Financial Statement Review and Audit Inspection

A financial statement review is a system in which the supervisory authority directly examines whether there is a violation of accounting treatment standards in a company's financial statements, and recommends a correction of the financial statements where it determines that there is a problem.

In the past, audit inspections were conducted primarily on the basis of the external auditor's audit report, but since 2018, direct supervision of the financial statements themselves has become possible through reviews.

Reviews are carried out through sampling or on a suspicion basis, and companies with a high possibility of a violation or with a past history of error corrections, among others, become the subjects.

Where the violation is serious, or where the company does not implement the correction recommendation, the matter is converted to an audit inspection, and additional investigation and measures are carried out.

A financial statement audit inspection is a procedure that, where a violation is found, identifies where responsibility lies and imposes sanctions on the company and the external auditor.

Where the violation is intentional or of significant materiality, heavy sanctions, such as a penalty surcharge, suspension of duties, or notification to the prosecutors' office, may be imposed.

In addition, where the unlawful act arose from a lack of oversight by an executive or the audit committee, responsibility for that may also follow.

The two systems differ in their purpose, procedures, and the seriousness of their subjects.

Review subjects are largely selected through either a sampling method or a suspicion-based method.

Sampling

Sampling is a method of selecting companies with a high possibility of violating accounting treatment standards and examining their financial statements.

At this stage, the possibility of a violation is judged based on numerical analysis, past review history, and similar factors, and some companies are selected at random.

Companies with issues that raise a significant concern of a violation of accounting standards also become a focus of examination.

Suspicion-based

On a suspicion basis, the following companies become review subjects.

However, where the suspicion is specific or serious, the audit inspection procedure begins immediately without a review.

The supervisory authority collects DART disclosure data, credit information, corporate information, and similar materials to examine the basic data, and, where necessary, requests the company to submit related materials.

The company must submit explanatory materials, supplementary materials, and similar documents related to its accounting treatment, and the completeness of the disclosures in the notes to the financial statements is also a major subject of the review.

Accordingly, beyond simple numerical errors, the company must thoroughly check whether the notes related to accounting policies, accounting estimates, and risks have been prepared in accordance with the standards.

When a violation of accounting treatment standards is found, the Financial Supervisory Service notifies the company of the substance of and grounds for the violation, and recommends a correction of the financial statements.

The company must review this, consult with the external auditor to decide whether to make the correction, and report the result to the supervisory authority.

However, where the company voluntarily makes the correction before or during the review, the matter may be closed without a separate recommendation.

By contrast, where the company does not comply within the deadline, or where it fails to comply without a reasonable plan, the matter may be converted to an audit inspection.

In the following cases, the matter is converted to an audit inspection, and a stronger sanction procedure proceeds.

For other general violations, if the company implements the correction recommendation, the review is closed with a warning or caution from the Governor of the Financial Supervisory Service.

All measures are notified through a prior notice, which also provides guidance on the procedures for objecting.

Recently, as the importance of the internal accounting management system has been strengthened, audit inspections of it are also being conducted in parallel.

When an audit inspection commences, the supervisory authority, including the Financial Supervisory Service, conducts the audit inspection on the basis of the following powers.

Contents of the audit inspection

At this stage, if there is no violation, the matter is closed as no suspicion of crime, and if a violation is found, an opportunity to confirm the facts and provide an explanation is given.

Where there are indications of an accounting treatment violation, a question-and-answer document or a questionnaire is sent to the company or the external auditor.

The opportunity to provide an explanation may be expanded beyond document submission to include an oral statement or attendance at the Audit Inspection Committee, among other means.

When the audit inspection is completed, if there is a violation, the supervisory authority notifies the company and the auditor of the result through a prior notice.

Flow of the measures procedure

The parties' right to submit opinions

The company or the auditor subject to the audit inspection may submit opinions in the following ways before the measures are finalized.

The main sanction measures imposed based on the audit inspection results are as follows.

Main sanction means by subject of the measures

※ The criterion for imposing the penalty surcharge varies greatly depending on ‘whether the violation was intentional or grossly negligent’.

The level of the measures is judged according to the following criteria (Article 27 of the Regulations on External Audit and Accounting, Etc.).

Motive of the accounting treatment violation

Beyond this, measures are imposed taking into account the materiality of the unlawful act.

If any one of the following applies, intent may be presumed.

However, intent may not be found where the party provides a reasonable explanation.

Gross negligence is found where both of the following two conditions are met.

The requirements for gross negligence may also be explained, and they may be excluded where there is an acceptable reason.

In the event of a violation of the accounting standards, measures such as a penalty surcharge may be imposed only within eight years from the time the violation occurred.

To prepare for audit oversight, a company should review in advance any matters that may involve a violation of accounting standards and, where necessary, obtain a review by an outside expert to secure the appropriateness of its accounting treatment.

The company can also reduce advance risk by focusing on the following items.

In addition, the Financial Supervisory Service publishes audit oversight findings each year.

Reviewing these closely and strengthening the internal control system in advance can also be of considerable help.

During the review or audit oversight process, an opportunity is given to explain the appropriateness of the accounting treatment.

At this stage, the company should submit sufficient supporting evidence centered on the facts, including not only the interpretation of the accounting standards but also the management judgment at the time, the relevant documents, and the records of outside advice.

In the case of the auditor, the auditor should specifically explain the records of audit evidence obtained and the basis for judgments made at the stages of planning and performing the audit.

Vague intuition or general opinions are unlikely to be accepted.

Where a party must attend the audit oversight committee to make statements directly or respond to questions, both the legal procedures and the accounting interpretation play an important role.

Accordingly, a strategy should be prepared in the following manner.

Where a violation is confirmed as a result of audit oversight, a sanction is imposed for it.

At this point, the company and the auditor may respond as follows.