Mahfuz Hossain
Department of Finance (23rd Batch)
University of Rajshahi.
Voucher: The documentary pieces of evidence such as counterfoil, cash memo, receipts and pay-in-slips used for
recording transactions in books of accounts is defined as a voucher
Example:
Internal voucher: invoices for purchase & sale, receipts, counterfoils, slip of bank, etc.
External voucher: consignment stock, mortgage deed, etc.
Types of Voucher
Two types of voucher are:
Primary voucher: All written evidences in original are primary vouchers.
Secondary voucher: Copies of original vouchers are called collateral vouchers.
Requirements of a Voucher
Some of the supporting documents in a voucher can include:
Invoice from the supplier
Vendor or supplier name to be paid
Terms for payment such as the amount owed, the due date, and any discounts granted by the supplier for paying the invoice
early. The company’s purchase order receipt showing that goods were received by the company from the supplier
The general ledger accounts to be used for accounting purposes. Signatures from authorized representatives at the company
for the purchase and payment. Proof of payment and date once the invoice to the supplier has been paid
Vouching:
The vouching is defined as the “verification of entries in the books of account by examination of documentary evidence or
vouchers, such as invoices, debit and credit notes, statements, receipts, etc.
Vouching, widely recognised as the backbone of auditing, is the process of examination of documentary evidence to
ascertain the authenticity of transactions in the books of accounts to detect and prevent financial errors and frauds of an
entity
Objectives of Vouching
It is the technique used by the auditors to judge the authenticity of the entries appearing in the financial statement.
Procedure and accuracy followed for performing vouching decide the success or failure of the auditing. Some major
objectives behind the vouching process are as follows:
To ensure that all the transactions took place during the financial year for the business purpose only (not for personal use),
and are appropriately recorded in the books of accounts with true and fair evidences.
To check the accuracy of the totalling and carrying forward amount recorded in the financial statements.
To ensure that the person responsible for the business has verified his records or not.
To make the financial records free from malpractices.
To make sure that financial records are prepared in a lawful manner.
Difference between Vouching and Verification:
Vouching
Introduction
Vouching is a process of
Examining the evidences.
Basis
Vouching is done on the basis
Feasible narrative evidences
Like invoice receipts.
Examination
Examining of profit and loss
accounts is done in vouching
process.
Verification
Verification is a process to
Verify the assets and liabilities
of the business.
Verification is done
On the basis information
Counting the observation.
Balance sheet is examined in
Verification process
Vouching is a never ending
process and conducted through
out the financial year.
Verification is done at the end
of the financial year.
Purpose
Vouching is done to check the
Accuracy of the evidences
provided by the party.
Verification is done to check
out the existence of the assets
And liabilities appearing in the
balance sheet
Sources of Vouchers
Internal vouchers: The vouchers prepared by the company inside its premises are termed as internal vouchers, such as sales
invoice.
External vouchers: The vouchers created outside the organisation are termed as external vouchers, such as bank statement.
Characteristics of Vouching:Imperative Aspect of Auditing: Vouching is an essential part of the auditing procedure. It makes the auditor’s opinion more
optimistic about the veracity of the transactions emerging in the records.
Basis of Auditing: Vouching acts as a base for the further procedures of auditing. To assure the fairness and accuracy of the
further accounts maintained by the auditor proper vouching of the presented documents should be done.
Drafted Evidence: Vouchers are the recorded form of evidence which proves that the transactions have genuinely occurred
for the business during the current financial year.
Disclosure of Extortion: Though vouchers are the recorded evidence signed by the owner, it helps in disclosing any
fraudulent transactions documented in the books of accounts.
Report on Business Activities Only: Vouchers helps in differentiating the business and personal transactions of the
proprietor. Only the business transactions’ vouchers will be taken into consideration by the auditor for evaluating the correct
profit and loss of the business, and no personal expense vouchers will be recorded in the books of accounts.
No Secret Transactions: Vouchers helps the auditor in identifying business transactions. Thus, the owner cannot enclose any
secret transaction other than business.
Course of Voucher: The date quoted in the voucher defines that the transaction has arisen currently
Steps of Vouching
➢ Reading Out: The vouching is a task of the auditor. The junior audit can read out the contents of the vouchers. He
can inform the senior auditor about the data name of organization, number of voucher and amount of vouchers.
➢ Comparison: The senior can head the contents called out by junior auditor. He tally each and every item stated in the
voucher with entries in the books of accounts. Thus comparison is a part of vouching procedure.
➢ Ticking: The senior auditor can use various ticks or symbols to clear the items checked. The ticks may be an
abbreviation of words. Such ticks or symbols may differ from auditor to auditor because these are code words.
➢ Stamping: The senior auditor instead of signature or initials he can use stamps for checking the vouchers can use the
rubber stamps. The rubber stamp may have the wording checking and cancelled on it.
➢ Signatures: The senior auditor can vouch the entries with the help of vouchers. He can put his signature or initials on
every voucher for safety measures. The signed vouchers cannot be presented again for another entry.
➢ Query: The voucher may be missing. The entries may be doubtful due to over writing and erasing. The audit staff can
make the word “Q” against such entry. This entry is recorded in working papers.
➢ Management: The audit staff can be giving sometime to the management for clearing the objections. The doubtful
entries are handed over in written form. The management can examine the record in detail.
➢ Reply :The management may reply after one or two days about the doubtful entries. The auditor can examine the
reply of the managers. The auditor can judge whether the reply is right or wrong.
➢ Clearance: The audit staff can clear the query for which proper answer is made available. The auditor may not be
satisfied with the answer of objections. He can inform the management about this query.
➢ No satisfactory: The may reject the unsatisfactory reply. He has skill, training and experience. He can use all
available means to test the truth. He can note down poor clarification in working papers.
➢ Objections: The objection stated in the working papers can be discussed with the management at the end of audit.
He can form an opinion on the basis of such objections. He can submit his report either clear or qualified
Principles of Vouching
1.Arranged Voucher
In the books of accounts the vouchers are based an entry. A voucher is helpful to support any transaction, which may be cash
memo fill, voucher, ticket or others.
2.Checking of Date
The voucher date can also be checked; it must be related to the current year. The date of the last or future year must not be
adopted.
3.Checking of Authority
The vouchers are considers correct only when the proper authority signs on them. For the approval of the dealing the owner
or the management must put the signatures for the approval of dealing if the vouchers are without the signatures of the
proper authority. They are not considers the true.
4.Cutting or Change
There should be no changes in the vouchers. Any person for making the fraud can change the time, date, amount and name
of concern. So, these changes cannot be acceptable till the approval authority has made the signature.
5.Compare the Words and Figures
The auditor should satisfy himself amount written on the vouchers, it figures and words are same or not.
6.Transaction Must Relate to Business
For the correctness of the vouchers it is necessary that it relate with the business. Concern, the vouchers must be in the
name of the business and also the manager. If it does not the vouchers are not acceptable and doubtful.
7.Case of Personal Vouchers
The auditor should not accept the voucher in personal name. There is a chance than an officer of the company has purchased
any item in his personal capacity.
8.Checking of Account Head
Auditor must be satisfied about the head of account in which cash is deposited and drawn. He should examine the
documentary evidence in these regards.
9.Revenue Stamps
For the stamps, the stamps act 1899 is applicable while fixing the revenue stamps. The stamps are required according to the
valuation of the amount or cash memo. There is no need of vouchers if amount is less than twenty rupees.
10.Case of Cancelled Voucher
The auditor should not accept the cancelled vouchers because it has already served the purpose of payment. There will be a
danger of double payments, if it is accepted.
11.Important Notes
For finding the correct decision, the auditor can also take help from the working papers of the previous year and others paper
or note related to business and available with the management.
12.Minutes Book
When the meeting of shareholders is held. All the resolutions and decisions of the directors and shareholders are recorded in
the minute’s book. This minutes book must be examine by the auditor. He has to check that these decisions have been
implemented in the books of accounts or not.
13.By Laws
In case of company the article of association and memorandum are basically the rules and regulations. But on the other hand
in the societies and clubs the by laws are used to determine the powers of management. The auditor goes through these
rules and regulations to find the true and fair view.
14.Agreements
The auditor must examine all the related papers of the business such as the agreement, correspondence and others. The
basic information can be received to the auditor by such papers.
15. Deed of Mortgage
Some times, you are the sale or purchase of any assets, the management can enter into the agreement is prepare in this
case. If the agreement is prepare in this case. If the agreement is made for a loan against the immovable property then the
mortgage deed is signed. It is compulsory for the auditor to study the content of the deed.
Vouching is the backbone of auditing
As stated earlier, vouchers are the primary documents relating to transactions. If the primary documents are wrong or
irregular or if the transactions are not correctly recorded in accordance with them, the whole accounting statements, in turn,
would become wrong or irregular. The auditor’s role is to see whether the financial statements are wrong or irregular, and
thus, for this, examination of vouchers is imperative.
It is through vouching that an auditor satisfies himself about the genuineness of transactions recorded in the client’s books of
account from where financial statements are drawn up. Unless the auditor examines the accuracy and authenticity of
transactions, he cannot express an opinion on the fairness of overall financial statements and the business’s results.
Verification and Valuation of Liabilities and Guidelines for auditors
Verification of liabilities is equally important as that of verification of assets. The Balance Sheet will reveal the true and fair
view of the state of affairs of the business concerns only when the liabilities as well as assets are properly valued and verified.
Verification of liabilities aims at ascertaining whether all the liabilities of the business are properly disclosed, valued,
classified, and shown in the Balance Sheet. The auditor should see that they are correctly stated in the Balance Sheet. He
should obtain a certificate from the responsible official as to the correctness of liabilities.
“The auditor is liable for omission of liabilities from the balance sheet, if such liabilities could be detected by the application
of reasonable care and skill
Verification and Valuation of liabilities – Audit procedure and role of auditors
In short, the auditor should have to examine and see that, all the liabilities have been clearly stated in the liability side of the
Balance Sheet. They are all relate to the business itself. They are all correct and authorized by the responsible official.
They are shown in the Balance Sheet at their actual figures.
We shall now discuss the verification and valuation of various liabilities.
1. Verification and Valuation of Trade Creditors
I.
The correctness of liabilities depends upon the correctness of purchases. Hence, the auditor should compare the
percentage of gross profits to purchase with that of the previous years to verify the correctness of purchases.
II.
The auditor should obtain a Schedule of creditors and verify them with the balances of ledger accounts and statements of
account received from creditors.
III.
He should check the Purchases Book and Purchases Returns Book with the help of invoices, credit notes, etc. He should
also check the postings into the Ledger.
IV.
He should examine the Goods Inward Book to ensure that the goods purchased have been actually received.
V.
He should see that all the purchases made during the year have been accounted for especially at the end of the year.
VI.
He should examine the discount allowed to creditors during the period and see that these substantiate the credit
balances.
VII.
In case of hire purchases, the auditor should see that the conditions of Hire Purchase Agreement are properly complied
with.
VIII.
He should examine the entries made at the beginning as well as at the end of year to check the employees have passed
any fictitious entries in this regard.
IX.
If any debt is found unpaid for a long time, an enquiry should be made since it is possible that instead of paying to the
creditor, the amount might have been misappropriated.
2. Verification and Valuation of Bills Payable
In case of bills payable, the auditor should follow the following verification procedure:
The auditor should obtain a Schedule of bills payable and its totals should be compared with the Bills Payable Book and Bills
Payable Account. The bills paid after the Balance Sheet date should be examined with the entries passed in the Cashbook.
The auditor should obtain confirmatory statements from the drawers directly with the permission of his client. He should pay
special attention to the bills that have been paid between the date of the Balance Sheet and the date of his audit have been
duly written in the books.
3. Verification and Valuation of Loans
I.
The auditor should verify the existence of loans, if any. In case of a company he should examine the correspondence,
contracts, and Directors’ Minute Book.
II.
The auditor should ascertain the terms of loan, amount of loan, period and nature of loan, etc. By referring to the
loan agreement.
III.
He should confirm the balances of the unpaid loans directly from the creditors of the company with the permission of
his client.
In case of loans or overdrafts taken from a bank, an agreement with the bank and a certificate to that effect should be
obtained and examined.
The auditor should see whether the interest due has been paid or not. If the interest is due but not paid till the date of the
Balance Sheet, he should see whether the same has been clearly shown as liability therein.
In case of a Joint Stock Company, the auditor should examine the borrowing powers of the company. He should also examine
the Register of Charges, and should see that a charge created has been registered with the Registrar.
It should be seen that the interest on loans has been paid up to date. If not he should see whether the amount due is
recorded as unpaid in the books of accounts.
4. Verification and Valuation of Outstanding Liabilities for Expenses
I.
In case of outstanding liabilities, the auditor should obtain a certificate from a responsible officer of the company
stating that all expenses become payable have been brought into account.
II.
He should see whether necessary provision for all the outstanding expenses have been made by checking receipts
and other vouchers.
III.
He should compare the expenses shown as unpaid during the current year with those of the last year and if he finds
any difference, the same should be enquired into.
5. Verification and Valuation of Capital
Capital is not the liability of an entity but still the auditor is required to verify it in order to report the genuineness and
correctness of the Balance Sheet. In case of a firm, the auditor should verify capital with the help of Partnership Deed,
Cashbook and the Passbook. He should see that it has been properly recorded in the books of account. In the case of a
company, verification of capital can be discussed under the two heads:
First Audit
In case of first audit, the auditor should examine the Memorandum of Association to see what is the maximum capital, which
the company is authorized to raise. He should also check the Articles of Association.
The Cashbook, Passbook, and Minute book of the Board of directors should be examined by the auditor in order to find the
amount of shares and different classes issued, the amount collected on each shares, and the balance due from the
shareholders in respect of calls, etc. The shares allotted to vendors, should be examined with the contract between the
vendors and the company.
Subsequent Audit
Normally, in case of subsequent years, the share capital would be the same as in the previous year unless the company has
made any alteration or addition by fresh issue or otherwise. If he come across any change, he should see that the relevant
provisions of Secs. 94, 95 and 100 to 105 of the Companies Act have been duly complied with.
6. Verification and Valuation of Reserves and Fund
Reserves and funds are appropriations out of profits. The directors of a company determine the amount of reserves and
funds to be created taking into account the circumstances of the business. The reserve and funds are to be shown on the
liability side of the Balance Sheet with footnotes.
7. Verification and Valuation of Debentures
I.
In case of debentures, the auditor should verify the Memorandum of Association and the Articles of Association of
the company and ascertain the power of the company to issue debentures. He should find out what is the borrowing
limit and ensure that the company has not exceeded the same.
II.
He should verify the Debenture Trust Deed to verify the amount of debentures issued and securities offered. If
necessary, he can obtain a certificate from the debenture holders to verify the amount of debentures issued.
III.
He should enquire as to what arrangement has been made for the redemption of debentures. In case debenture
redemption fund has been created, he should verify the Articles of Association.
IV.
If the debentures are issued at premium or at discount, the auditor should see that the debenture premium and
discount on issue of debenture are properly dealt with in the books of account.
V.
He should verify Register of Charges and Register of Debenture Holders to see that the debentures shown in the
Balance Sheet agree with the debentures recorded in the books of account.
VI.
Verification and Valuation of Income Received in Advance
Sometimes the firm receives some amount in advance, which is to be actually received in the next year. It is treated as a
liability and should be shown in the liability side of the Balance Sheet. The auditor should verify whether the items of incomes
received in advance are recorded in books. The auditor should obtain a Certified Schedule of income received in advance and
verify the same. He should ensure that income received in advance is fully shown in the liability side of the Balance Sheet.
8.Verification and Valuation of Employees Deposits
In commercial and industrial establishments, it is usual to require the employees who deal with cash or stores to give security
deposit. It acts as a safeguard against some possible misappropriation or pilferage on the part of such employees.
Sometimes, the employees instead of paying cash as security deposit endorse trustee securities in favour of the employers. In
such cases, the auditor should see whether such a security in cash or in securities deposited separately in the bank. He should
see whether they are shown distinctly in the liabilities side of the Balance Sheet. He should verify the amount of deposits by
reference to the Certified Schedule received from the client.
9.Verification and Valuation of Taxation Liability
Now-a-days, taxation has become an important liability and so the companies are required to make full provision in the
accounts in this regard. The auditor should see whether the provision made therefor is sufficient to meet the estimated
liability. Usually, auditors are required to advise on the adequacy of the liability and in such a case, they work as tax
consultant.
***Inherent Risks assessment
Inherent risk is any risk associated with errors or omissions in a company’s financial statements and reporting. These
misstatements generally occur whenever there are complicated transactions that occur or whenever there is a higher degree
of knowledge or judgment required to come up with financial estimates. In many cases, internal controls that are in place all
fail, resulting in inherent risk
Auditors play a very important role in the financial sector. These professionals act as independent parties who review
financial statements to ensure they are fair and accurate. They do this through routine audits, which are reviews that may
involve the financial examinations of corporate financial statements, as well as compliance issues and internal controls
involving a company’s financial reporting.
Audits are conducted by internal and external auditors. Internal auditors work for a company. Their examinations act as
managerial tools to identify process and internal control improvements. External auditors often review corporate financial
statements and internal controls.
In either case, auditors are responsible for identifying any errors and inconsistencies. The risk posed by these mistakes is
commonly referred to as inherent risk. Keep reading to learn more about inherent risk and what auditors do to assess it.
KEY TAKEAWAYS
Auditors help ensure that corporate controls and financial statements are free from errors, fraud, and misstatements.
Inherent risk is an inevitable part of doing business and occurs even when there are controls in place.
An auditor’s knowledge and judgment of the industry, corporate transactions, and company assets can help determine
inherent risk.
Companies with complicated business structures and transactions tend to have more inherent risk.
Lowering inherent risk often involves revaluating existing internal controls and implementing new practices.
What’s the Difference Between Inherent and Control Risk?
Inherent risk is unavoidable, which means it’s a natural part of doing business. Control risk, on the other hand, arises
whenever internal practices stop working and lead to material misstatements. Control risk also occurs whenever there aren’t
enough internal procedures in place to prevent or mitigate risk.
How Does Detection Risk Differ From Inherent Risk?
Inherent risk is any risk that arises as a result of doing business. It is commonly present even when controls and risk
management doesn’t work. Detection risk, on the other hand, is one of the three components of audit risk along with control
and inherent risk. When an auditor fails to find material misstatements in a financial statement or company’s financial
reporting, this is known as detection risk. These misstatements may be the result of fraud or errors.
Internal Audit: What It Is, Different Types, and the 5 Cs
What Is an Internal Audit?
Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. These
types of audits ensure compliance with laws and regulations and help to maintain accurate and timely financial reporting and
data collection. Internal auditors are hired by companies who work on behalf of their management teams. These audits also
provide management with the tools necessary to attain operational efficiency by identifying problems and correcting lapses
before they are discovered in an external audit.
KEY TAKEAWAYS
An internal audit offers risk management and evaluates the effectiveness of many different aspects of the company.
Types of internal audits include financial, operational, compliance, environmental, IT, or for a very specific purpose.
Internal audits provide management and the board of directors with a value-added service where flaws in a process may be
caught and corrected prior to external audits.
Similar to external audits, internal audits are conducted through planning, auditing, reporting, and monitoring steps.
Internal audits may enhance the efficiency of operations, motivate employees to adhere to company policy, and allow
management to explore specific areas of its operations.
Understanding Internal Audits
Internal audits play a critical role in a company’s operations and corporate governance, especially now that the SarbanesOxley Act of 2002 holds managers legally responsible for the accuracy of their company’s financial statements. SOX also
required that a company’s internal controls be documented and reviewed as part of its external audit.
In addition to ensuring that a company complies with laws and regulations, internal audits also provide a degree of risk
management and safeguard against potential fraud, waste, or abuse. The results of internal audits provide management with
suggestions for improvements to current processes not functioning as intended, which may include information technology
systems as well as supply-chain management.
Internal audits may take place on a daily, weekly, monthly, or annual basis. Some departments may be audited more
frequently than others. For example, a manufacturing process may be audited on a daily basis for quality control, while the
human resources department might only be audited once a year.
Audits may be scheduled, to give managers time to gather and prepare the required documents and information, or they
may be a surprise, especially if unethical or illegal activity is suspected.
Types of Internal Audits
Compliance Audit
A company may be required to adhere to local laws, compliance needs, government regulations, external policies, or other
restrictions. To demonstrate compliance with these rules, a company may task an internal audit committee to review,
compile appropriate information, and provide an overall opinion on the status of the compliance requirement.
Internal Financial Audit
Public companies are required to perform certain levels of external financial auditing where a completely independent third
party provides an opinion on the company’s financial records. Companies may want to dive further into audit findings or
perform an internal financial audit in preparation for an external audit. Many of the tests between an internal or external
auditor may be similar; the nature of independence separates the two types of audits for financial audits.
Environmental Audit
As companies become continually more environmentally conscious, some take the steps of reviewing the business’ impact on
the planet. This results in an internal audit covering how a company safely sources raw materials, minimizes greenhouse
gases during production, utilizes eco-friendly distribution methods, and reduces energy consumption. Companies leveraging
triple bottom line reporting may perform internal environmental audits as part of annual reporting.
Technology/IT Audit
An IT audit may have different objectives. The internal audit may be the result of an external lawsuit, a company complaint,
or a target to become more efficient. An internal audit focused on technology reviews the controls, hardware, software,
security, documentation, and backup/recovery of systems. The goal is likely to assess general IT accuracy and processing
capabilities.
Performance Audit
An internal audit focused on performance pays less attention to the processes and more on the final result. The company will
have likely have set performance objectives or metrics that may be tied to performance bonuses or other incentives. As a
result, an internal auditor assesses the outcome of an objective that may not be easily quantifiable.
For example, a company may wish to have expanded its use of diverse suppliers; the internal auditor, independent of any
purchasing process, will be tasked with analysing how the company’s spending patterns have changed since this goal was set.
Operational Audit
An operational audit is most likely to occur when key personnel leaves or when new management takes over an entity. The
company may want to assess how things are done and whether resources are being used more efficiently. During an
operational internal audit, the auditor will review whether current staff and processes fulfil the mission statement, value, and
objectives of a company.
Construction Audit
Development, operating, real estate, or construction companies may perform construction audits to ensure not only
appropriate physical development of a building but appropriate project billing along the life of the project. This mostly
includes adherence to contract terms with the general contractor, sub-contractors, or standalone vendors as necessary.
This may also include ensuring the company has remit the appropriate payments, collected the appropriate payments, and
internal project reports regarding project completion are correct.
Special Investigations
Many of the audits above may be recurring and performed each year. In some cases, it might make sense for an internal
audit committee to evaluate a special circumstance that will occur only once. This may entail gathering a report on the
efficiency on a recent merger, the hiring of a key employee, or a complaint from staff. When selecting the individuals for the
special investigation audit, a company must be especially mindful to select members with appropriate expertise and
independence.
Depending on the structure of the organization, the internal audit may be prepared by the board of directors of by upper
management.
Internal Audit vs. External Audit
Internal and external audits have the same objective. Both types of audits analyse an aspect of a company to determine a
specific opinion. However, there are many differences between the two types of audits.
In an internal audit, the company is often able to select its own audit team. As such, the team represents the interests of the
company’s management team. This may be advantageous to specifically place certain employees with very niche experience
on the team. In an external audit, the company can often select the external audit firm; however, the company often does
not have a say in the specific employees put on their external audit.
There may be some requirements regarding the external audit staff depending on the audit. For example, in an external
financial audit, a Certified Public Accountant (CPA) must certify the financial statements. In an internal audit, there is no
requirement that any member of the audit team must be a CPA.
The end goal of either audit is an audit report; however, audit reports are used for very different reasons. An internal audit
report is usually used by internal management to improve the operations, processes, or policies of the company. An external
audit report is often required for an outside reason and is more often used heavier by members outside of the company.
Finally, the nature of the engagement will be very different. During an internal audit, the employees of a company may often
freely give advice, discuss unrelated matters with the company, or may have a very fluid consulting agreement. During an
external audit, a very defined scope is often set, and the external auditor will often take great care to ensure they do not
exceed their audit boundaries.
Internal Audits
A company is usually able to select its own internal audit lead and team members. Members of the audit team often do not
need to have specific titles or licenses. Audit reports are primarily used by internal management to improve company
operations. Internal audits may be less formal with blurred structure as the auditor provides casual guidance.
External Audits
A company or board can usually pick the audit firm but not audit team members. Members of the audit team may be
required to hold specific titles or license as part of the audit agreement. Audit reports are primarily used by external parties
to satisfy a reporting requirement. External audits are often more formal with defined boundaries and disallowed services
Internal Audit Process
Internal auditors generally identify a department, gather an understanding of the current internal control process, conduct
fieldwork testing, follow up with department staff about identified issues, prepare an official audit report, review the audit
report with management, and follow up with management and the board of directors as needed to ensure recommendations
have been implemented.
Step 1: Planning
Before any audit procedures are performed, the internal auditors often start by developing the audit plan. This sets the audit
requirements, objectives, timeline, schedule, and responsibilities across audit team members. The audits may review prior
audits to understand management expectations for presentation and data collection.
The audit plan often has a checklist to ensure members of the team adhere to broad expectations. The internal audit team
may also preemptively plan to meet with management throughout the audit to communicate the status and any struggles of
the audit. The planning stage often ends with a kick-off meeting that launches the audit and communicates the initial
information needed.
Step 2: Auditing
Many of the auditing procedures used by internal audits are the same as external auditors. Assessment techniques ensure an
internal auditor gathers a full understanding of the internal control procedures and whether employees are complying with
internal control directives. To avoid disrupting the daily workflow, auditors begin with indirect assessment techniques, such
as reviewing flowcharts, manuals, departmental control policies or other existing documentation.
Auditing fieldwork procedures can include transaction matching, physical inventory count, audit trail calculations, and
account reconciliation as is required by law. Analysis techniques may test random data or target specific data, if an auditor
believes an internal control process needs to be improved.
The internal audit may have started with a defined scope; as the internal audit team gathers and analyses information, it may
become necessary to redefine the purpose and extent of the audit. This includes re-evaluating the original timeline or
resources allocated to the audit.
Step 3: Reporting
Internal audit reporting includes a formal report and may include a preliminary or memo-style interim report. An interim
report typically includes sensitive or significant results the auditor thinks the board of directors needs to know right away.
Similar to an interim financial statement, an interim audit communicates a partial set of information useful for laying the
road for the remaining portion. Often, a company may deliver a draft copy of the final audit report and host a pre-close
internal audit meeting with management. This may allow management to provide rebuttals, additional information that may
change findings, or provide commentary on their feedback regarding the audit findings. The final report includes a summary
of the procedures and techniques used for completing the audit, a description of audit findings, and suggestions for
improvements to internal controls and control procedures. The final report may also communicate next steps in terms of
changes to be implemented, future monitoring processes, and what future reviews will entail.
Step 4: Monitoring
After a designated amount of time, an internal audit may call for follow-up steps to make sure the appropriate post-close
audit changes were implemented. The details and process for these monitoring and review steps is often agreed to at the
delivery of the final audit.
For example, an internal financial audit may find severe internal control deficiencies that an internal auditor believes will not
pass an external financial audit. Management agreed to implement changes within the next six weeks. After six weeks, the
internal auditor may be tasked with implementing a small-scope or limited review of the deficiency to see if the issue still
persists. The monitoring step of an internal audit is technically not required. Management or the board may decide to
disregard internal audit findings and not implement the changes the audit report suggests.
Internal Audit Reports: The 5 C’s
Internal audit reports are often known for adhering to the 5 C’s reporting requirement. A complete, sufficient internal audit
often ends with a summary report that communicates answers to the following questions:
1. Criteria: What particular issue was identified, and why was the internal audit necessary? Is the internal audit in
preparation for a future external audit? Who requested the audit, and why did this party request the audit?
2.Condition: The issue in relation to a company target or expectation? Does the company have a policy that was broken, a
benchmark that was not met, or other condition that was not satisfied? Is the company confident no issue exists, or do they
believe an issue is at hand?
3.Cause: Why did the issue arise? Who was involved, what processes were broken, and how could the issue have been
avoided?
4.Consequence: What is the outcome of the problem? Are issues limited to internal matters, or are there risks of external
consequences? What is the financial implications of the issue?
5.Corrective Action: What can the company do fix the problem? What specific steps will management take to resolve the
issue, and what type of monitoring or review will occur after solutions have been put in place to ensure a fix has been
implemented?
Importance of Internal Audits
1.
2.
3.
4.
5.
6.
Management can be more efficient about what to explore.
Internal audits may save companies money.
The company enhances its control environment
Certain departments may need enhanced oversight
Internal audit reports give management a head start to make corrections
Internal audits may make companies more efficient.
Understanding Internal Audits
Internal audits play a critical role in a company’s operations and corporate governance, especially now that the SarbanesOxley Act of 2002 holds managers legally responsible for the accuracy of their company’s financial statements. SOX also
required that a company’s internal controls be documented and reviewed as part of its external audit.
Internal audits may take place on a daily, weekly, monthly, or annual basis. Some departments may be audited more
frequently than others. For example, a manufacturing process may be audited on a daily basis for quality control, while the
human resources department might only be audited once a year
Objectives of Internal Audit
1. Proper Control :One of the main objectives of an internal audit is to keep stringent control over all the activities of an
organization. The management needs assurance of the authenticity of the financial records and the efficiency of the
operations of the firm. An internal audit helps establish both.
2. Perfect Accounting System :An internal audit keeps a very close check on the accounting system of an organization. It
checks everything from the vouchers, to the authority of transactions to mathematical accuracy. All entries are verified
against documents and other proof. Chances of mistakes or frauds are greatly reduced.
3. Review of Business :The purpose of an internal audit is to keep a check on the financial and operational aspects of a
business. So as the current financial year is ongoing, internal audit can point out the mistakes, weak points, and
strengths of the business. This will allow an ongoing review, instead of waiting till the year-end.
4. Asset Protection :In the process of internal audit, there is always a valuation and verification of an asset. There is also a
physical verification of the ownership and possession of the asset. In case of special transactions like sale, purchase or
revaluation of the asset, the authorization of this is also audited in an internal audit. So the assets enjoy complete
protection.
5. Keeps a Check on Errors : In a financial audit, the auditor will be able to determine if any mistakes were made in the
financial records. But this only happens at the end of the financial year. the mistakes are corrected thereafter. But in
case of an internal audit, the mistakes are spotted as soon as they are made, and corrected immediately.
6. Detection of Fraud: In case the company has an internal audit in place, the detection of fraud becomes much easier.
This is because there is a year-round check on the employees. In fact, an employee is less likely to attempt fraud in the
presence of an internal auditor. He will not have any time gap between the occurrence of fraud and its detection to
cover it up. This will dissuade employees from committing fraud
Internal Controls: Definition, Types, and Importance
What Are Internal Controls?
Internal controls are accounting and auditing processes used in a company’s finance department that ensure the integrity of
financial reporting and regulatory compliance.
Internal controls help companies to comply with laws and regulations, and prevent fraud. They also can help improve
operational efficiency by ensuring that budgets are adhered to, policies are followed, capital shortages are identified, and
accurate reports are generated for leadership.
KEY TAKEAWAYS
Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial
and accounting information, promote accountability and prevent fraud. Internal controls aid companies in complying with
laws and regulations, and preventing employees from stealing assets or committing fraud.
They also can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.
Internal audits play a critical role in a company’s internal controls and corporate governance.
The Sarbanes-Oxley Act of 2002 made managers legally responsible for the accuracy of their companies’ financial statements.
Understanding Internal Controls
Internal controls have become a key business function for every U.S. company since the accounting scandals of the early
2000s. In the wake of such corporate misconduct, the Sarbanes-Oxley Act of 2002 was enacted to protect investors from
fraudulent accounting activities and to improve the accuracy and reliability of corporate disclosures.
This had a profound effect on corporate governance. The legislation made managers responsible for financial reporting and
creating an audit trail. Managers found guilty of not properly establishing and managing internal controls face serious
criminal penalties.
The auditor’s opinion that accompanies financial statements is based on an audit of the procedures and records used to
produce them. As part of an audit, external auditors will test a company’s accounting processes and internal controls and
provide an opinion as to their effectiveness.
Importance of Internal Controls
Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. These
internal controls can ensure compliance with laws and regulations as well as accurate and timely financial reporting and data
collection. They help to maintain operational efficiency by identifying problems and correcting lapses before they are
discovered in an external audit.
Internal audits play a critical role in a company’s operations and corporate governance, now that the Sarbanes-Oxley Act of
2002 has made managers legally responsible for the accuracy of its financial statements.
No two systems of internal controls are identical, but many core philosophies regarding financial integrity and accounting
practices have become standard management practices. While they can be expensive, properly implemented internal
controls can help streamline operations and increase operational efficiency, in addition to preventing fraud.
Components of Internal Controls
A company’s internal controls system should include the following components:
Control environment: A control environment establishes for all employees the importance of integrity and a commitment to
revealing and rooting out improprieties, including fraud. A board of directors and management create this environment and
lead by example. Management must put into place the internal systems and personnel to facilitate the goals of internal
controls.
Risk Assessment: A company must regularly assess and identify the potential for, or existence of, risk or loss. Based on the
findings of such assessments, added focus and levels of control might be implemented to ensure the containment of risk or
to watch for risk in related areas.
Monitor: A company must monitor its system of internal controls for ongoing viability. By doing so, it can ensure, whether
through system updates, adding employees, or necessary employee training, the continued ability of internal controls to
function as needed.
Information/Communication: Solid information and consistent communication are important on two fronts. First, clarity of
purpose and roles can set the stage for successful internal controls. Second, facilitating the understanding of and
commitment to steps to take can help employees do their job most effectively.
Control Activities: These pertain to the processes, policies, and other courses of action that maintain the integrity of internal
controls and regulatory compliance. They involve preventative and detective activities
Preventative vs. Detective Controls
Internal controls are typically comprised of control activities such as authorization, documentation, reconciliation, security,
and the separation of duties. They are broadly divided into preventative and detective activities.
Preventative control activities aim to deter errors or fraud from happening in the first place and include thorough
documentation and authorization practices. Separation of duties, a key part of this process, ensures that no single individual
is in a position to authorize, record, and be in the custody of a financial transaction and the resulting asset. Authorization of
invoices and verification of expenses are internal controls.
In addition, preventative internal controls include limiting physical access to equipment, inventory, cash, and other assets.
Detective controls are backup procedures that are designed to catch items or events that have been missed by the first line
of defence. Here, the most important activity is reconciliation, which is used to compare data sets. Corrective action is taken
upon finding material differences. Other detective controls include external audits from accounting firms and internal audits
of assets such as inventory.
Audit process/Sequences
The main objective of an internal audit assignment is to assess and, when necessary, improve by recommendation, the
effectiveness of internal business controls, risk management plans, and overall business processes. A typical audit procedures
starts by assessing current processes and procedures. Auditors then analyse and compare results against internal control
objectives to determine whether the audit results comply with internal policies and procedures; finally, the auditors compile
an audit report to present to the board of directors or to the audit committee, the CEO, and other stakeholders related to the
audit assignment. The audit process consists of 13 steps as we can summarized.
1. Initiate the audit: To start, the auditor must initiate the audit by contacting the process owner to be audited and
ensuring the audit will be feasible. This is important to make sure someone is available to present evidence when you
want to audit, rather than try to make a surprise appearance.
2. Review the documents: You then need to review the documents for the process. This will help you to know how big of
an audit it will be; this knowledge is critical for the next step. The lead auditor shall supervise the activity of the audit
team, and an audit notification memo is sent to the department / section to be audited at least three working days in
advance of the audit.
3. Develop audit plan: The purpose of the document review is to develop your audit plan of what will be audited, who will
do the auditing, when it will happen, and who will be audited. Here, you decide how the audit will be split up if more
than one auditor will be used, and how much time will be dedicated to each process in the audit.
4. Assign work to auditors per plan: Larger audits may assign work among several auditors, with each taking more than
one process to audit. In this way, you can shorten the amount of time that an audit disrupts the processes, such as
having three auditors working for one day rather than one auditor working for three days.
5. Prepare working papers: The assigned auditor then prepares the audit working papers that will identify what the
auditor wants to verify, what questions to ask, and what they expect as evidence.
6. Determine the audit sequence: The next step is to determine the sequence of audit from the opening meeting through
presenting audit findings. If done right, the sequence of process audits can help make the audit flow easier.
7. Conduct opening meeting: The audit begins with an opening meeting. This is to inform to the auditees that this is not a
surprise audit, and is being done to verify conformance rather than to find fault. Some fine-tuning of the audit times can
be done at the opening meeting, as well as making sure that everyone understands the scope and extent of this
particular audit.
8. Review documents and communicate: After the meeting, any documents immediately presented by the auditee should
be reviewed to gather relevant information that might not have been available before.
9. Carry out the audit: This step is often thought of as the actual audit. The auditor asks the questions, and collects the
records and observations that will demonstrate if the processes meet the requirements. Again, it is important to
remember that an auditor is there to try to verify that a process conforms to the requirements set out, not to dig until
fault is found.
10. Generate audit findings: After the auditor finishes the verification, they must generate the audit findings and prepare
any audit conclusions to be presented. If all is found to be conforming, then there will be no corrective actions
presented; if not, then the corrective actions need to be properly prepared. It is equally important to highlight best
practices in a process, as it is to identify any shortcomings. Some companies also use a process of having internal audits
identify opportunities for improvement, which the process owner can review and accept if they wish.
11. Present findings and conclusions: The findings and conclusions are then presented, normally at a closing meeting, in
order for the process owners to understand and ask questions as well as present clarification if something was
misunderstood in the audit.
12. Formally distribute audit report: The final findings are formally written and distributed in an audit report. This gives
everyone an easy reference on actions needed, as well as providing a record of the outcome of the audit.
13. Follow-up on actions/corrective actions: Probably the most important part of an audit is for the auditor to follow-up on
any actions, as a way of ensuring remedial action is taken and completing the audit. Without follow-up of corrections
and corrective actions, the same problems could be found continually during subsequent audits, which defeats the
purpose of the audit.
Accounting vs. Auditing: What’s the Difference?
Accounting vs. Auditing: An Overview
Accountants and auditors work with a business’s financial statements and ensure they are accurate, up-to-date, and in
compliance with various regulatory standards. Accountants prepare these financial statements, which include the balance
sheet, income statement, and statement of cash flows.
Beyond this, there are myriad additional duties that an accountant might perform, such as bookkeeping, tracking expenses
and revenues, forecasting future profits and cash flows, and tax preparation. An accountant could be a dedicated employee
of a company or work for a third party hired by businesses to manage their books and prepare their taxes.
KEY TAKEAWAYS
Financial careers for those with math savvy and a love for numbers may include either accounting or auditing.
Accountants are responsible for preparing financial documents, monitoring day-to-day bookkeeping for a firm’s operations,
and/or preparing and filing tax forms.
Auditors verify the accuracy of financial statements and tax filings and may search for clues as to why some figures don’t
quite add up.
Auditing and management
Our Audit and Management Accounting Department is responsible for performing audits, reviews and compilations of
financial statements and management accounting. However, as certified public accountants, we do more than express an
opinion on your financial statements. Our audit and management accounting department will analyse data to identify
business trends and enhance decision-making to help your keep your business growing. Whether the financial statements
involve historical financial information, budget, or planning information, our focus is to assist management in obtaining the
information required that will support and aid in improving the efficiency and effectiveness of the organization’s operations.
Our Audit and Management Accounting Department also provides a broad range of services such as computer risk
management, fund risk services, internal audit services, and business performance evaluations. We design and implement
accounting systems, using the most appropriate commercial computer software. In order to increase efficiency and
profitability, we can help you streamline your accounting procedures. Through management accounting, we help you to use
your financial statements manage your business and increase your profitability. We look beyond the numbers to provide
more value than traditional compliance services. Our process assessment services include analysis of financial or other
processes to understand how current practices compare to client policies and expectations.
What Is an Agency Problem?
An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best
interests. In corporate finance, an agency problem usually refers to a conflict of interest between a company’s management
and the company’s stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make
decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own
wealth.
KEY TAKEAWAYS
An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in the best interest
of another.
Agency problems arise when incentives or motivations present themselves to an agent to not act in the full best interest of a
principal.
Through regulations or by incentivizing an agent to act in accordance with the principal’s best interests, agency problems can
be reduced.
Valuation Audit
A company has a number of tangible and intangible assets on its books. Assets such as real estate, machinery, and financial
instruments need to be evaluated to provide a proper assessment of its value. Since a large number of assets can have
significant subjectivity in valuation, a proper audit is required.
Valuation is the process of assessing the value of a financial asset. Auditors may require a valuation for proper assessment of
the assets on the balance sheet. Derivatives are financial instruments that are linked to another asset. This makes them more
complicated and hence a greater need for proper valuation is necessary.
Transparency
Its main objective is to increase transparency in the activities of auditors and encourage greater trust in the financial and
business information that they provide to the markets. In line with best international practices in corporate governance, the
bill tries to guarantee the ability of auditors to carry out an independent and objective audit. It thus establishes that financial
auditors may not be engaged for less than three years, but nor may they be kept on for more than nine. If a company wishes
to extend the engagement for longer, they will have to hire another audit firm to perform a joint audit. Likewise, once
engaged, the audit firm’s contract may only be revoked when due grounds can be proven.
The requirements regarding the content of the audit have been tightened up significantly. The audited company must
provide more thorough information to the auditors, the investors, stakeholders, shareholders and regulators.
In order to ensure auditors can be more objective and avoid possible conflict of interest, the bill includes significant limits on
the fees that audit firms may charge. It includes an obligation to report these fees to the Spanish accounting supervisor each
year (Instituto de Contabilidad).
Corporate financial reporting is the system of making corporate financial reports. These corporate financial reports are
income statement, balance sheet, cash flow statement, statement of retained earning and financial policies explanation.
Corporate financial Reporting
Corporate financial reporting is the system of making corporate financial reports. These corporate financial reports are
income statement, balance sheet, cash flow statement, statement of retained earning and financial policies explanation.
1st Corporate Financial Report : Income Statement. It is also called profit and loss account. In income statement, we come to
know whether company is earning profit or suffering loss. We can find the main expenses of company and main sources of
earning. What amount , it is giving in the form of dividend which is showed in statement of retained earning. Net income
after all adjustments is transferred to reserve and surplus section in the liability side of balance sheet.
2nd Corporate Financial Report : Balance Sheet .This corporate financial report shows the financial position at given point of
time. It provides the information of all assets and liabilities. This financial report is useful for balance sheet analysis.
3rd Corporate Financial Report : Cash Flow Statement . In cash flow statement tells us the net cash flow in operating,
investing and financial activities. This indications are helpful to analyse cash flow. This report explains the sources and
applications of liquidity of company.
4th Corporate Financial Report : Explanation of Financial Policies and Notes Big corporates also makes some financial notes
and explain the financial policies in detail with above financial reports. In these policies, company shows its inventory policy,
depreciation policy, debt terms and dividend policy. It also shows list of loss of impairment on fixed assets.
Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial
data. These rules make it easier to examine financial data by standardizing the terms and methods that accountants must
use.
The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in
167 jurisdictions. The United States uses a separate set of accounting principles, known as generally accepted accounting
principles (GAAP).
Some of the most fundamental accounting principles include the following:
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
xi.
xii.
xiii.
Accrual principle
Conservatism principle
Consistency principle
Cost principle
Economic entity principle
Full disclosure principle
Going concern principle
Matching principle
Materiality principle
Monetary unit principle
Reliability principle
Revenue recognition principle
Time period principle
Financial Statement Audit
What is the Financial Statement Audit?
A financial statement audit is defined as an independent examination of the company’s financial statement and its
disclosures by auditors. It provides a true and fair view of its financial performance.
Top Financial Statements to Audit
Income Statement: This is the statement of a company’s financial performance
Over a specific accounting period. It shows revenue and expenses incurred through operating and non-operating activities
and net profit or loss incurred during this period.
Balance Sheet: This is a statement of the company’s financial position
At a specific point in time. It is done by detailing the assets, liabilities, and shareholders’ equity to give an idea of what the
company owns along with the liabilities. The balance sheet is prepared based on the idea that Assets = Liabilities +
Shareholders’ Equity.
Cash Flow Statement: This is a statement of the company’s cash and cash equivalents during a specific accounting period.
These financial statements are the ones often utilized for audit purposes. However, some adjustments might be made to the
statements by the company after the finalization of the audit for a better representation of facts.
Table of contents
What is the Financial Statement Audit?
Objectives of Financial Statement Audit
Phases of an Auditing Financial Statements
#1 – Planning & Risk assessment
#2 – Internal Controls Testing
#3 – Substantive Testing
Responsibility for Financial Statements Audit
Scope of a Financial Statement Audit
Importance
Limitations
Basic Principles Governing a Financial Statement Audit
Recommended Articles
Financial-Statement-Audit
The objective of a financial statement
Audit is to enable the auditor to express an opinion on financial statements. The entity’s management prepares an audit. It is
essential that financial statements are prepared as per the recognized accounting policies and practice and relevant statutory
requirements, and they should disclose all material matters. However, his opinion does not constitute an assurance as to the
future viability of the enterprise or the efficiency or effectiveness with which its management has conducted the enterprise’s
affairs.
Phases of an Auditing Financial Statements
#1 – Planning & Risk assessment
The initial stage involves putting together an audit team and laying down general guidelines for effectively carrying out an
audit. The next step is to determine any risks that could lead to material errors in the statements. Identifying such risks
requires the auditor to have a thorough knowledge of the industry and business environment in which the company
operates.
#2 – Internal Controls Testing : This stage involves a critical analysis of internal controls.
Adopted by a company and their level of efficacy in eliminating any possibility of material misstatements in financial
statements. These internal controls could include automated systems and processes employed by a company to ensure
higher operational efficiency, safeguard assets, and ensure that all transactions are accurately reported.
#3 – Substantive Testing
At this stage, the auditor looks for substantial evidence and cross-verification of facts and figures reported in the statements,
which might include the following:
Physical inspection of assets, if required.
Cross-checking recorded figures in statements against actual documents and records with the company;
Third-party or any external confirmations of financial transactions and their details reported by the company; This often
includes an independent verification of such statements from the banks and any commercial entities a company is engaged in
business with.
Responsibility for Financial Statements Audit
Below is the responsibility for the financial statementsThe management is responsible for maintaining an up-to-date and proper accounting system and preparing financial
statements. The auditor is responsible for forming and expressing opinions on the financial statements. The financial
statement audit does not relieve the management of its responsibility.
Scope of a Financial Statement Audit
The auditor decides the scope of his audit having regard to;
i.
ii.
iii.
The requirement of the relevant legislation
The pronouncements of the institute
Terms of engagement
However, the terms of engagement cannot supersede the pronouncement of the institute or the provisions of relevant
legislation.
Importance
Enhances Qualification of Business Process – A rigorous audit process may also identify areas where management may
improve their controls or processes, further adding value to the company by enhancing the quality of its business processes.
Assurance to Investors – An audited financial statement provides a high, but not absolute, assurance that the amounts
included in the company’s financial statements and notes to accounts (disclosures) are free from any material misstatement.
True and Fair View – An unqualified (“clean”) audit report provides the user with an audit opinion, stating that financial
statements show a true and fair view in all material aspects and are by generally accepted accounting principles.
Provides Consistency – Financial statements Audit provides a level of consistency in financial reporting that users of the
financial statements can rely on when analysing different companies and decision-making.
Limitations
The auditor cannot obtain absolute assurance.
➢ It is due to the inherent limitations of an audit due to which the auditor
➢ Obtains persuasive evidence rather than conclusive.
➢ It arises from the Nature of financial reporting, audit procedures, and Limitations concerning time and cost. Due to
aforesaid inherent limitations, there is an unavoidable risk that some material misstatements may remain
undetected.
Basic Principles Governing a Financial Statement Audit
Below are some of the basic principles governing a financial statement audit.
#1 – Integrity, Objectivity, and Independence – The auditor should be straightforward, honest, and sincere in his
professional work. He should be fair and must not be biased.
#2 – Confidentiality – He should maintain the confidentiality of information acquired during his work and not disclose any
such information to a third party.
#3 – Skill and Competence – He should perform work with due professional care. The audit should be performed by persons
having adequate training, experience, and competence.
#4 – Work Performed by Others – The auditor can delegate work to assistants or use work performed by other auditors and
experts. But he will continue to be responsible for his opinion on financial information.
#5 – Documentation – He should document matters relating to the audit.
#6 – Planning – He should plan his work to conduct an audit effectively and timely. Plans should be based on knowledge of
the client’s business.
#7 – Audit Evidence – The auditor should obtain sufficient and appropriate audit evidence by performing compliance and
substantive procedures. Evidence enables the auditor to draw reasonable conclusions.
#8 – Accounting System and Internal Control – Internal control system ensures that the accounting system is adequate and
that all the accounting information has been duly recorded. The auditor should understand the management’s accounting
system and related internal controls.
#9 – Audit Conclusions and Reporting – The auditor should review and assess the conclusions drawn from the audit evidence
obtained through the performance of procedures. The audit report should contain a clear written expression of opinion on
the financial statements.
Financial reporting and value creation:
Value creation. What Is Corporatization?
Corporatization refers to the restructuring or transformation of a state-owned asset or organization into a corporation. These
organizations typically have a board of directors, managers, regulations and frameworks in relation to non-financial
reporting.
What Is Corporatization?
Corporatization refers to the restructuring or transformation of a state-owned asset or organization into a corporation. These
organizations typically have a board of directors, management, and shareholders. Corporatization occurs when a government
attempts to reorganize the structure of a government-owned entity into one that resembles a private entity. Corporatized
companies tend to have a board of directors, management, and shareholders but the government is the only shareholder,
and the shares in the company are not publicly traded. The goal of the government is to retain ownership while allowing the
entity to operate efficiently and competitively.
Key Features of Corporatized Entities
Separate legal entity: the organization is a legal independent entity
Managerial autonomy: management has control over all inputs and issues related to production or service delivery
Transparency and reporting: The organization is likely to become subject to prevailing company law and accounting rules
Assets and liabilities: the corporatized entity will receive the resources it needs to perform its functions and be viable. It may
be that inappropriate to transfer all associated debt to a corporatized entity if the entity is unlikely to earn sufficient
revenues to service its debt and fund existing operations
What is Corporate Overhead?
Corporate overhead is comprised of the costs incurred to run the administrative side of a business. These costs include the
accounting, human resources, legal, marketing, and sales functions. When corporate costs are incurred, they are considered
to be period costs, and so are charged to expense as incurred. Unlike factory overhead, corporate overhead is not
accumulated into a cost pool and then allocated to the number of units produced. The concept of corporate overhead is
somewhat different in a multi-subsidiary company. In this situation, corporate overhead is considered to be the cost to
operate the corporate parent. The people working at the parent entity are engaged in such activities as setting policies and
procedures for the subsidiaries, reporting consolidated results, and engaging in merger and acquisition activities. The
management of the company may choose to allocate these overhead costs to the subsidiaries owned by the parent, based on
some activity measure, such as the sales or profits of the subsidiaries. This accounting treatment is not recommended, since
it skews the reported profitability of the subsidiaries, hiding their true profitability. A better approach is for the costs of the
corporate parent to be immediately charged to expense with no allocation elsewhere.
Corporate overhead always increases the breakeven point of a business, so it is good practice to maintain tight control over
these costs.
What Is the American Institute of Certified Public Accountants (AICPA)?
The American Institute of Certified Public Accountants (AICPA) is a non-profit professional organization representing certified
public accountants (CPA) in the United States.
KEY TAKEAWAYS
The American Institute of Certified Public Accountants (AICPA) is a non-profit professional organization representing certified
public accountants (CPA) in the United States The AICPA was founded in 1887, under the name American Association of
Public Accountants. The organization is integral to rule-making and standard-setting in the CPA profession and serves as an
advocate for legislative bodies and public interest groups.
What Are Generally Accepted Auditing Standards (GAAS)?
Generally accepted auditing standards (GAAS) are a set of systematic guidelines used by auditors when conducting audits on
companies’ financial records. GAAS helps to ensure the accuracy, consistency, and verifiability of auditors’ actions and
reports. The Auditing Standards Board (ASB) of the American Institute of Certified Public Accountants (AICPA) created GAAS.
Understanding the Generally Accepted Auditing Standards
GAAS are the auditing standards that help measure the quality of audits. Auditors review and report on the financial records
of companies according to the generally accepted auditing standards.
Auditors are tasked with determining whether the financial statements of public companies follow generally accepted
accounting principles (GAAP). GAAP is a set of accounting standards that companies must follow when reporting their
financial statements. Auditors review a company’s financial numbers and accounting practices to ensure they’re consistent
and comply with GAAP. The Securities and Exchange Commission (SEC) requires that the financial statements of public
companies are examined by external, independent auditors.
Generally accepted auditing standards (GAAS) are a set of principles that auditors follow when reviewing a company’s
financial records.
GAAS helps to ensure the accuracy, consistency, and verifiability of an auditors’ actions and reports. The generally accepted
auditing standards (GAAS) are contained within three sections that cover general standards, fieldwork, and reporting.
Value Creation, Distribution, and Integrated
Financial Reporting
ABSTRACT
This paper presents a theoretical rationale and framework for expanding or supplementing the current versions of financial
reporting in various economies under the label of Integrated Financial Reporting (IFR) for business and non-business
organizations. IFR, modeled on the lines of national income accounts (NIA), is distinguished from financial reporting in two
key respects:
➢ expanding its focus to include resource flows to and from shareholders as
well as other participants, and
➢ shifting the focus from gross resource flows to net (economic) surplus accruing to each participant or class of
participants.
The value of the firm to each participant would be the capitalized value of the net resource flows to each participant, and the
value of the firm as a whole will be the sum of its value of all participants. Such an integrated system of
reporting will furnish better data for corporate, governance, regulatory, and macro-economic decision making.
1. INTRODUCTION
The development of national income accounting (NIA) was one of the most consequential contributions of economics in the
twentieth century. It provided a quantitative basis for making and evaluating a vast variety of economic decisions; however,
NIA, like other systems of socio-economic measurement, is far from perfect. Fortunately, its value derives from its systematic
provision of admittedly imperfect measures of magnitudes which had heretofore remained unknown. Less than a century
later, it is hard to imagine how we—governments, businesses, and even individuals—lived and worked without the
information from NIA that we now take for granted. The NIA framework that transformed our thinking and measurement of
the wealth of an economy can also be applied to individual organizations in business, government, and society at large. For
example, national income may be defined:
(1) as the net total of commodities and services (economic goods) produced by the people comprising a nation; or
(2) as the total of such goods received by the nation’s individual members in return for their assistance in producing
commodities and services; or
(3) as the total of goods consumed by these individuals out of the receipts thus earned, or
(4) as the net total of desirable events enjoyed by the same individuals in their double capacity as producers and
consumers (Simon Kuznets, 1933). Further, “…National income is the end product of a country’s economic activity,
reflecting the combined play of economic forces and serving to appraise the prevailing economic organization in terms
of its returns”. This paper proposes to extend this accounting and measurement perspective to individual organizations
[under the label of integrated financial reporting (IFR)] and to outline why its framework, practical development and
implementation will yield comparable, if not larger, benefits. In addition, IFR data can be aggregated for extending the
coverage of NIA to include important magnitudes that have not yet been captured in the latter. No system of
measurement stands entirely on its own. National income account data intertwine with other sources such as data on
population, labour, employment, education, financial, and economic development.
Likewise, the data provided by IFR may find its applicability in conjunction with data from other sources. IFR presents
many new and difficult challenges. Deciding on who should prepare the reports calls for considering who has the
information, potential for bias, time delays, and errors of measurement (Kendrick, 1968; United Nations, 1993). The
preparation of NIA by a centralized government organization is rendered easier by its focus on economy-wide aggregate
magnitudes. Data from a variety of sources including surveys can be used to estimate the aggregates, and statistical
adjustments made for any identifiable biases. This is not done so easily for individual organizations, since the
information about their resource flows and opportunity sets are more difficult to ascertain by similar methods. This
initial proposal for developing an integrated financial reporting in individual organizations leaves this important step
for future work.
2. THE FIRM
We can think of firms and other organizations as alliances among people embedded in the larger matrices of society and
the natural environment. Their value depends on the perspective we choose to look at them. Let us examine the value of
the firm from alternative perspectives and compare it to the benchmark concept of shareholder value. Let us also explore
the accounting, managerial, and policy implications of these values. Social accounting, that came into vogue over the last
quarter of the twentieth century, has been concerned with some but not all of these issues.
Simon (1952) compared the neoclassical economics and organizational views of the firm. Under the organizational or
contract-theoretic view, based on Rousseau’s social contract and developed by Barnard (1936), Simon (1947), and Cyert
and March (1963), a firm is a set of contracts or alliances among agents. Each agent contributes factors of production to
the firm, and receives compensation or inducement in the form of cash or other resources in exchange. Each agent
chooses to participate in the firm if the value of inducements offered by the firm exceeds the opportunity cost of the
resource contributions. All agents are located symmetrically in this simple scheme, labeled O-theory (for organization
theory) in Simon (1952).
In neoclassical economic theory (labeled F-theory in Simon), a firm is seen as an instrument of the entrepreneur or
owner. In models of perfect or imperfect competition, all agents, other than the owner, are considered passive in the
sense that their behavior can be well represented by their respective functions. The owner, being the only active decision
maker, works with production, supply and demand functions to maximize the value of the firm he owns. Value to the
owner—the net present value of future benefits flows between the shareholder and the firm discounted at the owner’s
opportunity cost of capital—is the value of the firm. If the present value is zero, investment in the firm creates no value
for the shareholder relative to the next best investment opportunity available to him. Financial accounting reports as
well as some aspects of NIA are directed to, and based on the value to the owner. Many approximations and
compromises are made in moving from the economic concept to concrete measurements to produce financial and nonfinancial data, which we shall return to later. There have been lengthy debates about alternative specifications of the
objective(s) of the firm (see Sunder, 2016). Still, shareholder value reigns supreme in theory, data, accounting practice
and normative discussions of corporate functioning.
In contrast, contract theory of the firm treats all participating agents symmetrically. Agents contribute factors; the firm
uses its production technology to convert them into products and distributes them as inducements to the agents. For
example, a simple manufacturing firm with owner, labour, and customer as three agents, collects capital, labour and
cash as factors; and distributes dividends, wages, and widgets as products to them.
The standard assumption in micro-economic theory of the firm is that the firm maximizes its profit by choosing its
technology, production, and marketing. For a given output, factor costs (other than the cost of equity) are minimized. If
the entrepreneur/owner makes all the decisions, cost minimization is, at least, a credible possibility. As decision-making
is delegated to a hired manager who has asymmetric access to information and goals of his own, cost minimization does
not survive, even as a theoretical possibility. The cost to the entrepreneur is the compensation sought by the manager
who makes the decisions. As more levels of management are added to the corporate hierarchy, each with own ego,
goals, and asymmetric access to special information, cost minimization recedes to the background and becomes a remote
ideal. In agency theory, this ideal is labeled the first-best solution; and the theoretical impossibility of attaining it gives
rise to a new, second-best, benchmark that allows each participant a slice of the surplus or rent (compensation in excess
of the participant’s opportunity cost) in equilibrium contract with the superior. This excess is the (economic) income of
the respective agent to special information, cost minimization recedes to the background and becomes a remote ideal. In
agency theory, this ideal is labeled the first-best solution; and the theoretical impossibility of attaining it gives rise to a
new, second-best, benchmark that allows each participant a slice of the surplus or rent (compensation in excess of the
participant’s opportunity cost) in equilibrium contract with the superior. This excess is the (economic) income of the
respective agent.
Sunder (1997a, pp. 65-66; 1997b) emphasizes the income streams— inducements minus contributions—each participant
receives from the firm. He attributes the special status of the shareholder income as the income of the firm (and the
associated capitalized shareholder value as the value of the firm) to the lowest priority shareholders have as residual
claimants to a firm’s resources. The residual character imparts special information and contractual properties to the
shareholder income which is not shared with the income streams to other participants. Shareholder income carries, for
example, information about the continued viability of the firm’s contract set; if the income is, and is expected to remain
negative, the firm is not viable.
The special nature of income to shareholders need not diminish the significance of income to the other participants.
Corporations influence the lives of most people not only because they may own shares, but also because they may be
customers, employees, vendors, neighbours, or citizens. These influences take many forms—direct and indirect,
immediate and long run, local and global, through priced market transactions and externalities. Tracking these income
(or loss) streams from corporations to various agents in society can affect both private as well as public decision-making.
Matsumoto’s work (2007) on accounting for distribution of wealth in Japanese corporations is a good example.
An intensive effort has been made over recent decades to broaden corporate reporting to include some of these elements
under the label of social accounting (see, for example, AAA 1972, 1974; Estes 1972, 1976; Seidler and Seidler 1974 and
Zadek and Tuppen, 2000). Let us take an overview of this literature before returning to discuss the value of the firm.
3. SOCIAL ACCOUNTING
Social accounting by business and other organizations is an attempt to measure and report efforts, achievements, and
impact along “social” dimensions. Socioeconomic accounting, social responsibility accounting and social audit are used
almost synonymously. Energy conservation, minority hiring, environmental preservation, sustainability, and support of
community organizations are examples of such dimensions. Appendix A outlines a list of dimensions that may be
encompassed by social accounting, although rarely all at once. Internet links to many such accounts are easily available.
Social accounting reports can be descriptive, and may include financial or non-financial data. They may also include
data and analyses of non-priced externalities; justification for social expenditures in terms of long-term interests of the
shareholders1; development of acceptable and reliable ways of quantifying hard to measure costs and benefits; and
for some public organizations, cost-benefit analysis of social interventions and policies.
Interpretation of “social” in social accounting, as illustrated in Appendix A, tends to be construed narrowly; it leaves out
the production, sale, and distribution of goods and services, and employment. The likely reason is not that these
activities have no social impact or relevance. Instead, social accounting tends to focus on non-priced or unrecorded
consequences of organizational activities with the presumption that the priced activities are already included in regular
financial reports. A better interpretation of social accounting for an organization, it may be argued, should be to produce
a comprehensive picture that includes priced as well as non-priced consequences of its existence and operations.
The implementations of social accounting places the responsibility for information production on managers of the firm
(see Elliott, 1973). Managers can report only what they know. For many kinds of social consequences, managers have no
such informational advantage. Information is inherently dispersed among agents in society; and it is difficult for one to
know the preferences, knowledge, opportunity sets and certain actions of others. Social accounts prepared by corporate
managers, or any other single party, suffer from this inherent limitation of information accessible to them. When wellfunctioning markets exist, they bring the dispersed information together, incorporate it into pricing, and make it
available to all (Hayek, 1945). Since social accounting covers areas in which markets are weak or nonexistent, such
solutions are not available in social accounting.
A second problem of corporate social accounting is that most proposals have taken the perspective of the firm, instead of
the members of society at large—the principals. The traditional measure of value in business—value to the
shareholder—and accounting directed to that end, have served their limited purpose well because the concept and its
implementation take the consistent perspective of a principal. Attempts to broaden the shareholder perspective to a
broader set of agents have been spent on the descriptive details of corporate activity, making the social accounting
definition unclear and lacking focus. We may do better assessing corporate value creation from the perspective of each
relevant class of agents and the sum of these values in IFR.
4. VALUE OF THE FIRM
All participants in a firm receive, or expect to receive, a stream of income—inducements minus contributions—from the
firm. Accordingly, the value of the firm to the owner is but one component of the value of the firm to all its participants.
The concept of value in the contract model is the difference between the inducements distributed from the firm to
various agents, and the opportunity cost of resources contributed by them to the firm. In other words, the value of the
firm is the sum of surplus the firm gives to all agents. Let us explore the properties and implications of this extensive
concept of the firm’s value in some detail.
Value to Investors
Setting market imperfections aside, the value of a firm to a prospective shareholder is the discounted present value of
net cash flows (i.e., the difference between the cash returns from the firm and the cash investments or capital
contributions to the firm). The discount rate is the opportunity cost of capital for the investor. If the internal rate of
return (IRR) from a prospective investment is equal to the opportunity cost of capital, the value of the investment is zero;
if the IRR exceeds the opportunity cost of capital, this value is positive. Presumably, investors would not make the
investment when the IRR is lower. Skillful investment consists of finding investment opportunities where IRR is greater
than the opportunity cost of capital.
Value to Investors
Setting market imperfections aside, the value of a firm to a prospective shareholder is the discounted present value of
net cash flows (i.e., the difference between the cash returns from the firm and the cash investments or capital
contributions to the firm). The discount rate is the opportunity cost of capital for the investor. If the internal rate of
return (IRR) from a prospective investment is equal to the opportunity cost of capital, the value of the investment is zero;
if the IRR exceeds the opportunity cost of capital, this value is positive. Presumably, investors would not make the
investment when the IRR is lower. Skillful investment consists of finding investment opportunities where IRR is greater
than the opportunity cost of capital.
Much of financial reporting is focused on the gross return from the firm from the investors’ point of view—i.e., income
and equity to investors. We suggest switching from gross to net return (after subtracting the opportunity cost of
contributions) and then applying the same point of view to all participants in the firm. We shall then return to aspects of
accounting that address, or could address, those points of view.
The Value of the Firm to Its Customers
The value of a firm to a customer can be calculated in a manner parallel to the value to a prospective investor. The
customer “invests” in the firm in the form of research, learning, negotiation, payments and settlement of any disputes.
These investments are made in the expectation that the present value of benefits generated from the goods or services
received from the firm, discounted at the opportunity cost of the customer’s capital, will exceed the opportunity costs of
resources invested. Strictly speaking, this reckoning includes not only the transaction on hand, but also the consequences
of this transaction for resource flows associated with likely subsequent transactions. A satisfactory transaction, for
example, may increase the odds and cut the time to research, learn, and negotiate, frequency of disputes, and perhaps
even the price associated with subsequent transactions. These consequences, lumped together as customer goodwill, are
reckoned in the “investment” decision associated with the transaction at hand.
The customer transacts with the firm if the reckoning of resource flows outlined above shows that the benefits of the
transaction exceeds the opportunity cost of necessary sacrifices. The present value of this excess is the value of the firm
to the customer. This value is also the customer’s share of the surplus generated by the firm. If the customer pays the
firm in advance, the value of the firm to the customer increases by the amount of the advance (analogous to the change
in the value of the firm to prospective and existing shareholders).
If multiple firms create conditions of perfect competition in the product market, a customer’s opportunity cost of buying
from firm A is foregoing an identical product sold by its competitors at identical price. Therefore, the consumer’s share
of the surplus from buying from firm A instead of its competitors is zero. An individual firm therefore creates zero value
for the customers in a perfectly competitive market, and customer loyalty disappears. To create value for customers,
firms differentiate themselves by offering products that their competitors don’t offer.
Yet, a competitive industry as a whole may generate a positive surplus for its customers. In the absence of the industry’s
product, the customer may have to buy a less satisfactory substitute, possibly at a higher price. Therefore, the sum of
customer value generated by individual firms in an industry is less than or equal to the sum of customer value generated
by the industry as a whole. For example, even if all competing airlines offer the same quality of travel at the same fares
to their passengers, the airline industry as a whole may generate surplus for its customers if their next best alternatives
to flying, say a bus or train or car, may be less convenient or more costly in time and money. A similar argument is
applicable to factor markets we discuss next.
The Value of the Firm to Its Vendors
This value is defined analogously to the firm’s value to its customers, except that the vendors’ contributions take the
form of goods and services, and they tend to receive cash from the firm. If the market for the factor is competitive, an
individual firm generates no value for a vendor who can always sell his resource at the same price elsewhere. Following
the argument from the preceding section, buyers of the resource may yet, collectively, create value for the vendors. For
example, in the absence of coal-burning power plants, the demand for coal may be negligible, and coal mines may not
exist; the coal-burning power plants create value for coal miners by generating demand for their product at prices higher
than what they could get for coal elsewhere.
The Value of the Firm to Its Employees
Labour is a factor of production and the value to the employee can be evaluated in a manner outlined for other factors of
production. In this reckoning, resources expected by an employee include wages, benefits, satisfaction, relationships,
human interaction, and reputation over the employment horizon. The employee’s opportunity cost of skills and effort
contributed to the firm is subtracted from the value of resources received to arrive at the value of the firm. Again, unless
the expectation of this value is non-negative (benefits are not exceeded by the opportunity cost), there is no reason for
the employee to take the job. In a perfectly competitive job market, an individual employer generates no surplus for the
employee, making him indifferent among competing employers. Perhaps this surplus also should be reckoned on the
industry level – for example, surplus value captured by a welder in an automobile industry compared to his income
when such industry does not exist.
The Value of the Firm to the Government
Governments at various levels contribute resources to firms, mostly in the form of non-priced public services, such as,
health, education, public safety, courts, and laws, etc. They also receive resources from firms in the form of taxation on
corporate income, payrolls, property, sales, and vehicles, etc. In addition, governments contribute resources to firms in
the form of priced goods and services, such as, highway tolls, passports, and driving or fishing licenses. The value of a
firm to the government can be reckoned as the sum of values from priced and non-priced services. Since priced services
are mostly private goods, the value to the government of providing such services to a firm can be handled analogously
to valuation by other vendors. Valuation of non-priced services, (mostly public goods), is an important challenge we
shall discuss in the section on externalities. When a government receives a net contribution from a firm (taxes and fees
exceed the opportunity cost of resources spent on providing services to the firm), the firm has a positive value to the
government. Indeed, it is this value that provides, when appropriate, the basis for government concessions to locate
business in their jurisdictions.
The Value of the Firm to the Community
Community, like governments, can be considered at different levels— local, national or global. Most exchanges between
firms and community take the form of positive and negative externalities—i.e., uncompensated benefits conferred on,
and costs imposed on others. Firms may create employment and attract visitors, name recognition, and related
businesses to its neighbourhood, as well as add pollution and congestion. They may also contribute directly to civic and
charitable organizations. The value of the firm to the community is the net result of all these resource flows. We will
return to the difficult problems of estimating externalities in a later section.
Adding Them Up
The value of the firm is the sum of its value to all its participants—the excess of total resources generated and distributed
over the opportunity costs of all the resource inputs. Much has already been written about the shareholder value and
there is little to be added here. In the measurement section below, we focus our attention on the sum—the total value of
the firm, its other components, and their implications for accounting and management.
5. MEASUREMENT OF VALUE
J. M. Clark (1936) points to three fundamental challenges to determining the value of private enterprise.
One is that the problem of the collective efficiency of private enterprise involves quantities and qualities, of which actual
market prices are not the only measure, and, I would add, some of which command no market price at all under present
conditions, although with changes in law and custom, they might perhaps come to command one. Another is that
measures of value which may be less exact than those of the market are also much more fundamental. And a third is that
our most fundamental concepts would be independent of institutions of competitive exchange; they should be such as
would hold even in a socialistic state.
Resources flow to and from the firm under a variety of conditions. Some resources, of which equity capital in large
publicly traded companies is perhaps the best example, have well organized liquid markets that are closer to perfection
than others (see Sunder, 1999a, 1999b, 2000). Price is easy to observe and approximates opportunity cost well. At the
other extreme, markets do not exist for clean air and safe streets, raising difficult problems for value measurement. As
Clark rightly points out on the following :
“Or, let us take the statement that the rental value of land tends to equal the excess of the (competitive valuation of the)
goods and services produced upon it above the (competitive) expenses of production. This becomes quite indefinite the
moment we realize that the net product in question may or may not include robbing the neighbors of their light and
air, obstructing the streets, fouling streams, increasing or destroying the beauty of the landscape or the business
character of the neighborhood, admitting tenants whose very presence destroys the value of other real estate in the
adjoining blocks, etc.”
Let us explore the links between market conditions and measurement of firm value.
Markets and Value of the Firm
If all factors of production and all products were private goods traded in perfect markets, and the counterparties in
market were homogeneous (i.e., all customers had the same value for what they bought, and all vendors had the same
opportunity costs for all they supplied to the firm), the value of the firm to all its participants, and therefore its total
value, would be zero. The prices prevailing in the respective markets are the opportunity costs/values for the marginal
agents for their marginal units, and under this assumption all agents are marginal agents and all their units are marginal
units. Individual and aggregate surplus could arise from one or more reasons :
(1) vendors selling multiple units whose opportunity cost rises with volume or customers buying multiple units whose
opportunity value declines with volume;
(2) heterogeneity within each class of buyers of products and suppliers of factors which allows sub-marginal buyers and
vendors to earn a surplus, and
(3) imperfection or absence of some markets.
If all factors of production and all products were private goods traded in perfect markets, and the counterparties in
market were homogeneous (i.e., all customers had the same value for what they bought, and all vendors had the same
opportunity costs for all they supplied to the firm), the value of the firm to all its participants, and therefore its total
value, would be zero. The prices prevailing in the respective markets are the opportunity costs/values for the marginal
agents for their marginal units, and under this assumption all agents are marginal agents and all their units are marginal
units. Individual and aggregate surplus could arise from one or more reasons :
(1) vendors selling multiple units whose opportunity cost rises with volume or customers buying multiple units whose
opportunity value declines with volume;
(2) heterogeneity within each class of buyers of products and suppliers of factors which allows sub-marginal buyers and
vendors to earn a surplus, and
(3) imperfection or absence of some markets.
The existence of value for any agent requires the presence of heterogeneity or imperfection in the respective product or
factor markets. Heterogeneity is normal and can be taken for granted because not every customer values a TV set the
same and not every vendor has the same cost function.
While perfection is the tendency of competitive markets under classical conditions, it is not the goal of any participants.
Agents seek value for themselves by looking in the crevices of market imperfections. Each effort to exploit any
imperfections they may discover tends to diminish or eliminate the imperfections in the process of seeking profits. In
search of profits, agents not only seek out but also create market imperfections.
Even in otherwise perfect markets, agents specialize to create little local monopolies of their own, and seek to exploit
them in bargaining with others. A special skill, special knowledge, special product, special service, patent, are all ways to
create and exploit such monopolies. The creation of each monopoly makes the market a little less perfect, opening a gap
between the sale price and opportunity cost of the resource. This gap is the value. Agent’s exploitation of the value
created through specialization begins to close the gap and diminishes the value for the future. To stay ahead, the agent
must continually and dynamically seek other ways of distinguishing the resource he/she has to offer to create new
values, exhausting it in the process of capturing it. In this sense, creating value is more like a treadmill than a ski lift.
Of course, markets are hardly perfect. Even without conscious and explicit efforts to specialize and create value, various
kinds of transaction costs create gaps in which value exists. For example, my existing job retains its value for me because
it is costly for me to find another job that compensates me at the level I believe my skills deserve. I am paid my current
compensation because it is costly for my employer to find a worker with even better skills to do the job. The cost of a job
search lowers the employee’s opportunity cost of keeping the present job; the costs of search, recruitment, and training
make it cheaper for my employer to retain my services than to find a replacement.
Values rise as markets become less perfect. In more perfect markets, valuation is easier but values are smaller. In extreme
cases, markets disappear altogether, providing no assistance in valuation, as Clark (1937) suggested in the quote given
earlier.
Externalities in Value of the Firm
Difficult problems of measurement arise when goods and services are not priced even in relatively imperfect markets.
With zero marginal cost and the impossibility of excluding non-payers from their benefits, pure public goods are
inherently incapable of supporting a price. Most organizations produce and consume some public goods. Building an
auto assembly plant in a rural area improves skills, employment, retail stores, property values, roads, entertainment and
public schools. They are externalities to the extent there is no direct way for the firm to extract a price from individuals
who benefit from these public goods. The extensive concept value of the firm in IFR includes the value of these benefits
bestowed on individuals or the community.
Pollution and congestion are examples of negative externalities a firm may impose on others without compensating
them. This imposition is counted negatively in valuing the firm from the point of view of uncompensated parties. The
National Accountants Association’s social performance measures included in Appendix A list both positive and negative
externalities.
The Difficulties of Valuing Externalities
Absent transaction prices, externalities necessitate alternative methods for valuation. As an example, consider
complementary rides provided by a firm to transport employees between nearby subway stations and the factory. The
cost of the service to the firm, say X, is easily measured by the accounting system, and treated as an expense in
calculating net income to the shareholders. If we stop here, the extensive income of the firm to all agents is understated
because net income to shareholders ignores some of the benefits of the service to agents other than shareholders. A part
of benefits of the service flows back to the shareholders in the form of lowered costs of employee parking, absenteeism,
fatigue, etc. This benefit, say Y1, to the shareholders is included in net income through lowered labour costs and higher
productivity.
A second part of the benefit accrues to the employees in the form of avoided cost of alternative transportation, saving in
commuting time, fatigue, etc. These benefits, say Y2, must be added to other components of compensation in calculating
their income stream from employment. The saving in the cost of alternative transportation can be estimated reasonably
well in terms of money if there is a market for such services. Savings in time, fatigue, etc., vary across people, make it
difficult for the firm to approximate reasonable estimates. The benefits of less fatigue may be subjective, difficult to
estimate quantitatively and even more difficult to state in terms of money. In any case, there is little chance that the firm
can come up with a better estimate of Y2 than the employees who use the transportation service. Whether such estimates
can be reliably solicited from the employees as inputs to IFR is an implementation challenge.
A third part of the benefit of the transportation service accrues to fellow commuters by train (lowering the cost of mass
transportation through higher utilization), commuters by road (less rush hour traffic), transport companies (additional
customers), local government (less spending on roads and parking), and fellow citizens (less pollution). One could take
this argument further and identify progressively to diffuse second and third order consequences of the complementary
transportation service.
Perhaps it is best to group these agents together into a “community” and estimate its value to the firm by identifying
various positive and negative externalities in a lump sum. Tools of social cost-benefit analysis are widely employed for
this purpose (e.g., Pearce et al., 2006), though rarely in social accounting reports produced by corporations. Being based
on judgments and assumptions, estimates can be quite sensitive to the interests of the party who prepares them. Cost
benefit analyses produced to support or oppose public expenditures on stadiums for sports teams are a good example of
this perennial problem.
What is the appropriate discount rate for valuing the net cost-benefit stream to the community? The social discount
rates, lower than private discount rates, is used for this purpose. Voluminous literature already exists on the topic (see
Caplin and Leahy, 2000).
6. IFR FOR ASSESSING POLICY : MERGERS,
ACQUISITIONS AND CORPORATE VALUE
Consider the debates surrounding the consequences of corporate mergers and acquisitions. There have been numerous
studies (see Ruback, 1983; also literature reviews by Jensen and Ruback, 1983, and Jarrell, Brickley and Netter, 1988) of
the effect of mergers and acquisitions on shareholder value. On balance, findings of stock market event studies,
predicated on the assumption of stock market efficiency, report that, on average, there is a transfer of wealth from the
acquiring firm shareholders to the shareholders of the acquired firms; and there is a small gain, at most, in shareholder
value overall. Scherer (1988) on the other hand concludes that, while some mergers may increase shareholder value and
others decrease it, on the whole the effect of mergers on shareholder value is about even.
An interesting feature of these debates, especially those oriented to public policy, is that they are focused on the
consequences of mergers and acquisitions for shareholder value; only occasionally including the value to the holders of
debt securities and taxes to the government (see Dhaliwal and Sunder, 1988). The effects of these mergers on labour are
rarely examined (see Brown and Medoff, 1987 and Shleifer and Summers, 1987 for two exceptions) and the effects on
other classes of agents are generally ignored.
One way of making sense of this state of affairs is to assume that the debaters assume the standard neoclassical firm
perspective in which all factors of production except the equity capital earn their opportunity costs from the firm, and
get no share in the surplus generated by the firm. The economic profit accruing to the suppliers of all these other factors
of production being zero, the value of the firm for them is also zero; both before as well as after the merger or
acquisition. Under this perspective, changes in the value of the firm are confined to the shareholder value; therefore, it
makes sense to carry on the debate on consequences of mergers on the basis of empirical evidence on shareholder value
alone.
But this explanation runs into a difficulty. As we discussed in earlier sections of the paper, agents who transact with the
firm through relatively perfect markets for factors or products should expect to get close to their opportunity cost—the
price that is well-defined in these markets—and nothing more or less. In the U.S., markets for equity capital are
frequently cited to be efficient, at least more efficient than others. If a firm generates a surplus (value of output in excess
of the sum of opportunity costs of factors of production), holders of equity capital are least likely to capture any
significant piece of that pie. Most of the surplus ends up with the agents who transact with the firm through less perfect
markets.
Shareholders have the only open-ended contract in the firm; all others are negotiated periodically. Labour, customers
and vendors have frequent opportunities to renegotiate the terms of their transactions with the firm, and try to capture a
share of the surplus whenever possible. Given the short-term nature of their contracts, they have an option value that the
shareholders, tied into long-term contract as a group, lack. Agents with short-term contracts can quit when confronted
with having to absorb a negative surplus. Employees with unvested pension benefits and shareholders do not have this
option.
An assessment of the consequences of mergers and acquisitions require an analysis of not only the shareholder values,
but also of values accruing to other participating agents as suggested in this IFR proposal. Being tied into an indefinite
term contract and the imperfections of corporate governance, shareholders may not be able to capture all or even
most of the ex-post benefits of value-enhancing mergers and acquisitions; these benefits leak out to corporate managers
through holes in corporate governance, and to other agents through periodic negotiations under uncertainty and market
imperfections. Yet, the shareholders are left holding the bag when a merger turns out to be value depleting. Corporate
executives, labor, customers, vendors and the community may capture significant shares in value enhancements from
mergers, and bear only a smaller fraction of value depletions. Perhaps we cannot know for sure without careful
empirical analysis of the extensive value of the firm and implementing IFR.
7. CONCLUDING REMARKS
This paper presents a theoretical rationale and framework for expanding or supplementing the current version of
financial reporting systems in various economies under the label of Integrated Financial Reporting for business and
non-business organizations. IFR, modeled on the lines of national income accounts (NIA), is distinguished from
financial reporting in two key respects :
(1) expanding its focus to include resource flows to and from shareholders as well as other participants, and
(2) shifting he focus from gross resource flows to net (economic) surplus accruing to each participant or class of
participants. The value of the firm to each participant would be the capitalized value of the net resource flows to each
participant, and the value of the firm as a whole will be the sum of its value of all participants.
Such an integrated system of reporting will furnish better data for corporate, governance, regulatory, and macroeconomic decision making. Since the value of organizations to participants other than shareholders is not a part of the
current system of reporting, many corporate and policy decisions are less efficient since they are based on unnecessarily
incomplete information. The development of NIA during the first half of the twentieth century helped make a quantum
jump in macro-economic management. Similar gains can be expected from IFR in corporate, regulatory as well as macroeconomic domains.
Much remains to be done beyond the theoretical framework outlined here. Expansion for the reporting perspective to a
broader class of resource flows, including externalities, presents many challenges of measurement and estimation.
National income accounting deals with similar difficult challenges, and the development of IFR should not be hindered
by letting the pursuit of perfection become the enemy of good.