Private Capital Markets

Deciphering financial statements for non-financial professionals is a common concern for directors and they often search for questions they should ask to assist in discharging them of their fiduciary duty as a director.

If you’re a director of a corporation in Canada, in exercising your powers and discharging your duties as a director you must, among other things, exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances in adherence to the requirements of the Canada Business Corporations Act. Fiscal responsibility plays a significant part in the role of a director and knowledge is key in discharging one’s responsibilities. Understanding financial statements is a foundational skill essential to any board member. Depending on the nature of the organization the financial statement issues may vary widely. That said, there are a number of commonalities across financial statements, the understanding of which can assist you in monitoring your organization’s ongoing financial reporting.

1. The presence of an auditor’s report does not
ensure a company is free of fraud

Fraud can take many forms including misappropriation of assets, corruption and financial statement fraud. An audit involves certain considerations with respect to identifying indications of fraud; however it is important to understand that a standard financial statement audit is not designed specifically to identify fraud. Should the auditor identify fraud or indicators of fraud during their audit, they are obligated to take appropriate action, which ranges from informing an appropriate level of management of their findings to resigning altogether from the audit engagement. However, a well-orchestrated fraud, particularly one involving collusion, may not be identified by standard audit procedures.

The best tool to prevent and detect fraud is having anti-fraud policies and procedures. An important aspect of this is a well designed and executed internal control structure. The design of such internal controls should take into account specific fraud risks to which the company may be exposed and the cost vs. benefit of mitigating such risks. Proactive companies will take such issues into consideration when entering into new lines of business or branching out into new geographical areas, particularly where business practices differ from home.

If you do suspect that a fraud has occurred
within your company, it may be necessary to bring
in a specialist to assist in identifying and quantifying
the fraud and suggesting measures to prevent similar
frauds from occurring again. In addition, the specialist
can assist is dealing with recovery options (insurance,
civil or criminal), preserving evidence and employee
termination options. The involvement of a third party
is key given that there is a very high cost of fraud,
including reputational risk. A swift and professional
approach to managing a fraud investigation will
provide much-needed assurance to stakeholders.

2. Most audits do not ensure that internal controls
are well designed or carried out effectively

A standard financial statement audit does involve an assessment of a company’s internal controls, largely for two purposes (1) where internal controls may be tested to improve efficiency of the audit; and (2) to determine whether weaknesses in the internal control structure may give rise to audit risks. Further, when the auditor is considering internal control issues, they do so in the context of materiality, which often leaves smaller, yet operationally significant, weaknesses undetected. It is important that management and the Board not rely on a clean auditor’s report as an indication that internal controls are functioning effectively. Management should periodically review the company’s internal controls to ensure they remain appropriate and perform periodic tests of their effectiveness to ensure they’re being carried out effectively.

An important caveat to the above is that there are specific audits carried out to test the design and effectiveness of internal controls, such as those performed for the issuance of a Service Auditor Report. Such audits are carried out only in certain circumstances and typically only for organizations providing third party services, such as payroll providers. The resulting reports will clearly identify that they were for the purpose of testing internal controls.

The key here is to read the auditor’s report and be sure you understand what they are expressing an opinion on.

3. An organization’s management is responsible
for the financial statements and the many
decisions that factor into their preparation

The preparation of financial statements involves a combination of science and art - a matrix of management judgments and estimates, selection of accounting policies, and interpretations of accounting standards. An auditor performs procedures to ensure that the position management has taken is appropriate within the relevant accounting standards, but it is management who makes the decisions and the picture that is presented through the financial statements reflects their position.