Concept and Classification of Commercial Banks in the Economy

CHAPTER 1

THEORETICAL BASIS OF AUDITING FINANCIAL STATEMENTS OF COMMERCIAL BANKS AT INDEPENDENT AUDITING ENTERPRISES

To help the research process of theoretical basis for auditing financial statements of commercial banks performed by auditing firms most effectively, in this chapter 1, the author has delved into the main contents including: Overview of commercial banks and characteristics of commercial banks affecting the auditing of financial statements of commercial banks; Auditing financial statements of commercial banks performed by auditing firms and international experience in independent auditing of financial statements of commercial banks. Next, the author will present each of the above contents in detail to clarify the theoretical basis for auditing financial statements of commercial banks performed by auditing firms.

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1.1. OVERVIEW OF COMMERCIAL BANKS AND CHARACTERISTICS OF COMMERCIAL BANKS THAT AFFECT THE AUDIT OF COMMERCIAL BANK FINANCIAL STATEMENTS

To clarify the theoretical basis for auditing commercial bank financial statements, in this section the author presents an overview of the concepts, roles, functions and types of commercial banks as well as the characteristics in the business activities of commercial banks that affect the auditing of commercial bank financial statements.

1.1.1. Overview of commercial banks

1.1.1.1. Concept and classification of commercial banks in the economy

Concept of commercial bank

About 3,500 years before Christ, there are very few documents about the operation of anything similar to a bank. From 3,500 years before Christ to 1,800 years before Christ, documents show that there were some activities quite similar to some banking activities. History calls this the period of primitive banks. These banks were born when social organizations began to form. The formation and development of banks can be divided into 4 stages: 1- Activities of primitive banks; 2- Banking activities stage II; 3- Banking activities stage III; 4- Banking in the modern period.

The banking system is divided into two main systems: the Central Bank (CB) and intermediary banks. Due to the close connection with each other in the money and financial markets, many non-bank organizations also participate in lending and currency trading activities such as insurance companies, financial companies, securities trading and brokerage companies, etc. These organizations are considered by many countries as the third part of the banking system or other financial intermediary organizations. The organizational structure of the banking system in the economy is presented in Appendix No.

1.1 – Financial system organization chart .

The process of forming and perfecting the banking system has created commercial banks, the largest part of the group of intermediary banks with the characteristic of being a monetary business organization. So what is a commercial bank? There are many different views and definitions of commercial banks because of the complexity of banking operations, there are many different types of banks, the concept of banks changes according to space (customs, laws of each country) and over time (according to the progress of the economy - society).

According to Peter S. Rose: “ A bank is a type of financial institution that provides a wide range of financial services – especially credit, savings and payment services – and is an economic unit that performs the most financial functions of any business organization in the economy ” [37]. This definition states the basic business activities and also the characteristics of a bank in general and a commercial bank in particular. Some concepts of commercial banks are given based on its main activities.

For example, according to Article 20 of the Law on Credit Institutions of the Socialist Republic of Vietnam, passed by the 10th National Assembly, “A bank is a type of credit institution that is allowed to carry out all banking activities and other related business activities. According to the nature and objectives of its operations, the types of banks include commercial banks, development banks, investment banks, policy banks and other types of banks” and “Banking activities are monetary business activities and banking services with the regular content of receiving deposits and using this amount to grant credit and provide payment services” [40] . This definition fully describes the basic business activities of a typical commercial bank.

Nowadays, along with the development of the economy, under the impact of the competitive and cooperative environment, there has been mutual penetration between commercial banks and non-bank financial institutions, with companies that form large economic groups. Accordingly, the concept of commercial banks has also changed in different aspects, so it is difficult to give an exact definition of commercial banks. However, within the framework of this thesis, based on the basic functions and activities of commercial banks, the author draws the concept of commercial banks as follows:

A commercial bank is a type of credit institution that specializes in currency trading and providing banking services. The main activities of a commercial bank are receiving deposits, granting credit and providing payment services .

Through the above definitions of banks and commercial banks, it can be seen that commercial banks have the following basic characteristics: They are a type of intermediary financial institution operating for profit; They are a type of enterprise providing the most diverse portfolio of financial services, especially credit, savings, and payment services; They perform the most financial functions compared to any business organization in the economy.

To better understand the relationship between commercial banks in the system of credit institutions, it is necessary to learn some other terms related to commercial banks such as the Central Bank, State Bank, Investment Bank, Development Bank, Specialized Bank, Universal Bank, Wholesale Bank, Retail Bank, State Bank, Joint Stock Bank (See details in Appendix 1.2 - Explanation of some terms in the system of credit institutions).

Types of commercial banks in the economy

Although commercial banks in the economy have similar functions and types of activities, there are also differences between commercial banks in terms of type of activities, fields of operation or form of ownership. Normally, in the economy, commercial banks are divided into the following types:

- According to the type of operation, there are wholesale commercial banks and retail commercial banks;

- In terms of field of operation, there are specialized commercial banks and universal commercial banks;

- In terms of ownership, there are State-owned commercial banks, also known as Public Banks, and joint stock commercial banks.

1.1.1.2. Functions and roles of commercial banks

Economists have difficulty defining banks but agree on the role and functions of commercial banks as follows:

1.1.1.2.1. Functions of commercial banks

First, the function of being a treasurer for society: Commercial banks have this function because they receive deposits from the public, businesses and organizations, keep money for their customers, and meet their withdrawal and spending needs. This function of commercial banks leads to the payment intermediary and credit intermediary functions of commercial banks.

Second, the function of payment intermediary: Commercial banks act as payment intermediaries when they make payments at the request of customers such as withdrawing money from their deposit accounts to pay for goods and services or entering into customers' deposit accounts proceeds from sales and other revenues at their orders.

Third, the function of credit intermediation: Commercial banks act as credit intermediaries when they are the “bridge” between those with excess capital and those in need of capital. Through mobilizing temporarily idle monetary capital in the economy, banks form their own loan funds and then lend them to the economy. With this function, banks play the role of both borrowers and lenders.

Fourth, the function of creating money: Although currently commercial banks do not have the function of issuing bank notes, the combination of the credit intermediary function and the payment intermediary function makes the commercial banking system capable of creating payment deposits. A bank, after receiving a deposit on a customer's deposit account at the bank, will have a balance. With this amount of money, after leaving a reserve

Required reserves, banks will invest in lending from which it will be transferred to other banks' capital. With the circulation of capital through the credit and payment functions of banks, commercial banks have performed the function of creating money.

The functions of commercial banks are closely related, complementary and supportive to each other, in which the credit intermediary function is the most basic function, creating the basis for performing other functions. At the same time, when banks perform well the functions of cashier and payment intermediary, it contributes to increasing credit capital and expanding the scale of bank operations.

1.1.1.2.2. The role of commercial banks

Commercial banks were born due to the requirements of economic development. The production and circulation of goods, the economy increasingly developed, the more the need for the activities of commercial banks. Through the implementation of its functions, especially the credit intermediary function, commercial banks have become a part of promoting economic development. The role of commercial banks is shown as follows:

First, banks are the place that provides capital for the economy.

The more developed the economy is, the greater the demand for capital. Capital plays a very important role in investing in expanding production and business activities as well as maintaining those activities to ensure the efficiency of enterprises. Responsible for this task, commercial banks have mobilized temporarily idle capital sources from all organizations, individuals, and economic sectors. Through credit operations, commercial banks have provided capital to the economy, fully and promptly meeting the reproduction process. With this role, commercial banks are also the bridge between enterprises and the market.

Second, commercial banks are a tool for the State to regulate the macro economy.

Through credit and payment activities between banks in the system, commercial banks have contributed to expanding or narrowing the amount of money in circulation. Moreover, by providing credit to the economy, commercial banks lead cash flows, gather and divide market capital, control them effectively, and perform the role of macro-regulation in accordance with the motto "The State regulates banks, banks lead the market".

Third, commercial banks are the bridge between national finance and international finance.

The trend of association, cooperation, regionalization, and globalization has become a common trend in the world today. It is this trend that has brought countries, though geographically distant, closer together. Because the development of each country's economy is always linked to the development of the world economy and is an indispensable part of that development. Commercial banks with their deposit-taking, lending, payment, foreign exchange, and other activities have contributed to promoting the expansion of foreign trade.

Also through payment activities, foreign exchange trading, and credit relations with foreign banks, the banking system has performed the role of regulating domestic finance in accordance with the movement of international finance.

1.1.1.3. Basic business activities of commercial banks

Commercial banks usually have the following basic business activities:

Fundraising activities

Any commercial bank always starts its operations by mobilizing capital. The capital of a commercial bank is the entire monetary resources of the bank, created and mobilized by the bank and used for lending, investing and performing banking services. Specifically, the capital of a commercial bank includes the following types:

First , Owner's capital : Owner's capital is the capital owned by the commercial bank. The owner's capital of a bank usually includes: Charter capital, reserve funds and other liabilities according to the law of the commercial bank (preferred shares, convertible bonds, exchange rate differences...)

Second, Mobilized capital : The mobilized capital of commercial banks in the form of money (domestic currency, foreign currency), in gold is formed from two parts: Capital mobilized from deposits (transaction deposits and non-transaction deposits) and capital mobilized through the issuance of valuable papers (issuance of deposit certificates, issuance of bonds, promissory notes, bank bills). Because commercial banks are deposit-trading enterprises, capital formed from deposits always accounts for the largest proportion in the capital structure of the bank.

Third, Borrowing from other credit institutions and the Central Bank : Commercial banks can borrow from other banks such as borrowing from the Central Bank through the form of discounting, rediscounting valuable papers, credit contracts granted to customers, or borrowing from other financial institutions in the money market to supplement temporary capital shortages.

Fourth, Capital receiving activities : Commercial banks receive capital entrusted by the Central Bank for Government programs or from economic organizations of other countries and Governments or international financial institutions as well as other entities.

Credit activities

Commercial banks provide credit to organizations and individuals in the forms of loans, discounting of commercial papers and other valuable papers, guarantees, financial leasing and other forms as prescribed by law. In credit activities, lending is an important activity and accounts for the largest proportion.

 Lending : Lending is a transaction relationship between two entities (commercial bank and borrower), in which one party (commercial bank) transfers money or assets to the other party (borrower) for use within a certain period of time, and at the same time the party receiving the money or assets commits to repay the capital (principal and interest) to the lender unconditionally within the agreed term.

In a market economy, lending activities of commercial banks are very diverse and rich with many different forms or types of credit depending on the loan purpose, loan term and form of loan security.

 Financial leasing : Is a medium and long-term credit activity through the leasing of machinery, equipment, means of transport and other real estate on the basis of a leasing contract between the lessor (commercial bank) and the lessee.

 Bank Guarantee: Is a written commitment of a commercial bank (guarantor) to the entitled party (guarantee) to perform financial obligations on behalf of the customer (guarantee) when the customer fails to perform or improperly performs the obligations committed to the guarantee recipient. The customer must acknowledge the debt and repay the commercial bank the amount paid on behalf of the customer.

 Discounting of valuable documents (Discounting): Is a form of credit granting in which commercial banks receive valuable documents and give customers an amount equal to the face value of the discounted documents minus the profit and costs that the bank enjoys. Commercial banks currently often discount two basic types of documents: commercial papers and other valuable documents such as bonds, promissory notes, etc.

 Factoring: Is a form of credit granted by a commercial bank to the seller through the purchase of receivables arising from the purchase and sale of goods agreed upon by the seller and the buyer in the purchase and sale contract.

 Overdraft: Is a form of credit granted by commercial banks to customers by allowing customers to spend more than a certain amount in their payment account, meeting customers' urgent need for money, so interest rates are often high and calculated daily.

…

Payment and treasury services activities

Payment and treasury services of commercial banks include activities such as: Providing payment means; Performing domestic payment services for customers; Performing collection and payment services; Performing other payment services according to regulations of the State Bank; Performing international payment services when permitted by the State Bank; Performing cash collection and payment services for customers; Organizing internal payment systems and participating in domestic interbank payment systems; Participating in international payment systems when permitted by the State Bank.

Other activities

In addition to the main activities including deposit mobilization, credit granting and providing payment and treasury services, commercial banks also carry out a number of other activities, including: Direct investment activities; Indirect investment activities; Trust services; Services

Consulting; Providing insurance services; Brokerage; Issuing and paying for government bonds; Trading gold and foreign currencies; Renting cabinets, safes...

Before the explosion of IT, commercial banks provide many electronic banking services such as: Cards, Internet Banking, Phonebanking or international banking services provided by banks to their customers.

Not all commercial banks provide all of the above services. Depending on the legal regulations of each country, the characteristics, business strategies, and operational objectives of each bank, they choose the products to provide that are suitable for their bank. Commercial banks are now becoming a financial department store in the economy, so customers can satisfy all their financial service needs at a commercial bank through one location.

1.1.2. Concept of auditing financial statements of commercial banks

Many historical researchers believe that auditing was born a long time ago, around the third century BC, associated with the civilizations of ancient Egypt and Rome. Although auditing was born a long time ago, the understanding of auditing has not been unified. There are many different views on auditing. However, there is a view that is affirmed by theoretical and practical researchers as the most appropriate, complete and correct about auditing, which is the definition of Professor Alvin A. Arens of Missigan National University and Professor James K. Loebbecke of the University of Utah, stating that: " Auditing is the process by which independent and competent auditors collect and evaluate evidence about audited information to confirm and report on the level of conformity between this information and established standards " [17].

In a market economy, auditing activities are very diverse and rich and include many different types depending on classification criteria. According to the direct object, auditing can be classified into financial statement audit, operational audit and compliance audit. According to the organization of the auditing apparatus, auditing can be classified into state audit, independent audit and internal audit... Thus, financial statement audit is a specific type of audit when classified according to the direct object of the audit.

From the general concept of auditing mentioned above, the author draws the concept of auditing commercial bank financial statements as follows: " Auditing commercial bank financial statements is the process by which independent and competent auditors collect and evaluate evidence on the audited financial statements of commercial banks to confirm and report on the level of conformity of these financial statements with established standards ". This concept is specifically analyzed as follows:

 The subjects conducting the independent audit of commercial bank financial statements are auditors of independent auditing firms. According to general requirements, these auditors must ensure that they have appropriate professional competence and professional ethics. Regarding professional competence, auditors must ensure requirements on professional qualifications and ability to perform the job.

Auditing of commercial bank financial statements. Regarding professional ethics, auditors must ensure compliance with professional ethics principles such as Independence; Integrity; Objectivity; Professional competence and prudence; Confidentiality; Professional conduct and Compliance with professional standards.

 The subject of the audit is the audited financial statements of the commercial bank or the information shown on the audited financial statements of the commercial bank.

 The objective of the audit of a commercial bank's financial statements is for the auditor to express an opinion on the level of conformity of the commercial bank's financial statements with established standards.

 The established standards for evaluating the financial statements of commercial banks usually include: Accounting regulations such as the Accounting Law; Accounting standards; General corporate accounting regime and accounting regime applicable specifically to credit institutions; Accounting regulations at commercial banks themselves. In addition, when auditing the financial statements of commercial banks, auditors must also base on other legal regulations related to the operations of banks and credit institutions issued by competent authorities.

 At the end of the audit, the auditor prepares an audit report to clearly state the auditor's opinion on the truthfulness and reasonableness of the key aspects of the commercial bank's financial statements according to the provisions of auditing standards. In addition, the auditor also prepares a Management Letter to send to the bank's Board of Directors to point out the existing limitations and provide advice for the bank to improve the internal control system in particular and business operations in general.

To conduct an audit of a commercial bank's financial statements, auditors need to determine an audit approach as a guideline to guide auditors to conduct an audit that is scientific, effective and of high quality. Up to now, in auditing financial statements in general and auditing financial statements of commercial banks in particular, auditors can apply one of the following audit approaches: The substantive procedures approach ; The balance sheet approach ; The systems -based approach and The risk -based approach [61] .

With the substantive procedures approach, audit resources are focused on examining a large volume of transactions and account balances without any particular focus on specific areas of the financial statements. The major limitation of this approach is the large volume of audit work due to the auditor performing work in a diffuse, unfocused, and unstrategic manner.

With the balance sheet approach, substantive procedures are focused on balance sheet account balances with only very limited procedures performed on income statement/profit and loss statement items. This approach is quite similar to the substantive procedures approach and has the same limitations as the substantive procedures approach.