Finance

Finance is a term for matters regarding the management, creation, and study of
money and investments. Specifically, it deals with the questions of how and why
an individual, company or government acquire the money needed – called capital
in the company context – and how they spend or invest that money.

Types of Finance

There are mainly two types of finance:

1-Debt Finance and

2-Equity Finance.

The other types of finance are

-Public Finance,
-Personal Finance,
-Corporate Finance and
-Private Finance.

1. Debt Finance:
Basically, the cash which you acquire to maintain or run your business is known
as debt finance. Debt finance does not provide ownership control to the
moneylender; the borrower must repay the principal amount along with the
agreed upon interest rate. Mostly, the interest rate is determined based on the
loan amount, duration, the purpose for borrowing the specific type of finance
and inflation rate.

Debt finance can be classified into three types:

-Short-term
-Medium-term and
-Long-term

Short-term Debt Finance:

Loans generally needed for a period of more than one to one hundred and eighty
days is called short-term debt finance. These loans are borrowed for covering the
shortage of finance and temporary or occasional requirements. Short-term
finance is basically required for daily business activities such as paying wages to
the staffs or getting raw materials. The amount of getting a short-term loan is
dependent mostly on the other sources of income for repaying. The lines of
credit from the business’s suppliers are the most common forms of short-term
debt finance.
Trade credit, credit cards, bill discounting, bank overdraft, working capital loans,
small business loans, short-term loans from retail banks and advances from
customers are some other forms of short-term finance.
Medium-term Debt Finance:
Loans generally required for a period of more than one hundred and eighty to
three hundred and sixty-five days is called medium-term debt finance. The way
of utilizing the funds are mostly dependent on the type of business. The
businesses generally, repay the loan from the sources of cash-flow of the
businesses. Businesses choose this type of finance to purchase equipment, fixed
assets and the like.

Sometimes small business owners or startups use medium-term debt finance for
fulfilling the fund’s rotation. Because new businesses must pay beforehand to
suppliers for every required good such as buying equipment, machinery,
inventories and the like. Hire purchase finance, lease finance, medium-term
credits from commercial banks and issue of bonds/debentures are some
examples of medium-term debt finance.

Long-term Debt Finance:

Loans generally required for a period of more than three hundred and sixty-five
days is called long-term debt finance. This type of finance is mostly needed for
buying plant, land, restructuring offices or buildings, etc. for a business. Long-
term finance has a better interest rate than short-term finance. This debt finance
usually has a repayment duration of five, ten or twenty years.

Car loans or home loans are two popular examples of long-term finance. Issue of
bonds/debentures, Issue of preference shares, issue of equity shares, long-term
loans from government, financial services institutions or investment banks,
venture funding or funds from investors, are other examples of long-term debt
finance.

2. Equity Finance:
Equity finance is a classic way of raising capital for businesses by issues or
offering shares of the company. This is one of the major differences in equity
finance from debt finance. This finance is generally applied for seed funding for
start-ups and new businesses. Well-known companies apply this finance to raise
additional capital for the expansion of their business.

Equity finance is generally raised by issues or offering equity shares of the

business. Basically, each share is an owner’s unit for that specific company. For
instance, if the company has offered 10,000 equity shares to public investors. An
investor buys 1000 equity shares of that company, means s/he holds 10% of
ownership in the company.

The other types of finance are discussed below:

Public Finance:
Public finance deals with the study of the state’s expenditure and income. It
considers only the government’s finances. The scope of public finance includes
the fund’s collection and its allocation among different sectors of state activities
that are considered as essential functions or duties of the government.

Public finance can be classified into three types:

-Public Expenditure
-Public Revenues
-Public Debt

i. Public Expenditure:
Public expenditure means the expenses incurred by the government for its
maintenance and for the welfare and preservation of the economy, society, and
the nation.

ii. Public Revenues:

Broadly public revenues include all the receipts and income irrespective their
nature and source, which the government acquires during any given period. It
will also include the loans raised by the government. Narrowly, it will include
only the income from revenue resources which include taxes, price, fees,
penalties, fines, gifts, etc.

iii. Public Debt:

Public debt means the loans raised which is a source of public finance carrying
with it the repayment obligation to the individuals and the interest.

Personal Finance:
Personal finance denotes the application of finance’s principles to the monetary
decisions of a family or an individual. It includes the ways in which families or
individuals get, budget, spend and save monetary resources over a period,
considering different future life events and financial risks. Financial position is
focused on understanding the available personal resources by examining the
household cash flows and net worth. Net worth is an individual’s balance sheet,
derived by summing up all assets under that individual’s control, minus the
household’s all liabilities at a time.

Corporate Finance:
Corporate finance includes financial activities pertaining to running a
corporation. It is a department or division which oversees the financial functions
of a company. The primary concern of corporate finance is the maximization of
shareholder value through short-term and long-term financial planning and
different strategies’ implementation.

Private Finance:
Private finance denotes an alternative method of corporate finance helping a
company raise fund to avoid monetary problems with a limited time frame.
Basically, this method helps a company which is not listed on a securities
exchange or is incapable to obtain finance on such markets. A private financial
plan can also be suitable for a nonprofit organization.
 Financial audit

A financial audit is conducted to provide an opinion whether

"financial statements" (the information being verified) are stated in
accordance with specified criteria. Normally, the criteria are
international accounting standards, although auditors may conduct
audits of financial statements prepared using the cash basis or some
other basis of accounting appropriate for the organisation. In
providing an opinion whether financial statements are fairly stated in
accordance with accounting standards, the auditor gathers evidence
to determine whether the statements contain material errors or
other misstatements.

Financial statements (or financial reports) are formal records of

the financial activities and position of a business, person, or other
entity.

3 Types of Audit Risk

Audit risk is the risk that auditors give a clean opinion on financial
statements that contain material misstatement. There are three types
of audit risk that lead to auditors providing an inappropriate opinion.

These three types of audit risk include:

Inherent risk
Control risk
Detection risk

Inherent and control risk are the risks of material misstatement

arising in the financial statements. These types of audit risk are
dependent on the business, transactions and internal control system
that the client has in place.

On the other hand, detection risk is the risk that is dependent

entirely on the auditors. It is the type of audit risk that occurs due to
the auditors fail to detect material misstatements in the financial
statements.

Inherent Risk

Inherent risk is the risk that financial statements contain material

misstatement before consideration of any related controls. This is the
first type of audit risk as it occurs before putting any internal control
in place and already exist before any audit work performed.

Inherent risk is the susceptibility of transaction or account balance to

misstatement. It comes with the business’s transactions and its
environment.

Among the three types of audit risk, inherent risk comes directly
from the business nature itself. For example, if the business is in a
high-risk area, the level of inherent risk is also high.

It is related to the complexity and dynamic of the business and

transactions. So, the more complex and dynamic the business is, the
higher the inherent risk will be. If a transaction is so complex and
difficult for calculation, there is a higher chance of misstatement in
calculation than a transaction that is simple.

For example, the company in the financial service sector that

provides derivative products is inherently riskier than the trading
company that does not provide such products. This is due to the
derivative is the type of financial instrument that is generally
considered complex in the accounting field.
The inherent risk cannot be reduced as it is related to the nature of
the business and transaction itself. Hence, auditors can only assess
whether it is high, moderate, or low and plan the audit
procedures accordingly so that overall audit risk can be minimized.

Control Risk

Control risk is the risk that the internal control fails to prevent or
detect material misstatements in the financial statements. Among the
three types of audit risk, control risk is in the middle as the control is
usually put in place to reduce the chance of error or fraud that
inherits from the business and its environment.

In this case, once auditors have assessed that the inherent risk is
high, the level of risk of material misstatement can only be reduced if
the control risk is low. On the other hand, if both inherent and control
risks are high, auditors can only lower detection risk to have an
acceptable audit risk.

For example, if a restaurant allows its cashier to perform both

receiving cash from customers and recording it into the accounting
system, there is a risk that the cashier forgets to record the
transactions into the system or record the incorrect amount into the
system which leads to misstatement. This means that the control risk
is high.

Auditors need to perform control risk assessment when obtaining an

understanding of the client’s internal controls. In this case, they need
to assess whether the controls can prevent or detect material
misstatements related to relevant assertion for each significant
account and disclosure.

If auditors believe that the internal controls are effective in

preventing or detecting material misstatement, they will perform
the test of controls to obtain evidence in supporting the effectiveness
of controls before relying on the internal controls.
If the internal controls are strong and the auditors can rely upon, the
audit work can be reduced by lowering the amount of substantive
tests. However, if the internal controls are weak, the auditors will
have to perform more substantive tests so that the overall audit risk
can be minimized.
Detection Risk

Detection risk is the risk that auditors fail to detect the material
misstatement that exists in the financial statements. This type of
audit risk occurs when audit procedures performed by the audit
team could not locate the existed material misstatement.

Detection risk could occur due to many factors such as:

• Not proper audit planning

• Not appropriated audit procedures
• Not proper allocate of staff based on their skills and
experiences
• Not proper monitoring and supervision of work
• Not proper documenting and dealing with problem arose
• Not performing regular review neither hot review nor cold
review
• Staff’s not competent enough to perform the tasks etc.
• Lack of professional skepticism when performing the audit
work
Unlike inherent risk and control risk, auditors can influence the level
of detection risk. For example, if the risk of material misstatement is
high, auditors can reduce the level of detection risk by performing
more substantive tests or increasing the sample size in the tests of
details.

In this case, auditors need to make sure that the level of audit risk is
acceptably low. This is so that auditors can minimize the risk of
providing a wrong opinion on financial statements.

In summary, the three types of audit risk that include inherent risk,
control risk, and detection risk are closely related to each other. Even
though inherent risk and control risk are not in the control of
auditors, they need to make sure that the level of detection risk is
suitable in responding to these types of audit risk so that the overall
level of audit risk is acceptably low.