Financial reporting & auditing

Asad Rafaq

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 Lecture Objective
 To understand the importance of good CG of
understandable and honest financial statements.
 To Understand the ways in which Statements could
become misleading.
 To understand the Role of external auditors & purpose of
audit report.
 To discuss the need of Auditors Independence.
 To Discuss the threats to auditor independence
 Measures that could be taken to reduce these threats,
including regulations
 To understand the role of Audit Committee
 Appointments of the Auditors & their fees.
 Responsibilities of Directors for the Financial Statements.

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 Financial Reporting and Corporate Governance
 Financial Statement (FSs): A statement
containing financial information.
 Include Balance sheet
 Profit and loss account
 Cash Flow statement.
 FSs are the Principal way in which director
make themselves accountable to shareholders.
 Directors’ Report: A report by the BoD to
shareholders, contained in Annual report .
 Mainly contains statutory disclosures of
information.
 Much of it is in narrative form.
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 Purpose and Importance
 Used by shareholders ,investors and market
players to assess the financial health of the
company.
 Its important .... As by mean of it directors are
made accountable.
 It provides channel of communication from
directors to shareholders.
 FSs should be CLEAR and UNDERSTANDABLE to
readers with reasonable financial awareness.
 Should be Reliable and believable.
○ Reliability & honesty could be undermined by
 Frauds or errors
 Window dressing

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 Remember.......
 Aggressive Accounting are the Accounting policies ;
 Just within accepted accounting practices
 Accepted by the external auditors.

BUT
 Have the effect of making company’s performance seem
better.
 Hiding the real information in at least in short period.
 Examples: Recognition of Income at early stage in
transaction process ... OR ..... Defer the recognition of
expenses
 Hiding losses within subsidiary companies, not capitalizing
expenses.
 leasing and borrowing through Special Purpose Vehicles

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 Financial Reporting & Investor Confidence
 It is responsibility of Auditing profession to provide sufficient
assurances to investment community about reliability of FSs.
 In past in UK and USA (2002) major concerns were raised about the
quality of Financial Reporting.
 If Investors have doubts simply they will hold back, consequently
share values will suffer as a result.
 Similar is the case of bond markets.
 Companies borrow through issuance bonds to investors.
 Investors Rely on BOND CREDIT RATING.(They won’t buy unless it has
been rated creditworthy)
 In 2002 role of these agencies was also questioned.
 However these Companies also rely on Honest Financial reporting
from the companies they monitor.
 Moody’s Chairman Commented : “Full & fair Financial Disclosure is
critical to us to do our jobs, just as it is critical for many others in
market”

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 Key Issues :
 Why management of a company want to
prevent FSs from giving True & Fair view?
 What are consequences of FSs lacking
creditability?
 What should be role of External Auditors?
 In what way independence of the auditors
might be compromised?
 What measures to be taken to ensure
reliability?
 How can Investors obtain re-assurance
that company is not going to liquidate
suddenly?

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 How FSs can be Misleading ?
 There are three ways.
 Fraudulent misrepresentation of the
affairs. Where company’s management
want it deliberately.
 Use of aggressive/ creative accounting
techniques.
 Use of complex and difficult terms for
investors to understand. Relatively easy
matter for accountants.

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 The Role of external Auditors
• As discussed ; Investors ,other stakeholders
even Rating agencies rely on the information ,
audited by Independent auditors.
• Purpose of Independent audit is to ensure
objectivity and reliability of FSs.
• Auditors are required to prepare a report,
which has two main purposes:
– To give an expert and independent opinion about
whether the FSs give true & fair view.
– To give an expert view whether FSs comply with
relevant laws. 9
• Three Issues relating to auditors need to be
considered:

1. What is purpose of annual audit ? To what

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 Purpose of external Audit

• Reassurance that information in FSs is

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Responsibility of Detecting Fraud and error
• Misconception that auditor is responsible for
detection of fraud or error.
– Management of the company has responsibility ,
through adequate system of accounting and
internal controls.
– Auditor assess the risk or possibility that fraud or
error might have caused FSs to be materially
misleading.
– There are chances of occurring fraud or error, but
not detected.
– As system of accounting and internal controls are
also vulnerable.
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 Continued......
• Fraud or error may arise from:
– Criminal collusion between employees
– Decisions by management to override the system
control.
• Auditors are potentially liable to shareholders
or stakeholders who suffer loss as a result of
negligence in audit.
Negligence arise from failure to comply auditing
rules/ guidelines. And from a failure to carry out
the audit with due skill, diligence and
expedition. 13
 Audit Report
• Report for shareholders produced by the external
auditors on completion of annual audit, included in
the company’s published annual report and accounts.
– Report itself provide limited information.
– Usually have
• Unqualified opinion ...... That FSs give a true and fair
view, and are in accordance with IASs or National
standards.
• Qualified opinion ...... That FSs give true and fair view,
except.....matter .Also give disclaimer of opinion.
• Adverse opinion is most negative type .... Given when
there is disagreement.

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 Auditors Independence
“Relationship between the external auditors and client
company , whereby auditors are able to exercise their
independent professional judgement , where their
judgement will not be influenced by closeness of the
relationship with client company or matters of self interest.”
• Auditors are expected to give an unbiased and honest
professional opinion.
• However if suitable CG measures are not in place , a firm
auditors might be influenced.

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Ethics & Threats to Auditor Independence
• Qualified Accountants are expected to act with
integrity and honesty, and follow code of ethics in
the work they do.
– But there chances of ignoring such ethical considerations
and allow judgement to be affected by other
considerations/reason.
– There might be conflict between Job Role and
Responsibilities as an accountant to act in public interest.
• Most significant Threat to auditor independence is
Appointment/reappointment as Auditors.

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 Continued.....
• Auditors has to rely on firms management for
much needed information to carry out audit.
• International Federation of Accountants (IFAC)
identified few other risks;
– Relying on a client for major proportion of fee
could impair objectivity.
– When Auditors has mutual business interests with
company ... Is a risk to objectivity and
independence.
– Shares in client company
– IFAC Doesn’t have objection on non-audit services.
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 Auditing and Public Interest
• Accountancy profession should be required to
recognize the public interest when ;
– Formulating codes,
– Issuing guidelines,
– Regulations to its members.

“Public Interest involves forming a balanced view of

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 Controls Over Audit Profession
• Auditor regulations in US (Independence Requirements)
• Registered public accounting firms will be prohibited from
providing eight types of non-audit services to audit clients:
– Bookkeeping or other services related to company’s accounting
records or financial statements
– Financial information systems design and implementation
– Appraisal or valuation services, fairness opinions
– Internal audit outsourcing services
– Management functions or human resources
– Broker or dealer, investment adviser or investment banking services
– Legal services and expert services unrelated to the audit
– Any other service determined to be impermissible by the future
Public Company Accounting Oversight Board
– Mandatory Auditor rotation: Partner cannot be lead or review
partner for more than 5 consecutive years

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 Auditor Regulations in UK
• In 2002 Accountancy Foundation was
established.
– This system is non-statutory , foundation has no
legal powers.
– System intended to be independent of influence
and control of Accountancy profession .. As
majority board members are non-accountants.
– It oversee the work of 4 boards.
1. Audit Practice board
2. Ethics standards Board
3. Investigation and Discipline Board
4. Review board.

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 Auditor Regulation in Pakistan
• The Companies Ordinance, 1984, Sections 252 to 260 outlines the
audit requirements in relation to companies.
• Section 252 requires that every company will, at each annual general
meeting appoint an auditor to hold office from the conclusion of that
meeting until the conclusion of the next annual general meeting.
• Section 260 prescribes the penalties that may be imposed on the
auditor or any other person who signs the report which is found to
be not in compliance with the Companies Ordinance or if any untrue
statements are made or if any material facts are not brought out in
the report.
• All new International Standards on Auditing (ISA) issued by the
International Auditing Practices Committee (IAPC) are made known
to members of the national accounting bodies

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 SECP Auditor Independence Guideless
• No person can be appointed as auditor of a public company or
of a private company being subsidiary of a public company,
unless he is a chartered accountant. In terms of Section 254 of
the Companies Ordinance, a person is not qualified for
appointment as auditor of a company if he:

– is, or at any time during the preceding three years was, a director,
other officer or employee of the company;
– is a partner of or in the employment of, a director, officer or
employee of the company;
– is the spouse of a director of the company;
– is indebted to the company;
– is a body corporate;

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 Continued.....
– or his spouse or minor children, or in case of a firm, all partners of such
firm, hold shares of an audit client or any of its associated companies.
Where such a person holds shares prior to his appointment as auditor,
the fact shall be disclosed on appointment as auditor and shares will be
disinvested within ninety days;
– is disqualified for appointment as auditor of any other company which
is that company's subsidiary or holding company or a subsidiary of that
holding company.
• The listing regulations put additional restrictions on listed
companies in appointing their statutory auditors. The salient
requirements of the listing regulations are:
– The auditor of a listed company should possess a satisfactory rating
under the Quality Control Review (QCR) programme of the ICAP.
– The external auditors must be rotated after every five years.

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 Continued.....
• The auditors should not perform management functions or make
management decisions, responsibility for which remains with the Board
of directors and management of the listed company. Moreover, the
auditors should not be engaged to provide non-audit services, including
services
– related to the designing of accounting systems or compilation of
accounts.
• However, certain non-audit services that are synergistic to the audit and
are not likely to infringe on the independence of auditors have been
exempted from this restriction. The exempted services are as follows:
– Attestation, certifications, special purpose audits/reviews and agreed upon
Procedures as defined in the International Standards on Auditing
– Taxation services
– Opinion on accounting standards ........... etc
For complete guidelines see SECP manual of Corporate Governance

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