Audit Financial management

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Audit Financial management
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Content
I. Legal and institutional framework
II. Internal control and internal audit
III. Accounting and financial audit
IV. Performance audit
V. Auditing practices and procedures
VI. Financial framework of the EU
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I. Legal and institutional framework
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International regulatory system

• International Accounting Standards (IAS) and
  International Financial Reporting Standards
  (IFRS)
• Produced by the International Accounting
  Standards Board (IASB), set up in 1973
• National legislations must comply with IAS/IFRS
• European Commission attends IASB meetings
• From 2005 EU listed companies must prepare their
  consolidated accounts in accordance with IAS/IFRS

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The European Court of Auditors

• Established in 1975, operating since 1977
• Treaty of Maastricht CoA is one of the five
  institutions (art. 246-248 of TEU)
• One member per Member State
• President Hubert Weber (since January 2005)
• Aim improving financial management and reporting
  to EU citizens
• Main task auditing the accounts and the
  implementation of the EU budget
• Output annual report (including statement of
  assurance), special reports, opinions

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European Anti-Fraud Office (OLAF)

• Set up in 1999 under the European Commission (EC
  Decision 1999/352)
• Replacing UCLAF
• Under the Vice-President responsible for
  administrative affairs, audit and anti-fraud
• Director Franz-Hermann Brüner (since March 2000)
• Aim protect the interests of the EU, fight
  fraud, corruption and irregular activities
• Task conduct internal end external
  investigations

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Internal Audit Service (IAS)

• Separation of internal audit from ex-ante
  financial control (Council Regulation 762/2001)
• IAS is an internal Commission department
• Aim contribute to rigorous and effective
  management of EC resources
• Task audit the internal control systems, asses
  the performance of Commission departments
• Output opinions and recommendations
• Planning three-year rolling audit plan

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Council Company Law Directives

• Aim harmonisation of national company laws,
  limit risks resulting from discrepancies in
  rules, protect stakeholders
• Most important Directives
• Fourth (78/660/ECC) presentation, content and
  publication of annual accounts and reports
• Seventh (83/349/ECC) consolidated accounts
  (group accounts)
• Eighth (84/253/EEC) qualifications of persons
  responsible for carrying out statutory audits of
  accounting documents

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A typical test question might be

• The Fourth Company Law Directive sets out
  valuation rules regarding financial statements.
  Which of the following is NOT included in these
  rules?
• Prudence
• b) Substance over form
• c) Separate valuation of assets and liabilities
• d) Going concern

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II. Internal control and internal audit
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Internal control

• Definition
• Adopted by the management
• Policies and procedures to ensure economic,
  efficient and effective achievement of objectives
• Ensure compliance with laws
• Prevent or detect misstatements
• Safeguard of assets and information
• Maintain the quality of control system
• Principle of segregation of duties
• Authorisation
• Execution
• Accounting

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Internal audit

• Definition
• Independent, objective assurance and consulting
  activity
• Add value and improve operations
• Systematic, disciplined approach to evaluate and
  improve the effectiveness of risk management,
  control, and governance processes
• Independent internal auditor in each institution
  (in the Commission IAS)
• Internal audit capability within each DG

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Internal control standards

• 24 internal control standards within the
  Commission services
• Structured around five key control components
• Control environment
• Performance and risk management
• Information and communication
• Control activities
• Audit and evaluation

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Irregularity and fraud

• Irregularity
• Infringement of Community law resulting from an
  act or omission
• Effect of prejudicing the EU budget, by reducing
  revenue or unjustified expenditure
• Fraud
• Intentional act or omission
• Use or presentation of false, incorrect or
  incomplete statements or documents
• Non-disclosure of information in violation of a
  specific obligation
• Misapplication of EU funds
• Management is responsible for no occurrence

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A typical test question might be

• Which of the following is NOT an internal
  auditors responsibility?
• a) Asses the control environment of the audited
  entity
• b) Evaluate fraud detecting procedures followed
  by the management
• c) Take measures to avoid irregular and
  fraudulent activities
• d) Report findings on governance processes

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III. Accounting and financial audit
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Financial vs. management accounting

• Financial accounting
• Detail the performance of an entity over a period
• Legal requirement, format determined by law
• Concentrate on business as a whole
• Monetary nature
• Historic picture of past operations
• Management accounting
• Aid management activities, help decision making
• No legal requirement, no strict form
• Focus on specific areas
• Both monetary and non-monetary measures
• Both historical record and future planning tool

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Principles of accounting

• Asset resource controlled by the enterprise
• Fixed assets property, plant, equipment,
  goodwill
• Current assets inventories, trade receivables,
  cash
• Liability present obligation of the enterprise
• Long term liabilities borrowings over 1 year
• Current liabilities trade payables, short term
  loans
• Equity issued capital, reserves, accumulated
  profits
• ASSETS EQUITY LIABILITIES
• Working capital current assets current
  liabilities
• Profit categories gross, operating, PBIT, net
• Ledger accounting
• Debit increase in asset, decrease in liability,
  expense
• Credit increase in liability, decrease in asset,
  income

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Depreciation

• Systematic allocation of the depreciable value of
  an asset over its useful life
• Residual value to be considered
• Depreciation methods
• Straight line method
• Reducing balance method
• Sum of digits method
• Machine hour method

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Inventory valuation

• To be measured at the lower of cost and net
  realisable value
• Allowed treatments
• FIFO first-in-first-out
• AVCO weighted average cost
• LIFO last-in-first-out
• Not allowed treatments
• HIFO highest-in-first-out
• LOFO last-in-first-out
• NIFO next-in-first-out
• Timely write down of inventories is necessary to
  net realisable value

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Financial statements

• Financial statements according to IFRS
• Balance Sheet
• Income Statement
• Cash Flow Statement
• Statement of Changes in Equity
• Related notes
• Understand the content, layout and relationship
  between the statements!!!
• Cash flow operating investment financial

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Performance measurement

• Interpretation of fin. statements ratio analysis
• Profitability and return return on investment
  (ROI), net/gross profit margin, asset turnover
• Liquidity current ratio, quick ratio, debtors
  payment period, stock turnover, creditors
  payment period
• Gearing leverage, interest cover
• Stock market ratios dividend yield, interest
  yield, earnings per share (EPS), price earnings
  (P/E)
• Horizontal (between similar businesses) and
  vertical (over periods) comparison
• In public sector financial performance, volume
  of output, quality of service, efficiency targets

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Costing

• Cost classification
• Nature materials, wages, etc.
• Function production, marketing, administration,
  etc.
• Period and product costs fix, semi variable,
  variable
• Standard (pre-calculated) and actual
• Break-even analysis
• Break-even point sales volume which gives a nil
  profit
• Contribution sales variable costs
• Relevant costs in decision making
• Sunk cost already spent or committed money
• Avoidable cost avoided if activity didnt exist
• Opportunity benefit foregone by selecting
  alternative action

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Investment appraisal

• Payback method, accounting rate of return or
  return on capital employed (ROCE)
• DCF methods net present value (NPV), internal
  rate of return (IRR)
• Advantages of DCF time value of money
  considered, allows timing of cash flows,
  universally accepted
• Present value the cash equivalent now of a sum
  of money receivable or payable at a stated future
  date, discounted at a specified rate of return
• Annuity constant CF for a number of years
• Perpetuity constant CF forever

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Financial audit

• Definition verifying financial statements
  whether they are in accordance with generally
  accepted auditing standards
• General objective gather and evaluate audit
  evidence in order to form an opinion on the
  reliability of the financial statements
• Audit evidence relates to the completeness,
  existence, accuracy and valuation of the recorded
  value of assets, liabilities and equity
• Called also statutory or regularity audit

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A typical test question might be

• In a period, when the cost of raw materials has
  been decreasing steadily, which of the following
  stock valuation methods would maximise net
  profits?
• a) FIFO method
• b) LIFO method
• c) LAFO method
• d) Average cost method

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Or another typical test question might be

• Which of the following ratios would fit the best
  to have an indication about the gearing of a
  company?
• a) Interest yield
• b) Interest cover
• c) Dividend yield
• d) Return on capital employed

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IV. Performance audit
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Concept

• Called also value-for-money audit or audit of
  sound financial management
• Concerned with the examination of economy,
  efficiency, effectiveness
• May include examination of systems and/or
  substantive examinations
• Wide ranging in nature and open to judgement and
  interpretation
• Typical in the public sector

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Three Es

• Economy minimising the costs of resources or the
  use of assets employed (the inputs)
• supply of goods/services, procurement, tendering
• Efficiency relationship between the outputs
  (goods, services) and inputs (resources) to
  produce them
• Comparison with input/output ratios of similar
  bodies
• Effectiveness extent to which the objectives
  were achieved, relation between intended and
  actual impact
• Comparison of outcomes with goals

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A typical test question might be

• Which of the following is an indicator of
  effectiveness?
• a) Reduction of unit cost per medical treatment
• b) Reduction in the purchase price of a new
  hospital bed
• c) Increase in total number of hospital beds
• d) Reduction in sickness rates as a result of a
  medical care

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V. Auditing practices and procedures
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Audit planning

• Audit plan includes
• Legal basis of the audit
• Brief description of the audited entity/project
• Risk assessment
• Audit objectives, scope and approach
• Inventory of information
• Time and activity budget
• Staff planning schedule
• Audit programme
• For each material account balance or audited
  activity
• How the audit approach to be implemented
• How much evidence to be gathered and evaluated
• Nature, timing, extent of audit procedures

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Audit risk and materiality

• Audit risk risk of a material misstatement not
  being identified by the auditor
• Converse of audit assurance
• Components inherent, control, detection risk
• AR IRCRDR
• Auditors asses IR and CR, and try to reduce DR
• Materiality threshold maximum tolerable amount
  of misstatements
• Quantitative monetary value
• Qualitative accuracy of presentation, disclosure
• Expressed in absolute () or relative amount ()
• Used at planning and reporting stage

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Test of controls

• Adoption of system based approach, if internal
  controls are sufficiently effective
• Activities performed by auditors in gathering
  evidence as to the effectiveness of operation of
  internal control procedures
• Evidence gathering techniques
• Observation
• Inspection
• Inquiry
• Computer-assisted audit techniques (CAATs)

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Substantive testing

• Adoption of direct substantive testing approach,
  if no sufficient assurance on operation of
  controls
• Activities performed by the auditor to gather
  evidence as to the completeness, validity and/or
  accuracy of account balances and transactions
• Two categories
• Tests of detail vouching, physical examination,
  confirmation, recalculation, inquiry, cut-off
  test
• Analytical procedures reasonableness test,
  scanning, review, ratio analysis, regression
  analysis, cut-off test, roll forward procedure

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Audit sampling

• Examination of less than 100 of the units
  comprised in a population
• Sample should be representative
• Objective draw a conclusion about the
  characteristics of the entire population
• Sampling risk conclusion may be different if the
  entire population would be subject of the same
  audit procedure
• Techniques
• Statistical monetary unit sampling
• Non-statistical haphazard, stratified

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Reporting

• Written opinion or report setting out the
  findings
• Include only information supported by audit
  evidence
• Provide reasonable assurance whether or not the
  financial statements are materially misstated
• Audit opinion
• Unqualified or clean opinion
• Qualified or reserved opinion
• Adverse opinion
• Disclaimer of opinion

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Other relevant issues

• Auditor must be fully independent
• Using the work of other auditors
• Other external or internal auditors
• At the planning and/or testing and/or reporting
  stage
• Be aware of limitations!
• Documentation
• Working papers indicate date, auditor, audited
  entity
• Permanent and current files
• Walk through
• Selecting a particular transaction or economic
  event and tracing it through the accounting
  information system
• Following the audit trail

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A typical test question might be

• Which statement is a proper description of the
  audit evidence?
• a) Standard against which to assess existing
  conditions
• b) Necessary information to form opinion on the
  completeness, accuracy and validity of records
• c) Indication of the extent to which the
  financial statements are materially misstated
• d) None of the above

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Or another typical test question might be

• A cut-off test is usually carried out when
  auditing
• a) Trade debtors
• b) Plant and machinery
• c) Dividends
• d) Corporate tax

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VI. Financial framework of the European Union
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Financial perspective

• Multi-annual financial framework
• To improve the operation of budgetary procedure
• To guarantee budgetary discipline
• Maximum amounts (ceilings) by broad category of
  expenditure (headings)
• Based on inter-institutional agreement
• Current framework Agenda 2000 (2000-2006)
• Own resources ceiling 1.24 of GNI
• Adjustment for 2004-2006 due to enlargement
• Next framework 2007-2003
• Own resources annual average ceiling 1.14 of
  GNI
• Annual average substantial margin 0.10 of GNI

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Budgetary principles

• Legal framework
• Articles 268-280 of TEU financial provisions
• Council Regulation 1605/2002 Financial
  Regulation
• Commission Reg. 2342/2002 implementing rules
• Principles of the EU budget
• Unity
• Budgetary accuracy
• Annuality
• Equilibrium
• Unit of account
• Universality
• Specification
• Sound financial management
• Transparency

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Structure of the budget - revenues

• Key figures in 2005
• Appropriations for commitments 116.6 billions
• Appropriations for payments 106.3 billions
• Represents 1.004 of GNI of the enlarged EU
• Revenues own resources (based on 2005 figures)
• Agricultural levies 1.5
• Customs duties 10.1
• VAT resource 14.4
• GNP based additional resource 73.0
• Other resources 1.0
• UK rebate 66 of the imbalance is reimbursed

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Structure of the budget - expenditures

• Expenditures (based on 2005 figures)
• Agriculture and rural development 42.6
• Structural operations 36.4
• Internal policies 7.8
• External actions 4.5
• Administrative expenditure 5.4
• Pre-accession strategy 1.8
• Compensation 1.1
• Reserves 0.4
• European Development Fund not included
• Types of expenditure
• Compulsory expenditure 39.2
• Non-compulsory expenditure 60.8

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Restructuring of the budget

• Balance between discipline and flexibility
• Headings for period 2007-2013
• Sustainable growth1a. Competitiveness for growth
  and employment1b. Cohesion for growth and
  employment
• Preservation and management of natural resources
• Citizenship, freedom, security and justice
• The EU as a global partner
• Administration
• Compensations
• Possible reform of own resources system
• To be approved

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Yearly budgetary procedure

• Budgetary authority Council and Parliament
• Sequence of stages and timetable
• Preliminary draft budget by the Commission 15
  June
• First reading and draft budget by Council 31
  July
• First reading by Parliament October
• Second reading by Council November
• Second reading an adoption by Parliament
  December
• Exceptionally amendment by Commission during the
  year, following the same procedure
• Final word on compulsory expenditure Council
• On non-compulsory expenditure Parliament

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Budget execution

• Within the responsibility of the Commission
• Financial actors segregation of duties
• authorising, accounting officer, financial
  controller
• Centralised mgmt internal policies, external
  actions
• Through Commission departments
• Externalisation to individuals or agencies
• Shared management agriculture, regional policy
• Implementation by Member States administrations
• Commission ensures respect of appropriate rules
• Decentralised management
• Implementation delegated to third countries

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Accounting system

• Financial statements of the European institutions
• Balance sheet and economic outturn account
• Cash flow table and statement of changes in
  capital
• Annexes accounting principles, rules and
  methods, notes
• Two types of accounts
• Budgetary accounts record of budget
  implementation
• General accounts record all events and
  operations
• New accounting system from 2005 - ABAC
• Accrual based instead of cash based accounting
• Accrual basis the effects of transactions are
  recognised when they occur, and recorded and
  reported of the periods to which they relate

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Accounting principles

• Financial statements drawn up according generally
  accepted principles
• Going-concern basis
• Prudence
• Consistent accounting methods
• Comparability of information
• Materiality
• No netting
• Reality over appearance
• Accrual-based accounting
• Financial statements are presented in millions

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Budgetary control

• Internal control
• Authorising officer of each institution
• Mechanisms of combating fraud, on-the-spot checks
• External audit
• European Court of Auditors
• Annual report, statement of assurance, special
  reports
• Discharge
• Parliament acting on Council recommendation
• Political aspect of external control
• Releases the Commission from responsibility to
  manage the budget, end of budgets existence
• Based on CoA reports and Commission replies
• Granting, postponement or refusal of discharge

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A typical test question might be

• What is unity, as a budgetary principle?
• a) No revenue shall be collected and no
  expenditure effected unless booked to a line in
  the budget
• b) All revenue and expenditure shall be entered
  in full without any adjustment against each
  other
• c) The budget shall be drawn up and implemented
  in euro and the accounts shall be presented in
  euro
• d) No expenditure may be committed or
  authorised in excess of the authorised
  appropriations

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And finally another typical test question might
be

• Which of the following is NOT a heading under the
  financial perspective 2007-2013?
• Citizenship, freedom, security and justice
• b) Administration
• c) Structural operations
• d) Preservation and management of natural
  resources