an identifiable framework, such as generally accepted accounting principles (GAAP) or

# Springer International Publishing Switzerland 2016 A. Farazmand (ed.), Global Encyclopedia of Public Administration, Public Policy, and Governance, DOI 10.1007/978-3-319-31816-5_2304-1

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another comprehensive basis of accounting (GAO-03-673G). Financial statements are a structured representation of the financial position and financial performance of an entity (IPSAS 2015. 1, 15). Fiscal year is a period used for calculating annual (“yearly”) financial statements. All of definitions are considered for the public sector.

Introduction Nowadays, with globalization of the economy, good governance of public finance is of fundamental importance for all countries to ensure the sustainability of the national budget and financial systems, as well as mutual financial security and sustainable economic growth. The public sector of many economies has been subject to dramatic change. Accounting is a major mechanism by which many of these changes have been enacted. Effective budget implementation is an important factor in influencing the volume and quality of public services. Furthermore, it is important to bear in mind that leakage of resources through poor accounting directly threatens fiscal stability since it requires more resources than should be necessary to achieve any given result. Government auditing provides independent assessments of that information for the benefit of those charged with oversight and for the public. When public are confident that the information they receive is relevant, reliable, understandable, consistent, and comparable, it creates trust. Transparency and public accountability further engender trust in a representative democracy. Working together, these factors lead to greater citizen satisfaction and better access to capital at a lower cost. As long as budget resources come from the public in the form of taxes, every citizen demands greater understanding of where their tax money goes and how it is spent and control. Financial statement audit as part of governmental auditing will focus attention on how budget resources are spent. Assessment procedures of financial auditing serve to avoid

Auditing for Financial Reporting

misrepresentation and fraud in public sector financial statements. Since the public sector financial statements are placed on the Internet, any citizen can get acquainted with this reporting. And citizens can trust the information set in these financial statements if it is verified by auditors properly. Auditors should assess fair presentation of public sector financial statements. When financial statements “furnished by a state agency are in fact reliable, citizens’ trust should be increased by auditors. When, on the other hand the information is significantly unreliable, auditors should reveal that and consequently decrease citizens’ trust” (Budding and Grossi 2014, p. 146). On the other hand, “fair presentation is not equivalent to financial health (i.e., a good picture is not necessarily a pretty picture). . .Yet there is no inconsistency between a government receiving an unqualified opinion on the fairness of its financial statements and that same government experiencing financial difficulties. The financial statement audit is designed to vouch for the reliability of the financial statements, not the soundness of the finances they portray. Just as the image of something unattractive in a photograph is no indication of a defective camera, a poor financial condition is in no way inconsistent with fair financial statement presentation” (Gauthier 2009). Indeed, the quality of financial reports also depends on the indicators used to present them.

Financial Statement Audit in the Public Sector First of all, it is necessary to know the structure of the public sector. The most common public sector comprises general government and public corporations. Government-owned enterprises, such as the central bank, post office, or railroad are often referred to public corporations. General government usually consists of three levels: central government, state or regional government, and local government. Public corporations are divided on nonfinancial (e.g., post office) and financial (e.g., central bank). To understand the essence of financial statement audit, it is necessary to define its subject and


object. The subject is the audit institution and the object is the auditee. The subject depends on the public sector level. At the central government level, financial statements are audited by federal government or parliamentary bodies like Government Accountability Office (GAO), Supreme Audit Institutions (SAI), federal financial control bodies, treasury, Accounts Chambers, etc. At the state/regional government level, financial statements auditing (control) is conducted by regional branches of federal financial control bodies, state Accounts Chambers, regional Accounts Chambers. At the local government level, financial statements auditing (control) is conducted by local parliamentary bodies like local Accounts Chambers and some of central and state governments body in sharing functions. The object is auditee – public sector entities belonging to the public sector that present financial statements. Financial statements of an entire country presented to the International Monetary Fund (IMF) are prepared and approved by the member country’s Ministry of Finance in accordance with Government Financial Statistics Manual (GFSM 2014). All 188 IMF member countries (including European countries) must comply with GFSM 2014 and ESA 2010. Inside any country, financial (including budgetary) statements of each separate public sector (budgetary) entity are prepared by accountants and approved by the head of this organization. Many regulations (e.g., budget code) and rules are usually ordered by the Ministry of Finance and spread inside the country. The financial statements of each budgetary entity presented depend on the level of budget system of this country. For instance, federal level budgetary entity presented their financial statements to the federal authority, etc. Many countries use IPSAS to accomplish this. Subsequently, financial statements are consolidated on each level of the budget system and then for whole country. To conduct financial statement audit in the public sector, auditors must know public sector accounting standards (e.g., GAGAS, IPSAS), rules, laws, and regulations for preparing financial

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statements, as well as auditing standards (e.g., INTOSAI, SAS, ISA, PCAOB), rules, laws, and regulations for writing auditor’s reports. Because “the auditor’s report is the most important product of the audit. The auditor’s report is normally directed to parliament and the cabinet. It is thereby often made available to citizens.” (Budding and Grossi 2014, p. 155). The report should include all significant instances of noncompliance and abuse and all indications or instances of illegal acts that could result in criminal prosecution that were found during or in connection with the audit (GAO/OP-4.1.2, p. 40). When giving the auditor’s report, auditors must be sure that financial statements are complete, reliable, accurate, consistent, and timely. In addition to law, “the rules and regulations specifically relevant to audit in the public sector can be presented in four categories: the Lima declaration, the Code of Ethics, auditing standards and practice notes” (Budding and Grossi 2014, p. 151). In order to carry out financial statements audit, it is necessary to perform two main procedures: (1) verification of financial statements compliance to laws and regulations and (2) analysis of financial statements elements. Verification of Financial Statements Compliance to Laws and Regulations When checking the correctness of financial statements, one should determine (Antipova 2014): 1. The guidance of international and domestic accounting rules. A simplified block diagram of generalized audit procedures for compliance with the existing legal framework is shown in Fig. 1. 2. Completeness and timeliness of reporting. Completeness means that all requirement statements (see Table 1) are presented. The composition of public sector financial reporting is established in international regulations such as GFS, IPSAS, and others. A comparison of the required forms for reporting is shown in Table 1. Timeliness depends on the end of the reporting period. Usually financial statements must follow a strictly defined deadline, for

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Auditing for Financial Reporting, Fig. 1 Block scheme of financial statements control procedures

Review auditee Financial Statements Are Financial Statements complying with applicable laws and regulations?

No Query and check primary and analytical documentations

Yes

No

Is the evidence of the violations in primary documentations? Yes Classify and record a fact of the violations, attach proof documents

Auditor’s report

Auditing for Financial Reporting, Table 1 The required forms for reporting GFSM (2014) Statement of operations Statement of other economic flows Balance sheet Statement of sources and uses of cash Statement of total changes in net worth Summary statement of explicit Contingent liabilities and net Implicit obligations for future Social security benefits

IPSAS (2015), 1, 2, 24 A statement of financial performance – A statement of financial position A cash flow statement A statement of changes in net assets/equity Notes, comprising a summary of significant accounting policies and other explanatory notes

example, in 20 days after the end of the reporting period or fiscal year. In addition, according to the budgetary rules, all transactions of public sector entities must fit into the fiscal year (see Table 2). Usually audit bodies prefer to check financial statements for whole fiscal year because it is clearly seen how to execute year budget. That is all of budget

money that was received by budgetary entity must be spent during fiscal year and this spending must be reflected in financial statements. As shown in Table 2, different countries have fiscal years which end in different dates, complicating data comparability by comparing statements between those countries.


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Auditing for Financial Reporting, Table 2 Fiscal year duration’s in some countries Country Canada, Norway, Sweden Most Continental European countries Russian Federation and post-Soviet Countries Turkey United Kingdom, Japan USA

3. Whether all transactions with budget funds are accounted for the fiscal year. 4. The availability of authentic primary documents, timeliness, and accuracy of recording reflected into the accounts. 5. Whether the total amount on the accounts equal the sum in their detailed transcript. 6. Compliance with the instructions of the Ministry of Finance on the accounting and registers. 7. Compliance with established procedure for correcting errors in primary documents received by the accounting department in the accounting records, as well as printouts. 8. Whether considered the results of previous audits of accounting and reporting. Analysis of Financial Statements Elements During a financial audit, key financial elements, such as assets, liabilities, revenue, and expenses, are analyzed and checked. These elements are reflected mostly in two main statements: the balance sheet and the statement of operations. Let’s look at the essence of these statements’ elements. A balance sheet is a statement of the values of the stock positions of assets owned and of the liabilities owed by an institutional unit or group of units, drawn up in respect to a particular point in time (GSFM 2014, 3.56). In accordance with a double-entry system, each transaction gives rise to at least two equal-value entries, traditionally referred to as a credit entry and a debit entry (GSFM 2014, 3.54). In other words, balance sheets consist of a left side which reflects all assets’ leftover and right side which reflects all liabilities’ leftover. Asset is a store of value representing a benefit or series of benefits accruing to the economic

Beginning of fiscal year 1st July 1st January 1st January 1st March 1st April 1st October

End of fiscal year 30th June 31st December 31st December 28th February 31st March 30th September

owner by holding or using the resource over a period of time. It is a means of carrying forward value from one reporting period to another (GFSM 2014, 3.42). Assets are resources controlled by an entity as a result of past events and from which future economic benefits or service potential are expected to flow to the entity (IPSAS 2015 1, 7). Liability is established when one unit (the debtor) is obliged, under specific circumstances, to provide funds or other resources to another unit (the creditor) (GSFM 2014, 3.45). Liabilities are present obligations of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits or service potential (IPSAS 2015. 1, 7). As net worth equals assets minus liabilities, it is the balancer of the balance sheet. If the difference between the sum of assets and liabilities is positive (assets > liabilities), net worth is added to liabilities to the balance as shown on Fig. 2. Thence assets = liabilities + net worth. If liabilities > assets, net worth will be moved to the left side and balance assets. Therefore it will be assets + net worth = liabilities. The left side must always equal right side in the balance sheet due to the double-entry system. Since the net worth equals assets minus liabilities, it becomes necessary to check the assets and liabilities during balance sheet control to perform financial statement auditing. So in the balance sheet (also designed “statement of financial position”) auditing must control two main elements: assets and liabilities. Assets are classified differently depending on the

6 Auditing for Financial Reporting, Fig. 2 Balance between main balance sheet elements


NET WORTH

ASSETS

regulations. General rules for determining the regulated assets are GFSM (2014) and IPSAS (2015). When controlling the elements of the balance sheet, auditors need to ensure: 1. The accuracy and completeness of elements provided in the forms of reporting, and the coordination of related elements presented in separate forms and the balance. 2. Compliance with the actual performance on the reporting date (end of the financial year). 3. That all assets and liabilities actually existed at the reporting date; in case of doubt an inventory should be conducted. 4. Whether the same analytical and synthetic accounting data. If any discrepancies exist, the deviation of each of the accounts should be calculated. The magnitude of the deviation should indicate the amount of distortion of financial statements. 5. The correctness of the assets’ and liabilities’ amount. 6. Controlling of the operation with different debtors and creditors. To do this, auditors must check the reasons for the formation of receivables and payables; the terms of the debt of each debtor and creditor, the reality of receivables and payables. The statement of operations presents details of transactions in revenue and expense. Revenue minus expense equals the net operating balance, reflecting the total change in net worth due to transactions with financial assets and liabilities (GSFM 2014, 4.16, 4.17). Since the net operating balance equals revenue minus expense, it becomes necessary to control the revenue and expense during financial statement audit.

LIABILITIES

Any of budget revenues can be classified as all proceeds from transactions that result in an increase in the value of assets. But the detailed classification of revenue for operations statement purposes is significantly different depending on the regulations ordered by Ministry of Finance from country to country. So compliance factual revenue with classification needs to be controlled in the audit. First of all, control starts with checking the completeness and correctness of the reported amounts of revenues and expenses. Revenue is an increase in net worth resulting from a transaction (GSFM 2014, 4.23). Revenue is the gross inflow of economic benefits or service potential during the reporting period when those inflows result in an increase in net assets/equity, other than increases relating to contributions from owners (IPSAS 2015 1, 7). Expense is a decrease in net worth resulting from a transaction (GSFM 2014, 4.24). Expenses are decreases in economic benefits or service potential during the reporting period in the form of outflows or consumption of assets or incurrence of liabilities that result in decreases in net assets/equity, other than those relating to distributions to owners (IPSAS 2015 1, 7). A key point when checking revenue and expense is the recording bases because the amount of revenue and expense depend on applicable recording bases. Broadly, the time of recording could be determined on four bases: the accrual basis, the commitments basis, the due-forpayment basis, and the cash basis. In practice though, many variations on these bases of recording may exist (GSFM 2014, 3.61). According to GSFM (2014) and IPSAS, the accrual basis is a preferable recording base for


financial accounting. But the result of research of 14 European countries shows that “out of 14 countries covered, five use cash, four apply modified cash, two use modified accrual, while there are only three countries using full accruals for budgeting purposes (Austria, Switzerland and the United Kingdom)” (Brusca et al. 2015, p. 236). In the course of checking revenue, the auditor pays particular attention to: – The completeness and correctness of recording and reporting all revenue. – A contract between the government/state and the contractor, the definition of contractual compliance with applicable laws. – The presence of an integral part of the contract between the customer (the state) and the performer – budget programs and activities justifying the targeted use of budgetary funds; special attention in the implementation of this complex work should be focused on coming budgetary allocations to finance capital (current assets) and operating costs. – The nature of the receipt of funds – if the entity is a budgetary entity or state budget funds, the budget comes to exercise their statutory activities within the estimates of revenues and expenses. If the budget comes in the form of grants, subsidies, and other transfers, it is necessary to examine the contract for their provision; especially attentively one must check the performance of all the essential conditions of the contract. The main thing in this block is the control over the use of finance, which should confirm the reasonable assertion that the budget users achieve the goals set in their outcome. To check expense, the auditor performs the following procedures: 1. Check the distribution of the sum of debit turnover of the account “expenses,” taking into account the formation of the cost of the transaction log.

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2. Check the completeness, accuracy, and timeliness of the entries in the transaction logs. 3. Verify the resulting amount of expenses of primary documents with a total transaction log on the account “expenses” for a month, and then – with a total of the general ledger for each month and a whole year. Then compare the results of the general ledger with a total cost in the statement of operations. 4. In the event of discrepancies in the amounts of analytical and synthetic accounting, find out the cause. 5. Pay attention to the procurement procedure because it is known that during public procurement some officials have enriched. 6. Control for whether government activities are operating in accordance with the principles of economy, efficiency, and effectiveness. 7. Control of social spending. A financial statement audit should be led to ensure the issuance of reliable financial information and to deter fraud, waste, abuse, and others violations of public resources. The most common violations in the public sector are: abuse, fraud, waste, bribery, and kickbacks. However, unfortunately these kinds of violations are really difficult to reveal, because such violations very often do not have documentary proof and are made as a result of face-to-face agreements in cash (black) or virtual money, and so are not reflected in the financial statement. This is caused by the appearance and prosperity of the shadow economy, and some senior officials became oligarchs due to these nonrevealed and nonidentified violations.

Conclusion Now seems like an opportune time to improve financial statements auditing that is dealing with some major headwinds across a variety of fronts. Many types of crisis, government failures, bureaucratizing, and budget troubles called for a new innovative approach to financial statements auditing around the world. Financial statement auditing needs to rethink its priorities, put transparent decision-making, simpler legislation, make

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better methodology, and simplify the rules it uses to define and measure auditing results. The improvement of the financial statement auditing in the public sector has two sides: how to further improve the financial reporting process and how to further improve the financial auditing. In considering how to further improve the public sector financial reporting process in their countries, researchers thought that the following measures were a high priority (IFAC 2008, p. 21): • Continue convergence to one global set of financial reporting standards • Globally unify, simplify, and clarify financial reporting standards focusing more on the best practice • Ensure that boards of directors pay attention to the quality of financial reports • Provide additional education and training for preparers. The priorities to further improve the financial statement auditing in the public sector were (IFAC 2008, p. 26): • Continue to focus on independence, objectivity, and integrity • Converge to one set of global, principles-based auditing standards over time • Ensure consistent use of audit standards and safeguarding of quality within auditing bodies • Improve the auditor’s communication, both internally and externally • Raise the auditor’s competence and professionalism • Consider limited/proportionate liability for auditors Currently, no more than 60 % of budget organizations and operations with budgetary funds are object to the government audit. The existence of the shadow economy and an impressive amount of violations indicate that many financial transactions with budget money go out of control. We need a transition to a fuller control of the budget organization and operations with budgetary funds.


This can help a new approach to financial statements auditing – digital auditing. Moving auditors to new and evolving techniques will modernize financial statement auditing by making full use of current and emerging technologies to overhaul traditional samplingbased auditing approaches and fully leverage technology to digital auditing. Digital auditing allows leveraging sophisticated tools, such as online analytical processing to analyze large populations of both manual and automated journal entries from the financial management system. Getting there will take dedicated investments, concerted effort, executive-level commitment, and strong partnerships with agency management, who will likewise greatly benefit from this evolution. In doing so, it will enable the auditor’s profession to move into the future and add even greater value to managing the cost of government and providing the highest levels of accountability and transparency to the public (Lewis et al. 2014, p. 34). In addition, it is necessary to note that “many auditors want further hands-on guidance to be included in the standards” (Budding and Grossi 2014, p. 159). Despite the fact that auditors have many types of instructions, there are still not enough really workable, clear, and easy manuals for beginners and students.

Cross-References ▶ Auditing ▶ Auditing Principles ▶ Contingency Model of Reforms in Public Sector Accounting ▶ Cost Accounting in Public Services ▶ Ethics in Public Administration and Government ▶ Financial Reporting ▶ Financial Statements ▶ Innovation ▶ IPSAS ▶ New Public Financial Management ▶ Performance Auditing


▶ Performance Evaluation and Reporting ▶ Performance Management ▶ Performance Measurement ▶ Provisions and Contingent Liabilities ▶ Whole-of Government Accounts

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9 GAO-06-729G (2006) Government auditing standards. United States general accounting office by the comptroller general of the United States GAO-03-673G (2003) Government auditing standards. United States general accounting office by the comptroller general of the United States GAO/OP-4.1.2 (1989) United States general accounting office. Office of policy Gauthier SJ (2009) Better understanding the financial statement audit. Govt Fin Rev 25(3):44–48 Government finance statistics manual (2014) International Monetary Fund, Washington, DC Hyytinen A, Kallunki J-P (2014) Auditing. In: Encyclopedia of law and economics. Springer, New York International Federation of Accountants (IFAC) (2015) International public sector standards (IPSAS) Lewis AC, Neiberline C, Steinhoff JC (2014) Digital auditing: modernizing the government financial statement audit approach. J Govt Fin Manage 63(1):32–37 Shakespeare W (1623) Timon of Athens (2.2), Flavius