Bank for International Settlements (Financial Stability Institute) - Committee of Banking Supervisors of West and Central Africa Khartoum, Sudan, 11 April 2002

1
Bank for International Settlements (Financial
Stability Institute) - Committee of Banking
Supervisors of West and Central AfricaKhartoum,
Sudan, 11 April 2002

• EXTERNAL AUDIT

Errol Kruger Deputy Head - Bank Supervision
South African Reserve Bank

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Agenda

• Responsibility of the board and senior management
  vis-à-vis the external audit function
• The role of the external Auditor
• The role of the banking supervisor
• The relationship between the supervisor and the
  external auditor
• Conclusion

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Introduction

• Banks play a central role in economy
• General public interest
• Annual financial statements audited by external
  auditors
• Promotes confidence in banking system
• Business of banking grows in complexity
• Supervisors and external auditors face similar
  challenges
• External auditors undertake additional tasks

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Responsibility of the board and senior management

• Primary responsibility for conduct of the
  business of a bank is vested in board of
  directors and management appointed by it
• Responsibility includes
• those entrusted with banking tasks have
  sufficient expertise and integrity and that there
  are experienced staff in key positions
• adequate policies, practices and procedures
  related to different activities of bank are
  established and complied with, including
• promotion of high ethical and professional
  standards
• systems accurately identify and measure all
  material risks and adequately monitor and control
  these risks
• adequate internal controls, organizational
  structures and accounting procedures
• evaluation of quality of assets and proper
  recognition and measurement

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Responsibility of the board and senior management
(cont.)

• adequate policies, practices and procedures
  related to different activities of bank are
  established and complied with, including (cont.)
• know your customer rules - prevent bank being
  used, intentionally or unintentionally, by
  criminal elements
• adoption of suitable control environment, aimed
  at meeting banks prescribed performance,
  information and compliance objectives
• testing of compliance and evaluation of
  effectiveness of internal controls by internal
  audit function
• appropriate management information systems are
  established
• appropriate risk management policies and
  procedures
• statutory and regulatory directives, including
  directives regarding solvency and liquidity, are
  observed
• interests not only of shareholders but also of
  depositors and other creditors adequately
  protected

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Responsibility of the board and senior management
(cont.)

• Management responsible for
• preparation of financial statements
• establishment of accounting procedures
• responsibility includes ensuring that external
  has unhindered access to all relevant information
• Audit committee
• ensuring existence and maintenance of an adequate
  system of internal controls
• reinforces both internal control system and
  internal audit function
• external auditors allowed and encouraged to
  attend meetings of audit committee

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Responsibility of the board and senior management
(cont.)

• Internal audit
• established by management
• part of ongoing monitoring of system of internal
  controls
• commensurate with size and nature of operations
• to be fully effective, should be independent from
  organisational activities it audits
• span the business
• adequately staffed

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Role of the external auditor

• Objective of an audit
• external auditor to express an opinion as to
  whether banks financial statements in accordance
  with an identified financial reporting framework
• Reporting framework may differ from country to
  country
• ISA 700
• Report addressed to shareholders or board of
  directors
• No assurance on future viability
• Designs audit procedures and assesses
• inherent risk
• control risk
• Misstatements arising from fraud or error

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Role of the external auditor (cont.)

• Characteristics that distinguish banks from
  commercial enterprises
• custody of large amounts of monetary items
• engage in transactions that are initiated in one
  jurisdiction, recorded in a different
  jurisdiction and managed in another jurisdiction
• operate with very high leverage
• assets can rapidly change in value and value is
  often difficult to determine
• significant amount of funding is usually derived
  from short-term deposits
• fiduciary duties in respect of assets held that
  belong to other persons
• large volumes and variety of transactions whose
  value may be significant

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Role of the external auditor (cont.)

• Characteristics that distinguishes banks from
  commercial enterprises (cont.)
• operate through network of branches and
  departments - geographically dispersed
• transactions can be directly initiated and
  completed by customer without any intervention by
  the banks employees
• assume significant commitments without any
  initial transfer of funds
• regulated by governmental authorities whose
  regulatory requirements often influence
  accounting principles that banks follow
• customer relationships might affect auditors
  independence
• exclusive access to clearing and settlement
  systems for checks and fund transfers, foreign
  exchange transactions, etc.
• issue and trade in complex financial instruments

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Role of the external auditor (cont.)

• Detailed audit of all transactions impracticable,
  bases audit on
• inherent risk
• control risk
• testing of internal controls - substantive
  procedures performed on test basis
• Reliance on internal audit
• assesses internal audit function
• nature timing and extent of external auditors
  procedures
• Professional judgement
• Risk of not detecting material misstatement
  resulting from fraud gt risk of not detecting
  material misstatement resulting from error ?
  fraud may involve sophisticated and carefully
  organized schemes designed to conceal it

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Role of the external auditor (cont.)

• External auditor discovers misstatement material
  to the financial statements ? management to
  adjust the financial statements
• Management refuses ? issues qualified or adverse
  opinion on financial statements (serious effect
  on credibility and stability)
• Communication to management re certain
  information supplementary
• In South Africa, external auditors required to
  report on
• Process of corporate governance Reg 38(6)
• Guidelines relating to the conduct of directors
  Reg 39(4)(d)
• Audit reports Reg 45

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Role of the banking supervisor

• Key objective of prudential supervision is to
  maintain stability and confidence in the
  financial system
• Banking supervision is based on a system of
  licensing, which allows supervisors to identify
  the population to be supervised and to control
  entry into the banking system
• Basic requirement for banking license
• suitable shareholders and members of board
• management must be honest, trustworthy and
  possess appropriate skills and experience
• the banks organisation and internal control must
  be consistent with its business plans and
  strategies
• legal structure in line with its operational
  structure
• adequate capital to withstand the risks inherent
  in the nature and size of its business
• sufficient liquidity to meet outflows of funds

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Role of the banking supervisor (cont.)

• Banking supervisors ? recourse to legal powers to
  bring about timely corrective action when a bank
  fails to meet prudential requirements
• Foundation of prudential supervision is capital
  adequacy
• Basel Committee proposes a new capital adequacy
  framework based on three complementary pillars
• minimum capital requirements
• supervisory review process
• market discipline
• Banks subject to a variety of risks. Supervisors
  monitor a range of banking risks, such as
• credit risk
• market risk (including interest and foreign
  exchange risk)
• liquidity and funding risk
• operational risk
• legal risk
• reputational risk

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Role of the banking supervisor (cont.)

• Most significant of banking risks - customer/
  counterparty will not settle obligation for full
  value
• capital used as supervisory standard against
  which exposures are measured or limited
• supervisor relies on managements judgment of
  proper valuation of assets, and on valuations
  that appear in financial statements - subject to
  external audit
• Supervisors attach considerable importance for
  banks to have in place internal controls that are
  adequate for nature, scope and scale of business
• Sophisticated real-time computerized information
  systems improved potential for control
• but, has brought with it additional risks arising
  from possibility of computer failure or fraud

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Role of the banking supervisor (cont.)

• Supervisors to ensure quality of management
  adequate for nature and scope of business. This
  is achieved by
• on-site inspections
• interviews with management on a regular basis
• use opportunities to understand management's
  business plans and strategies
• Effective supervision requires collection and
  analysis of information about supervised banks ?
  identify potential problems
• Supervisors must have means to validate
  information they receive
• To enhance supervisors understanding of a banks
  corporate governance and system of operation
  supervisory authorities meet periodically with
  the
• audit committee
• board of directors

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Role of the banking supervisor (cont.)

• Banking supervisors are interested in ensuring
  all work performed by external auditors carried
  out by auditors who
• are properly licensed and in good standing
• have relevant professional experience and
  competence
• are subject to quality assurance program
• are independent in fact and appearance of the
  bank audited
• are objective and impartial
• Supervisor has statutory powers over appointment
  of external auditors
• Supervisors have clear interest in ensuring high
  standards of bank auditing and important concern
  of supervisors is independence of external
  auditor who performs audit of bank

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The relationship between the supervisor and the
external auditor
Supervisor and the external auditor have
complementary concerns regarding the same matters
though the focus of their concerns is different
Banking supervisor
External auditor

• Is primarily concerned with maintaining the
  stability of the banking system and fostering the
  safety and soundness of individual banks in order
  to protect the interests of the depositors
• Is concerned with the maintenance of a sound
  system of internal control as a basis for safe
  and prudent management of the banks business
• Must be satisfied that each bank maintains
  adequate records prepared in accordance with
  consistent accounting policies and practices that
  enable the supervisor to appraise the financial
  condition of the bank and the profitability of
  its business, and that the bank publishes or
  makes available on a regular basis financial
  statements that fairly reflect its condition

• Is primarily concerned with reporting on the
  banks financial statements ordinarily either to
  the banks shareholders or board of directors.
• Is concerned with the assessment of internal
  control to determine the degree of reliance to be
  placed on the system in planning and performing
  the audit.
• Is concerned with whether adequate and
  sufficiently reliable accounting records are
  maintained in order to enable the entity to
  prepare financial statements that do not contain
  material misstatements and thus enable the
  external auditor to express an opinion on those
  statements.

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The relationship between the supervisor and the
external auditor (cont.)

• When a banking supervisor uses audited financial
  statements in the course of supervisory
  activities, the supervisor needs to bear in mind
  the following factors
• Supervisory needs not ordinarily primary purpose
  for which financial statements were prepared
• Audit in accordance with ISAs designed to provide
  reasonable assurance that financial statements
  taken as a whole are free from material
  misstatement
• Importance of accounting policies used in
  preparation of the financial statements as
  financial reporting frameworks require exercise
  of judgment - may allow choices in certain
  policies or how they are applied
• Financial statements include information based on
  judgments and estimates made by management and
  examined by auditor
• Financial position of bank may have been affected
  by subsequent events since financial statements
  were prepared

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The relationship between the supervisor and the
external auditor (cont.)

• When a banking supervisor uses audited financial
  statements in the course of supervisory
  activities, the supervisor needs to bear in mind
  the following factors
• Supervisor cannot assume that auditors
  evaluation of internal control for purposes of
  audit will necessarily be adequate for purposes
  for which supervisor needs an evaluation, given
  different purposes for which internal control is
  evaluated and tested by supervisor and auditor

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The relationship between the supervisor and the
external auditor (cont.)

• Areas where the work of banking supervisors and
  external auditors can be useful to each other
• Communications from auditors to management and
  other reports submitted by auditors can provide
  supervisors with valuable insight into various
  aspects of the banks operations
• External auditors may obtain helpful insights
  from information originating from banking
  supervisor. This information provides an
  independent assessment in important areas
• Communications of matters that came to the
  attention of the auditor and may require urgent
  action by the banking supervisor
• information that indicates a failure to fulfil
  one of the requirements for a banking license
• a serious conflict within the decision-making
  bodies or the unexpected departure of a manager
  in a key function

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The relationship between the supervisor and the
external auditor (cont.)

• Communications of matters that came to the
  attention of the auditor and may require urgent
  action by the banking supervisor (cont.)
• information that may indicate material breach of
  laws and regulations or the banks articles of
  association, charter, or by-laws
• intention of auditor to resign or removal of
  auditor from office
• material adverse changes in risks of the banks
  business and possible risks going forward
• External auditor could also carry out specific
  assignments or issues special reports in
  accordance with statutes or at request of banking
  supervisor to assist supervisor in discharging
  its supervisory functions

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Conclusion

• Banking supervisors and external auditors
  therefore cooperate with each other to make their
  contributions to the supervisory process more
  efficient and effective