FINAL COURSE STUDY MATERIAL

PAPER

3

Advanced Auditing and Professional Ethics
Volume – 1

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

This study material has been prepared by the faculty of the Board of Studies. The objective of the study material is to provide teaching material to the students to enable them to obtain knowledge and skills in the subject. Students should also supplement their study by reference to the recommended text book(s). In case students need any clarifications or have any suggestions to make for further improvement of the material contained herein they may write to the Director of Studies. All care has been taken to provide interpretations and discussions in a manner useful for the students. However, the study material has not been specifically discussed by the Council of the Institute or any of its Committees and the views expressed herein may not be taken to necessarily represent the views of the Council or any of its Committees. Permission of the Institute is essential for reproduction of any portion of this material.

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The Institute of Chartered Accountants of India

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PREFACE
Auditing is an important area of core competency of the Chartered Accountancy profession. Millions of investors, potential investors and other stakeholders of an organization repose faith and confidence on the auditor’s report and the Indian Chartered Accountancy Profession has aptly served the society and contributed for the national growth and development. This became possible simply because of adherence to the strict norms of professional selfdiscipline and pursuance of the global class auditing and assurance practices. On the wake of many corporate failures in the USA, Sarbanes–Oxley Act was enacted which encompasses newer ideas of internal control and Peer review apart from reinforcing old best practices of auditing and assurance. Enhanced role of the auditors has also been perceived at home in the context of implementing code of corporate governance and various fiscal legislations. Students of the Final level must appreciate these developments, understand and apply the same even in their day to day work. Students should in the first instance focus on learning of auditing concepts, procedures and techniques from the study material. The knowledge being so derived may be related by the students to the practical work in the field of auditing which they do as part of their training. Auditing is largely a practical and application oriented discipline. Students should learn the auditing concepts and techniques as also their intricacies purely for the purposes of applying them in their audit work. The auditing knowledge inputs provided to the students by the Institute through the study material and other publications and the practical training inputs provided by the audit firms during the articleship training stage compliment one another. Students should, as part of their articleship training, involve themselves deeply in the professional audit work done by their principals, for the purpose of getting an intense practical knowledge and learning skills in Auditing. Here are few tips for examination preparation. Students must familiarise themselves with the syllabus in detail. Since they are expected to exhibit “advanced knowledge”, it is absolutely essential that they should be able to apply theoretical knowledge to diverse practical situations. Therefore, students must study intensively AASs, Accounting Standards, relevant provisions of the Companies Act, 1956, case laws, etc. A good knowledge of these would help you to tackle practical-oriented questions in the examination. The Institute’s professional pronouncements like Accounting Standards, Statements on Standard Auditing Practices and Guidance Notes on various matters relating to Accountancy, Auditing and Taxation etc. are of critical importance to CA Final students as they form the base of their knowledge and its application to practical problems in the relevant subject areas. Students are expected to have a good insight of the contents of the above publications for their immediate purpose of examinations and also otherwise in their day to day work they are expected to make use of them. Some of these publications have been incorporated at the appropriate places in the study material. While reading through the chapters, you must take special note of various pronouncements issued by the Institute. As a matter of practical convenience, all important guidance notes and AASs have been covered at appropriate places. Some important guidance

notes have been covered in the Advanced Accounting study material as well. Students must read monthly Journal “The Chartered Accountant” and the students’ newsletter “The Chartered Accountant Student” regularly. The Institute’s monthly Journal “The Chartered Accountant” is a valuable source of articles on topical interest, relevant notifications and clarifications by Government of India, RBI, SEBI, etc., information on contemporary developments in Accounting, Finance, Auditing and Corporate and Tax Laws, etc. Students, especially Final students, should regularly keep in touch with the Journal to enrich their knowledge base, relevant for examination and other purpose. “The Chartered Accountant Student”, the students’ monthly newsletter, published by the Board is another regular channel of communication with students which contributes to the fund of knowledge required of CA students, through articles, case studies, reports, academic updates, announcements, etc. Students may also refer to compilation of suggested answers of Final (Old) Course to the extent these are relevant for the Final (New) Course. In addition, video CDs of various topics will also be made available which students may listen. These CDs contain lectures of eminent experts in the field of auditing. This study material is divided into twenty three chapters covering in details principles of Auditing, Audit and Assurance Standards issued by the ICAI , specific audit issues classified by organizations like Company Audit , audit of Banks , Audit of General Insurance Business , Audit of Co-Operative Societies and Audit of Public Sector Undertakings, special audit issues like audit under Fiscal Laws , role of auditor under clause 49 of the Listing Agreement , Audit of Consolidated Financial Statements, Investigation and Due Diligence. In Chapter 21, the latest concept of Peer Review has been explained in details, which are considered as an important step towards maintenance and improvement of audit quality. In Chapter 22, relevant aspects of the Sarbanes Oxley requirements are elaborated which will help the students to appreciate the global trend in auditing and build up international perspective. Lastly, in Chapter 23 Professional Ethics are dealt with which is regarded as a foundation to the audit function, which is essentially developed on the foundation of ethical norms, which has so far brought name and fame to the profession. All students of Final course should read this chapter with sincerity and imbibe the norms explained. These norms should be the guiding force while they will work as a chartered accountant. This study material is developed by a team of experts comprising of CA. T.P.Ghosh, Director of Studies, CA.Vikas Kumar, Executive Officer, Ms.Srishti Gupta and Ms.Ginni Aggarwal, Management Trainees in the Board of Studies. Contributions are also made by CA.K.S.Chauhan, Kanpur and CA.D.R.Sengupta, Kolkata. While preparing this material, various publications of the ICAI are adopted appropriately. Moreover, a good portion of this study material is taken from the Advanced Auditing study materials of the Final (Old) Course prepared by Shri Vijay Kapoor, Director, ICAI. The Board of Studies acknowledges the contributions made by all these faculty members. We would welcome suggestions to make this study material more useful to the students. In case of any doubt, students are welcome to write to the Director of Studies, The Institute of Chartered Accountants of India, C-1, Sector-1, Noida-201 301.

SYLLABUS
PAPER 3 : ADVANCED AUDITING AND PROFESSIONAL ETHICS
(One Paper- Three hours - 100 marks) Level of Knowledge: Advanced knowledge Objectives: (a) To gain expert knowledge of current auditing practices and procedures and apply them in auditing engagements, (b) To develop ability to solve cases relating to audit engagements. Contents: 1. Auditing Standards, Statements and Guidance Notes Auditing and Assurance Standards (AASs); Statements and Guidance Notes on Auditing issued by the ICAI; Significant differences between Auditing and Assurance Standards and International Standards on Auditing. 2. Audit strategy, planning and programming Planning the flow of audit work; audit strategy, planning programme and importance of supervision: review of audit notes and working papers; drafting of reports; principal’s ultimate responsibility; extent of delegation; control over quality of audit work; reliance on the work of other auditor, internal auditor or an expert. 3. Risk Assessment and Internal Control Evaluation of internal control procedures; techniques including questionnaire, flowchart; internal audit and external audit, coordination between the two. 4. Audit under computerized information system (CIS) environment Special aspects of CIS Audit Environment, need for review of internal control especially procedure controls and facility controls. Approach to audit in CIS Environment, use of computers for internal and management audit purposes: audit tools, test packs, computerized audit programmes; Special Aspects in Audit of E-Commerce Transaction. 5. Special audit techniques (a) Selective verification; statistical sampling: Special audit procedures; physical verification of assets, direct confirmation of debtors and creditors (b) Analytical review procedures (c) Risk-based auditing.

6.

Audit of limited companies Statutory requirements under the Companies Act 1956; Audit of branches: joint audits; Dividends and divisible profits % financial, legal, and policy considerations.

7. 8.

Rights, duties, and liabilities of auditors; third party liability. Audit reports; Qualifications, notes on accounts, distinction between notes and qualifications, detailed observations by the statutory auditor to the management vis-a-vis obligations of reporting to the members. Audit Committee and Corporate Governance

9.

10. Audit of Consolidated Financial Statements, Audit Reports and Certificates for Special Purpose engagements; Certificates under the Payment of Bonus Act, import/export control authorities, etc.; Specific services to non-audit clients; Certificate on Corporate Governance. 11. Special features of audit of banks, insurance companies, co-operative societies and nonbanking financial companies. 12. Audit under Fiscal Laws, viz, Direct and Indirect Tax Laws. 13. Cost audit 14. Special audit assignments like audit of bank borrowers, audit of stock and commodity exchange intermediaries and depositories; inspection of special entities like banks, financial institutions, mutual funds, stock brokers. 15. Special features in audit of public sector companies. Directions of Comptroller and Auditor General of India under Section 619; Concepts of propriety and efficiency audit. 16. Internal audit, management and operational audit Nature and purpose, organisation, audit programme, behavioural problems; Internal Audit Standards issued by the ICAI; Specific areas of management and operational audit involving review of internal control, purchasing operations, manufacturing operations, selling and distribution, personnel policies, systems and procedures. Aspects relating to concurrent audit. 17. Investigation and Due Diligence. 18. Concept of peer review 19. Salient features of Sarbanes – Oxley Act, 2002 with special reference to reporting on internal control. 20. Professional Ethics Code of Ethics with special reference to the relevant provisions of The Chartered Accountants Act, 1949 and the Regulations thereunder.

VOLUME-1
ADVANCED AUDITING AND PROFESSIONAL ETHICS CONTENTS
CHAPTER 1 : AUDITING STANDARDS, STATEMENTS AND GUIDANCE NOTES - AN OVERVIEW 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 Introduction ................................................................................................... 1.1 Historical Retrospect ..................................................................................... 1.2 Auditing and Assurance Standards Board – Scope and Functions .................... 1.2 Framework of AASs and Guidance Notes on Related Services ........................ 1.4 Auditing Standards ........................................................................................ 1.6 Guidance Notes........................................................................................... 1.29 Guidance Note(S) on Related Services......................................................... 1.35 Authority Attached to the Documents issued by the Institute .......................... 1.35

CHAPTER 2: AUDIT STRATERGY, PLANNING AND PROGRAMMING 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 Commencing an Audit.................................................................................... 2.1 Formulating an Audit Programme ................................................................... 2.4 Designing Audit Strategy ............................................................................. 2.17 Using the work of an Expert ......................................................................... 2.20 Relying upon the work of Internal Auditor ..................................................... 2.23 Using the work of another Auditor ................................................................ 2.23 Principal’s ultimate Responsibility ................................................................ 2.23 Reliance on the Management or other Certificates by the Auditor .................. 2.24 Management Representations ...................................................................... 2.26 Drafting of Report ........................................................................................ 2.27 Control of Quality of Audit Work ................................................................... 2.28

CHAPTER 3: RISK ASSESSMENT AND INTERNAL CONTROL 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 Introduction ................................................................................................... 3.1 Internal Control System - Nature, Scope, Objective and Structure.................... 3.2 Components of Internal Control ...................................................................... 3.6 Review of the System of Internal Control ........................................................ 3.7 Methods of Recording .................................................................................... 3.9 Evaluation of Internal Control ....................................................................... 3.19 Internal Control and Risk Assessment .......................................................... 3.20 Internal control in Small Business Enterprises .............................................. 3.26 Reporting to clients on Internal Control Weaknesses ..................................... 3.26

CHAPTER 4: AUDIT UNDER COMPUTERISED INFORMATION SYSTEM (CIS) ENVIRONMENT 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 Introduction ................................................................................................... 4.1 Scope of Audit in a CIS Environment .............................................................. 4.1 Impact of changes on Business Processes (for shifting from manual to electronic medium)........................................................................................................ 4.3 Audit Approach in a CIS environment ............................................................. 4.3 Types of Computer Systems .......................................................................... 4.7 Effect of Computers on Internal Controls ...................................................... 4.12 Effects of Computers on Auditing ................................................................. 4.14 Internal controls in a CIS environment .......................................................... 4.15 Consideration of Control Attributes by the Auditors ....................................... 4.17 Internal control requirement under CIS Environment ..................................... 4.17 Approach to Auditing in a CIS Environment................................................... 4.19 Review of Checks and Controls in a CIS Environment ................................... 4.21 Auditors Involvement in the Clients System Development and Documentation Control........................................................................................................ 4.28 Computer assisted audit techniques (CAATs) ............................................... 4.31

CHAPTER 5: SPECIAL AUDIT TECHNIQUES 5.1 5.2 5.3 5.4 5.5 5.6 Introduction ................................................................................................... 5.1 Statistical Sampling in Auditing .................................................................... 5.10 Audit of Fixed Assets ................................................................................... 5.18 Audit Risk ................................................................................................... 5.20 Risk-Based Audit ......................................................................................... 5.22 Materiality and Audit Risk ............................................................................ 5.24

CHAPTER 6: THE COMPANY AUDIT 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14 Introduction ................................................................................................... 6.1 Appointment of Company Auditor ................................................................... 6.1 Remuneration.............................................................................................. 6.12 Functions, Duties and Rights of Auditors ...................................................... 6.19 Audit of Branches ........................................................................................ 6.26 Reliance on the Work and Report of the other Auditor ................................... 6.28 Joint Audit................................................................................................... 6.31 Gist of Important Circulars ........................................................................... 6.34 Compliance with Relevant Provisions of the Companies Act, 1956 ................. 6.39 Auditor’s Duty under Companies Act, 1956 ................................................... 6.45 Final Accounts Preparation and Presentation................................................ 6.51 Significance of True and Fair ....................................................................... 6.54 Divisible Profits, Dividends and Reserves ..................................................... 6.55 Depreciation................................................................................................ 6.77

CHAPTER 7: LIABILITIES OF AUDITORS 7.1 7.2 7.3 7.4 Nature of Auditor’s Liability ............................................................................ 7.1 Professional Negligence ................................................................................ 7.3 Cases Concerning the Civil Liability of Auditors for Negligence...................... 7.15 Civil Liabilities under the Companies Act ...................................................... 7.17

7.5 7.6 7.7

Criminal Liability under the Companies Act ................................................... 7.22 Cases Concerning the Misconduct of Auditors under the Chartered Accountants Act .......................................................................... 7.25 Liabilities under Income Tax Act,1961 .......................................................... 7.27

CHAPTER 8: AUDIT REPORT 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 Auditor’s opinion ........................................................................................... 8.1 The Auditor’s Report on Financial Statements................................................. 8.4 Statement on Qualifications in the Auditor’s Report ....................................... 8.16 Distinction between Audit Report and Certificate ........................................... 8.32 Audit Reports and Certificates for Special Purposes ...................................... 8.35 Audit of Company Prospectuses................................................................... 8.38 Audit Reports/Certificates on Financial Information in Offer Documents ......... 8.41 Statement on the Companies (Auditor’s Report) Order, 2003 ......................... 8.54

CHAPTER 9: AUDIT COMMITTEE AND CORPORATE GOVERNANCE 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 Introduction ................................................................................................... 9.1 Definition of Corporate Governance................................................................ 9.2 Management’s Responsibility ......................................................................... 9.3 Audit Committee under Clause 49 .................................................................. 9.3 Functions of the Audit Committee................................................................... 9.6 Review of Information by Audit Committee...................................................... 9.6 Audit Committee Under Section 292 A of The Companies Act, 1956 ................ 9.7 Audit Committee – A Comparative .................................................................. 9.8 Role of Auditor in Audit Committee and Certification of Compliance of Conditions of Corporate Governance...................................... 9.10 Disclosures ................................................................................................. 9.22 Report on Corporate Governance ................................................................. 9.23 Auditors’ Certificate ..................................................................................... 9.24

CHAPTER 10: AUDIT OF CONSOLIDATED FINANCIAL STATEMENTS 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 10.9 10.10 10.11 Introduction ................................................................................................. 10.1 Definitions................................................................................................... 10.2 Responsibility of Parent ............................................................................... 10.2 Responsibility of the Auditor of the Consolidated Financial Statements .......... 10.2 Audit Considerations ................................................................................... 10.3 Auditing the Consolidation ........................................................................... 10.5 Special Considerations ................................................................................ 10.7 Management Representations .....................................................................10.10 Reporting ...................................................................................................10.11 When the Parent’s Auditor is also the Auditor of its Subsidiaries...................10.11 When the Parent’s Auditor is not the Auditor of its Subsidiary (ies) ...............10.11

CHAPTER 11: AUDIT OF BANKS 11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9 Introduction ................................................................................................. 11.1 Special Features ......................................................................................... 11.2 Legal Framework......................................................................................... 11.3 Form and Content of Financial Statements ................................................... 11.3 Audit of Accounts ........................................................................................ 11.6 Internal Control in Certain Selected Areas ...................................................11.16 Verification of Assets and Balances.............................................................11.20 Capital Adequacy .......................................................................................11.70 Concurrent Audit ........................................................................................11.70

CHAPTER 12: AUDIT OF GENERAL INSURANCE COMPANIES 12.1 12.2 12.3 Introduction ................................................................................................. 12.1 Legal Framework......................................................................................... 12.2 Insurance Regulatory and Development Authority (IRDA) Act, 1999 and Regulations Framed there under............................................................ 12.5

12.4 12.5 12.6 12.7 12.8 12.9 12.10 12.11

Features of Accounting System of Insurance Companies............................... 12.5 Audit of Accounts .......................................................................................12.16 Specific Control Procedures related to General Insurance Business..............12.19 Audit Procedures ........................................................................................12.20 Items Relating to Balance Sheet .................................................................12.28 Reinsurance ...............................................................................................12.35 Co-Insurance .............................................................................................12.41 Solvency Margin .........................................................................................12.41

CHAPTER 13: AUDIT OF CO-OPERATIVE SOCIETIES 13.1 13.2 13.3 13.4 13.5 13.6 Introduction ................................................................................................. 13.1 Auditor and Management ............................................................................. 13.2 Special features of Co-operative Audit.......................................................... 13.7 Right and Duties of Co-operative Auditors .................................................... 13.9 Form of Audit Report ..................................................................................13.10 Audit, Inquiry and Inspection of Multi-State Co-operative Societies ...............13.11

CHAPTER 14: AUDIT OF NON-BANKING FINANCIAL COMPANIES 14.1 14.2 14.3 14.4 Introduction ................................................................................................. 14.1 Audit Procedure .......................................................................................... 14.2 Audit Check-List .......................................................................................... 14.6 Auditor’s duty .............................................................................................. 14.9

CHAPTER 15: AUDIT UNDER FISCAL LAWS 15.1 15.2 15.3 15.4 Introduction ................................................................................................. 15.1 Audit(s) Under the Income-Tax Act, 1961 ..................................................... 15.1 Tax Audit under section 44AB ...................................................................... 15.4 Audit Provisions under Vat Law ...................................................................15.53

CHAPTER 16: COST AUDIT 16.1 16.2 16.3 16.4 16.5 16.6 16.7 16.8 16.9 Concept of Cost Audit .................................................................................. 16.1 Types of Cost Audit ..................................................................................... 16.2 Advantages of Cost Audit............................................................................. 16.3 Functions of Cost Auditor............................................................................. 16.4 Programme of Cost Audit ............................................................................. 16.7 General Features of Cost Records ............................................................... 16.8 Cost Audit under the Companies Act ...........................................................16.15 Steps in Cost Audit .....................................................................................16.17 Right and Duties of Cost Auditor .................................................................16.22

CHAPTER 17: SPECIAL AUDIT ASSIGNMENTS 17.1 17.2 17.3 17.4 17.5 17.6 17.7 17.8 17.9 17.10 17.11 17.12 17.13 17.14 17.15 Audit of Members of Stock Exchanges ......................................................... 17.1 Functioning of Stock Exchanges................................................................... 17.2 Rolling Settlement ......................................................................................17.11 Derivatives .................................................................................................17.12 Circuit Filters of Circuit Breakers.................................................................17.13 Accounting for Stock Exchange Transactions...............................................17.14 Conduct of Audit.........................................................................................17.16 Auditor’s Report .........................................................................................17.23 Audit of Mutual Funds .................................................................................17.24 Audit of Depositories ..................................................................................17.27 Certification Pursuant to Companies (Acceptance of Deposit) Rules, 1975 ....17.28 Environmental Auditing ...............................................................................17.31 Energy Audit ..............................................................................................17.35 Audit of Accounts of Non-Corporate Entities (Bank Borrowers) .....................17.36 Audit of Depositories ..................................................................................17.40

Note: Chapters 18-23 of Advanced Auditing And Professional Ethics and Appendices I-III are in Volume-2.

1
AUDITING STANDARDS, STATEMENTS AND GUIDANCE NOTES – AN OVERVIEW
Introduction 1.1 The past decade has been one of unprecedented change in the global economy and capital markets. Key aspects of the current business environment include a globalized, highly competitive, expanding economy; explosive growth in the development and use of technology; dramatic increases in new economy service- and technology-based businesses with predominantly intangible assets; unparalleled expansion in the number of public entities; large increases in the number of individuals who directly or indirectly own equity securities; and unprecedented growth in the market value of those securities. The expanded use of technology in both the operating and financial systems of companies also has significantly affected the audit environment, forcing audit firms to recruit, train and deploy a large number of information technology specialists to support their audit efforts. It also has caused firms to reconsider their audit methods and techniques in an effort to harness technology to improve audit efficiency and effectiveness. In the changing environment, it is obvious that a professional accountant should to adhere to standards and procedures laid down by the professional accountancy bodies of which he is a member while discharging his duties in a responsible manner. In this direction, the role of a professional accounting body is to lay down such standards and procedures with the aim of providing guidance to members. The Institute of Chartered Accountants of India (ICAI) has been formulating auditing and accounting standards for the guidance of its members on its own volition in the larger interests of the society. In this chapter, we provide an overview of auditing standards and guidance notes issued by the Institute from time to time. Though these standards and guidance notes have been dealt at appropriate places, the main purpose is to acquaint and inculcate appreciation on the part of students in a focused manner as to significance of the standards in their day to day auditing activities. Towards the end of the Chapter, the clarification issued by the Council of the Institute is also included, which would go a long way in understanding as well as significance to the mandatory status of “Statements” and “Standards”.

1.2

Advanced Auditing and Professional Ethics

Historical Retrospect 1.2 The Institute, since its inception, has been committed to research in the field of accountancy. As early as in 1955, the Council set up the Research Committee. The Council at that point of time felt the necessity to establish such a Committee to deal with the growing complexities of the problems faced by membership at large and with a view to ensuring the highest of traditions and technical competence in the discharge of the duties by chartered accountants. As back as in 1964, the Council published the “Statement on Auditing Practices” as prepared by the Research Committee not only for the benefit of its members but also for others outside the profession, who might be interested in this subject. It was hoped that this Statement would provide valuable guidance in the performance of audits, particularly of companies. The Council of the Institute fully realised that techniques of accounting and auditing had undergone and were undergoing important changes. Since the members were expected to keep pace with recent developments, this Statement attempted to set out practices which were generally accepted in other countries and which the Council considered desirable in the light of prevailing circumstances in India. The issuance of the Statement on Auditing Practices might be considered as a path break as far as establishing sound auditing practices is concerned. The Statement was further revised in 1968 and 1977. Prior to establishment of the Auditing Practices Committee (APC), the Research Committee issued the following Statements in Auditing: ♦ ♦ ♦ ♦ Statements on Qualifications in Auditor’s Report Statement on the Manufacturing and Other Companies (Auditor’s Report) Order, 1975/1988 (Issued under Section 227(4A) of the Companies Act, 1956) Statement on Responsibilities of Joint Auditors Statement on Payments to Auditors for Other Services

Auditing and Assurance Standards Board – Scope and Functions 1.3 The Following are the important points as regards scope and functions of Auditing and Assurance Standards Board – 1.3.1 Setting up of AASB - The International Federation of Accountants (IFAC) came into existence in 1977 and constituted International Auditing Practices Committee (IAPC) to formulate International Auditing Guidelines. These guidelines were later on converted into International Standards on Auditing (ISA). Considering the developments in the field of auditing at international level, the need for issuing Standards and Guidance Notes in tandem with international standards but conforming to national laws, customs, usages and business environments was felt. With this objective, our Institute constituted the Auditing Practices Committee (APC) on September 17, 1982, to spearhead the new framework of Statements on Standard Auditing Practices (SAPs) and Guidance Notes (GNs) inter alia to replace various chapters of the old omnibus Statement on Auditing Practices issued in 1964.

The main function of the AASB is to review the existing auditing practices in India and to develop Statements on Auditing and Assurance Standards (AASs) so that these may be issued by the Council of the Institute.3.2 Scope and Functions of AASB . The AAS is then issued under the authority of the Council. On the basis of the work of the Study Groups.4 Procedure for issuing AASs . Statements and Guidance Notes – An Overview 1. regulators. Any limitation on the applicability of a specific AAS is made clear in the introductory paragraph of the AAS. that is. In the preparation of AASs. The AASB has also been entrusted with the responsibility to review the AASs at periodical intervals.3. 1. as appropriate. it is the duty of the members of the Institute to ensure that the AASs are followed in the audit of financial information covered by their audit reports.3.While discharging their attest function. his report should draw attention to the material . through participation of representatives of various segments of the society and interest groups.3 In July. or legal form (unless specified otherwise) when such an examination is conducted with a view to expressing an opinion. The AASs may also have application. and. if necessary.3 Scope of AASs . The AASB also issues Guidance Notes on the issues arising from the AASs wherever necessary. to be in line with the international trend. to other related functions of auditors. whether profit oriented or not.Auditing Standards. If for any reason a member has not been able to perform an audit in accordance with the AASs. industry and academics. The nomenclature of SAPs has also been changed to Auditing and Assurance Standards (AASs). an exposure draft of the proposed AAS is prepared by the Committee and issued for comments by members of the Institute.The AASs apply whenever an independent audit is carried out. the AASB takes into consideration the ISAs issued by the IAPC. A significant step has been taken aimed at bringing in the desired transparency in the working of the Auditing and Assurance Standards Board. After taking into consideration the comments received. the Auditing Practices Committee has been converted into an Auditing and Assurance Standards Board by the Council of the Institute. applicable laws. The AASs are issued under the authority of the Council of the Institute. and irrespective of its size.3. the draft of the proposed AAS is finalised by the AASB and submitted to the Council of the Institute. 1. provision is made for participation of a cross-section of members of the Institute. the following procedure is adopted for the formulation of AASs: ♦ ♦ The AASB determines the broad areas in which the AASs need to be formulated and the priority in regard to the selection thereof. in the independent examination of financial information of any entity. ♦ ♦ ♦ 1. such as. The Council of the Institute considers the final draft of the proposed AAS. In the formation of Study Groups.Broadly. usages and business environment in India. modifies the same in consultation with the AASB.5 Compliance with the AASs . While formulating the AASs. the AASB is assisted by Study Groups constituted to consider specific subjects. 1. customs. 2002.

agreed-upon procedures and compilations. The degree of satisfaction achieved and. As such. but Comparative level of not absolute assurance assurance provided by the auditor Report provided Positive assurance on assertion(s) Moderate assurance No assurance Negative assurance on assertion(s) Factual findings of procedures Identificatio n of information compiled Assurance in the above context refers to the auditor's satisfaction as to the reliability of an assertion being made by one party for use by another party. the auditor assesses the evidence collected as a result of procedures conducted and expresses a conclusion. becomes liable to the disciplinary proceedings of the Institute under clause (9) of Part I of the Second Schedule to the Chartered Accountants Act. Auditing Nature of service Audit _____Related Services_____ Review Agreedupon Procedures No assurance Compilation High. a member who does not perform his audit in accordance with these statements and fails to disclose the material departures therefrom. 1. therefore.3. Auditors are expected to follow AASs in the audits commencing on or after the date specified in the Standard. audits and reviews are designed to enable the auditor to provide high and moderate levels of assurance respectively. Framework of AASs and Guidance Notes on Related Services 1. To provide such assurance. the level of assurance .4 Framework of Auditing and Assurance Standards and Guidance Notes on Related Services issued recently distinguishes audits from related services. Related services comprise reviews. 1949 which specifies that a member of the Institute shall be guilty of professional misconduct if he “fails to invite attention to any material departure from the generally accepted procedure of audit applicable to the circumstances”.The AASs (as well as other statements on auditing) represent the generally accepted procedure(s) of audit.6 Linkage between AASs and Disciplinary Proceedings .1. such terms being used to indicate their comparative ranking. As illustrated in the diagram below.4 Advanced Auditing and Professional Ethics departures therefrom. Engagements to undertake agreed-upon procedures and compilations are not intended to enable the auditor to express assurance.

rather than conclusive. the inherent limitations of any accounting and internal control systems and the fact that most of the evidence available to the auditor is persuasive. Instead. the use of test checks. . third parties can assume no responsibility of the auditor. no assurance is expressed in the report. in all material respects. the procedures of a review make the achievement less likely than in an audit engagement. but not absolute. auditor simply provides a report of the factual findings.5 which may be provided is determined by the procedures performed and their results. in accordance with an identified financial reporting framework. in nature. For agreed-upon procedures. thus the level of assurance provided in a review report is correspondingly less than that given in an audit report. Statements and Guidance Notes – An Overview 1. However. confirmation and computation. The objective of a review of financial statements is to enable an auditor to state whether.Auditing Standards. The procedures employed are not designed and do not enable the member to express any assurance on the financial information. Objective of an audit is to enable the auditor to express an opinion whether the financial statements are prepared. observation. unaware of the reasons for the procedures. it does not ordinarily involve on assessment of accounting and internal control systems. If the auditor is not associated in this manner. in accordance with an identified financial reporting framework "give a true and fair view". users of the report draw their own conclusions from the auditor's work. on the basis of procedures which do not provide all the evidence that would be required in an audit. This is expressed in the form of negative assurance. In an engagement to perform agreed-upon procedures and auditor is engaged to carry out those procedures of an audit nature to which the auditor and the entity and any appropriate third parties have agreed and to report on factual findings. classify. although the users of the compiled information derive some benefit from the involvement of a member of the Institute. anything has come to the auditor's attention that causes the auditor to believe that the financial statements are not prepared. While a review involves the application of audit skills and techniques and the gathering of evidence. An auditor is associated with financial information when the auditor attaches a report to that information or consents to the use of the auditor's name in a professional connection. In a compilation engagement. In an audit engagement. level of assurance that the information subject to audit is free of material misstatement expressed positively in the audit report. The report is restricted to those parties that have agreed to the procedures to be performed since others. in all material respects. In a compilation engagement. the auditor provides a moderate level of assurance that the information subject to review is free of material misstatement. In a review engagement. the auditor attempts to become aware of all significant matters. may misinterpret the results. a member of the Institute is engaged to use accounting expertise as opposed to auditing expertise to collect. users derive some benefit as a result of the member's involvement because the service has been performed with due professional skill and care. Absolute assurance in auditing is not attainable as a result of such factors as the need for judgement. and summaries financial information. tests of records and of responses to inquiries by obtaining corroborating evidence through inspection. no assurance is expressed. the auditor provides a high.

1. 1985. if any.5. are as follows:♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ Integrity. objectivity and independence Confidentiality Skills and competence Work performed by others Documentation Planning Audit evidence Accounting systems and internal controls Audit conclusions and reporting Compliance with the aforestated basic principles requires the application of auditing procedures and reporting practices appropriate to the particular circumstances. The statement also requires the auditor to assess the reliability and sufficiency of the information contained in the underlying accounting records and other source data and also determine whether the relevant information is properly disclosed in the financial statements. Besides. However. the terms of engagement cannot restrict the scope of an audit in relation to matters which are prescribed by statute or the pronouncements of the Institute. AASB has issued thirty four AASs. . the auditor's opinion is in no way an assurance as to the future viability of the enterprise or the efficiency or effectiveness with which management has conducted the affairs of the enterprise. The Statement lays down that the objective of an audit of financial statements.6 Advanced Auditing and Professional Ethics Auditing Standards 1. This AAS became operative for all audits relating to accounting periods beginning on or after April 1. as laid down by the Standard.1 AAS 1 : Basic Principles Governing an Audit .1.5 Till date. However. These basic principles. the requirements of the relevant legislation and the pronouncements of the Institute. and irrespective of its size or legal form. the Statement also states that the scope of an audit of financial statements will be determined by the auditor having regard to the terms of the engagement.This AAS describes the overall objective and scope of the audit of general purpose financial statements of an enterprise by an independent auditor.The Statement defines ‘audit’ as an independent examination of financial information of any entity.5. prepared within a framework of recognised accounting policies and practices and relevant statutory requirements. when such an examination is conducted with a view to express an opinion thereon. whether profit oriented or not. This Statement also describes the basic principles which govern the auditor's professional responsibilities and which should be complied with whenever an audit is carried out. A brief summary of each AAS is given below: 1.2 AAS 2 : Objective and Scope of the Audit of Financial Statements . is to enable an auditor to express an opinion on such financial statements.

the auditor should consider the risk of material misstatements in the financial statements resulting from fraud or error. In planning the audit. 1985. broadly. While this AAS focuses on the auditor's responsibilities with respect to fraud and error.Auditing Standards.5. the term 'financial information' encompasses 'financial statements'. test nature and other inherent limitations of an audit. the primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. current audit files which contain information relating primarily to the audit of a single period. permanent audit files which are updated currently with information of continuing importance to succeeding audits. and second. in his audit report.The purpose of this AAS is to establish standards on the auditor's responsibility to consider fraud and error in an audit of financial statements. the nature. and the conclusion drawn from evidence obtained. The AAS also prescribes the duration for which working papers are to be retained.5.4 AAS 4 (Revised) : The Auditor's Responsibility to Consider Fraud and Error in an Audit of Financial Statement . When planning the audit. The auditor should also set out the constraints on the scope of the audit. In some circumstances. in connection with the performance of his audit and the advantages of maintaining working papers. the auditor should discuss with other members of the audit team. 1. the latter may at his discretion make portions thereof or extracts therefrom available to his clients. Statements and Guidance Notes – An Overview 1.The AAS deals with the working papers prepared or obtained by the auditor and retained by him. This standard is operative for all audits relating to accounting periods beginning on or after April 1. the susceptibility of the entity to material misstatements in the financial statements resulting from fraud or error. This AAS became operative for all audits relating to accounting periods beginning on or after July 1. the auditor should make inquiries of management: • to obtain an understanding of: ♦ ♦ . This AAS becomes operative for all audits relating to accounting periods commencing on or after April 1. there is always an unavoidable risk that some material misstatement might remain undiscovered. however. timing and extent of audit procedures performed.7 The statement furthermore clarifies that due to pervasive rather than conclusive nature of audit evidence. 1. In this Standard. 1985. The AAS. specific legislations and regulations may require the auditor to undertake procedures additional to those set out in this AAS. The AAS also lays down that working papers are the property of the auditor. ♦ When planning and performing audit procedures and evaluating and reporting the results thereof. lays down that the working papers should record the audit plan.3 AAS 3 : Documentation . together with the inherent limitations of any system of internal control. 2003. The AAS divides working papers into two categories – first.

1. the financial statements are materially misstated as a result of fraud or error. particularly the reliability of management representations. In considering the risk of material misstatement resulting from fraud. If during the performance of the audit. the auditor should consider the implications of the misstatement in relation to other aspects of the audit. the auditor should consider how the financial statements might be materially misstated as a result of fraud or error. • • • to obtain knowledge of management's understanding regarding the accounting and internal control systems in place to prevent and detect error. the auditor should address the fraud risk factors that the auditor has identified as being present. ♦ When assessing inherent risk and control risk in accordance with AAS 6 (Revised). When the auditor confirms that. Based on the auditor's assessment of inherent and control risks (including the results of any tests of controls). the auditor should consider whether fraud risk factors are present that indicate the possibility of either fraudulent financial reporting or misappropriation of assets. When the auditor encounters circumstances that may indicate that there is a material misstatement in the financial statements resulting from fraud or error. the auditor should perform procedures to determine whether the financial statements are materially misstated. and to determine whether management has discovered any material errors. the auditor should design substantive procedures to reduce to an acceptably low level the risk that misstatements resulting from fraud and error that are material to the financial statements taken as a whole will not be detected. “Risk Assessments and Internal Control”. In designing the substantive procedures. When the auditor identifies a misstatement.8 Advanced Auditing and Professional Ethics management's assessment of the risk that the financial statements may be materially misstated as a result of fraud. the auditor should consider the implications for the audit. and the accounting and internal control systems management has put in place to address such risk. the auditor should ♦ ♦ ♦ ♦ ♦ . or is unable to conclude whether. The auditor should document fraud risk factors identified as being present during the auditor's assessment process and document the auditor's response to any such factors. fraud risk factors are identified that cause the auditor to believe that additional audit procedures are necessary. the auditor should consider whether such a misstatement may be indicative of fraud and if there is such an indication. to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating.

to the financial statements taken as a whole. If the auditor has: • • identified a fraud. and if the auditor withdraws: discuss with the appropriate level of management and those charged with governance. when so required by the laws and regulations. in some circumstances. to regulatory and enforcement authorities also. to ♦ • • .Auditing Standards. both individually and in the aggregate. the auditor should consider the auditor's responsibility to communicate that information to management. and consider the need to report such matters to those charged with governance.9 When the auditor identifies a misstatement resulting from fraud. the auditor's withdrawal from the engagement and the reasons for the withdrawal. Statements and Guidance Notes – An Overview document the presence of such risk factors and the auditor's response to them. If the auditor has identified a material misstatement resulting from error. and consider the need to report it to those charged with governance. whether or not it results in a material misstatement in the financial statements. in some cases. or error. and consider whether there is a professional or legal requirement to report to the person or persons who made the audit appointment or. The auditor should inform those charged with governance of those uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial. ♦ ♦ ♦ ♦ the auditor should communicate these matters to the appropriate level of management on a timely basis. ♦ 1. or obtained evidence that indicates that fraud may exist (even if the potential effect on the financial statements would not be material). or a suspected fraud. including whether there is a requirement for the auditor to report to the person or persons who made the audit appointment or. consider the possibility of withdrawing from the engagement. in some cases. the auditor should communicate the misstatement to the appropriate level of management on a timely basis. those charged with governance and. to regulatory authorities. the auditor should: • consider the professional and legal responsibilities applicable in the circumstances. If the auditor concludes that it is not possible to continue performing the audit as a result of a misstatement resulting from fraud or suspected fraud.

enquiry and confirmation.. In developing the audit programme. 1. The auditor should use professional judgement to assess audit risk and to design audit procedures to ensure that it is reduced to an acceptably low level. The AAS also deals with the compliance and substantive procedures to be performed for obtaining assurance regarding various assertions such as existence. continuity. inter alia. prescribes the various methods for obtaining audit evidence . and the accounting and financial reporting process. When the auditor makes an assessment that the inherent risk is not high. from the initiation of significant transactions and other events to their inclusion in the financial statements. 1989. The AAS also lays down general rules regarding the extent of reliability of evidence having regard to source and nature of audit evidence. valuation. computation and analytical review. control risk and detection risk. This AAS is operative for all audits relating to accounting periods beginning on or after January 1. 1. significant accounting records.5. The AAS lists the factors which may affect the sufficiency and appropriateness of audit evidence. supporting documents and specific accounts in the financial statements. 2002.6 AAS 6 (Revised) : Risk Assessments and Internal Control . the auditor's withdrawal from the engagement and the reasons for the withdrawal. measurement etc.1. ♦ ♦ . of assets/liabilities. In developing the overall audit plan. the auditor should relate such assessment to material account balances and classes of transactions at the level of assertions made in the financial statements.5. the auditor should assess inherent risk at the level of financial statements.The purpose of this AAS is to establish standards on the procedures to be followed to obtain an understanding of the accounting and internal control systems and on audit risk and its components: inherent risk. completeness. The Statement. observation. how such transactions are initiated. This Standard becomes operative for all audit relating to accounting periods beginning on or after April 1. or assume that inherent risk is high for the assertion. taking into account factors relevant both to the financial statements as a whole and to the specific assertions.inspection. he should document the reasons for such assessment. effectiveness.5 AAS 5 : Audit Evidence .10 Advanced Auditing and Professional Ethics regulatory authorities.The AAS deals with the various aspects of `audit evidence' on the basis of which the auditor expresses his opinion. The auditor should obtain an understanding of the accounting system sufficient to identify and understand: • • • • major classes of transactions in the entity's operations. ♦ The auditor should obtain an understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach.

Where. the auditor would make specific inquiries to consider their implications. he would amend the same unless the audit evidence obtained from other tests of control supports that assessment. ♦ ♦ ♦ ♦ The auditor should document in the audit working papers. and the assessment of control risk. for each material account balance or class of transactions. the auditor concludes that the deviations are such that the preliminary assessment of control risk is not supported. Before relying on procedures performed in prior audits. the auditor should make a preliminary assessment of control risk. the auditor should evaluate whether the internal controls are designed and operating as contemplated in the preliminary assessment of control risk. based on the results of substantive procedures and other audit evidence obtained by the auditor.Auditing Standards. The auditor should obtain audit evidence through tests of control to support any assessment of control risk which is less than high. The auditor should obtain an understanding of the control procedures sufficient to develop the audit plan. After obtaining an understanding of the accounting system and internal control system. Before the conclusion of the audit. awareness and actions regarding internal controls and their importance in the entity. at the assertion level. Statements and Guidance Notes – An Overview ♦ 1. The auditor should consider whether the internal controls were in use throughout the period. Where the auditor concludes that the ♦ ♦ ♦ ♦ ♦ . The preliminary assessment of control risk for a financial statement assertion should be high unless the auditor: • • is able to identify internal controls relevant to the assertion which are likely to prevent or detect and correct a material misstatement. Based on the results of the tests of control.11 The auditor should obtain an understanding of the control environment sufficient to assess management's attitudes. the auditor should obtain audit evidence which supports this reliance. the auditor would also document the basis for the conclusions. In case of deviations from the prescribed accounting and internal control systems. the understanding obtained of the entity's accounting and internal control systems. on the basis of such inquiries. the auditor should consider whether the assessment of control risk is confirmed. The lower the assessment of control risk. When control risk is assessed at less than high. and plans to perform tests of control to support the assessment. the more evidence the auditor should obtain that accounting and internal control systems are suitably designed and operating effectively.

i. coordinating the work to be performed.5. policies and internal control procedures. When the auditor determines that detection risk regarding a financial statement assertion for a material account balance or class of transactions cannot be reduced to an acceptable level. that plans should be based on knowledge of client's business.e. The AAS also deals with scope and objectives of internal audit function. he would modify the nature. the auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner. The AAS. technical competence and due professional care. The auditor should make management aware. states that. timing and extent of audit procedures. This AAS became operative for all audits relating to accounting periods beginning on or after April 1. the auditor should perform some substantive procedures for material account balances and classes of transactions.1. timing and extent of his planned substantive procedures. knowledge of client's accounting systems. and that plans should cover. timing and extent of his compliance and substantive procedures. as also the coordination between the internal and the external auditor. of material weaknesses in the design or operation of the accounting and internal control systems. the auditor should express a qualified opinion or a disclaimer of opinion as may be appropriate. establishing the expected degree of reliance to be placed on internal control. ♦ The auditor should consider the assessed levels of inherent and control risks in determining the nature. as soon as practical and at an appropriate level of responsibility..7 AAS 7 : Relying upon the Work of an Internal Auditor . The AAS also deals with the . inter alia. among other things.The purpose of this AAS is to amplify various principles regarding `planning'. 1989. the report given by him is his sole responsibility which is not in any way reduced because of the reliance he places on internal auditor's work. scope of functions. timing and extent of substantive procedures required to reduce audit risk to an acceptably low level. However. which have come to the auditor's attention.5. aspects to be considered in general evaluation of internal audit function such as organisational status. determining nature. ♦ ♦ ♦ 1. the external auditor should evaluate the internal audit function and also internal audit work to the extent he considers that it will be relevant in determining the nature.12 Advanced Auditing and Professional Ethics assessed level of control risk needs to be revised. the more audit evidence the auditor should obtain from the performance of substantive procedures. specific evaluation of internal audit work.This AAS deals with the procedures which should be applied by the external auditor in assessing the work of an internal auditor for the purpose of placing reliance upon that work. and. 1.8 AAS 8 : Audit Planning . The higher the assessment of inherent and control risks. Regardless of the assessed levels of inherent and control risks.

♦ ♦ ♦ When the principal auditor uses the work of another auditor. knowing the context in which his work is to be used by the principal auditor.Though an auditor is responsible for forming and expressing his opinion on financial information. he is entitled to rely on the work performed by others. 1995.5. and the procedures the auditor should consider in using the work of an expert as audit evidence.Auditing Standards. This AAS discusses auditor's responsibility in relation to. should co-ordinate with the principal auditor.This AAS discusses the procedures to be applied in situations where an independent auditor reporting on the financial statements of an entity.10 AAS 10 (Revised) : Using the Work of Another Auditor . There should be sufficient liaison between the principal auditor and the other auditor. The Statement also discusses the principal auditor's responsibility in relation to his use of the work of other auditor. competence and objectivity of the expert and his work. the principal auditor should determine how the work of the other auditor will affect the audit. in the context of the specific assignment. This Standard becomes operative for all audit relating to accounting periods beginning on or after April 1. as also the timing for audit plan. evaluating skill. The other auditor. The principal auditor should consider the significant findings of the other auditor. based on his procedures. Statements and Guidance Notes – An Overview 1. The principal auditor should perform procedures to obtain sufficient appropriate audit evidence. uses the work of an independent auditor with respect to the financial statements of one or more divisions or branches included in the financial statement of the entity.13 factors to be considered in audit planning and development of audit plan. This AAS became operative for all audits relating to accounting periods beginning on or after April 1. When the principal auditor concludes. that the work of the other auditor is adequate for the principal auditor's purposes. 1. When planning to use the work of another auditor. and acquiring the knowledge of client's business. The AAS also deals with factors to be considered in determining the need to use an expert's work. This AAS became operative for all audits relating to accounting periods beginning on or after April 1.9 AAS 9 : Using the Work of an Expert . the principal auditor should consider the professional competence of the other auditor in the context of specific assignment if the other auditor is not a member of the Institute of Chartered Accountants of India. 1991.5. The auditor should obtain reasonable assurance that work performed by other auditors/experts is adequate for his purpose. that the work of the ♦ ♦ ♦ ♦ ♦ . The auditor should consider whether the auditor's own participation is sufficient to be able to act as the principal auditor. The AAS also lays down the considerations in referring to an expert's work in the auditor's report. provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. 1989. 1.

5. The AAS became effective for all audits relating to accounting periods commencing on or after April 1. covering items like accounting policies. and the action to be taken if management refuses to provide appropriate representations. investments. The AAS also deals with the basic elements of a management representation letter. current assets and liabilities etc. lays down that the joint auditors should. The AAS describes the areas for which joint auditors are jointly and severally responsible. inventories. 1995.5.11 AAS 11 : Representations by Management . 1. evaluate whether the representations appear to be reasonable and consistent with other audit evidence obtained. each joint auditor is entitled to assume that the other joint auditors have carried out their part of the audit work in accordance with generally accepted audit procedures. the auditor should seek corroborative audit evidence from sources inside/outside the entity. his report should state clearly the division of responsibility for the financial information of the entity by indicating the extent to which the financial information of components audited by the other auditors have been included in the financial information of the entity. the principal auditor should express a qualified opinion or disclaimer of opinion because there is a limitation on the scope of audit. normally.g. The AAS became operative for all audits relating to accounting periods beginning on or after April 1.13 AAS 13 : Audit Materiality .14 Advanced Auditing and Professional Ethics other auditor cannot be used and the principal auditor has not been able to perform sufficient additional procedures regarding the financial information of the component audited by the other auditor. The AAS also states that each joint auditor is responsible only for the work allotted to him.1. fixed assets. 1. whether or not he has prepared a separate report on the work performed by him. inter alia. that in respect of management representation relating to matters material to the financial statements. As per the AAS.12 AAS 12 : Responsibility of Joint Auditors . divide the audit work among themselves. The AAS. the number of divisions/ branches/subsidiaries or other components audited by other auditors. e. 1996.The AAS 13 establishes standards on the concept of materiality and its relationship with audit risk. 1. The AAS lays down. The division of work among joint auditors as also the areas of work to be covered by all of them should be adequately documented and preferably communicated to the entity. The AAS states that information is material if its . the procedures to be applied in evaluating and documenting management representations. and consider whether the individuals making the representations can be expected to be well-informed on the matter.This AAS deals with the professional responsibilities which the auditors undertake in accepting appointments as joint auditors. It also deals with the reporting responsibilities of the joint auditors. capital commitments. ♦ When the principal auditor has to base his opinion on the financial information of the entity as a whole relying upon the statements and reports of the other auditors. by mutual discussion..5.This AAS establishes standards on the use of management representations as audit evidence. among other things.

The AAS also extensively deals with each of the aforesaid items and illustrates the factors influencing sample size for tests of control and those for substantive procedures. When the going concern assumption becomes doubtful. The AAS also deals with advantages of performing analytical procedures. 1996. sampling risk. The AAS also deals with the factors to be considered in evaluating the going concern . Statements and Guidance Notes – An Overview 1. The AAS became effective for all audits relating to accounting periods beginning on or after April 1.16 AAS 16 : Going Concern . states that when planning and performing audit procedures and in evaluating the results thereof. there exists an inverse relationship between materiality and the degree of audit risk. 1998. Besides. The AAS. inter alia. The AAS. 1. 1997. The auditor should apply analytical procedures at the planning stage to assist in understanding the business and in identifying areas of potential risk and at or near the end of the audit to corroborate conclusions formed during the audit of individual elements of financial statements and to arrive at overall conclusion as to reasonableness of the financial statements. and the factors influencing the extent of reliance that can be placed on results of analytical procedures. inter alia.Auditing Standards.This AAS. 1. The AAS became operative for all audits relating to accounting periods beginning on or after April 1. the auditor should consider the specific audit objectives.5. the auditor should gather sufficient appropriate audit evidence to attempt to resolve.The AAS establishes standards on the design and selection of an audit sample and evaluation of the sample results. The AAS also states that materiality should be considered both at overall financial information level and in relation to individual account balances and classes of transactions. factors to be considered when performing analytical procedures as substantive procedures. This AAS also deals with the factors influencing materiality.15 misstatement could influence the economic decisions of the users taken on the basis of the financial information and that materiality depends on the size and nature of the items. to the auditors satisfaction.15 AAS 15 : Audit Sampling . the auditor should consider the appropriateness of the going concern assumption underlying the preparation of financial statements. timing and extent of his audit procedures and in evaluating the effect of misstatements. judged in the particular circumstances of its misstatements. lays down that the auditor should apply analytical procedures at the planning and overall review stages of the audit. When designing an audit sample. Materiality should be considered by the auditor in determining nature. matters comprising analytical procedures. inter alia. the population from which auditor wishes to draw sample. 1. the sample size.5.14 AAS 14 : Analytical Procedures .5. factors to be considered relating to materiality and audit risk in evaluating audit evidence as also the duties of an auditor when uncorrected misstatements approach materiality level. and applies to both statistical and non-statistical sampling methods. The AAS became effective in respect of audits relating to accounting periods beginning on or after April 1. lays down that performing audit procedures on samples and evaluating sampling results can provide sufficient appropriate audit evidence.AAS 14 establishes standards on application of analytical procedures during an audit. the said doubt. tolerable error and the expected error.

1. including evaluation of date and evaluation of assumptions underlying the estimates.The AAS establishes standards on quality control policies and procedures of an audit firm regarding audit work generally. Since. and also reviewing their performance. testing the calculations involved in the estimate.5. comparison of estimates and actual results of prior periods.5. At firm level.1. inter alia. and evaluation of the approval procedures of the management. lays down that audit firm should implement quality control policies and procedures designed to ensure that all audits are conducted in accordance with AASs. acceptance and intention of clients and monitoring. (C) Review of subsequent events which confirm the estimates. The AAS became effective for all audits relating to accounting periods beginning on or after April 1. appropriately disclosed in the financial statements. and procedures regarding the work delegated to assistants on an individual audit. According to the AAS. the AAS also deals with aspects like providing direction and supervision to the assistants to whom work on individual audits has been delegated. 2000. However. the objectives of the quality control policies to be adopted by an audit firm normally include professional requirements. it would be considered as a misstatement and the auditor would need to consider its effect on the financial statements. the auditor needs to obtain sufficient appropriate audit evidence as to whether and accounting estimate is reasonable in the circumstances. accounting estimates are the responsibility of the management. 1999. delegations. skills and competence. 1. he should request the management to revise the same. assignment. This AAS became effective for all audits relating to accounting periods beginning on or after April 1. If the management refuses to revise its estimate. the procedures for evaluating the audit evidence regarding appropriateness of going concern.16 Advanced Auditing and Professional Ethics assumption.17 AAS 17 : Quality Control for Audit Work . . (B) Comparison of the management’s estimate with an independent estimate. At individual audit level. this has been discussed at length later in the Chapter. This AAS became operative for all audits commencing on or after April 1. The final assessment of reasonableness of an accounting estimates would be based on the auditor’s knowledge of the client’s business and its consistency with other audit evidence obtained during the audit.18 AAS 18 : Audit of Accounting Estimates . and when required. Having regard to the importance of AAS for the auditor. the auditor should follow either or all of the following procedures to audit an accounting estimates:(A) Review and test the process used by management to develop the estimate. the AAS is not applicable to the examination of prospective financial information. The AAS. the duties of the auditor and reporting requirements in case going concern question is either not resolved or going concern assumption is considered inappropriate.The objective of this AAS is to establish standards on the audit of accounting estimates contained in financial statements viz. If the auditor is of the opinion that the accounting estimate prepared by the management is significantly different from that assessed by him. the auditor should obtain sufficient appropriate audit evidence regarding accounting estimates. 1999. consultation.

The AAS illustrates a number of sources from which the knowledge can be obtained. .20 AAS 20 : Knowledge of the Business . budgets. The auditor should have or should obtain knowledge of the business efficient to identity and understand the events. “Contingencies & Events Occurring After the Balance Sheet Date” for the purposes of “Subsequent Events”. the auditor would consider whether such events have been properly accounted for in the financial statements. affecting the financial statements. which in his judgement might have a significant effect on the financial statements or on examination or audit report. by employing the following procedures:♦ ♦ ♦ ♦ ♦ Review of management’s procedures to identify subsequent events. Statements and Guidance Notes – An Overview 1. discussion with legal advisors etc. The AAS becomes operative for all audits commencing on or after 1st April. The AAS defines subsequent Events as significant events occurring between the balance sheet date and the date of the auditor’s report. 1. where required. the auditor would need to express a qualified or an adverse opinion as appropriate. forecasts etc. In case of subsequent events materially affecting the financial statements.Auditing Standards. transactions and practices. discussion with internal auditors. In case of a new engagement.17 1. 2000. Where the management does not account for such events. timing and extent of audit procedures. Inquiring the lawyers of the entity as to the litigations and claims. board of directors etc. review of internal audit reports. have been identified and adjusted/disclosed. its importance to the auditor and the audit staff. Auditor’s level of knowledge would include a general knowledge of the economy and the industry within which the entity operates and a more particular knowledge of how the entity operates. and how the auditor obtains and uses the knowledge. The AAS also refers to Accounting Standard 4. viz. the auditor would need to update and reevaluate information gathered previously and would also perform procedures designed to identify significant changes that have taken place since the last audit. discussion with senior operating personnel of the entity. the auditor should consider the effect of subsequent events on the financial statements and on the auditor’s report. Inquiring management as to any subsequent events after the balance sheet date.19 AAS 19 : Subsequent Events . The AAS requires the auditor to obtain sufficient appropriate audit evidence that all “subsequent events”.This AAS deals with the definition of the knowledge of the business. Reading the latest available interim financial information. Reading of minutes of meetings of shareholders.5. The auditor should be such knowledge to assess inherent and control risks and to determine the nature. viz. the auditor would need to obtain a preliminary knowledge of the industry and of nature of ownership/management and operations of the entity.5.. in the financial statements. previous experience with entity/industry. its relevance to the audit.This AAS outlines the auditor’s responsibility in respect of subsequent events. For continuing engagements.

in planning and performing audit procedures and in evaluating results thereof. plan and perform the audit. may act as a deterrent.21 AAS 21 : Consideration of Laws and Regulations in an Audit of Financial Statements The AAS lays down the standards in respect of the auditor’s responsibility regarding consideration of laws and regulations in an audit of financial statements. he should obtain an understanding of the nature of the act.1. and its compliance therewith. Effective use of knowledge requires the auditor to consider its effect on the financial statements taken as a whole and also consider whether the financials statement assertions are consistent with his knowledge of the business. 1.5. The AAS is operative for all audits commencing on or after 1st April. accordingly. The auditor should ensure that the audit staff should obtain sufficient knowledge of the business. the auditor should recognize that non-compliance by the entity with laws and regulations may materially affect the financial statements. evaluating audit evidence. the auditor should perform procedures to identify the instances the non-compliance affecting the financial statements. The AAS requires the auditor to obtain written representations from management regarding possible or actual non-compliance with laws and regulations whose affects should be considered while preparing financial statements. however. and is generally based on the advice of an informed expert qualified to practice law but ultimately can only be decided by a court of law. and sufficient other information to evaluate the possible effect on the financial statements. and audit. and providing better services to clients. The auditor should also document the findings and discuss them with management. (b) The responsibility of ensuring that the entity’s operations are carried out in accordance with laws and regulations and that of prevention and detection of non-compliance is that of the management. 2000. planning and performing audit effectively and efficiently. The auditor should also obtain evidence regarding compliance with such laws and regulations which effect the determination of material amounts and disclosures in financial statements. (d) The risk that some material misstatements of financial statements are not detected by audit is higher in case of material misstatements resulting from non-compliance with laws and regulations. the circumstances in which it had occurred. When the .. viz. provides that: (a) Whether an act constitutes non-compliance is a legal determination that is ordinarily beyond the auditor’s professional competence. After obtaining a general understanding of the legal and regulatory framework applicable to the entity. When the auditor becomes aware of information regarding a non-compliance. The AAS. (e) The auditor should recognise that the audit may reveal conditions or events that would lead to questioning the compliance with laws and regulations by the entity and should.18 Advanced Auditing and Professional Ethics The knowledge so obtained would assist the auditor in assessing risks and identifying problems. (c) The auditor is not and cannot be held responsible for preventing non-compliance. however.

The auditor would also need to be satisfied regarding the following matters in respect of the opening balances: ♦ ♦ ♦ ♦ Accounting policies followed by the entity.Opening Balances . the auditor should express a qualified or a disclaimer of opinion.. AAS requires that the auditor should review information provided by the management of the entity identifying the names of all known related parties and should perform the necessary procedures such as review of records.22 AAS 22 : Initial Engagements .Auditing Standards. The AAS is effective for all audits commencing on or after 1st July.. Statements and Guidance Notes – An Overview 1. that the opening balances do not contain misstatements that materially affect the financial statements for the current period. even though the non-compliance is not material to the financial statements. as appropriate. minutes books. The AAS also requires that the auditor should as soon as practicable communicate the noncompliance to the appropriate level of management. the auditor should consider the effect of lack of evidence on his report.clean/ qualified etc. If the opening balances contain misstatements which materially affect the financial statements for the current period and the effect of the same is not properly accounted for and adequately disclosed.This AAS establishes standards regarding audit of opening balances in case of initial engagements. It requires that the auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence regarding the identification and disclosure by management of related parties and the related party transactions that are material to the financial statements. In case where the entity does not take remedial steps deemed necessary by the auditor. 1. income-tax . Nature of opening balances and the risk of their misstatement in the current period.19 aforesaid information cannot be obtained. Materiality of opening balances relative to the financial statements for the current period. The auditor should obtain sufficient For initial audit engagements the auditor should obtain sufficient audit evidence that the closing balances of the preceding period have been correctly brought forward to the current period.23 AAS 23 : Related Parties . the auditor should express a qualified or an adverse opinion. also that appropriate accounting policies are consistently applied. the auditor should express qualified opinion or an adverse opinion.5. The AAS is operative for all audits commencing on or after 1st July. If the auditor concludes that the non-compliance materially affects the financial statements. the auditor must withdraw from the engagement.e. Nature of audit report of the preceding period .This AAS establishes standards on the auditor’s responsibilities and audit procedures regarding related parties and transactions with such parties. If the auditor is unable to obtain sufficient appropriate audit evidence concerning opening balances. as adequate. 2001. when the financial statements are audited for the first time or when the financial statements for the preceding period were audited by another auditor.5. 1. 2001. i.

the auditor of the client should ♦ ♦ . by the auditor of the client. While auditing transactions with related parties. as may be appropriate.1. When the auditor uses the report of a service organisation's auditor. such disclosure is adequate. While planning the audit.5. the auditor of the client should determine the significance of the activities of the service organisation to the client and their relevance to the audit. AAS requires that the auditor should obtain sufficient appropriate audit evidence as to whether these transactions have been properly recorded and disclosed. and the adequacy of related party disclosures in the financial statements. In examining the identified related party transactions. If the auditor concludes that the activities of the service organisation are significant to the entity and relevant to the audit. Finally. When using a service organisation auditor's report. 2001. 2003. The auditor should also consider the adequacy of control procedures over the authorisation and recording of related party transactions. the auditor of the client should consider the professional competence of the other auditor in the context of specific assignment if the other auditor is not a member of the Institute of Chartered Accountants of India. the auditor should review information provided by directors and key management personnel of the entity identifying related party transactions and should be alert for other material related party transactions. Appendix to the AAS also gives an example of a management representation letter regarding related parties. which may be obtained. to enable completeness of this information. ♦ ♦ ♦ The auditor should consider how a service organisation affects the client's accounting and internal control systems so as to plan and develop an effective audit approach. or a lower level if tests of control are performed. the auditor should obtain sufficient information to understand the accounting and internal control systems of the service organisation and to assess control risk at either the maximum. 1. relevant agreements. if the auditor is unable to obtain sufficient appropriate audit evidence concerning related parties and transactions with such parties or concludes that their disclosure in the financial statements is not adequate. This AAS also describes the reports of the auditors of the service organisation. the auditor should express a qualified opinion or a disclaimer of opinion in the audit report. This Standard becomes operative for all audits related to accounting period beginning on or after April 1. The auditor should obtain a written representation from management concerning the completeness of information provided regarding the identification of related parties.24 AAS 24 : Audit Considerations Relating to Entities Using Service Organisations The purpose of this Standard is to establish standards for an auditor whose client uses a service organisation.20 Advanced Auditing and Professional Ethics returns. AAS also requires the auditor to satisfy himself that where the financial reporting framework requires disclosure of related party relationships. etc. This AAS becomes operative for all audits related to accounting periods beginning on or after 1st April.

This Auditing and Assurance Standard (AAS) establishes standards on auditor's responsibilities regarding comparatives.21 The auditor should consider the scope of work performed by the service organisation's auditor and should assess the usefulness and appropriateness of reports issued by the service organisation's auditor. ♦ • ♦ In such circumstances.25 AAS 25 : Comparatives . the auditor of the client should consider whether the nature. The auditor should obtain sufficient appropriate audit evidence that the corresponding figures meet the requirements of the relevant financial reporting framework. When the auditor of the client uses a report from the auditor of a service organisation. When the auditor's report on the prior period. the auditor's report should also be modified regarding the corresponding figures.Auditing Standards. This Standard becomes operative for all audits relating to accounting period beginning on or after April 1. ♦ 1. with the financial reporting framework relevant to the financial statements being audited. or unresolved. the auditor should examine that: • • . ♦ ♦ 1. the auditor's report should be modified regarding the corresponding figures. Statements and Guidance Notes – An Overview consider the nature of and content of that report. For those specific tests of control and results that are relevant. timing and extent of such tests provide sufficient appropriate audit evidence about the effectiveness of the accounting and internal control systems to support the client auditor's assessed level of control risk. but does not result in a modification of the auditor's report regarding the current period figures. ♦ ♦ ♦ The auditor should determine whether the comparatives comply. no reference should be made in the client auditor's report to the service organisation's auditor's report. 2003. and results in a modification of the auditor's report regarding the current period figures. included a qualified opinion. When the comparatives are presented as corresponding figures. in all material respects. as previously issued. appropriate disclosures have been made. or if appropriate disclosures have not been made.5. including the corresponding figures. the auditor's report should not specifically identify comparatives because the auditor's opinion is on the current period financial statements as a whole. or adverse opinion and the matter which gave rise to the modification in the audit report is: • unresolved. the auditor should issue a modified report on the current period financials modified with respect to the corresponding figures included therein. disclaimer of opinion.

This Auditing and Assurance Standard is effective for all audits relating to accounting periods beginning on or after April 1. This AAS does not provide guidance on communications by the auditor to parties outside the entity. is requested to change the engagement to one which provides a lower level of assurance.27 AAS-27 : Communications of Audit Matters with those Charged with Governance The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on communications of audit matters arising from the audit of financial statements between the auditor and those charged with governance of an entity. ♦ ♦ ♦ ♦ ♦ 1. The auditor should determine the relevant persons who are charged with governance . should consider the appropriateness of doing so. the auditor should consider whether circumstances require the terms of the engagement to be revised and whether there is a need to remind the client of the existing terms of the engagement. An auditor who. The auditor should not agree to a change of engagement where there is no reasonable justification for doing so. for example. On recurring audits. Where the terms of the engagement are changed.The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on agreeing the terms of the engagement with the client. 1.1. ♦ ♦ The auditor should communicate audit matters of governance interest arising from the audit of financial statement with those charged with governance of an entity. the auditor and the client should agree on the new terms. preferably before the commencement of the engagement. 2003. the incoming auditor should state in the auditor's report that the corresponding figures are unaudited. ♦ ♦ The auditor and the client should agree on the terms of the engagement. the auditor should withdraw and consider whether there is any obligation. and the auditor's response to a request by a client to change the terms of an engagement to one that provides a lower level of assurance. external regulatory or supervisory agencies. such as the board of directors or shareholders. In the interest of both client and auditor. 2003. If the auditor is unable to agree to a change of the engagement and is not permitted to continue the original engagement. to report the circumstances necessitating the withdrawal to other parties. either contractual or otherwise. the auditor should send an engagement letter. This Standard becomes operative for all audits relating to accounting periods beginning on or after April 1. to help avoid any misunderstandings with respect to the engagement.22 ♦ Advanced Auditing and Professional Ethics When the prior period financial statements are not audited.26 AAS-26 : Terms of Audit Engagement . before the completion of the engagement.5. These communications relate to audit matters of governance interest as defined in this AAS.5.

When audit matters of governance interest are communicated orally. 2003. Much of the standards laid down by this AAS can be adapted to auditor's reports on financial information other than financial statements. as described in AAS 28.23 The auditor should consider audit matters of governance interest that arise from the audit of financial statements and communicate them with those charged with governance.28 AAS-28 : The Auditor's Report on Financial Statements . ♦ 1. If the auditor considers that having regard to the facts and circumstances of the case a modification of the auditor's report on financial statements is required. the auditor should document in the working papers the matters communicated and any responses to those matters. The auditor's report should be appropriately addressed as required by the circumstances of the engagement and applicable laws and regulations. The auditor's report should contain a clear written expression of opinion on the financial statements taken as a whole. ♦ ♦ ♦ ♦ 1. The auditor's report should have an appropriate title.5. The auditor's report should describe the audit as including: ♦ . Statements and Guidance Notes – An Overview and with whom audit matters of governance interest are to be communicated. The auditor's report should identify the financial statements of the entity that have been audited. Such matters may include: The auditor should communicate audit matters of governance interest on a timely basis.Auditing Standards. The auditor's communication with those charged with governance may be made orally or in writing. “The Auditor's Report in Financial Statements" communications between the auditor and those charged with governance cannot be regarded as a substitute.The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the form and content of the auditor's report issued as a result of an audit performed by an auditor of the financial statements of an entity. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1. ♦ ♦ ♦ ♦ ♦ ♦ The auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. including the date of and period covered by the financial statements. The report should include a statement that the financial statements are the responsibility of the entity's management and a statement that the responsibility of the auditor is to express an opinion on the financial statements based on the audit.

An unqualified opinion should be expressed when the auditor concludes that the financial statements give a true and fair view in accordance with the financial reporting framework used for the preparation and presentation of the financial statements. where appropriate. The report should name specific location. Where the firm is appointed as the auditor. the auditor should not date the report earlier than the date on which the financial statements are signed or approved by management. The date of an auditor's report on the financial statements is the date on which the auditor signs the report expressing an opinion on the financial statements. The auditor should consider modifying the auditor's report by adding a paragraph if there is a significant uncertainty (other than going concern problem).1. assessing the significant estimates made by management in the preparation of the financial statements. and evaluating the overall financial statement presentation. on a test basis. The report should be signed by the auditor in his personal name. which is ordinarily the city where the audit report is signed. Since the auditor's responsibility is to report on the financial statements as prepared and presented by management. the resolution of which is dependent upon future events and which may significantly affect the financial statements. assessing the accounting principles used in the preparation of the financial statements. evidence to support the amounts and disclosures in financial statements. the report should be signed in the personal name of the auditor and in the name of the audit firm. The report should include a statement by the auditor that the audit provides a reasonable basis for his opinion. A qualified opinion should be expressed when the auditor concludes that an unqualified ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ . The auditor should modify the auditor's report by adding a paragraph to highlight a material matter regarding a going concern problem where the going concern question is not resolved and adequate disclosures have been made in the financial statements.24 • • • • ♦ ♦ Advanced Auditing and Professional Ethics examining. The opinion paragraph of the auditor's report should clearly indicate the financial reporting framework used to prepare the financial statements and state the auditor's opinion as to whether the financial statements give a true and fair view in accordance with that financial reporting framework and. whether the financial statements comply with the statutory and regulatory requirements.

1. including quantitative data.5.The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's use of external confirmations as a means of obtaining audit evidence. Statements and Guidance Notes – An Overview 1. External confirmation is the process of obtaining and evaluating audit evidence through a direct communication from a third party in response to a request for information about a . This Auditing and Assurance Standard (AAS) becomes operative for all audits related to accounting periods beginning on or after April 1. Whenever the auditor expresses an opinion that is other than unqualified. ♦ ♦ ♦ ♦ 1. An adverse opinion should be expressed when the effect of a disagreement is so material and pervasive to the financial statements that the auditor concludes that a qualification of the report is not adequate to disclose the misleading or incomplete nature of the financial statements. or limitation on scope is not so material and pervasive as to require a disclaimer of opinion.5. unable to express an opinion on the financial statements. of significance to the audit. the auditor should express a qualified or an adverse opinion. A qualified opinion should be expressed as being 'subject to' or 'except for' the effects of the matter to which the qualification relates. For the purposes of this AAS. unless impracticable.29 AAS-29 : Auditing in a Computer Information System Environment . or the adequacy of disclosures in the financial statements. ♦ A disclaimer of opinion should be expressed when the possible effect of a limitation on scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and is. whether those computers are operated by the entity or by a third party. a clear description of all the substantive reasons should be included in the report and. When there is a limitation on the scope of the auditor's work that requires expression of a qualified opinion or a disclaimer of opinion. on the financial statements should be mentioned in the auditor's report. 2003.30 AAS-30 : External Confirmations .The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on procedures to be followed when an audit is conducted in a computer information systems (CIS) environment.25 opinion cannot be expressed but that the effect of any disagreement with management is not so material and pervasive as to require an adverse opinion.Auditing Standards. individually and in aggregate. the method of their application. a CIS environment exists when one or more computer(s) of any type or size is (are) involved in the processing of financial information. a quantification of the possible effect(s). the auditor's report should describe the limitation and indicate the possible adjustments to the financial statements that might have been determined to be necessary had the limitation not existed. The auditor may disagree with management about matters such as the acceptability of accounting policies selected. accordingly. If such disagreements are material to the financial statements.

26 Advanced Auditing and Professional Ethics particular item affecting assertions made by management in the financial statements. the accountant should issue a report.31 AAS-31 : Engagements to Compile Financial Information . Communicating the confirmation request to the appropriate third party. The process of external confirmations. An engagement letter confirms the accountant’s acceptance of the engagement and helps avoid misunderstanding regarding matters such as the objective and scope of the engagement and the extent of auditors responsibilities. This Auditing and Assurance Standard is effective for audits related to accounting periods beginning on or after 1st April.1. The financial statements on other financial information compiled should be approved by ♦ ♦ ♦ ♦ . consists of the following: ♦ ♦ ♦ ♦ ♦ Selecting the items for which confirmations are needed. The accountant should obtain an acknowledgement from management of it responsibility for the accuracy and completeness of the underlying accounting data and the complete disclosure of all material and relevant information. if the same is not rectified by the management. Designing the form of the confirmation request. Evaluating the information or absence thereof. ordinarily. the auditor considers the characteristics of the environment in which the entity being audited operates and the practice of potential respondents in dealing with requests for direct confirmation. the same should be brought to the attention of management and.The purpose of this Auditing and Assurance Standard (AAS) is to establish Standards on professional responsibilities of an accountant when an engagement to compile financial statements or other financial information is undertaken and the form and content of the report to be issued in connection with such a compilation so that the association of the name of the accountant with such financial statements or financial information is not misconstrued by a user of those statements or information as having been audited by him. Obtaining response from the third party. It is in the interest of both the accountant and the entity that the accountant sends an engagement letter documenting the key terms of appointment. 1.5. In deciding to what extent to use external confirmations. it should be included in the Notes to Accounts and the compilation report of the accountant. ♦ ♦ In all circumstances when an accountant’s name is associated with financial information compiled by him. 2003. If the accountant becomes aware of material non-compliance with any applicable Accounting Standard (s). The accountant should read the complied information and consider whether it appears to be appropriate in form and free from obvious material misstatements.

Auditing Standards, Statements and Guidance Notes – An Overview the client before the compilation report is signed by the accountant.

1.27

This Auditing and Assurance Standard is applicable to all compilation engagements beginning on or after April 1, 204. 1.5.32 AAS-32 : Engagements to Perform Agreed-upon Procedures regarding Financial Information - The purpose of this AAS is to establish standards and provide guidance on the auditor’s professional responsibilities when an engagement to perform agreed-upon procedures regarding financial information is undertaken and on the form and content of the report that the auditor issues in connection with such an engagement. ♦ The objective of an agreed-upon procedures engagement is for the auditor to carry-out procedures of an audit nature to which the auditor and the entity and any appropriate third parties have agreed and to report on factual findings. The auditor should ensure with representatives of the entity and, ordinarily, other specified parties who will receive copies of the report of factual findings, that there is a clear understanding regarding the agreed procedures and the conditions of the engagement. The auditor should carry out the procedures agreed-upon and use the evidence obtained as the basis for the report of factual findings. The procedures applied in an engagement to perform agreed-upon procedures may include: • • • • • ♦ Inquiry and analysis Recomputation, Comparison and other clerical accuracy checks Observation Inspection Obtaining confirmations

♦ ♦

The report on an agreed-upon procedures engagement needs to describe the purpose and the agreed-upon procedure of the engagement in sufficient detail to enable the reader to understand the nature and the extent of the work performed. The report should also clearly mention that no audit or review has been performed.

This Auditing and Assurance Standard is applicable to all agreed-upon procedures engagements beginning on or after April 1, 2004. 1.5.33 AAS.33 : Engagements to Review Financial Statements - The purpose of this Auditing and Assurance Standard (AAS) is to establish standards and provide guidance on the auditor's1 professional responsibilities when an engagement to review financial statements is
As explained in the Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services, the SAPs (now AASs) and Guidance Notes use the term "auditor" when describing both auditing and
1

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Advanced Auditing and Professional Ethics

undertaken and on the form and content of the report that the auditor issues in connection with such a review. This AAS is directed towards the review of financial statements. However, it is to be applied to the extent practicable to engagements to review financial or other related information, for example, interim financial statements prepared by an entity pursuant to Accounting Standard (AS) 25, Interim Financial Reporting. The objective of a review of financial statements is to enable an auditor to state whether, on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to the auditor's attention that causes the auditor to believe that the financial statements are not prepared, in all material respects, in accordance with the financial reporting framework used for the preparation and presentation of the financial statements2 (negative assurance). 1.5.34 AAS-34 : Audit Evidence - Additional Considerations for Specific Items - The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's responsibilities, audit procedures and provide additional guidance to that contained in AAS 5, "Audit Evidence", with respect to certain specific financial statement amounts and other disclosures. Application of the standards and guidance provided in this AAS will assist the auditor in obtaining audit evidence with respect to the specific financial statement amounts and other disclosures. The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence during his attendance at physical inventory counting. The auditor should carry out audit procedures in order to become aware of any litigation and claims involving the entity which may have a material effect on the financial statements. The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence for valuation and disclosure of long term investments. When long-term investments are material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding their valuation and disclosure. The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence for appropriate disclosure of segment information.
related services which may be performed. Such reference is not intended to imply that a person performing related services need be the auditor of the entity's financial statements.
2

Paragraph 3- of Framework of Statements on Standard Auditing Practices" and Guidance Notes on Related Services, issued by the Institute of Chartered Accountants of India, discusses the financial reporting framework.
The paragraph reads as under: "Financial Reporting Framework Financial statements are ordinarily prepared and presented annually and are directed towards the common information needs of a wide range of users. Many of those users rely on financial statements as their major source of information because they do not have the power to obtain additional information to meet their specific information needs. Thus, financial statements need to be prepared in accordance with one, or a combination of: (a) relevant statutory requirements, e.g., the Companies Act, 1956, for companies; (b) accounting standards issued by the Institute of Chartered Accountants of India; and (c) other recognized accounting principles and practices. E.g., those recommended in the Guidance Notes issued by the Institute of Chartered Accountants of India.”

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(Students may note that the Framework of AASs and Guidance Notes on Related Services and AAS 1 to AAS 34 are reproduced in Volume to the book) Guidance Notes 1.6 Various technical committees of the Institute are involved in the task of issuing guidance notes on topics relating to accounting and auditing for guidance of the members. Some of the important topics in auditing on which guidance notes have been issued are discussed below: 1.6.1 Independence of Auditors - Professional integrity and independence is an essential characteristic of any member of the accounting profession. A detailed note on this topic was first published by the Council in 1968. In the light of the experience gained over a period of years, this note was revised by the Council and published as a guidance note in 1975. The revised Guidance Note contains essentially a discussion on relevant section of the Companies Act, 1956, and the provisions of the Chartered Accountants Act, 1949 which aim at ensuring independence of auditors. 1.6.2 Provision for proposed Dividend - Proposed dividend does not represent a liability nor does it amount to a provision, pending the approval of the shareholders in General Meeting. Since the meeting to approve the accounts would take place after the Balance Sheet date, there could not be any liability in respect of the proposed dividend on the date of the Balance Sheet. The Council is of the opinion that merely because the form requires proposed dividend to be shown under “Current Liabilities and Provisions”, it does not mean that in fact the proposal for the dividend becomes a liability or is necessarily a provision. However, forms of accounts laid down under the Insurance Act, 1938 and the Banking Regulation Act, 1949, in both of which it is not a requirement to show “proposed dividend” and it cannot be contended that merely because proposed dividend is not shown in the accounts, that the accounts of Insurance and Banking Companies do not disclose a ‘true and fair’ view. Since, however, the form of Balance Sheet prescribed in Part 1 of Schedule VI requires “proposed dividends” to be shown under “Provisions”, and since paragraph 3(xiv) of Part II of the same Schedule requires the “proposed dividends” to be disclosed, the Council is of the opinion that, though on correct accounting principles, the proposed dividend does not become a liability for reasons mentioned above, the attention of the shareholders would have to be drawn to the fact that no appropriation has been made for the proposed dividend, the amount in respect of which should be specified. The Council of the ICAI , therefore, recommends that the fact that provision for proposed dividend has not been made should be disclosed by means of a note in the accounts and that the auditor should refer to the note in his report and make his report subject thereto. 1.6.3 Auditing of Liquidators - Members of the profession are called upon to conduct the audit of the accounts submitted by a Liquidator in a voluntary winding-up under Section 551. There are no statutory provisions in regard to the manner of conducting such audit, nor is there any statutory provision regarding the form in which the auditors' report is to be submitted after such an audit under Section 551. The Research Committee has considered this question in all its aspects and its recommendations in this connection are outlined below:

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First, the professional skill and audit procedures to be applied in case of an audit under Section 531 would be similar to those applied in the case of the normal audit of a company. Secondly, there should be a fair measure of uniformity in the reports submitted by auditors conducting an audit under Section 551 of the Companies Act, 1956. The Research Committee recommends that the report of the auditor may be on the following lines: (a) Whether he has obtained all the information and explanations, which to the best of his knowledge and belief, were necessary for the purposes of his audit, (b) Whether in his opinion, proper books of account as required by the Companies Act, 1956 and Companies (Court) Rules, 1959 have been kept by the Liquidator, so far as appears from his examination of these books, (c) Whether the Liquidator's Account relating to realisations and disbursements is in agreement with the books and records produced before him, (d) Whether in his opinion, and to the best of his information and according to the explanations given to him, the Liquidator's Account including Annexure I (excepting items included in I (a) in so far as they relate to estimates of the Liquidator and items 4, 5, 6 and 7), Annexure II, III, 1V and V, give the information required by the Companies Act, 1956, and the Companies (Court) Rules, 1059 in the manner so required and give a true and correct view of the realisations and disbursements of the Liquidator. Thirdly, “in order to establish a healthy convention, the Council recommends that, where a chartered accountant acts as a liquidator, the statements of accounts to be filed under Section 551(1) of the Companies Act, 1956, should be audited by a qualified chartered accountant other than the chartered accountant who is the liquidator of the company”. 1.6.4 Guidance Note on Section 293 A of the Companies Act and the Auditor - The Guidance Note was first issued by the Company Law Committee in 1976 when, under Section 293A of the Companies Act, 1956, companies were prohibited from making contributions to a political party or for any political purpose. Since elaborate amendments were incorporated in Section 293A by the Companies (Amendment) Act, 1985, which came into force from May 24, 1985, the Company Law Committee revised the existing Guidance Note in consonance with the amended provisions in 1986. 1.6.5 Guidance Note on Auditor’s Report on Revised Accounts of Companies Before Circulation to Shareholders – This Guidance Note considers the question of the manner in which the auditor should report on accounts amended by the Board after approval and authentication under section 215 of the Companies Act, 1956. This Guidance Note was issued by the Council in December, 1979. The Balance Sheet and the Profit and Loss Account of companies, approved by the Board of Directors and authenticated on its behalf in terms of Section 215 of the Companies Act and audited and reported upon by the statutory auditors are amended by the Companies for various reasons, before circulation to the shareholders. In such cases, the amended accounts are re-approved by the Boards of the Companies and statutory auditors are requested to make a report once again on the amended accounts.

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The Council recommends that members of the Institute, when called upon to issue a report on the amended accounts for the same period consequent upon the revision of the Balance Sheet and/or the Profit and Loss Account should ensure that unless all copies of the original accounts and report are returned to the auditor, and adequate disclosure of the fact of the revision on the accounts already approved by the Board and reported upon by the statutory auditors appears as a specific Note on the amended accounts. In case the statutory auditor is satisfied that the disclosure so made by the company in the Note on the accounts is adequate, there may not be any further need for the auditor to refer to the revision of the Balance Sheet and/or the Profit and Loss Account in his report. However, if the Notes to accounts do not contain any note on the revision or if such a note is contained therein but not considered by the statutory auditor as adequately comprehensive, it will be the duty of the statutory auditor to refer to the fact of revision of the accounts in his report. 1.6.6 Guidance Note on Certificate to be Issued by the Auditor of a Company Pursuant to Companies (Acceptance of Deposits) Rules, 1975 - Section 58A of the Companies Act, 1956, contains certain restrictions on acceptance of deposits by companies. The rules framed in 1975 were amended in 1978 when a provision was made for certification by auditors of the Return of Deposits to be filed by companies. Rule 10(1) of the Companies (Acceptance of Deposits) Rules, 1975 as it stands after the amendment referred to above requires, every company to which these rules apply shall, on or before the 30th day of June of every year, file with the Registrar, a return in the form annexed to these rules and furnishing the information contained therein as on 31st day of March of that year, duly certified by the auditor of the Company. It follows, therefore, that every company to which these rules apply shall prepare the return as on 31st March of every year, shall get the return certified by the concerned auditor and shall submit the audited return to the Registrar of Companies by 30th June. It may be observed that neither the amended Rule 10 of the Companies (Acceptance of Deposits) Rules, 1975 nor the form of return prescribed thereunder provides the manner in which the auditor should certify the return. Even in the form of return, no space has been provided for auditors' certificate. Consequently, no statutory guidance is available to the auditor as regards the scope, manner and limitations inherent in this requirement of certification. This guidance note was issued by the Company Law Committee in 1979 for aiding the members in correctly understanding the implications involved and for securing uniformity in approach. For a detailed discussion refer to Chapter 17. 1.6.7 Guidance Note on Accountants’ Report on Profit Forecasts and/or Financial Forecasts Traditionally, the attest function performed by the members has been in relation to past events. However, our growing and dynamic society seeks professional association in its exercises relating to future events. A manifestation of this is the requirement of banks and financial institutions regarding the preparation of projected cash flow and profitability statements by intending borrowers for the purpose of making an appropriate appraisal of their loan applications. These institutions placed a great reliance on such statements if they were prepared or reviewed by chartered accountants. Research Committee issued this guidance

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note in 1982 to provide guidance to members for preparation and review of profit and financial forecasts for submission to banks and financial institutions. 1.6.8 Guidance Note on Audit Reports and Certificates for Special Purposes - The increasing involvement of members in giving audit reports or certificates on special purpose statements or other information prepared by an enterprise necessitated the need for guidance to the auditor regarding various facets of such assignments including the form and contents of audit reports and certificates for special purposes. In view of this, the Research Committee of the Institute brought out this Guidance Note on Audit Reports and Certificates for Special Purposes in 1984. 1.6.9 Guidance Note on Audit of Accounts of Members of Stock Exchanges - The provision for audit of accounts of members of stock exchanges by chartered accountants was introduced with effect from the financial year commencing April 1, 1984. The Research Committee issued this guidance note explaining the implications of this new provision in 1984. In response to the changes in the working of Stock Exchanges because of introduction of new concepts, this guidance note was amended in 2002. Refer to Chapter 17 for a detailed discussion. 1.6.10 Guidance Note on Tax Audit under Section 44AB of the Income-Tax Act - This Guidance Note was first issued by the Taxation Committee in 1985 and was revised in 1989 and 1998. Recently when tax audit forms were revised, the Fiscal Laws Committee has revised this guidance note in 1999. Refer to Chapter 15 for a detailed discussion. 1.6.11 Guidance Note on Audit of Accounts of Non-Corporate Entities (Bank Borrowers) - The Professional Development Committee issued this guidance note in 1985 when RBI issued a circular advising all scheduled banks to ensure that non-corporate borrowers enjoying aggregate working capital credit limits of Rs.10 lakh or more from the banking system get their accounts audited by chartered accountants in the prescribed manner. Refer to Chapter 17 for a detailed discussion. 1.6.12 Guidance Note on Reports in Company Prospectuses - This Guidance Note was issued by Company Law Committee in 1985. In order that the prospective investors in companies may make their decisions on the basis of proper and adequate information, the Companies Act, 1956, introduced stringent requirements which the companies were required to comply with whenever they intended to offer shares or debentures for public subscription. It was in this context that the requirements relating to issuance of prospectuses by companies assumed importance. The legal formalities in this behalf sought to ensure that the information which would be relevant for the investors to make investment decisions should be complete, comprehensive and at the same time truthful. The requirements, inter alia, included certain reports to be given by the chartered accountants about the companies to the investors. This Guidance Note explains the manner of giving such reports given by our members. 1.6.13 Guidance Note on Audit of Abridged Financial Statements - The Companies (Amendment) Act, 1988, brought about significant changes in Section 219 of the Companies Act, 1956. By virtue of these amendments, a company listed on a recognised stock exchange could send abridged balance sheet and abridged profit and loss account to its members, etc. subject to certain conditions. The form of these abridged financial statements had been

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prescribed by the Central Government. The Companies Act, 1956, did not specifically require audit of abridged financial statements. The audit of abridged financial statements assured the readers that the relevant information was properly disclosed in such statements and thus lended a greater degree of credibility to them. Considering this, the AASB issued this Guidance Note in 1990 which provides guidance to the members on issues relating to such audit. 1.6.14 Guidance Note on Certification of Documents for Registration of Charges - The Department of Company Affairs had directed the appropriate authorities to take the documents relating to registration of a charge, on record, if such documents were duly certified as correct, among others, by a chartered accountant in practice. This, in retrospect reflected the growing faith in the competence of members of our profession. Since the procedure for registration of charges involves a number of documents, the Corporate Laws Committee issued this guidance note in 1994, with a view to provide guidance to the members, who may be called upon to certify the relevant documents. 1.6.15 Guidance Note on Audit of Banks - The Institute had, in 1967, issued a study on audit of banks. However, banking is a dynamic activity, which has constantly been undergoing a change. In recent years, there has been a remarkable change in the nature, volume and spread of transactions of banks. Apart from this, the non-traditional functions of banks, e.g., foreign exchange activities, merchant banking, portfolio management, investment, etc. have acquired considerable importance during this period. Another significant development from the auditors’ view point was the issuance, by the Reserve Bank of India, of detailed guidelines regarding income recognition, asset classification, provisioning and other related matters. Yet another development which affected the work of bank auditors was the revision of formats of financial statements. Accordingly, in 1994, AASB issued this comprehensive guidance note for the guidance of our members on, amongst others, these important issues. In 2001, a thoroughly revised guidance note was issued by the Institute. Refer to Chapter 11 for a detailed discussion. 1.6.16 Guidance Note on Audit Reports / Certificates on Financial Information in Offer Documents - Investors’ confidence is an important pre-requisite for the sustained development of capital markets to ensure economic development of a country. One of the confidence building measures was the provision of detailed relevant information to the investors for taking well-informed investment decisions. In this context, an offer document for corporate securities is like a window through which the prospective investors get authentic details about the prospects of a company. Recognising this, SEBI issued Guidelines for Disclosure and Investors Protection which required, inter alia, more transparent, detailed, and dependable offer documents which would promote investors confidence to maintain a conducive investment atmosphere in Indian capital market. SEBI has also been issuing clarifications to the aforesaid Guidelines with a view to, inter alia, enhancing the qualitative characteristics of offer documents. Much of the information contained in an offer document is financial in nature. To impart credibility to the financial information, Schedule II to the Companies Act, 1956, requires some important financial information to be contained in the auditor’s report and the report of the accountant in Schedule II now has to be adjusted for amounts in respect of the qualifications in the report of the auditor on annual accounts, previous year adjustments,

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change in accounting policies, etc. so as to provide a uniform trend of profit in the statement of profit to the prospective investors. The said clarifications also required additional financial information to be disclosed in the offer document, e.g., accounting ratios. These new requirements have increased the responsibility of the reporting auditors and accountants. The Research Committee issued this Guidance Note in 1996. 1.6.17 Guidance Note on Revision of Audit Report - A revision of audit report may be warranted in other instances involving reasons such as apparent mistakes, wrong information about facts, subsequent discovery of facts existing at the date of the audit report, etc. The nature and range of instances may vary from one enterprise to another depending upon facts and circumstances. The Guidance Note on Revision of Audit Report provides guidance regarding revision of the audit report if the same has been issued, in case the auditors consider. 1.6.18 Guidance Notes on Audit of Items in Financial Statements - AASB has issued guidance notes on audit of various items appearing in the financial statements from time to time. These guidance notes explain the manner in which audit of records relating to these items should be carried out. These guidance notes have been issued on the following topics: ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ Fixed Assets Investments Inventories Debtors and Loans and Advances Cash and Bank Balances Miscellaneous Expenditure Liabilities Revenue Expenses

1.6.19 Guidance Note on Special Considerations in the Audit of Small Entities - The objective of this Guidance Note is to describe the characteristics that are commonly found in small entities and indicate how they might affect the application of AASs. This Guidance Note, thus, includes: (a) discussion of the characteristics of small entities; and (b) guidance on the application of AASs to the audit of small entities; 1.6.20 Guidance Note on Audit of Consolidate Financial Statements - The Guidance Note on Audit of Consolidate Financial Statements lays down the audit principles and procedures in case an entity consolidates financial statements. Special consideration like permanent consolidation adjustments current consolidation adjustments etc. and the reporting have also been dealt with.

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1.6.21 Guidance Note on Computer Assisted Audit Techniques - For Computerised Information System (CIS) environment Computer Assisted Audit Techniques (CAATs) enjoy wide acceptability on account of ease of use, reliability, cost and time effectiveness and analytical capabilities. Recognising the developments in the field of technology and its impact on the accounting profession in India, Auditing and Assurance Standards Board had issued AAS 29. ‘Audit in Computer Information System Environment’. This Guidance Note is issued as a sequel to that AAS. The Guidance Note deals with the concepts of CAATs and related pertinent issues like what CAATs are, how to use, test and control them. This Guidance Note applies to all uses of CAATs when a computer of any type or size is involved whether that computer is operated by the entity or by a third party. Refer to Chapter 4 for a detailed discussion. Guidance Note(S) on Related Services 1.7 The framework for auditing and related services makes it clear that there can be different layers of assurance depending upon the nature of services being performed by the chartered accountant. Related Services comprise of Review engagements, Agreed upon Procedures and Compilation Engagement. Reviews engagements involve providing moderate assurance (or negative assurance) but other two services, viz., and compilation and agreed upon procedures provide no assurance at all. The Institute has issued guidance notes covering these aspects of related services in a comprehensive manner. Authority Attached to the Documents Issued by the Institute 1.8 The Institute has, from time to time, issued ‘Statements’ and ‘Guidance Notes’ on a number of matters. With the formation of the Accounting Standards Board and the Auditing and Assurance Standards Board, Accounting Standards and Auditing and Assurance Standards have also been issued. The level of authority attached to these documents and the degree of compliance required in respect thereof has been explained by the Institute through its various announcements issued from time to time. 1.8.1 Statements - The ‘statements’ have been issued with a view to securing compliance by members on matters which in the opinion of the council of the institute are critical for the proper discharge of their functions. ‘statements’ therefore are mandatory. Accordingly, while discharging their attest function, it is the duty of the members of the institute. (a) to examine whether ‘Statements’ relating to accounting matters are complied with in the presentation of financial statements covered by their audit. In the event of any deviation from such ‘Statements’, it is their duty to make adequate disclosures in their audit reports so that the users of financial statements may be aware of such deviations; and (b) to ensure that the ‘Statements’ relating to auditing matters, are followed in the audit of financial information covered by their audit reports. If, for any reason, a member, has not been able to perform an audit in accordance with such ‘Statements his report should draw attention to the material departures there from. A list of ‘Statements issued by the Institute which are in force is given below: (i) Statement on Auditing practices.

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Advanced Auditing and Professional Ethics Statement on Payments to Auditors for Other Services,

(iii) Statement on the Companies (Auditor’s Report) Order, 2003 (Issued under Section 227(4A) of the Companies Act, 1956). (iv) Statement on Qualifications in Auditor’s Report. (v) Statement on the Amendments to Schedule VI to the Companies Act. 1.8.2 Guidance Notes - ‘guidance notes’ are primarily designed to provide guidance to members on matters which may arise in the course of their professional work and on which they may desire assistance in resolving issues which may pose difficulty. Guidance notes are recommendatory in nature. A member should ordinarily follow recommendations in a guidance note relating to an auditing matter except where he is satisfied that in the circumstances of the case, it may not be necessary to do so. Similarly, while discharging his attest function, a member should examine whether the recommendations in a guidance note relating to an accounting matter have been followed or not. If the same have not been followed, the member should consider whether keeping in view the circumstances of the case, a disclosure in his report is necessary. 1.8.3 Accounting Standards and Auditing and Assurance Standards - The ‘accounting standards’ and ‘auditing and assurance standards’ establish standards which have to be complied with to ensure that financial statements are prepared in accordance with generally accepted accounting standards and that auditors carry out their audit in accordance with the generally accepted auditing practices. They become mandatory on the dates specified in the respective document or notified by the council. There can be situations in which certain matters are covered both by a ‘Statement’ and by an ‘Accounting Standard’/ ‘Auditing and Assurance Standard. In such a situation, the ‘Statement’ prevails till the time the relevant ‘Accounting Standard’/ Auditing and Assurance Standard becomes mandatory. Once an ‘Accounting Standard’/ ‘Auditing and Assurance Standard’ becomes mandatory, the concerned ‘Statement’ or the relevant part thereof automatically stands withdrawn. Auditing and Assurance Standards (AASs) establish standards, which have to be complied with to ensure that auditors carry out their duties in accordance with the generally accepted auditing practices. They become operative (i.e., mandatory) in respect of audit of all enterprises on the dates specified in the respective AASs or notified by the Council. The duties of the members of the Institute in relation to operative AASs are similar to those in respect of ‘Statements’ relating to auditing matters, as described in paragraph 2 (b) above. 1.8.4 Accounting Standards - Accounting Standards are formulated by the Accounting Standards Board and issued by the Council of the Institute. The Accounting Standards are issued for use in the presentation of ‘general purpose financial statements’ which are issued to the public by such ‘commercial, industrial or business enterprises’ as may be specified by the Institute from time to time and subject to the attest function of its members. They become mandatory on the dates specified in the respective Accounting Standards or notified by the Council in this behalf.

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(a) The term ‘General Purpose Financial Statements’ includes balance sheet, statement of profit and loss and other statements and explanatory notes which form part thereof, issued for the use of shareholders/members, creditors, employees and public at large. (b) The reference to ‘commercial, industrial or business enterprises’ is in the context of the nature of activities carried on by an enterprise rather than with reference to its objects. The Accounting Standards apply in respect of commercial, industrial or business activities of any enterprise, irrespective of whether it is profit oriented or is established for charitable or religious purposes. Accounting Standards will not, however, apply to those activities which are not of commercial, industrial or business nature (e.g. an activity of collecting donations and giving them to flood affected people). The exclusion of an entity from the applicability of the Accounting Standards is permissible only if no part of the activity of entity is commercial, industrial or business in nature. In other words, even if a very small proportion of the activities of an entity is considered to be commercial, industrial or business in nature, then it can not claim exemption from the application of Accounting Standards. In such a case the Accounting Standards will apply to all its activities including those which are not commercial, industrial or business in nature. The Companies Act, 1956, as well as many other statutes require that the financial statements of an enterprise should give a true and fair view of its financial position and working results. This requirement is implicit even in the absence of a specific statutory provision to this effect. However, what constitutes ‘true and fair’ view has not been defined either in the Companies Act, 1956, or in any other statute. The Accounting Standards (as well as other pronouncements of the Institute on accounting matters) seek to describe the accounting principles and the methods of applying these principles in the preparation and presentation of financial statements so that they give a true and fair view. The ‘Preface to the Statements of Accounting Standards’ issued by the Institute in 2004 states (paragraphs 6.1 and 6.3): “6.1 While discharging their attest function, it will be the duty of the members of the Institute to examine whether the Accounting Standard is complied with in the presentation of financial statements covered by their audit. In the event of any deviation from the Accounting Standard, it will be their duty to make adequate disclosures in their reports so that the users of such statements may be aware of financial deviations.” “6.3 Financial Statements can not be described as complying with the Accounting Standards unless they comply with all the requirements of each applicable standard.” Once an Accounting Standard becomes mandatory, the duties of an auditor with respect to such standard are the same as those specified at paragraph 2(a) above.

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Standards 4 and 5 were made mandatory in respect of accounting periods commencing on or after 1.1.1987 for all commercial industrial or business enterprises. Accounting Standards 1, 7, 8, 9 and 10 were initially made mandatory in respect of accounting periods commencing on or after 1.4.1991 for companies governed by the Companies Act, 1956 as well as for other commercial, industrial or business enterprises except the following: (a) Sole proprietory concerns/individuals (b) Partnership firms (c) Societies registered under the Societies Registration Act (d) Trusts (e) Hindu undivided families (f) Associations of persons. Accounting Standards 1, 7, 8, 9 and 10 were made mandatory in respect of general purpose financial statements of enterprises listed at (a) to (f) above, for accounting periods commencing on or after 1.4.1993 where such statements were statutorily required to be audited under any law. In this regard, the Council of the Institute has clarified that the mandatory accounting standards also apply in respect of financial statements audited under Section 44AB of the Income tax Act, 1961. Accordingly, members should examine compliance with the mandatory accounting standards when conducting such audit. AS-6 was made mandatory in respect of accounts for periods commencing on or after 1.4.1995. The remaining Accounting Standards i.e. AS 11, 12, 13, 14 and 15 have been made mandatory with effect from the dates specified in the standards themselves. While discharging their attest function, the members of the Institute may keep the following in mind with regard to mandatory Accounting Standards. AS I - Disclosure of Accounting Policies - In the case of a company, members should qualify their audit reports in case : (a) accounting policies required to be disclosed under Schedule VI or any other provisions of the Companies Act, 1956, have not been disclosed, or (b) accounts have not been prepared on accrual basis, or (c) the fundamental accounting assumption of going concern has not been followed and this fact has not been disclosed in the financial statements, or (d) proper disclosures regarding changes in the accounting policies have not been made. Where a company has been given a specific exemption regarding any of the matters stated in paragraph 16 above but the fact of such exemption has not been adequately disclosed in the accounts, the member should mention the fact of exemption in his audit report without necessarily making it a subject matter of audit qualification. If accounting policies have not been disclosed at one place or if certain significant accounting policies have not been disclosed, by a company on the ground that their disclosure is not required under the Companies Act, 1956, the member should disclose the fact in his audit report without necessarily making it a subject matter of audit qualification. Such a disclosure
The Council has classified the enterprises for the purpose of applicability of Accounting Standards into three Categories, viz. Level I, Level II and Level III. This scheme comes into effect in respect of accounting periods commencing on or after 1-4-2004
*

*Accounting

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would not constitute a reservation, qualification or adverse remark except where the auditor has specifically made it a subject matter of audit qualification. Accordingly in the case of a company, the Board of Directors need not provide information or explanation with regard to such a disclosure (except where the same constitutes a qualification) in their report under subsection (3) of Section 217 of the Companies Act, 1956. In the case of enterprises not governed by the Companies Act, 1956, the member should examine the relevant statute and make suitable qualification in his audit report in case adequate disclosures regarding accounting policies have not been made as per the statutory requirements. Similarly, the member should examine if the fundamental accounting assumptions have been followed in preparing the financial statements or not. In appropriate cases, he should consider whether, keeping in view the requirements of the applicable laws, a qualification in his report is necessary. In the event of non-compliance, by enterprises not governed by the Companies Act, 1956, with the disclosure requirements of AS1 in situations where the relevant statute does not require such disclosures to be made, the member should make adequate disclosure in his audit report without necessarily making it a subject matter of audit qualification. Other Mandatory Accounting Standards - While making a qualification, the auditor should follow the requirements of the ‘Statement on Qualifications in Auditor’s Report’ issued by the Institute. Subject to this, non-compliance with any of the requirements of a mandatory Accounting Standard other than AS 1 by any enterprise should be a subject matter of qualification except that, to the extent that the disclosure requirements in the relevant standard are in addition to the requirements of the Companies Act, 1956, or any other applicable statute, the member should disclose the fact of non - compliance with such disclosure requirements in his audit report without necessarily making it a subject matter of audit qualifications. Financial Statements Prepared on a Basis other than Accrual - With regard to the fundamental accounting assumption of accrual, the Council of the Institute has made a specific announcement that in respect of individuals/bodies covered by para AS I - Disclosure of Accounting Policies above, the auditor should examine whether the financial statements have been prepared on accrual basis. In cases where the statute governing the enterprise requires the preparation and presentation of financial statements on accrual basis but the financial statements have not been so prepared, the auditor should qualify his report. On the other hand, where there is no statutory requirement for preparation and presentation of financial statements on accrual basis, and the financial statements have been prepared on a basis other than ‘accrual’, the auditor should describe in his audit report, the basis of accounting followed, without necessarily making it a subject matter of a qualification. In such a case the auditor should also examine whether those provisions of the accounting standards which are applicable in the context of basis of accounting followed by the enterprise have been complied with or not and consider making suitable disclosures/qualifications in his audit report accordingly.

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Manner of Making Qualification Disclosure in the Audit Report - In making a qualification/disclosure in the audit report in respect of non-compliance with a Statement, AAS, Accounting Standard or Guidance Note, the auditor should consider the materiality of the relevant item. Thus, the auditor need not make qualification/disclosure in respect of items which, in his judgement, are not material. While making a qualification, the auditor should follow the requirements of the ‘Statement on Qualifications in Auditor’s Report’ issued by the Institute. A disclosure, which is not a subject matter of audit qualification, should be made in the auditor’s report in a manner that it is clear to the reader that the disclosure does not constitute an audit qualification. The paragraph containing the auditor’s opinion on true and fair view should not include a reference to the paragraph containing the aforesaid disclosure. Examples of Qualifications/Disclosures in the Audit Report - Given below are some examples which illustrate the manner of making qualification/disclosure in the audit report. It may be clarified that these examples are aimed only at illustrating the manner of making qualifications/disclosures and are not intended in any way to be exhaustive. Examples of Qualifications (a) Where proper disclosures regarding changes in accounting policies have not been made by a company. "The profit and loss account and balance sheet comply with the accounting standards referred to sub-section (3C) of Section 211 of the Companies Act, 1956, except Accounting Standard (AS) 5, 'Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies', as the company has not disclosed in its accounts the fact of change, from this year, in the method of providing depreciation on plant and machinery from straight-line method to written-down value method, as also the effect of this change. As a result of this change, the net profit for the year, the net block as well as the reserves and surplus are lower by Rs. …. Each as compared to the position which would have prevailed had this change not been made. Subject to the above, we report that ……..". (b) Where a manufacturing company has accounted for interest income on receipt basis and not on time proportion basis. "The profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of Section 211 of the Companies Act, 1956, except Accounting Standard (AS) 9, 'Revenue Recognitions', as the company has followed the policy of accounting for interest income on receipt basis rather than on time proportion basis. As a result, the net profit for the year and the current assets are understated by Rs…… each as compared to the position which would have prevailed if the company had accounted for interest income on time proportion basis. Subject to the above, we report that ….."

Auditing Standards, Statements and Guidance Notes – An Overview

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(c) Where an enterprise has capitalised financing costs related to certain fixed assets for periods after such assets were ready to be put to use. "The profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of Section 211 of the Companies Act, 1956, except Accounting Standard (AS) 16, 'Borrowing Costs', as interest payable on borrowings related to the acquisition of fixed assets has been capitalised for the periods after which the assets were put to use. Consequently, the net profit for the year, the net block of fixed assets and the reserves and surplus have been overstated by Rs….. each as compared to the position which would have prevailed if the company had complied with the requirements of AS 16. Subject to the above, we report that ……" Examples of Disclosures (a) Where a company has not disclosed all significant accounting policies and has also not disclosed the accounting policies at one place. "The profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of Section 211 of the Companies Act, 1956, except Accounting Standard (As) 1, 'Disclosure of Accounting Policies', as the company has disclosed those accounting policies the disclosure of which is required by the Companies Act, 1956. Other significant accounting policies, relating to treatment of research and development costs have not been disclosed nor have all the policies been disclosed at one place. We report that ….." (b) Where a partnership firm does not make adequate disclosures regarding the revaluation of its fixed assets. "During the year, the enterprise revalued its land and buildings. The revalued amounts of land and buildings are adequately disclosed in the balance sheet. However, the method adopted to compute the revalued amounts has not been disclosed, which is contrary to Accounting Standard (AS) 10, 'Accounting for Fixed Assets' issued by the Institute of Chartered Accountants of India. We report that ……." (c) Where a sole proprietary concern enterprise follows cash basis of accounting. "It is the policy of the enterprise to prepare its financial statements on the cash receipts and disbursements basis. On this basis revenue and the related assets are recognised when received rather than when earned, and expenses are recognised when paid rather than when the obligation is incurred. In our opinion, the financial statements give a true and fair view of the assets and liabilities arising from cash transactions of …….. at ……… and of the revenue collected and expenses paid during the year then ended on the cash receipts and disbursements basis as described in Note X."

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Advanced Auditing and Professional Ethics

Applicability of Accounting Standards to charitable and/or religious organisations - The Accounting Standards Board has received a query as to whether the accounting standards formulated by it are applicable to organisations whose objects are charitable or religious. The Board has considered this query and its views in the matter are set forth in the following paragraphs. The Preface to the Statements of Accounting Standards states: “The Institute will issue Accounting Standards for use in the presentation of the general purpose financial statements issued to the public by such commercial, industrial or business enterprises as may be specified by the Institute from time to time and subject to the attest function of its members”. The reference to commercial, industrial or business enterprises in the aforesaid paragraph is in the context of the nature of activities carried on by an enterprise rather than with reference to its objects. It is quite possible that an enterprise has charitable objects but it carries on, either wholly or in part, activities of a commercial, industrial or business nature in furtherance of its objects. The Board believes that Accounting Standards apply in respect of commercial, industrial or business activities of any enterprise, irrespective of whether it is profit oriented or is established for charitable or religious purposes. Accounting Standards will not, however, apply to those activities which are not of a commercial, industrial or business nature. (e.g. an activity of collecting donations and giving them to flood affected people). It is also clarified that exclusion of an entity from the applicability of the Accounting Standards would be permissible only if no part of the activity of such entity was commercial, industrial or business in nature. For the removal of doubts, it is clarified that even if a very small proportion of the activities of an entity was considered to be commercial, industrial or business in nature, then it could not claim exemption from the application of Accounting Standards. The Accounting standards would apply to all its activities including those which were not commercial, industrial or business in nature.

2 AUDIT STRATEGY. (b) establishing the expected degree of reliance on internal control.Before an auditor accepts a new appointment. volume and technicality of the economic operations. and (c) coordinating the work to be performed. timing and extent of the audit of procedures to be performed. Planning in auditing encompasses developing an overall plan for the expected scope and conduct of the audit and developing an audit programme showing the nature. and (v) co-ordination of work done by other auditors and experts. among other things: (a) acquiring knowledge of the client’s accounting system. AAS-8 issued by the Institute deals with ‘Audit Planning’. therefore. Any such important technical function as auditing requires a thorough planning to avoid slips and omissions which may take place because of the complexity. It is needless to say that multitudes of significant decisions in the economic society are taken based on the financial information and. AAS-1 on Basic Principles Governing an Audit of Financial Statements states that audit planning is necessary to conduct an effective audit in an efficient and timely manner.1 Before Engagement . (iii) completing the work expeditiously. (c) determining and programming the nature. According to this. PLANNING AND PROGRAMMING Commencing an Audit 2. Careful and adequate audit planning is helpful in: (i) ensuring devotion of appropriate attention to important areas of the audit.1 Auditing has been conceived of to provide a highly useful technical service to the economy to know performances in financial and other appropriate terms in a reliable manner. plans should be made to cover. ensuring reliability of such information is an imperative necessity. (ii) promptly identifying potential problems. he should communicate by a letter with the retiring auditor to see if there is any professional reason why . and internal control procedures. (iv) proper utilisation of assistants.1. It is necessary to document reasons of significant changes in audit planning. policies. Planning is a continuous process and changes in conditions or unexpected results of audit procedures may cause revisions of the overall plan as well as the detailed audit programme. timing and extent of audit procedures. It has been stated that the audit plans should be based on a knowledge of client’s business. 2.

The extent of any audit work must be precisely defined to ensure that there are no misunderstandings as to the scope of work. To emphasise that the directors are primarily responsible for producing ‘true and fair’ accounts. and even to undue pressure being placed upon auditors to comply with directors’ wishes concerning the accounts. To confirm any other services which are to be provided.2. from whom authority must be obtained before writing.1. the auditor can begin collecting the information necessary to commence his detailed . To stress that the audit should not be relied upon necessarily to prevent or detect fraud and error as this is not its main purpose. although it should also be stressed that normal audit procedures can be expected to considerably reduce the likelihood of such occurrences. one to be signed and returned by the client as acknowledgement of and agreement to the terms contained therein. If the audit is that of a limited company. to dubious trading practices. then the appointment should not be accepted. including the basis on which fees will be charged.1. and the engagement has been documented in the form of an engagement letter. 2. engagement letter has the following functions: ♦ ♦ ♦ ♦ ♦ ♦ To define the scope of the audit in the event that it is not defined by statute. Two copies of the letter should be sent. and it can also be seen as a matter of professional courtesy to the previous holder of the post. If such authority is not forthcoming or if the existing auditor is prevented from revealing anything of the client’s affairs. Such circumstances may range from failure to pay fees. but occasionally circumstances may reveal which could affect an acceptance decision. But if the client is a partnership or sole trader. And whatever may be the type of audit. 2. The Many audit firms have standard engagement letters to cover different circumstances. The duty to communicate should be explained to the potential client. at this stage it will also be appropriate to discuss the basis for charging the fee. To confirm any verbal agreements. then it will be very necessary to discuss the precise scope of the work that is required.2 Advanced Auditing and Professional Ethics the appointment should be refused.AAS-26 deals with Terms of Audit Engagement.Once a satisfactory reply has been received from the retiring auditor. and this is the best achieved by an engagement letter as discussed below. Such communication is an ethical requirement as opposed to a legal requirement. To explain in outline how the auditor will approach his task. carefully distinguishing between audit and accountancy work and any other services. the scope of the work is defined by statute. for such would be a strong indication that something is amiss. The requirement to communicate may be seen as one of the ways in which the profession seeks to protect itself against this latter ever-present risk. These and other matters must be put in writing to safeguard the auditor in case of future legal disputes.3 Commencement procedures . Normally the communication will be a routine matter. this can assist considerably in preventing future misunderstandings.2 Audit Engagement Letter . or to point out other services which may possibly be of interest and value to the client.

Details of the financial history of the company. An accounts manual. shops. 2. During the course of acquiring the information it can be extremely valuable to visit the client’s various locations. and whether it is director controlled. Details as to the nature of the business. such as leases. stockbrokers.1. The previous year’s audit working papers. Memorandum and Articles of Association. in his judgement.As per AAS 8. Names and addresses of the client’s advisers. including budgets. etc.Audit Strategy. Details of physical location of factories. the knowledge of the client’s business is one of the critical element in formulating the audit programme. Internal financial management reports for current and previous periods. .. Minutes of meetings of shareholders.4 Knowledge of the client’s business . may have a significant effect on the financial information. the auditor can obtain such knowledge from: ♦ ♦ ♦ ♦ ♦ ♦ ♦ The client’s annual reports to shareholders. This will include: ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ 2. transactions and practices that. Copies of important documents. or club rules. Among other things. with special emphasis on those employees with whom the auditor is likely to have regular contact. or other details as to the accounting system and the accounting records of which it is composed. Having regard to significance of this aspect. e. Board of Directors and important committees. offices. and other relevant files. The client’s policy and procedures manual. including solicitors. The auditor needs to obtain a level of knowledge of the client’s business that will enable him to identify the events. Planning and Programming work. noting whether it is listed or unlisted. An organisation chart of the client’s staff. debenture deeds and major contracts. etc. Discussions with the client. and to meet the employees with whom the auditor is likely to have frequent dealings. 3 A copy of the regulations (if any) of the client. bankers and management consultants. AAS 20 elaborates on this aspect.g. Firm personnel responsible for non-audit services to the client who may be able to provide information on matters that may affect the audit. Copies of previous annual accounts. or partnership agreement. if any. In this way a very valuable initial impression can be gained of the efficiency of the company and of the sort of problems that may be encountered during the course of the audit.

type of products or services and production or distribution methods. Changes in accounting practices and procedures and in the system of internal control.2. Formulating an Audit Programme 2. Assistance of client’s personnel in data preparation. It is useful for students to know how to plan an audit programme. Current Government legislation. industry publications. For example. in addition. Scope and timing of the examination. Visits to the client’s premises and plant facilities. newspapers or text books. trade journals. Discussions with the client might include such subjects as: ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ Changes in management. in the area of fixed assets. we have discussed audit programme generally so as to enable the students to know the utility and nature of audit programmes. audit report and management letters. magazines. organisation structure and activities of the client. The next step in planning is to prepare a written audit programme setting forth the procedures that are needed to implement the overall plan of audit. Existence of parties in whom directors or persons who are substantial owners of the entity are interested and with whom transactions are likely. rules. ♦ ♦ With respect to the previous year’s audit working papers and other relevant files. It may be emphasised that a clear spelling out of audit objectives for each area is important to link up the procedures with audit objectives and to ensure a purposeful audit. Consideration of the state of the economy and its effect on the client’s business. Recent or impending changes in technology. Significant matters arising from previous year’s financial statements. audit objectives can be the following: (i) Ascertaining their existence on the balance sheet date. New or old premises and plant facilities.4 ♦ Advanced Auditing and Professional Ethics Relevant publications of the Institute of Chartered Accountants of India and other professional bodies. Current business developments affecting the client. The programme. . Relevance of any work to be carried out by the client’s internal auditors. may contain audit objectives for each area and should have sufficient detail to serve as a set of instructions to the assistants involved in the audit and as a means to control the proper execution of work. the auditor should pay particular attention to matters that require special consideration and whether they might affect the work to be done in the current year.2 In PCC study material. regulations and directives affecting the client. if any.

he must study the audit programme of different types of business to find out audit procedures that are considered suitable under different conditions and circumstances.Audit Strategy. financial and accounting set-up of the company. (a) Nature of business in which the organisation is engaged . They should be able to identify the assertions made in the Balance Sheet and Profit and Loss Account because that provides key to the auditor’s selection of the procedures. (c) System of internal control and accounting procedures. (e) Information regarding the organisation of business. the quantitative records maintained and the manner in which statistics are compiled in respect of losses in process. This linkage in the mind of the assistants on job is imperative and without this the audit would be just a mechanical performance. (iv) Determining the valuations. In addition. review of working papers. The auditor. the auditor should examine in detail the financial and accounting organisation of the business by visiting the client’s office. (vi) Proper categorisation of assets. (v) Presentation of relevant information for a proper understanding of their nature value and usefulness. He also must find out the technical details of manufacture so that he can test check that the quantities of materials shown to have been issued for various processes of manufacture are in consonance with the technical formulae reported to him. Procedures of verification for this purpose may include physical verification. 2. review of accounting policy on fixed assets. The important matters which need to be considered in this regard are: (a) Nature of business in which the organisation is engaged. and that losses in different processes are not larger than those anticipated. verification of compliance with legal requirements about disclosure and verification of jobs work performed by the assets. he must also visit the factory to acquaint himself with the different processes of manufacture. (d) Size of the organisation and structure of its management.On his first appointment. document verification including verification of loan documents. In the case of an industrial concern. therefore. The . 5 (iii) Finding out encumbrances attaching the assets. checking of provisions for depreciation. for his general guidance. should draw up the programme of audit on a consideration of the technical. the record that is kept and the titles of books in which it is kept. (b) Overall plan prepared for the audit. Planning and Programming (ii) Confirming ownership. (f) Accounting policies followed by the client. The nature of business carried on by the concern has a great relevance to different audit procedures. by observing different stages through which papers pass before each transaction is authorised and recorded. if any. (vii) Generally ascertaining whether the assets are in good working order.

2. Further. any divergence from the overall plan becomes necessary. In the context of our country. Under Section 227(3) of the Companies Act. advertising.6 Advanced Auditing and Professional Ethics Institute of Chartered Accountants of India has brought out Technical Guides concerning audit of specified industries. Internal control may contribute to the reasonable assurance the auditor seeks. 2003 issued under Section 227(4A) of the Companies Act directly requires the auditor to study and evaluate internal control in specific areas. it also unearths errors. (c) System of internal control and accounting procedures . If in drawing the audit programme. he should examine the procedures followed for recording transactions. Therefore it has become an accepted audit practice to study and evaluate internal control. for example.Overall plan for the audit programme should be drawn up to ensure a systematic approach to the work. in framing his opinion on financial statements needs reasonable assurance that transactions are properly authorised and recorded in the accounting records and that transactions have not been omitted. both of omission and of commission. sugar.The existence of a system of internal control is essential for every business organisation. He should also verify that there exists a system of internal . The frame provided by the overall plan should be strictly adhered to. it is essential that the auditor should verify that proper records of transactions entered into by the entity have been maintained and that accounting data collected has been duly analysed. inter alia. The study and evaluation of internal control helps the auditor to establish the reliance he can place on the internal control in determining the nature. it is at these points that he must be satisfied that internal control procedures applied by the entity are effective for his purpose. etc. Students will do well to read them to understand the several technical aspects to be gone into while undertaking the audit of such industries. 2003. It ensures that both financial and statistical records are checked continuously. timing an extent of his substantive auditing procedures. (b) Overall plan . type. first the overall plan should be modified after due consideration and thereafter only the matter may be taken in the audit programme. The auditor. For the purpose. whether proper books of account required by law have been maintained by the company. The auditor also obtains an understanding of the accounting system to identify points in processing of transaction and handling of assets where errors or fraud may occur. It amounts to a statutory requirement to study and evaluate this aspect of internal control. Before commencing an audit. the auditors are required to give their assessment of the internal controls in relation to the nature and size of the company under the Companies (Auditor’s Report) Order. textiles. Maintenance of accurate and complete accounting records constitutes an integral part of internal control. an auditor has to report. When the auditor relies on internal control. the study and evaluation of internal control has become a standard audit procedure for the contribution it can make towards satisfactory discharge of auditing responsibilities and also for the very nature of statutory duty cast on company auditors. the CARO. Maintenance implies maintenance in a complete and accurate manner and it requires a study and evaluation by the auditor. The nature and size of the business is a basic fact to be reckoned in devising the audit procedures and in assessing the adequacy of the internal control in recognition of this.

he may have to modify the nature. questionnaire and flow-chart are available to the auditor to record information relating to internal control. Based on the results of his compliance procedure including observed deviations. The review is made by reference to documents i. (i) Review and preliminary evaluation . provided further that the Stock Section records are properly and regularly maintained. If based on the results of compliance procedure. 7 control which guards against occurrence of mistakes and frauds.The auditor should review the accounting system and related internal control to gain an understanding of the flow of transactions and the specific control procedures to be able to make a preliminary evaluation and identification of these aspects of internal control on which it might be efficient and effective to rely in conducting his audit. testing of compliance and evaluation. If he cannot find another supportive control procedure. It may be useful to trace a transaction through the accounting system to assist in understanding that system and its related internal controls. For example. The auditor may also decide not to rely on any particular internal control. He should enquire whether the internal controls intended to be relied upon were in use throughout the period for which accounts were made up. Selection of the particular technique is a matter of auditor’s own judgement the purpose of preliminary evaluation is to identify the particular controls on which the auditor still intends to rely and to test them through compliance procedures. Compliance procedure is essentially a testing procedure. Different techniques such as narrative description. The auditor’s examination of the system of internal control should have three features: review and preliminary evaluation.e. job descriptions and flow charts and discussions with related personnel of the client. the auditor should evaluate whether the internal controls are adequate for his purposes. The verification of the system of the internal control obtaining in the client’s office is thus the primary duty of the auditor.Audit Strategy.. the auditor concludes that a particular control cannot be substantially relied upon. timing and extent of audit procedures to be applied for that period. He carries it out by examining the manner in which it operates and by application of procedural checks and test checks to a number of transactions of different kinds recorded in the books. If substantially different controls were in use at different times during the period. manuals. Planning and Programming 2. A break-down in internal controls for specific portions of the period would necessitate a separate consideration of the nature.Compliance tests should be conducted by the auditor to gain evidence that those internal controls on which he intends to rely operate generally as identified by him and that they function effectively throughout the period of intended reliance. timing and extent of his substantive audit procedure. (ii) Test of compliance . The compliance procedure normally should be applied to transactions selected from those of the whole period under examination. the auditor should consider each of them separately. he should ascertain whether there exists another control that may satisfy his purpose. he may prefer to rely on Stock Section checking for receipt of the materials as correct quantity. if he finds that materials are not regularly checked for quantity when received at the Receiving Section but Stock Section carries out a quantity check before accepting the materials in stock. It demands that important sections of the record of the concern or selected items of income and expenditure of transactions should be examined “in depth” and by the application of .

. The goods received note and inspection certificate. payment of wages. the auditor should consider to what extent the transactions under review are material in relation to the affairs of the company as a whole.g. evidenced and recorded. to verify in depth a payment to a creditor in respect of goods supplied. Further. The results of compliance procedure directly provide the basis for this evaluation and..g. In the case of a small concern. In certain cases. The evidence that goods have been entered in stock records. in the case of stocktaking. The examination in depth is a method whereby a few selected transactions are traced through various stages from the origin to the conclusion: at each stage. the record and the authority are examined and the operation of internal check and delegation of authority considered. for purpose of verification.2. e. while examining payments to creditors for goods supplied. generally. it would be possible for him to review the main aspects of the system of internal control over a period of years. The number of transactions selected for examination in depth. A copy of the original order and the authority therefore. . sales. need examine only a proportion of these cases with the suppliers’ invoices and statements and a still smaller proportions of the evidence that goods have been recorded in the stock records and so on until a comparatively small proportion is verified completely in depth. In addition. etc. in turn. basis to determine the nature. payment of wages and salaries. e. a large proportion of transactions should be selected for examination in depth or application of procedural tests than is necessary in the case of a large concern since the latter would normally have a more comprehensive system of internal control. purchases.g. Based on the degree of reliance which may be full. after he has verified all the acknowledgements for payments. timing and extent of the substantive audit procedure. the auditor. there are several other audit tests which can be applied to strengthen the effectiveness of the system of internal control.8 Advanced Auditing and Professional Ethics procedural tests to ensure that the transactions have been properly authorised. In this way. in selecting items for examination as well as for deciding the scope of tests. procedural test. e. In addition to the annual review of all procedures.It is essentially an objective process of application of auditor’s judgement to determine whether all or any of the internal controls in the client’s organisation can be relied upon in carrying out the audit. can be reduced as the intricacy of examination increases. it is desirable that each year the auditor makes an intensive review of the accounting procedures relative to one main aspect of the activities of the business.. (iii) Evaluation . For example. partial or none. In evaluating the auditor recognises that some deviations from compliance may have occurred. it will be necessary to examine the following documents: ♦ ♦ ♦ ♦ The invoice and the statement of account received from the supplier. the auditor will programme for the substantive verification of transactions for expression of audit opinion. For example. it is necessary to observe the operation of the system by actual attendance.

(d) Size of the organisation and structure of its management . he may decide to rely upon the control. their impact on the true and fair position of the records should be assessed by extending the area selected for examination. would have a large Board of Directors. the auditor should ascertain the nature and causes thereof. the test checks applied and matters observed on their application as a general guide for drawing up the programme of audit. the controls which may be relied upon only in conjunction with another control and the controls which cannot be relied upon together with appropriate basis. With the increase in the size ordinarily the scope and extent of the system of internal control also should increase but it may not be so in every case. In such cases. he needs only report the result of his findings to the management with a recommendation that the system of internal control be strengthened in such ways as he considers appropriate. a company which is big and is engaged in diverse trade or business. It has been the experience that while many small businesses have excellent controls. For example. If despite this. commercial. financial accounting. In specific terms he will identify the controls which he has decided to rely upon. For instance. depending upon the position the company occupies in the trade or industry in which it is engaged. if it is the duty of the sales manager to verify that various items of goods have been correctly billed to customers and the examination of sales invoices that reveals wrong rates have been applied in the case of one or two invoices. he should state in his report that books of account have not been properly kept. a number of whole-time directors and a team of qualified managers to attend to different aspects of the business activity-technical. In the end. etc. a small . In case they are the result of some inherent defect in the system of recording. there are many such instances. however. the magnitude of the tasks of the auditor increases considerably. management structure of a company is one contemplated by the Companies Act. It is simple or elaborate. If. The structure of management of a concern is governed by law as well as its status in the industry. the presumption would be that the sales manager had failed to discharge his duty. 9 If the tests applied by the auditor reveal certain mistakes in accounting due to which either some transactions have not been recorded or have been wrongly recorded. the auditor should prepare a memorandum as regards the system of internal control in operation. On the other hand.Audit Strategy. Planning and Programming 2. it should be assessed whether the mistake are accidental or otherwise. If. For example. the reports of the Comptroller and Auditor General on audit of accounts of Public Enterprises show that some of them have a very poor system of internal control. the auditor is satisfied that the magnitude of discrepancies or irregularities is not sufficiently large to affect the true and fair character of the accounts of the concern. For example. If he is still not satisfied that the records are sufficiently reliable. In such a case.An increase in the size of the organisation enhances the complexity of the examination of its accounting records specially when it has a number of branches. he may have to extend his substantive audit procedure significantly. the auditor considers that the internal control is inadequate to such an extent that reliance cannot be placed. deals in several products or has a very large turnover. some of the large enterprises are deficient in their operational controls. however.

the auditor should satisfy himself as to the desirability of being associated with the job. On the other hand. its affairs are managed by persons who neither have had formal training nor any commercial or administrative experience.10 Advanced Auditing and Professional Ethics company may only have a managing director who attends to all the affairs of the company and a small board of directors to guide its operations. he should enquire into its standing. by obtaining reports. provided the application of procedural tests shows that accounts are properly maintained. it is necessary that the auditor should obtain from his client information as regards the undermentioned matters: ♦ ♦ ♦ Client’s history and business. etc.To plan audit programme. is absent in a co-operative enterprise. no member of the managing committee has a sizeable investment. nature of business and other similar matters.2. Before accepting a new audit. On that account the Co-operative Societies Act provides a detailed control over the working of co-operative institutions by a Governmental agency (the Registrar). (e) Information as regards organisation of the business . The auditor should have information as regards work of all the companies associated with the client through common ownership of capital or the management. financial background. it may be sufficient for the auditor to carry out only a balance sheet audit.. Moreover. it would be necessary for the auditor to examine the correctness and validity of a large number of transactions entered into by them. Thus. in the case of a co. As far as practicable. For instance. Usually. self-interest which is an incentive to efficient management. on account of the limitation on shareholdings. Details of products manufactured or services rendered and methods of their distribution. The name of subsidiary companies or affiliates as well as the nature of business carried on by each of them. he should also try to ascertain the reputation of the concern as also the honesty and integrity of principal executive. On the basis of the enquiries made he should gather information on the following points: ♦ ♦ Date of incorporation and commencement of business. it would be his duty to examine these matters in greater detail. The structure of management of a co-operative society is the one contemplated by the Cooperative Societies Act. If the concern is not known to him. in the case of a concern in which powers and duties of the management are distributed among a large number of persons and the work of each person is being effectively supervised by the top management. Purpose and nature of engagement. In the alternative. ♦ . Time schedule for the completion of audit. It is also important for the auditor to examine the character of management for determining the seat of power.operative society or a proprietary or partnership concern. it would not be necessary for him to examine each and every decision taken by the management in so far as it affects the finances of the company. If he is satisfied.

The names of financial. on the first appointment it is necessary that the auditor should review the financial statements of the past several years. audited by his predecessors specially those of the immediately preceding previous year. Ltd. (f) Accounting and management policies . On these considerations. also. The objective for which the audit is being conducted so that where necessary the auditor may take the necessary precautions to see that he may not incur any liability for negligence to a person or persons to whom these reports might be presented. but they invariably deal with the following matters: (i) (ii) The method of maintaining the record of stocks. This would indicate to him the last date by which the audit report should be submitted. This matter has become of special importance since the decision in the case of Hedley Byrne & Co. On the other hand. This he should do in all other cases as well.In view of the provisions under Clause (3) (xv) of Part II of Schedule VI to the Companies Act. This information would be helpful to him in preparing a time schedule of his work and that of his assistants so that the audit can be completed by the date the audit report would be required. he must plan to have all the pertinent facts recorded in his working paper. In case it is for filing the income-tax return. This would depend on the purpose for which the auditor has been engaged. If the engagement is in the nature of a tax audit. . The basis adopted for making a provision for payment of bonus to staff. 11 The status in the industry or in the geographical areas or among similar concerns operating within the State. Names and designations of officers holding important positions in the administration of the company. the duties of each officer being demarcated separately. if the audit is for release of financial statements to the shareholders for the annual meeting. Heller and Partners Limited (an English case) and the case of Equity Funding in the United States. This would reveal to him a great deal of information regarding accounting and management policies which have been followed in the past and whether these have been employed consistently. In drawing up the time schedule adequate provision should be made for unforeseen complications and other delays. Planning and Programming ♦ ♦ ♦ ♦ ♦ 2. preparation of the closing inventory and the basis of its valuation. the last date by which the notice should be issued should be ascertained. it is necessary for an auditor to know whether there has been any change in the basis of accounting in order that he may report its effect to the shareholders. the date by which the same is ordinarily required to be filed should be ascertained. It is desirable that the auditor should know the date when the audit report shall be required. These. the accounting principles require a disclosure of change in the basis of accounting.Audit Strategy. technical and tax consultants working for the company. The policies affecting accounts of business engaged in diverse trades differ. This time-schedule should separately show time that a partner would be required to spend and that which the supervisor and senior assistants and junior assistants would be required to spend. vs. in turn must be coordinated with the demands on them of other clients to attain an economical staff utilisation. Location of plants and offices together with a description of activities at each location.

Similarly. the vertical form of balance sheet introduced in the Schedule VI to the Companies Act requires disclosure of Accounting Policies. In this regard. (viii) Procedure for inclusion of expenses for arriving at cost of fixed assets. the details should be filled up on a consideration of the deficiencies in the system of internal control. He will also be able to decide the specific audit procedures which should be applied in each case. verification of provision for tax liability in case of a shipping company regarding freight . (vi) Provision for expenses on post sale services that would have to be rendered to customers in respect of sales of various items of machinery or equipment. On this account. special procedures may have to be applied on a consideration of the nature of business e. After the internal and accounting procedures have been reviewed. The prime test should be that whether the treatment is consistent with the basic principles of accounts.g. It may be noted that AS-1 in mandatory for all corporate as well certain specified non-corporate entities. independent verification of balances of debtors and creditors. He can now decide the areas to be covered by audit.2.g. it is important to note that the Institute of Chartered Accountants of India has always recommended that the auditor should critically examine the accounting policies adopted by the management and test them for conformity with the accounting standards recommended by the Institute. These procedures vary widely because of the conditions under which each concern operates. 2.. (v) Provisions for gratuities payable to staff on retirement.12 Advanced Auditing and Professional Ethics (iii) Treatment to be accorded to research and development expenses. development expenses.. e. e. 1999 has also made it obligatory on the part of companies to follow Accounting Standards (Refer to Section 211). it is not practicable to draw up a typical audit programme.After the auditor has collected the aforementioned information. he will be in a position to draw up the programme of audit. also those to be covered in detail and those which should be covered by the applications of the test checks. (iv) Provision of depreciation in respect of assets. When an auditor is appointed to audit the accounts of an entity for the first time. the extent to which the special procedures need to be applied should be determined. (iii) After the detailed checking formality is over. the audit programme should be developed in three stages stated below: (i) (ii) To begin with. It may also be noted that the Institute of Chartered Accountants of India has issued Accounting Standard-1 and recommended disclosure of significant Accountants Policies.1 Drawing up the audit programme . or with any other authoritative statement. etc. physical inspection of fixed assets. The Companies (Amendment) Act. goodwill. personal inspection of various items of stock included in closing inventories and testing their values. which strictly do not require to be depreciated according to Sub-section (2) of Section 205 of the Companies Act.g. where available. its nature of business and the condition of its accounts.2. mining rights and leaseholds. At times. (vii) Treatment to be accorded to items of deferred revenue expenditure. its form of organisation. a broad outline of the audit programme should be drawn up.

Given below are a few circumstances where in the audit programme would have to be suitably altered: (1) If the audit procedures were designed for a certain volume of turnover and subsequently the volume has substantially increased. (3) Where there has been an extraordinary increase in the amount of book debts or that in the value of stocks as compared to that in the previous year. At each subsequent engagement the programme should be reviewed and. 13 booked in different countries or for making a provision for unexpired liability in case of an insurance company. Such re-consideration is based on the auditor’s review of internal control. modified on account of: (i) (ii) experience gained during the previous audits. it has been discovered that internal control procedures were not as effective as assumed at the time the audit programme was framed. manpower development and co-ordination of work with the client. Identification of significant audit areas.Overall plan is basically intended to provide direction for audit work programming and includes the determination of timing. Applicable legal or statutory requirements. procedures and personnel subsequent to the audit procedures. accounting procedures or in the structure of management or of the scope of business. Accounting policies adopted by the client and changes in those policies. Planning and Programming 2. when there have been significant changes in the accounting organisation.Audit Strategy. other auditors and other experts.2 Development of an overall plan . The auditor should consider the following matters in developing his overall plan for the expected scope and conduct of the audit: ♦ ♦ ♦ ♦ ♦ ♦ Terms of his engagement and any statutory responsibilities Nature and timing of reports or other communication. important changes that have taken place in the business specially in the system of internal control. his preliminary evaluation thereof and the result of his compliance and substantive procedures. It may be noted that the audit plan and related programme should be reconsidered as the audit progresses. (2) Where during the course of an audit. Also. 2. . (4) When a suspicion is aroused during the course of audit or information has been received that assets of the company have been misappropriated. if necessary. etc. and (iii) evaluation of internal control made for the current year. Effect of new accounting or auditing pronouncements on the audit.2.

3. Allocation of work to be undertaken between joint auditors and the procedures for its control and review.10. Involvement of experts.. Final audit to be completed . to be completed by December. Delhi and Kanpur (all the branches to be audited by separate branch auditors). (iii) Branches at Bombay. Name and address of the client Nature of professional work Period for which the professional Particulars of establishment of the client : : : : Progressive Industries Ltd. logical and an adequate audit programme. Annual audit under the provisions of Companies Act. An illustration of documentation of overall plan may be as under: Plan dated 17. and followed by an interim report to the Board. Establishing and co-ordinating staffing requirements. Nature and extent of audit evidence to be obtained. Latest date within which the company is to hold its annual general meeting : 30th September. ♦ ♦ ♦ ♦ ♦ ♦ ♦ ♦ Documentation of the overall planning on due consideration of the above should be done for drawing a systematic. 19XX Accounting year ending on 31st services required March. Madras.XX. Involvement of other auditors in the audit of subsidiaries or branches of the client. (ii) Factory at Tiljala. 52. XXXX 6.14 ♦ ♦ Advanced Auditing and Professional Ethics Setting of materiality levels for audit purposes. Degree of reliance he expects to be able to place on accounting system and internal control. Bose Road. Conditions requiring special attention. Possible rotation of emphasis on specific audit areas. 5.2. Work of internal auditors and the extent of their involvement. such as the possibility of material error or fraud or involvement of parties in whom directors or persons who are substantial owners of the entity are interested and with whom transactions are likely.XX 1. XXXXY (i) Registered office and Head office client at the above address. 2. XYXX. if any. Manner of audit agreed to with the : client Interim checking up to 30. Calcutta. 4. J. in the audit.

10. No. indepth evaluation will be done on payroll and transport. Partner-in-charge of the previous year Letter of appointment for 1994-95 Any non-statutory duty : Mr. 15 and report submitted by 5th August. 15.Senior Mr. 8. : ----: Yes. or assessed Assistants to be deputed for 199495 : : 14. 13. Reliefs on sales. : 18. 19. . apart from overall evaluation. Bilkash – Inventory.10.Semi-Senior Mr.alongwith the other three. : Mr. Mr. Robin . Plan for final checking will be made later. Rohin – Articled Student for interim checking. Pulokesh .Semi-Senior Mr. : Mr. Pulokesh . This year. Number of man hours expected to be devoted in the interim checking Is thorough evaluation of internal control due this year? Any change in the accounting policies compared with the previous year Any statement/ standard pronouncement/note issued by the ICAI during the period that may have a bearing on the present audit Does any area of accounting require special attention in view of : : 320 man hours No. Alokesh . Raman .Security verification Mr. dated on 12.Audit Strategy. Transport Discounts. Roychowdhury : Received on 5. 19XX. cash Mr. 9.10. Certification to Royalty statement and Export statement besides reports to the Board on interim verification Yes. Rebates. No significant change intimated/assessed. consumption of raw materials. Payroll. It will be due next year. 11.Articled Student Mr. 16. 10. 17.XXXX : Yes.XXXX with the company management. Alokesh . Man hours required to completing the audit in preceding year in two phases Assistants deputed in the previous year : Interim audit for the first half-year involved 350 man hours and the final phase of audit involved 450 man hours.XXXX. T. volume or nature of work intimated. Any letter of engagement issued Any change in the scope. as per the discussion held on 15. 7. Jayanta –Senior 12. Planning and Programming 2.

: 28. Whether inventory verification will be witnessed : 22. Whether cash and investment will be physically verified How the fixed assets shall be verified How other areas to be examined/ verified Associated party transaction : : : : Yes. 20. vouchers. 29. Bases provided by Schedule VI and the AAS-13. 30. 21. the internal auditor reports to the Managing Director. Yes. to whom does the internal auditor report? : 27. also surprise verification before year-end day. By reference to documents. How to establish materiality of transaction Is there only internal audit system headed by a qualified internal auditor? If yes. Roychowdhury. Also.16 Advanced Auditing and Professional Ethics the observations made on the previous year’s accounts in the audit report or in the working papers? 20. Detailed audit or test audit : Normally test audit. surprise verification of some of the selected items should be done after the physical verification by the management is over. confirmations. Review of internal audit programme : and report/reports Should be completed before drawing up detailed audit programme. should be done in the light of points 16. Yes. verification of debtor’s balance and value of inventory will be done by adopting statistical sampling plan. On 15. When. as may be appropriate. etc. the reports of Branches auditor expected Need for review of previous year’s audit programme Partner-in-charge of this year’s audit : : 31. 19. 22. Partner-in-charge should be consulted where consultation is required. 23. Also.7. Mr.XXXX Yes. Officially confirmed list of associated parties should be obtained and bonafides and reasonableness of transactions ascertained. Documentary verification and scrutiny of physical verification of working papers of the company. 25. by arrangement with the client.2. : . T. 21. 26. Areas of work sharing should be discussed with the Internal Auditor at that stage. 25 and 28 by the Senior-in-charge and shown to partner-in-charge. 24.

. To make effective use of knowledge about the business. transactions and practices that. (v) Formulating the strategy. may have a significant effect on the financial statements or on the examination or audit report.3 As stated earlier.AAS-20 on. “Analytical Procedures” states that the auditor should apply analytical procedures at the planning and overall review stages of the audit. “Knowledge of Business” states that in performing In performing an audit of financial statements. (iv) Evaluating Internal Control system for strategy purpose. Understanding the business and using this information appropriately assists the auditor in: ♦ ♦ ♦ ♦ Assessing risks and identifying problems. the auditor should ensure that the audit staff assigned to an audit engagement obtain sufficient knowledge of the business to enable them to carry out the audit work delegated to them. the auditor should consider how it affects the financial statements taken as a whole and whether the assertions in the financial statements are consistent with the auditor's knowledge of the business. (ii) Performing Analytical Procedures . the auditor should have or obtain knowledge of the business sufficient to enable the auditor to identify and understand the events. and as cost effective as possible to perform. 17 2. Audit strategy generally involves the following steps: (i) (ii) Obtaining knowledge of business. Let us deal with above stages step-wise: (i) Obtaining Knowledge of Business . Providing better service to the client. Audit procedures should be relevant to the important assertions.AAS-14 on. Performing analytical procedures at initial stages.Audit Strategy. Evaluating audit evidence. Audit strategy is concerned with designing optimised audit approaches that seek to achieve the necessary audit assurance at the lowest cost within the constraints of the information available. (iii) Evaluating inherent risk. Knowledge of the business is a frame of reference within which the auditor exercises professional judgment. Finally. audit planning is the process of gathering information and designing audit strategies. The auditor would also ensure that the audit staff understands the need to be alert for additional information and the need to share that information with the auditor and other audit staff. Analytical procedures may also be applied at other stages. the main output of audit planning is a tailored audit approach supported by appropriate administrative arrangements. Planning and performing the audit effectively and efficiently. Planning and Programming Designing Audit Strategy 2. in the auditor's judgment.

the complexity of its capital structure. economic and competitive conditions as indicated by financial trends and ratios. Unusual pressures on management. for example. the potential for technological obsolescence of its products and services. accounts which required adjustment in the prior period or which involve a high degree of estimation. ♦ ♦ ♦ At the level of Account Balance and Class of Transactions: ♦ ♦ ♦ ♦ . The complexity of underlying transactions and other events which might require using the work of an expert.To assess inherent risk. The nature of the entity’s business. The use of analytical procedures during the planning stage requires the extensive use of accounting and business knowledge and experience to assess the potential for material misstatement in the financial statements as a whole.2. for example. (iii) Evaluating Inherent Risk . for example. for example. and his knowledge of any significant changes which might have taken place since his last assessment. Quality of the accounting system. Financial statements are likely to be susceptible to misstatement. the auditor would use professional judgement to evaluate numerous factors. for example. Examples of are such factors are: At the Level of Financial Statements: ♦ Management’s experience and knowledge and changes in management during the period. analytical techniques applied during the planning stage are not generally as precise as the analytical techniques at the substantive stage. having regard to his experience of the entity from previous audit engagements of the entity. corroboration is not normally necessary at this stage beyond this stage beyond the discussions that would usually take place with the client during the planning of the audit. circumstances that might predispose management to misstate the financial statements. the significance of related parties and the number of locations and geographical spread of its production facilities. any controls established by management to compensate for a high level of inherent risk. The degree of judgement involved in determining account balances. the inexperience of management may affect the preparation of the financial statements of the entity. and changes in technology. because the key aspect of the task is to identify the relevant risk indicators and to interpret them properly.18 Advanced Auditing and Professional Ethics The purpose of analytical procedures at the planning stage is attention-directing. such as the industry experiencing a large number of business failures or an entity that lacks sufficient capital to continue operations. Factors affecting the industry in which the entity operates. Furthermore. consumer demand and accounting practices common to the industry.

or if the engagement is new or substantially changed. (v) Formulating the Strategy . The initial assessment of the quality and complexity of the client’s systems will affect the amount of the information the auditor needs to gather.Audit Strategy. Whether this work is done before determining the strategy or subsequently as part of the fieldwork is a matter of audit efficiency. assets which are highly desirable and movable such as cash. and (b) making preliminary judgements about materiality. to help design and perform substantive tests and draw conclusions on whether proper accounting records have been kept. Transactions not subjected to ordinary processing. particularly at or near period end. The completion of unusual and complex transactions. This should be done by: (a) documenting the extent to which the system is computerised. the objective will normally be to carry out the minimum work necessary to update this previous understanding. even if auditor has not carried out an overview assessment of the IT controls for strategy purposes. the auditor should carry out an overview assessment of IT controls. the auditor should obtain an understanding or the IT controls so decide whether to make an extended assessment of monitoring controls. The auditor should consider the following matters: (a) For many existing clients. the necessary information gathering will be extensive. Sometimes. the appropriate strategy may be obvious from a limited amount of investigative work. 19 Susceptibility of assets to loss or misappropriation. inherent risk and control effectiveness.The auditors’ assessment of the control environment is crucial to the decision on whether to make an extended assessment of controls. on a new engagement.The auditor should develop the strategy by: (a) considering the results of gathering or updating information about the client. Whether it is necessary to carry out any preliminary work for strategy purposes to ascertain whether IT controls are likely to be satisfactory will depend on the auditor’s previous knowledge about IT controls. However. The auditor needs an understanding of the accounting systems. If more information is needed. for example. it may be necessary to do so later. For an existing audit. the majority of the information the auditor needs will . In other cases. and (b) preparing or updating overview flowcharts to record the files and transactions relating to significant systems-derived account balances. Planning and Programming ♦ ♦ ♦ 2. If there are significant computer systems. For strategy purposes the auditor should obtain a sufficient understanding of the control environment. This is because a good control environment is conducive to the maintenance of a reliable system of accounting and control procedures. These will include identification of the system(s) the auditor proposes to subject to an extended assessment of controls. regardless of whether the audit strategy will involve an extended assessment of internal accounting controls. (iv) Evaluating Internal Control .

This will ensure that the informationgathering process is carried out in as efficient and effective a manner as possible. any evidence of a high level of risk to the firm. (d) Identified inherent risks.4 During the audit the auditor may seek to obtain. (b) The results of the business review. Accordingly. unchanging business and accounting environment. (b) On a new. it may be necessary to gather extensive information before determining the strategy. The team should also consider the risk of fraud and. extent and timing of substantive tests. it will often be possible to restrict the work to updating existing knowledge. (d) If the auditor has had substantial contact with the client in the current period it may be possible to determine the strategy without gathering additional information. in particular. Accordingly. audit evidence in the form of reports. significant operating results and financial arrangements. They should take into account the results of procedures for the acceptance and continuation of clients. (c) If the auditor determines that there have been significant changes to risks. the engagement manager and the in-charge should consider together their knowledge of the matters listed in the preceding paragraph before undertaking further information gathering. (c) Preliminary judgements as to materiality. and statements of an expert. . or changes to the previous year’s strategy for substantive testing. (g) Main points relating to planning and controlling the audit or comments on the adequacy of the existing arrangements. including major developments in the client’s business and industry. more information would be required for a client with an acquisition or a significant new system than for a client with a stable. For example. large or complex engagement the auditor may be uncertain about the extent of information that should be gathered. considering whether there are any significant new or changed risks and confirming that there are no new or substantially changed significant systems. Using the Work of an Expert 2. (e) The degree to which the team should carry out further assessment of controls as a means of reducing substantive tests. in conjunction with the client or independently. in such cases the engagement partner.2. audit strategy may be evolved after considering the following: (a) The engagement objectives. Finally. systems and other client circumstances. valuations. (f) The broad nature. opinions.20 Advanced Auditing and Professional Ethics already exist in the prior year’s strategy and in the audit programme.

Planning and Programming Examples are: ♦ ♦ 2. he should satisfy himself as to the expert’s skills and competence by considering the expert’s: ♦ ♦ professional certification. determination of quantities or physical condition of assets.Audit Strategy. mineral and petroleum reserves. Objectivity of the expert . . determination of amounts using specialised techniques or methods. and precious stones. the measurement of work completed and to be completed on contracts in progress for the purpose of revenue recognition. or lie might consider engaging another expert. when the auditor uses the work of an expert employed by him. experience and reputation in the field in which the auditor is seeking evidence. the nature and complexity of the item including the risk of error therein. for example.When the auditor intends to use the work of an expert. the auditor should (after taking into account the factors stated above) consider performing more extensive procedures than would otherwise have been planned. the materiality of the item being examined in relation to the financial information as a whole. works of art. regulations. plant and machinery. he should examine evidence to gain knowledge regarding the terms of the experts’ engagement and such other matters as: ♦ ♦ the objectives and scope of the expert’s work. or related in some other manner to the client. notifications circulars. and remaining useful life of plant and machinery. and the other audit evidence available with respect to the item. ♦ ♦ ♦ When determining whether to use the work of an expert or not. legal opinions concerning interpretations of agreements. for example. Evaluating the work of an expert . 21 valuations of certain types of assets. the auditor should consider: ♦ ♦ ♦ Skills and competence of the expert . a general outline as to the specific items in the expert’s report. lie will not need to inquire into his skills and competence. land and buildings. However. for example. statutes. minerals stored in stockpiles. an actuarial valuation.When the auditor plans to use the expert’s work as audit evidence. in these circumstances. Accordingly. The risk that an expert’s objectivity will be impaired increases when the expert is: ♦ ♦ employed by the client.The auditor should also consider the objectivity of the expert. etc. licence or membership in an appropriate professional body.

The procedures to be applied by the auditor should include: ♦ ♦ making inquiries of the expert to determine how he has satisfied himself that the source data are sufficient. relevant and reliable. and the results of the expert’s work in the light of the auditor’s overall knowledge of the business and of the results of his audit procedures. or that the work of the expert does not constitute sufficient appropriate audit evidence (e.g.22 ♦ Advanced Auditing and Professional Ethics confidentiality of the client’s information used by the expert. the auditor should attempt to resolve the inconsistency by discussions with the client and the expert. on grounds of confidentiality. the expert refuses to make available to the auditor the source data used by him. the auditor should also satisfy himself that the substance of the expert’s findings is properly reflected in the financial information. therefore. a disclaimer of opinion or an adverse opinion. The auditor does not have the same expertise and. and conducting audit procedures on the data provided by the client to the expert to obtain reasonable assurance that the data are appropriate. cannot always challenge the expert’s assumptions and methods. The auditor should consider whether the expert has used source data which are appropriate in the circumstances. If after performing these procedures. . may also assist the auditor in resolving the inconsistency. he should express a qualified opinion. by considering: ♦ ♦ ♦ ♦ the source data used. where the work of the expert involves highly technical matters or where. completion of the above procedures will provide the auditor with reasonable assurance that he has obtained appropriate audit evidence in support of the financial information. the assumptions and methods used and.2. the auditor concludes that: ♦ ♦ the work of the expert is inconsistent with the information in the financial statements. based on the auditor’s knowledge of the client’s business and on the results of his audit procedures. their comparison with the prior period. as may be appropriate. Normally. The auditor should seek reasonable assurance that the expert’s work constitutes appropriate audit evidence in support of the financial information. Applying additional procedures. However. The appropriateness and reasonableness of assumptions and methods used and their application are the responsibility of the expert. In exceptional cases where the work of an expert does not support the related representations in the financial information. if appropriate. including possibly engaging another expert. the auditor should obtain an understanding of those assumptions and methods to determine that they are reasonable.

It should. extent of the auditing procedures but much of the work of the internal audit function may be useful to him in his examination of the financial information. he will continue to be responsible for forming and expressing his opinion on the financial information. however.Audit Strategy. timing. Where in doing so. If. he will be entitled to rely on work performed by others. Such a situation may arise in case a company having branch or having different branch auditors or the auditor is using the work of another independent auditor with respect to the financial statement of one or more subsidiaries or associated companies. In the case of any independent statutory appointment to perform the work on which the auditor has to rely in forming his opinion. the auditor considers it appropriate to disclose the identity of the expert. the principal auditor would be entitled to rely upon the work of such auditor unless there are circumstances to indicate that he should not rely. the auditor should obtain reasonable assurance that such work is adequate for the purpose of the audit. The responsibility of the external auditor is not reduced by any means because of the reliance placed upon the internal auditor’s work. It should however be noted that the aforesaid instances do not cover cases where two or more auditors are appointed as joint auditors nor does it deal with the auditor’s relationship with the predecessor auditor. Relying upon the Work of Internal Auditor 2. he should obtain prior consent of the expert for such disclosure if such consent has not ready been obtained. The procedure to be followed by the company auditor in relation to branch auditor is outlined in Chapter on the Company Audit.When expressing an unqualified opinion. be remembered that the external auditor has sole responsibility for his report and for the determination of the nature. refers to or describes the work of the expert. Principal’s Ultimate Responsibility 2. Generally when another auditor has been appointed for the branch / division/ component. as a result of the work of an expert. it may in some circumstances benefit the reader of his report if the auditor. the auditor decides to express other than an unqualified opinion. However. such as in the case of the work of branch auditors appointed under the Companies Act. 23 Reference to the Expert in the Auditor’s Report . provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. Using the Work of another Auditor 2. 1956 the auditor’s report should expressly state the fact of such reliance.6 When the auditor uses work performed by other auditors. Planning and Programming 2.5 AAS-7 entitled ‘Relying upon the Work of an Internal Auditor’ deals with the procedure which should be applied by the internal auditor for the purpose of placing reliance upon that work.” . in explaining the nature of his reservation.7 “When the auditor delegates work to assistants or uses work performed by other auditors and experts. the auditor should not refer to the work of an expert in his report.

Mention may be made in this connection of the case of Thomas Gerrard & Son (1967) and Colmer v Merrett Son & Street (1964). the conscious acknowledgement of the amount at which the item concerned is stated. It is clear. be noted that it would not be considered proper for an auditor to seek or accept certificates from the management when the subject-matter is such as is capable of direct verification by the auditor himself. viz. Although the judgement in the Kingston Cotton Mill’s case held that there is no duty on the auditor to take stock physically. For example. The development of the professional practices mentioned above is the result of the timely notice taken by the accounting profession of the gradual erosion of the dictum in the Kingston Cotton Mills case. Letter of representation obtained from the management will not protect the auditor in a legal action for negligence if he has failed to perform his duties according to the generally accepted auditing standards and procedures. Notwithstanding anything stated above. put to test the inventory figures. Provision for liabilities. that the request for a certificate and its receipt constitute no more than the initial step in the auditor’s verification of the relevant item whereby he seeks to obtain from those legally responsible. therefore. that he may. The object of this practice is to obtain information for which the management can be specifically held responsible.24 Advanced Auditing and Professional Ethics Reliance on the Management or other Certificates by the Auditor 2. without putting the same to appropriate tests and intelligent scrutiny. decided long after the Kingston Cotton Mill’s case were quite forthright in stating that a blind acceptance of certificate from the management by the auditor. an auditor who fails to count cash.2. cash in hand at the end of the year can be verified by the auditor himself and obtaining a certificate without actually undertaking the verification will amount to a non-performance of duty.. the disclosure of contingent liabilities etc. the directors. contemporary professional auditing practice requires a thorough investigation into the adequacy or otherwise of the internal check system regarding the movement and periodic counting of stocks with particular enquiry into deviations from the prescribed procedure. possession of such certificates does not absolve the auditor from carrying out a proper audit.8 It is customary for the company auditor to obtain certificates from the management certifying the value of inventories. However. Thus. . verify debtors and liabilities according to the recognised practices. the auditor can accept certificates from the director and the officials under the following circumstances: (1) The subject matter should not be capable of direct verification of the auditor and should be one which is accepted to be beyond the competence of a professionally qualified accountant. At best certificates can only act as the second line of defence for an auditor who has carried out his work with reasonable care and skill. does not amount to a proper performance of duty. however. will derive little support from certificates of directors or company officials certifying the accuracy of these items. It should. Certain cases. in the absence of suspicious circumstances rely upon the certificate of a responsible official has not been categorically overruled.

before accepting and relying upon a certificate from a third party. during the course of an audit. The bankers may certify the investments or securities held by them on behalf of the company. cumbersome for him to do so. (d) the certificate is prima facie reliable and reasonable. an auditor is under no compulsion to accept a legal opinion. the auditor should ensure that the case for opinion is properly drawn up so that all the relevant facts are brought to the notice of the legal adviser. warehousemen. and reference to the third party is available in the books and documents of the client as in possession of the concerned goods. During the course of an audit. banks in the ordinary course of business hold securities for their customers and. But before accepting a legal opinion. the architect may certify the value of property held as security and an agent or distributor may certify the value of property held as representatives of the company.Audit Strategy. On the other hand. The auditor should review such records and internal checks to ascertain their reliability. therefore. (b) the certificate relates to an item which is normally dealt with or held by such party. the auditor should satisfy himself that: (a) the party issuing the certificate is reputable and trustworthy. A chartered accountant is not necessarily competent to interpret law and. etc. an auditor may have to deal with certificates from outside parties such as the company’s bankers. it may be stated that. however respectable and responsible those brokers may be. It was held that a company’s brokers are not the proper people to have the custody of its securities. City Equitable Fire Insurance Co. agents. property and/or securities belonging to the client. If a written opinion is sought. therefore. . an auditor would be justified in accepting the certificate of a respectable bank whilst verifying the existence of the securities. (c) the auditor himself is not in a position to verify the item because of its technical nature or because it would be too costly. if he has reasons to believe that such opinion is erroneous or inadequate. As a general rule. If a verbal opinion is being obtained. architects. the auditor should satisfy himself about the competence and impartiality of the lawyer. Ltd. (iii) Not infrequently. The question of auditor’s duty in such circumstances was discussed in Re. local issues arise which have a bearing on accounts. (3) The certificate should be prima facie in agreement with the records maintained. However. Even if the legal opinion turns out to be erroneous the auditor cannot be held to be negligent in the performance of his duties if he has acted honestly and in good faith and if the opinion relied upon was prima facie reasonable. (4) The certificate should be put to common sense tests by the auditor. 25 (2) There exist proper records and “internal check” in the client’s system that can enable the directors or the officials to prepare and issue the certificate. it may be desirable for him to obtain legal advice from his own or his client’s attorney or counsel. the auditor should attend the conference at which the matter is to be discussed to make sure that the facts are correctly presented. Planning and Programming 2.

the matters on which the auditor wishes to obtain such representations in writing should be determined by the auditor using his professional judgement. management makes many representations to the auditors either unsolicited or in response to specific enquiries. For example. AAS-9 emphasises that the auditor should obtain representations from management. In certain instances such as where knowledge of the facts is confined to management or where the matter is principally one of intention. intention of management to hold a specific investment for long-term appreciation. thus. Representation by Management as Audit Evidence .26 Advanced Auditing and Professional Ethics Management Representations 2. where considered appropriate. including other representations. Representations by management cannot be a substitute for other audit evidence that the auditor could reasonably expect to be available. AAS 9 became operational for all audits relating to accounting period beginning on or after April 1995. representations should be obtained from management invariably in writing on matters material to financial information.2. a representation by management may be the only audit evidence which can reasonably be expected to be available. AAS-11 on “Representations by Management” expounds in detail to establish standards on the use of management representations as audit evidence the procedures to be applied in evaluating and documenting management representations. However. (b) evaluate whether the representations made by management appear reasonable and consistent with other audit evidence obtained. Similarly. If the auditor is unable to obtain sufficient appropriate audit evidence that he believes would be available regarding a matter which has or may have a material effect on the financial information. . have significant implication for an auditor to formulate his opinion on the financial information. and the action to be taken if management refuses to provide appropriate representations. and (c) consider whether the individuals making the representations can be expected to be wellinformed on the matter.9 Representations by management are the single most important source of audit evidence to an auditor and. For example. when other sufficient appropriate audit evidence cannot reasonable be expected to exist. During the course of an audit. existence and cost of inventories is no substitute for adopting normal audit procedures regarding verification and valuation of inventories.The auditor should exercise his professional judgement in determining the matters on which he wishes to obtain representations from management. the auditor should: (a) seek corroborative audit evidence from sources inside or outside the entity. a representation by management as to the quantity. either individually or collectively. When such representations relate to matters which are material to the financial information. this will constitute a limitation on the scope of his examination even if he has obtained a representation from management on the matter. Acknowledgement by Management of its Responsibility for the Financial Information The auditor should obtain evidence that management acknowledges its responsibility for the appropriate preparation and presentation of financial information and that management has approved the financial information.

A written representation is better audit evidence than an oral representation and can take the form of: (a) a representation letter from management. If the manage refuses to acknowledge or confirm the letter sent by the auditor. Basic Elements of a Management Representation Letter (i) (ii) A management representation letter should be addressed to the auditor containing the relevant information and be appropriately dated and signed. e. The . reconsider the reliability of other representations made by management. when necessary. this will constitute a limitation on the scope of his examination. (v) In case management is not willing to give in writing the representations made by it during the course of audit. the auditor should evaluate any reliance on those representations and consider if the refusal may have any additional effect on his report..Audit Strategy. A management representation letter would normally be dated the same date as the auditor’s report on the financial information or a date prior thereto.10 AAS 28 establishes standards on the form and content of the auditor’s report issued as a result of an audit performed by an auditor of the financial statements of an entity. Drafting of Report 2. Documentation of Representations by Management . finance director. In such circumstances. managing director. duly acknowledged and confirmed by management. in certain circumstances. (c) a duly authenticated copy of relevant minutes of meetings of the board of directors or similar body. the auditor should evaluate any reliance he has placed on other representations made by management during the course of his examination and consider if the refusal may have any additional effect on his report.The auditor should document in his working papers evidence of management’s representations. this will constitute a limitation on the scope of his examination. Planning and Programming 2. separate representation letters may also be obtained during the course of audit. 27 If a representation by management is contradicted by other evidence. (iv) If management refuses to provide representations on any matter that the auditor considers necessary. the auditor should himself prepare a letter in writing setting out his understanding of management’s representations that have been made to him during the course of audit and send it to the management with a request to acknowledgement and confirm that his understanding of the representations is correct. However. in respect to specific transactions or events. the auditor should examine the circumstances and.g. (b) a letter from the auditor outlining the auditor’s understanding of management’s representations. (iii) A management representation letter should ordinarily be signed by the members of the management who have primary responsibility for the entity and its financial aspects. In such circumstances.

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Advanced Auditing and Professional Ethics

auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. This review and assessment involves considering whether the financial statements have been prepared in accordance with an acceptable financial reporting framework applicable to the entity under audit. It is also necessary to consider whether the financial statements comply with the relevant statutory requirements. The auditor’s report should contain a clear written expression of opinion on the financial statements taken as a whole. The auditor’s report includes the following basic elements, ordinarily, in the following layout: (a) Title; (b) Addressee; (c) Opening or introductory paragraph; (d) Scope paragraph (describing the nature of an audit); (e) Opinion paragraph containing; (f) Date of the report; (g) Place of signature; and (h) Auditor’s signature. A measure of uniformity in the form and content of the auditor’s report is desirable because it helps to promote the reader’s understanding of the auditor’s report and to identify unusual circumstances when they occur. A statute governing the entity or a regulator may require the auditor to include certain matters in the audit report or prescribe the form in which the auditor should issue his report. For detail students may refer AAS 28 (The Auditor’s Report on Financial Statements). Control of Quality of Audit Work 2.11 AAS-1 on Basic Principles Governing an Audit of Financial Statements lists control of the quality of work performed by others as one of the basic principles governing an audit. The relevant parts are reproduced below: When the auditor delegates work to assistants or uses work performed by other auditors and experts, he will continue to be responsible for forming and expressing his opinion on the financial information. However, he will be entitled to rely on work performed by others, provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. In the case of any independent statutory appointment to perform the work on which the auditor has to rely in forming his opinion, such as in the case of the work of branch auditors appointed under the Companies Act, 1956 the auditor’s report should expressly state the fact of such reliance. The auditor should carefully direct, supervise and review the work delegated to assistants. The auditor should obtain reasonable assurance that work performed by other auditors or experts is adequate for his purpose.

Audit Strategy, Planning and Programming

2. 29

As is clear from the aforesaid principle, an auditor is required to control the audit work delegated to assistants and work performed by other auditors and experts. Accordingly, the procedure to be followed by a statutory auditor in controlling the quality of audit work performed by assistants, the quality of work performed by experts, the question of relying upon the work of the internal auditor and the assessment of work performed by others is discussed in the following paragraphs: 2.11.1 Control of the quality of work-Audit staff - As stated earlier, as per the basic principles governing an audit, the auditor is required to carefully direct, supervise and review the work delegated to assistants. It may be noted that the nature and extent of a firm’s quality control procedures depend on a number of factors such as the size and nature of its practice, its geographic dispersion, its organisation and appropriate cost benefit considerations. Accordingly, the procedures adopted by the individual firm will vary as will the extent of their documentation. The audit staff includes all partners and professional staff of an audit firm and other personnel, namely audit assistants involved in an individual audit other than the auditor. The AAS lists the policies and procedures to be adopted by an audit firm to provide reasonable assurances regarding the quality of audit work generally and procedures to be adopted by an auditor to comply with this basic principle as it relates to the work delegated to assistants in an individual audit. The controls suggested in the AAS all discussed in the following paragraphs: 2.11.2 General quality controls - Quality controls are the policies and procedures adopted by a firm to provide reasonable assurance that all audits done by the firm are being carried out in accordance with the Basic Principles Governing an Audit, as set out in Auditing and Assurance Standard (AAS) 1. An audit firm should adopt quality control policies that incorporate the following objectives and should implement appropriate procedures that provide reasonable assurance of achieving those objectives: (a) Professional requirements - Personnel in the firm should adhere to the principles of integrity, objectivity, independence and confidentiality. Firms should therefore frame appropriate procedures to ensure compliance with this policy. For instance an important procedure would be to communicate the firms policies relating to independence to personnel at all levels within the firm. (b) Skills and competence - The firm should be staffed by personnel who have attained and who maintain the skills and competence required to enable them to fulfil their responsibilities. Implementation of this policy would involve following proper recruitment procedures designed to obtain appropriately qualified personnel and procedures to maintain a high degree of skills through periodic staff training, continuing professional educational programmes and dissemination of information relating to current developments in professional/technical standards. (c) Assignment - Audit work should be assigned to personnel who have the degree of technical training and proficiency required in the circumstances. If, however, special skills required for the conduct of an audit e.g. a good EDP background to evaluate controls over computer programs are not available within the firm, then reliance will have to be placed on work delegated to outside experts.

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Advanced Auditing and Professional Ethics

(d) Delegation - There is to be sufficient direction, supervision and review of work at all levels to provide reasonable assurance that the work performed meets appropriate standards of quality. (e) Consultation - Whenever necessary, consultation within or outside the firm is to occur with those who have appropriate expertise. (f) Acceptance and retention of clients - An evaluation of prospective clients and a review, on an ongoing basis, of existing clients is to be conducted. In making a decision to accept or retain a client, the firm’s independence and ability to serve the client properly are to be considered.

(g) Monitoring - The continued adequacy and operational effectiveness of quality control policies and procedures is to be monitored. A firm’s general quality control policies and procedures should be communicated to its personnel in a manner that provides reasonable assurance that the policies and procedures are understood. The form of communication would vary depending on the size of the firm and the criticality of various policies and procedures and need not necessarily be documented in all instances. Special procedures should be developed to ensure that all personnel are kept fully aware of the pronouncements of the Institute of Chartered Accountants of India, changes in the law and appropriate notifications and clarifications issued by statutory authorities. The firm should carry out an evaluation of a prospective client prior to acceptance and should review, on an ongoing basis, the association with existing clients. In making a decision to accept or continue with a client a firm should consider its own independence, its ability to service a client properly, and the integrity of the client’s management. In evaluating the firm’s ability to service the clients properly, consideration should be given to the need for technical skills, knowledge of the industry and availability of suitable personnel. In evaluating the integrity of the client’s management, consideration should be given to the possibility of reviewing financial information available regarding the prospective client, such as annual reports. Communication with the previous auditor may also provide significant information or other similarly significant matters as also the predecessor’s understanding as to the reason for the change in auditors. 2.11.3 Control on Individual AuditsDelegation - Any delegation of work to assistants should be in a manner that provides reasonable assurance that such work will be performed by persons having independence and the degree of skills and competence required in the circumstances. Some of the factors which need to be considered in this context are: (i) (ii) Audit size and complexity Personnel availability

Audit Strategy, Planning and Programming (iii) Special expertise required (iv) Timing of the work to be performed.

2. 31

The auditor and assistants with supervisory responsibilities should consider the skills and competence of assistants in performing the work that is delegated to them and in deciding on the extent of direction, supervision and review appropriate in each situation. Direction - Appropriate directions should be given to assistants to whom work is delegated. Direction involves informing assistants of their responsibilities and the objectives of the procedures they are to perform. It also involves informing them of matters, such as the nature of the entity’s business and possible accounting or auditing problems that may affect title nature, timing, and extent of audit procedures with which they are involved. Supervision - Supervision is closely related to both direction and review and may involve elements of both. Personnel carrying out supervisory responsibilities should perform the following functions during the performance of an audit. (a) Monitor the progress of the work to determine that: ♦ ♦ ♦ assistants appear to have the necessary skills and competence to carry out their assigned tasks: assistants appear to understand the audit directions; and the work is being carried out in accordance with the audit programme and other planning documents.

(b) Become informed of significant accounting and auditing questions raised during the audit, assess their significance and modify the audit programme where appropriate. (c) Resolve any differences of professional judgement between personnel. The use of standardized forms, checklist and questionnaires assist in the performance of audit and supervision of audit work. Review - The work performed by each assistant should be reviewed by personnel of equal or higher competence to determine whether: (a) the work has been performed in accordance with professional and firm standards and specific policies and procedures adopted by the audit firm; (b) the work performed and the results obtained have been adequately documented; (c) all significant audit matters have been resolved; and

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(d) the objectives of the audit procedures have been achieved and the conclusions expressed are consistent with the results of the work performed and support the auditor’s opinion on the financial information. The following major review stages can often be identified in an audit: (a) Review of the initial audit plan and the audit programme. (b) Review of the study and evaluation of internal control, including compliance procedures, and of the modifications, if any, made to the audit programme as a result thereof. (c) Review of the documentation of the audit evidence obtained and the conclusions drawn therefrom. (d) Review of the financial information and proposed auditor’s report.

3
RISK ASSESSMENT AND INTERNAL CONTROL
Introduction 3.1 Audit risk means the risk that the auditor gives an inappropriate audit opinion when the financial statement are materially misstated. Thus, it is the risk that the auditor may fail to express an appropriate opinion in an audit assignment. An auditor may consider audit risk both at overall level as well as at the level of individual account balances or classes of transactions. This means that at overall level the auditor applies their professional judgement to determine the extent of risk which he considers to be an acceptable level. At account balance level, audit risk refers to the risk that error in monetary terms exists beyond a tolerable error limit in the account balances or class of transaction which the auditor fails to defect. The Internal Control structure in an organization is referred to as the policies and procedures established by the entity to provide reasonable assurance that the objectives are achieved. The control structure in an organization basically has the following components: 1. Control Environment - Control environment covers the effect of various factors like management attitude; awareness and actions for establishing, enhancing or mitigating the effectiveness of specific policies and procedures. 2. Accounting System - Accounting system means the series of task and records of an entity by which transactions are processed for maintaining financial records. Such system identifies, assemble, analyze, calculate, classify, record, summarize and report transactions and other events. 3. Control Procedure - Policies and procedures means those policies and procedures in addition to the control environment and accounting systems which the management has established to achieve the entity’s specific objectives. In this regard, Auditing Assurance Standard No.1 : Basic Principles Governing an Audit also specifies that management is responsible for maintaining an adequate accounting system incorporating various internal controls to the extent that they are appropriate to the size and nature of the business. There should be reasonable assurance for the auditor that the accounting system is adequate and that all the accounting information required to be recorded has in fact been recorded. Internal controls normally contribute to such assurance. The auditor

3.2

Advanced Auditing and Professional Ethics

should gain an understanding of the accounting system and related internal controls and should study and evaluate the operation of those internal controls upon which he wishes to rely in determining the nature, timing and extent of other audit procedures. Where the auditor concludes that he can rely on certain internal controls, he could reduce his substantive procedures which otherwise may be required and may also differ as to the nature and timing. Specific Requirement under Auditing and Assurance Standard Number - 6 Risk Assessment and Internal Control." In AAS-6 (Revised ) - “Risk Assessment and Internal Control” procedures to be followed to obtain an understanding of accounting and internal control systems and on audit risk and its components has been explained. AAS-6 defines the system of internal control as the plan of organization including methods and procedures adopted in achieving management objectives, like: (a) adherence to policies; (b) safeguarding of assets; (c) prevention and detection of fraud and error; (d) accuracy and completeness of accounting records; and (e) timely preparation of reliable financial information. AAS-6 further states that the auditor should obtain an understanding of the accounting and internal control system sufficient to plan the audit and develop an effective audit approach. The auditor should use professional judgement to assess audit risk and to design audit procedures to ensure that it is reduced to an acceptable low level. Internal Control System - Nature, Scope, Objectives and Structure 3.2 The Following are the Nature, Scope, Objectives and Structure of an Internal Control Audit: Nature - A set of internally generated policies and procedures adopted by the management of an enterprise is a prerequisite for an organisations efficient and effective performance. It is thus, a primary responsibility of every management to create and maintain and adequate system of internal control appropriate to the size and nature of the business entity. AAS-6 defines the system of internal control as all the policies and procedures adopted by the management of an entity to assist in achieving management’s objective of ensuring, as far as practible, the orderly and efficient conduct of its business. Scope - The scope of internal controls extends beyond mere accounting controls and includes all administrative controls concerned with the decision - making process leading to managements authorization of transaction, such controls include, production method, time and motion study, pricing policies, quality control, work standard, budgetary control, policy appraisal, quantitative controls etc. In an independent financial audit, the auditor is primarily concerned with those policies and procedures having a bearing on the assertions underlying the financial statements. These comprise primarily controls relating to safeguarding of assets, prevention and detection of fraud and error, accuracy and completeness of accounting records and timely preparation of reliable financial information.

Risk Assessment and Internal Control

3.3

Administrative controls, on the other hand, have only a remote relationship with financial records and the auditor may evaluate only those administrative controls which have a bearing on the reliability of the financial records. Objectives - The objectives of internal control systems are determined by the management, after considering the nature of business, scale operations, the extent of professionalism of the management etc. AAS-6, identifies the following objectives of internal controls relating to the accounting system: (i) Transactions are executed through general or specific management authorization. (ii) All transactions are promptly recorded in an appropriate manner to permit the preparation of financial information and to maintain accountability of assets. (iii) Assets and records are safeguarded from unauthorized access, use or disposition. (iv) Assets are verified at reasonable intervals and appropriate action is taken with regard to the discrepancies. The basic accounting control objectives which are sought to be achieved by any accounting control system are: (a) whether all transactions are RECORDED; (b) (c) (d) (e) (f) (g) Whether recorded transactions are REAL; whether all recorded transactions are PROPERLY VALUED; whether all transactions are RECORDED TIMELY; whether all transactions are PROPERLY POSTED; whether all transactions are PROPERLY CLASSIFIED AND DISCLOSED; whether all transactions are PROPERLY SUMMARIZED;

If the response to all the above answer is positive, the auditor would be justified in limiting his account balance tests considerably. In case of excellent companies it may also be possible to rely on account balance with minimum of external tests, such as direct confirmation, management representation etc,. Where in a system a particular control is found to be deficient, audit attention can be focused on the areas where basic accounting control objectives are not being adhered to. For example, if it found that sales transactions are not being properly valued in accordance with the price list determined by the management, the auditor would have to perform extensive searching tests on sales invoices to assure himself that the recoverable amounts are correctly posted. He may also want to expand his confirmation request at the year end to cover a large majority of debtors. Limitations of Internal Control - An Internal Control system can provide only reasonable assurance that the management’s objectives in establishing the system are achieved. That is, no internal control system can provide absolute assurance that the control objectives are achieved. This is due to the fact that any internal control system has certain internal limitations. The limitations may arise due to: (i) Controls have to be cost-effective.

3.4 (ii)

Advanced Auditing and Professional Ethics Most controls address transaction of usual and routine nature. They fail in respect of transactions of unusual nature.

(iii) The potential of human error remains in any system of control. (iv) In any system of control, the possibility of circumvention of controls through collusion between two or more persons might exist. (v) A member of the management may himself override the controls. (vi) Controls may not keep pace with changes in condition. (vii) Management itself may manipulate transactions or accounting estimates. The inherent limitation of internal control system requires the auditor to perform substantive procedure to be able to express an opinion. Structure - In order to achieve the objectives of internal controls, it is necessary to establish adequate control policies and procedures. Most of these policies and procedures cover: Segregation of duties - Transaction processing are allocated to different persons in such a manner that no one person can carry through the completion of a transaction from start to finish or the work of one person is made complimentary to the work of another person. The purpose is to minimize the occurrence of fraud and errors and to detect them on a timely basis, when they take place. The following functions are segregated (a) authorization of transactions; (b) (c) execution of transactions; physical custody of related assets; and

(d) maintenance of records and documents, while allocating duties, the considerations of cost and efficacy should be kept in mind as there is a tendency to stretch the allocation of tasks involved in a job to more persons than what is required resulting in cumbersome procedures, over elaboration of records and unduly high cost of administration. Apart from segregation of duties, periodic rotation of duties of personnel is also desirable. The rotation of duties seeks to ensure that if a fraud and error is committed by a person, it does not remain undetected for long. It also ensures that a person cannot develop vested interest by holding a position for to long. Rotation of duties also ensures that each employee keeps his work up to date. This also makes an employee to be careful because he is aware that his performed tasks will be reviewed by others when duties are rotated. Authorization of Transaction - Delegation of authority to different levels and to particular persons are required to establish by the management for controlling the execution of transaction in accordance with prescribed conditions. Authorization may be general or it may be specific with reference to a single transaction. It is necessary to establish procedures which provide assurance that authorizations are issued by persons acting within the scope of their authority, and that the transactions conform to the terms of the authorizations. This objective can be achieved by making independent comparison of transaction document with general or specific authorizations, as the case may be.

Risk Assessment and Internal Control Adequacy of Records and Documents - Accounting controls should ensure that (i) Transactions are executed in accordance with management’s general or specific authorization. (ii) Transactions and other events are promptly recorded at correct amounts.

3.5

(iii) Transactions should be classified in appropriate accounts and in the appropriate period to which it relates. (iv) Transaction should be recorded in a manner so as to facilitate preparation of financial statements in accordance with applicable accounting standards, other accounting policies and practices and relevant statutory requirements. (v) Recording of transaction should facilitate maintaining accountability for assets (vi) Assets and records are required to be protected from unauthorized access, use or disposition. (vii) Records of assets such as sufficient description of the assets (to facilitate identification) its location should also be maintained so that the assets could be physically verified periodically. For prompt, accurate, complete and appropriate recording of accounting transaction, several procedures are often established by the management. The assurance that transactions have been properly recorded can also be obtained through a comparison of records with an independent source of information which provides an indication of the execution of the relevant transactions. Accountability and Safeguarding of Assets - The process of accountability of assets commences from acquisitions of assets its use and final disposal. Safeguarding of assets requires appropriate maintenance of records, their periodic reconciliation with the related assets. Assets like cash, inventories, investment scrips require frequent physical verification with book records. The frequency of reconciliation would differ for different assets depending upon their nature and amount. Assets which are considered sensitive or susceptible to error need to be reconcile more frequently than others. For proper safeguarding of assets, only authorized personnel should be given access to such asset. This not only means physical access but also exercising control over processing of documents relating to authorization for use and disposal of assets. It is essential to have effective controls over physical custody of cash, inventories, investments and other fixed assets. In some cases, as per requirement, special procedures regarding physical custody of assets may have to be designed by the management. Independent Checks - Independent verification of the control systems, designed and implemented by the management, involves periodic or regular review by independent persons to ascertain whether the control procedures are operating effectively or not. Such process may be carried out by specially assigned staff under the banner of external audit.

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Advanced Auditing and Professional Ethics

Components of Internal Controls 3.3 The overall systems of inter control comprises of Administrative Control and Accounting Controls, Internal Checks and Internal Audit are important constituents of Accounting Controls. Internal Check System - Internal check system implies organization of the overall system of book-keeping and arrangement of Staff duties in such a way that no one person can carry through a transaction and record every aspect thereof. It is a part of overall control system and operates basically as a built-in-device as far as organization and job-allocation aspects of the controls are concerned. The system provides existence of checks on the day to day transactions which operate continuously as part of the routine system whereby the work of each person is either proved independently or is made complimentary to the work of another. The following are the objectives of the internal check system: (i) To detect error and frauds with ease. (ii) To avoid and minimize the possibility of commission of errors and fraud by any staff. (iii) To increase the efficiency of the staff working within the organization. (iv) To locate the responsibility area or the stages where actual fraud and error occurs. (v) To protect the integrity of the business by ensuring that accounts are always subject to proper scrutiny and check. (vi) To prevent and avoid the misappropriation or embezzlement of cash and falsification of accounts. The effectiveness of an efficient system of internal check depends on the following considerations (i) Clarity of Responsibility - The responsibility of different persons engaged in various operations of business transactions should be properly identified. A well integrated organizational chart depicting the names of responsible persons associated with specific functions may help to fix up responsibility. (ii) Division of Work - The segregation of work should be made in such a manner that the free flow of work is not interrupted and also helps to determine that the work of one person is complementary to the other. Then, it is suggested that rotation of different employees through various components of job should be effectively implemented. (iii) Standardization - The entire process of accounting should be standardized by creating suitable policies commensurate with the nature of the business, so as to strengthen the system of internal check. (iv) Appraisal - Periodic review should be made of the chain of operations and work flow. Such process may be carried out by preparing an audit flow chart. The general condition pertaining to the internal check system may be summarized as under (i) no single person should have complete control over any important aspect of the business operation. Every employee’s action should come under the review of another

Risk Assessment and Internal Control person.

3.7

(ii) Staff duties should be rotated from time to time so that members do not perform the same function for a considerable length of time. (iii) Every member of the staff should be encouraged to go on leave at least once a year. (iv) Persons having physical custody of assets must not be permitted to have access to the books of accounts. (v) There should exist an accounting control in respect of each class of assets, in addition, there should be periodical inspection so as to establish their physical condition. (vi) Mechanical devices should be used, where ever practicable to prevent loss or misappropriation of cash. (vii) Budgetary control should be exercised and wide deviations observed should be reconciled. (viii) For stock taking, at the close of the year, trading activities should, if possible be suspended, and it should be done by staff belonging to several sections of the organization. (ix) The financial and administrative powers should be distributed very judiciously among different officers and the manner in which those are actually exercised should be reviewed periodically.

(x) Procedures should be laid down for periodical verification and testing of different sections of accounting records to ensure that they are accurate. The scope of statutory audit is limited by both time and cost. Therefore, it is increasingly being recognized that for an audit to be effective especially in case of large organization, the existence of a system of internal check is essential. Internal Audit - Internal audit may be defined as, an independent appraisal function established within an organization to examine and evaluate its activities as a service to the organization. The scope of the internal audit is determined by the management. Internal auditing includes a series of processes and techniques through which an organizations own employees ascertain for the management, by means of on-the-job observation, whether established management controls are adequate, and are effectively maintained; records and reports financial, accounting and otherwise reflect actual operation and results accurately and properly; each division, department or other units are carrying out the plans, policies and procedures for which they are responsible. For a detailed discussion on internal audit refer to Chapter 19. Review of the System of Internal Controls 3.4 The review of the internal control system enables the auditor (i) to formulate his opinion as to the reliance he may place on the system itself i.e. whether the system is such as would enable the management to produce a true and fair set of

3.8

Advanced Auditing and Professional Ethics financial statements; and

(ii)

to locate the areas of weakness in the system so that the audit programme and the nature, timing and extent of substantive and compliance audit procedures can be adjusted to meet the situation. For example, if the auditor is not satisfied with the control system as regards debtors, he may decide to have a wider coverage for confirmation of debtor’ balances. Normally, investments and cash are physically verified at the end of the period and this routine is known to the client and his employees. In case the auditor comes across a weakness in the control either he may provide in the programme for a surprise cash count or investment verification on a day preceding or succeeding the routine verification. In such a case, a surprise check will be more useful if it is undertaken after the routine verification is over. Similarly if he is of the view that because of weak controls the possibility of wrong billing to customers exists, be may extend the programme for comparison of the invoices with the forwarding notes and for checking of the extensions and castings of the invoices. Deciding the point of time appropriate for undertaking the review of the internal controls is a matter for individual judgement of the auditor. This decision can be taken on a consideration of the size and complexity of the client’s operations. If the auditor, because of his continuing relationship with his client, is already aware of the features and efficacy of internal controls, he may just review the changes that have taken place in the intervening period because of changes in the operations of the client. However, a comprehensive review in such cases must be made at an interval of, say, 3 years. Ordinarily, the review of internal controls should be undertaken as a distinct phase of audit before finalisation of the audit programme. However, if the size of operations is rather small, the review can be undertaken in conjunction with other audit procedures and the programmes can be adjusted for any extension or elimination of checking. When the auditor finds inadequacies or weaknesses in the internal control system, he should advise his client about such inadequacies and weaknesses and the consequences that may follow. It should be the duty of the auditor to see, in the course of his audit, how far the inadequacies and weaknesses have been removed. He will take this into account in preparing his audit report. It is a useful practice to note the following after each function, set out in the audit programme (i) (ii) Any change in the system of internal control from that record in the appropriate section of the internal control questionnaire. Any further weakness noted in the internal control.

(iii) Any instance where the prescribed system or procedure has not been followed. These should be considered in deciding whether any further modification in the audit programme is called for. Also, these should be communicated to the client and confirmation should be sought as regards changes in the system. The review of internal control consists mainly of enquiries of personnel at various organisational levels within the enterprise together with reference to documentation such as procedures, manuals, job description and flow-charts, to gain knowledge about the controls

Risk Assessment and Internal Control

3.9

which the auditor has identified as significant to his audit. The auditor may trace a few transactions through the accounting system to assist in understanding that system and it is related to internal controls. The auditor’s preliminary evaluation of internal controls should be made on the assumption that the controls operate generally as described and that they function effectively throughout the period of intended reliance. The purpose of the preliminary evaluation is to identify the particular controls on which the auditor still intends to rely and to test through compliance procedures. Different techniques are used to record information relating to an internal control system. Selection of a particular technique is a matter for the auditor’s judgement. Methods of Recording 3.5 The following are the methods of recording: 3.5.1 Questionnaire - Because of the widespread experience that auditors possess about the business operations in general and the knowledge about the appropriate control, most of the auditing firms have developed their own standardised internal control questionnaire on a generally applicable basis. In developing the standard questionnaire, endeavour is made to make it as wide as possible so that all situations, generally found, are included therein but all of these may not be applicable in a particular case. A questionnaire is a set of questions framed in an organised manner, about each functional area, which has as purpose the evaluation of the effectiveness of control and detection of its weakness if any. A questionnaire usually consists of several separate sections devoted to areas such as purchases, sales, debtors, creditors, wages, etc. The questionnaire is intended to be filled by the company executives who are in charge of the various areas. However, this poses some practical difficulties. The questionnaire is to travel from executives and, therefore, it may take a pretty long time to be filled; also the questions may not be readily intelligible to busy executives and there is a possibility of the questionnaire being misplaced while travelling from one table to another. Having regard to these difficulties, it is now almost an accepted practice that the auditor (or his representative) arranges meetings with the executives concerned and gets the answers filled by each executive. Sometimes, the auditor himself may be required to fill the answers. In such a case, he should ensure that the concerned executive has initiated the answers as a token of his agreement therewith. Questions are so framed as generally to dispense with the requirement of a detailed answer to each question. For this purpose, often one general question is broken down into a number of questions and sub-questions to enable the executive to provide a just ‘Yes’, ‘No’ or ‘Not applicable’ form of reply. Questions are also framed in such a manner that generally a “No” answer will effect weakness in the control system. This requires giving a positive power to the question, keeping in view what the proper control should be. Consider the question ‘Are all receipts recorded promptly and deposited in bank daily? If the answer to this is ‘Yes’, it fits with the plan of good internal control. But if it is ‘No’ it indicates weakness in the system in as much as the moneys received may not be recorded and may be defalcated because the cashier has continued control over the amount for an uncertain period. However, this should not be taken as an unbreakable rule. Questions may be framed also when a ‘Yes’ answer would indicate weakness. The only thing that should be borne in mind is that the scheme of

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questions should be consistent, sequential, logical, and if possible corroborative. Wherever it is necessary, slightly detailed answers also may be asked for to bring clarity to the matter. In the use of standardized internal control questionnaire, certain basic assumptions about elements of good control are taken into account. These are (i) Certain procedures in general used by most business concerns are essential in achieving reliable internal control. This is a time-tested assumption. Deposit into bank of the entire receipts of a day or daily balancing of the cash book and ledgers or periodic reconciliation with the control accounts are examples of widely used practices which are considered good internal control practices. Besides, basic operations giving rise to these practices exist in all businesses irrespective of their nature. Organisations are such that permit an extensive division of duties and responsibilities. The larger the organisation, the greater is the scope of such division.

(ii)

(iii) Employees concerned with accounting function are not assigned any custodial function. (iv) No single person is thrust with the responsibility of completing a transaction all by himself. (v) There should always be evidence to identify the person who has done the work whether involving authorisation, implementation or checking. (vi) The work performed by each one is expected to come under review of another in the usual course of routine. (vii) There is proper documentation and recording of the transactions. The questionnaire serves the purpose of a record so far as the auditor is concerned about the state of internal control as given to him officially. A question naturally arises as to whether it is necessary to issue questionnaire for every year of the auditor’s engagement. For the first year of engagements issue of questionnaire is necessary. For subsequent years, the auditor, instead of issuing a questionnaire again, may request the client to confirm whether any change in the nature and scope of business has taken place that necessitated a corresponding change in the control system, or whether, even without a change in the nature and scope of business, the control system has undergone a change. If there has been a change, the auditor should take note of its and enter appropriate comments on the relevant part of the questionnaire. However, it would be a good practice in the case of continuing engagements to issue a questionnaire irrespective of any change, say, every third year. This will obviate unnecessary trouble of filling the answers every time and to that extent the client’s and the auditor’s own time will be saved. The rationale for issuance of a questionnaire every three years, in the case of even no change, lies in altering the client as regards unnoticed and unspectacular changes that might have taken place during the intervening period; also this will make the client more control-conscious. Questionnaires can be prepared for various aspects of the internal control system. A few sample questionnaires are given in Annexure 3.1. 3.5.2 Check List - It is a series of instructions or questions on internal control which the auditor must follow or answer. When a particular instruction is carried out, the auditor initials the space opposite the instruction. If it is in the form of a question the answer generally ‘Yes’, ‘No’

Risk Assessment and Internal Control

3.11

or ‘Not Applicable’ is entered opposite the question. A check list is more in the nature of a reminder to the auditor about the matters to be checked for testing the internal control system. While a questionnaire is basically a set of questions put to the client, a check list which may be in a form of instructions, questions or just points to be checked may be meant for the auditor’s own staff it is a set of instructions or points; it may be meant for the client if it is in the form of questions. The question form of check list may even be meant for the auditor’s own staff. For example, questions in the check list may be formed in the following manner (this is an illustrative set of questions to be answered by the audit staff). 1. Have you checked that the cashier (i) (ii) is not responsible for opening the incoming mails; does not authorise any of the ledgers;

(iii) does not authorise any expenditure or receipt; (iv) does not sign cheques; (v) takes his annual leave regularly; (vi) inks and balances the cash book everyday; (vii) verifies physical cash balance with the book figure daily at the end of the day; (viii) prepares monthly bank reconciliation statement; (ix) holds no other funds or investment; (x) holds no unnecessary balance in hand; (xi) does not pay money without looking into compliance with proper procedure and due authorisation; and (xii) has tendered proper security or has executed a fidelity bond? When the check list is in question form it is hardly different from a questionnaire. However, generally questionnaire is a popular medium for the evaluation of the internal control system. The basic distinction between internal control questionnaire and check list are as under: 1. 2. 3. The ICQ incorporates a large number of detailed questions but the check list generally contains questions relating to the main control objective with the area under review. ICQ, the weaknesses are highlighted by the ‘Yes’ while in the check list, it is indicated by ‘No’. The significance of ‘No’ in an ICQ does indicate a weakness but the significance of that weakness is not revealed automatically. However, in the check list, a specific statement is required where an apparent weakness may prove to be material in relation to the accounts as a whole.

3.5.3 Flow chart - The flow charting technique can also be resorted to for evaluation of the internal control system. It is a graphic presentation of internal controls in the organisation and is normally drawn up to show the controls in each section or sub-section. As distinct from a narrative form, it provides the most concise and comprehensive way for reviewing the internal

A flow chart is normally a horizontal one in which documents and activities are shown to flow horizontally from section to section and the concerned sections are shown as the vertical column heads. It has been started earlier that a flow chart is a symbolic representation the flow of activity and related documents through the section from origin to conclusion. wages. department or operations. (v) checking authorisation and matching at relevant stages. The suggestion has been made to ensure readability and intelligibility of the flow charts. however.12 Advanced Auditing and Professional Ethics controls and the evaluator’s findings. it can successfully bring the whole control structure. sales with sundry debtors and collections. in appropriate cases an individual also may be shown as the vertical column head. a flow chart will become self contained. purchases. also it demands a highly analytical mind to be able to see clearly the inter division of a job and the appropriate control at relevant points. Care should be taken to see that the first column head is devoted to the section or the individual wherefrom a transaction originates and the placements of other column heads should be in the order of the actual flow of the transaction. . It should. adopting flow-charting technique for evaluation of internal controls. Essentially a flow chart is a diagram full with lines and symbols and. By this process. Purchase is to be linked with sundry creditors and payments. It gives a bird’s eye view of the system and is drawn up as a result of the auditor’s review thereof. (vi) filing of the documents. It has been stated earlier that flow charts should be made section-wise or department-wise. A properly drawn up flow chart can provide a neat visual picture of the whole activities of the section or department involving flow of documents and activities. specially the essential parts thereof. it is probably the most effective way of presenting the state of internal controls in the client’s organisation. though cannot perhaps be totally banished are reduced to the minimum and by that process. Each one of the main functions is to be linked with related functions for making a complete course. if judicious use of them can be made. More specifically it can show (i) (ii) at what point a document is raised internally or received from external sources. Every detail relevant from the control point of view and the details about how an operation is performed can be included in the flow chart. Drawing of a flow chart . in a condensed but wholly meaningful manner. (iv) distribution of the documents to various sections.3. the number of copies in which a document is raised or received. In a flow chart. (iii) the intermediate stages set sequentially through which the document and the activity pass. not be understood that details are not reflected in a flow chart. and (vii) final disposal by sending out or destruction. production. etc. narratives. complete and meaningful for evaluation of internal controls. These can be sales. As a matter of fact a very sound knowledge of internal control requirements is imperative for.

the questionnaire is a guide for the study of a control system through flow charts. incorporating questions.13 Generally. answers are available in the flow chart and they will reveal weakness. in the system. . The internal control questionnaire contains questions. In fact. This is an evaluation of the control system through the process of flow charting. if any. the answers to which are to be looked into from the flow chart.Risk Assessment and Internal Control 3. a questionnaire is also enclosed with a flow chart.

after despatch of the goods. Inventory recording function. the Section again initiates fresh sales advices in respect of the unfulfilled part and all the processes. 3. 4. The orders received from customers are temporarily filed in the alphabetical order. number of copies.14 Advanced Auditing and Professional Ethics We may examine the flow charting techniques for evaluation of internal controls on the sales and debtors function. Main accounting function. that there exists an alternative possibility. These sales advices are consecutively numbered (by reference to the last number on the order book) and entered in the order book with the consecutive number. the Order receiving Section enters the date of dispatch and the quantity despatched in the order book. All these functions are carried out in distinct sections. The salesmen use the same advice form as is being used by the order receiving section. As regards the Order Receiving Section. Order receiving function. 2. the books. If the quantity despatched is fulfillment of the quantity ordered. if any. date. if stock is then available. Let us assume that these are 1. the copy of the sales advice is kept in a temporary file in numerical order. Upon receipt of the last copy. 4. The sales advices are prepared in sets of four with a noting for the customer’s sales-tax status. the section raises internal “Sales advices”. however. internal and external. by telephone. The despatch section. and (iii) through the company’s salesmen. For the purpose of drawing a flow chart to incorporate the above narration it is useful to know 1. The last copy of the original set is annexed to the customer’s order and kept in the customer’s file. the documents. the party and other relevant details. All the four copies are sent to the despatch section. are repeated. 5. the point for originating the flow of transaction. the last copy of the sales invoices is annexed to customer’s order and filed in the customer’s file. distribution flow and the details. Accounting in the debtors’ ledger. Basing the receipts of orders of customers. Billing function. maintained and the details recorded there in and the source or sources for the details. 6. and the flow of the transaction. 3. . Despatch function. sends back to the Order receiving Section the last copy of the sales advice after entering thereon the date of despatch and the quantity despatched. If. let us further assume that the section receives orders: (i) (ii) through mail.3. 2. as in the case of original. Periodically this file is checked to determine the unfulfilled orders and. the order is only partly executed.

when the goods are sent either by rail. can be prepared. the head of the Section initials the advices. the despatch section arranges despatch of materials and put the date of despatch and the quantities despatched. The first copy is sent as a packing slip with the goods. etc. In case of goods not directly delivered to the buyers.. The last copy of the advice is sent back to the Order Receiving Section. The work and procedure content of the despatch section is assumed to be as follows: After the receipt of the sales advices in sets of four.e. is received back and filed date-wise. the copy constitutes the basis for raising the relevant forwarding note on the basis of which R. . the second copy goes to the Billing Department and the third copy accompanies the goods when delivered to the buyer and.R. i. road or water transport.Risk Assessment and Internal Control The flow chart for the above may be as under - 3.15 CHART 1 We can extend the activity flow now to the despatch section which is the logical second stage of operation.. obtaining the buyer’s acknowledgement of the receipt of the goods therein.

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Advanced Auditing and Professional Ethics

The flow chart for the despatch section may be as follows -

CHART 2 This flow is taken to the Billing Section. The Section generally accumulates the second copy of the Sales Advice for two or three days and prepares sales invoices in sets of four. The pricing of the sales invoice is done by reference to the company’s current price list or the catalogue. The number of the sales advice is entered on the corresponding invoice which is pre-numbered, also, the number of the invoice is recorded on the copy of the sales advice which is then filed alphabetically. The first copy of the invoice is sent to the customer while the second, third and fourth copies are respectively sent to the sundry debtors’ ledger clerk, the Stock Section and the Accounts Section. The Billing Section also is responsible for raising credit notes on the basis of documents received. Credit notes are also prepared in sets of four and are distributed in exactly the same way as invoices. The stocks of invoice and the credit note forms remain in the Billing Section.

Risk Assessment and Internal Control The Flow Chart for this Section is given below -

3.17

CHART 3 Now, in the order of the flow of activities, more sectional flow charts can be prepared to cover the activities in the Accounts Section and the Stock Section and they together, when sequentially assembled, will constitute the complete flow chart for the sales transactions and sundry debtors recordings. (These flow charts have been prepared on the basis of the approach and the symbols used in the book “Analytical Auditing” by Skinner and Anderson. Students who desire to study the subject of preparation of flow charts further may refer to Chapter 4 of that book.) It is now left for us to see how these flow charts reveal the state of internal control. A close look into flow charts will show the following: (i) The advices are sent by salesmen; though prepared on the same sales advice form as is prepared in the section, there is no check that all the advices sent by salesmen have been received. This may entail loss of business because of non-receipt of sales advice. (Refer to the flow chart for the Order Receiving Section).

3.18 (ii)

Advanced Auditing and Professional Ethics The raising of sales advises on the basis of telephonic orders, irrespective of the party’s standing and record of performance is risky from the business point of view. (Refer to the flow chart for the Order Receiving Section).

(iii) There is no system of prior credit sanction to the parties; in consequence, there may be despatch of goods to bad credit risks. (Refer to the flow chart for the Despatch Section). (iv) There is no check that all the second copies of the sales advices sent by the Despatch Section have been received by the Billing Section. The possibility of despatch not being, billed exists, (Refer to the flow chart for the Despatch as well as the Billing Section. (v) There is no check in respect of pricing, extension and addition on the invoice or the credit notes. This may result in loss of revenue for wrong pricing or wrong calculation. (Refer to the flow chart for Billing Section). (vi) It is not clear whether the supporting documents are adequate for authorising the issue of credit notes where there is a need for a greater caution. (Refer to the flow chart for Billing Section). So far we have seen the points of weaknesses that are evident from these flow charts. For a clearer understanding of the flow chart as a medium for evaluating internal controls, the following further points may be useful: (a) There exists proper numerical control over orders booked (except the case for the salemen’s orders). (b) There is a permanent and continuous record of the orders booked in the form of order book. (c) There is a definite basis for raising sales advices. (d) The order book record is always kept complete by entering the information about the execution of the order and this keeps the information about the pending orders ready at any moment. (e) Partly executed orders are reviewed from time to time so that as soon as goods are available, the same may be despatched to customers. (f) The customer’s purchase order and the related sales advises are matched and kept together in the customer’s file.

(g) The sales advices are initialed by the Despatch Section head as token of his having satisfied himself about the correctness of the entries as regards the quantity despatched and the date of despatch. (h) Record of actual direct delivery is maintained through the copy of the sales advice bearing the customer’s, acknowledgement of his having received the goods. Similarly, the record of out station deliveries is kept in the copy of the forwarding note annexed to the sales advice copy. (i) Documents have as many copies as are necessary for ensuring proper flow and proper control. There is no wastage through unnecessary copies nor any hold up because of

Risk Assessment and Internal Control inadequacy of copies. (j) There are supporting documents for raising invoices and credit notes.

3.19

(k) The distribution of invoices and credit notes is such as would enable the recording of billing at the relevant centres independent of each other. (l) There is control over the number of invoices and credit notes by pre-numbering. Thus, by flow charting has an auditor can very clearly see the inter- relationships of the activities and flows and how they are integrated from stage to stage. However, the auditor has to be careful about the readability and intelligibility of the chart. Identification of all individual functions in a section is also highly relevant for preparation of the flow chart. The smaller the segment, the better is the possibility of quick comprehension. Naturally, the auditor should try to see each section as the natural assembly of distinct and identified components. Evaluation of Internal Control 3.6 The auditor, in forming his opinion on financial information, needs reasonable assurance that transactions are properly authorised and recorded in the accounting records and that transactions have not been omitted. Internal controls, even if fairly simple, may contribute to the reasonable assurance the auditor seeks. The auditor’s objective in studying and evaluating internal controls is to establish the reliance he can place thereon in determining the nature, timing and extent of his substantive auditing procedures. Compliance procedures are tests designed to obtain reasonable assurance that those internal controls on which audit reliance is to be placed are in effect. These procedures include tests requiring inspection of documents supporting transactions to gain evidence that controls have operated properly (for example, verifying that the document has been authorised) and enquiries about the observation of controls which leave no audit trial (for example, determining who actually performs each function trial not merely who is supposed to perform it). The auditor should review the accounting system and related internal controls to gain an understanding of the flow of transactions and the specific control procedures to be able to make a preliminary evaluation and identification of those internal controls on which it might be effective and efficient to rely in conducting his audit. The purpose of preliminary evaluation is to identify the particular controls on which the auditor intends to rely and to test through compliance procedures. It should be remembered that preliminary evaluation of the internal control is made on the assumptions that the controls operates generally as described and that they function effectively throughout the period of intended reliance. Compliance procedures should be conducted by the auditor to gain evidence that those internal controls on which he intends to rely operate generally as identified by him and that they function effectively throughout the period of intended reliance. The concept of effective operation recognises that some deviations from prescribed controls may have occurred. Deviations from prescribed controls may be caused by such factors as changes in key personnel, significant seasonal fluctuations in volume of transactions and human error. The auditor should make specific enquiries concerning these matters, particularly as to the timing

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of staff changes in key control functions. He should then ensure that his compliance procedures appropriately cover such a period of change or fluctuation. Based on the results of his compliance procedures, the auditor should evaluate whether the internal controls are adequate for his purposes. If based on the results of the compliance procedures, the auditor concludes that it is not appropriate to rely on a particular internal control to the degree previously contemplated, he should ascertain whether there is another control which would satisfy his purpose and on which he might rely (after applying appropriate compliance procedures). Alternatively, he may modify the nature, timing or extent of his substantive audit procedures. The auditor’s compliance procedures normally should be applied to transactions selected from those of the entire period under examination. When, however, a shorter period is initially tested, the auditor needs to consider what is necessary to provide reasonable assurance as to the reliability of the accounting records for the whole period. The auditor’s judgement as to the nature, timing and extent of compliance or substantive procedures to be applied to transactions occurring in the remaining period will be affected by such factors as the following(a) the results of the procedures already conducted; (b) the responses to enquiries as to whether the internal control system is still operating in the same manner as when studied and evaluated; (c) the length of the remaining period (d) the nature and amount of transactions or balances involved; (e) the auditor’s evaluation of internal control environment, especially supervisory controls; and (f) the substantive procedures which the auditor intends to carry out irrespective of the adequacy of internal controls.

The aforesaid study and discussion to give an overall idea of the control plan as it is and may be considered as the first step of evaluation. This is followed by a process which enables the auditor to know the specific control, its appropriateness and weakness of redundancy in the context of the specific operation. This process is essentially a question and answer exercise. For this, the auditor should have sufficient knowledge and experience about what should be the appropriate and exact control in the given circumstances for the specific operation. Accordingly, he frames questions for the answers to which will provide him insight into the effectiveness or otherwise of the given controls. This question- answer exercise can be undertaken either by framing a questionnaire or a check list. Internal Control and Risk Assessment 3.7 The auditor should obtain an understanding of the control environment sufficient to assess management's attitudes, awareness and actions regarding internal controls and their importance in the entity. Such an understanding would also help the auditor to make a preliminary assessment of the adequacy of the accounting and internal control systems as a basis for the preparation of the financial statements, and of the likely nature, timing and extent

Risk Assessment and Internal Control of audit procedures.

3.21

The auditor should obtain an understanding of the control procedures sufficient to develop the audit plan. In obtaining this understanding, the auditor would consider knowledge about the presence or absence of control procedures obtained from the understanding of the control environment and accounting system in determining whether any additional understanding of control procedures is necessary. Because control procedures are integrated with the control environment and the accounting system, as the auditor obtains an understanding of the control environment and the accounting system, some knowledge about control procedures is also likely to be obtained, for example, in obtaining an understanding of the accounting system pertaining to cash, the auditor ordinarily becomes aware of whether bank accounts are reconciled regularly. Ordinarily, development of the overall audit plan does not require an understanding of control procedures for every financial statement assertion in each account balance and transaction class. 3.7.1 Control Risk Preliminary Assessment of Control Risk - After obtaining an understanding of the accounting system and internal control system, the auditor should make a preliminary assessment of control risk, at the assertion level, for each material account balance or class of transactions. The preliminary assessment of control risk is the process of evaluating the likely effectiveness of an entity's accounting and internal control systems in preventing or detecting and correcting material misstatements. The preliminary assessment of control risk is based on the assumption that the controls operate generally as described and that they operate effectively throughout the period of intended reliance. There will always be some control risk because of the inherent limitations of any accounting and internal control system. The auditor ordinarily assesses control risk at a high level for some or all assertions when: (a) the entity's accounting and internal control systems are not effective; or (b) evaluating the effectiveness of the entity's accounting and internal control systems would not be efficient. In the above circumstances, the auditor would obtain sufficient appropriate audit evidence from substantive procedures and from any audit work carried out in the preparation of financial statements. The preliminary assessment of control risk for a financial statement assertion should be high unless the auditor: (a) is able to identify internal controls relevant to the assertion which are likely to prevent or detect and correct a material misstatement; and (b) plans to perform tests of control to support the assessment. Documentation of Understanding and Assessment of Control Risk - The auditor should document in the audit working papers: (a) the understanding obtained of the entity's accounting and internal control systems; and

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(b) the assessment of control risk. When control risk is assessed at less than high, the auditor would also document the basis for the conclusions. Different techniques may be used to document information relating to accounting and internal control systems. Selection of a particular technique is a matter for the auditor's judgement. Common techniques, used alone or in combination, are narrative descriptions, questionnaires, check lists and flow charts. The form and extent of this documentation is influenced by the size and complexity of the entity and the nature of the entity's accounting and internal control systems. Generally, the more complex the entity's accounting and internal control systems and the more extensive the auditor's procedures, the more extensive the auditor's documentation will need to be. Tests of Control - Tests of control are performed to obtain audit evidence about the effectiveness of the: (a) design of the accounting and internal control systems, that is, whether they are suitably designed to prevent or detect and correct material misstatements; and (b) operation of the internal controls throughout the period. Tests of control include tests of elements of the control environment where strengths in the control environment are used by auditors to reduce control risk. Some of the procedures performed to obtain the understanding of the accounting and internal control systems may not have been specifically planned as tests of control but may provide audit evidence about the effectiveness of the design and operation of internal controls relevant to certain assertions and, consequently, serve as tests of control. For example, in obtaining the understanding of the accounting and internal control systems pertaining to cash, the auditor may have obtained audit evidence about the effectiveness of the bank reconciliation process through inquiry and observation. When the auditor concludes that procedures performed to obtain the understanding of the accounting and internal control systems also provide audit evidence about the suitability of design and operating effectiveness of policies and procedures relevant to a particular financial statement assertion, the auditor may use that audit evidence, provided it is sufficient to support a control risk assessment at less than a high level. Tests of control may include: ♦ Inspection of documents supporting transactions and other events to gain audit evidence that internal controls have operated properly, for example, verifying that a transaction has been authorised. Inquiries about, and observation of, internal controls which leave no audit trail, for example, determining who actually performs each function and not merely who is supposed to perform it. Re-performance of internal controls, for example, reconciliation of bank accounts, to ensure they were correctly performed by the entity.

Risk Assessment and Internal Control ♦

3.23

Testing of internal control operating on specific computerised applications or over the overall information technology function, for example, access or program change controls.

The auditor should obtain audit evidence through tests of control to support any assessment of control risk which is less than high. The lower the assessment of control risk, the more evidence the auditor should obtain that accounting and internal control systems are suitably designed and operating effectively. When obtaining audit evidence about the effective operation of internal controls, the auditor considers how they were applied, the consistency with which they were applied during the period and by whom they were applied. The concept of effective operation recognises that some deviations may have occurred. Deviations from prescribed controls may be caused by such factors as changes in key personnel, significant seasonal fluctuations in volume of transactions and human error. When deviations are detected the auditor makes specific inquiries regarding these matters, particularly, the timing of staff changes in key internal control functions. The auditor then ensures that the tests of control appropriately cover such a period of change or fluctuation. In a computer information systems environment, the objectives of tests of control do not change from those in a manual environment; however, some audit procedures may change. The auditor may find it necessary, or may prefer, to use computer-assisted audit techniques. The use of such techniques, for example, file interrogation tools or audit test data, may be appropriate when the accounting and internal control systems provide no visible evidence documenting the performance of internal controls which are programmed into a computerised accounting system. Based on the results of the tests of control, the auditor should evaluate whether the internal controls are designed and operating as contemplated in the preliminary assessment of control risk. The evaluation of deviations may result in the auditor concluding that the assessed level of control risk needs to be revised. In such cases, the auditor would modify the nature, timing and extent of planned substantive procedures. Quality and Timeliness of Audit Evidence - Certain types of audit evidence obtained by the auditor are more reliable than others. Ordinarily, the auditor's observation provides more reliable audit evidence than merely making inquiries, for example, the auditor might obtain audit evidence about the proper segregation of duties by observing the individual who applies a control procedure or by making inquiries of appropriate personnel. However, audit evidence obtained by some tests of control, such as observation, pertains only to the point in time at which the procedure was applied. The auditor may decide, therefore, to supplement these procedures with other tests of control capable of providing audit evidence about other periods of time. In determining the appropriate audit evidence to support a conclusion about control risk, the auditor may consider the audit evidence obtained in prior audits. In a continuing engagement, the auditor will be aware of the accounting and internal control systems through work carried out previously but will need to update the knowledge gained and consider the need to obtain further audit evidence of any changes in control. Before relying on procedures performed in

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Advanced Auditing and Professional Ethics

prior audits, the auditor should obtain audit evidence which supports this reliance. The auditor would obtain audit evidence as to the nature, timing and extent of any changes in the entity's accounting and internal control systems since such procedures were performed and assess their impact on the auditor's intended reliance. The longer the time elapsed since the performance of such procedures the less assurance that may result. The auditor should consider whether the internal controls were in use throughout the period. If substantially different controls were used at different times during the period, the auditor would consider each separately. A breakdown in internal controls for a specific portion of the period requires separate consideration of the nature, timing and extent of the audit procedures to be applied to the transactions and other events of that period. The auditor may decide to perform some tests of control during an interim visit in advance of the period end. However, the auditor cannot rely on the results of such tests without considering the need to obtain further audit evidence relating to the remainder of the period. Factors to be considered include: ♦ ♦ ♦ ♦ ♦ ♦ The results of the interim tests. The length of the remaining period. Whether any changes have occurred in the accounting and internal control systems during the remaining period. The nature and amount of the transactions and other events and the balances involved. The control environment, especially supervisory controls. The nature, timing and extent of substantive procedures which the auditor plans to carry out.

Final Assessment of Control Risk - Before the conclusion of the audit, based on the results of substantive procedures and other audit evidence obtained by the auditor, the auditor should consider whether the assessment of control risk is confirmed. In case of deviations from the prescribed accounting and internal control systems, the auditor would make specific inquiries to consider their implications. Where, on the basis of such inquiries, the auditor concludes that the deviations are such that the preliminary assessment of control risk is not supported, he would amend the same unless the audit evidence obtained from other tests of control supports that assessment. Where the auditor concludes that the assessed level of control risk needs to be revised, he would modify the nature, timing and extent of his planned substantive procedures. 3.7.2 Relationship between the Assessments of Inherent and Control Risk - Management often reacts to inherent risk situations by designing accounting and internal control systems to prevent or detect and correct misstatements and therefore, in many cases, inherent risk and control risk are highly interrelated. In such situations, if the auditor attempts to assess inherent and control risks separately, there is a possibility of inappropriate risk assessment. As a result, audit risk may be more appropriately determined in such situations by making a combined assessment.

Risk Assessment and Internal Control

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3.7.3 Detection Risk - The level of detection risk relates directly to the auditor's substantive procedures. The auditor's control risk assessment, together with the inherent risk assessment, influences the nature, timing and extent of substantive procedures to be performed to reduce detection risk, and therefore audit risk, to an acceptably low level. Some detection risk would always be present even if an auditor were to examine 100 percent of the account balances or class of transactions because, for example, most audit evidence is persuasive rather than conclusive. The auditor should consider the assessed levels of inherent and control risks in determining the nature, timing and extent of substantive procedures required to reduce audit risk to an acceptably low level. In this regard the auditor would consider: (a) the nature of substantive procedures, for example, using tests directed toward independent parties outside the entity rather than tests directed toward parties or documentation within the entity, or using tests of details for a particular audit objective in addition to analytical procedures; (b) the timing of substantive procedures, for example, performing them at period end rather than at an earlier date; and (c) the extent of substantive procedures, for example, using a larger sample size. There is an inverse relationship between detection risk and the combined level of inherent and control risks. For example, when inherent and control risks are high, acceptable detection risk needs to be low to reduce audit risk to an acceptably low level. On the other hand, when inherent and control risks are low, an auditor can accept a higher detection risk and still reduce audit risk to an acceptably low level. Refer to the Appendix to this AAS for an illustration of the interrelationship of the components of audit risk. While tests of control and substantive procedures are distinguishable as to their purpose, the results of either type of procedure may contribute to the purpose of the other. Misstatements discovered in conducting substantive procedures may cause the auditor to modify the previous assessment of control risk. Refer to the Appendix to this AAS for an illustration of the interrelationship of the components of audit risk. The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any substantive procedures. Regardless of the assessed levels of inherent and control risks, the auditor should perform some substantive procedures for material account balances and classes of transactions. The auditor's assessment of the components of audit risk may change during the course of an audit, for example, information may come to the auditor's attention when performing substantive procedures that differs significantly from the information on which the auditor originally assessed inherent and control risks. In such cases, the auditor would modify the planned substantive procedures based on a revision of the assessed levels of inherent and control risks.

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Advanced Auditing and Professional Ethics

The higher the assessment of inherent and control risks, the more audit evidence the auditor should obtain from the performance of substantive procedures. When both inherent and control risks are assessed as high, the auditor needs to consider whether substantive procedures can provide sufficient appropriate audit evidence to reduce detection risk, and therefore audit risk, to an acceptably low level. When the auditor determines that detection risk regarding a financial statement assertion for a material account balance or class of transactions cannot be reduced to an acceptable level, the auditor should express a qualified opinion or a disclaimer of opinion as may be appropriate. Internal Control in Small Business Enterprises 3.8 The auditor needs to obtain the same degree of assurance in order to give an unqualified opinion on the financial statements of both small and large entities. However many controls which would be relevant to large entities are not practical in small business. For example, in a small business, accounting procedures may be performed by a few persons. These persons may have both operating and custodial responsibilities and segregation of functions may be missing or severely limited. Inadequate segregation of duties may, in some cases, be offset by supervisory controls exercised by the owner. This supervisory function by the owner becomes possible because of the fact that he has direct personal knowledge of the business and involvement in the business transactions. In circumstances where segregation of duties is limited and the evidence of supervisory controls is lacking the evidence necessary to support the auditor’s opinion on the financial information may have to be obtained largely through substantive procedures. Reporting to Clients on Internal Control Weaknesses 3.9 During the course of audit work, the audit may notice material weaknesses in the internal control system. Material weaknesses are defined as absence of adequate controls on flow of transactions that increases the possibility of errors and frauds in the financial statements of the entity. For example, if monthly age-wise analysis of debtors is not performed then it may result in inadequate provisioning of bad debts for the fiscal year under audit. The auditor should communicate such material weaknesses to the management or the audit committee, if any, on a timely basis. This communication should be, preferably, in writing through a letter of weakness or management letter. Important points with regard to such a letter are as follows: (a) The letter lists down the area of weaknesses in the system and offers suggestions for improvement. (b) It should clearly indicate that it discusses only weaknesses which have come to the attention of the auditor as a result of his audit and that his examination has not been designed to determine the adequacy of internal control for management. (c) This letter serves as a valuable reference document for management for the purpose of revising the system and insisting on its strict implementation.

Risk Assessment and Internal Control

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(d) The letter may also serve to minimize legal liability in the event of a major defalcation or other loss resulting from a weakness in internal control. It should be appreciated that by writing a letter to the management about the weaknesses in the system, the auditor is not absolved from his duty to report the shortcomings in the accounts by way of qualification where the defects have not been corrected to the auditor’s satisfaction weighing the materiality of weaknesses and their impact, if considered necessary. The practice of the issue of letter of weaknesses has a great merit in relieving the auditor from liability in case serious frauds or losses have occurred, which probably would not have taken place had the client taken due note of the auditor’s points in the letter of weakness. In the case Re S.P. Catterson & Ltd. (1937, 81, Act L.R. 62), the auditor was acquitted of the charge of negligence for employee’s fraud in view of the fact that he had already informed the client about the unsatisfactory state in the specific areas of accounts and had suggested improvements which were not acted upon by the management. Self-examination Questions 1. Indicate which of the following are administrative controls: (a) Attendance record of employees. (b) Purchase requisition. (c) Stock control account. (d) Invitation for quotations. (e) Inspection of goods received as to quality. (f) Fire insurance of the factory. (g) Indemnity Bond. (h) Bank reconciliation. (i) (j) 2. 3. Budget. Observation of the disbursement of wages.

Explain three important elements of internal controls? Read the following and state whether proper controls exist or not. In case answer is negative, state the reason: (i) (ii) Raw jute purchased by a jute mill is weighed on trolleys and the jute purchase officer who is present at the time of weighment signs the weighment record. Post Office Savings Bank Certificates, being investments, are lodged with the banker for sale custody and collection when due. The company also maintains a register showing details of the certificates, their dates of maturity, etc. in view of the fact that the certificates are numerous the company official reviews the register on a half-yearly basis and advises the bank to collect the matured ones.

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Advanced Auditing and Professional Ethics (iii) As a matter of routine, a budget is prepared well in advance in respect of each financial year. The annual budget is broken down to quarterly budgets for facilitating review. At the expiry of each quarter a thorough reconciliation is made between the budgeted figures and the actuals. (iv) The cashier, being a highly reliable person, is discouraged from taking periodic leave; he is compensated by extra payment. (v) Annual stock-taking is carried out by employees drawn from various sections-but not a single one from the stock section. (vi) Wages sheets are prepared in the time section. (vii) Before finalising any sales tender, the sales manager sends the tenders to the costing section for proper product or job costing. (viii) Cheques up to Rs. 1,000 are signed by the accountant and those in excess are jointly signed by the finance manager and the accountant. (ix) The cashier is under instruction to carry cash in hand just enough to meet next day’s requirements. Excess requirement of the day, if any, is met by borrowing from the executive director. (x) The moment bank balance falls below a certain level, the bank is under a standing instruction to transfer securities lodged with it for safe custody to the pledge account of a requisite amount and raise the balance to certain level. After the inflow of cash into the account, the bank is to re-transfer the securities.

4.

State the reasons for the following procedural requirements, all of help to strengthen internal control: (a) The gateman of a cinema house is required to tear each ticket presented for admission into two and hand over the stub to the patron. (b) After the chief accountant signs the disbursement cheques, they are listed and the supporting data are retained in the Accounts Department but the cheques are passed on to the Mailing Department for onward transmission. (c) The copy of the “Goods Received Note” passed on to the quality inspector for Quality Report does not contain the name and particulars of the supplier. (d) Department Attendance Registers are maintained in the factory even though the workers while entering the factory are to punch their respective clock-cards. (e) In a bank no director, officer or employee is entitled to act on behalf of a customer in relation with any transaction with the bank. (f) The driver of each vehicle is to maintain a log book showing details of trips and petrol purchased. The log-book is presented to the Office Manager once a week for his verification.

Risk Assessment and Internal Control 5. Comment on the following questions in a questionnaire prepared by an audit firm. (i) (ii) What is the nature of business?

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Is there a case that more than one fund is under the charge of a single employee?

(iii) Is cash given against I.O.Us.? (iv) Do you have a daily physical verification of petty cash and postage stock? (v) Do you keep -inventory of table stationery? (vi) Is there a typists’ pool in your organisation? (vii) What are the thrusts in your advertisement campaign? (viii) Who looks after your investments? (ix) Are payers required to sign vouchers for all disbursements? (x) Do you obtain clearance from the Credit Control Department in each and every case, before supplies are made on credit? 6. 7. Prepare a flow chart in respect of the function of the Sales Ledger Clerk? Tick the items given below that can be known by a study of the organisation chart of concern: (a) Scope of the business (b) Accountability. (c) Line and staff functions. (d) Job division. (e) Internal check. (f) Accounting records. (g) Inter-relationship of the functionaries. (h) Exercise of authority. (i) (j) (l) Personnel policy. Accounting policies. Clerical distribution.

(k) Authority for exceeding limits.

Answer to the Self-examination Questions 1. 2. (a), (e), (f), (o) (i) Job division (ii) Separation of recording and custodial functions. (iii) Internal auditing.

3.30 3. (i)

Advanced Auditing and Professional Ethics No; because the jute purchase officer, who is directly in touch with supplying parties, has opportunity of causing wrong weights being recorded at the cost of the mill. No; there is a gap of six months in between two reviews and there will be loss of interest in respect of certificates maturing in the intervening period.

(ii)

(iv) No; opportunity for a second person to look into details about what the cashier has been doing. (v) No; provides no opportunity manipulation. (vi) No; it involves the company into avoidable borrowings and provides opportunities for wrong payments to the executive director instead the estimation of the next day’s requirement should be made a little more liberally, taking into account the past experience about excess requirement. (vii) No; it provides uncontrolled latitude to the bank to convert company’s securities meant, for safe custody into security for funds borrowed. 4. (a) The pass collected by the gate man can be checked against total sale of ticket as per the counterfoils of ticket books. Any presentation of unauthorised tickets will be known; also the patrons will carry with them the evidence of their authorised entry into the exhibition hall by retaining the stub. (b) It provides an independent record with the Accounts Department about daily issue and actual forwarding of cheques. (c) The quality inspector should not know the supplying party in the interest of an objective quality inspection. (d) It records actual attendance to the work and also helps to keep check on wastage of time in reaching his work spot. (e) It avoids conflict of interest. (f) It enables exercise of control over trips and consumption of control; also unauthorised trips or excessive consumption of petrol may be known at an early date.

5.

Items (i) to (iv) and (viii) to (x) are all right. (v) From materiality point of view the question is not relevant. (vi) Normally, an auditor is not concerned with the typing organisation of the client. (vii) Not of any direct relevance from the point of view of accounting control.

7.

(b), (d), (c), (g), (h).

Risk Assessment and Internal Control

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Annexure I Sample Internal Control Questionnaire I. Investments (i) Segregation and rotation of duties: Is there a proper segregation of duties? Are the following functions relating to investments segregated? (a) (b) (c) (d) Authorization of transactions relating to investments. Execution of transactions. Recording of transactions. Physical custody of investment scrips.

(ii) Are the duties of various persons relating to investments rotated periodically? Authorization of Transactions (i) Are the authorities for acquisition, disposal and other decisions relating to investments clearly laid down? Are the limits on authorities of managers at various levels clearly defined? (ii) Are the procedures for acquisition, disposal, etc., of investments? (iii) Are the relevant legal provisions duly considered in taking decisions regarding acquisition/disposal of investments? (For example, in the case of insurance companies, there are restrictions regarding the nature of investments that can be acquired. Similarly, in the case of other companies, the law lays down conditions which have to be followed if investments exceed prescribed limits.) (iv) Are the transactions of acquisition/ disposal of investments in the form of shares, debentures, etc., required to be executed only through brokers who are members of recognized stock exchanges? Are there any limits on exposure with each broker (e.g., there may be a limit on the total value of transactions outstanding with a broker at any point of time)? Do these limits appear reasonable?

Maintenance of Records and Documents
(i) Are all transactions relating to investments recorded properly and promptly? Is there an investment register (or other appropriate record) wherein particulars relating to investments are recorded? Are the records sufficiently detained to facilitate identification of investments and determination of their cost? In particulars, whether the records show, in respect of each investment, the nature of investment, or cum interest, due dates of interests or the likely dates of the receipt of the dividends, financial year of the enterprise in which the investment has been made, date of maturity (in the case of debentures and similar investments), purchased price and incidental costs (brokerage, stamp fee, etc.)? (ii) Are all accretions to investments (i.e., bonus shares, right shares, etc?) Properly recorded? Similarly are changes in the nature of investments (e.g. conversion of debentures into equity shares) properly recorded? (iii) Do the records include particulars of significance developments relating to investments, e.g., Right offers, bonus announcements, options for conversion, warrants, etc.? For e.g., do the records show whether rights were offered and whether they were subscribed or soled or otherwise renounced? (iv) Is a proper record maintained in respect of scrips belonging to third parties which are in the possession of the enterprise ( e.g., as security for loans granted)? Are there adequate procedures to ensure that the scrips belonging to third parties can be readily identified? (v) Are proper records maintained in respect of investments which have been sent for registration of transfer, splitting-up or similar purposes? Does the enterprise keep a photo copy ( or other detailed

Special safeguards in respect of investment scrips accompanied by blank transfer deeds include dual custody. as security for loan from a bank ) and under proper authorization? In such cases.. etc.. Inventories Segregation and Rotation of Duties (i) Are the duties relating to inventories properly segregated? As far as possible. split. the persons responsible for handling physical inventories should not be assigned any duties relating to purchasing.. where the company / transfer agent returns the documents without affecting the transfer due to certain defects? Accountability for and Safeguarding of Investments (i) Are all investments held in the name of the enterprise? Are the circumstances in which investments may not be held in the name of the enterprise clearly specified? Are the authorities for approving the acquisition or holding of investments in the name of other persons clearly laid down? Are adequate measures taken to safeguard the interests of the enterprise in such cases? (ii) Are investment scrips kept under lock and key in the custody of a responsible official? Are there adequate safeguard against theft. separate storage of transfer deeds and related scrips. fire. So that the necessary details are available even if the original documents are lost? (vi) Is the validity of transfer deeds accompanying the investment scrips acquired by the enterprise checked? Is it ensured that the investments scrips along with the transfer deeds are lodged with the company / transfer agent within the validity period? (vii) Is immediate action taken in case of bad deliveries. etc? (iii) Are there any special safeguards against misappropriation of investment scrips which are accompanied by blank transfer deeds? (In blank transfer deeds.32 Advanced Auditing and Professional Ethics record) of all transfer deeds and investment certificates sent for registration of transfer.) (iv) Are investment scrips kept with third parties only in appropriate cases (e. including a review of the rates at which the various transactions have been effected? Does the internal audit examine whether the rates conform to the prevalent market rates? In case of divergence.g. particularly prone to misappropriation. etc. is there a system of obtaining certificates from the third parties periodically? Do the certificates contain sufficient details of investments held by the third parties? Is there a system whereby a periodic review is made to ensure that all such investments in the hands of third parties are safe? (v) Is there a system of periodic physical verification of the scrips? Are the differences between the results of physical verification and the book records analyze? Is there a proper follow-up on all discrepancies noticed on physical verification? Independent Checks (i) Is there a regular internal audit of transactions relating to investments. therefore. (ii) Are the duties of various persons relating to inventories rotated periodically? .. the name of the transferee is not filled in. does the internal audit specifically examine the authorization for the relevant transactions and the reasons for not effecting the transactions at market rates? (ii) Is there an independent review of compliance with rules and regulations governing investments? Is there also a review of compliance with conditions attached to certain investments which restrict the right of ownership/disposal of investments (for e. billing or accounting. i. certain shares allotted to promoters cannot be sold by them for a certain period)? II.3.e.g. They are.

and safeguarding of..33 (i) Have the authorities for purchases. etc.? (x) Are proper records maintained in respect of stocks belonging to third parties which are in the possession of the enterprise. for processing? (xi) Are there adequate cut-off procedures to ensure that: (a) goods purchased but not yet received are included in the inventories. consignees. etc.Risk Assessment and Internal Control Authorization of Purchases. e. receipt of goods and their issuance from stores been clearly laid down? (ii) Are issues from stores made only against proper requisition notes or Challans approved by authorized managers? (iii) Are transfers of inventory items from one department to another made only after obtaining the approval of authorized managers? Maintenance of Records and Documents (i) Is there a proper documentation of receipt of goods from suppliers as well as issue of goods from the factory? (ii) Is there a proper documentation of transfer of inventory items from one department to another? (iii) Is there a perpetual inventory system whereby receipts and issues are recorded in the inventory records as soon as they take place? (iv) Are perpetual inventory records reconciled periodically with financial records / cost accounting records? (v) Does the enterprise have a proper cost accounting system for determining the cost of work-inprocess and finished goods? (vi) Are overhead absorption rates properly determined in the light of current experience? (vii) Are actual costs compared with standard and / or budgeted costs and the variance analyze and properly adjusted? (viii) Are proper records maintained in respect of waste. scrap. sub. Receipts and Issues 3.? Is the insurance cover adequate? Is it reviewed periodically? . deterioration. goods sent to customers on approval. theft. inventories Storage (ii) Is the storage of various items of inventories methodical? Does it protect them against damage.contractors. restricted? Are there suitable safeguards to ensure that inventory item cannot be taken out of the stores without proper authorization? Insurance (i) (ii) Have different items of inventories been insured against fire. purchases are debited and a liability is created from the same. returnable containers and by-products? (ix) Are proper records maintained in respect of inventories belonging to the enterprise but lying with third parties such as public warehouses. sales are credited and the amount of sundry debtors is suitably adjusted? Accountability for. riots. and (b) goods sold but not yet despatched are excluded from inventories. etc? (ii) Is the access to areas where inventories are stored .g.

Recording of transactions. particularly regarding proper identification and counting of stocks and for recording the quantities and the condition of the stocks? Are these instructions proper? (iii) Are stocks belonging to third parties which are in the possession of the enterprise physically segregated from the stocks of the enterprise. Fixed Assets A.to-date? (iv) Are the insurance policies / cover notes kept in proper custody? Physical Stock Taking (i) What is the system of stock taking . Segregation and rotation of duties (i) Is there a proper segregation of various duties relating to fixed assets? As far as possible.3.34 Advanced Auditing and Professional Ethics (iii) Is insurance premium paid up. the following duties should be assigned to different persons. Execution of transactions relating to acquisitions and disposals. Authorization of acquisitions. (a) Is there a well laid down procedure for stock taking? (b) Are persons responsible for stock taking independent of the stores personnel? (c) Are there written instructions for stock taking. (a) (b) (c) (d) Authorizations of acquisitions and disposals.continuous. on a regular basis during the year as also at the year-end? (iv) Are physical verification sheets checked for arithmetical accuracy and internal consistency by a person other than the person who prepares them? (v) Are variations between stocks as per physical stock taking and stock records as per the books investigated and adjusted in the stock records and financial accounts with proper authorization? Inventories held by third parties Are stocks held with third parties physically verified periodically by the third party or by the enterprise? Are certificates obtained from the holders of the stocks regarding the quantity and quality of the stocks on a regular basis during the year as well as at the year-end? Independent Checks Is there an internal audit of inventories? III. (ii) Are duties of various persons relating to fixed assets rotated periodically? B. Transfer and Disposal (i) Is there an effective system of capital budgeting with well laid down procedures? The following aspects are particularly important in this regard. (a Are proposals for capital expenditure invited from various departments of the enterprise well-in-time? . in respect of stocks held on their behalf. Physical custody of items. annual or both? (ii) How effective is the system of continuous / annual stock taking? In this regard the following aspects may be specifically examined. or otherwise properly identified during the course of physical stock taking? Are confirmations regarding the quantity and quality obtained from third parties.

identification number.Risk Assessment and Internal Control 3. particularly with regard to invitation of quotations. particularly with regard to invitation of quotations. commercial and technical aspects of a proposal? (c) Are the proposals for capital expenditure scrutinized by a committee consisting of senior managers and then a composite budget put up to the top management or governing body for approval? (d) Is the approved budget communicated in writing to various departments including the purchase department and the accounts department? (ii) Is prior written authorization of a manager at a sufficiently senior level required for incurring capital expenditure for items included in the budget? (iii) Is there a well laid down procedure for acquisition of items of fixed assets? Does the procedure provide for adequate controls. approval of prices.35 (b) Are the proposals received in a properly laid down format which provides for complete details about the financial. is there a requirement for documenting the reasons for making purchases otherwise than at the lowest price? (v) Are controls over receipts of items of fixed assets effective? In particular are the technical specifications of the items received verified with the purchase order before accepting them? In case any items are rejected. rate of depreciation. payment terms and other terms of the purchase contract including technical specifications and delivery schedule? Are there sufficient safeguard to ensure timely delivery / construction of fixed assets. measurement of impairment loss on assets? (ii) Is a proper record maintained in respect of fixed assets given by the enterprise on lease and of assets owned by others but used by the enterprise? (iii) Where applicable. supplier’s name. and approval of prizes. location. estimated life. details of cost. such as provision for penalty in case of delayed delivery. are debit notes raised promptly? (vi) Is there a periodic comparison of capital expenditure incurred with the capital budget? In cases where the amounts actually expended indicate the likelihood of cost over-runs. does the enterprise maintain proper records of intangible assets? (iv) Does the system ensure that all disposals are recorded in the books of account promptly? (v) Is a register containing particulars of title deeds of land and buildings maintained? Are the title . are supplementary budgets prepared and got approved from competent authority? (vii) Is there a system of obtaining prior approval of a senior manager in case of transfer of fixed assets (e. accumulated depreciation till date and where applicable. from one department or unit to another department or unit)? (viii) Are there adequate controls over disposal of fixed assets. etc. estimated residual value.? (d) Is there a proper documentation of the disposal of fixed assets? Maintenance of Records and Documents (i) Does the enterprise maintain proper records of all fixed assets? Do the records contain details of such fully depreciated assets also which are in use or are kept for disposal? Are the records kept upto-date and reconcile periodically with financial accounts? Do the records contain such particulars as date of purchase.g. selection of suppliers. especially with regard to the following? (a) Are fixed assets scrapped or retired from use only on written authorization of a senior manager? (b) Are limits prescribed on the authority of the specified managers to scrap or retire fixed assets? (c) Are there proper controls over disposal of fixed assets..? (iv) Where purchases are made on the basis of competitive bids. etc.

etc. Such as restricting access to items of fixed assets to authorized personnel and use of devices like locks. are certificates of lodgment obtained periodically from banks financial institutions or other parties with whom the title deeds have been lodged? (vi) Are registration books of vehicles maintained properly and verified periodically? (vii) Does the enterprise maintain detailed records of projects under construction? Are job numbers assigned to each such project? Is there a proper system for identifying the direct expenditure incurred on each project ( e. (a) Is the insurance cover against fire. Fixed Assets (ii) Is there a system whereby each item of fixed assets is given an identification number indicating its location. wages ) and for allocation or apportionment of overheads to various projects? Is a separate account maintained in the ledger to monitor the actual amounts expended on each projects? (viii) Is the basis of allocating expenditure between capital and revenue proper? Accountability for and safeguarding of. etc. Cost of materials and stores. to recognize the fall in the value of fixed assets due to damage . with the approval of a senior manager. use. with proper approval of a senior manager. the following aspects are particularly important. obsolete and idle fixed assets? Is there an adequate follow-up on such fixed assets? Are the fixed asset records and financial accounts adjusted. is there a procedure for obtaining confirmation from such third parties? (vi) Is there a proper follow-up on discrepancies between the book records and the results of physical verification? Are these discrepancies investigated and responsibilities fixed? Are fixed asset records and financial accounts adjusted. to take cognizance of the discrepancies noticed on physical verification? (vii) Is there a system of identifying and reporting damaged. theft and other losses adequate? (b) Is the adequacy of insurance cover reviewed periodically? (c) Are insurance policies renewed on a timely basis? (d) Are values of items of fixed assets determined properly for the purpose of insurance? Do insurance policies cover replacement values of fixed assets? Is the system of determining replacement values proper? (e) In case certain assets are left uninsured.3. is it on the basis of a conscious decision by an authorized manager? Is such a decision properly recorded? (f) In case the enterprise resorts to self-insurance.. burglar alarms. fire. flood.36 Advanced Auditing and Professional Ethics deeds kept in safe custody? Are these deeds periodically verified? Where such deeds have been lodged as security against loans..? Is the identification number marked on the item in such a manner that it cannot be removed easily? (ii) Are there adequate safeguards to protect the items of fixed assets from theft. etc.? (iii) Are the items of fixed assets properly insured? In this regard. is there a proper system whereby adequate funds are allocated to the self-insurance fund? Does the past experience indicate that the self-insurance fund is adequate to take care of the various kinds of possible losses? (iv) Are fixed assets verified periodically on the basis of a well laid down written procedure? (v) Does the verification procedure extend to fixed assets with third parties? In case it is not possible to physically verify the fixed assets with third parties.g.

37 Is there an internal audit of fixed assets? Is the internal audit work relating to fixed assets properly planed and executed? IV. e. freight. i. quantity and other important terms of the sale order? (viii) Is there a system of fixing credit limits for regular customers? Are these limits approved by a senior manager as per the credit policy determined by the top management? Are these limits reviewed periodically in the light of the experience in dealing with the customer? (ix) Is credit limit of the customer concerned checked before sanctioning the credit on the sale order? Is up-to-date information on the extent of credit already extended to the customer readily available for this purpose? (x) Is a copy of each sale order sent to the despatch department and to the accounts department? (xi) Is a despatch document.. price..g.Risk Assessment and Internal Control obsolescence or idleness? Independent Checks 3.e. Sales Processing Orders and Dispatching Goods (i) Are standard price lists maintained? Is a special sanction from a senior manager required in the case of sales at prices lower than the standard prices? (ii) Does the system of allowing quantity rebates and discounts provide for adequate controls? In particular. is there a clear cut policy for allowing such rebates and discounts? Are the authorities of various managers in this regard clearly laid down and are they reasonable? (iii) Are special sanctions required in case of sales to affiliate companies or individuals. A goods outward Challans. description and quantity of goods sold. Goods outward Challans/gate pass sent to the customer and to the accounts department? (xv) Is an acknowledgment of receipt of goods obtained from the customer or from his agent on the copy of the despatch document? Billing Customers and Recording Sales (i) Is there a system of preparing sale invoices immediately on receipt of despatch documents? (ii) Do the sale invoices contain all the relevant details including the name of the customer. prepared at the time the goods are despatched to the customer? Is it matched with the bill of lading or the railway receipt/ transporter’s receipt? (xii) Are despatch documents pre-numbered and missing document numbers duly enquired into? (xiii) Is there a system of checking each consignment of goods leaving the premises with the related despatch document? (xiv) Is a copy of the despatch document. sales tax and other charges as well as other . sale price. or other enterprises in which the managerial personnel or senior employees are interested? (iv) Is there a well-defined policy for making sales to employees at concessional prices? Does it lay down any limits in this regard? (v) Is there a timely preparation of a written sale order on receipt of an order from a customer? (vi) Are sale orders pre-numbered? Is a lack of continuity in sale order numbers duly enquired into? (vii) Is there a proper authorisation of credit. insurance.

As appearing in the copies of the sale orders.. calculation and terms of payment) and authorised before despatch? Are the particulars such as the name of the customer. etc. indicating the quantity and specifications of the goods received back? (iv) Are the inward returned notes per-numbered? Are missing note numbers duly enquired into? (v) Are returned goods sent to the stores immediately? Are inward return notes entered promptly in inventory records? (vi) Is a credit note prepared on the basis of the inward return note? It is properly checked with reference to the relevant inward return note before it is approved and sent to the customer? Are . railway receipt/transporter’s receipt/ bill of lading attached with the relevant invoice? Follow-up on Sales after-sale Service (i) What is the nature of after-sale service rendered by the enterprise? (ii) Does the enterprise maintain adequate records (e. are they required to deposit the cash so collected the same day along with copies of provisional receipts? Are the provisional receipts pre-numbered? Are missing receipt numbers duly enquired into? (vi) Is the customer sent a final invoice/receipt for the services rendered and/or for the parts replaced? (vii) Are invoices entered into the customer cards immediately? (viii) Is there a periodic comparison of the cost of parts replaced free of charge with the budgeted figures? Are any unusual fluctuations duly investigated? Sale returns (i) Does the system relating to sale returns prescribe limits on the authority of managers at various levels to accept return of goods? (These limits may be in terms of value of the goods returned and the period during which they are returned.) (ii) Are the returned goods accepted only after they have been properly inspected for their quantity and quality? (iii) Is an inward return note prepared promptly against each sale return. (iv) Is the original invoice sent to the customer immediately and entries made in the accounting records on a timely basis? (v) Are sale invoices pre-numbered and entered sequentially in the sale summary sheet or the sale book? Is a lack of continuity in sale invoice numbers duly enquired into? (vi) Are copies of sale order.g.sale service provided to each customer? Does the format of the record provide for a clear distinction between customers being serviced under warranty period and those under maintenance contracts? (iii) Are the service engineers required to fill up a form describing the services rendered/ parts replaced on each visit? Is the form required to be signed by the customer? (iv) Are cases of major replacements reviewed by a senior official? (v) Are service engineers authorised to collect cash and issue provisional receipts to customers in the case of chargeable parts? In such a case. quantity.38 Advanced Auditing and Professional Ethics major terms of the sale? (iii) Are the sale invoices properly checked (particularly for prices.3.. and the railway receipt/transporter’s receipt/bill of lading compared with those in the invoices to ensure that proper amounts have been billed to appropriate customers. despatch document. gate pass/other despatch document. Customer cards) of after.

technical specifications. etc.39 (vii) Is there a proper control over the issue of credit notes specially with regard to the authority for issuing the same? (viii) Are credit notes pre-numbered? Are missing credit note numbers duly enquired into? (ix) Is the sale commission paid in respect of goods returned recovered through an appropriate debit note? (x) Are sale returns analyzed with reference to the reasons? Are appropriate follow-up steps taken? Claims by Customers (i) Are all claims ( for shortfall in quantity.? (iii) Have the authorities regarding sanctioning of purchases been clearly laid down? Is the distribution of authorities proper? Have limits been prescribed within which purchases can be sanctioned by each authority? (iv) Is a list of approved suppliers maintained for each major item? Is the list updated regularly? Does it contain appropriate remarks in respect of suppliers who fail to comply with the terms of purchase orders? Are purchases made from approved suppliers only? (v) Are tender / quotations invited from more than one supplier (usually three or more) on the basis of a clear cut specification of the item required? . (c) recording of sales. or for poor quality. and (d) custody of goods? Are the duties of various persons relating to sales rotated periodically? (ii) Are there adequate cut-off procedures in relation to sales? (iii) Are there adequate cut-off procedures in relation to sale returns? (iv) Is there an internal audit of the entire sales cycle? (v) Is there a system of sending monthly statements of accounts to regular customer? Are the discrepancies intimated by customers in their response and are they properly dealt with? V.Risk Assessment and Internal Control appropriate entries made in the books of account promptly? 3. Purchases Processing Purchase Orders (i) What is the organization of the purchase function? Are purchases centralized or decentralized? (ii) Does the purchase procedure provide for preparation of written purchase requisitions by authorized personnel? Are these prepared in a standard format? Does the format require furnishing of sufficient details about quantity required. delivery schedule. or for delay in delivery and similar other reasons) approved by an authorized manager? Is the approval granted only after a proper examination of the matter? (i) Is a credit note sent to the customer in respect of each approved claim? Are appropriate entries made in the books of accounts promptly? Import Entitlements Are adequate records maintained in respect of import entitlements against export of goods? Are the entitlements properly utilized? Overall Controls (i) Is there a proper segregation of duties in the various segments of the total sales cycle? Have the duties relating to sales been so allocated that different persons are entrusted the functions of (a) authorization of sales (b) execution of sale transactions.

g.. are quotations opened at one time by a senior officer and in the presence of the representatives of the suppliers? In case negotiations are carried on after the opening of the tenders / quotations. (c) Entering into long-term purchase contracts. Directors.. e. organizations in which managerial personnel (e. Companies Act. specification of goods. etc..40 Advanced Auditing and Professional Ethics (vi) Have any long-term purchase contracts been entered into with the suppliers? Are the stipulations regarding price. (xii) Are purchase orders pre-numbered? Are unused forms kept in proper custody? Are missing numbers duly enquired into? (xiii) Are purchase orders sufficiently detailed and precise so as to leave no scope for misunderstanding? (For this purpose. freight. User departments / customers / sub-contractors. e.. Holding company. the purchases under which are likely to involve a large amount over a period of time. joint ventures.g. subsidiaries.3. in the case of a company) lays down certain requirements in respect of such purchases.) (xiv) Is a copy of purchase order required to be signed by the supplier signifying his acceptance of the terms of the order? In appropriate cases (e. are formal purchase agreements entered into with the suppliers? (xv) Are copies of each purchase order / agreement forwarded to the goods receiving department and the accounts department? (xvi) Is there a periodic review of purchase orders which remain partly or fully unexecuted beyond the due dates? Receiving Goods (i) Are all goods and suppliers received only in the receiving department? Where goods can also be received by others. does the system ensure compliance with such requirements? Is there a system by which all managerial personnel up to a certain level are required to disclose their interest in various organizations? (b) Purchase of abnormally large value. etc. e. 1956. associates. payment. in such contracts clear and unambiguous? (vii) Where tenders / competitive quotations are invited.g. price as well as other terms and conditions relating to delivery. In case the law governing the enterprise (e. For long-term purchase contracts or contracts involving large amounts).g.g.. senior managers) are interested. is there a procedure for obtaining confirmation about he quantity and quality of the goods received? (ii) Is every receipt of materials supported by a goods received note? Are the goods received notes prenumbered? Are missing goods received duly enquired into? (iii) Is there a procedure for verifying the quantities of materials at the time of receipt through counting . etc. the description of the goods ordered their quantity. insurance.. Is to be included in the purchase order / agreement. a purchase order should clearly mention the name of the supplier.. etc. it is ensured that no supplier gets an undue advantage? For example.g. Emergency purchases or purchases involving small amounts? Is the system reasonable? (x) In case a price variation clause or variation in terms of delivery. does it require prior approval of prescribed authorities? (xi) Are specific approvals required for the following? (a) Purchases from entities or individuals which are affiliates of the enterprise. is an equal opportunity given to all the short-listed suppliers? (viii) Is a special authorization required in case the lowest quotation is not accepted? (ix) What is the system of approving prices and other terms and conditions in case purchase are not made on the basis of competitive quotations.

Risk Assessment and Internal Control weighing / measurement? 3. indicating the quantity and specifications of goods to be returned? Are the goods returned promptly and an acknowledgment of return of goods obtained from the supplier? Where materials are accepted despite shortage or variations from specifications. does the receiving department reject the materials? In such a case. goods received note. etc. (b) Purchase department. the goods received note and the record of advance payments (where applicable)? (ii) Are all invoices checked thoroughly to ensure that the terms and conditions of the relevant purchase orders / agreements have been complied with? (iii) Are invoices checked for arithmetical accuracy? Does the person responsible for such checking initial the invoice? (iv) Are all invoices entered promptly in the purchase book? (v) In case of variation of quantity or quality of materials received vis-a-vis those specified in the purchase order. on the basis of the copies of the outward return notes? (vi) Are debit notes pre-numbered? Are missing numbers duly enquired into? (vii) Is there a proper control over the issue of debit notes specially with regard to the authority for issuing the same? (viii) Are debit notes recorded promptly in the books of account? (ix) Is each invoice given a running serial number? Is the serial number as marked on an invoice also marked on the supporting documents attached to the invoice such as purchase order. are debit notes raised promptly against the suppliers concerned for goods returned. is an outward return note prepared.41 (iv) Is the quality of the materials checked on receipt? Are the specifications of materials received matched with those in the purchase order? Are proper laboratories or other analyses conducted in appropriate cases? (v) In case of shortage of quantity or variations from specifications given in the purchase order. (vii) Are the materials received sent to the stores or to the requisitioning department promptly? Recording Purchases (i) Are the suppliers invoices received directly in the accounts department where they are matched with the purchase order. on the basis of the observations of the receiving department / examination of the suppliers! Invoices? Similarly. or in case in non-compliance with other terms and conditions of the purchase order.? (x) Is it ensured that duplicate invoices are accepted only with proper authorization and only in such cases where the original invoices were not received? Are duplicate invoices prominently marked duplicate and attached with the supporting documents regarding the relevant purchase? . are debit notes raised promptly against the suppliers concerned. (c) Stores or the department to which the materials received are sent. is the shortage in quantity or the nature of qualitative defects/variations from specifications mentioned on the challan sent to the supplier as well as on the goods received note? (vi) Does the receiving department send a copy of each goods received note containing its remarks regarding the quantity and quality of the materials received to the following? (a) Accounts department.

the old books being handed over to an authorized officer. (c) recording of purchases.) (iii) Are the adequate cut-off procedures in relation to purchase returns? (iv) Is there an internal audit of the entire purchase cycle? (v) Is there a system of sending monthly statements of account to suppliers? Are the discrepancies intimated by suppliers in their responses properly dealt with? . For example.3. appropriate cut-off procedures are required to identify goods in which property has passed to the enterprise but which have not been received by the end of the accounting year. and (d) custody of goods? Are the duties of various persons relating to purchases rotated periodically? (ii) Are the adequate cut-off procedures in relation to purchases? (These procedures seek to ensure that the purchase of a preceding or a subsequent accounting period are not included in the purchases of the current period. Similarly. and vice versa. Another example of cut-off procedures is the use of new goods received note books from the commencement of a new accounting year. (b) execution of purchase transactions. is a proper entry made in the books of account recognizing the purchase ( even though the goods have not been physically received in the stores)? (xii) Are advance against purchases made only as per the terms of the purchase order and with proper authority? (xiii) Are all advances for purchases reviewed periodically and followed up properly? (xiv) Is there a system of periodic reconciliation of the goods paid for as per financial accounts with the goods received as per stores record? Overall Controls (i) Is there a proper segregation of duties in the various segments of the total purchase cycle? Have the duties relating to purchases been so allocated that different persons are entrusted the functions of (a) authorization of purchases. an enterprise may have a system whereby the goods receiving department is required to intimate to the accounts section the serial number of the last goods received note issued on the last day of the Accounting year.42 Advanced Auditing and Professional Ethics (xi) Where the accounts department has received a written intimation from the purchase department that the supplier has supplied the goods to the representatives / customers / sub-contractors of the enterprise.

Scope of Audit in a CIS Environment 4.4 AUDIT UNDER COMPUTERISED INFORMATION SYSTEM (CIS) ENVIRONMENT Introduction 4.1 Information Technology throughout the world has revolutionized and dramatically changed the manner in which the business is conducted today. (3) Concentration of duties .2 Impact of computerisation on audit approach needs consideration of the following factors: (1) High speed . Auditing in a CIS environment even though has not changed the fundamental nature of auditing. This cuts down the time enabling the auditor to extend their analytical review for under coverage with high speed of operation. as computer programs perform more than one set of activities at a time thereby concentrating the duties of several personnel involved in the work. flow of document information processing and so on. even to the extent of using sophisticated Audit software. the traditional approach does not apply in many cases. the Auditor can expand their substantive procedures for collection of more evidence in support of their judgement. (2) Low clerical error . it has definitely caused substantial changes in the method of evidence collection and evaluation. (4) Shifting of internal control base (i) Application systems development control . software etc.Computerised operation being a systematic and sequential programmed course of action the changes of commission of error is considerably reduced. Even complex reports in specific report format can be generated for audit purposes without much loss of time. Students are advised to study the technical issue relating to Information Technology from the study material of paper 6. to establish control.In a CIS environment information can be generated very quickly. Clerical error is highly minimised.) and keep pace with rapidly changing technology. This also requires auditors to become knowledge about computer environment (Hardware.In a manual environment the auditor needs to deploy separate individuals for carrying out the verification process. over: . Computerization has a significant effect on organization control. In a CIS environment.Systems development control should be designed to provide reasonable assurance that they are developed in an authorised and efficient manner.

evaluation and implementation of interactive computing systems for human use and with the study of the major phenomena. implementation and documentation of new system software systems software modifications. The approach is user centered and integrates knowledge from a wide range of disciplines. implementation. In such creative effort. In creating such logical models many stages required under manual operations are either deleted or managed to create a focused computer system. a computerised information system environment may do more harm to integrated business operation than good.If system analysis and designs falls short of expected standard of performance. (5) Disappearance of manual reasonableness .4.Man-machine interface ensures maximum effectiveness of the information system. Here the value of a variable is only reported if it lies outside some pre-determined normal range. Human-computer interaction is a discipline concerned with the design. conversion. approval testing. changes to application system. (8) Man-machine interface / human-computer interaction .Systems software controls are designed to provide reasonable assurance that system software is acquired or developed in an authorised and efficient manner including: a) b) authorisation. acquisition of application system from third parties. Exception Reporting is a departure from straight reporting of all variables.This is a part of Management information system. .The shift from traditional manual information processing environment to computerised information systems environment needs a detailed analysis of the physical system for transformation into a logical platform.2 a) b) c) d) Advanced Auditing and Professional Ethics testing. Thus. Organisation concentrated on presenting information that is required by the user and to present that information in the most uncluttered way. access to system documentation. (7) Exception reporting . This form of reporting and analysis is familiar to the accountant. (ii) Systems software control . care has to be taken in adopting manual operations switch-over to computerised operations for ensuring performance quality standards. the manual reasonableness may be missing. It is required to determine what information was necessary to achieve through a careful analysis of the job or task for which the user needed the information. (6) Impact of poor system . putting restriction of access to system software and documentation to authorised personnel. The main strength of exception reporting lies in its recognition that to be effective information must be selectivity provided. surrounding them. and documentation of new revised system.

they may find difficulty in coping with such advancement.In a computerised information system environment. primary records and the principal records. (2) There is a shift from proprietary operating system to more universal ones like UNIX. (5) Absence of link between transaction . Primary Changes (1) Process of recording transactions .Mechanisation often results in the abandonment in whole or in part of the primary records. diskettes. In a computerised information system. The accountants as well as the Auditors has to get themselves familiarised with the use of such codes which initially may pose considerable problems in understanding the various transactions. destruction or substitution. (3) Relational Date Base Management (RDBMS) are increasingly being used. This necessarily require proper control over such records to prevent their unauthorised us. alpha-numeric codes are extensively used to represent names and description. (2) From of accounting records . Recent Changes The growth and development in the field of information technology is a fast paced one and unless the auditors are alert to such developments and take pre. printouts replace the traditional records. This create special problems for the auditors. Following are a few instance of the recent changes which the may need to be addressed in discharging their responsibilities in such environment: (1) Mainframes are substituted by mini/micro users. LINUX.3 The effect of changes on accounting process may be stated as under: A. magnetic tapes. In many cases all the three processes Prime book of Entry →Ledger →Final accounts (Balance Sheet and Profit and Loss Account) are carried on simultaneously. (4) Use of accounting code – In computerised information systems. B. (3) Use of loose-leaf stationeries .3 Impact of Changes on Business Processes (For Shifting From Manual To Electronic Medium) 4.The process of recording transaction undergoes a major change when accounting process are computerised under CIS environment.Bound hand written records as used in manual accounting processes are replaced by loose-leaf machine written records in electronic medium. floppy disks. there may be an inadequacy or even total absence of cross-reference between the basic documents. the order of recording transaction from basic document to prime books and finally to principal book may not be followed strictly in sequential from as is observed in manual system.emptive action in upgrading their knowledge. Programming in 'C' etc. The auditors may find it difficult to trace a transaction from start to finish there by having a doubt in their mind as to loss of audit trials. Punch card installation or electronic data processor changes the form of both intermediate and ultimate records much more radically than manual records. .Audit under Computerised Information System (CIS) Environment 4.

. . digitized image processes. (b) improper use of decision support system can have serious repercussion. voice recognition system etc. The Impact of all such change on auditing may be summarised as: (a) wide.4 Advanced Auditing and Professional Ethics (4) The methodology adopted for systems development is becoming crucial and CASE (Computer Aided Software Engineering) tools are being used by many organisation. Also their underlying assumption must be clearly documented.e. (f) The move toward paperless EDI would eliminate much of the traditional audit trail radically changing the nature of audit trails.4. B.e. Audit Approach in a CIS Environment 4. (8) Conventional data entry giving way to scanner. (6) The need for data communication and networking is increasing.. Also coordinated program modification may not be possible. (d) Auditors non-participation at System Development Life Cycle State (SDLC) pose considerable problem in understanding the operational controls. A Black-box approach i. or A White-box approach i.spread end-user computing may result in unintentional errors creeping into systems owing to inept handling. Auditing through the computer. (7) Common business documents are getting replaced by paperless electronic data interface (EDI). the audit approach in a CIS environment could be either: A. (c) Usage of sophisticated audit software would be a necessity. (e) Data communication and net working would introduce new audit risk.4 Based on The knowledge and expertise of Auditors in handling computerised data. Auditing around the computer. (5) End user computing is on the increase resulting in decentralized data processing.

the Auditor concentrates on input and output and ignores the specifics of how computer process the data or transactions. however. is that the auditor not having directly tested the control. . the auditor assumes that the processing of transaction/data must have been correct.5 Client Input CPU Client Output Auditing Around The Computer Compare with Client Output Auditor's Predetermined Output In the Black box approach or Auditing around the computer. The Black Box Approach 4. The computer assisted approach has the advantage of permitting the auditor to make more comparisons than would be possible. in some of the more complex computer systems intermediate printout may not be available for making the needed comparisons. rates and extensions. A major disadvantage. The comparison of inputs and outputs may be done manually with the assistance of the computer. In testing.Audit under Computerised Information System (CIS) Environment A. If input matches the output. if done manually. Payroll Application. say. Auditing around the computer has the advantage of ease of comprehension as the tracing of documents to output does not require any in-depth study of application program. the auditor might first examine selected time cards for hours worked and employee earning cards for rates and then trace these to the payroll summary output and finally compare hours. cannot make assertions about the underlying process. Moreover.

(b) facilities to analyze computer security logs for unusual usage of the computer. (d) the facility to execute and observe the computer treatment of "live transaction" by moving through the processing as it occurs. These packages may typically contain: (a) interactive enquiry facilities to interrogate files. In order to help the auditor to gain access to these processes computer Audit software may be used. (c) the ability to compare source and object (compiled) program codes in order to detect dissimilarities. e) the generation of test data. substantive testing before an audit report is produced.6 Advanced Auditing and Professional Ethics B. The White Box Approach Auditor’s Input CPU Client Output Auditing Through The Computer Compare with Client Output Predetermined Output The processes and controls surrounding the subject are not only subject to audit but also the processing controls operating over this process are investigated. . f) the generation of aids showing the logs of application programs. The actual controls and the higher level control will be evaluated and then subjected to compliance testing and. if necessary.4.

the processing task of multiple user is performed on a single centralised computer. these systems have become more efficient and sophisticated. From the view point of analysis of computerised information system..Audit under Computerised Information System (CIS) Environment 4.In large system computers. experiences and application of knowledge and expertise to differing circumstances.7 It is obvious. (4) Output control and (5) Data transmission control. The auditors task will also involve consideration of the separation of functions between staff involves in transaction processing and the computerised system and ensuring that adequate supervision of personnel is administered. the auditors need not only have adequacy on knowledge regarding information requirement and computer data security they must also get exposed to system analysis and design so as to facilitate post implementation audit. It involves exposure. allowing data processing at local levels. The auditor will also need to be satisfied that there are adequate controls over the prevention of unauthorised access to the computer and the computerised database. . direct-supervise and review the work performed. The process of auditing is not a straight forward flow of work from start to finish to be completed by satisfying oneself against a standard checklist or a list of questions. i. In many instances dumb terminals have given way to intelligent terminals i. The areas covered in an audit will concentrate on the following controls: (1) Input controls. Types of Computer Systems 4. With time. that to follow this approach the auditor needs to have sufficient knowledge of computers to plan. No two information system is same.e. A.5 There is large variety of computer systems applicable to accounting and other type of information processing. (2) Processing control.. (3) Storage control. Systems configuration System configuration may be classified as: (1) Large system computers . and B) Processing systems. The nature and type of system affect the various types of controls for its efficient and effective functioning Computer System may be broadly classified as under: A) System configuration.e. All the terminals in these systems were called 'dumb terminals' as these terminals were not capable of processing data on their own and casually serve only as input/output terminals. all inputs move directly from the terminal to central processors and after processing goes back to users from central processors.

4. Modems are used to convert analog signals into digital and vice versa. When a LAN extend in the metropolitan area using the WAN technology. The main computer and the decentralised units communicate via communication links. Database servers provide a powerful facility to process data. it stores the program and data files centrally. Hardware resources include: (a) Client Server . The networks can also be classified on the basis of areas covered. WAN uses modem to connect computers over telephone lines (PSTN) PSTN system transfer analog signals.A stand alone system is one that is not connected to or does not communicate with another computer system.Networks that employ public telecommunications facilities to provide users with access to the resources of centrally located computers. It consists of hardware located at least two geographically distinct sites connected electronically by telecommunications where processing / data storage occur at two or more than one sites. Network share hardware and software resources.The term has been used to cover many varities of computer system. Computing is done by an individual at a time. A WAN uses the public switched telephone network. two or more computers located within a small well-defined area such as room. Therefore. retrieve and move data.They provide a variety of communication methods which takes the form of graphics.Most of the data base are client server based. office or campus are connected through cables. (e) Print Server . Common types of servers are: (b) File Server . These programs and data files can be accessed by the other computers forming part of the LAN. data and physical resources like hard disks peripherals. it is called Metropolitan Area Network (MAN). One processor .8 Advanced Auditing and Professional Ethics (2) Stand alone personal computers . (d) Message Server .A server in a network is dedicated to perform specific tasks to support other computers on the network. (c) Data base server . public telephone system are not appropriate to connect computers. Software resource sharing provides a facility to share information in the organisation. (2) Wide area network .Print server manages print services on the network. One of the computers acts as the server. high speed fibre optic cable. a transmission medium and rules for communication.In a local area network (LAN). All networks have something to share. Many small business rely on personal computers for all their accounting functions. (3) Distributed data processing . A more integrated connection occur with 'cooperative processing where processing is handled by two cooperating geographically distinct processors. Software resources include: (1) Local area network .. (3) Network computing system .A network is a group of interconnected system sharing services and interacting by a shared communication links. digitized audio/video etc. All input data and its processing takes place on the machine itself.File servers are the network applications that store. ratio links or the internet. LAN provide the additional advantage of sharing programs.

9 send the output of its processing to another for completion.After processing and master file updation. as required are periodically generated. By providing these services the third party adds value to the data transmission and is thus called value added network (VAN). Cooperative operating system may be required under such situation. reduced human involvement reduces error. The following benefits accrue under EDI systems. the data being structured in a commonly agreed format so that it is directly usable by the receiving organisation computer system. Processing system Transaction processing systems include: (1) Batch processing . (4) Electronic data interchange (EDI) . the costs of transaction processing are reduced. (b) Recorded in a Transaction file .EDI can be defined as: The transfer of electronic data from one organisations computer system to another's. There are four steps in batch processing. the source documents are stored separately for future reference. (d) Generation of output . the report. (c) Updation of Master file . a) b) c) d) B.A batch of source is periodically transferred to the data entry operator to extract information from the source document and enter it into the computer format. where operating system of both machines are different. Batch processing system are used for processing large volumes of repetitive transactions where control considerations and efficient utilisation of computing capacity are important.Audit under Computerised Information System (CIS) Environment 4.Under batch processing a large volume of homologous transactions are aggregated and processed periodically. The system becomes more complex.The occurrence of business events is recorded in the source document. as much of the need for human interpretation and processing is removed. The computerised format is the transaction file to be processed in the system. The speed with which an inter-organisational transaction is processed is minimised.After all the data is entered in the system and it is processed and summarised. EDI may be introduced where a group of organisations wish to ensure that electronic transactions are passed between one another. These are often provided by a third party in more than merely the transmission of the data. Data entry is usually done off line. Once the data entry is done. . Once the records are checked. the records entered are confirmed with the source document. the master files are updated. the paperwork involved in transaction processing is eliminated. (a) Occurrence of transaction . EDI groups require EDI services in order to effect the data exchanges.

One line processing refers to processing of individual transactions as they occur from their point of origin as opposed to accumulating them into batches.The term ' Real Time' refers to the technique of updating files with transaction data immediately after the occurrence of the event. inquires are also handled by the on-line processing system.4. (4) On-line real time processing . The response time would naturally differ from one activity to another. In transaction processing. a DSS supports the human decision making process.A time-sharing allows access to a CPU and files through many remote terminals. In other words. (6) Service Bureau . It is also called 'transaction driven' processing as transactions dealt with completely on an individual basis through all the relevant processing operations before dealing with the next transaction occur and enquiries to be dealt with on an immediate response basis. Apart from transaction processing and file updating.10 Advanced Auditing and Professional Ethics (2) On Line Processing System . This increases both availability and reliability of the system. CPU's in real time systems should possess the capability of 'Program Interrupts'. (3) Interactive Processing . (5) Time Sharing . The response of a real time system is one type of feed back control system. A DSS is not intended to make decisions for managers. Real time system are basically on-line system with one speciality in enquiry processing.A service bureau is a company that processes transaction for other entities. rather then providing a means to replace it. Some computer systems are dedicated to real time operations and others are designed to operate in both batch and real time modes so that they can also serve as stand by units to each other. Such units may handle the computer processing for small companies that singly do not have sufficient transactions to justify the acquisition of a computer. The response of the system to the enquiry itself is used to control the activity. Real time system usually operates in multi-programming and multi-processing. Advanced processing system further includes: (a) Decision Support System . a continuous dialogue exists between the user and the computer. time sharing occurs when a computer processes transactions of more than one entity. various departments in a company can be connected to the processor by cables. On-line processing ensures that the records are in a updated status at any time whereas this is not so with batch processing.A Decision Support System (DSS) can be defined as a system that solving provided tools to managers to assist them in soloing semi-structured and an unstructured problem. This is possible by direct access devices such as magnetic disk and number of terminals connected to and controlled by a central processors. Multiprogramming is the method of implementing time shared operations. . but rather to provide managers with a set of capabilities that enables them to generate the information that is required by them for decision making. In this way. These are temporary stoppage of halts in the execution of a program so that more urgent message can be handled on priority. but the fact remains that online processing is costly.Under this processing mode.

These systems update many files simultaneously as transaction is processed. A knowledge base is the computer equivalent of all the knowledge and insight that an expert or a group of experts develop through years of experience in their field.This program allows the user to design.This program contain the logic and reasoning mechanisms that stimulate the expert system logic process and deliver advice. (7) Integrated File System . (iv) Explanation Facility . involves both a human expert and a know ledge engineer. Inference Engine .Audit under Computerised Information System (CIS) Environment The decision-support system are characterised by: (i) (ii) they support semi-structured or unstructured decision making they are flexible enough to respond to the changing needs of decision makers. . update. (iii) Planning Language – include general purpose planning language like spread sheets/special purpose planning languages. A decision-support system has 4 basic components: (i) (ii) The Users – represent managers at any given level of authority in the organisation.An expert system a computerised information system that allows nonexperts to make decision comparable to that of an expert. (ii) (iii) Use interface . (v) Knowledge acquisition Facility – Building a knowledge base (also called knowledge engineering). rules of thumb to and decision rules used by experts to solve a particular type of problem.This facility provides the user with an explanation of the logic the expert system use to arrive. and.This includes data. 4. Minilab etc. (iv) Model Base – Model base is the 'Brain' of the decision support system because it perform data manipulations and computations with the data provided by the user and data base. forms its conclusion and recommends a course of action. SPSS. create. The knowledge engineer is responsible for extracting an individuals expertise and using the knowledge acquisition facility to enter into the knowledge base. SAS.11 (iii) they are easy to operate. relationships. It uses data obtained from both the knowledge base and the user to make associations and inference. (b) Expert System . Processing of a sales order updates the accounts receivable control accounts and the related subsidiary ledger is also updated and the sales control and sales details are also posted as the sales order is processed. Expert system are used for complex or ill structured tasks that require experience and special knowledge in specific subject areas. As expert system typically contains (i) Knowledge Base . use and communicate with the expert system. knowledge. Data bases – contains both routine and non-routine data from both internal and external sources.

employee number). in a computer system. Such operation through a program will be considered as incompatible functions in a manual system. does not always apply in a computer system. delegation of authority and responsibility.g. 'Indexed' records are physically stored randomly with a sequentially ordered index field (e.A structured authority and responsibility is an essential control within manual and computer environment. 'Indexed Sequential' records are physically stored sequentially ordered by some field together with an index which provides access by some possibly other field. Thus. separation of incompatible function could be even more difficult. However.In a manual system. 'Randomly' records are stored at a physical address computed by an algorithm working on a field value. physical control over assets and records. by customer) and a pointer to the physical location of each record. Some such forms. (2) Delegation Of Authority And Responsibility . In minicomputer and microcomputer environments. a system of authorisation.12 Advanced Auditing and Professional Ethics Integrated data base system contains a set of interrelated master files that are integrated in order to reduce data redundancy. adequate documents and records. The software used to control input processing and output is referred to as Data Based Management System (DBMS) which handles the storage.g. allows. Effect of Computers on Internal Controls 4. Controls within these systems are harder to test and assess due to the danger of file destruction. then one of the other storage method may be used.4. For example. In CIS environment. employee name. Some of the effects are as under: (1) Separation of Duties .6 nternal control system include separation of duties. Files may be physically stored on disk in the following way: 'Sequentially' records are physically ordered by some field (e. a program may carryout reconciliation of vendor invoice against a receipt document and also prepare a cheque payable to a creditors. safeguarding of assets. a clean line of authority and responsibility might be difficult to establish because some . updating and maintenance of the data in the data base.. if individuals records are required to be accessed from time to time by some field e. The sequential update of an employee master file by time sheet data is an example. In a computer system however. independent checks on performance and periodic reconciliation of assets with records. Integrated files are most commonly associated with OLRT (on-line real time) system and pose the greatest challenge to the Auditor's. then they may be stored sequentially. all these components must exist but computers affects the implementation of these internal control in many ways. management supervision. different persons are responsible for carrying out function like initiating. recording of transaction. users to change programs and data entry without providing a record of these changes. it becomes difficult to determine whether incompatible function have been performed by system users. retrieval.g. If files are required to be processed sequentially.

auditors evaluate the adequacy of procedures for authorisation by examining the work of employees. competent.13 resources are shared among multiple users. auditors have to examine not only the work of employees but also the varacity of the programme processing. (3) Competent And Trustworthy Personnel .Physical access to assets and records is critical in both manual systems and computer system.Management authorisation of transaction may be either: a) b) general authorisation to establish policies for the organisation. operation and maintenance within the organisation. authorisation procedures often are embedded within a computer program. This creates a serious control problem. Some information systems personnel lack a well developed sense of ethics and some enjoy in subverting controls. (5) Adequate Documents And Records . In well-designed computer systems. it is not always easy to trace who is responsible for corrupting the data and who is responsible for identifying and correcting the error. specific authorisation applying to individual transactions. in evaluating the adequacy of authorisation procedures. when multiple users have access to the same data and the integrity of the data is somehow violated. it is also more difficult to assess whether the authority assigned to individual persons is constant with managements policies.Audit under Computerised Information System (CIS) Environment 4. provided the systems have been designed to maintain a record of all events and that they are easily accessible. In a computer system. document support might not be necessary to initiate. execute and records some transaction. Moreover. If the organisation does not have another suitable backup. competent and trustworthy personnel is very much in demand. implementation. The concentration of information systems assets and record also increases the losses that can arise from computer abuse or disaster. (4) System Of Authorisation . In computer system. (6) Physical Control Over Assets And Records . The task of a visible audit trail is not a problem for auditors. In a computer system the information system assets and records may be concentrated at a single site. audit trails are more extensive than those maintained in manual systems unfortunately not all computer systems are well designed. Unfortunately. thereby reducing the control problems that arise with maintaining redundant data. the non availability of competent personnel. well-trained and experienced in formation system personnel have been in short supply. adequate documents and records are required to provide an audit trail of activities within the system.Skilled. . forced many organisation to compromise on their choice of staff. it might be unable to continue operations. In a computer system. one objective of using a data base management system is to provide multiple users with access to the same data. it is not always easy for organisation to assess the competence and integrity of their system staff. In manual system. Since substantial power is often vested in the person responsible for the computer information system development. High turnover among those staff has been the norm.In a manual system. Thus. Some organisation identified a single user as the owner of the data. For instance.

Hardware and Software develop quite rapidly.In a computer system. Because many activities are electronically controlled managers must periodically access the audit trial of employee activities and examine it for unauthorised actions. With increasing use of data communication for data transfer.4. the control emphasis shifts to ensuring the veracity of programme code. The continuing and rapid development of control technology also makes it more difficult for auditors to collect evidence on the reliability of controls. However. because traditional separation of duties no longer applies to the data being prepared for comparison purposes. Auditors.7 The objective of auditing. Even collection of audit evidence . Supervisory controls must be built into the computer system to compensate for the controls that usually can be exercised through observation and in inquiring computer system also make the activities of employees less visible to management. modification operation and maintenance. it will become difficult to evaluate the reliability of communication network competently. Effects of Computers on Auditing 4. research is focussed an cryptographic controls to project the privacy of data.14 Advanced Auditing and Professional Ethics (7) Adequate Management Supervision . independent staff prepare the basic data used for comparison purposes.In a manual system. Unless auditor's keep up with these developments. must now evaluate the controls established for program development. system development control include procedures for testing programs that again are not necessary in manual control. Since. Thus. independent checks on the performance of programs often have little value.Collecting evidence on the reliability of a computer system is often more complex than collecting evidence on the reliability of a manual system. independent opinion as to whether the financial statements records and report a true and fair view of the state of affairs of an entity. In a computer system. (8) Independent Checks On Performance . do not undergo a sea change in a CIS environment. if a program code is authorised accurate. Auditors have to face a diverse and complex range of internal control technology that did not exist in manual system. computer systems have affected how auditors need to collect and evaluate evidence. Instead. (9) Comparing Recorded Accountability With Assets . Auditor must provide a competent. If unauthorised modifications occur to the program or the data files that the program uses. an irregularity might not be discovered. and complete the system will always follow the laid down procedures in absence of other type of failures like hardware or systems software failure. In a computer system software is used to prepare this data. These aspects are discussed below: (1) Changes to Evidence Collection . supervision of employee might have to be carried out remotely. like: a) b) accurate and complete operations of a disk drive may require a set of hardware controls not required in manual system.Checks by an independent person help to detect any errors or irregularities. understanding the control technology is not easy.

which may be difficult to understand. Data base management system etc. Though generalized audit softwares are available the development of these tools cannot be relied upon due to lack of information. auditors have to run through computer system themselves if they are to collect the necessary evidence.. system authorisation. The auditors must ensure that these control are sufficient to maintain assets safeguarding.8 Internal control is an essential prerequisite for efficient and effective management of any organisation. Errors in computer program can involve extensive redesign and reprogramming. Printers etc.) Software (Operating system. they are the policies and procedure adopted by a management to achieve the entity's specific objectives like. physical verification of assets. application programs. due to difference in approach there is various other types of controls which are quite specific to CIS environment. it is becoming more and more difficult for the auditors to evaluate the consequences of strength and weaknesses of control mechanism for placing overall reliability on the system.15 through manual means is not possible. CIS organisation..With increasing complexity of computer systems and control technology. are determined on similar consideration as in a manual system. Internal Controls in a CIS Environment 4. Monitor. The basic components that can be identified in a CIS environment are: ♦ ♦ ♦ Hardware (CPU. the errors are generated at high speed and the cost and effort to correct and rerun program may be high. periodic review and reconciliation of accounts. In setting up an internal control system in a CIS environment. data integrity.) People (Data entry operator. However. Consequences of errors in a computer system is a serious matter as errors in computer system tend to be deterministic. end users) . Auditors need to understand: a) b) whether a control is functioning reliably or multi functioning. addressing each function separately so that auditors can place reliance on them. the plan of organisation. Often auditors are forced to compromise in some way when performing the evidence collection (2) Changes to Evidence Evaluation . specific control on computer generated data etc.Audit under Computerised Information System (CIS) Environment 4. An internal control is a CIS system depends on the same principal as that of manual system. an erroneous program will always execute data incorrectly. distribution of duties etc. physically disparate user. Hence. system effectiveness and system efficiency and that they are in position and functioning. traceability of control strength and weakness through the system. Thus.e. i. Thus. in a CIS environment. the overall CIS operation need to be broken down into defined subsystem and controls established accordingly. delegation of powers. Basically. internal controls that ensure high quality computer systems should be designed implemented and operated upon. In a shared data environment a single input transaction may update multiple data item used by diverse. Moreover.

(e. In a computer system many different types of controls are used to enhance component reliability. Its function is to establish execute modify and maintain control activities so that the reliability of the system in maintained at an acceptable level.g.) (6) Audit Trail Controls . minimise irregularities. The accounting audit trail shows the source and nature of data and process that update the database. batch cancellation stamp.g. Major classes of control that the auditor must evaluate are: (1) Authenticity Controls . auditors must evaluate their reliability with respect to each type of error or irregularity that might occur. preventive maintenance. fulfil statutory requirements. physical barriers. detect the consequences of error etc.Existence controls attempt to ensure the ongoing avail ability of all system resources (e. data compaction.) (3) Completeness Control .) (9) Effectiveness Controls .Privacy controls ensure that data is protected from inadvertent or unauthorised disclosure. The operations audit trail maintains a record of attempted or actual resource consumption within a system. program validation check. circulating error files etc.Authenticity control are exercised to verify the identify of the individuals or process involved in a system (e.) (10) Efficiency Controls .Accuracy control ensure the correctness of data and processes in a system (e.Redundancy controls attempts to ensure that a data is processed only once. A control is stated to be a set of activities designed to prevent.g. database dump and logs for recovery purposes duplicate hardware. periodic cost benefit analysis etc. post audits. personal identification numbers. . cryptograph. program validation cheek that a numeric field contains only numeric. (e. overflow checks.) (4) Redundancy Control .Asset safeguarding control attempt to ensure that all resources within a system are protected from destruction or corruption (e.g. (e.g. The reliability of a component is a function of the controls that act on the component.) (5) Privacy Controls .Audit trail control ensure traceability of all events occurred in a system. control totals. monitoring of user satisfaction. sequence check etc.4.g. (7) Existence Controls .Completeness control attempt to ensure that no data is missing and that all processing is carried through to its proper conclusion.Efficiency controls attempt to ensure that a system uses minimum resources to achieve its goals.. hash total etc. This record is needed to answer queries.g. check point and restart control) (8) Asset Safeguarding Controls . digital signatures) (2) Accuracy Control .16 ♦ Advanced Auditing and Professional Ethics Transmission media Once components have been identified.Effectiveness control attempt to ensure that systems achieve their goals.g. detect or correct errors or irregularities that affect the reliability of the components. (e. The set of all control activities performed in a system constitutes the control subsystem within a system. libraries etc. password control. inference control etc.

(2) generality versus specificity of the control with respect to the various types of errors and irregularities that might occur.Controls are designed to establish an organisational frame work for CIS activities including: a) b) Policies and procedures relating to control functions. to establish control over: a) b) c) d) testing. the auditor needs to assess the reliability by considering the various attributes of a control.Control are designed to provide reasonable assurance that systems are developed and maintained in an authorised and efficient manner. detect or correct errors. General control inhibit the effect of a wide variety of errors and irregularities as they are more robust to change controls in the application sub-system which tend to be specific control because component in these sub-system execute activities having less variety. Multi-component controls are more complex and more error prone but they are usually used to handle complex errors and irregularities. implementation and documentation of new revised system. Some of the attributes are: (1) whether the control is in place and is functioning as desired. The auditor focuses here on i) ii) iii) Preventive controls: Controls which stop errors or irregularities from occurring. Auditors expect to see a higher density of preventive controls at the early stages of processing or conversely they expect to see more detective and corrective controls later in system processing. changes made to application system.17 4. Appropriate segregation of incompatible functions. (4) the number of components used to execute the control. Internal Control Requirement Under CIS Environment 4.Audit under Computerised Information System (CIS) Environment Consideration of Control Attributes by the Auditors 4. Detective controls: Controls which identify errors and irregularities after they occur.9 In evaluating the effects of a control.10 The requirement of internal control under CIS environment may cover the following aspects: (1) Organisation And Management Control . (3) Whether the control acts to prevent. (2) Application System Development and Maintenance Control . Corrective controls: Controls which remove the effects of errors and irregularities after they have been identified. access to system documentation. acquisition of application system from third parties. conversion. .

an authorisation structure is established over transaction being entered into the system. transaction are not lost. processing errors are detected and corrected. (8) Control Over Output . approval. duplicated or improperly changed. testing. implementation and documentation of new system software and system software modification. (5) Data Entry And Program Control . processing errors are identified and corrected on a timely basis.18 Advanced Auditing and Professional Ethics (3) Computer Operation Controls . transaction are not lost.Designed to provide assurance: (6) Control Over Input . only authorised programs are to be used. corrected and if necessary. output is provided to appropriate authorised personnel on a timely basis. access to data and program is restricted to authorised personnel. transactions are properly authorised before being processed by the computer.Controls are designed to provide reasonable assurance that: a) b) c) a) b) c) a) transactions including system generated transactions are properly processed by the computer.4. restriction of access to system software and documentation to authorised personnel. resubmitted on a timely basis.Designed to provide reasonable assurance that (9) Other Safeguards . access to output is restricted to authorised personnel. (4) System Software Control . added duplicated or improperly changed. transactions are accuratelyconverted into machine readable from and recorded in the computer data files.Control are designed to provide reasonable assurance that: (7) Control Over Processing and Computer Data Files . incorrect transactions are rejected.Designed to control the operation of the system and to provide reasonable assurance that: a) b) c) d) the systems are used for authorised purposes only. added. Offsite back-up of data and program.Controls are designed to provide reasonable assurance that system software is acquired or developed in an authorised and efficient manner including: a) b) a) b) a) b) c) d) authorisation.Other safeguards include: . results of processing are accurate. access to computer operation is restricted to authorised personnel.

However. The standard provides for the following: (1) Skill and Competence . analysis and reporting undertaken in the CIS installation and ( c) the impact of computerisation on the audit trail that could otherwise be expected to exist in a manual system. if any ) The significance and complexity of computerized processing in each significant accounting application. The auditor should also obtain an understanding of the accounting and internal control system in terms of AAS . which emphasis that the overall objective and scope of an audit do not change in a CIS environment.Auditing in a computer Information System Environment. Determination of the organizational structure of the client. (a) the extent of use of computers for preparing accounting information( c) efficacy of internal control over input. the standard specifies that.Audit under Computerised Information System (CIS) Environment b) c) 4. Computer information systems c) d) .The standard provides that an auditor should have sufficient knowledge of the computer information systems to plan. storage. The auditor should consider whether any specialized CIS skills are needed in the conduct of the audit. Approach to Auditing in a CIS Environment 4. direct. the use a computer changes the processing. The standard requires the auditor to consider the effect of the factor like. The auditor needs to determine extent of availability of data by reference to source documents. Auditors understanding the process would include a) b) The computer information systems infrastructure ( hardware.11 The institute of Chartered Accountants of India has come out with Auditing Assurance Standard 29 . as they may affect segregation of duties. loss or intentional or accidental destruction. supervise control and review the work performed.6 ( Revised ) to plan the audit and to determine the nature. The sufficiency of knowledge would depend on the nature and extent of the CIS environment. If the answer is in affirmative the auditor would seek the assistance of an expert possessing such skills. operating system (s) and application software used by the entity. Provision of offsite processing in the event of disaster. timing and the extent of the audit procedures. including changes therein since last audit. CIS activities and the extent of concentration or distribution of computer processing throughout the entity. particularly. processing. computer files and other evidential matters.In regard to planning. retrieval and communication of financial information and may affect the accounting and internal control systems employed by the entity. (2) Planning .19 Recovery procedures for use in the event of theft. Significance relates to materiality of the financial statement assertions affected by the computerized processing. the auditor should obtain an understanding of the significance and complexity of the CIS activities and the availability of the data for use in the audit.

While evaluating the reliability of the accounting and internal control systems. In such cases.Computer programs processing transactions uniformly. the authorization for which may not be documented as in manual system. there may not be a complete trail. or may enable the auditor to economically apply certain procedures to the entire population of transactions.When the computer information systems are significant the auditor should assess whether it may influence the assessment of inherent and control risks.20 Advanced Auditing and Professional Ethics may generate reports that might be useful in performing substantive tests (particularly analytical procedures). Where a complex application system performs a large number of processing steps. (h) Use of Computer . (g) Increased management Supervision . authorization of these transactions may be implicit. . (3) Risk . The nature of the risks and the ICS in CIS environment include the following: (a) Lack of Transaction Trails . (f) Dependence of Other Controls over Computer Processing . Accordingly errors embedded in an application’s program logic may be difficult to detect on a timely basis by manual procedures.The potential for human error in the development. the effectiveness and consistency of transaction processing controls are dependent on the effectiveness of general computer information systems controls. maintenance and execution of computer information systems may be greater than in manual systems.Certain manual control procedures are dependent on computer generated reports and outputs for their effectiveness. In term. Also. if programming error exists all transactions will be processed incorrectly.In a CIS process certain types of transactions are triggered internally by the system. virtually eliminating the occurrence of clerical errors.Assisted Audit Techniques . correct and complete data is made available for processing.Some computer information systems are designed so that a complete transaction trail that is useful for audit purposes might exist for only a short period of time or only in computer readable form. the potential for individuals to gain unauthorized access to data or to alter data without visible evidence may be greater in CIS environment than in manual systems. (c) Lack of Segregation of functions .4. The potential for use of CAATS may permit increased efficiency in the performance of audit procedures. (e) Initiation or Execution of Transactions .Many controls become concentrated in a CIS environment allowing data processing of incompatible functions. the auditor would consider whether these systems: (i) Ensure that authorized. because of the level of detail inherent in these activities.The Auditor may apply general or specialized computer audit techniques and tools in the execution of audit tests. (d) Potential for errors and Irregularities . However.Computer information can offer management a variety of analytical tools that can enhance the effectiveness of the entire internal control structure. (b) Uniform processing of Transactions . management.

(b) Specific data base or master files. some of the audit evidence may be in electronic form. (vi) Prevent unauthorized amendments to the program. i.12 General controls in a CIS environment falls under the three basic control approaches as seen under manual system. Feedback. the nature. As new CIS technologies are emerging for data processing and Clients are adopting the same for building complex computer systems.The Auditor should document the audit plan. or (c) Specific processing activities.Audit under Computerised Information System (CIS) Environment (ii) Provide for timely detection and correction of errors. (4) Risk Assessment .fold categorization computer based information system also required different controls. mechanical or processing failures. In an audit in CIS environment. wrong processing..21 (iii) Ensure that the case of interruption in the work of the CIS environment due to power. the system restarts without distorting the complection of the entries and records. Risk may result from deficiencies in. Risk may also increase the potential for errors or fraudulent activities in. feed-forward and preventive control. timing and extent of audit procedures performed and the conclusions drawn from the evidence obtained. Review of Checks and Controls in a CIS Environment 4. these may increase risk which needs further consideration (5) Documentation . frauds etc. (a) Specific applications. (c) Operations (d) Physical CIS security. (v) Provide adequate data security against fire and other calamities. should make an assessment of inherent and control risk for material financial statement assertions. The auditor should satisfy himself that such evidence is adequately and safely stored and is retrievable in its entirety as and when required. (iv) Ensure that accuracy and completeness of output. (a) Program development and maintenance.The auditor in accordance with AAS-6 " Risk Assessment and Internal Controls ”. These deficiencies would tend to have a negative impact on all application systems that are processed through the computer. (b) System software support. . 4. (vii) Provide for safe custody of source code of application software and data files. Apart from the three .e. (e) Control over access to specialized utility programs.

22 Advanced Auditing and Professional Ethics though the emphasis is on preventive controls. (c) System Analyst . Without separation of duties. (g) Librarian . errors and irregularities might remain undetected. Some of the typical function that must be performed by select group includes: (a) Data Administrator . must be adequately documented and properly approved before being used: Documentation ordinarily assumes the following form: . facilitates implementation of information systems. Erroneous data processing by a computer system is likely to be the result of incorrect data input. designs information systems architectures to meet these requirements.Designs programs to meet information requirements.Generates the data requirements of the users of information system services: formulates data policies. Auditors should be concerned about two matters: i) ii) Responsibilities of each job position must be clear. monitors and improves operational efficiency along with capacity planning. (b) Database Administrator . Controls are present over many aspects of the computer system and its surrounding social environment. assist users to use database better. 4.Maintains and enhances operating systems software. They operate over data moving into.Systems and programs as well as modifications. improve efficiency. library software.Manages information requirement for new and existing applications.1 Review Process (1) Organization Structure / Control . This is the major point at which the human interfaces with the machine and it is here where important controls are placed. plans the evaluation of the Corporate data bases.Maintains library of magnetic media and documentation. maintains data documentation. Further controls are effective at preventing deterioration or collapse of the entire computing function.4. staff involvement with the computer and access to data. writes procedures and users documentation. and utility software.Responsible for the operational efficiency of corporate database. network software. complete and reliable processing and storage.12.CIS function in an organization need to be so organized that different groups are formed to perform different duties in a large CIS installation. modify program to remove errors. (f) Operation Specialist . authority and responsibilities.Plans and control day-to-day operations. through and out of the computer to ensure correct. and incumbents must fully understand their duties. tests and debugs programs documents programs. (e) Application Programmer . codes. The jobs performed within the information system function should maintain separation of duties to the extent possible. There are other controls present over staff. (2) Documentation Control . (d) System Programmers . provides when unusual systems failure occurs.

e.Entry logs should be uses to determine and documents those who have had access to the area. . but must also decrypt the data i. identifies him and is disconnected from the system. or other biometric devices. Access to data files and programs should be limited to those individuals authorized to process data. Then. palm prints. either an individual manually finds the authorized telephone number or the system automatically finds the authorized telephone number of the individual and finally the user is called back. files and documentation should have controls to limit access only to authorized individuals. (a) using a guard. (b) automated key cards. (a) Segregation Controls ♦ ♦ ♦ Access to program documentation should be limited to those persons who require it in the performance of their duties. fingerprints. (3) Access Control .Access controls are usually aimed at for preventing unauthorized access. Access to computer hardware should be limited to authorized individuals ( e. This coding protects data because to use the data unauthorized users must not only obtain access. (d) new access devices like. as well as preventing unauthorized persons from gaining access to the system as a whole. Program change.23 Adequate documentation evidencing approval of changes minimises the probability of unauthorized system and program changes that could result in loss of control and decreased reliability of financial data. (d)Hardware and Software access controls . Operator instructions. Program description (explaining the purpose for each part of the program) 4.Access control software like ‘user identification’ may be used. The controls may seek to prevent persons who are authorised for access from accessing restricted data and program. User identification is a frequently used control and is a combination of a unique identification code and a confidential password. (e) Call back . (f) Encryption In encryption data is encoded when stored in computer files / and or before transmission to or from remote locations.It is a specialized form of user identification in which the user dials the system. (b) Limited Physical Access to the computer Facility ♦ ♦ (c) Visitor entry Logs .g. Computer operators).Audit under Computerised Information System (CIS) Environment a) b) c) d) e) A system flowchart. (c ) manual key locks. The physical facilities that hold the computer equipment.. Types of controls may include. A program flowchart.

The encoded number = 21482 The check digit can be recalculated for verification as under: . The system should verify all significant data fields used to record information i. If they are the same. Calculation Of Check Digit A simple way is to add the digits in a number and assign the result as a suffix. the following procedure can be applied: (a) Pre-printed form . Make weighed average = 2x5 + 1x4 + 4x3 + 8x2 =42 Divide by Modules 11 = 42/11 -3 with remainder 9 Subtract the remainder from the modules = 11-9 =2 (check digit) Check digit is added as a suffix = 21482. the code is most likely to be correct. Conversion of data into machine readable form should be controlled and verified for accuracy.All constant information be printed on a source document.. this does not protect transposition error. The Calculation steps are as under: The desired number = 2148. The input steps converts human readable data into computer readable form. if only limited number of responses to a question is considered appropriate then preprint the responses and have the user tick or circle the correct responses deleting those that are inappropriate. (g) Computer Application Controls . 5 (dropping tens digit ).e. The check digit can act as a prefix or suffix character or it can be placed somewhere in the middle of the code. like 2814.4.Programmed application controls apply to specific application rather than multiple applications. Processing and output. (4) Input Controls .. One control used to guard against these types of errors is a ‘Check Digit’.24 Advanced Auditing and Professional Ethics decode it from encoded form. A Check Digit is a redundant digit (s) added to a code that enables the accuracy of other characters in the code to be checked. For validation of input controls. These controls operate to assure the proper input and processing of data. Should perform editing of the data. This problem can be overcome by Module -11 test .Errors made in transcribing and keying data can have serious consequences. The code is 21485 However. a program recalculates the check digit to determine whether the entered check digit and the calculated check digit are the same. When the code is entered. (b) Check Digit .e. All CIS application are classified under 3 heads: Input. Example: The number is 2148 the check digit is 2+1+4+8=15 i. The incorrect code will still produce the correct check digit.Input into the CIS system should be properly authorized and approved. For example.

4.The following types of field checks may be applied: (i) Missing data / blank . (iv) Sequence Checks . 50 transactions. (iii) Batch Record Totals .Does the data for a field fall within its allowable value range? (iv) Master Reference . The method is not foot proof as compensating errors is possible.These are sophisticated forms of limit checks. if a batch of invoices is to be inputed a total of all the invoices amounts might be calculated manually. A total of all the data value of some important field is made. can only one be detected? Does the field contain blanks when data always should be present.The transactions are collected together in batches of say. The check might consists of subtracting the last reading recorded from the current reading and comparing this with the average usage for that quarter. A difference indicates either a lost transaction or the input of an incorrect invoice total. An example might be a check on an electricity meter reading. there is a high probability that the code is correct.length fields are used and a set of permissible sizes is defined does the field delimiter show the field to be one of these valid sizes? (vi) Format Mask . The control total is then compared with a computer generated control total.To input data erroneously is one type error.Data entered into a field might have to conform to a particular format.Does a field that should contain only alphabetic or numeric contain alphanumeric characters? (iii) Range . (ii) Batch Hash Total .Account is taken of the number of transactions and this is compared with the record count produced by the computer at the end of the batch.Audit under Computerised Information System (CIS) Environment Weighted average = (2x1)+(8x2)+(4x3)+(1x4)+(2x5) = 44.Documents may be pre-numbered sequentially before entry and at a later stage the computer will perform a sequence check and display any missing number.The idea is similar to control totals except that Hash totals are meaningless totals prepared purely for control purposes. (e) Field Checks .If the master file can be referenced at the same time input data is read. is there a master file match for the key field? (v) Size . like ‘yy mm dd’ (f) Record Checks . (c) Completeness Totals . though they might be in a variable position. To leave out or lose data completely is another type of error against which controls are provided. Division by the modules = 44/11 = 4 with no remainder. (ii) Alphabetic / Numeric .25 If the remainder is zero.The following types of record checks can be applied: . after input of batch transaction. (i) Batch Control Totals . (d) Reasonableness Checks . For example. If the reading differs by a given percentage then it is investigated before processing. The total of all customer account numbers in a batch is meaningless but may be used for control by comparing it with computer generated hash totals.Is there any missing data in the field? If a code should contain 2 hyphens.If variable .

The content of one field might determine which sign is valid for a numeric field. (a) Error Log . (ii) Valid-Sign-Numeric .The contents of one record type field might determine which sign is valid for a numeric field. the contents of another field might determine what is a reasonable value for the field. . (i) Overflow .Separate control totals can be developed for related fields and cross footed at the end of a run.This is particularly important in batch entry and batch processing system. (6) Recording Control .If Variable . The following validation checks may be indicated in this regard. The permissible size of the fixed and variable . (iii) Sign Test . the size of the record is a function of the sizes of the variable length fields or the sizes of fields that optionally might be omitted from the record. Almost all of the controls mentioned under input may also be incorporated during processing stage. and complete. (iii) Size . (v) Run-to-Run Control . the processing of transaction file may involve several runs.Overflow can occur if a field used for computation is not initiated to zero at start.In file checks. (ii) Range . validation control examines whether the characteristics of a file used during data entry are matching with the stated characteristics of the file. or unexpected high values occur. Some error in computation occurs. The errors can then be corrected or investigated with the relevant department before being input and processed. a tape based order processing system might have a transaction tape that is used to update first a stock master file.Even though a field value might pass a range check.In a tape based system. Processing controls are essential to ensure the integrity of data.length records are used.Recording controls enable records to be kept free of errors and transactions details that are input into the system. the erroneous transaction is written to a error log file.An allowable value range can apply to a field. it usually is processed through multiple steps. It is important that a detected error does not bring the run to a halt. Processing validation checks primarily ensure that computation performed on numeric fields are authorized.4. accurate. which is examined at the end of processing.When input has been accepted by the computer. on discovery. (iv) Cross – Footing . (5) Processing Controls . then a sales ledger followed by a general ledger. For example if auditors validate some of the characteristic of data that is keyed into an application system against a master file. for instance.length records also might depend on a field indicating the record type. they can check whether they are using the latest version of the master file. Many of the accuracy checks can only be carried to during run time processing.26 Advanced Auditing and Professional Ethics (i) Reasonableness . various control totals may be passed from one run to the next as a check on completeness of processing. (g) File Checks .

Audit under Computerised Information System (CIS) Environment 4.These consists of magnetic machine readable information encoded on the storage medium identifying its contents. Trailer labels at the end of files often contain controls that are checked against those calculated during file processing. the type of transaction the amount and the debit and credit references.The transaction log provides a record of all transactions entered into the system as well as storing transaction details such as the transaction reference number. If a fault in database. The back-up is usually a tape which is then stored together with the transaction log tape of all transactions occurring between the last and the current dump. (e) Database Back . such as disk crash. As the process of providing back-up often involves a computer operation in which one file is used to produce another.The contents of a data base held on a direct access storage device (DASD) such as magnetic disk are periodically dumped on to a back-up file. uses a description key to reproduce the plain text or message. The transaction log can form the basis of an audit trail and may be printed out for investigation during an audit. (f) Cryptographic Storage . the stored transaction and the current log of transactions occurring between the dump and the crash point. The controls are particularly accidental erasure of files and the precision of back-up and recovery facilities. happens afterwards the state of the data base can be recreated using the dumped data base tape. File header labels appear at the start of a file and identify the file by name. Data is a vital resource for an organization and is the heart of CIS activities.These are attached to tape reels or disk packs to identify the contents. (7) Storage Control . give the date of last update and other information.up routines .Magnetic tape files have rings that may be inserted if the files are to be written or erased.27 (b) Transaction Log .up Routines .Data is commonly written to files in a way that uses standard coding like ASCII or EBCDIC. If the data is confidential or sensitive then it may be scrambled prior to storage and described on reading.These controls ensure the accurate and continuing and reliable storage of data. The controls in respect of floppy disks have a plastic lever. These typically include input time. (d) File Back . terminal number and user number. the date. If the encryption and decryption key . if both the master and the back-up were lost. (c) Magnetic Labels . The opposite process. the account number. It can be interpreted easily by unauthorized reader gaining access to the file. which is switched for read only purposes. input date. a fault in this process would have disastrous results. The security process involves the conversion of the plain text message or data into cipher text by the use of an encryption algorithm and an encryption key. This is checked by a software prior to file up dating. It is used for multi-access main frame systems accounting transactions. Special care must be taken to ensure the integrity of the database or file system. input day.Copies are held of important files for security purposes. The transaction will be "Stamped” with details of input. The following checks may be considered: (a) Physical Protection Against Erasure . (b) External Label . Read only files have the ring removed.

Such association may help the auditors in suggesting appropriate trails in post implementation audit. For the purpose of achieving the goals (objectives) set for the CIS as a whole. In order to ensure that a stage is satisfactorily and some deliverable is produced at the stage end. This is known as the ‘exit criteria for the stage’. The major functions may be elaborated as under: Analysis of the system involves identification understanding and critically examining the system and its inter-related parts (sub-system). . The process cannot progress from one stage to the next until it has completed all the required work of the stage. Stages and Objectives System Analysis Detailed Design → Deliverable output Systems Investigation and Feasibility Report →Feasibility Report. and (B) Understanding the role and inter-relationships of elements with other elements of the same system. →Logical Model Of The System →A Detailed Physical Specification Of The System System Design → The Intended System Design In Broad Outline. may be consulted while designing appropriate controls over the development of computerized system within an enterprise. This would enable the auditor to identify the consequences of any errors discovered in the output. complete and are directed to authorize recipient. These stages (as shown in the schematic) are completed in sequence.4.13 Auditors both external and internal. The Methodology involves: (A) Identification of the system (setting system boundary ). (8) Output Control . B. Through this identification and understanding process the capability (or background) to analyze and compare various alternatives regarding components and system functioning is generated. the system components. System Development Life Cycle Stage A. generally. through modification. changed inter-relationship of components. Auditors Involvement In The Clients System Development And Documentation Control 4. the system objectives. D. deleting or merging or separating or break-up of component. it is known as asymmetric cryptograph. The auditor should examine whether audit trail relating to output was provided and the date and time when the output was so provided. C. E. In order to develop a Computerized Information System it is necessary to pass through a number of distinct stages. this is a piece of documentary evidence on the work carried out. They may also involve upgrading the system as a whole. otherwise.28 Advanced Auditing and Professional Ethics are identical the entire procedure is called Symmetric Cryptograph.Output control ensures that the results of data processing are accurate.

(3) The deliverables being documentation provide a historical trace of the development of the project. This should come to light when the exit criteria are considered. The purpose of this stage is to involve a decomposition of the functions of the system into their logical constituents and the production of a logical model of the process and data flows . the next task for the analyst is to build a logical model of the existing system. (5) The stages are designed to the ‘natural’ division points in the development of the project. This promote easy assessment of the nature of the work completed during the stage. At the end of each stage the output documentation provides an initial input into the subsequent stage. (4) The document deliverables are designed to be communication tools between analyst. lengthy project into discrete chunks of time.Provided that the project has been given the ago ahead as a result of the feasibility study. This will be partly based on information gathered from the existing system during the stage of system investigation and partly on new information. G. The relevant tasks will need to be redone before exit from the stage can be made. (6) The stage allows a creeping commitment to expenditure during the project. (B) System Investigation and Feasibility Study . makes the project more manageable and thereby promotes better project control.Before an analyst can attempt to undertake a reasonable systems investigation. It is common for some of the tasks carried out during a stage of the process to be initially unsatisfactory.29 Evaluation and Maintenance →Evaluation Report. The documentation provided on this acts as the analysts initial terms of reference. (2) Although different parts of a project may develop independently during a stage. programmers.The output of this stage is a report on the feasibility of a technical solution to the problems or opportunities mentioned in the statement of scope and objectives in stage A. (C) System Analysis . Although slooping within a stage is quite common but once a stage has been left it should not be necessary to return to it from a later stage. This promotes coordination between the various components of large projects. H. The benefits of this staged approach are: (1) Sub-division of a complex. users and management. The solution will be present in broad outlines. analysis and design. Project Stages (A) Determination of Scope and Objective . Implementation Changeover →The New System With Documentation Procedure →The New System With Documentation Procedure 4. there must be some indication given of the agreed overall scope of the project.Audit under Computerised Information System (CIS) Environment F. the parts of the project reaches the same point of development at the end of the stage.

The analyst will suggest two or three design alternatives to management together with their implication. Shortcomings. This will involve corrective actions for errors in program that become apparent after an extended period of use. Throughout the remainder of the useful life of the system it will have to be maintained if it is to provide a proper service.4. if any. (G) Changeover . are identified and corrective actions are taken. The programs are written and tested individually. Any initial problem in running will be rectified. whether manual or computer based on the new system. The old system can be run in parallel with the new. The report will compare the actual system with the objectives required to be designed. (E) Detailed Design .Once the analysis is complete the analyst has a good idea of what is logically required of the new system. The database or file structure is created and historic data from the old system is loaded. Hardware Data Storage D) E) F) Schedule for Implementation. The maintenance will involve hardware and software. Programs may also be altered to enable the machines to run with greater technical efficiency. at the time the new system starts. There will be a number of ways that this logical model can be incorporated into a physical design.Detailed physical specifications need to be made so that the system can be purchased / build and installed. There are a number of distinct areas that must be considered. Security User Machine Interface The Systems Specifications is a highly detailed set of documents covering every aspect of the system. (H) Evaluation and Maintenance . These areas can be summarized as: A) B) C) Software. The software need to be maintained as well. Particular attention will be paid to security features surrounding the conversion of existing files.30 Advanced Auditing and Professional Ethics necessary to perform these through data flow diagram. to produce an evaluation report on the system after it has been functioning for some time.Changeover is that time during which the old system is replaced by the newly designed computer system. Alternative method of changeover exists.At this time. the system is running and in continual system use. The hardware is purchased and installed. It is customary. Management will then decide amongst them. . running the old system is discarded. It is normal to transfer the maintenance of the hardware to the manufacturer of the equipment or some specialist third party organization.During implementations the system as specified is physically created. This period may be short if. It should be delivering the benefit for which it was designed and installed. (D) System Design . (F) Implementation . This will be drawn up after the system has settled into its normal daily functioning.

In some cases. tests of general controls. Utility Programs are used by an entity to perform common data processing functions. for example. for example. a brief description of the programs commonly used is given below. however. for example. CAATs are computer programs and data that the auditor uses as part of the audit procedures to process data of audit significance. creating and printing files. the use of audit software for recalculating interest or the extraction of invoices over a certain value from computer records. selecting and analyzing information.31 4. and perform audit tests more efficiently. The application of auditing procedures may. the entity being audited or an outside programmer hired by the auditor. These programs are generally not designed for audit purposes. Purpose-Written Programs perform audit tasks in specific circumstances.CAATs may be used in performing various auditing procedures. creating data files and reporting in a format specified by the auditor. such as sorting. testing the set-up or configuration of the operating system or access procedures to the program libraries or by using code comparison software to check that the version of the program in use is the version approved by management . ♦ ♦ . sampling programs to extract data for audit testing. These programs may be developed by the auditor. including the following: ♦ tests of details of transactions and balances. tests of application controls. caats may consist of package programs. analytical procedures. utility programs or system management program. for example. contained in an entity’s information systems. Uses of CAATs .Audit under Computerised Information System (CIS) Environment Computer Assisted Audit Techniques (CAATs) 4. such as reading data. require the auditor to consider techniques known as Computer Assisted Audit Techniques (CAATs) that use the computer as an audit tool for enhancing the effectiveness and efficiency of audit procedures. purpose-written programs. ♦ ♦ ♦ ♦ ♦ Audit Software . the auditor may use an entity’s existing programs in their original or modified state because it may be more efficient than developing independent programs. and reperforming calculations performed by the entity’s accounting systems. and therefore may not contain features such as automatic record counts or control totals. ♦ Package Programs are generalized computer programs designed to perform data processing functions. performing calculations.CAATs allow the auditor to give access to data without dependence on the client. testing the functioning of a programmed control.14 The overall objectives and scope of an audit do not change when an audit is conducted in a Computer Information Systems (CIS) environment. identifying inconsistencies or significant fluctuations. test the reliability of client software.

the factors to consider include: ♦ ♦ ♦ ♦ ♦ the IT knowledge. effectiveness and efficiency. ♦ Impracticability of Manual Tests .32 ♦ Advanced Auditing and Professional Ethics System Management Programs are enhanced productivity tools that are typically part of a sophisticated operating systems environment. Before using caats the auditor considers the controls incorporated in the design of the entity’s computer systems to which caat would be applied in order to determine whether. to assist with activities such as loading and running of CAAT on the entity’s system. such as pcs or laptops. how. the impracticability of manual tests. specifically. the auditor may consider an appropriate combination of manual and computer assisted audit techniques. because of an incompatibility between the auditor’s package program and entity’s computer. Considerations in the Use of Caats . in determining whether to use caats.4. The auditor may plan to use other computer facilities when the use of caats on an entity’s computer is uneconomical or impractical. for example. The lack of hard copy evidence may occur at different stages in the business cycle. Availability of CAATS and Suitable Computer Facilities . . caats should be used. and if so.The auditor considers the availability of caats. many computer information systems perform tasks for which no hard copy evidence is available and. the audit team should have sufficient knowledge to plan. for example. “auditing in a computer information systems environment” deals with the level of skill and competence the audit team needs to conduct an audit in a cis environment.Some audit procedures may not be possible to perform manually because they rely on complex processing (for example. it may be impracticable for the auditor to perform tests manually. Expertise And Experience Of The Audit Team : Auditing and Assurance Standard (AAS) 29. suitable computer facilities and the necessary computer-based information systems and data. it provides guidance when an auditor delegates work to assistants with cis skills or when the auditor uses work performed by other auditors or experts with such skills. As with utility programs these tools are not specifically designed for auditing use and their use requires additional care. In addition. expertise and experience of the audit team. and to provide copies of data files in the format required by the auditor. therefore. The cooperation of the entity’s personnel may be required to provide processing facilities at a convenient time. the auditor may elect to use their own facilities. the level of knowledge required depends on “availability of caats” and “suitable computer facilities”.When planning an audit. the availability of CAATs and suitable computer facilities and data. Additionally. advanced statistical analysis) or involve amounts of data that would overwhelm any manual procedure. It Knowledge. execute and use the results of the particular caat adopted. data retrieval software or code comparison software. and time constraints.

(i) (j) refine the estimates of costs and benefits. Thus. The initial planning. for copies of the relevant files or database tables to be made at the appropriate cut off date and time. design. (c) identify the specific files or databases to be examined. the auditor will need to make arrangements for the retention of data required. Where the time available to perform an audit is limited. such as transaction details. the auditor considers the continuing use of CAAT application. confirmations). (h) identify the personnel who may participate in the design and application of CAAT. (g) arrange with the user and IT departments. (e) define the specific tests or procedures and related transactions and balances affected. CAATs are often an efficient means of testing a large number of transactions or controls over large populations by: ♦ ♦ ♦ ♦ ♦ ♦ ♦ analyzing and selecting samples from a large volume of transactions. Time Constraints Certain data. and performing substantive procedures. Using CAATs -The major steps to be undertaken by the auditor in the application of CAAT are to: (a) set the objective of CAAT application. the auditor may plan to use CAAT because its use will meet the auditor’s time requirement better than other possible procedures. designing and printing of forms (for example. applying analytical procedures. if appropriate. (b) determine the content and accessibility of the entity’s files. technical review and assistance hours. are often kept for a short time and may not be available in machine-readable form by the time auditor wants them. ensure that the use of CAAT is properly controlled. . the time taken to plan. or may need to alter the timing of the work that requires such data. and availability of computer resources Matters relating to efficiency that an auditor might consider include: In evaluating the effectiveness and efficiency of CAAT.The effectiveness and efficiency of auditing procedures may be improved by using CAATs to obtain and evaluate audit evidence.Audit under Computerised Information System (CIS) Environment 4. execute and evaluate CAAT.33 Effectiveness and Efficiency . (f) define the output requirements. design and development of CAAT will usually benefit audits in subsequent periods. (d) understand the relationship between the data tables where a database is to be examined.

The nature. by reviewing output and control information. timing and extent of testing is dependent on the commercial availability and stability of CAAT. reliability. (n) evaluate the results. When such controls cannot be relied on to ensure the integrity of CAAT. controls over program changes and access to computer files. and (p) assess the effect of changes to the programs/system on the use of CAAT.The auditor should obtain reasonable assurance of the integrity. Controlling CAAT Application .4. and (c) ensure appropriate integration of the output by the auditor into the audit process. processing and review of documentation. (b) checking. usefulness. This should be done before reliance is placed upon CAAT.The specific procedures necessary to control the use of CAAT depend on the particular application.34 Advanced Auditing and Professional Ethics (k) arrange the administrative activities. (m) execute CAAT application. for example. (o) document CAATs to be used including objectives. and (g) establishing appropriate security measures to safeguard the integrity and confidentiality of the data. (e) checking whether the correct files were used. if applicable. the auditor considers the need to: (a) approve specifications and conduct a review of the work to be performed by CAAT. high level flowcharts and run instructions. design. the auditor may consider processing CAAT application at another suitable computer facility. for example. testing. . for example. (b) review the entity’s general controls that may contribute to the integrity of CAAT. including the necessary skills and computer facilities. and that those files were complete. (c) asking the entity’s staff to review the operating system instructions to ensure that the software will run in the entity’s computer installation. (d) running the audit software on small test files before running it on the main data files. and security of CAAT through appropriate planning. the coding of the program to ensure that it conforms with the detailed program specifications. Testing CAAT . such as control totals maintained by the user. (l) reconcile data to be used for CAAT with the accounting and other records. Procedures carried out by the auditor to control CAATs applications may include: (a) participating in the design and testing of CAAT. (f) obtaining evidence that the audit software functioned as planned. by checking external evidence. In establishing control.

provide practical advantages. predicting the results of the test data and comparing it with the actual test data output. 4. Explain the following checks and controls Control total Check digit Transaction log Hash total Reasonableness check Sequence check 7. confirming that the current version of the programs was used to process the test data. the auditor reviews those procedures with appropriate client personnel and obtains approval before conducting the tests to help avoid the inadvertent corruption of client records. performing test runs containing small amounts of test data before submitting the main audit test data. What is an EDI system. the presence of the auditor is not necessarily required at the computer facility during the running of CAAT. for the individual transactions and in total. Differentiate between auditing around and through the computer. such as being able to control distribution of the output and ensuring the timely correction of errors.Audit under Computerised Information System (CIS) Environment 4. 5. however. It may. if the wrong input file were to be used. the auditor considers whether the staff improperly influenced the results of CAAT. application controls and user controls. When using CAAT. and testing whether the programs used to process the test data were the programs the entity used throughout the applicable audit period. Audit procedures to control test data applications may include: ♦ ♦ ♦ ♦ ♦ controlling the sequence of submissions of test data where it spans several processing cycles. Why auditors might prefer to review general control before reviewing application controls? Why auditors prefer to apply a combination of techniques in directly testing computer controls. 8. for example. . 6. To ensure appropriate control procedures. Why are systems and programs documentation important to effective internal control. 3.35 When the auditor intends to perform audit procedures concurrently with online processing. the auditor may require the cooperation of entity staff with extensive knowledge of the computer installation. In such circumstances. Define and give an example of general controls. Differentiate between batch processing and online real time processing. Self-examination Questions 1. 2.

36 9. . Explain why? 11.4. Advanced Auditing and Professional Ethics Identify the advantages and disadvantages of each of the following: Test data approach. Parallel simulation is though to be an automated version of auditing around the computer. Why the adequacy of controls in a sophisticated computerized environment more important than in a computerized system that maintains hard copy evidence. 10. ITF approach. What is the impact of IT on the audit procedures. 12.

The PC may constitute the entire computer-based information system or merely a part of it. a workstation which is part of a local area network of PCs. 08. 03.Audit under Computerised Information System (CIS) Environment 4. data storage unit.e. The programs and data are stored in the PC or in close proximity and. A PC can act as an intelligent terminal because of its logic. On the other hand. Multiple users. PCs can be linked to central computers and used as part of such systems. for example. Programs and data are stored on removable or non-removable storage media. 02. PC Configurations 04. video display unit. certain types of control procedures need to be emphasised due to the characteristics of PC and the environments in which they are used. A local area network is an arrangement where two or more PCs are linked together through the use of special software and communication lines. PC’s can be used to process accounting transactions and produce reports that are essential to the preparation of financial statements. A PC can be used in various configurations. 05. Certain controls and securities. data and programs stored in shared files. The stand-alone workstation can be operated by single user or a number of users at different times accessing the same or different programs. data are entered manually through the keyboard. 07. and a workstation connected to a central computer. The user of the stand-alone workstation who processes accounting applications may be knowledgeable about programming and typically performs a number of functions. 06. for example. i. as an intelligent on line workstation part of a distributed accounting system. writing the computer program themselves. A local area network may be referred to as distributed system. IT environments in which PCs are used are different from other IT environments. These include (a) (b) (c) a stand-alone workstation operated by a single user or a number of users at different times. Since control considerations and the characteristics of the hardware and software are different when a PC is linked to other computers.37 Annexure I. data are entered manually through the keyboard. keyboard and connections for a printer and communications. storage and basic computing capabilities. operating application programs and. This programming may include the use of third-party software packages to develop electronic spreadsheets or database applications. transmission. can have access to information. in some cases. Stand-Alone Personal Computers (Pcs) Stand-Alone PCs 01. generally. Such an arrangement may be reffered to as an on-line system. entering data.. Generally. “PCs” are economical yet powerful self-contained general purpose computers consisting typically of a processor. such environments are described in other Guidance . The user of the stand-alone workstation who process generally. Typically. one of the PCs will act as the file server which manages the network. memory. measures that are used for large computer systems may not be practicable in PC. A local area network allows the sharing of resources such as storage facilities and printers.

control. . adequate documentation and operations. In such cases.38 Advanced Auditing and Professional Ethics Statements. use.. the information in this statement is relevant. e. For example. 10. Software. Characteristics of PCs 09.g. In the former application programs can be developed relatively quickly by users possessing only basic data processing skills. may not be viewed by the developer. the user or management as being as important or costeffective in a PC environment. is subject to accidental erasure. the degree of accuracy and dependability of financial information produced will depend upon the internal controls prescribed by management and adopted by the user. e. the controls over the system development process for example. including diskettes. accounts receivable. misplacement or theft. cartridges and removable hard disks. the distinction between general IT controls and IT application controls may not be easily ascertained. such as electronic spreadsheets or database. production and inventory. when there are several users of a single PC. physical damage.. 11. Users can also develop other applications with the use of generic software packages. it may not contain as many control and security features. Although PCs provide the user with substantial computing capabilities. Another characteristic is that operating system software. which are essential to the effective control of a large computer environment. However. Software for a wide range of PC applications can be purchased from third-party vendors to perform. The operating system software.4. Management’s policy statement may include: (a) (b) management responsibilities. Users with basic computer skills can learn to operate a PC easily since many operating system software and application programs are “user-friendly” and contain step-by-step instructions. is less comprehensive than that found in larger computer environments. alteration or theft by other users. Generally the IT environment in which PCs are used is less structured than a centrally-controlled IT environment. owing to its small size and portability. In a typical PC environment. to the extent that a micro computer which is linked to another computer can also be used as a stand-alone workstation. are relatively inexpensive and can be placed in operation quickly. programs and data stored on non-removable storage media by one user may be susceptible to unauthorised access. they are small enough to be transportable. 13. purchased from third-party vendors. application programs and data can be stored and retrieved from removable storage media. because the data are being processed on a computer. without appropriate controls. for example. such as password controls. However.g. Such software packages are typically used without modification of the programs. Internal Control in PC Environments 12. Management can contribute to the effective operation of stand-alone PCs by prescribing and enforcing policies for their control and use. programs and data can also be stored on hard disks that are not removable. instructions on PC use. Since PCs are oriented to individual end-users. Such storage media. users of such data may tend to place unwarranted reliance on the financial information stored or generated by a PC. Management Authorisation for Operating PCs 14. which is generally supplied by the PC manufacturer. general ledger accounting. particularly by persons unfamiliar with such media or by unauthorised users. access control procedures.

One method of physical security is to restrict access to PCs when not in use by using door locks or other security protection during non-business hours. but may be effective in controlling unauthorised use. (c) fastening the PC to a table. Diskettes and cartridges can be removed physically from the PC. for example. authorisation for access to programs and data. Depending on the nature of the program and data files. Additional physical security over PCs can be established. Physical control over non-removable storage media is probably the best established with locking devices. altered without authorisation or destroyed. This . 4. users may develop a casual attitude toward the storage of the application diskettes or cartridges for which they are responsible. cartridges and hard disks in a fire-proof container. As a result. and Appropriate segregation of duties. 16. by: (a) locking the PC in a protective cabinet or shell. Control over removable storage media can be established by placing responsibility for such media under personnel whose responsibilities include duties of software Custodians or librarians. either onsite. physical damage. Such control procedures help ensure that removable storage media are not lost. for example. it is appropriate to keep current copies of diskettes. When a PC is used by many individuals.39 Physical Security – Equipment 15. (b) using an alarm system that is activated any time the PC is disconnected or moved from its location. financial data vital to the information system. Programs and data used on a PC can be stored on removable storage media or non-removable storage media. unauthorised access or misuse. data and error correction. Physical Security – Removable and Non-Removable Media 17. misplaced or given to unauthorised personnel. while hard disks are normally sealed in the PC or in a stand-alone unit attached to the PC. application development and documentation standards. 18. critical diskettes or cartridges may be misplaced. data integrity standards. offsite or both. back-up and storage requirements. This may result in the loss of information stored in the PC. personal usage policies. responsibility. 19. PCs are susceptible to theft. for programs. policies to prevention authorised copying of programs and data security.Audit under Computerised Information System (CIS) Environment (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) training requirements. Control can be further strengthened when a program and data file check-in and check-out system is used and designated storage locations are locked. standards of report format and report distribution controls. Because of their physical characteristics. or (d) installing locking mechanism to control access to the on/off switch may not prevent PC theft.

In either case. 24. Password software can be developed by the entity. but it can also be used on intimation processed by a PC. These techniques. (b) using hidden files and secret file names. control procedures can be strengthened by installing software that has a low likelihood of being thwarted by users. 25. When PCs are accessible to many users. For critical and sensitive information. Such functions may merely clear the file name from the hard disk directory. The user should be aware that many software programs include in “erase” or “delete” function. 23. Cryptography is the process of programs transforming programs information into an unintelligible form.’ which determine the degree of access granted to a user. and (d) using cryptography. The use of a file directory allows the user to segregate information is removable and nonremovable storage media. 21. (c) 22 employing passwords. It is general used when sensitive data are transmitted over communication lines. there are several control procedure which can be built into the application programs to help ensure that data are processed and read as authorised and that accidental destruction of data is prevented. The password is assigned and monitored by an employee who is independent of the specific system to which the password applies. include: (a) segregating data into files organised under separate file directories. user authentication software and cryptography can be used for PCs that have both removable and non-removable storage media. An additional access control for confidential or sensitive information. For PCs that have removable storage media. which limit access to programs and data to authorised personnel. Control over the diskette or cartridge can then be established in the same manner as over other sensitive or confidential data stored in diskettes or cartridges.4.40 Advanced Auditing and Professional Ethics applies equally to operating system and utility software and backup copies of hard disks. an effective control procedure is the use of passwords. Program and Data Security 20. but in instances it will be purchased. 26. When PCs are used by multiple users. stored on non-removable storage media is to copy the information diskette or cartridge and delete the files on the nonremovable storage media. Incryption and dycryption of data require the use of special programs and a code key known only to those users to whom the programs or information is restricted. Programs and data are in fact removed from the hard disk only when new data are written over the old files or when special . Cryptography can provide an effective control for protecting confidential or sensitive programs and information from unauthorised access and modification by users. an effective means of program and data security is to remove diskettes and cartridges from the PC and place them in custody of the users responsible for the data or the file librarians. but that such a function may not actually clear erased or deleted files from the hard disk. there is a risk that programs and data may be altered without authorisation. this technique can be supplemented by assigning secret file names and “hiding” the files. Directories and hidden files. Because PC operating system software may not contain many control and security features.

source of data processed. application software integrity and consistency may be improved when application programs are developed and maintained at one place rather than by each user dispersed throughout an entity. The end-user could use this information to validate the results of the application. Such documentation may include step-by-step instruction. loss or destruction. illustrate some of the considerations in designing cost effective control procedures for stand-alone PCs. i.. Data integrity can be strengthened by incorporating control procedures such as format and range checks and cross checks of results. entry and processing of data and generation of reports. A summary of some of the key considerations and their effects on general IT application controls is described below. 28. Software and data integrity controls may ensure that processed information is free of errors and that software is not susceptible to unauthorised manipulation. a description of individual reports. including identifying important programs and data files to be copied periodically and stored at a location away from the micro-computers. It is particularly important to establish back-up procedures for users to perform on a regular basis. The Effect of PCs on the Internal Control Structure 32. Hardware. . The degree of accuracy and dependability of financial information produced will depend on the internal controls prescribed by management and adopted by users.e. management may specify in writing the procedures for developing and who processes the data may be expected to demonstrate that appropriate data were used and that calculations and other data handling operations were performed properly. A review of purchased software may determine whether it contains appropriate error checking error trapping facilities. For user developed software. (b) the type and significance of financial transactions being processed. PCs are oriented to end-users for development of application programs. a description of reports prepared. and (c) the nature of files and programs utilised in the applications. that authorised data are processed in the prescribed manner. files and other specifications. 30. software and data in the event of their failure. users are normally responsible for processing. The effect of PCs on the information system and the associated risks will generally depend on: (a) the extent to which the PC is being used to process transactions. Software and Data Back-Up 31. including electronic spreadsheet templates and database applications.41 27. Back-up refers to plans made by the entity to obtain access to comparable hardware. Software and Data Integrity 4. 29. such as calculations. If the same accounting application is used at various locations. Purchased software packages from third-party vendors generally come with a back-up copy or with a provision to make a back-up copy. described earlier in the statement. Adequate written documentation of applications that are processed on the PC can strengthen software and data integrity controls further. 33. as well as on controls included in the application programs. In a PC environment. The characteristics of PC systems.Audit under Computerised Information System (CIS) Environment utility programs are used to clear the files.

Control may be established by an independent function which would normally : (a) receive all data for processing. larger sample sizes and greater use of computer-assisted audit techniques. (f) using or distributing output. (d) verify the proper distribution of output. (d) changing programs and data files. and (b) permit the perpetration and concealment of fraud. This lack of segregation of functions in a PC environment may. IT Application Controls 36. where 39. in coordination with management policies. In a PC environment. more tests of details. the auditor may find it more cost-effective. the auditor may often assume that control risk is high in such systems. hardware and data files. it is common for users to be able to perform two or or more of the following functions in the information system: (a) initiating and authorising source documents. after obtaining an understanding of the control environment and flow of transactions. such functions would normally be segregated through appropriate general IT controls. In other IT environments. In a PC environment. In this situation. (b) direct supervision.42 Advanced Auditing and Professional Ethics General IT Controls . (c) follow up all errors detected during processing. The existence and use of a appropriate access controls over software. combined with controls over input. and (g) modifying the operating systems 35. Effective controls may include: (a) a system of transaction logs and batch balancing. (b) entering data into the system.4. (b) ensure that all data are authorised and recorded. compensate for some of the weaknesses in general IT controls in PC environments. Thus. and (c) reconciliation of record counts or cash totals. and (e) restrict physical access to application programs and data files. not to make a review of general IT controls or IT application controls. The Effect of a PC Environment on Audit Procedures 38.Segregation of Duties 34. (c) operating the computer. but to concentrate the audit efforts on substantive tests at or near the end of the year. . 37. processing and output of data may. it may not be practicable or cost effective for management to implement sufficient controls to reduce the risks of undetected errors to a minimum level. (a) allow errors to go undetected. This may entail more physical examination and confirmation of assets.

and ongoing assessment of adequacy of the software to meet user requirements. (iii) reconciliation of system balances to general ledger control accounts. (a) Segregation of duties and balancing procedures: (i) (ii) segregation of functions as listed in paragraph 36. Such software may be used by the auditor. electronic spreadsheet or utility software) which has been subjected to review by the auditor. The following are examples of control procedures that an auditor may consider when assessing control risk in relation to stand-alone PCs. These circumstances may include PC systems that process a large number of transactions when it would be cost effective to perform audit work on the data at a preliminary date. the use of key locks on the computer and terminals.43 Computer-assisted audit techniques may include the use of client software’ (database. Access to the PC and its files: (i) (ii) (iii) (iv) placement of the PC within sight of the individual responsible for to it. to add transactions or balances in the data files for comparison with control records or ledger account balances. to develop an audit approach which includes testing of those controls on which he intends to rely. files. 4. or the use of the auditor’s own software programs. For example. the auditor may decide. capacity and controls. the use of passwords for access to the PCs programs and data restriction on the use of utility programs. and controlling access (c) Use of third-party software: (i) (ii) (iii) review of application software prior to purchasing. In certain circumstances.Audit under Computerised Information System (CIS) Environment appropriate. rotation of duties among employees. 40. on the basis of a preliminary review of controls. including functions. 41. . an entity processing a large number of sales transactions on a stand-alone PC may establish control procedures which reduce control risk. adequate testing of the software and the modifications to it prior to use. 42. the auditor may decide to take a different approach. for example. however. to select accounts or transactions for detail testing or confirmation or to examine databases for unusual items. and (iv) (b) periodic review by management of the processing schedule and reports which identify individuals that used the system.

for example. making. (ii) (iii) PC . and updating master files. (b) Special Purpose Terminals.used for entering data without any validation within the terminal and for displaying from the computer system on the screen. the product code is validated by the main computer and the result of the validation is displayed on the terminal screen. requesting reports.used to initiate. The functions performed by these terminal devices vary widely depending on their logic. intelligent terminal . 04. for example. the correct number of characters in the product code is verified by the intelligent terminal and existence of the product code master file is verified by the main computer. On-line systems allow users to initiate various functions directly. The purpose of this guidance (issued by the IASC) describe the effects of an on-line computer system on the internal control structure and on audit procedures. such as: (i) basic keyboard and screen . (ii) . minicomputers or PCs structured in a network environment. a list of inventory items with negative ‘on hand’ quantities. sales transactions in a retail store. Computer systems that enable users to access data and programs directly through terminal devices are referred to as on-line computer systems. transmit and complete various banking transactions. Such systems may be based on mainframe computers.used for the functions of the basic keyboard and screen with the additional functions of validating data within the terminal. for example.44 Advanced Auditing and Professional Ethics II Auditing Guidance Statement: On-Line Computer Systems 01. For example. cash withdrawals in a bank and shipment of goods in a plant. current customer account or balance information. transmission. Depending on the design of the system. setting up new customer accounts and changing general ledger codes. record. On-line Computer Systems: 02. Many different types of terminal devices may be used in on-line computer systems. certain of these functions are performed by the automated teller machine and others are performed on-line by the main computer. Continuing the above example. for example. storage and basic computer capabilities. Types of terminal devices include: (a) General Purpose Terminals.4. all verification of the product code may be performed on the PC. inquiries. validate. in entering a sales order. maintaining transaction logs and performing other local processing. such as: (i) point of sale devices-used to record sales transactions they occur and to transmit them to the main computer on-line cash registers and optical scanners used in the retail trade are typical point of sale devices : automated teller machines . In the above sales order example. Such functions include: (a) (b) (c) (d) entering transactions.used for all of the functions of an intelligent terminal with additional local processing and storage capabilities. 03.

whereas remote terminal devices require the use of telecommunications to link them to the computer. also known as shadow. all at the same time. update. (d) On-Line/Enquiry. (e) On-Line Downloading/Uploading Processing. These same transactions are added to a transaction file for subsequent validation and updating of the master file on a batch basis. On-Line/Batch Processing 09. Terminal devices may be used by many users. Types of On-line Computer Systems 07. In addition to the users of these systems. individual transactions are entered at a terminal device. the withdrawal . Computer supplier personnel may also have on-line access to provide maintenance and support services. or reports generated from. Later. on-line computer systems functions are classified as follows: (a) On-line/Real Time Processing. such as access control software which monitors on-line terminal devices. These systems also require other software. journal entries may be entered and master file being updated on a monthly basis. Inquiries of. For purposes of this statement. (c) On-Line/Memo Update (and Subsequent Processing). during a subsequent processing cycle the transaction file may be validated further and then used to update the relevant master file. the master file will not include transactions entered subsequent to the last master file update. individual transactions are entered at terminal devices. 06. Individual transactions immediately update a memo file containing information which has been extracted from the most recent version of the master file. Local terminal devices are connected directly to the computer through cables. On-Line/Memo Update (and Subsequent Processing) 10. In such cases application software and data are kept on-line to meet the needs of the users. In an on-line/real time processing system. Terminal devices may be located either locally or at remote sites. An example is cash receipts which are applied directly to customers’ accounts. for different purposes. combines online/real time processing and on-line/batch processing. in different locations. subjected to certain validation checks and added to a transaction file that contains other transactions entered during the period. Users may be within the entity or outside. On-Line/Real Time Processing 08. On-line input with memo update processing. In a system with on-line input and batch processing. validated and used to update related computer files immediately. For example. For example. On-line computer systems may be classified according to how information is entered into the system. programmers may use the online capabilities through terminal devices to develop new programs and maintain existing programs. Inquiries are made from this memo file.45 05. The results of such processing are then available immediately for inquiries or reports.Audit under Computerised Information System (CIS) Environment 4. (b) On-Line/Batch Processing. how it is processed and when the results are available to the user. such as customers or suppliers.

the system may provide details of the transactions on request or through the use of transaction logs or other means. is immediately posted to the customer’s account on that file to reduce the balance by the amount of the withdrawal. this system will seem no different than on-line/real time processing since the results of data that are entered are available immediately. For example. 15. 16 An on-line computer system may be designed in a way that does not provide supporting documents for all transactions entered into the system. Characteristics of On-line Computer Systems 13. data at the head office representing transactions of a branch may be downloaded to a terminal device at the branch for further processing and preparation of branch financial reports. Unlimited access to all of these functions in a particular application is undesirable because it provides the user with the potential ability to make unauthorised changes to the data and programs. 14. The extent of this access will depend upon such things as the design of the particular application and the implementation of software designed to control access to the system. On-line downloading refers to the transfer of data from a master file to an intelligent terminal device for further processing by the user. to enter transactions and to read. usually on a batch basis. Data failing this validation would not be accepted and a message may be displayed on the terminal screen. From the user’s perspective. an error message will be displayed enabling the user to re-enter a valid part number. In such systems. they are usually subject to immediate validation checks. On-line inquiry restricts users at terminal devices to making inquiries of master files. Illustrations of these types of systems include orders received by a telephone operator who enters them online without written purchase orders. on-line access to the system by users.4. Users may have on-line access to the system that enables them to perform various functions.46 Advanced Auditing and Professional Ethics of cash through an automated teller machine. providing the user with the ability to correct the data and re-enter the valid data immediately.. prior to accepting an order from that customer. On-Line Downloading/Uploading Processing 12. The characteristics of on-line computer systems may apply to a number of the types of on-line systems discussed in the previous section. the master files are updated by other systems. even though the transactions have not been subjected to complete validation prior to the master file update. and cash withdrawals through the use of automated teller .g. For example. the user may inquire of the credit status of a particular customer. On-Line/Inquiry 11. e. However. For example. if the user enters an invalid inventory part number. possible lack of visible transaction trail and potential programmer access to the system. The results of this processing and other locally processed data may be uploaded to the head office computer. where the withdrawal is checked against the customer’s balance on the memo file. change or delete programs and data files through the terminal devices. The particular characteristics of a specific on-line system will depend on the design of that system. When data are entered on-line. The most significant characteristics relate to on-line data entry and validation.

Certain IT application controls are particularly important to on-line processing. authorisation tables. Specifically. Programmers may have on-line access to the system that enables them to develop new programs and modify existing programs. In such cases. are included in the system during its development and maintenance. Access may be restricted by controls such as the use of separate operational and program development libraries and the use of specialised program library software. programmers may be authorised to change the operational programs. in some systems. files and programs that users are permitted to access the procedures also include physical controls such as the use of key locks on terminal devices: (b) (c) controls over passwords . time and user) as well as the transaction’s details. Such reports often document the source of a transaction (terminal. formal control procedurs would be followed subsequent to the emergency situation to ensure appropriate authorisation and documentation of the changes. Certain general IT controls are particularly important to on-line processing. transaction logs .reports which are designed to create an audit trail for each on-line transaction. such as the use of a (d) (e) 19. Unrestricted acess provides the programmer with the potential to make unauthorised changes to programs and obtain unauthorised access to other parts of the system. pre-processing authorisation . in emergency situations which require changes to programs that are maintained on-line. whereas.procedures for the assignment and maintenance of passwords to restrict access to authorised users. system development and maintenance controls-additional procedures to ensure that controls essential to on-line applications such as passwords. For example.Audit under Computerised Information System (CIS) Environment machines. programmers may have access only to programs maintained in a separate program development and maintenance library. programming controls .permission to initiate a transaction. These include : (a) . entry of unauthorised transactions- (iii) unauthorised changes to data files. (iv) use of operational computer programs by unauthorised personnel. and (v) use of computer programs that have not been authorised.47 17. These include: (a) access controls-procedures designed to restrict access to programs and data.procedures designed to prevent or detect improper changes to computer programs which are accessed through on-line terminal devices. Internal Control in an on-line Computer System 18. programs and data. such procedures are designed to prevent or detect: (i) (ii) unauthorised access to on-line terminal devices. access controls. It is important for on-line changes to programs to be adequately documented. passwords. These access control procedures include the use of passwords and specialised accesscontrol software such as on-line monitors that maintain control over menus. on-line data validation and recovery procedures. 4. The extent of this access depends on the requirements of the system.

file controls . balancing .the procedures which ensure that transaction are processed in the proper accounting period. The effect of an on-line computer system on the information system and the associated risks will generally depend on: (a) (b) (c) (a) (b) (c) the extent to which the oil-line system is being used to process transactions. cut-off procedures . there is less risk that such transactions will not be corrected and re-submitted on a timely basis.procedures which ensure that the correct data files are used for on-line processing. in on-line systems where sales order and shipments are being recorded through the use of on-line terminal devices in various locations. (b) terminal device edit. there is less risk that the transactions will not be recorded. inventory relief and invoice processing.4. reasonableness and other validation tests . accuracy and reasonableness.48 Advanced Auditing and Professional Ethics bank card together with a personal identification number before making a cash withdrawal through an automated teller machine. if on-line data entry is performed at or near the point where transactions originate. Risk of fraud or error in on-line systems may be reduced in the following circumstances: (d) . since master file data may have a pervasive effect on processing results. the type and significance of financial transactions being processed. the data entry process may be less prone to errors than when it is performed by. These are particularly necessary in systems which have a continuous flow or transactions. there is less risk that they will be processed in the wrong an accounting period. These routines may be performed on an intelligent terminal device or on the central computer. if data entry is performed on-line by individuals who understand the nature of the transactions involved.changes to master files are controlled by procedures similar to those used for controlling other input transaction data. master file controls . there is a need to coordinate the actual shipment of goods. individuals unfamiliar with the nature of the transactions. more stringent enforcement of these controlprocedures may be necessary.programmed routines that check the input data and processing results for completeness. 21.the process of establishing control totals over data being submitted for processing through the on-line terminal devices and comparing the control totals during and after processing to ensure that complete and accurate data are transferred to each processing phase. if transactions are processed immediately on-line. However. (c) (d) (e) (f) Effect of On-Line Computer Systems on the Internal Control Structure 20. if invalid transactions are corrected and re-entered immediately. For example. and the nature of files and programs utilised in the applications.

on-line access to data and programs through telecommunications may provide greater opportunity for access to data and programs by unauthorised persons. the on-line computer system may not be designed to provide printed reports. for example.Audit under Computerised Information System (CIS) Environment 22 4. for example only totals from individual on-line data entry devices can traced to subsequent processing. the effect of the on-line computer system on the timing of auditing procedures. On-line computer systems may also have an effect on control procedures. modification of computer programs. The following matters are of particular importance to the auditor in an on-line computer system: (a) authorisation. the opportunity for unauthorised use of a terminal device and the entry of unauthorised transactions may increase. procedures carried out during the audit planning stage (see paragraph 25). due to faulty telecommunications. The characteristics of on-line computer systems. there may be a greater chance that transactions or files may be lost and that recovery may not be accurate and complete.49 Risk of fraud or error in on-line computer systems may be increased for the following reasons: (a) (b) if on-line terminal devices are located throughout the entity. due to on-line access to the system by many users and programmers. (iii) the lack of visible transaction trails. Effect of On-Line Computer Systems on Audit Procedure 24. completeness and accuracy of on-line transactions (b) integrity of records and processing. results of processing may be highly summarised. illustrate some of the considerations influencing the effectiveness of controls in on-line computer systems. on-line terminal devices may provide the opportunity for unauthorised uses such as: (i) (ii) (c) modification of previously entered transactions or balances. Such characteristics may have the following consequences: (a) (b) (c) there may not be source documents for every input transaction. (c) changes in the performance of audit procedures including the use of CAAT’s due to matters such as: (i) (ii) (iv) (v) (vi) the need for auditors with technical skills in on computer systems. (d) 23. audit procedures performed concurrently with on-line processing (see paragraph 26). and procedures performed after processing has taken place (see paragraph 27). as described earlier in this statement. and (iii) access to data and programs from remote locations. if on-line processing is interrupted for any reason. edit reports may be replaced by edit messages displayed on a terminal device screen. for example. .

A database is a collection of data that is shared and used by a number different users for different purposes. 03. Generally. this may be by means of entering test transactions through the on-line terminal services or by the use of audit software. 27. III Auditing Guidance Statement: Database Systems Introduction 01 The purpose of this note (issued by the IASC) is to describe the effects of a database system on the internal control structure and on audit procedures.50 Advanced Auditing and Professional Ethics 25. Database Systems 02. For example. Each user may not necessarily be aware of all the data stored in the database or of the ways that the data may be used for multiple purposes. A well designed and controlled on-line system will affect the auditor’s assessment of control risk and influence the nature. individual users are aware only of the data that they use and may view the data as computer files utilised by their applications. the database and the database management system (DBMS). It may also provide the auditor with sufficient time to develop and test audit procedures in advance of their use. This pre-implementation review may provide the auditor with an opportunity to request additional functions. The characteristics of on-line computer systems may make it more effective for the auditor to perform a pre-implementation review of new on-line accounting applications than to review the applications after installation. 26. Database systems are comprised principally of two essential components. Procedures performed after processing has taken place may include: (a) (b) compliance testing of controls over transactions logged by the on-line system for authorisation. These tests may be used by the auditor either to confirm his understanding of the system or to test controls such as passwords and other access controls. re-processing transactions as either a compliance or substantive procedure. such as detailed transaction listings. timing and extent of audit procedures.4. Procedures carried out during the planning stage may include: (a) (b) the participation on the audit team of individuals with technical proficiency in on-line computer systems and related controls. or controls within the application design. (c) 28. completeness and accuracy. . substantive tests of transactions and of processing results rather than tests of controls. Audit procedures performed concurrently with on-line processing include compliance testing of the controls over the on-line applications. preliminary determination during the risk assessment process impact of the system on the audit procedures. Database systems interact with other hardware and software aspects of the overall computer system. The auditor would be advised to review such tests with appropriate client personnel and to obtain approval prior to conducting the tests in order to avoid inadvertent corruption of client records. where the former may be more cost effective or where the system is not well-designed or controlled.

Usually.51 04. Database systems are distinguished by two important characteristics data sharing and data independence. It also serves as a tool to maintain standardised documentation and definitions of the database environment and application systems. A significant implication of data sharing and data independence is the potential for the recording of data only once for use in several applications. however. True data independence is achieved when the structure of data in the database can be changed without affecting the application programs. Database Administration 11. For example. This software within the DBMS is known as a data dictionary. however. Data Sharing 07. The use of the same data by various application programs emphasises the importance of centralised coordination of the use and definition of data and the maintenance of its integrity. Because various application programs need to access this data. The software that is used to create. In a database system. maintains the interrelationships among the data. a single file of data (or database) is used by many applications. DBMS’s differ in the degree of data independence they provide. Individual applications share the data in the database for different purposes. . an inventory item unit cost maintained by the database may be used by one application program to produce a cost of sales report and by another application program to prepare an inventory valuation. Such systems are not considered to be databases for the purposes of this Statement. A database is composed of data which are set up with defined relationships and are organised in a manner that permits many users to use the data in different application programs. and vice versa. are applicable to all multiple user environments. Data Dictionary 10. and makes the data available to application programs. separate data files are maintained for each application and similar data used by several applications may be repeated on several different files. including a PC system. 09. Together with the operating system. the DBMS facilitates the physical storage of the data. Data Indepedence From Application Programs 08. This is achieved by the DBMS recording the data once for use by various application programs. a software facility is required to keep track of the location of the data in the database. the DBMS software is supplied by a commercial vendor. Because of the need for data sharing. database systems are used by a single user. The contents of this Statement. maintain and operate the database is referred to as DBMS software. 05. In some PC environments. there is a need for data independence from application programs.Audit under Computerised Information System (CIS) Environment 4. These characteristics require the use of a data dictionary (paragraph 10) and the establishment of a database administration function (paragraphs 10-14). In non-database systems. with data redundancy kept to a minimum. Database systems may reside on any type of computer system. The degree of data independence is related to the ease with which personnel can accomplish changes to application programs or to the database. Database System Characteristics 06.

The database administrator is responsible generally for the definition. more than one database may be used. The individual who heads this function may be referred to as the “database administrator”. (b) coordination of functions is maintained. and (v) (c) (d) (e) arranging total recovery in the event of a loss. 14. by a group of individuals whose responsibility is typically referred to as ‘database administration”. accuracy and completeness.e. through passwords and authorisation tables. Internal Control in a Database Environment 15.52 Advanced Auditing and Professional Ethics security. Database administration tasks may also be performed by individuals who are not part of a centralised database administration group. (iv) securing the database from unauthorised access and destruction. implementing and enforcing the rules for data integrity. security. maintaining data integrity. Where the tasks of database administration are not centralised. and (c) data contained in different databases are consistent.coordinating and liaising with the vendor of the DBMS. the DBMS and the applications. completeness and access. 13. Coordination is usually performed. the different tasks still need to be coordinated. The effectiveness of internal controls depends to a . Responsibilities include: (i) (ii) defining who may access data and how the access is accomplished. but are distributed among existing organisational units. assessing new releases issued by the vendor of the DBMS and the extent of their impact on the entity. 12. coordinating computer operations related to the database-assigning responsibility physical computer resources and monitoring their use relative to the operation of the database.4. the tasks of the database administration group will need to ensure that: (a) adequate linkage exists between databases. In these circumstances. Generally. operational control and efficiency of databases. Database administration tasks typically include: (a) defining the database structure . security and completeness . In some applications. internal control in a database environment requires effective controls over the database. structure. (b) (iii) detecting the absence of data. installing new releases and ensuring that appropriate internal education is provided. i. including the definition of the rules by which data are accessed and stored. providing administrative support . preventing the inclusion of incomplete or invalid data. monitoring system performance .developing.determining how data are defined.developing performance measurements to monitor the integrity of the data and the ability of the database to respond to the needs of users. stored and accessed by users of the database in order to ensure that all their requirements are met on a timely basis.

Audit under Computerised Information System (CIS) Environment 4. A single data owner should be assigned responsibility for defining access and security rules. where many individuals may use program. For example. the credit manager may give salesmen authority to refer to a customer’s credit limit. Implementing a standard approach to develop and modify application programs is a technique that can help improve the accuracy. General EDP controls over the database. EDP application controls on database systems. Standard Approach for Development and Maintenance of Application Programs 17. such as who can use the data (access) and what functions they can perform (security). terminal devices and programs. User access to the database can be restricted through the use of passwords. The resulting analysis would indicate the effects of the changes on the security and integrity of the database. maintaining secrecy of passwords and reviewing and investigating attempted security violations. . and (d) segregation of duties. the likelihood increases of the data becoming corrupted or improperly used. Due to data sharing. For example. (c) access to the database. 16. The general EDP controls of particular importance in a database environment can be classified into the following groups: (a) standard approach for development and maintenance of application programs. amend or delete data. Access to the Database 19. In a database environment. Since data are shared by many users. programs and data helps to ensure that only authorised users and programs can access. to input and modify data. This includes following a formalised. step-by-step approach that requires adherence by all individuals developing or modifying an application program. These restrictions apply to individuals. integrity and completeness of the database. Data Ownership 18. data independence and other characteristics of database systems. adequate procedures are required for changing passwords. general EDP controls normally have a greater influence that. a clear and definite assignment of responsibility is required from the database administrator for the accuracy and integrity of each item of data. (b) data ownership. Relating passwords to defined terminal devices. Assigning specific responsibility for data ownership helps to ensure the integrity of the database. control may be enhanced when a standard approach is used for developing each new application program and for application program modification. the credit manager may be the designated “owner” of a customer’s credit limit and would therefore be responsible for determining the authorised users of that information. If several individuals are able to make decisions affecting the accuracy and integrity of given data.53 great extent on the nature of the database administration tasks. the DBMS and the activities of the database administration function have a pervasive effect on application processing. described in paragraphs 11-14 and how they are performed. It also includes performing an analysis of the effect of new and existing transactions on the database each time a modification is required. For passwords to be effective. whereas a warehouse clerk may not have such authorisation.

Alternatively. design. where the same data are stored in several files and update. (c) the nature of the database.. those persons responsible for modifying personnel database programs should not be the same persons who are authorised to change individual pay rates in the database. the database administration tasks and type applications (e. such as recovery/restart routines. Maintaining adequate segregation of these duties is necessary to ensure the completeness. this may not be possible. in a database system. Users access to the various elements of the database may be further controlled through the use of authorisation tables. and audit procedures. rather than in non-database systems. and query languages. For example. as inadequate database administration controls cannot always be compensated for by the individual users. In a typical non-database environment. controls exercised by individual users may compensate for weaknesses in general EDP controls. For example. which may be used to identify inconsistencies in the data. (c) other functions available with the DBMS can facilitate control. .4. the DBMS (including the data dictionary). following factors. Database systems typically provide the opportunity for greater reliability of data than nondatabase systems. Responsibilities for performing the various activities required to design. This can result in reduced risk of fraud or error in the accounting system fraud or error in the accounting system where databases are used. These functions include report generators which may be used to create balancing reports. The effect of a database system on the information system and the associated risks will generally depend on: (a) the extent to which databases are being used by accounting applications. contribute to this. However. database design. generalised edit find validation routines.g. Improper implementation of access procedures can result in unauthorised access to the data in the database. risk of fraud or error may be increased if database systems are used without adequate controls. and security and control features. 23. accounts receivable personnel cannot effectively control accounts receivable data if other personnel are not restricted from modifying accounts receivable balances in the database.54 Advanced Auditing and Professional Ethics 20. 24. implement and operate a database are divided among technical. Their duties include system design. The Effect of Databases on the Internal Control Structure 22. integrity and accuracy of the database. (b) integrity of data will be improved by effective use of facilities included in the DBMS. (b) the type and significance of financial transactions being processed. administrative and user personnel.. and (d) the general EDP controls which are particularly important in a database environment. batch or on-line update). improved reliability of data: (a) improved consistency of data is achieved because data are recorded and updated only once. Segregation of Duties 21. administration and operation. combined with adequate controls. at different times and by different programs.

28. 29. 30. the auditor may consider how the controls described in paragraphs 17-21 are used in the system. (c) the database administration function. (b) the standards and procedures for development and maintenance of application programs using the database. Where the auditor assesses control risk as less than high in relation to the database system. as inadequate database administration controls cannot always be compensated for by the individual users. in assessing control risk related to the use of databases in the information system. he would consider whether performing additional substantive tests on all significant accounting applications which use the database would achieve his audit objective. In order to obtain an understanding of the database control environment and the flow of transactions. the auditor may consider the effect of the following on audit risk in planning the audit. (a) the DBMS and the significant accounting applications using the database. 26. Where the auditor decides to perform compliance or substantive test related to the database system. (b) provide an audit trail. administration and operation of the database. design. standards and procedures for those individual responsible for technical support. During the risk assessment process. (d) job descriptions. (e) obtain information necessary for the audit. the auditor may find it cost-effective to utilise some of the procedures in the following paragraphs.55 25. security and completeness of the financial information contained in the database and (f) the availability of audit facilities within the DBMS. audit procedures may include using the functions of the DBMS (see paragraph 23) to : (a) generate test data. Audit procedures in a database environment will be affected principal by the extent to which the data in the database are used by the accounting system.Audit under Computerised Information System (CIS) Environment The Effect of Databases on Audit Procedures 4. administration and operation of the database. When using the facilities of the DBMS. the auditor will need to obtain reasonable -assurance regarding their correct functioning. The auditor would perform tests of control to support an assessment to control risk that is less than high. The characteristics of database systems may make it more effective for the auditor to perform a pre-implementation review of new accounting applications rather than to review the applications after installation. 27. design. Where significant accounting applications use a common database. This pre-implementation review may provide the auditor with an opportunity to . (d) job descriptions. standards and procedures for those individual responsible for technical support. (e) the procedures used to ensure the integrity. (c) check the integrity of the database.

56 Advanced Auditing and Professional Ethics request additional functions. It may also provide the auditor with sufficient time to develop and test the audit procedures in advance of their use. such as built-in audit routines. .4. or controls within the application design.

Chapter 3 of the Professional Competence Course Study Material contains various techniques generally employed for auditing the books of account. In this Chapter. etc. For example. Loans and Advances issued by the Institute of Chartered Accountants of India has recommended that balances outstanding against debtors and as loan and advances should be confirmed by a procedure of communication with the parties. If it appears that they are not collectible. an audit programme specifies the techniques to be employed in the specific case by relating the techniques to the respective areas of accounting. Debts often include claims made against insurance companies. the auditor should satisfy himself whether the write off was based on appropriate considerations of the relevant facts. shipping companies. The debtors’ schedule should have appropriate columns to indicate the period over which each account is outstanding. 5. Vouching will be in respect of all the transactions whether appearing in the cash book or in any journal. checking and casting all related to the subsidiary books of account and the principal books of account. The auditors must not assume that any balance which is confirmed is necessarily realisable. Same procedure is applicable in case of creditors as well. Each account should be scrutinised in order to do the ‘aging’ of the debtors. the techniques of posting. Where debts are written off. Correspondence should be seen in all major cases in order to ascertain whether the claims have been acknowledged and whether there is a reasonable possibility of their being realised.1 Confirmation . The Guidance Note on Audit of Sundry Debtors. bank balances or securities lodged with others. The confirmation technique is appropriate in relation to personal accounts balances. railways. It may be interesting to note that the AICPA included direct confirmation of sundry debtors in its Auditing Standards after the decision of Mckesson and Robbins. they should be shown as . and the auditor should ascertain that the claims are realisable.1.AAS 5 (Audit Evidence) defines confirmation as a method of collecting audit evidence which consists of the response to an inquiry to corroborate information contained in the accounting records. For example.1 Normally. the auditor requests confirmation of receivable by direct communication with debtors. we shall deal with some of these techniques in greater detail. The Guidance Note provides the following: The checking of the debtors’ ledger balances does not merely involve a comparison of the balances in the ledger with those shown in the schedule.5 SPECIAL AUDIT TECHNIQUES Introduction 5.

A stamped envelope containing the auditor’s name and address should be enclosed. it should be verified that either the balances have been confirmed or the amounts confirmed can be satisfactorily reconciled with the balances shown by the books of account of the client. 7. Based on the above recommendations an outline of a confirmation procedure may be as under: 1. not afforded to a party. the client should be requested to prepare statements of account showing the position of the balances as at the date of confirmation. Letters or statements should be posted under the supervision of the auditor. The confirmatory letters should be sent out within a period of 15 to 21 days of the end of the year. before balances are selected for confirmation. 9. 6. 8. In cases where replies are not received within a reasonable time. the balances wherein are to be confirmed. where a reconciliation statement has been prepared. as may have been mutually agreed upon. selected according to some system. 2. letters may be issued only in respect of major debtors and creditors. These recommendations can be applied to creditors as well.5. a reminder should be sent out by the auditor. it should be confirmed that there exists a provision equal to the difference which ultimately may have to be credited to him. If the difference is the result of some dispute or claim for allowance or return. On receipt of replies from the parties. If the number of balances is large. if any. 4. 5. The client should be requested to prepare reconciliation statements where necessary. The statements of account prepared by the client should be compared by the auditor with the balances of debtors and creditors. Either each statement of account should contain a request for confirmation of the balance shown therein or it should be forwarded with a separate letter by the auditor or the client. A nil balance account should also be included. The letter or the statement should show the address of the auditor to which the statements of account after the confirmation are to be returned. . etc. it should be verified that the difference in the amount confirmed and that shown by the books of account is not the result of an omission to credit any amount received from the party or failure to debit him with any amount of sales or to credit him with the value of goods received with a view to suppressing or inflating profit. Direct confirmation procedure may be performed both for sundry creditors and sundry debtors. he should maintain control over them until they are posted. Therefore. even when the audit is taken up much later in respect of balances either as at the date of the Balance Sheet or as at another selected date before the close of the year. Having selected the accounts. Special precautions in respect of creditors to be taken are as under: (i) The Creditors’ ledger trial balance should be extracted by the client and agreed with the Control Account. In every case. 3. Letters received back undelivered should be sent again at the correct address.2 Advanced Auditing and Professional Ethics doubtful.

3 The provision made for the amount payable in respect of goods received within the last week of the close of the year should be verified by comparing entries in the Goods Inward Register with the Purchase Journal. This requirement suggests that inquiry is one of the processes of the whole scheme of auditing and. How the auditor is expected to perform the duty of enquiry as contained in Section 227(lA) is given in Chapter “Audit Report”. Special precautions in respect of sundry debtors to be taken are as under: (i) (ii) The Debtors’ ledger trial balance should be extracted by the client and agreed with the Control Account. (iii) The accounts to be verified by direct confirmation should be settled on the basis of internal control procedures. such as a comparison of the entity’s ratio of sales to accounts .1.1. accordingly. Besides. the Companies Act. The need for inquiry may arise at every stage of auditing. such as budgets or forecasts. Responses to inquiries may provide the auditor with information which he did not previously possess or may not provide him with corroborative evidence. 5.Special Audit Techniques (ii) 5. observation consists of witnessing a process being performed by others.According to AAS 5. Wherever any transaction or entry is not readily understandable or its effects are not readily apparent. Section 227(IA) of the Companies Act.1. The adjustment of sales made at the close of the year should be verified by comparing the entries in the Goods Outward Register for two weeks before the close of the year with these in the Sales Journal. the auditor should not hesitate to make enquiry from the appropriate official of the client. (iii) A certificate should be obtained from the client that all the liabilities which have accrued up to the date of the Balance Sheet have been taken into account. Analytical procedures include comparison of financial information with: ♦ comparable information for a prior period or periods. 1956 has given certain powers to the auditor in Section 227(1) and has cast certain duties on company officials in Section 221. and ♦ similar industry information. Apart from this.3 Observation . students should remember that the auditor of a company has to make a statement in his report on whether he has obtained all the information and explanations that he considered necessary for his audit. if any. 1956 casts upon the auditor a specific duty to inquire into certain specified transactions. the auditor may observe the counting of inventories by the client personnel or the performance of internal control procedures that leave no audit trail. Inquiries may range from formal written inquiries addressed to third parties to informal oral inquiries addressed to persons inside the entity. 5.2 Inquiry – AAS 5 mentions inquiry as one of the methods of collecting audit evidence by seeking appropriate information from knowledgeable persons inside or outside the entity. ♦ anticipated results. 5.Analytical review procedures may be defined as substantive tests of financial information made by a study of comparisons and relationship among data. For example. before balances are selected for confirmation.4 Analytical Review Procedures .

what yard-stick)? (c) Are there any variations between (a) and (b) which the auditors would expect to occur? Analytical procedures also include study of relationships: ♦ among elements of financial information that would be expected to conform to a predictable pattern based on the entity’s experience. ratios and statistics exist which are of significance for the business? (b) What should they be compared with (i. or current assets and current liabilities). Budgets and forecasts (if available). (c) The auditor’s knowledge of the business. for example inventory turnover ratio) (i) (ii) (i) (ii) (i) (ii) Comparison with Corresponding previous period. The choice of procedure. items in annual statements. Entries in accounting records. The auditor should ask the following questions: (a) What data. . divisions or segments). etc. Other financial data.g. such as a study of payroll costs to number of employees. methods and level of application is a matter of professional judgment. financial information of components (such as subsidiaries. (b) Known trends. Analytical procedures may be applied to consolidated financial information. Various methods may be used in performing the above procedures. management accounts.4 Advanced Auditing and Professional Ethics receivable with industry averages or with other entities of comparable size in the same industry. such as a study of gross margin percentages.) Non-financial data (e. (iii) Industry Statistics. Essentially these procedures ensure that the various items making up the financial statements are consistent with: (a) Each other (for example. and ♦ between financial information and relevant non-financial information..5. Financial data (e. Budgets and forecasts. Preceding period. The following table summarizes the position: Types of data. These range from simple comparisons to complex analyses using advanced statistical techniques. budgets.. production and employment statistics) Ratios and percentages (developed from financial and non.financial data.g. and individual elements of financial information.e. the relationship between debtors and sales. ratios etc..

5 (a) To assist the auditor in planning the nature.Special Audit Techniques Analytical procedures are used for the following purposes: 5. In addition. volume of goods produced and similar information. . he should consider the following: ♦ The objective of the analytical procedures. in some cases. budgets may have been established as goals to be achieved rather than expected results. The auditor will normally inquire of management as to the availability. Analytical procedures in planning the audit .for example. ♦ The nature of the entity . The auditor may find that it is efficient to use analytical data prepared by the client. than when applied to the financial statements of the entity as a whole.for example. such as number of employees. When the auditor intends to perform analytical procedures.In the planning stage. Analytical procedures used as substantive tests . analytical procedures can be more effective or efficient than tests of details in reducing detection risk for specific financial statement assertions. analytical procedures may be more effective when applied to financial information on individual sections of a business operation or to financial statements of components of diversified entities. This information will assist the auditor in determining the nature. and reliability of information needed to apply analytical procedures and the results of any such procedures performed by the client.for example. ♦ The availability of information. analytical procedures assist the auditor in understanding the client’s business and in identifying areas of potential risk by indicating aspects of and developments in the entity’s business of which he was previously unaware. from analytical information procedures. (b) As a substantive test to obtain evidential matter about particular assertions related to account balances or classes of transactions. or from a combination of both. The decision about which procedure or procedures to use to achieve a particular audit objective is based on the auditor’s judgement about the expected effectiveness and efficiency of the available procedures. and the extent to which he may be able to rely on their results. square feet of selling space. ♦ The reliability of the information available . timing and extent of other auditing procedures. Analytical procedures in planning the audit use both financial data and non-financial information. provided he is satisfied that such data are properly prepared.The auditor’s reliance on substantive tests to reduce detection risk relating to specific financial assertions may be derived from the tests of details. either financial such as budgets or forecasts or nonfinancial such as the number of units produced or sold. (c) As an overall review of the financial information in the final review stage of the audit. timing and extent of his other audit procedures. Analytical procedures should be applied to some extent for the purposes referred to in (a) and (c) above for all audits of financial statements. ♦ The relevance of the information available . experience may indicate that budgets are prepared with insufficient care.

broad industry data may not be comparable to that of an entity that produces and sells specialized products. ♦ Accuracy with which the expected results of analytical procedures can be predicted. For example. if any. ♦ Other audit procedures directed toward the same audit objectives. for example. ♦ Evaluation of internal controls. might confirm or dispel questions raised from the application of analytical procedures to an aging of customers’ accounts. in fact. When such controls are adequate. the auditor will normally expect greater consistency in comparing gross profit margins from one period with another than in comparing discretionary expenses. Extent of reliance on analytical procedures . an entity in establishing internal controls over the processing of sales invoices may include controls over the recording of unit sales in conjunction with his compliance procedures to test the controls over the processing of sales invoices. a material misstatement exists. when inventory balances are significant to the financial information. such as the review of subsequent cash receipts. reliance to be placed on the results of analytical procedures will depend on the auditor’s assessment of the risk that the analytical procedures may identify relationships as expected when. if the auditor has concluded that internal controls over sales order processing are weak. The auditor should consider the need for testing the controls over the preparation of nonfinancial information. .5. However. for example. The controls over non-financial information can often be tested in conjunction with compliance procedures performed in the study and evaluation of the accounting system and related internal controls.for example. such as research or advertising. used in applying analytical procedures. The extent of reliance that the auditor places on the results of analytical procedures depends on the following factors: ♦ Materiality of the items involved in relation to the financial information taken as a whole (e. together with his understanding of the effectiveness of internal controls and the types of problems that in preceding periods have given rise to accounting adjustments. other procedures performed by the auditor in reviewing the collectability of accounts receivable. therefore.The application of analytical procedures is based on the expectation that relationships among data exist and continue in the absence of known conditions to the contrary. he may have to rely more on the tests of details of transactions and balances than on analytical procedures in drawing his conclusion on sales. for example. The presence of these relationships provides audit evidence as to the completeness. the auditor will have greater confidence in the reliability of the non-financial information and. the auditor does not rely only on analytical procedures in forming his conclusions).6 Advanced Auditing and Professional Ethics ♦ The comparability of the information available . he will have a greater degree of assurance as to the results of his analytical procedures. he may rely solely on analytical procedures for certain expense items when they are not individually significant to the financial information taken as a whole and there is an absence of unexpected fluctuations. accuracy and validity of the data produced by the accounting system. ♦ The knowledge gained by the auditor during previous examinations. On the other hand.g.

Through the process of ratio analysis. the internal control system may not be in a position to reveal anything about them. Ratio analysis is an audit approach that helps the auditor to make an overall assessment of the data by reference to attendant factors. It should be appreciated that an audit programme will be realistic only after the auditor has modified in the light of his experience of the changes and of the state of internal controls operating in the organisation. inter-company relations. It. deviations and unexpected variations.Special Audit Techniques 5.7 This technique has been discussed at the PCC level. if the materials are needed. But if certain transactions are omitted altogether. interpretation and conclusion. scarcity conditions. howsoever good. Internal control systems. any abnormal relationship between two related matters is most likely to be disclosed. An auditor should always bear in mind these limitations of the control system. The auditor normally performs an audit by placing reliance on the internal control system. Relevance of Ratio and Trend Analysis . however. captive market. valid and consistent. Conflict of interests. are some of the forces that condition a company’s working and management approach to a large extent. by overall tests which are based on judgment of what is reasonable. A ratio measures the relative magnitude of two related factors. It is a means to objectively assess or diagnose the financial health of a business. He can assess whether the data is reasonable. the management will avail of the same. presupposes certain amount of knowledge on the part of the auditor about what should be the reasonable relationship. This may be acquired by the auditor from his knowledge and experience gained elsewhere or from the knowledge of the . As and when the company is allotted a quota or permit for that material irrespective of any consideration. etc. it is obvious that the internal control rule about the maximum or minimum holding of the raw material is of no use to the management which is concerned with the running of the business. However in view of importance of this technique in the context of growing complexities. It should also be understood that significant non-routine transactions are entered into sometimes in complete disregard of the laid down rules of control. will be of no use in such cases. If the auditor can perceive some of the imperatives under which the management operates and the relationship of the business with the economy and environment. For goods to be imported it is often the practice to ask for and obtain an import license for a quantity far larger than is reasonably needed simply to avoid the procedural red tape involved in obtaining a license. These limitations have made it even more important for the auditor to supplement his routine audit programme. it requires a more detailed treatment in the specific area of ratio analysis and related matters. The internal control system may be good as far as the transactions that have been recorded. It does not have any significance of its own except to provide material for further analysis. The auditor can take a broad view of the data under audit by adopting ratio analysis. diversities and volumes of business. A company’s control system may provide for a maximum holding of a particular raw material but if the raw material is a controlled commodity and the supply is irregular. inflation. he would be able to make the audit programme far more objective. Besides the management will not mind even to procure such material from the open market at a price different from the controlled price.Ratio analysis is an important supplement to the audit process which has the merit of bringing to focus the abnormalities. control by the State.

explanation and evaluation of the changes and their significance in light of the circumstances. The basis and method of compilation. a business offering cash discount for prompt settlement of accounts will have a high debtors’ turnover ratio. Similarly.relationships in data. e.g. There may be circumstances. It has been stated earlier that data must be inter-related for any effective ratio analysis. On the other hand. If the ratio is low. though he should not hasten to the conclusion that it is an error. A business with high sales volume at a low margin of profit is expected to have a high inventory turnover ratio. certain businesses have their own features. This knowledge can be derived from either a comparison with the concerned business’s past corresponding data or by reference to readymade data available about the industry from some official source or by comparing the data with the corresponding data found in another company engaged in the same line of industry in similar circumstances. For example..5. He will be able to devote an appropriate amount of time and effort in areas where abnormalities have been detected. the data are subjected to ratio analysis. The determination and measurement of changes and inter. 2.8 Advanced Auditing and Professional Ethics past relationships. These. it will be a pointer for further probe. The external data are generally considered to be objective and independent in character. such background knowledge is essential. it may be said that ratio analysis makes it possible for the auditor to locate problem areas which can thereafter be subjected to scrutiny for confirming that the problem really exists or it is manifestation of some real abnormality that business has experienced during the period covered by the audit. the Reserve Bank of India Bulletin. the period covered and the source and author of the data are some of the considerations needed before they are used for comparisons. if the rate of Provident Fund contribution is 10% of the basic pay and dearness allowance. If the auditor finds the Provident Fund contribution to be of the order of say 6% of the total of basic pay after dearness allowance. the auditor would be in a position to plan his audit programme more purposefully. For the auditor to properly understand the implications of ratios. the . if there exists certain known relationship. in a business where Government is the principal buyer. The analysis of ratios and relationships has two phases: 1. should be used with discretion. A business dealing with a widely needed scarce material will in most cases have customer’s advances against supply rather than any debtors’ balances. newly appointed employees are not entitled to the Provident Fund benefit for certain period or there may be some retired persons re-employed who are not entitled to any provident fund benefit. the matter becomes simpler. this immediately alerts him that some abnormal feature exists. it is the general nature that the margin of profit is high and the debtors outstanding quite large. The scrutiny. the auditor is expected to possess the knowledge of normal relationship between related variables in the business he is auditing so that he can discern deviation from the normal and assess significant variation in the relationship. This may help also in forestalling an approaching danger before it has done much damage. It is felt that if. either set of the data can be proved by the other having regard to the given relationship. Also. at the audit planning stage. Therefore. Apart from this. In India. however. In addition.

Subject to review of these data for adjustment these may be used for comparison. Now if the gross profit ratio shows any abnormality. what they would reveal and how to relate matters. e. However. Like. Of course.. It is also possible that (i) sales have been inflated or (ii) the credit policy was defective to result into huge accumulation of debtors or (iii) there had been defalcation of sales proceeds. having localised the problem areas. However. the ratio between the main raw material consumed to total production may prove both the figures. The auditor should inquire why it is so. also. (ii) stock overstated or over valued. further inference may be drawn for verification and confirmation. Such a procedure may prove immensely helpful when used as a supplementing technique to the normal vouch and post audit. the possibilities that immediately should strike one are: (i) sales overstated. expenses. Ratio analysis can be of great use for overall checks.Special Audit Techniques 5. For example. a physician. and comparing them with the previous years. may be dissimilar. Working out the relationship of ratios. therefore. the circumstances. depending upon the abnormality. But the mutual relationship of most related figures can change only because of extraordinary circumstances. To the extent reasonableness is established. . It is also natural for the auditor to expect the ratio of gross profit to net profit to be up in such circumstances unless explained by other abnormal factors working in the opposite direction. (iv) wages and other costs understated. individually or as a class. etc. analyses them and works out a diagnosis. etc. It is to be expected that figures of sales will change together with changes in purchases.9 Bombay Stock Exchange Directory.. it should be noted that ratios are one of the ways of application of overall tests. the selling and distribution cost or interest on borrowings might have gone up significantly to eat up the excess margin of gross profit. wages. If the gross profit ratio is higher than normal. Take another example: suppose the turnover ratio (Sales/Capital) shows a considerable improvement over the last year and there is no concurrent increase in the solvency or liquidity ratios. There are certain quantitative ratios which may be particularly helpful to the auditor. Auditors can use a number of other quantitative ratios like ratio of man hours to production to verify the accuracy of figures in the Profit and Loss Account and the Balance Sheet. can check them extensively to find out whether the doubts are true or certain abnormal situations did prevail that accounts for the distortion. It is quite possible that the company has evolved a better system of financial management. the auditor may compute gross profit ratio. etc. they should not be considered as a readymade material for comparison because the manner of compilation. the auditor can identify areas where detailed enquiries are called for. (iii) purchases understated. For example. what can be expected as a result of particular ratio. to know whether the concern’s cost of sales bears the normal relation to sales. he examines symptoms. It would thus be seen that by working out ratios. the auditor should be experienced and skillful enough to know what ratio is appropriate for his purpose. Most of the ratios known to us from our study of Advanced Accounting can be used by the auditor in evaluating different aspects of the financial health of a concern. Kothari’s Economic and Industrial Guide are some of the publications that contain reliable financial information about companies. the Calcutta Stock Exchange Directory.g. the auditor may feel to be on a firm ground when he issues his report. favourable or adverse. Now the auditor. corresponding ratios serve to establish the apparent reasonableness of the figures.

If trends of sales and purchases are studied over a reasonable period say 5 years . would be required if management is unable to provide an explanation or if the explanation is not considered adequate. However. Further investigation. the auditor should investigate them. the auditor should perform analytical procedures at or near the end of the audit. be developed as a useful audit tool also to locate areas showing abnormalities. that is.any distortion in their relations will be apparent. enable the auditor to form an opinion on the financial information. ♦ Consider the need to apply other audit procedures based upon the results of such inquiries. Investigating unusual fluctuations and Items . it may. In forming such an opinion. relationships that are unexpected or inconsistent with evidence obtained from other sources. The conclusions drawn from the results of such procedures are intended to corroborate conclusions formed during the audit on individual elements of financial information and assist in arriving at the overall conclusion as to the reasonableness of the financial information. Even the trend of significant ratios can be studied by the auditor over a number of years either by plotting them on a graph paper or by setting them chronologically. in total.10 Advanced Auditing and Professional Ethics A good approach is to study the trends. The objective of comparison of absolute figures by reference to the corresponding figures of the previous year has been stated by the Government in the context of the requirement in the Schedule VI to the Companies Act.In forming his overall conclusion that the financial information as a whole is consistent with his knowledge of the entity’s business and relevant economic conditions. Statistical Sampling in Auditing 5. as follows: “The intention of displaying the figures relating to the previous year is to facilitate the comparative study of the items in the Balance Sheet and Profit and Loss Account. they may also identify areas requiring further procedures. Analytical procedures used in the overall review . The investigation usually begins with inquiries of management and the auditor should: ♦ Corroborate management’s responses .5.When analytical procedures identify unusual fluctuations and items. Similarly. the auditor does not normally examine all of the information that is available to him because he can reach a conclusion about an account . Students are referred to Study Material in Advanced Accounting. These all highlight one fact: those relevant ratios may be of great value for proper financial analysis and this may bring out the problem areas on which the auditor is directly interested. Trend analysis is of course mainly resorted to in investigations.for example. by means of audit procedures designed to produce a satisfactory conclusion. However. so that the significance of the figures for the current year can be more readily appreciated and understood”. trend of cost of production can be studied along with the trend of the major components of cost. by comparing them with his knowledge of the business and other evidence obtained during the course of the audit. “The audit evidence should.2 According to AAS-5 on ‘Audit Evidence”.

11 balance. a small loss of the degree of satisfaction will be more than compensated by the considerable savings in time and costs for having checked only a fraction of the total data. Such items might imply some characteristic of the remaining portion of the population but would not be the basis for a valid conclusion about the remaining portion of the population. represents his overall assessment of the truth and fairness of the accounting statement based on his satisfaction that he has applied all professional skill at his command to see that no material error or fraud exists to distort the true and fair view of the accounting statements. Statistical sampling in auditing stands for the technique of forming an opinion about a group of items on the basis of an examination of a few of the items.Special Audit Techniques 5. but he takes a risk of being challenged about the validity of his opinion. It may be recalled that test checking technique is one of the accepted auditing techniques.g. It is important to recognize that certain testing procedures do not come within the definition of sampling. . not as simplistic as the test checks. In expressing his opinion the auditor never guarantees absolute accuracy of the accounting statements. When he checks only a part of the total accounting data in lieu of checking of all the data. all items over a certain amount) does not qualify as sampling with respect to the portion of the population examined nor with respect to the population as a whole. It is however. but from a practical consideration the minimum requisite sample size. The greatest merit of statistical sampling technique lies in its being based on the statistical theory of probability. manipulation. however. Even after a complete checking. including the Institute of Chartered Accountants of India have recommended for use by the members on a proper consideration of facts and applicability. about truth and fairness of the accounting statements. We have also seen the shortcomings of the test check technique as a basis for forming informed opinion about the accounts under audit.. Statistical sampling technique may be considered as a refined application of the test check technique which has all the advantages of the latter with the shortcomings removed. However. he cannot be sure that the accounts and the resulting accounting statements are absolutely free from error. an auditor is required to give a report containing his opinion. Likewise the technique of selecting all items within a population which have a particular significance (e. which most of the professional bodies of the world. class of transactions or a control by way of judgmental or statistical sampling procedures”. Statistical sampling technique is increasingly becoming popular with the auditors. It is again true that bigger the sample. the opinion that he expresses. On the basis of the audit carried out. it is obvious that the degree of satisfaction obtainable from the latter would not be available. the greater would be the satisfaction. Tests performed on 100% of the items within a population do not involve sampling. since the items were not selected from the total population on a basis that was expected to be representative. if determined statistically will be adequate to express an opinion about the overall truth and fairness of the total data within a reasonable range of precision and with reasonable confidence. fraud or mistake.

The reliability referred to is usually termed the confidence level. he could define the sampling unit for confirmation purposes as either customer balances or individual customer invoices. Petty cash vouchers. The auditor should define the sampling unit in order to obtain an efficient and effective sample to achieve the particular audit objective. if he was testing for understatement of accounts payable. or ‘universe’ (i. the total number of items potentially subject to scrutiny within a defined area.The population is the entire set of data from which the auditor wishes to sample in order to reach a conclusion. and (ii) accessible. if the auditor’s objective is to test the validity of the entity’s accounts receivable.e. Confidence level . More precisely. must be sufficiently large.In designing an audit sample. the auditor has to consider the following Audit objectives . (c) All items within a particular population must be homogeneous. his population would not be the accounts payable trial balance but could be subsequent disbursements. (b) The system which produces the records to be tested must be sufficiently reliable. (d) Items within the population must be both (i) identifiable.1 Design of the sample and its evaluation . the nature of the audit evidence sought and possible error conditions or other characteristics relating to that evidence will assist the auditor in defining what constitutes an error and what population should be used for sampling. On the other hand. it is the mathematical probability that the error rate in the . On the other hand. In addition.12 Advanced Auditing and Professional Ethics 5. Further regarding population. when performing substantive tests of invoices processed during the period. For example. The population can be divided into sampling units in a variety of ways. when performing compliance tests of a company’s purchasing procedures. For example. For example. the auditor will be concerned with matters such as the proper reflection of the monetary amounts of such invoices in the financial information. unfair invoices.5. i. his population could be defined as the accounts receivable trial balance. the auditor will be concerned with matters such as whether an invoice was clerically checked and properly approved. and for this purpose random number tables are often used. The difficulty often arises. it will hardly be practical for the auditor himself to set about entering the numbers on the vouchers. The individual items that make up the population are known as sampling units. The auditor determine that the population from which he draws the sample is appropriate for the specific audit objective. when audit sampling is appropriate. Population .The auditor should first consider the specific audit objectives to be achieved to enable him to determine the audit procedure or combination of procedures which is likely to be the best to achieve those objectives. in an auditing context. that the items within the population are themselves not identifiable in a way which enables such random selection to take place. for example.e. unmatched receiving reports or other populations that would provide evidence of understatement of accounts payable. Such selection should therefore be entirely random. or ‘field’. they must all fall within the same ‘category’.2. are rarely preprinted with a sequential numbering series and randomness will thus have to be ensured in some other way. it should be noted: (a) ‘Population’. if the auditor’s objective were to test for overstatement of accounts receivable. however.

g.e. but its nature. 5. Materiality of the amounts involved.Sampling risk arises from the possibility that the auditor’s conclusion. if Rs.13 sample will not differ from the error rate in the population by more than a stated amount. The smaller the tolerable error. the auditor should consider sampling risk. at a specified level of precision). 100. in compliance testing any error will be significant irrespective of its monetary value. the larger the sample size the auditor will require. With substantive testing. It is not the size of the error that is significant in these circumstances. against 10 chances. our sample may be chosen such that the errors in the population can be proved to be within 5 percent of the monetary value. Thus. clearly the more precise we can be. (indeed there may be no monetarily quantifiable misstatement at all e. when we speak of a confidence level of 90% we mean that there are 90 chances that the item would fall within the confidence intervals of about 90 to 100. Examples of some factors affecting sample size are contained in Tables 1 and 2. Precision . but it may still be correct).000 of errors in a sales ledger population of Rs. For example.When determining the sample size. The auditor is faced with sampling risk in both tests of control and substantive procedures as follows: . From this you will deduce that confidence level and precision limits are essentially inter-related. The auditor’s assessment of the following factors will primarily be responsible for selecting total limit: (i) (ii) Evaluation of the functioning of the system of internal control in the area under examination. for this will in turn determine the way in which we conduct our tests. For example. on the other hand. we must determine the significance of potential errors. Hence tests of detail will have to be extended. and the expected error. because any failure of internal control procedures reduces the reliance that we can place on those procedures. But how precise do we require this percentage to be? The bigger our sample. Tolerable error is considered during the planning stage and is related to the auditor’s preliminary judgement about materiality.The precision may be defined with which we can describe the attributes of a given population.2. but we can never be completely precise for the same reasons as we can never be 100 percent confident.2.4 Sampling risk . we are interested in discovering whether there is material misstatement.2 Defining error . i. Tolerable error is the maximum error in the population that the auditor would be willing to accept and still conclude that the result from the sample has achieved his audit objective. 3. based on a sample. Confidence level is conveniently expressed as a percentage. and the two combined would determine the quality of testing. 5.The auditor must determine the significance of potential error as it will determine the way in which tests should be conducted. 5. may be different from the conclusion that would be reached if the entire population were subjected to the same audit procedure.2. then 3 percent would be our precision limits. For example.3 Sample size . so in this situation it is purely the amount of the error that is relevant. Further. The degree of precision required will depend on the materiality of the items in question.000 would be considered to be just not material. the risk we take. The confidence level is therefore seen to be complementary to risk. that it will not (once again. the tolerable error.Special Audit Techniques 5. a payroll may not have been check cast.

(ii) (b) Substantive Procedures (i) (ii) The risk of under reliance and the risk of incorrect rejection affect audit efficiency as they would ordinarily lead to additional work being performed by the auditor. 5.2. the tolerable error is the maximum monetary error in an account balance or class of transactions that the auditor would be willing to accept so that when the results of all audit procedures are considered. although the sample result supports the auditor’s assessment to control risk. Risk of Incorrect Rejection: the risk that. the greater the sample size will need to be. in fact it is not materially mis-stated. the tolerable error is the maximum rate of deviation from a prescribed control procedure that at the auditor would be willing to accept. Smaller sample size are justified when the population is expected to be error free.6 Expected error . although the sample result does not support the auditor’s assessment of control risk. although the sample result supports the conclusion that a recorded account balance or class of transactions is not materially misstated in fact it is materially mis-stated. The risk of over reliance and the risk of incorrect acceptance affect audit effectiveness and are more likely to lead to an erroneous opinion on the financial statements than either the risk of under reliance or the risk of incorrect rejection. Sample size is affected by the level of sampling risk the auditor is willing to accept from the results of the sample. although the sample result support the conclusion that a recorded account balance or class of transactions is materially misstated. the auditor would consider such matter as error levels identified in . for substantive procedures.Tolerable error is the maximum error in the population that the auditor would be willing to accept and still conclude that the result from the sample has achieved the audit objective. Risk of Over Reliance: the risk that. which would establish that the initial conclusions were incorrect.14 Advanced Auditing and Professional Ethics (a) Tests of Control (i) Risk of Under Reliance: the risk that. Tolerable error is considered during the planning stage and. the actual compliance rate would support such an assessment. a larger sample than when no error is expected ordinarily needs to be examined to conclude that the actual error in the population is not greater than the planned tolerable error. In determining the expected error in a population. the actual compliance rate would not support such an assessment. in substantive procedures. In tests of control. the auditor is able to conclude. or the entity. with reasonable assurance.2. the greater the sample size will need to be. 5. that the financial statements are not materially misstated.5 Tolerable error . is related to the auditor’s judgement about materiality. The smaller the tolerable error. Risk of Incorrect Acceptance: the risk that.5.If the auditor expects error to be present in the population. The lower the risk the auditor is willing to accept. based on the preliminary assessment of control risk.

While applying statistical sampling.15 previous audits. (b) calculate the sample size using an appropriate formula or tables designed for the purpose.The computer is programmed to select every nth item stored on magnetic tape. each entry must be carefully examined and authenticated by the auditor. but whatever type is used. agents.The auditor may use a computer to render considerable assistance in the performance of statistical sampling tests. etc. In actual practice many firms of Chartered Accountants have found limited use of statistical sampling than anticipated by them. the random numbers being stored on tape or generated by the computer separately for each application.The dangers of selecting a biased example by the use of a uniform interval can be avoided through the use of random variation of the interval between successive items. which may be used to determine: (a) population variables. and evidence available from other procedures. it should be remembered that materiality is one of the major considerations to decide whether or not a sample should be selected. therefore. Random intervals are selected from random number tables maintained on magnetic tape. or (b) population attributes.Special Audit Techniques 5. employing the following methods: (a) Interval sampling . For example. The various reasons which may be attributed to this state of affairs . Statistical sampling procedures . (c) select the sample using random methods: (d) carry out the necessary tests. or produced by means of a random number generator program. the year end closing entries in the journal may be manipulated and. Selection with the aid of the computer . (c) Random Interval selection . The most common types of plans adopted by auditors are: Acceptance sampling (with discovery sampling a variation) or Estimation sampling. (b) Random number selection . merchant houses. there are certain items which are so significant that the records relating to them should be scrutinized by the auditor at new item by item basis.There are many different types of statistical sampling plans. For instance in case of certain enterprises like real estate builders.The technique of random number selection can be computerised. procedures for conducting a test will be as follows: (a) decide on the relevant confidence level and precision limits. (e) appraise the results. changes in the entity’s procedures. and the items so selected can be copied on to a separate tape and printed out in the form required by the auditor. Even in case of major enterprises. the total number of transactions may be relatively very small and hence are not appropriate for the selection of a sample.

The interval might be based on certain number of items (for example. even though it may have an effect on other areas of the audit such as the assessment of doubtful accounts. all members of the audit team should have an excellent grasp of the statistical principles involved.2. For example. as they may not be representative. Haphazard selection.2.In analysing the errors detected in the sample.000 increase in the cumulative value of the population). (iii) To draw valid conclusions on the basis of statistical sampling. the auditor will have defined those conditions that constitute an error by reference to the audit objectives. ensures that all items in the population have an equal chance of selection. towards items which are easily located. This requires that all items in the population have an opportunity of being selected. every Rs. if a positive account receivable confirmation has been requested and no reply was received.16 Advanced Auditing and Professional Ethics are as under: (i) (ii) Audit has never been a mathematical discipline.1. For example.7 Selection of the sample . a mis-posting between customer accounts does not affect the total accounts receivable. When the auditor uses this method. the auditor will first with a view to evaluating the sample results. if in a population of branch sales.5. a particular branch’s sales occur only as every 100th item and the sampling interval selected is 50. Systematic selection. care needs to be taken to guard against making a selection that is biased. When using systematic selection. project such errors and reasons the sampling risk need to determine that an item in question is in fact an error. involves selecting items using a constant interval between selections. every 20th voucher number) or on monetary totals (for example. the auditor may be able to obtain sufficient appropriate audit evidence through performing alternative procedures. Therefore. 5. in a substantive procedure relating to the recording of accounts receivable.The auditor should select sample items in such a way that the sample can be expected to be representative of the population. the result would be that the auditor would have selected all or none of the sales of that particular branch. may be an acceptable alternative to random selection. While there are a number of selection methods. the first interval having a random start. the auditor should analyse any errors detected. for example. the auditor may be able to obtain sufficient appropriate audit evidence that the receivables is valid by reviewing subsequent payments from the . For example. for example by use of random number tables. In designing the sample.8 Analysis of errors in the sample . Designing and sampling schemes properly take unduly long time. provided the auditor attempts to draw a representative sample from the entire population with no intention to either include or exclude specific units. the auditor would need to determine that the population is not structured in such a manner that the sampling interval corresponds with a particular pattern in the population. it may be inappropriate to consider this an error in evaluating the sample results of this particular procedure. 5. three methods commonly used are Random selection. When the expected audit evidence regarding a specific sample item cannot be obtained.

perform satisfactory alternative procedures. There are several acceptable methods of projecting error results. When the population has been divided into sub-population.10 Reassessing Sampling Risk . the auditor needs to keep in mind the qualitative aspects of the errors found. the method of projection will need to be consistent with the method used to select the sampling unit.17 customer. If the auditor does not.2. Factor Assessment of control risk Tolerable error Allowable reliance risk of over Smaller Sample Size Higher Preliminary assessment of control risk Higher acceptable rate of deviation Higher risk of over reliance Lower expected rate deviation in population in of Larger Sample Size Lower preliminary assessment of control risk Lower acceptable rate of deviation Lower risk of over reliance Higher expected rate of deviation in population (1) Expected error or deviation Number of population items Virtually no effect on sample size unless population is small. for example.2. . the auditor may decide to identify all items in the population which possess the common feature. In such circumstances. These include the nature and cause of the error and the possible effect of the error on other phases of the audit.The auditor needs to consider whether errors in the population might exceed the tolerable error.Special Audit Techniques 5. When the projected error exceeds tolerable error. in all the cases. product line. the auditor reassesses the sampling risk and if that risk is unacceptable.The auditor projects the error results of the sample to the population from which the sample was selected. 5. location. the auditor compares the projected population error to the tolerable error taking into account the results of other audit procedures relevant to the specific control or financial statement assertion.9 Projection of errors .. The auditor would also consider the qualitative aspects of the errors. In analysing the errors discovered. or if the procedures performed do not enable the auditor to obtain sufficient appropriate audit evidence the item would be treated as an error. thereby producing a sub-population. To accomplish this. The projected population error used for this comparison in the case of substantive procedures is net of adjustments made by the entity. the projection of errors is done separately for each subpopulation and the results are combined. type of transaction. When projecting error results. Table 1: Examples of Factors influencing Sample Size for Tests of Control Conditions leading to. the auditor may observe that many have a common feature. However. 5. or period of time. would consider extending the audit procedure or performing alternative audit procedures. or is unable to. The auditor would then perform a separate analysis based on the items examined for each sub-population.. and extent audit procedures in this area.

The verification of records would include verifying the opening balances of the existing fixed assets from records such as the Schedule of fixed assets. if appropriate Lower acceptable level of detection risk No stratification population of the Number of population Acceptable level of detection risk Stratification Audit of Fixed Assets 5. reduction of control risk and therefore.3 The Guidance Note on Audit of Fixed Assets issued by the ICAI recommends that the verification of fixed assets consists of examination of related records and physical verification. The auditor should normally verify the records with reference to the documentary evidence and by evaluation of internal controls. tests of controls might be omitted. Table 2: Examples of Factor influencing Sample Size for Substantive Procedures Conditions leading to ….. work orders and independent confirmation of the work performed from . receiving reports and title deeds. Factor Assessment of control risk Reduction in detection risk because of other substantive tests related to the same financial statement assertions Tolerable error Expected error Population value Smaller Sample Size Lower control risk Greater use of substantive tests other Larger Sample Size Higher control risk Reduced use of substantive tests other Smaller measure of Tolerable error Smaller errors frequency or lower Large measure of tolerable error Large errors frequency or higher Smaller monetary Larger monetary significance significance to the financial to the financial statements statements. Self-constructed fixed assets and capital work-in-progress should be verified with reference to the supporting documents such as contractors’ bills.5. invoices. ledger or register balances to acquisition of new fixed assets should be verified with reference to supporting documents such as orders. items in Virtually no effect on sample size unless population is small Higher acceptable level of detection risk Stratification of the population.18 Advanced Auditing and Professional Ethics (1) High expected deviation rates ordinarily warrant little. if any.

if material.Special Audit Techniques 5. In case the asset has impaired the auditor must ensure that the asset has met the criteria as specified in AS 28. Further. The management is required to carry out physical verification of fixed assets at appropriate intervals in order to ensure that they are in existence. The auditor should see that the fixed assets have been valued and disclosed as per the requirements of law and generally accepted accounting principles. the auditor should examine these appraisal. “impairment of Assets”. It would also include making technical estimates of future working life and the possibility of obsolescence. To the extent possible. 1956. He should examine whether discrepancies noticed on physical verification have been properly dealt with. if it feels that the normal working life of the asset is low. The ownership of assets like land the buildings should be verified by examining title deeds. the auditor should examine whether these were recorded in the fixed assets register before being written off or depreciated. the auditor should satisfy himself that such verification was done by the management wherever possible and by examining the relevant working papers. it cannot provide depreciation at the rates lower than the rate prescribed by the Schedule XIV to the Companies Act. The company may provide depreciation at higher rate than the rates prescribed under Schedule XIV to the Companies Act. As long as the appraisal appears reasonable and based on . However. In respect of retirement of fixed assets. 1956.19 other parties. architects. The auditor should test check the calculations of depreciation and the total depreciation arrived at should be compared with that of the preceding years to identify reasons for variations. the auditor should examine whether retirements were properly authorised. When fixed assets have been written off or fully depreciated in the year of acquisition. However. Physical verification of fixed assets is primarily a responsibility of the management. In case the title deeds are held by other persons such as bankers or solicitors. if conditions so warrants the reversal norms of impairment loss are duly complied with. if the company feels that the normal working life of the assets is much higher. The Institute has also recommended that the company should provide deprecation so as to write off the asset over its normal working life. etc. He should particularly examine whether the depreciation charge is adequate keeping in view the generally accepted basis of accounting for depreciation. The reasonableness of the frequency of verification should also be examined by the auditor in the circumstances of each case. whether depreciation accounts have been properly adjusted. Re-valuation of fixed assets implies re-statement of their books values on the basis of systematic scientific appraisal which would include ascertainment of working condition of each unit of fixed assets. independent conformation should be obtained directly by the auditor through a request signed by the client. Such an appraisal is usually made by independent and qualified persons such as engineers. The auditor should also examine whether the method of verification was reasonable in the circumstances relating to each asset. have been properly adjusted and disclosed in the profit and loss account. In such a case the rates given in Schedule XIV should be followed. whether the sale proceeds. The auditor should test check the books records of fixed assets with the physical verification reports. have been accounted for and the resulting gains or losses. if any.

Low-risk areas are those which require the application of routine “nuts and bolts” audit procedures in the ordinary course of vouching. casting. e. industry. High-risk areas are those which should be the primary concern of partners and senior managers. For example. by capitalising expenditure. etc. management. an auditor may give an unqualified opinion on financial statements without knowing that they are materially misstated. and (i) drafting the audit report itself. on “Objective and scope of Financial Statements”.Audit risk is the risk that an auditor may give an inappropriate opinion on financial information that is materially misstated. (d) post–balance sheet review of subsequent events. Audit risk at the financial statement level . the auditor should undertake an overall audit risk assessment based on his knowledge of the client’s business. it becomes significant that an auditor is aware of risks which are inherent in any audit with reference to materiality of transactions involved and accordingly test and evaluate internal control systems so as to assess the extent of risk. the procedure to be adopted by an auditor to assess risk in the internal control system is elaborated. checking. (g) detecting overstatement of assets.4 Students may recall that according to AAS-2. Such risk may exist at overall level or while verifying various transactions and balance-sheet items. first of all various facts of audit risks are discussed followed by relationship between materiality and audit risk. 1. usually occupying up to 80% of all audit effort. and will include such matters as: (a) adequacy of provisions. control environment and operations. he is entitled to accept the revaluation made by the experts. AAS-5 on “Audit Evidence” also makes it clear that an auditor’s judgement as to what is sufficient and appropriate audit evidence is affected by the degree of risk of misstatement. (f) implications of tax legislation. (b) full disclosure of liabilities.g.Audit risk is considered at the financial statement level during the audit planning process. In the following paragraphs.20 Advanced Auditing and Professional Ethics adequate facts. including contingent liabilities. (c) interpretation of AASs and company legislation. At this time. there is unavoidable risk that even some material misstatements may remain undiscovered due to the test nature and other inherent limitations of any system of internal control. Following this.5. at both compliance and substantive stages. (h) identifying high-value items and ‘error-prone’ conditions. Therefore.. the auditor’s staffing needs and the framework within which materiality and . Such an assessment provides preliminary information about the general approach to the engagement. Audit Risk 5. Concept of audit risk . (e) analytical reviews on draft financial statements.

To assess inherent risk.21 audit risk assessments can be made at the individual account balance or class of transactions level.The paragraphs that follow provide guidance directed to the assessment of audit risk at both the overall and the account balance and class of transactions level. ♦ the completion of unusual and complex transactions. particularly at or near year end. if available.The majority of audit procedures are directed to.g.g. the in experience of management may affect the preparation of the financial statements of the entity). ♦ the complexity of underlying transactions which might require the use of the work of an expert. and the number of locations and geographical spread of its production facilities). Three components of audit risk are: ♦ inherent risk (risk that material errors will occur).g.g. knowledge and changes during the period (e.Special Audit Techniques 5. Assessment of audit risk by reference to its components . Audit risk at the account balance and class of transactions level . liquidity or going concern problems. factors affecting the industry in which the entity operates (e. significance of related parties. ♦ the amount of judgement involved in determining account balances. economic and competitive conditions. and ♦ transactions not subjected to the normal processing mode. for example. complex capital structure. accounting practices common to the industry and. examples of which are: At the financial statement level: ♦ the integrity of management. the auditor uses professional judgement to evaluate numerous factors. Accordingly. ♦ management experience. audit risk should be considered by the auditor at this level taking into account the results of the overall audit risk assessment made at the financial statement level. As part of this overall risk assessment. such as an entity in an industry experiencing a large number of business failures or an entity that lacks sufficient capital to continue operations). ♦ the nature of the entity’s business (e. and carried out at the account balance and class of transactions level.g. ♦ susceptibility of assets to loss or misappropriation. At the Account balance and class of transaction level: ♦ financial statement of accounts likely to be susceptible to misstatement (e. its technological obsolescence of products and services. and changes in technology. 2. circumstances that might predispose management to mis-state the financial statements. ♦ unusual pressures on management (e. the auditor should consider whether there is potential for pervasive problems. . financial trends and ratios). a financial statement of account which required adjustment in the previous period).

is the susceptibility of an account balance or class of transactions to misstatement that could be material.5 Audit should be risk-based or focused on areas of greatest risk to the achievement of the audited entity’s objectives. Inherent and control risks are functions of the entity’s business and its environment and the nature of the account balances or classes of transactions. as well as test adherence to control procedures. The auditor does not normally need to perform specific audit procedures on all areas of audit. There will always be some control risk because of the intrinsic limitation of any system of internal control. sets materiality thresholds based on audit risk analysis and develops audit programmes that allocate a larger portion of audit resources to high-risk areas. or that are particularly susceptible to changes in consumer demand or technology that could affect their value. assuming that there were no related internal controls. such as a complex accounting estimate. The nature of each of these types of risk and their interrelationship is discussed below: Inherent risk . . the auditor should consider the adequacy of control design. and ♦ detection risk (risk that any remaining material errors will not be detected by the auditor). such as jewellery. accounts involving a high degree of management judgement.is the risk that an auditor’s procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material.is the risk that misstatement that could occur in an account balance or class of transactions and that could be material. risk would always be present even if an auditor were to examine 100 percent of the account balance or class of transaction because. To assess control risk. will not be prevented or detected on a timely basis by the system of internal control. thereby reducing audit risk to an acceptably low level. For example. for example.5. Risk-Based Audit 5. It is a function of the entity’s business and its environment and the nature of the account balance or class of transactions. In the absence of such an assessment.Inherent and control risks differ from detection risk in that they exist independently of an audit of financial information. will involve more inherent risk than other accounts. the auditor should assume that control risk is high. regardless of whether an audit is conducted. individually or when aggregated with mis-statements in other balances or classes.22 Advanced Auditing and Professional Ethics ♦ control risk (risk that the client’s system of internal control will not prevent or correct such errors). Risk-based audit (RBA) is an approach to audit that analyzes audit risks. or that are difficult to compute. or that involve highly desirable and movable assets. the auditor can assess them and design his substantive procedures to produce an acceptable level of detection risk. Some detection. Detection risk . individually or when aggregated with mis-statements in other balances or classes. individually or when aggregated with misstatements in other balances or classes. The level of detection risk relates directly to the auditor’s procedures. Even though inherent and control risks cannot be controlled by the auditor. Interrelationship of the components of audit risk . the auditor may select an inappropriate audit procedure. Control risk . misapply an appropriate audit procedure or misinterpret the audit results.

reduction of . critical information processing. It is part of the professional judgment of the auditor and of the particular circumstances.Special Audit Techniques 5. In the context of performance audit. In Para 5. It is the risk that the auditor may unknowingly fail to appropriately modify his opinion on financial statements that are materially misstated.1 Audit risk analysis .23 He only needs to design audit programmes and procedures on areas earlier identified as major risks that could result in the financial statements being materially misstated. 5. This affords an opportunity to the auditee to improve its operations from recommendations on risks that do not have a current impact on the financial statements but impact the audited entity’s operational strategies and performance over the longer term.RBA consists of four main phases starting with the identification and prioritization of risks. efficiency and effectiveness helps focus audit attention on them. falsification of accounting records. Risk assessment is a subjective process. Awareness of areas that puts the programme or resources at risk from the point of view of economy. It is intended to deceive financial statement users or to conceal misappropriations.5. Audit risks are brought about by error and fraud: ♦ Error is an unintentional mistake resulting from omission.The auditor should perform an analysis of the audit risks that impact on the auditee before undertaking specific audit procedures. An error risk may arise from an error in principle. transactions or other significant information.4 ‘audit risk’ has been explained in details. or misrepresentation in the financial statements of events. as when legitimate transactions and/or balances are excluded from the financial statements. 5. it is the risk to delivery of an activity or scheme or programme of the entity with economy.5.2 General Steps in the Conduct of RBA . RBA is an essential element of financial audit. as when erroneous transactions and/or balances are included in the financial statements. ♦ The auditor has the responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. It also provides indicators of risks as a basis of opportunity for improvement of auditee risk management and control processes. Fraud is an intentional misstatement in the accounting records or supporting documents from which the financial statements are prepared. financial reporting process or disclosure. to the determination of residual risk. estimate. whether caused by error or fraud. or by commission. efficiency and effectiveness. or misapplication of accounting principles or misappropriation of funds. Fraud risk involves manipulation. The risk analysis provides a framework for assurance in performance auditing. It focuses primarily on the identification and assessment of the financial statement misstatement risks and provides a framework to reduce the impact to the financial statement of these identified risks to an acceptable level before rendering an opinion on the financial statements.both in the attest audit of the financial statements and in the audit of financial systems and transactions including evaluation of internal controls.

The Statement on Auditing Practices issued by the Institute of Chartered Accountants of India states that the recommendations contained therein apply primarily to items which are material and significant in relation to the affairs of a company. summarize and report financial data. The results of audit shall be communicated by the auditor to the audited entity. such as weaknesses in the internal control system. The auditor must immediately communicate to the auditee reportable conditions that have been observed even before completion of the audit. operational performance and information process framework. deficiencies in the design and operation of internal controls that affect the organization’s ability to record. and the process or activities integral to the audited entity’s success in meeting its objectives are the key factors to an understanding of agency risks. Likewise. Questions of materiality arise in various circumstances.24 Advanced Auditing and Professional Ethics residual risk to acceptable level and the reporting to auditee of audit results. Whatever is important or essential in a given auditing situation would automatically be material. in order to identify and prioritize the error and fraud risks that impact the audit of financial statements. thus the SAI should evaluate the effectiveness of internal audit to determine the extent to which reliance can be placed upon it in the conduct of substantive tests. The environment in which the auditee operates. It is a relative term and what may be material in one set of circumstances may not be so in another. The role of internal audit in promoting a sound accounting system and internal control is recognized. framework of operations. classification and presentation of accounting information. which were earlier known through the analytical procedures undertaken. Assessment of management risk strategies and controls is the determination as to how controls within the auditee are designed. These are achieved through the following: ♦ ♦ ♦ ♦ Understand auditee operations to identify and prioritize risks Assess auditee management strategies and controls to determine residual audit risk Manage residual risk to reduce it to acceptable level Inform auditee of audit results through appropriate report Understanding auditee operations involves processes for reviewing and understanding the audited organization’s risk management processes for its strategies.5. Management of residual risk requires the design and execution of a risk reduction approach that is efficient and effective to bring down residual audit risk to an acceptable level. a performance review of the audited entity’s delivery of service by comparing expectations against actual results may also aid in understanding agency operations. The concept of materiality is fundamental to the process of aggregation. process. This includes the design and execution of necessary audit procedures and substantive testing to obtain evidence in support of transactions and balances. More resources should be allocated to areas of high audit risks. the information required to monitor changes in the environment.6 The concise Oxford Dictionary defines the term “material” as “important or essential. Materiality and Audit Risk 5. .

aggregate. aggregate. However. For example. (2) Profits or Losses in respect of transactions of a kind not usually undertaken by the company. Clause 2 (b) of Part II of Schedule VI requires the disclosures of every material feature including credits or receipts and debits or expenses in respect of non-recurring transactions or transactions of an exceptional nature. by which any items shown in the Profit and Loss Account are affected by any change in the basis of accounting should be disclosed. The concept of materiality has implicit as well as explicit recognition in the requirements contained in Schedule VI: As regard implicit recognition. if material in amount. The auditor has to keep this in view while examining the truth and fairness of the statements of account. Some more specific instances of mention of the materiality consideration in Part II of Schedule VI are as follows: (1) Aggregate if material. At various places of Part II of Schedule VI to the Companies Act reference is made to materiality and the same is also a matter of importance in relation to items in the balance sheet. (1) Any item under which expenses exceed 1 per cent of the total revenue of the company or Rs. of any amounts set aside to reserves. as it is neither desirable nor necessary that members should devote their time and energies in the pursuit of matters of a trivial nature. Explicit reference to materiality exists at a number of places in Part II of Schedule VI and that requires due consideration and judgement at the time of preparation of the profit and loss account by a company. what is material has not been defined by the statute. for example. The auditor has to satisfy himself that the statements exhibit a true and fair state of affairs having regard to all material aspects.material items should not extend to a group of items whose cumulative effect on the accounts may be material or significant. of the amounts withdrawn from such provisions are required to be disclosed. (2) All those items of raw materials which in value individually account for 10 per cent or more of the total value of the raw material consumed shall be shown as separate and . are to be drawn up in accordance with the form and disclosure requirements prescribed in the Schedule VI to the Companies Act. if material of any amounts withdrawn from such reserves. The Profit and Loss Account and the Balance Sheet of a company with a view to disclosing a true and fair state of affairs. freedom to deal expediently with non. the very items which have been identified for a distinct disclosure both in Part I and Part II of Schedule VI.25 Items of little or no significance may be dealt with as may be found expedient. It is clear from the above that the concept of materiality is fundamental to the accounting process. we can say that it has provided some sort of guidance in this matter in specific circumstances. right from the stage of aggregation to preparation of the annual accounts. 5. (3) Amount. are based on materiality consideration Viewed from legislative angle.Special Audit Techniques 5. disclosure of remuneration paid to the auditor. if material of the amount set aside to provisions made for meeting specific liabilities and aggregate if material. in a way. if material. However. Even though the statute has not defined the concept of materiality. should be disclosed. Part II of Schedule VI requires the following disclosures.000 whichever is higher should be shown as a separate and distinct item.

either individually or in the aggregate. The concept of materiality recognises that some matters. The auditor needs to consider the possibility of misstatements of relatively small amounts that. if any. non-compliance with which may have a significant bearing on the financial information. must be disclosed. An example of a qualitative misstatement would be the inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled by the description. The auditor considers materiality at both the overall financial information level and in relation to individual account balances and classes of transactions. This process may result in different levels of materiality depending on the matter being audited. 3. 1.5. as the case may be. such as the legal and regulatory requirements. It stresses that the assessment of what is material is a matter of professional judgement. it being a material factor for assessing the causes of the change in the profitability of the company. Materiality may also be influenced by other considerations. even if it is small. cumulatively. For example.26 Advanced Auditing and Professional Ethics distinct items with quantities thereof in the break-up. Thus. materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which the information must have if it is to be useful. Loans from Directors should be shown separately. Further. wherever there is a change in the basis of accounting. judged in the particular circumstances of its misstatement. Materiality depends on the size and nature of the item. stock or turn over. in giving the break-up of purchases. could have a material effect on the financial information. 2. are relatively important for true and fair presentation of financial information in conformity with recognized accounting policies and practices. Likewise. information is material if its misstatement (i. Although the auditor ordinarily establishes an acceptable materiality level to detect quantitatively material misstatements. stocks and turnover.e. The maximum amount due by directors or other officers of the company at any time during the year should be disclosed by way of a note.. omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information. According to it. . the effect thereof. AAS-13 on “Audit Materiality” requires that the auditor should consider materiality and its relationship with audit risk when conducting an audit. items like spare parts and accessories should be shown as separate and distinct items if their value as individual items account for 10 percent or more of the total value of purchases. both the amount (quantity) and nature (quality) of misstatements need to be considered. and considerations relating to individual account balances and relationships. an error in a month-end (or other periodic) procedure could be an indication of a potential material misstatement if that error is repeated each month or each period. of any director with the bankers or other officers of the company at any time during the year should be disclosed by way of a note. The following are some of the specific requirements in the form of balance sheet based on materiality consideration implicit in the very process of prescribing the format in Part I of Schedule VI. Nature of interest.

2 Materiality and Audit Risk in Evaluating Audit Evidence .1 Relationship between Materiality and Audit Risk . can be expected to support the audit opinion at an acceptably low degree of audit risk. the auditor should consider whether the effect of aggregate uncorrected misstatements on the financial information is material. For example. audit risk is increased. projected errors). related to specific account balances and classes of transactions. In forming his opinion on the financial information. This may be done to cover a larger number of items and thereby reduce the likelihood of undiscovered misstatements and to provide the auditor with the margin of safety when evaluating the effect of misstatements discovered during the audit. helps the auditor decide such questions as what items to examine and whether to use sampling and analytical procedures. including the net effect of uncorrected misstatements identified during the audit of previous periods. This enables the auditor to select audit procedures that. the assessment of materiality and audit risk may also change.when planning the audit. the higher the materiality level. the lower the audit risk and vice versa.27 5. For example. in combination. and (b) the auditor’s best estimate of other misstatements which cannot be specifically identified (that is. If actual results of operations and financial position are substantially different. after planning for specific audit procedures. the auditor considers what would make the financial information materially misstated. the risk that a particular account balance or class of transactions could be misstated by an extremely large amount might be very low. the auditor determines that the acceptable materiality level is lower. that is. The auditor’s preliminary assessment of materiality. This could be because of a change in circumstances or a change in the auditor’s knowledge as a result of the audit. timing and extent of audit procedures.Special Audit Techniques 5. if the audit is planned prior to period end. but the risk that it could be misstated by an extremely small amount might be very high. 5.The auditor’s assessment of materiality and audit risk may be different at the time of initially planning the engagement from that at the time of evaluating the results of his audit procedures. The auditor takes the inverse relationship between materiality and audit risk into account when determining the nature. the auditor may. Qualitative considerations also influence an auditor in reaching a conclusion as to whether the misstatements are material. The aggregate of uncorrected misstatements comprises: (a) specific misstatements identified by the auditor. if.6. Additionally. There is an inverse relationship between materiality and the degree of audit risk. and supporting the reduced degree by carrying out extended or additional tests of control. timing and extent of planned substantive procedures. The auditor would compensate for this by either: (a) reducing the assessed degree of control risk. For example. in planning the audit work. the auditor will anticipate the results of operations and the financial position. where this is possible. or (b) reducing detection risk by modifying the nature.6. intentionally set the acceptable cut off level for verifying individual transactions at a lower level than is intended to be used to evaluate the results of the audit. .

for example. application of appropriate accounting principles. after performing additional work if needed. issue a qualified or adverse opinion. That projected misstatement. of the mis-statements the auditor brings to its attention. the auditor should express a qualified or adverse opinion. If the management refuses to adjust the financial information and the results of extended audit procedures do not enable the auditor to conclude that the aggregate of uncorrected misstatements is not material. not just the misstatements that he identified. In evaluating whether the financial statements give a true and fair view (or “are presented fairly”). other adjustments in amounts. the auditor ordinarily would have to employ other procedures to enable him to estimate the aggregate misstatement in the balance or class. the management may want to adjust the financial information for known misstatements. or if auditor determines that the aggregate of uncorrected misstatements causes the financial information to be materially misstated. request management to correct the material mis-statement and. contributes to the auditor’s assessment of aggregate misstatement in the balance or class. he projects the amount of known misstatements identified by him in his sample to the items in the balance or class from which his sample was selected. the auditor should take into account the aggregate of all uncorrected misstatements.Management may decide to adjust the financial statements for some. . If the aggregate uncorrected misstatements exceed the final assessment of materiality for the financial information. or the addition of appropriate disclosure of inadequately disclosed matters. the auditor should. or all.3 Responsibility of Management . account balances or classes of transactions. as appropriate. If the analytical procedure indicates that misstatements might exist. If the aggregate of the uncorrected misstatements that the auditor has identified approaches the materiality level. including those involving estimates. but not its approximate amount. 5. The aggregation of mis-statements should include the auditor’s the best estimate of the total misstatements in the account balances or classes of transactions examined.6. he ordinarily would not specifically identify misstatements but would only obtain an indication of whether misstatements might exist in the balance or class and possibly its approximate magnitude. In any event.28 Advanced Auditing and Professional Ethics When the auditor tests an account balance or class of transactions by an analytical procedure. if management refuses.5. The adjustment of financial information may involve. When an auditor uses audit sampling to test an account balance or class of transactions. he should consider requesting the management to adjust the financial information or extending his audit procedures. along with the results of other substantive tests.

6 THE COMPANY AUDIT Introduction 6.1 The shareholders of the company are the real owners of the Company. Clause (b) of sub-section (3) of Section 226 of the Act disqualifies an officer or employee of the company from being appointed as its auditor. However the management of the company lies in the hands of the directors. nevertheless the auditor must make a report to the shareholders where non compliance results in affecting the accounts materially. In other cases. 1956. 1956 deals with the qualification of company auditors.Section 226 of the Companies Act. A body corporate can not be appointed as an auditor because it has a limited liability. Appointment of Company Auditor 6.2.2 The following are the important considerations regarding the appointment of the company auditor : 6. Audit of accounts ensures that the statements of account are properly drawn up and they disclose all the requisite information. It intends to ensure that the auditors are independent of the companies they audit.CA. State of Saurashtra (1957 S. Auditor must also ensure that the company has not violated any of the provisions contained in the companies Act. Generally the shareholders do not have the skills required to understand the financial statements. According to a clarification of the Department of Company Affairs the legal position is as follows: “Where the chartered accountant is employed whole-time. or to borrow the words of Lord Uthwatt. Although compliance with the relevant provisions of the companies Act. 1956 is the responsibility of the directors and officers of the company. the proper test is whether . Thus audit of account of company has been made compulsory in order to protect the interest of the shareholders. p. 216) the Supreme Court has laid down that the prima facie test for determination of the relationship between master and servant is the existence of the right in the master to supervise and control the work done by the servant not only in matter of directing that work the servant is to do. he is an employee of the company. In Dhrangadhra Chemicals Works v. They invest their money in the company.1 Who can be Auditor . generally speaking there would appear to be only a contract for service and not a contract of service between the company and chartered accountant. but also the manner in which he shall do his work.

if the total monthly remuneration exceeds prescribed limits (Section 314). Moreover.” . the appointment of an auditor who is a relative of a director or a firm of auditors in which a director of the company or his relative is a partner would be an office of profit under Section 314 requiring the consent of the company by a special resolution. has given any guarantee or provide any security in connection with the indebtedness of any third person to the company for an amount exceeding Rs. a chartered accountant is not disqualified under Section 226(3)(b) of the Companies act. a question may come up as to whether such indebtedness would arise in cases where. Applying this test in any case. however. The provisions of Section 297(1) would also not apply to the appointment of such a person as an auditor because an audit is in the nature of rendering personal service obtained not on the basis of the lowest tender but on account of professional expertise irrespective of cost involved. Prior consent of the company and approval of Central Government (Company Law Board) would also be required in appropriate cases. The term “relatives” is to be construed with reference to Section 6 of the Companies Act. Some special situations are discussed below: (a) In this context.2 Advanced Auditing and Professional Ethics or not the hirer had authority to control the manner of execution of the act in question. 1. 1956". his firm or a partner in his firm or any of his relatives have a substantial interest. he cannot be said to be indebted to the company at any stage.g. the expression “substantial interest” is to have the same meaning as is assigned thereto under Explanation 3 to Section 13 of the Income Tax Act. resolution passed by the general meeting) the auditor recovers his fees on a progressive basis as and when a part of work is done without waiting for the completion of the whole job. It is.000 is not qualified for appointment as an auditor. where in accordance with such terms. clause (d) of sub-section (3) of Section 226 of the Act states that a person indebted to the company for an amount exceeding Rs. a chartered accountant in practice shall be deemed to be guilty of professional misconduct under the Chartered Accountants Act. the auditor recovers his fees on a progressive basis as and when a part of the work is done without waiting for the completion of the whole job. In these circumstances. “A Chartered Accountant’s main business is to render professional service for reward like a lawyer or a doctor. 1. clear that there is no prohibition on a relative of a director or a partner of such relative to be appointed as an auditor. Where such service is rendered professionally and not as an officer or employee of the company. Similarly. where the chartered accountant is consulted only professionally on income tax matters by a company. Further. the auditor recovers his fees on a progressive basis. in which he. unless he discloses the interest also in his report. in accordance with the terms of appointment by a client. However.6. 1961. he can not be said to be an officer or employee of the company. 1949 if he expresses his opinion on the financial statements of any enterprise.000 or a person who. According to the Research Committee of the Institute “a question often arises as to whether indebtedness arises in cases where in accordance with the terms of his engagement by a client (e.

In such situations. The aim of the provision is to curb possible insider trading on the part of auditors. Section 226(3) has been amended by the Companies (Amendment) Act.2 Reappointment of Auditors .000. the provisions concerning disqualification of auditors as contained in Section 226(3)(d) will be attracted. therefore. he must be a Chartered Accountant (holding Certificate of Practice) within the meaning of the Chartered Accountants Act. irrespective of the nature of the purchase or period of credit allowed to other customers. 3 (b) A question of indebtedness may also be raised where an auditor of a company purchases goods or services from the company audited by him. 1949 or a Restricted State Auditor [Section 226(l) & (2)]. though the appointment is made in the individual name of a partner. appointment or filling of casual vacancies in the office of the auditor. (d) There may also be situations in which.e. The appointment is subject to the following conditions: (i) The auditor proposed to be appointed or re-appointed must possess the qualifications prescribed under Section 226 of the Companies Act..The Company Audit 6.The Companies Act. 2000 shall be disqualified from being appointed as auditor of the company. Except in cases of appointment of the first auditor. has laid down that an auditor shall hold office from the conclusion of the annual general meeting in which he is appointed till the conclusion of the next annual general meeting. 6. the firm will be deemed to be acting as auditor and the disqualification will be attracted in the case of indebtedness either of firm or a partner. In such a case. (c) Another question which arises for consideration is whether a partner is disqualified from appointment as auditor when the firm of which he is a partner is indebted to the company in excess of the limit prescribed and whether the firm is disqualified from appointment as auditor when a partner of the firm is indebted in excess of the prescribed limit. . (ii) (iii) The proposed auditor does not suffer from the disqualifications enumerated in subsections (3) and (4) of Section 226 of the Companies Act. 2000 whereby a person holding any security carrying voting rights after a period of one year from December 13.2. companies are required to appoint the auditor or auditors in the annual general meeting as a routine feature. i. In both cases disqualification will apply because when a firm is appointed as an auditor. 1956 stipulates that the office of an auditor in a company is a continuing one and. 1. A firm of Chartered Accountants whereof all the partners practising in India are qualified for appointment may also be appointed as the auditor in its firm name [Section 226(l)]. each partner is deemed to be so appointed and when a firm is indebted each partner is deemed to be indebted. if the amount outstanding exceeds Rs. the work is in fact carried out by the firm and the fees are credited to the account of the firm.

there can only be one annual general meeting held during the tenure of office of any particular auditor. In view of the provisions in Section 224(l). whether it is a case of a new auditor being appointed or the retiring auditor being reappointed. shall in no way affect the factual conclusion of the next annual general meeting of the company. the company is to give intimation thereof to the concerned auditor within seven days of the appointment. Appointment in a general meeting of the company means appointment by the shareholders of the company. The auditor. It should also be noted that the auditors shall hold office until conclusion of the next annual general meeting meaning thereby that the non-holding of the next annual general meeting or its adjournment without considering the business of appointment or re-appointment of auditors. it cannot be presumed that the auditor’s term expires on the date on which the annual general meeting ought to have been held. . (d) a written certificate has been obtained from the proposed auditor to the effect that the appointment or re-appointment. it should be ensured that: (a) he has not given notice to the company in writing of his unwillingness to be re-appointed. Upon an auditor being appointed in the annual general meeting. it is from the conclusion of the annual general meeting to the conclusion of the next annual general meeting and cannot therefore. Notionally. whereunder the auditor in office has to audit every balance sheet and profit and loss account and every other document in it or annexed to it which is laid before the general meeting held during his tenure of office. incapacity or disqualification of other person or persons [Section 224(2)]. (c) no notice of the intended resolution to appoint some other person or persons in place of retiring auditor was received by the company that could not be proceeded with due to death. if made. A detailed clarification has been issued by the Department of Company Affairs in this regard according to which: “The tenure of an auditor is laid down in Section 224(l).4 Advanced Auditing and Professional Ethics (iv) In the case of re-appointment of the retiring auditor. (b) no resolution has been passed at the annual general meeting appointing somebody else instead of the retiring auditor or providing expressly that the retiring auditor shall not be reappointed. in his turn. The duty of the auditor is laid down in Section 227(2). That also shows that the auditor’s appointment is not related to any particular balance sheet or profit and loss account or to any particular financial year. be for any particular year or financial year as such.6. upon receipt of the intimation from the company about his ‘appointment’ is required to send a written communication to the concerned Registrar of Companies within 30 days of the receipt of the intimation stating whether he has accepted or declined the appointment. will be in accordance with the limits specified in sub-section (1B) of Section 224.

This may arise due to a variety of reasons which include death. dissolution of the firm of auditors. no auditors are appointed or re-appointed. etc.” 6. 5 “In the above context the Board decided that the tenure of an auditor appointed under Section 224 of the Companies Act will continue upto the factual conclusion of the next general meeting held by the company.Where the appointment of a person as the auditor in the annual general meeting is void ab initio.2. The auditor appointed to a casual vacancy shall hold office till the conclusion of the next general meeting.A casual vacancy in the office of the auditor can be filled by the Board of Directors. will be known. The expression ‘casual vacancy’ has not been defined in the Act. it should be noted that a casual vacancy does not arise in the office of auditors on the expiry of one year of their appointment if the annual general meeting is not held in time.3 Defective appointment .Where. 1971: “A case of an alleged unjustified removal of auditors was reported to the Council where the existing auditors were removed and new auditors were appointed by the board of directors before holding the annual general meeting. it stands for the vacancy created by the auditor ceasing to act after he was validly appointed and the appointment was accepted. The Council felt that the existing auditor continued to be the statutory auditor until the conclusion of the next annual general meeting. it was held that the change of auditors sought to be made in the circumstances was not justified and in the Council’s opinion the appointment sought to be made of the new auditors was not valid. Filling of a casual vacancy . If the resigning auditor could be found to be conscientious and honest the general meeting may even request him to reconsider his decision and take appropriate steps to cure the evils. that might have contributed to the resignation. disqualification. provided such vacancy has not been caused by the resignation of the auditor. in the management.4 Appointment of Auditor by Central Government .” 6. since no vacancy had arisen in the office of the auditors. if any. In the case of a casual vacancy arising on account of resignation. it appears that the provision of Section 224(3) will be attracted and the appointment of the auditor can be made by the Central Government. on the footing that a casual vacancy in the office of the auditors of the company had occurred on the expiry of the period of one year. only the company in general meeting can fill the vacancy. The provision to require filling of casual vacancy caused by the resignation of the auditor by the annual general meeting is in consonance with the principle of auditor’s independence. According to the Annual Report of the Institute of Chartered Accountants of India for the year ended 31 March. This process may bring out facts regarding the auditor’s resignation to the notice and scrutiny of the shareholders. However. On a review of the facts and circumstances of the case reported. even though no annual general meeting was held. resignation.The Company Audit 6. The decision was communicated both to existing auditors and new auditors who were also informed that accepting the appointment in such circumstances would not be proper. Any abuse of authority or financial impropriety by the management. at the annual general meeting.2. the Central Government may appoint a . Taking its natural meaning.

1988 provides that no company or its Board of Directors shall appoint or re-appoint any person who is in full time employment elsewhere or firm as its auditor if such firm or person is. the amended section tends to suggest that an individual chartered accountant in full time employment practising as a sole proprietor can audit 20 companies while a chartered accountant practising as a soleproprietor not in full-time employment elsewhere can audit unlimited number of companies). Further it provides that in the case of a firm of auditors. However.5 Ceiling on Audits . if made. Explanation II after sub-section (1C) of Section 224 further amplifies the manner of identifying the audit units for calculating the specified number. the overall ceiling will be 3 ×20 = 60 company audits of which not more than 30 should be in companies having paid-up capital of Rs. Each of the joint auditors is considered an auditor for the purpose. Section 224(1B) of the Companies Act as amended by Companies (Amendment) Act. at the date of such appointment or re-appointment. It is the duty of the company to give notice of the fact that no auditor was appointed in the annual general meeting to the Central Government within 7 days of the annual general meeting. the company must obtain a certificate from him to the effect that the appointment.ceiling of 10 large company audits. the company and every officer in default shall be punishable with Fine that may extend to Rs. appointment as a branch auditor will not be counted.6 Advanced Auditing and Professional Ethics person to fill the vacancy. all the firms in which he is a partner or proprietor will be together entitled to 20 company audits on his account.2. The limit of 20 company audits is per person. will not result in an excess holding of company audit assignments by the auditor concerned over the limit laid down in Section 224(1B). In such a case. The question arises whether the audits of branches of Indian companies and the audits of Indian business accounts of foreign companies which have established their place of business in India and are doing business in India are to be taken into account for computing . However. subject to the sub. the part will be considered as a unit of audit for the purpose of calculation of the ceiling. 25 lakh or more. How they allocate the 20 audits between themselves is their affair. (Note: It may be noted that the intention of the Central Government in amending this section was to plug the loophole whereby chartered accountants in full-time employment could not be considered for the purpose of conducting company audits. specified number of companies shall be construed as the number of companies specified for every partner of the firm who is not in full-time employment elsewhere. any joint audit held by an auditor will be included as one audit unit for the purpose of calculating ceiling. Under this explanation. Sometimes a single chartered accountant can be a partner or proprietor in a number of auditing firms. 25 lakhs or more. 6. holding appointment as auditor of the specified number of companies.6. 5000.It has been mentioned earlier that before appointment is given to any auditor. Often one comes across what is known as joint audit when two or more auditors are appointed to audit the accounts of a company. In case of any default to give notice to the Central Government. In the case of an auditing firm having 3 partners. Specified number has been defined to mean 20 company audits subject to a further limit of 10 company audits in respect of companies having paid up capital of Rs. when an auditor is appointed to audit even a part of company’s accounts.

Provided that in the case of a firm of chartered accountants in practice. the branch audits are not to be included while calculating the specified number of 20 units. Pursuant to this amendment. The guidelines finalised by the Council are reproduced below: “No. Hence the audit of the accounts of foreign companies is also not to be included within the specified number of 20 as laid down in explanation I to sub-section (1C) of Section 224 of the Act. the private companies will be excluded while computing the ceiling limit of 20 companies. The said words relate to the antecedent number and not companies in so far as they are of any material significance to the context. if he holds at any time appointment of more than the “specified number of audit assignments of the companies under Section 224 and /or Section 228 of the Companies Act. as the case may be. Hence. the number of audit assignments which may be taken for all the firms together in relation to such partner shall not . The Companies (Amendment) Act. the Council of the Institute of Chartered Accountants of India hereby specifies that a member of the Institute in practice shall be deemed to be guilty of professional misconduct. the specified number of audit assignments shall be construed as the specified number of audit assignments for every partner of the firm. A point has been raised as to whether companies limited by guarantee are to be included in reckoning “specified” number of auditors within the meaning of Explanation I to sub-section (1B) and (1C). This has been examined and the Department is of the view that such companies as having no share capital are to be excluded from the reckoning.” As regards the audit of the accounts of foreign companies. account of the company as a whole including the branches audited by branch auditor. Provided further that where any partner of the firm of chartered accountants in practice is also a partner of any other firm or firms of chartered accountants in practice. Consequently. audits the accounts of the particular branch only for which he is appointed and forwards his report to the auditor appointed under Section 224 of the Act and hence he cannot be equated with the company auditor appointed under Section 224 who has to report to the annual general meeting on the. 2000 has also amended Section 224(1B) dealing with ceiling on company audits. the Department is of the view that they are outside the scope of Section 224 since the definition of company under Section 3 of the Act does not include a foreign company. 1949. The Department of Company Affairs clarified that “the branch auditor of Indian companies. 7 the limit of 20 companies as laid down in Explanation I of sub-section (1C) of Section 224 of this Act. 1956”. The words “any part of which” appearing in Explanation II cannot have any reference to branch audit which as noted above does not fit into the context of Section 224.The Company Audit 6. the auditor can accept audit of any number of private companies subject to the overall limits laid down by guidelines of the Institute. appointed under Section 228 of the Act.1-CA(7)/53/2001: In exercise of the powers conferred by clause (ii) of Part II of the Second Schedule to the Chartered Accountants Act.

For the above purpose. shall be taken into account. or by any of the partner of the firm in his individual name or as a partner of any other firm as far as possible. A chartered accountant in practice as well as firm of chartered accountants in practice shall maintain a record of the audit assignments accepted by him or by the firm of chartered accountants. thirty audit assignments per partner in the firm. 2. or in the name of his proprietary firm. shall not exceed ten.6. Provided further that where any partner of a firm or firms of chartered accountants in practice accepts one or more audit assignments in his individual capacity. Provided that out of such specified number of audit assignments. whether in respect of private companies or other companies. the number of audit assignments of public companies each of which has a paid-up share capital of rupees twenty-five lakhs or more. the total number of such assignment which may be accepted by all firms in relation to such chartered accountant and by him shall not exceed the specified number of audit assignments in the aggregate. In computing the specified number of audit assignments: (a) the number of such assignments. (b) the audit of the head office and branch offices of a company by one chartered accountant or firm of such chartered accountants in practice shall be regarded as one audit assignment. which he or any partner of his firm has accepted whether singly or in combination with any other chartered accountant in practice or firm of such chartered accountants. Explanation: 1.8 Advanced Auditing and Professional Ethics exceed the specified number of audit assignments in the aggregate. in the following manner: 3. (c) the audit of one or more branches of the same company by one chartered accountant in practice or by firm of chartered accountants in practice in which he is a partner shall be construed as one audit assignment only. (b) in the case of a firm of chartered accountants in practice. (d) the number of partners of a firm on the date of acceptance of audit assignment shall be taken into account. the specified number of audit assignments means : (a) in the case of a chartered accountant in practice or a proprietary firm of chartered accountant. thirty audit assignments whether in respect of private companies or other companies. 4. (e) a chartered accountant in full time employment elsewhere shall not be taken into account This notification shall come into force from the date of its publication in the Official Gazette. .

and later issue the required notice in accordance with law. where a change in the shareholding pattern in the company has taken place between the date of issue of notice of the general meeting and the date of actual passing of this resolution regarding appointment of auditor. In this case a doubt has been expressed in some quarters about the material date for considering the 25% holding . In determining whether the appointment calls for a special resolution or not the measuring yardstick is the proportion of the subscribed capital held by the various categories mentioned above. the company may either (i) adjourn the meeting to another date. or (ii) omit or pass over the item on the agenda regarding appointment of auditor. pass a special resolution required to be passed under Section 224A of the Act. since generally articles of association of companies provide for closure of the register of members before the general meeting during a period not exceeding thirty days at any one time. If any of them singly or several of them jointly held 25% of the subscribed capital of the company as on the day of the closing of the register of members before the annual general meeting of the company will be covered by the provisions of Section 224A and.2. In exceptional cases.Section 224A provides for appointment of auditors in certain cases only by a special resolution. shall appoint or re-appoint an auditor in the annual general meeting only by passing a special resolution. it is unlikely that the position regarding shareholding in the company will be different between the date of issue of notice and date of the general meeting.6 Auditor not to be appointed except with the approval of the company by a Special Resolution . .The Company Audit S. In case the aforesaid company omits or fails to pass a special resolution in the annual general meeting to appoint an auditor or auditors it shall be deemed that no auditor or auditors have been appointed. and thereafter. or (iii) a nationalised bank or an insurance company carrying on general insurance business. 9 Date on which Form 23-B filled with Registrar of Companies 6 1 2 3 4 5 6. Moreover. and thereupon the Central Government’s power to appoint the auditors pursuant to Section 224(3) will become exercisable. or (iv) any combination of the above categories. consequently. or (ii) any financial or other institution established by any Provincial or State Act in which a State Government holds not less than 51% of the subscribed share capital.as to whether it should be the date of passing of the special resolution. a company in which not less than 25% of the subscribed capital is held by (i) a public financial institution or a government company or the Central Government or any State Government. however. The Department of Company Affairs has clarified that “material date is the date of the annual general meeting at which the resolution is required to be passed. However. It should be remembered that normally an auditor can be appointed or reappointed by an ordinary resolution.No Name of the company/Audit Assignment Registration Number Date of Appointment Date of Acceptance 6. the appointment of the auditor can only be made by passing a special resolution. in terms of Section 224A. It should be noted that subscribed capital includes preference share capital also.

and one or more State Governments and one or more Government companies. not less than 51% of the paid up share capital is held by: (a) the Central Government and one or more Government companies. (e) the Central Government.2. 1956. such holding of shares will have to be taken into account for the purposes of Section 224A of the Act. General Insurance Corporation of India and Industrial Development Bank of India are corporations/institutions owned or controlled by the Central Government within the meaning of Section 619B.A Government company has been defined in Section 617 of the Companies Act as “any company in which not less than 51% of the paid-up share capital is held by the Central Government or by any State Government or governments or partly by the Central Government and partly by one or more State Governments. if the name of the bank is entered in the register of members of the company as holder of shares. (d) the Central Government.1975).2. or Governments and one or more Government companies.7 Appointment of Auditor of a Government Company .” In respect of any Government company appointment of auditor is governed by the provisions of Section 619 of the Companies Act.6. If. and includes a company which is a subsidiary of a Government company as thus defined. Nationalised Banks. This provision is contained in Section 619B of the Companies Act (in force on and from 1. The aforesaid provisions applicable to the appointment of auditors of Government companies also apply to another category of companies even though they are not Government companies. However. According to this Section.10 Advanced Auditing and Professional Ethics In the event of the company adopting the procedure at (ii) above. in a company. one or more corporations owned or controlled by the Central Government. The auditor of such a company shall be appointed by the Comptroller and Auditor General of India. 6. (c) the Central Government. It has also been clarified by the Department that irrespective of the circumstances in which a nationalised bank is holding shares (whether beneficially or as security for loan advanced to constituents). one or more State Governments and one or more corporations owned or controlled by the Central Government. (b) any State Government. (f) one or more corporations owned or controlled by the Central Government or the State Governments. the appointment will be subject to the ceiling discussed above. But co-operative institutions. (g) more than one Government company or by combination of above. According to the clarification issued by the Department. Industrial Credit and Investment Corporation of . the auditor of a Government company shall be appointed or re-appointed by the Comptroller and Auditor General of India. the situation would then be covered by Sub-section (2) of Section 224A of the Act.

” (2) The Board of Directors....” (3) The last para of the resolution of the General Meeting and the resolution itself of the Board of Directors... Otherwise.. It should be noted that the provision of Section 224A which requires a special resolution for the appointment of auditor and Section 619B have made the acceptance of the position of auditor in a company somewhat difficult... passed a resolution as under: “Resolved that in the event of any of the Auditors declining to accept the assignment.The Company Audit 6... Before acceptance of the appointment given by any company on the strength of an ordinary resolution an auditor should specifically satisfy himself that the company is not covered by either Section 224A or Section 619B which require compliance with special procedure... fail to accept the appointment? For knowing the correct legal procedure that should be followed in such a case. appointed at annual general meeting.8 Auditor appointed at an Annual General Meeting failing to accept appointment .” “Resolved further that Shri Y (Chartered Accountant) be and hereby re-appointed as a joint auditor for the current year on an overall remuneration of Rs. 6.Can the Board of Directors be authorised by the General Meeting to appoint auditors in the event of auditors. and as such there was a possibility of the appointments being rejected by the auditors on that account. the Research Committee of the Institute had posed the following query to its Counsel: (1) A company appointed auditors for the current year by a resolution passed in the Annual General Meeting as under: “Resolved that Shri X (Chartered Accountant) be re-appointed as auditor for the current year on the overall remuneration of Rs. Shri Z should be appointed as joint auditor.. were intended to meet a contingency of the appointments being declined by any or both of the auditors appointed by the General Meeting.. However.. Further resolved that in the event of both or either of the auditors declining the assignments. he may find the appointment to be a nullity. the Board may fill up the vacancy at their own discretion. subsequently...2....only.. since the remuneration fixed by the General Meeting was less than that proposed by the retiring auditors.. Y declined to accept the assignment and Z was called upon to intimate his willingness or otherwise to accept the assignment pursuant to the resolution of the Board of Directors. Whether the vacancy caused by Y declining to accept the appointment constituted a casual vacancy under Sub-section 6 (a) of Section 224 or due to resignation of an (4) The Counsel’s opinion was sought on the following points: (a) . only. the aforesaid list of corporations is only illustrative and not exhaustive. Unit Trust of India and Industrial Finance Corporation are not covered under Section 619B. 11 India.

For this purpose. . Thus. sub-section (3) could not be invoked. He should also see whether the requirements of Section 224 (6) in respect of such an appointment have been complied with.3 Under Section 224(8) of the Act. as he will not under Sections 8 and 10 of the Chartered Accountants Act. [Notes: (1) Though there is no provision in the Act for an auditor ceasing to hold office on becoming bankrupt or insane. 6. 1949 have his name on the Register of Chartered Accountants. may be fixed by the Board or the Central Government as the case may be.] Remuneration 6. In practice. Further. it is fixed: (a) in case of an auditor appointed by the Board or the Central Government. the appointment of auditor having been made by shareholders.6. since the existing auditor’s consent to the proposal. valid? The Counsel was of the opinion that the Board of Directors could appoint an auditor only under the circumstances completed under Sub-section 5 and under Sub-section 6(a) of Section 224. (2) In the case of appointment of an auditor to act jointly with an existing auditor. the refusal of Y to accept the appointment as joint auditor did not create a vacancy either casual or by resignation since Y’s appointment had not become effective. Z could only be appointed by shareholders at a general meeting.An auditor. however. will have been secured in advance. Further that. it is expected. should verify that the resolution appointing him as the auditor at the general meeting was duly moved and approved by the share holders. shall be fixed by the company in General meeting or in such manner as the company in general meeting may determine.A. it will not be possible for a person of unsound mind or an undischarged insolvent to hold such office. Act as reproduced in the Code of Ethics. and (b) subject to clause (a) above.9 When appointment is made to fill up a vacancy caused by resignation of the previous Auditor . and (b) Was the appointment of Z. made by the Board of Directors in place of Y. in the specific case referred to him for opinion. he should refer to the resignation submitted by the previous auditor and also communicate with him so as to ascertain: (i) the circumstances which led up to his resignation. the expression “remuneration” should be deemed to include any sums paid by company in respect of the auditor’s expenses. In addition.12 Advanced Auditing and Professional Ethics auditor. compliance with the formalities would not give rise to any difficulties.2. the procedure would be similar to that where the existing auditor is being removed (as discussed hereinafter). and (ii) whether there existed any circumstances on account of which he should not accept the appointment. (3) Students should also refer to the Guidance Note on Compliance with provisions of Sections 224 and 225 of the Companies Act in the context of Clause 9 of Part I of the First Schedule to the C. before accepting the appointment in place of an auditor or who has resigned.

a disclosure should be made accordingly. he is entitled to receive remuneration in addition to the normal fee for the audit. his remuneration in the absence of any resolution fixing a different remuneration. the auditor is also required to undertake the writing up of the books. is considered to be the amount already fixed. Section 224(8)(aa) has been inserted whereby it is provided that. in addition to the normal audit. (b) as adviser or in any other capacity in respect of: (i) taxation. in the case of an auditor appointed under section 619 by the Comptroller and Auditor General of India. Such additional remuneration is a matter of arrangement with the directors. and (c) in any other manner. 13 Students may note that the Act does not require that the remuneration should be fixed at the same meeting of the company at which the appointment is made. to prepare the annual accounts of the company and do the income-tax or secretarial work. management services. Earlier this power was vested in the Central Government. Where. (iv) internal auditing. in respect of the previous appointment. It may. be fixed at a subsequent meeting. Where a retiring auditor has been re-appointed. (ii) company law matters.The Company Audit 6. if other services were rendered by one of the joint auditors or in case of a company having a branch. the remuneration shall be fixed by the company in a general meeting or in such manner as the company in general meeting may determine. the other services were rendered by the branch auditor. company law matters. expenses or otherwise for such service must be disclosed in the Profit & Loss Account. other services. But any remuneration paid as fees. The Council of the Institute of Chartered Accountants of India in the ‘Statement on Payment to Auditors for other Services’ has recommended that the fees paid to the auditors for other services rendered should be disclosed in the profit and loss account of the companies under the following heads in order to give precise and correct information to shareholders and others who read the accounts: (i) (ii) (iii) (v) tax representation. The remuneration paid to the auditor is required to be shown in the Profit & Loss Account separately: (a) as auditor. . (iii) management service. In case of joint audit. therefore.

for example. e. (c) Company Law Services which include giving advice in relation to compliance with the various provisions and procedures under the Companies Act. etc. production. management information system. (g) Issue of certificates as required by the Government and other authorities for various specific purposes. scheme of reconstruction and reorganisation.. exports. The very fact that the law requires specific disclosure of the payment for other services shows that the Parliament did contemplate rendering of such services and did not consider anything “prima facie” wrong about them. The issues arising out of this practice have been considered by the Institute of Chartered Accountants of India. selection of Senior Personnel in the Finance Department. Certificates of gross profit and available surplus under the Payment of Bonus Act. The views of the Institute in this regard are given below: The payments for other services which are statutory required on the face of the published accounts of a company represent perfectly legitimate payments for services rendered by the auditors to the company which services the company needs and from which the benefit derived by the company and the shareholders at large is more than commensurate with the cost thereof. (iii) Certificate for consumption for raw materials. The other services which might be usefully rendered by an auditor of a company against payment of additional fees may comprise the following: (a) Taxation Representations before the tax authorities and tax planning and advisory services. (f) Valuation of shares of limited companies for various purposes. etc. etc. (e) Advice in connection with amalgamation and merger.3.One often finds that statutory auditors of the companies are called upon to render other services to the client like tax consultancy. internal audit. (d) Investigation of accounts for various purposes.1 Rendering other services . both national and international. suspected fraud. in case of purchase of business. required by the Joint Chief Controller of Imports. etc. (iv) Certificates at the specific request of lending institutions. management consultancy. (v) Certificates based on verification of financial records to various Government.g. public and other authorities. . etc.6.14 Advanced Auditing and Professional Ethics 6. (i) (ii) Certificates required by the Reserve Bank of India for exchange control purposes. (b) Management Services which may include advice on the installation of a costing or budgetary control system.

on the one hand. on the other. etc. The next question is whether there is anything wrong in such services rendered by the company’s auditors if they are competent to render them. it will be appreciated that it is only normal and natural for a company to need such services and to pay for them. in respect of which usually the fees are paid by the company itself. this is desirable. etc.. in relation to cash transactions. The intimate knowledge which the auditor possesses of the company’s business affairs and accounts is of material help in the representation before the tax authorities. This question may be viewed from the angle of the benefit of the company and the shareholders. particularly. Such a review is followed by recommendation for internal control for the benefit of the company. and its effect on the independence of the auditor. which would enable him to carry out a more effective and more purposeful audit. it may be desirable that the services are rendered by the company’s own auditor who is expected to have overall knowledge of the accounts and the financial affairs of the company and. a surplus verification of cash or inventories or surprise visit to branches under special circumstances. If the services are not rendered by the company’s own auditor. purchases made by the company. The cost of other services to the company when rendered by its own auditor may also be comparatively less because he would need to expend less direct time on the job than a person who has not audited the accounts. Sometimes. For example. The work done by the auditor in rendering other services may enable him to get a greater insight into the accounts and affairs of the company. 15 (h) Special assignments required by a company for its own benefit.The Company Audit 6. fairness of the opinion expressed on the certificate issued and also the benefit to the company as well as its shareholders. also from the point of view of ensuring effectiveness of the work. Audits of ancillary institutions of the company like the Employee’s provident fund. for example. It is usually a matter of advantage to the company and the Income Tax Department if the tax representation of the company is handled by its own auditor. they will have to be rendered by some other Chartered Accountant or by some other similar agency. (j) From the above illustrative list of the various services rendered by the auditors for which additional fees are paid. Chances of errors and accidental misstatements or omissions are reduced and the tax officers are then able to complete the assessments more expeditiously and with a greater degree of confidence. It is emphasized that the other services rendered are also those which are considered essential and beneficial to the company by the management and they would normally have to be rendered by a professional accountant or other similar agency. an auditor who has been engaged for rendering managements services to . He can draw upon the work already performed in the course of the audit where as another person may need to follow certain procedures which have already been covered by the statutory auditor. (i) Review of systems and procedures and of the internal controls. inventories’ sale effected by the company. The company’s auditor with his overall knowledge of the affairs of the company would be in a much better position to render such services compared to others.

The Institute. would have comparatively fewer clients. The Council has also advised its members to refrain from expressing professional opinion on financial statements of a company in which he or his relatives are substantially interested. In fact. In recent time. the Institute does not consider that there is anything inherently improper in the auditor receiving an additional fee for services rendered under such circumstances that his independence is not likely to be adversely affected. From time to time. for valid reasons. Any unreasonable restriction on company auditors in the matter of rendering other services would unjustifiably hit this young generation whom the Institute considers its pillars of strength. If the management.16 Advanced Auditing and Professional Ethics the company by way of a review of the systems and procedures and the internal control systems of the company would acquire valuable additional knowledge which would certainly help to perform a more efficient audit. a Notification issued by the Council lays down that a statutory auditor cannot act as a cost auditor. For Example. The Council has also advised the members to be always on guard and not to accept any professional assignment under such circumstances that his independence may be affected. most young entrants to the profession who. is quite mindful of the utmost necessity of ensuring high standard of independence and integrity by its members in the performance of their duties as company auditor. Such a restriction would retard professional development and would at the same time not be in the interests of the company and its shareholders nor in the public interest. etc. However. However.6. the rendering of useful professional service in consideration of a fees is not a matter of favour nor does it amount to have a financial interest . There is no doubt that an auditor should not seek favour from his client company nor should he has a financial interest in the company if he has to maintain his independence and authority. Many young and promising members of the profession are trained to render management services. It may also be clarified that there is no compulsion on the company to engage its own auditors for rendering other services. If the company so chooses it can engage the services of any other person. concludes that it can have more efficient and less expensive services from its own auditor. in their early career. taxation and company law services. It is for the management of the company to judge as to which course would be in the best interest of the company. to their clients. there has been a growing appreciation in business and industrial circles of the constructive and effective assistance that a chartered accountant can render to the management in various fields. the Council of the Institute has issued recommendations to its members with this object in view. It is not proper to suggest that mere receipt of fees for such services is likely to taint the auditor’s conscience or that such payment of other fees which under statutory requirements are disclosed on the face of the accounts are made with an untoward or ulterior motive. of course. do render varied services to their clients with mutual advantage without sacrificing public interest. An analysis published in the press suggested that it is the bigger firms who derive most benefit from rendering other services. This has opened up new horizons particularly for the young members in the profession who are in a very good position to develop these new skills and to use them to the advantage of every one concerned. there seems to be no justifiable reason why it should be deprived of such services.

There need not be any misgiving in this matter nor any apprehension that by such payments the public interest of the generality of the shareholders is compromised. It would. management service and in any other manner are required to be disclosed separately. 455 dated 27. therefore. In most of the cases the High Court has reduced the punishment. expenses or otherwise. Thus. April 1974. In disciplinary matters the standard maintained by the Institute is so high that there has been not a single case where the High Court has enhanced the punishment suggested by the Institute for an erring member. This approach is in keeping with the profession’s desire to play its proper role in the affairs of the nation by contributing its utmost for developing the natural resources of the country. the other services rendered by a company’s auditor are only such services which are directly within the scope of the accountancy profession. the Council had recommended disclosure of the breakdown of the fees paid to the auditor in other capacity under certain heads. It may also be stated that the Institute has provided enough safeguard for ensuring proper performance of duties by its members. increasing the national wealth and improving the standards of the millions of our countrymen. 6. In fact. Even prior to the issuance of the aforesaid Notification. Whilst the breakdown required by the aforesaid Notification is somewhat narrower than the break-down earlier recommended by the Council.2 Recommendations regarding disclosures for payments to auditors for other services By Notification No. for services rendered as auditor and adviser or in any other capacity in respect of taxation matters. A very strict disciplinary control is maintained by the Institute and action is quickly taken by the Disciplinary Committee against erring members. While the Council of the Institute will continue to exercise the utmost vigilance in order to ensure the highest standards of independence and discipline. Such services and such payments are perfectly legal and perfectly within the code of conduct and ethics of the professional.The Company Audit 6. where such development does. it would be a mistake to stand in the way of normal professional development. in the interest of better and fuller disclosure. It may also be pointed out that a practising Chartered Accountant is precluded from engaging in business or activities which are not directly within the scope of his profession. company law matters. the fees paid to auditors. Therefore. The Council issued this note in the hope that it would clarify the matter with regard to the payment of fees to auditors in ‘other capacity’. be entirely incorrect to suggest that a company’s auditor compromises his independence or obtains an undue advantage or interest in the company merely by accepting an engagement for rendering other professional services to his client on payment of specific fees for such services. there is hardly any possibility of any misuse or abuse if other professional services are rendered by the auditor. not compromise the auditor’s independence or authority. the Council . the Council actively encourages diversification in the professional services rendered by the members of the profession so that new horizons and more avenues of useful and constructive work may open up for the young entrants to the profession. whether as fees.3. 17 in the company. the Government amended the requirements of Part II of Schedule VI to the Companies Act. 1956 as a result of which.

g. In such a case. 50 crore or more in a year and accepts any other work(s) or assignment(s) or service(s) . for management services.3 Management Consultancy and Other Services . Likewise a company may pay fee to its branch auditor appointed under Section 228 of the Companies Act. 1956 for services rendered in other capacity.. legal or ethical. In such a case also while disclosing the fee paid in other capacity the fact that it was paid to a branch auditor may be specified. the company may pay fees in other capacity to one out of several firms of joint auditors. (iv) for internal audit. in respect of fees paid to the auditor in other capacity should continue to be under the following head: (i) (ii) (iii) (v) for taxation matters. 6.in regard to the same Undertaking(s)/Company(ies) on a remuneration which in total exceeds the fee payable for carrying out the statutory audit of the same Undertaking/Company. management consultancy etc. Provided that in case appointing authority(ies)/regulatory body(ies) specify(ies) more stringent condition(s)/restriction(s). A question arises as to whether. in the interest of proper disclosure. there does not arise a situation of conflict. It may be noted that according to the Institute of Chartered Accountants of India.3. for company law matters. for other services. and It may happen that the fees paid to the auditor in other capacity may have been fixed or settled in a composite manner in respect to more than one head. it may be indicated that the fee is paid to one of the joint auditors specifying the name of such auditor to whom the fee is paid.A member of the Institute in practice shall be deemed to be guilty of professional misconduct. it is recommended that the composite amount may be disclosed describing that it was fixed as such for the specified matters. In such a case. e. the same shall apply instead of the conditions/restrictions specified in this Notification. accordingly. if he accepts the appointment as statutory auditor of Public Sector Undertaking(s)/Government Company(ies)/Listed Company(ies) and other Public Company(ies) having turnover of Rs. if a company pays fee or remuneration to one of the partners of a firm which is acting as its auditor. The Council is of the view that the requirement as to the separate disclosure of fees paid in other capacity should be more properly construed in the context of the spirit behind such requirement and. to the client at the same time.6. separate disclosure is required in respect of the fee or remuneration so paid. tax advice. when the statutory auditor renders other services. .18 Advanced Auditing and Professional Ethics recommended that such disclosure. Sometimes. recommends that even in the aforesaid case separate disclosure should be made in respect of fees paid by the company to the partner of the firm which is its auditor.

It is the primary duty of the auditor of a company to make a report to the shareholders on the accounts examined by him and on every Balance Sheet and Profit & Loss Account as well as any other document declared by the Act to be part of and annexed to the Balance Sheet or Profit & Loss Account. ♦ the term “other work(s)" or "service(s)" or "assignment(s)" shall include Management Consultancy and all other professional services permitted by the Council pursuant to Section 2(2)(iv) of the Chartered Accountants Act. 1949 but shall not include: (i) audit under any other statute. In regard to taking up other work(s) or service(s) or assignment(s) of the undertaking/company referred to above.4 The following are the functions. 2. This notification shall apply for any appointment(s) on or after 1st April. duties and rights of auditors: 6.The primary function of an auditor is to report on different types of financial statements prepared in a variety of situations mentioned below: (i) Reporting on Balance Sheet and Profit & Loss Account . 19 The above restrictions shall apply in respect of fees for other work(s) or service(s) or assignment(s) payable to the statutory auditors and their associate concern(s) put together. Duties and Rights of Auditors 6. For the above purpose. 1956 . (ii) certification work required to be done by the statutory auditors. it shall be open to such associate concern or corporate body to render such work(s) or service(s) or assignment(s) so long as aggregate remuneration for such other work(s) or service(s) or assignment(s) payable to the statutory auditor I s together with fees payable to its associate concern(s) or corporate body(ies) do/does not exceed the aggregate of fee payable for carrying out the statutory audit. . ♦ 3. 4. Functions.1 Functions of an Auditor under the Companies Act. 6.The Company Audit Explanation: 1. 2002. 1988. the terms "relative" and "substantial interest" shall have the same meaning as are assigned under Appendix (10) to the Chartered Accountants Regulations. and (iii) any representation before an authority ♦ the term "associate concern" means any corporate body or partnership firm which renders the Management Consultancy and all other professional services permitted by the Council wherein the proprietor and/ or partner(s) of the statutory auditor firm and/ or their "relative(s)" is/are Director / s or partner / s and/or jointly or severally hold" substantial interest" in the said corporate body or partnership.4.

(iii) Certification of Statutory Report . Exercising this power the Government of India issued the Manufacturing and other Companies (Auditor’s Report) Order 1975. The matters which should be dealt with by the auditor in his report are set out in detail in subsection (3) of section 227. and (b) in the case of the profit and loss account the amount of profit or loss during the financial year. the auditor’s report should also include a statement on such matters as may be specified therein. as may be specified in the order. Also. This Order was applicable to the following categories of companies: (a) (b) (c) (d) Manufacturing. Supplying and rendering services. 2003. that in case of any class or description of companies.20 Advanced Auditing and Professional Ethics which are laid before the company in general meeting during his tenure of office. the auditor is to inquire and.By the Companies (Amendment) Act 1965.e. sub-section (4A) has been added to section 227 empowering the Central Government to direct. if necessary. November 1.Section 60 (3) of the Companies Act 1958. A deemed . The report should state whether. Trading.6. nidhi or mutual benefit companies. cash received in respect of such shares and payments of the company. contemplates three circumstances under which it is necessary for a Chartered Accountant to report on the statements of account. Part II or Schedule II to the set contains the reports to be included in prospectus. The 1988 Order has been further substituted by the Companies (Auditor’s Report) Order. (ii) Report to be set out in the Prospectus . by a general or a special order. to report on the matters Specified in Section 227 (1A). The 1975 Order was replaced by the 1988 Order which came into force w. chit fund. and Financing. It should be certified by the auditor of the company. investment. the said accounts give the information required by the Act in the manner so required and give a true and fair view: (a) in the case of balance sheet. mining or processing. in his opinion and to the best of his information and according to the explanations given to him. 1988. operating results and assets and liabilities of a going company which issues a prospectus. of the state of the company’s affairs as at the end of its financial year. in so far as the report relates to the shares allotted by the company.f. It is a general power which authorises the Government to extend the scope of audit in case of a particular class of companies. Power of Government to amplify the scope of audit .Every public company limited by shares and every company limited by guarantee and having share capital must prepare a statutory report for being placed before the shareholders in accordance with section 165.

the directors of the company make a declaration of solvency. the Central Government may appoint a person who is a Chartered Accountant. whether or not he is the auditor of the company. (vi) Report on the Accounts of Liquidators . industry or business to which it pertains. 21 public company will not be required to hold statutory meeting or issue statutory report if a period of 6 months has expired after incorporation at the time. but not less than twice at year. he has to report to the Central Government. Furthermore. information is required on certain specific points. The procedure is a short cut to an investigation and is simpler. the Balance Sheet of the company on last mentioned date embodying the statement of the company’s assets and liabilities as at that date (section 488).When. instead of making a report to the company. (iv) “Special Audit” (Section 233 A) . on company being put to voluntary winding-up. at such times as may be prescribed by the Court. present to the Court an account of amounts received and paid by him. if it fails to do so within a period of four months from the date of the receipt of the report. the Government is required to send to the company either a copy or the relevant extract of the report with its comments thereon and require the company either to circulate the copy or the extract among the members or have them read before the members at the next General Meeting.It is an audit procedure alternative to investigation when the Central Government is authorised to adopt in the under mentioned circumstances: (a) when the affairs of the company are not being managed in accordance with sound business principles or prudent commercial practices. may take such action on it as it considers necessary but. either on the basis of any information in its possession or those aroused from a perusal of the statements of account. The special auditor for purposes of carrying on the audit is invested with the same powers and has the same duties as the statutory auditor except for the fact. it should be accompanied by a copy of the report of the auditors of the company on the Profit and Loss Account of the company for the period commencing from the date up to which the last such account was prepared and ending on the latest practicable date. it is so deemed. It is therefore preferred in cases where. To conduct such an audit. its liquidator.The Company Audit 6. or (b) when it is being managed in a manner likely to cause serious injury or damage to the interest of the trade. instead of a detailed roving enquiry. as well as. It is obligatory for the Court to have the accounts audited (Section 462). in the case of a . immediately before the declaration is made. The Government on receipt of the report. or (c) when the financial position of the company is such as would endanger its solvency. The Central Government is authorised to determine the scope of such an examination so that it may be able to obtain such information as it may require to prove or disprove any suspicion that it may have. (v) Report on the Accounts prepared on voluntarily winding-up .When a company is being wound up by the Court.

Neither does the Act define the scope of such an examination (except requiring verification of propriety of certain transactions stated in sub-section (lA) of Section 227 or looking into the matters specified in the Companies (Auditor’s Report) Order 2003. Generally. the Act does not prescribe the procedures that should be followed for the examination of books of account or verification of assets and liabilities included in the Balance Sheet of a company. and to verify that the statements of account. (b) To assist Government in the prosecution of directors. unless the liquidation is concluded within one year of its commencement. [section 242 (1)]. nor does it suggest the attitude of mind with which the task should be approached. it is the duty of the auditor to examine the company’s books of account to ascertain that they do. (3). to make a declaration that all the requirements of the Act have been complied with [section 33 (2)]. truly and fairly .22 Advanced Auditing and Professional Ethics company. But such an audit is not necessary in a case where the provisions of section 462 are applicable. under different conditions and circumstances.6.2 Nature of duties of a Company Auditor .Though in sub-sections 1A. duly audited: (a) in the case of a winding-up by or subject to the supervision of the Court. the duties of the auditor are set out in some detail. Such a duty extends to all persons who were employed as auditors whether as statutory or as internal auditors [section 240 (1) (b)]. (vii) Other Duties of the Company Auditor .The auditor can be called upon to carry out the undermentioned duties: (a) To assist the Inspector appointed by the Central Government either on the application of the members or on a report by the Registrar of Companies under section 235 of the Act. truly and fairly record the transactions entered into by the company. in the investigation of the affairs of the company. drawn up on the basis of the books. It is because these are matters in regard to which members. (d) In the event of his being engaged in the formation of a company. 6. (2). would be guided by informed opinion in the profession. it is expected. (4) and 4A of section 227.4. and (b) in the case of voluntary winding -up. or by the pronouncements of learned judges in cases concerning the duties and responsibilities of auditors. which is being wound voluntarily under the supervision of the Court or by the Court. provided the auditor is not himself involved in pursuance of the Inspector’s report under section 241 of the Act. with the Registrar (section 551). especially the statements issued by professional bodies. the liquidator must file a statement of receipts and payments in the prescribed form. in the Court. (c) To give such reasonable assistance as is necessary in cases where prosecution has been instituted against delinquent officers and members of the company in the capacity of an officer of the company [section 545 (7)]. in fact.

They are also responsible for safeguarding the assets of the company. The scope and depth of checking of the entries in the books for the verification of the statement of account is. However. he must extend his examination. The compliance with the accounting standards is also required to be ensured by the auditor. existence of the system of internal control and the character of the management. Often. The directors are responsible for maintenance of accounts and for financial control of the affairs of the company. however. However. The informed opinion in the profession in this regard is that. that the auditor would not accept the financial position of the company as shown by books of account. but he need not imagine the spectre of a loss which might have been suffered where in fact. It is expected. Under section 209 of the Companies Act. If they fail to exercise the requisite degree of supervision. should he extend his examination to trace down any fraud or would it be enough if he merely reports that the internal check is inadequate. he does not guarantee or certify them as a result. they are responsible for ensuring the maintenance of adequate records and the preparation of annual accounts showing a true and fair view of the state of affairs of the company. or are kept in a manner that either the amount of the revenue receipts. to a large extent.The Company Audit 6. before making a thorough enquiry so as to satisfy himself that the books of account in fact show the true position and it is properly reflected in the statements of account reported upon by him. the report should be qualified in this regard only after the auditor has verified the condition of the records. It is a primary duty of the auditor to verify the books of account presented to him for audit and to report on the final statements of account. if circumstances so warrant. also. after the audit has been completed. or the values of assets or the amounts of liabilities cannot be properly ascertained he must report the fact to the shareholders. or that of expenditure. they cannot plead in defence that the auditor had not drawn their attention to the dangers to which the assets were exposed. if a fraud is discovered. a question is asked that if the internal check is found by the auditor to be inadequate. that the Profit and Loss Account contains all the information required to be disclosed according to the Part II of the same Schedule. [Subsection (4) of Section 227]. provided he had conducted the audit with due care and skill in consonance with professional standards. 23 reflect the financial position disclosed by them. it being the duty of the auditor to report any loss or defalcation resulting from the non-existence of internal check. a matter which the auditor must determine himself on taking into account the conditions of the record in the books. for any failure to perform his duties competently. Another duty of the auditor is to see that the Balance Sheet of the company is drawn up in the form contained in the of Schedule VI to the Companies Act. . no loss has occurred. the auditor would not be liable for any breach of duty or negligence. If the books of account do not contain a complete record of the transactions.

Though the scope of an audit cannot be restricted (Newton v. be rules made in this behalf. in such form as may be prescribed. True and Fair . It shall not be less than 0. Section 441A provides for levy and collection of cess on turnover or gross receipt of companies.J in Re London and General Bank). The decision. The Central Government may. that where the directors of a private company are its sole shareholders and the auditor has reported to the directors that he has not been able to satisfactorily examine the entries in the company’s cash book.An audit report should be clear.005% and not more than 0. Every company shall furnish. Cess on Companies .) it has been held in Pendleburys Ltd. An Auditor who gives the shareholders “the means of information” in respect of company’s financial position. to the Central Government and the Tribunal the details of its turnover and gross receipts with payment of cess. . at his peril and runs the serious risk of being held judicially to have failed to discharge his duty (Lindley L. whichever is more as the Central Government may.A cess on companies will be levied for purpose of rehabilitation or revival of sick industrial companies. 1956 by introducing additional reporting requirements under clauses (e) and (f) of Section 227(3) of the Act where by the auditor shall state his observations having adverse effects on functioning of company in thick type or italics [clause (e)] and ascertain whether any Director of the Company suffers any disqualification under section 274 (1)(g) [clause (f)]. Ellis Green and Co. 2002 has added Clause (g) in section 227(3). [section 441A(3)]. The provisions are made in sections 441A to 441F. does so. for the purposes of rehabilitation or revival or protection of assets of the sick industrial company. Section 441A(1) provides that there shall be levied and collected.By the substitution of these words in the report which an auditor makes on the statements of account of a company for the words “true and correct” by the Companies Act. The Companies (Second Amendment) Act. Every company shall pay to the Central Government the cess referred to in section 441A(1) within three months from the close of every financial year. which are placed in part relating to winding up of company by Tribunal. from time to time. the details of the amount of cess not so paid. specify by notification in the Official Gazette. 1956 explaining in detail the manner of reporting by the auditor. Can the scope of the audit be restricted . The Institute has issued a Guidance Note on Section 227(3)(e) and (f) of the Companies Act. Auditor’s Report . whereby the auditor’s report shall have to state whether the cess payable u/s 441A has been paid and if not. in view of inadequacy of the system of recording entries.6. specific and complete. specify the manner in which the cess shall be paid u/s 441A(2) [section 441A(4)]. 2000 has further amplified the duties of an auditor under the Companies Act. [Section 441A(2)]. may not now provide protection to auditors in similar circumstances. though good law at the time it was delivered. he cannot be held guilty of negligence for not having qualified his report to the shareholders. if a third party is aggrieved. Birmingham Small Arms & Co.1% on the value of annual turnover of every company or its annual gross receipt. v. a levy by way of cess. in order that anyone who has an occasion to read it may know exactly what is wrong with the company.24 Advanced Auditing and Professional Ethics The Companies (Amendment) Act.

In the event of any deviation from the standards. exceptional or non-recurring items of income and expenditure must be disclosed separately. should be examined. where any one of these has been entered into.3 Rights of an Auditor . and (g) that the accounts should comply with the requirements as to the disclosure contained in Schedule VI to the Companies Act. the scope of the responsibility of the auditor has been widened. as a result should not only correspond with the entries as contained in the books of account but should also present a true and fair view of financial position of the company.The Company Audit 6. For example. as at the close of the year. if material.4. (e) that events. the valuation of assets possessed or liabilities owned by the company. commented upon. or certain amounts have had to be paid on account of losses suffered in the past. The statements of account. Now it is incumbent upon the management of a company to ensure whether the financial statements have complied with the accounting should are not in terms of section 211 of the Companies Act. In the context of ascertainment of true and fair view and drafting of the audit report. must be taken into account. 6. (d) that the statements of account should neither over or understate the financial position of the company. This demands: (a) that the statements must disclose all material facts affecting the profits made. it will be also their duty to make adequate course in their reports so that the users of such statements may be aware of such deviations. 25 1956. The right of access to the “books of account” and “vouchers” must be construed as a right to inspect all the books of account and records kept whether in compliance with the statutory . in respect of which no provision existed in the books of account. if there has been a loss of some stocks of raw-material by fire. 1956.These are set out in detail in Sections 227(l) and 231. 1956. subsequent to the close of the year. which were not insured. (c) that the propriety of transactions specified in sub-section (1A) of Section 227. which enable the auditor to determine in a better way the profits or the financial position of the company. While discharging their attest functions it will be ‘the duty of the members of the Institute to ensure that the Accounting Standards are implemented in the presentation of financial statements covered by their audit reports. losses incurred. it is necessary that students also acquaint themselves with the requirement of the Accounting Standards issued by the Accounting Standards Board of the Institute of Chartered Accountants of India. (b) that all unusual. (f) that the statements of account should be drawn up in conformity with the accepted standards of accounting principles consistently applied from year to year. these facts should be disclosed separately and.

the Central Government has the power to declare any establishment falling under (i) or (ii) above as not a branch office in relation to the company owning it.26 Advanced Auditing and Professional Ethics provision or for financial purpose at a reasonable time. Until this has been done. the auditor may report to the members that he has not been able to obtain all the information or the explanations he required. the auditor normally should not start the audit. any establishment carrying on either the same or substantially the same activity as that carried on by the head office of the company. Accordingly. 1956 provides that where a company has a branch office. Audit of Accounts governed by Special Acts . Section 2(9) of the Companies Act.5. The auditor’s power to obtain information and explanation is indeed very wide and. sub-section (6) of section 211 of the Companies Act provides that the final accounts of companies governed by a special Act. It is the duty of the management to balance and agree the books and prepare the final statements of account.1 Relevant provisions of Companies Act. 1956 . If a person other than the statutory auditor has been appointed to audit the accounts of a branch or branches. the accounts of that office shall be audited either by the company’s auditor appointed under Section 224 or by another auditor possessing qualifications prescribed .The duties and responsibilities of an auditor in case of companies which are governed by a special Act. Section 228 of the Companies Act.In accordance with the principle of independent professional audit of the company accounts. 1956 defines a branch office as: (i) (ii) any establishment described as a branch by the company. and drawn up according to requirements thereof. the Companies Act. Section 227 casts a duty specifically on the officers and other persons associated with the management of the company to furnish any particulars or information required by the company or auditor for being included in the Final Accounts or in any documents to be annexed thereto.6. Audit of Branches 6.5 The following are the points regarding audit of branches: 6. either with or without notice. or (iii) any establishment engaged in any production. processing or manufacturing but does not include any establishment specified in any order made by the Central Government under Section 8. in case any information is refused. Under Section 8. is much the same as in case of others except to the extent that these have been modified by the provisions contained in the relevant special Act. 1956 in Section 228 has provided for the audit of accounts of branches. it would be the duty of the branch auditor to forward his report to the statutory auditor before he makes the accounts of the company. would not be considered as not disclosing a true and fair view on the ground that they do not disclose information not requiring disclosure under the special Act.

Also. 6. For example. The branch auditor shall have the same powers and duties in respect of the audit of the branch accounts as the company auditor has in relation to the company accounts. 27 under Section 226.In the opinion of the Institute of Chartered Accountants of India. Naturally it is reasonable to presume that the branch auditor will not necessarily hold office for the same statutory period as is held by the statutory auditor under Section 224. However a company may decide to have the branch accounts audited by a person other than the company auditor in a general meeting. has provided that under certain circumstances the accounts of the branch may not be audited . The powers that the company auditor enjoys in relation to branch accounts are the rights (i) to have access at all times to the books of accounts and vouchers of the branch. The branch auditor shall receive such remuneration as may be fixed for him by the general meeting appointing him or by the Board of Directors. (ii) to visit the branch. The scheme of Section 228 presumes that normally the company auditor shall be appointed as the branch auditor.2 Branch Auditor Appointment and Powers . it may well be necessary for the statutory auditor to bring this to the notice of the Board of Directors. But the branch auditor. where an auditor or a partner of his has been the subject matter of adverse disciplinary proceedings under the Chartered Accountants Act and the statutory auditor knows it. unlike the company auditor. having regard to the element of materiality and other considerations. and (iii) to obtain information and explanation considered necessary for the audit of the branch accounts.5.5.3 Exemption of Branches from audit requirements in certain situations . if so authorised by the general meeting. 6.The Company Audit 6.Though independent professional scrutiny of the branch accounts is the principle in providing audit. the company is required to appoint the branch auditor from out of the eligible categories in the same meeting or it is to authorize the Board of Directors to appoint one in consultation with the company’s auditor appointed under Section 224. will not have the right to attend the general meeting of the company or to receive the notice and other related communications in connection with the general meeting. the appointment of branch auditors in consultation with the company’s statutory auditor should not be taken to mean that the statutory auditor is in any way taking responsibility in respect of the work done by the branch auditor. The provision regarding consultation with the statutory auditor only implies that the statutory auditor should be satisfied that prima facie. In such a situation. The branch auditor is required to prepare a report on the accounts of the branch office examined by him and forward the same to the company’s auditor. It is obvious that when the company auditor himself is the auditor for the branch accounts. the legislature. He as the auditor for the company. In the case of a branch situated outside India. there cannot be any question of any report being made on the branch accounts audited. any of the above or an accountant qualified to act as auditor in the country concerned can be appointed as the branch auditor. is under a duty to make a report on the consolidated accounts in accordance with Section 227(2) of the Companies Act. he is not aware of any reason why the proposed auditor should not be appointed as branch auditor. he is to hold office subject to the terms and conditions specified by the appointing body.

even though such person is an employee of the company. The exemption discussed above is mandatory in nature. part of . the Central Government is satisfied that exemption may be granted.6. But these exemptions are discretionary.28 Advanced Auditing and Professional Ethics [Section 228(4)]. Reliance on the Work and Report of the Other Auditor 6. (iv) If for any other reason. or (iii) the amount of the expenditure. manufactured or processed. If arrangements are made for the audit of the accounts of the branch office by a person possessing the qualifications necessary for appointment as a branch auditor. whether of a revenue or a capital nature. subject to the satisfaction of the Central Government. incurred by a branch office during a financial year. processing or trading activity accounting for average quantum of activity not exceeding higher of Rs. The average of the quantum of activity is to be computed by including the activities for the three years immediately preceding the year in respect of which the question of exemption is to be determined. having regard to the nature and quantum of activity carried on at the branch or having regard to any other reason. 2 lakhs or 2% of the average total turnover of the company shall be exempt from the purview of compulsory audit of branch accounts. if the condition about the quantum of activity is met. by a person who is competent to scrutinise and check the accounts. The grounds on which exemption may be granted by the Central Government are the following: (i) If there are satisfactory arrangements for the scrutiny and check at regular intervals of the accounts of the branch office of a company. an auditor may be called upon to report on financial statements. 1961. or the aggregate value of the goods or articles sold and of services rendered.6 Occasionally. 1961 have been issued to provide for the exemptions. Quantum of activity means the highest out of the following: (i) (ii) the aggregate value of the goods or articles produced. In case the company did not exist for all the three years referred to above. under the above Rules a branch of a company carrying on manufacturing. the number of years in which the company actually existed will constitute the base of computing the average. It should be noticed that the question of exemption is to be considered every year by reference to the yardstick given above. The Companies (Branch Audit Exemption) Rules. The company auditor in his report is to make a mention about exemption from audit granted to any of the branches of the company under the Companies (Branch Audit Exemption) Rules. (ii) (iii) If a branch auditor is not likely to be available at a reasonable cost. There may be exemption also on other grounds. not carrying on manufacturing or processing or trading activities.

he considers it necessary for the proper audit of the accounts of the company. The manner in which to deal with the report is left to him.The Company Audit 6. The Institute of Chartered Accountants of India has come out with an Auditing and Assurance Standard (AAS) 10 . are consolidated with the holding company’s accounts also where branch accounts audited by other auditors are merged in the head. consolidation of the subsidiaries accounts with the holding company’s accounts is not a legal requirement. The Companies Act.office account. If in his own assessment of the situation. however it is sufficient if the company’s auditor is allowed access to the copies and extracts from the books and accounts of the branch as have been transmitted to the principal office of India.6. accounts and vouchers maintained at branch even when the branch audit is conducted by a person other than the company’s auditor. the company’s auditor is required to deal with the branch audit report received from the branch auditor. Certain matters may appear material and important in the limited context of the operations of the branch but may be considered not much significant in the setting of . Also there is no question of any separate and distinct right to visit the branch or to have access to the books. This requirement is supplemental to the main duty cast on him under Section 227(3)(c) to state in his report whether the branch audit report has been forwarded to him and how he has dealt with the same. listed companies are required to get their accounts consolidated as per the SEBI’s requirement. However. the Companies (Branch Audit Exemption) Rules. In our country. but it is not compulsory that he must visit the branch or branches. this problem arises. 1956 branch accounts may be audited by auditor different from the company auditor provided of course he holds the requisite qualification. It is clear that the law has left the question of how to deal with branch audit report to the company auditor and only requires him to state in his report how he has dealt with the same. This phenomenon is particularly present where the accounts of subsidiaries. 6. audited by other auditors. in preparing his own report. There remains no question of any separate report on the branch accounts for consideration. companies are required to comply with the requirements of AS-21. has given a right to the company’s auditor to visit the branch and to have access to the books. In that connection. When the branch accounts are audited by a person other than the company’s auditor it is necessary to define the position of the company auditor in relation to branch accounts and branch auditor.“Using the Work of another Auditor”.1 Company’s Auditor in relation to Branch Accounts. In other words. Branch Audit and Branch Auditor When the company’s auditor himself is the auditor for the branch accounts. he treats the whole company as an audit unit and ensures that the branch accounts have been properly incorporated in the main office accounts. accounts and vouchers. full freedom of judgement has been given to the company auditor to decide the prima facie relevance and impact of the branch audit report on the total company accounts. Under Section 228(3)(c). accounts and vouchers maintained there. 1961 has retained this right for the company’s auditor in respect of branches granted exemption from audit this is a right given to the company auditor and not a duty cast on him. 29 which has been audited by other auditor or auditors. he may visit the branch and may have access to the books. As regards foreign branch of a banking company. under Section 228(2). Also. Under the Companies Act.

therefore. if any. The legal opinion obtained by the Institute of Chartered Accountants of India and published in the “Opinion regarding certain provisions of the Companies Act. He. if he so feels.30 Advanced Auditing and Professional Ethics the total company accounts. then it is obvious that the company auditor is left with no choice but to incorporate them in his own report after confirming the accuracy of the report. He. he has to make disclosure of anything in regard to the branch which he thinks is not in order and which has come to his notice. For example. This is shown by the fact that he has a right to visit the branch and has access to the papers and documents of the branch. It seems that in a situation where the branch audit is being conducted by a person other than the company auditor the law has recognised a degree of overlapping responsibility. if depreciation on the fixed assets of the branch has not been charged in the branch accounts. he and not the branch auditor will be responsible for the omission. about the achievability of work performed by the branch auditor. However. He is in substance in overall supervision as the company’s auditor and. he will not retain the branch auditor’s qualification in his report. The Auditing and Assurance Standards Board of the Institute of Chartered Accountants of India in their Auditing and Assurance Standard entitled “Using The Work of Another Auditor” (AAS 10) has reviewed the relationship between the statutory auditor and the branch auditor and has come to a conclusion that the statutory auditors would not be responsible for work entrusted to branch auditors except in circumstances which should have aroused his suspicion. made in the branch audit report if he considers the same relevant in making the consolidated accounts true and fair. no doubt the branch accounts will not show a true and fair view and it will be quite legitimate for the branch auditor to qualify his report on that point. It should be understood that this discretion allowed to the company auditor is highly sensible. 1956”. Since the company auditor is to report upon the combined accounts of the main office and the branches. may incorporate the points. it is he who can judge the requirements of true and fair in an overall context. For example. But if the company auditor can satisfy himself that such charge of depreciation has been in fact made in the head office books. having regard to materiality. in that capacity. It should also be understood that discretion is simultaneously a very big responsibility on the company auditor. without sufficient consideration. If he omits any of the qualifications appearing in the branch audit report. The statutory auditor would normally be entitled to rely upon the work of the branch auditor . if the branch audit report contains a qualification about non-disclosure of loans granted by the branch to a firm of which a partner is the subsidiary of the company. if the branch audit report contains qualifications on matters specially required to be disclosed in the company accounts. the auditor has to include it in his report unless he has reasons to doubt the veracity of the branch audit report itself.6. at his discretion may drop any or all the qualifications made in the branch audit report. holds the view that the company’s auditor has a certain measure of responsibility in respect of the accounts and papers of the branch. in this context. pursuant to the Schedule VI requirements. accounting principles and the requirements of disclosure.

The statutory auditor is not required to evaluate the professional competence or independence of the branch auditor. the number of branches / divisions audited by other auditors. Similarly.. in relation to the financial statements of the entity on which the principal auditor is reporting. The branch auditor. etc. When the principal auditor has to base his opinion on the financial statements of the entity as a whole relying upon the statements and reports of the other auditors. adhering to the time table for audit of the branches.The Company Audit 6. Joint Audit 6. For this purpose. There should be sufficient liaison between the principal auditor and the branch auditor. the principal auditor should consider whether the subject of the qualification is of such nature and significance. The principal auditor would not be responsible in respect of the work entrusted to the branch auditors. With a view to providing a clear idea of the professional . knowing the context in which his work is to be used by the principal auditor. Where the statutory auditor’s report is other than unqualified. the principal auditor should also document how he has dealt with the qualifications or adverse remarks contained in the branch auditor’s report in framing his own report. the principal auditor should advise the other auditor of any matters that come to his attention that he thinks may have an important bearing on the branch auditor’s work. the statutory auditor should ordinarily advise the branch auditor of the use that is to be made of his work and report. He should ensure compliance with the relevant statutory requirements. When using the work of the branch auditor.7 The practice of appointing Chartered Accountants as joint auditors is quite widespread in big companies and corporations. e. He should advise the branch auditor of the significant accounting. his report should state clearly the division of responsibility for the financial statements of the entity by indicating the extent to which the financial statements of branches audited by the other auditors have been included in the financial statements of the entity. by bringing to the principal auditor’s immediate attention any significant findings requiring to be dealt with at entity level. He should make sufficient arrangements for the coordination of their efforts at the planning stage of his audit. that it requires a qualification in his report. 31 unless there are special circumstances to make it essential for him to visit the branch and / or to examine the books of account and other records of the said branch. If the branch auditor qualifies his report. except in situations which create doubt about the professional competence or independence of the other auditor.g. should cooperate with him and assist him actively. auditing and reporting requirements and obtain representation as to compliance with them. except in circumstances which should have aroused his suspicion about the reliability of the work performed by the branch auditors. Ascertain from the other auditor any limitation on the scope of his work imposed by the terms of engagement. The statutory auditor should also consider the significant audit findings of the other auditor. for example. the principal auditor may find it necessary to issue a written communication to the branch auditor.

divide the audit work among themselves. they should.In respect of audit work divided among the joint auditors. April.Where.6. On the other hand. or application of judgement by. by mutual discussion. timing or extent of the audit procedures agreed upon among them. Certain areas of work. owing to their importance or owing to the nature of the work involved. In some cases. (c) in respect of matters which are brought to the notice of the joint auditors by any one of them and on which there is an agreement among the joint auditors. It may. .Where joint auditors are appointed. other joint auditors. each joint auditor is responsible only for the work allocated to him. Coordination . he should communicate the same to all the other joint auditors in writing.f.e. would often not be divided and would be covered by all the joint auditors. all the joint auditors are jointly and severally responsible: (a) in respect of the audit work which is not divided among the joint auditors and is carried out by all of them. Relationship among joint auditors . timing or extent of the audit procedures to be performed by any of the joint auditors. due to the nature of the business of the entity under audit. The division of work among joint auditors as well as the areas of work to be covered by all of them should be adequately documented and preferably communicated to the entity. proper execution of these audit procedures is the separate and specific responsibility of the joint auditor concerned. (b) in respect of decisions taken by all the joint auditors concerning the nature. whether or not he has prepared as separate report on the work performed by him. in the course of his work. however. a joint auditor comes across matters which are relevant to the areas of responsibility of other joint auditors and which deserve their attention. the division of work may be with reference to items of assets or liabilities or income or expenditure or with reference to periods of time. The division of work would usually be in terms of audit of identifiable units or specified areas.32 Advanced Auditing and Professional Ethics responsibility undertaken by the joint auditors. (d) for examining that the financial statements of the entity comply with the disclosure requirements of the relevant statute. 1996. In such situations. such a division of work may not be possible. and (e) for ensuring that the audit report complies with the requirements of the relevant statute. Basic principles laid down in AAS 12 are discussed in following paragraphs: Division of Work . the Institute of Chartered Accountants of India had issued a statement on the Responsibility of Joint Auditors which now stands withdrawn with the issuance of AAS 12 on “Responsibility of Joint Auditors” w. be clarified that all the joint auditors are responsible only in respect of the appropriateness of the decisions concerning the nature. Thus should be done by the submission of a report or note prior to the finalisation of the audit. or which require disclosure or require discussion with.

In the case of audit of a large entity with several branches. timing and extent of audit procedures to be applied in relation to the area of work allocated to him. . they may agree among themselves as regards the division of work relating to the review of such branch returns. In cases where specific responsibility of each joint auditor to obtain appropriate information and explanations from the management in respect of such divisions/zones/units and to evaluate the information and explanations so obtained by him. It is not necessary for a joint auditor to review the work performed by other joint auditors or perform any tests in order to ascertain whether the work has actually been performed in such a manner. In such cases. the other joint auditors are entitled to proceed on the basis that such financial statements comply with all the legal and professional requirements regarding the disclosures to be made and present a true and fair view of the state of affairs and of the working results of the division/branch concerned. it is the separate and specific responsibility of each joint auditor to study and evaluate the prevailing system of internal control relating to the work allocated to him. timing and extent of the enquiries to be made in the course of audit as well as the other audit procedures to be applied are solely the responsibility of each joint auditor. subject to such observations as may be communicated by the joint auditor concerned. Subject to paragraph (b) above. In respect of the branches which do not fall within any divisions or zones which are separately assigned to the various joint auditors. The issues such as appropriateness of using test checks or sampling should be decided by each joint auditor in relation to his own area of work. 33 If any matters of the nature referred above are brought to the attention of the entity or other joint auditors by an auditor after the audit report has been submitted. This responsibility is not shared by the other joint auditors. A significant part of the audit work involves obtaining and evaluating information and explanations from the management. Where separate financial statements of a division/branch are audited by one of the joint auditors. the nature.The Company Audit 6. This responsibility is shared by all the joint auditors unless they agree upon a specific pattern of distribution of this responsibility. the branch audit reports/returns may be required to be scrutinised by different joint auditors in accordance with the allocation of work. it is the specific and separate responsibility of each joint auditor to review the audit reports/returns of the divisions/branches allocated to him and to ensure that they are properly incorporated into the accounts of the entity. including those required to be audited by branch auditors. it is the responsibility of each joint auditor to determine the nature. Each joint auditor is entitled to assume that the other joint auditors have carried out their part of the audit work in accordance with the generally accepted audit procedures. Similarly. the other joint auditors would not be responsible for those matters. Each joint auditor is entitled to rely upon the other joint auditors for bringing to his notice accounting principles or any material error noticed in the course of the audit. It is also the separate and specific responsibility of each joint auditor to exercise his judgement with regard to the necessity of visiting such divisions/branches in respect of which the work is allocated to him. Thus.

dated 27-8-1976 as corrected by Circular No. the independence of an auditor is likely to be jeopardised. Part XI. made in auditor’s report . qualifications made in auditor’s report and give their explanations to the said remarks in terms of Section 217(3) . the joint auditors are able to arrive at an agreed report. where the joint auditors are in disagreement with regard to any matters to be covered by the report. Need for appointment of independent auditors . 1956 . dated 8-4-1977. May. Statutory auditor cannot undertake work of writing books of account .34 Advanced Auditing and Professional Ethics Reporting Responsibilities .Year ended 31st March. Statutory auditor cannot be internal auditor .6. Retiring auditor can be deemed to be reappointed or automatically appointed at annual general meeting. Such practice deserves to be discouraged Source: Extract from Seventh Annual Report on Working and administration of Companies Act. For the purpose of computation of the number of company audits held by an auditor pursuant to the ceiling rule introduced in the Companies Act.Source: The Chartered Accountant. dated 16-81978. As such a statutory auditor of a company cannot also be its internal auditor .. XII. However. 5/[77(1)/1/76-CL. it will not be possible for him to give an independent and objective report under-Section 227.Source: Circular No. the board has to meet once again to consider the reservations.Where due to near relationship of an auditor with managing or a whole-time director. Vol. 1963.The acceptance of the book-keeping work by the statutory auditor is likely to place the statutory auditor in a rather vulnerable position in the matter of free expression of his professional opinion as an auditor on the annual accounts of the company. 1956 each joint auditorship in a company will be counted as one unit. 29/76(1)/[76-CL-V]. etc. and acting in the best traditions of the profession. qualification. 1964 issue.If the statutory auditor of the company is also the internal auditor.V].It is not correct to say that in the absence of the resolution to the . he shall use his good sense.8 A gist of some important circulars issued from time to time by the Company Law Department is given below: Another meeting to be held by directors for considering reservation. Gist of Important Circulars 6.Normally. refrain from accepting the appointment .Source: Letter No.In case the auditors’ remarks are not available to the board at the time of its consideration and authentication of the balance-sheet and profit and loss account under Section 215(3). 8/22(215)/76-CL-V. A joint auditor is not bound by the view of the majority of the joint auditors regarding matters to be covered in the report and should express his opinion in a separate report in case of a disagreement. each one of them should express his own opinion through a separate report.

The intimation for the appointment or reappointment of a person or firm as the auditor under sub-section (1C) of Section 224 does not provide for prescribing any form for furnishing the said intimation to the Registrar .Source: Letter No.9-1975. dated 24. without disclosing the identity of the signatory since the firm has no locus standi of its own in the eye of law . Central Government’s power to appoint auditors exercisable only where auditors are not appointed in annual general meeting . guarantee companies. The audit of the accounts of companies is also not to be included within the specified number of 20 as laid down under Explanation I to sub-section (1C) of Section 224 . 7/26/76-IGC. as read with sections 225. dated 22-9-1975. dated 28-9-1974. Branch audits of Indian companies and audit of Indian business accounts of foreign companies not to be included while calculating specified number of audits .Source: Circular No.The intimation in token of acceptance or refusal to accept the appointment is only a ministerial act which can be performed by a duly authorised person on behalf of the auditor’s firm. Continuation of tenure of auditor up to factual conclusion of next annual general meeting .The branch auditor of the Indian Companies appointed under section 228 audits the accounts of the particular branch only for which he is appointed and forwards his report to the auditor appointed under section 224 and. 8/12(224)/74-CL.Source: Circular No. 23B. necessary that the identity of person who signs Form No. Guarantee companies are not to be counted in reckoning specified number of audits Such companies as have no share capital.-V. 190 and 224(3) relating to the Government’s power to appoint auditors becomes attracted in the matter .e. dated 21-2-1972.Source: Clarification issued by Department of Company Affairs.It is only where an auditor is not appointed at . must be disclosed as such. Signing of Form 23B by auditors in firm’s name without disclosing identity of signatory . the tenure of an auditor appointed under section 224 will continue up to the factual conclusion of the next annual general meeting held by the company . 21/75(35/3/75-CL-III).Where no annual general meeting is held. he cannot be equated with the company’s auditors appointed under section 224. Hence. 35 effect that that retiring auditors shall not be reappointed.Source: Letter No. Requirement of sending certificate by auditors to Registrar . 5/72. as it will not be enough if the form is signed only in the firm’s name.Source: Circular No. It is. the branch audits are not to be included while calculating the specified number of 20 audits. are to be excluded from the reckoning of ‘specified’ number of companies within the meaning of Explanation 1 to sub-sections (1B) and (1C) . dated 31-10-1977.The Company Audit 6. however. hence. the retiring auditors shall stand reappointed as auditors of the company. whether he be a partner or a clerk of the firm. Where auditors are not appointed or reappointed in accordance with the provisions of the Act including section 224(2). i. 20/75[35/3/75-CL-III].

35/13/74-CL-III. whether qualifies for appointment as auditor . dated 5-6-1976. however. the company may either: (i) adjourn the meeting to another date.The material date for the appointment or reappointment of an auditor is the date of the annual general meeting at which the special resolution is required to be passed. Interpretation of expression “other than retiring” as occurring in section 225(1) Passing of a resolution in the annual general meeting appointing another person as an auditor of the company without mentioning the words ‘instead of him is quite sufficient and valid’ under Section 224(2)(c) and similarly a special notice proposing to move a resolution to appoint a new person as an auditor of the company without mentioning the words ‘in place of retiring auditor’ is sufficient compliance under section 225(l) . In the event of the company adopting the procedure at (ii) above. Proprietary firm.Source: Circular No. In exceptional cases.36 Advanced Auditing and Professional Ethics an annual general meeting that the Central Government can exercise the powers under section 224(3) .Source: Circular No. articles of association of companies provide for closure of the register of members before general meeting during period not exceeding thirty days at any one time. and later issue the required notice in accordance with the law and thereafter pass the special resolution required to be passed under section 224A.7-1976. dated 18-11-1969. Moreover.V). since generally.Source: Letter No.6.A company must appoint the proprietor of the proprietary firm by his name in his individual capacity as its . between the date of issue of notice of the general meeting and the actual passing of this resolution regarding appointment of auditor. or (ii) omit or pass over the item on the agenda regarding appointment of auditor. where a change in the shareholding pattern in the company has taken place. dated 17-10-1981. Material date for appointment or reappointment of auditor is date of annual general meeting at which special resolution is required to be passed . 2/76(1/176-CL-V).The effect of nonforwarding of notice under Section 225(2) to the retiring auditors will make the resolution for appointing or removing auditors illegal and ineffective . 35/6/68-CL-III.CL-III). dated 21-11-1974. 22/76(35/4/76 . Service of copy of special notice to retiring auditors to be effected by registered postThe copy of the special notice under Section 225(2) should be sent to the retiring auditors by the registered AD post-Source: Circular No. 2/81(1/1/81-CL. and 8/20(225)/81-CL(V). dated 26. the situation would be then covered by sub-section (2) of section 224A-Source: Circular No. it is unlikely that the position regard shareholding in the company will be different between the date of issue of notice and date of the general meeting. Consequence of non-forwarding of notice to retiring auditors .

V.Source: Letter No.Source: Extract from Minutes of Meeting of Bombay Chambers’ Company Law Sub-Committee with Secretary. including that for appointment of branch auditor . dated 20-3-1957.The auditors will not be fulfilling their duties if they have given clean certificate on the company accounts audited by them without looking into matters which were clearly relevant to a ‘true and fair’ view of the affairs of the companies concerned. 8/46(1)/61 -PR. much less to draw company’s attention to inadequate depreciation. Department of Company Law Administration. dated 11-7-1957.The company’s auditor need refer in his report to the branch audit only when the branch accounts are audited by a person other than himself . Instances of lapses on part of auditors .Source: Circular Letter No. Where such service is rendered professionally and not as an officer or employee of the company’ a chartered accountant is not disqualified under section 226(3)(b) . held on 2-6-1961. 8/13(215)/65-CL.The term ‘auditor’ mentioned in section 225 means statutory auditor. to improper allocation of reserves.or over-valuation of current assets like stock-in-trade. but here again it is a matter for the auditors to decide . he is not disqualified under section 226(3)(b) .Source: Letter No. Branch audit can be conducted at head office without visiting branches .The Company Law Board does not consider that there is any contravention of section 215 in a case where the audit of the final accounts is completed before the approval of the balance sheet by the board of directors of the company . in all cases. shall be regarded . 8/16(1)/61-PR. dated 29-9-1996. 37 auditor and the auditor’s report will have to be signed by the proprietor himself in his own name . 8/1/57-PR.A chartered accountant’s main business is to render professional service for reward like a lawyer or a doctor. dated 9-5-1961. etc. Followance of procedure of section 225 for appointment of branch auditor . for the purpose of carrying out an audit. Source: Extract from Third Annual Report on Working and Administration of Companies Act. Section 215 not contravened where audit of final accounts is completed before approval of balance sheet by board of directors of company . Place of manufacture can be deemed to be branch office for purposes of carrying out audit . Statutory auditor is to refer to branch audit only when branch accounts are audited by a person other than himself . 1956 Year ended 31-3-1959.Source: Letter No. It would not be a proper discharge of their responsibilities of auditors were not to disclose the infringements of the provisions of the Companies Act or those of the other important laws. It would be preferable if companies followed the procedure laid down in section 225. to improper classification of debts and loans.Source: Circular No.The Company Audit 6. 8/1229/56-PR.For the auditor of the branch accounts there is no compulsion to visit branches. dated 9-5-1961. Where chartered accountant renders services professionally and not as an officer company. to under.The place of manufacture.

Source: Letter No. the cost audit report shall be signed by any one of the partners of the firm responsible for the conduct of cost audit in his own hand. However.Source: Letter No. which has been approved for appointment as cost .Source: Letter No. The revised guiding principles on which applications of banking companies for exemption from branch audit be dealt with. were formulated keeping in view the fact that the accounts of the branches of banking companies are generally inspected regularly by their trained inspectors.Source: Extract from Sixth Annual Report on Working and Administration of Companies Act. dated 27-4-1961. 1961.The partner concerned shall invariably sign in his own hand for and on behalf of the firm appointed to audit a company’s accounts.38 Advanced Auditing and Professional Ethics as a branch office and should be audited as such under Section 228 unless it is exempted from audit under the Companies (Branch Audit Exemption) Rules. 1956 .V). 8/16(1)/1. are namely. dated 29. 1962. Interpretation of definition of “accounts” as occurring in Section 228 (3)(c) . and the further.There can be no administrative objections to a copy of the branch audit report being sent to the board of directors simultaneously with the direct transmission of the original branch audit report to the statutory auditor . As regards any accounts or other papers relating to this branch office kept at the head office. No. 14/12/72.fact that many banks have a large number of branch offices spread throughout the country .The ‘accounts’ maintained in the branch office would necessarily depend largely on type of businesses carried on in branch.7-1972. 1956 . Appointment of cost auditors in firm’s name . I0(1)-CL-VI/61.Year ended 31st March. 8/16(1)/61-PR.There is no inconsistency between the provisions of the Chartered Accountants Act and section 233A whereby the Central Government has been empowered to appoint a chartered accountant who is not in practice for the special audit of a company . Signing of auditors’ report in firm’s name . dated 9-5-1961. 1961. the auditors should certify that (a) proper books of account have been kept a branch. and (b) that the accounts or returns of the branch show a true and fair view of working of the branch . it is for the concerned auditor to decide about the procedure he should follow .Source: Extract from Fifth Annual Report on Working and Administration of Companies Act.6.Year ended 31st March. dated 9-5-1961. 26/72 (F. and this is what is required by the provisions of the Act .Whether cost audit report could be signed by merely affixing firm’s name .In cases where a firm of cost auditors is approved for appointment under sub-section (2) of section 233B. two requirements. for and on behalf of the firm.Source: Circular No. Copy of branch audit report could be sent to the board of directors simultaneously with transmission of original branch audit report to statutory auditor .CL. in addition to the other requirements of Section 227 that might be applicable to any particular branch that have to be complied with. Appointment of a chartered accountant who is not in practice .

Any request that certain details may not be disclosed in the report (on any ground whatsoever) should be inconsistent with the object and purpose of the Cost Audit Report Rules and the requirements there under. where noncompliance with the provisions of the Companies Act. A brief list of some of the important sections of the Companies Act. 1956. The Companies Act.The duties of the cost accountants appointed to conduct an audit of cost accounts of the company flow directly from the above provisions and as such they should in strict compliance therewith ensure that full and complete details in respect of the accounts of the company are furnished in their reports. Generally speaking.Source: Circular No. Whether appointment of cost auditor as internal auditor permissible . 1956 lays down detailed provisions regarding various matters and casts an obligation upon directors and officers of the company to carry out the requirements of the law. However. dated 20-1-1983.9 One of the fundamental duties of the auditor is to verify that the statements of account are properly drawn up and they disclose all the required information. it is the duty of the directors and the management to ensure that the provisions of the Companies Act. dated 18-3-1983. dated 24-8-1984. bring such instances to the notices of Government by a specific note in their reports . 1/83.Source: Circular No. the auditor would in the normal course of his inquiry become aware of the breaches of the Act and may have an obligation to bring this to the attention of the shareholders. In the process. 1956 has a bearing upon the accounts and transactions of the company. Nevertheless. 1956 is the responsibility of the directors and officers of the company. 52/409/60-CLB.Source: Letter No.The Company Audit 6. The cost auditors should. the report should not be signed by merely affixing the firm’s name . where noncompliance results in affecting the accounts materially. 3/83. Compliance with Relevant Provisions of the Companies Act. Whether cost auditor is under legal obligation to make disclosure of full details in his cost audit report . 1956 have been complied with. 39 auditors of the company. He can properly discharge such onerous duty only if he is aware of the duties of the management prescribed by the Companies Act. 1956 is given below: . In any case. Since the auditor is not associated with day-to-day management of the company. 1956. if necessary. he must also ascertain that the company has not violated any of the provisions contained in the Companies Act. 1956 6. the auditor must make a report to the shareholders.The cost auditor should not be the internal auditor of a company for the period for which he is conducting the cost audit . compliance with the relevant provisions of the Companies Act.

10FB-10FP Contribution of National Company Law Tribunal. by special resolution. 75. 76. This Section deals with the return of allotment. . This Section prohibits any allotment of shares unless the minimum subscription stated in the prospectus has been received in cash. 60A. Alteration of Articles of Association of a company. This Section described the circumstances under which a private company would become a public company under the Act. 43A. Initial offer of securities to be in dematerialised form in certain cases. This Section requires that the investments of a company are held in its own name. 10FQ-10GF Appellate Tribunal. 73. Civil liabilities for misstatements in prospectus. Effect of irregular allotment. Explains the meaning of Holding Company and Subsidiary Company. Concept of information memorandum and red herring prospectus introduced. It also provides that all monies received from applicants for shares shall be kept deposited in a scheduled bank for the period specified in sub-section (4). 2000. 71. Dissolution of Company Law Board.40 Advanced Auditing and Professional Ethics Section 4. 68B. This Section deals with allotment of shares and debentures to be dealt in on a recognised stock exchange. 58AA.6. Small Depositors. This Section read with Rules framed thereunder regulates acceptance and renewal of deposits by certain classes of companies. 60B. Attention is invited to sub-section (4A) which prohibits the payment of commission in certain circumstances. 31. 13. This Section prescribes requirements with respect to the Memorandum of Association. except as otherwise permitted by it and the auditor should see that its provisions have been complied with. Concept of Shelf Prospectus. 62. 63. 10FA. 49. This section has been amended by Companies (Amendment) Act. 58A. 69. Criminal liabilities for misstatements in the prospectus. This Section deals with underwriting commission and brokerage.

109. Transfer by a legal representative. 86. This Section provides for the increase in share capital under orders of the Central Government relating to conversion of debentures or loans into share capital. 80. 41 This Section prohibits a company from purchasing its own shares or giving a loan or guarantee in order to facilitate the purchase of its shares except under certain circumstances and it should be seen that no loans are made in contravention of its provisions. 94A.77AA & 77B. 108. This Section deals with the application of securities premium amounts received. Deals with the alteration of share capital. 81. If a company has made an issue of shares at a discount it should be seen that the provisions of this Section have been complied with. Nomination of shares/Transmission of shares. It should be seen that these provisions are complied with. 93. 79A. 80A. 100 & 102. Redemption of irredeemable preference shares. Deals with the payment of dividend in proportion to the amount paid up under certain circumstances. This Section deals with the terms and conditions on which redeemable preference shares may be issued. 109 A & 109 B. . Where any shares are issued by a company. 94. 77A. it should be seen that the provisions of Section 81 have been complied with New issues of share capital to be only of two kinds: The concept of equity share capital with differential voting rights introduced. These Sections deal with the reduction of share capital under a court’s order. 79. This Section deals with Issue of sweat equity shares by a company. Transfer not to be registered except on production of instrument of transfer. 78.The Company Audit 77. These Sections deals with buy back of shares by the company. 6. This Section gives the existing equity shareholders of a public company the right to be offered any shares subsequently issued subject to certain limitations and conditions.

204. This Section provides that the commission or other remuneration payable to any officer or employee of the company (other than a director. Establishment of Investor Education and Protection Fund. Company’s Register of charges. This Section deals with overall managerial remuneration and minimum remuneration to managerial personnel. 208. This Section deals with restrictions on appointment of a firm or body corporate to an office or place of profit under a company for a term exceeding five years at a time.42 Advanced Auditing and Professional Ethics Creation of Debenture Trust Deed. Company not to appoint more or employ certain different categories of managerial personnel at the same time. . 165. 143. 350 & 351. This Section prohibits payment by a company to its officers and employees remuneration free of tax calculated with reference to the tax payable by the employee. If a company has paid interest on its share capital it should be ascertained that the provisions of this Section have been complied with. This Section deals with payment of dividends only out of profits after providing for depreciation. This Section lays down certain restrictions on public companies in regard to commencement of business including new business.6. Appointment and duties of debenture trustees and liability of company to create security and debenture redemption reserve. 205. 205A. This Section deals with transfer of unpaid dividends to a separate Unpaid Dividend Account in a Scheduled Bank. 149. 192A. 200. Passing of resolutions by postal ballot. Rules framed under this Section regulate the utilisation of past reserves for declaration of dividends. The Section further requires compulsory transfer of profits to reserve and regulates excess transfers in accordance with the Rules. 197A. 198. or manager) if fixed at a percentage of the company’s net profits. 199. Concept of interim dividend introduced. 205C. Any breach of this section should be brought to the attention of the shareholders. 117A/117B & 117C. etc. 152A. should be calculated on the net profits as set out in Sections 349. Register and Index of beneficial owners Statutory Meeting and Statutory Report.

Before consenting to act as an auditor he should certify that the number of companies of which he is the auditor is within the limits specified in Section 224 (lB). These Sections deal with the appointment. The auditor should ascertain that the account have been properly authenticated as required by this Section before he signs the report on the accounts. 225 & 226 224A. and in particular to sub-section (2)(b). together with Schedule VI to the Act. This Section requires constitution of National Advisory Committee on Accounting Standards. 43 This Section provides for the keeping of proper books of account by a company. It deals with power and duties of an auditor. 215. . of the auditors. Board's Report to include Director's Responsibility Statement. 211. pursuant to sub-section (4A) and the Statement issued by the Institute under this order. qualification. Attention is also invited to the rules issued from time to time by the Central Government under sub-section (1)(d) of Section 209. etc. deals with the form and contents of the Balance Sheet and Profit and Loss Account. Compliance with accounting standards has been made mandatory. definition of the term “financial year” etc. Attention is invited to the Statement on Section 227(lA) issued by the Institute. 217(2AA). Attention is also invited to the orders issued by the Government titled Companies (Auditor’s Report) Order 2003. which prescribe the requirements for maintenance of cost records by certain classes of companies. 6. 222. This Section. This Section deals with annual accounts and balance sheet of a company. 210A. This Section provides that any document to be annexed or required to be annexed to company’s account shall not include Board’s report. It should be noted that the auditor is specifically required to report if proper books of account are not kept. Compliance with the accounting standards referred to in sub- 210. Section 209(3) requires keeping books on accrual basis of accounting. It includes provisions regarding the accounts to be laid before the annual general meeting of the company. 227. remuneration.The Company Audit 209. Section 224A requires appointment of auditors by a special resolution under certain circumstances. removal. 224. Attention is invited to the provisions of Section 541. The auditor is required to report to the shareholders in the terms set out in this Section. 216. This Section requires Profit and Loss Account to be annexed and Auditor’s Report to be attached to the Balance Sheet.

loans to directors etc. companies and firms in which directors are interested. 297. should be opined by the auditor. It should be seen that the provisions of the Section read with the Companies (Branch Audit Exemption) Rules 1961 have been complied with.. 309.44 Advanced Auditing and Professional Ethics section (3C) of Section 211. Clauses (e) and (f) also added to sub-section (3) of section 227. relating to Managing Directors. 296. 299 & 301. 295. 268& 269. the auditor should report the matter. This Section deals with the power of the Central Government to direct audit of cost accounts in certain cases. 310 & These Sections deal with remuneration of directors. 292A. Restriction on the Powers of a Board. National Defence Fund etc. 233B. Audit Committees. The auditor should see that the provisions of this Section have been complied with where transactions with such parties have come to his attention. the 311. This Section deals with contacts between a company and its director or his relative. political parties.6. This Section requires a special resolution of the shareholders for the appointment of a director and/or his relative to an office of profit under the .. This Section prohibits. Wherever applicable. 229. The auditor should enquire whether the company has observed the terms and conditions stipulated by the Central Government in its approval wherever applicable. 293A & 293B. 293. and Wholetime Directors. 228. This Section deals with the audit of the accounts of a company. These Sections deal with the Register of contracts. a firm in which the director or relative is a partner. This Section deals with application of Section 295 to book debts in certain cases. terms and conditions of the orders of the Central Government should be looked into. These Sections deal with appointment. 233A. This Section deals with the power of the Central Government to direct special audit in certain cases. and other persons connected with them. If any loans are given in contravention of this Section. any other partner in such a firm or a private company of which the director is a member or director. except under certain conditions. This Section deals with signing of audit report by the auditor. These Sections prescribe certain limitations in respect of donation to charitable organisations. re-appointment and variation etc. 314.

1956. This Section deals with special provisions relating to Government companies. 424A-424L Revival and Rehabilitation of Sick Industrial Companies (Second Amendment. Where prima facie the provisions of sub-section (2) are attracted.Every company under Section 143 is required to keep a Register of charges to enter therein all the charges specifically affecting the property of the company as well as the floating charges on the undertaking or on the property of the company. This Section deals with Inter-corporate loans and investments. 1956 6. and. 619B. its nature. 619. In respect of monthly remuneration exceeding specified amount approval of the Central Government is also necessary vide sub-section (1B). If any such appointment has been made. 318 & 319. 417 & 418. 45 Company. This Section deals with foreign companies. This Section deals with the terms of office of a managing director. or willfully authorises or permits the ommission of any entry required to be made in pursuance of Section 143(l). 594. Section 143(2) of the Companies Act. Auditor’s Duty Under Companies Act. 317. 372A. if so. The auditor shall enquire from the company whether the conditions are prima facie attracted. “Office or place of profit” is defined in sub-section (3). This register should be examined by the auditor to ascertain whether any of the assets belonging to the company except bearer securities. is subject to charge. These Sections make provision regarding the treatment of security deposits of employees and company’s provident fund schemes. 350. These Sections deal with compensation to directors for loss of office. This Section deals with the manner of computing the profits for the purposes of determining the remuneration of various classes of managerial personnel. lays down that if any officer of a company knowingly omits. the company should comply with the rules which may be framed under this Section. This Section deals with the accounts of foreign companies.The Company Audit 6. The particulars of each property charged that should be entered in the register are: (a) a short description of the property. Ascertainment of depreciation. (b) the amount of charge: and (c) the names of the persons entitled to exercise the charge. Companies Act) 591. This Section extends the applicability of Section 619 to non-government companies under certain circumstances. The auditor should enquire into the compliance with such of the Sections as have a bearing on his role as auditor. it should be seen that the provisions of this Section have been prima facie complied with.10 The following are the duty of an auditor under companies act 1956: (i) Register of mortgages and charges . he may be . 349.

But where under sub-sections (2). partner. referred to in Section 297(2) (c). materials or services. or the giving of such guarantee or the provision of such security. (a) contracts or arrangements for the sale or purchase or supply of goods..46 Advanced Auditing and Professional Ethics punishable with fine which may extend to five hundred rupees. in the same manner on payment of the same fees as in the case of the register of members of the company. investments have been made in the names of nominees. value and such other particulars as may be necessary to identify the shares . It contains a record of particulars of contracts or arrangements that attract the provisions of Sections 297 and 299. and transactions of banking and insurance companies in the ordinary course of business with any director. The provisions of Section 297 are not applicable to. The particulars of investment. by banking companies for the collection of bills in the ordinary course of business. The register referred to in sub-section (5) shall be kept at the registered office of the company concerned shall be open to inspection at such office and extracts may be taken therefrom and copies thereof may be required.In pursuance of sub-section (5) (a) of Section 372A. 5000.6. The names of firms and bodies corporate in which the Directors are interested. (iv) Register of investments held in the names of Nominees . every company shall keep a register showing the following particulars in respect of every investment or loan made. guarantee or security referred to in clause (a) shall be entered chronologically in the register aforesaid within seven days of the making of such investment or loan. relative. guarantee given or security provided in relation to any body corporate .This Register is maintained pursuant to sub-section (1) of Section 301. It is the duty of the auditor to examine the Register to find out whether transactions of purchase or sale of goods in which a director or directors were interested were entered into under the sanction of the Board and the directors concerned had disclosed their interest.Normally. (4) and (5) of Section 49. (3). and the provisions of Section 163 shall apply accordingly.. etc. (iii) the date on which the investment or loan has been made. etc. by any member of the company to the same extent. a company is expected to hold investments in its own name [Section 49]. namely: (i) the name of the body corporate. of which a notice has been given by the directors under sub-section 297(2)(c) are also entered in it. (ii) the amount. loan. dates of Board meetings at which contracts were approved and that of the names of directors who voted for or against the proposal. if the value or cost thereof in any year does not exceed Rs. terms and purpose of the investment or loan or security or guarantee. (iii) Register of investment or loan made. a register must be kept and the following particulars recorded therein: (a) the nature. and (iv) the date on which the guarantee has been given or security has been provided in connection with a loan. (ii) Register of contracts with companies and firms in which the directors are interested . and (b) contracts. guarantee given or security provided by it in relation to any body corporate under sub-section (1).

it is obligatory for a company to maintain a record.The Company Audit or securities.It contains a record of the particulars of shares and debentures of the company. (v) Register of directors. . payment from Provident Fund in excess of own contribution and interest thereon. This register is being maintained pursuant to the requirement under Section 307. any change in the officers or any of the particulars of an officer must be incorporated in the register and notified to the Registrar of Companies within 30 days of the change taking place. as well as those of similar securities in the capital of any other body corporate. in a register. separately. (d) Pensions. manager and secretary .Under the provisions of Section 303 of the Companies Act. managing director. consideration in connection with retirement from office. which is a subsidiary or holding company or subsidiary of the company’s holding company held by a director or which lie in trust with him or of which he has any right to become the holder whether on payment or not. The information required to be disclosed is: (a) Remuneration paid or payable for the financial year to the directors (including managing directors. or managers). (vii) Managerial Remuneration . (vi) Register of shareholding of directors and manager . compensation for loss of office. he is not expected to check the accuracy of entries in the register. Particulars of original appointment also should be notified to the Registrar within 30 days of appointment. The auditor should refer to this register to find out the names of persons who had held different offices during the year under audit to confirm that various transactions entered into by the company have been authorised by a competent person. Under sub-section (2) of the aforesaid Section. he should see that the purchase and sale of shares by the directors are properly recorded in the register. Elaborate provisions are contained under Clause (4) of Part II of Schedule VI to the Companies Act in the matter of disclosure of remuneration paid during the financial year to the group of persons commonly referred to as managerial personnel. gratuities. 6. But in the course of regular audit. (c) Any other perquisites or benefits in cash or kind (stating approximate money value where practicable). The auditor should examine the register during the course of inspection of securities. 47 (b) the name of the person or the bank in whose name or custody the shares or securities are standing. of the names and addresses and that of other particulars relevant for the administration of the Act in respect of all the officers aforementioned. (b) Other allowances or commission including guarantee commission (details are to be given). Where the auditor carries out a share transfer audit.Disclosure in the accounts is made.

372A (1) No company shall. also such moneys or securities must not be used for any purpose except for purpose is agreed to in the contract of service.All payments to directors by way of remuneration or perquisites whether in the case of a public or private company are required to be authorised both in accordance with the provisions of the Companies Act and Articles of Association of the company. If the terms of appointment of a director include payment of expenses of personal nature then such expenses can be incurred by the company.6. sanction of the Government is also necessary. 1882 The term contribution referred to above means contribution both by the employee and the employer. (ix) Employees’ Provident Fund (Section 418) . directly or indirectly: (a) make any loan to any other body corporate. or in the State Bank of India within 15 days of receipt. (b) give any guarantee.48 Advanced Auditing and Professional Ethics A note showing the computation of net profits in accordance with Section 349 of the Act with relevant details of calculation of the commission payable by way of such profits the directors (including managing directors or managers) should be given. the contract with the director or the conditions of employment does not contain any provision for payment of expenses of a personal nature. Where.All moneys or securities deposited by the employees of a company in pursuance to their contract of service must be kept deposited by the company with a Scheduled Bank or in Post Office Saving Bank Account. (x) Inter-Corporate Loans and Investments (Section 372A) . it may require only approval of the Directors. In the case of public companies and private companies which are subsidiaries of public companies. (viii) Employees’ Securities (Section 417) . as also in the accounts. or provide security. the remuneration may require sanction of the shareholders either by an ordinary or special resolution while. together with interest accrued thereon shall have to be deposited in a: (i) Post Office Saving Bank account.All moneys contributed to a Provident Fund constituted by a company for its employees. In some cases. or (iii) shall be invested in the securities referred to in clauses (a) to (e) of Section 20 of the Indian Trusts Act. depending upon the provisions contained in the Articles. then there is no warrant for incurring or reimbursement of such expenses by the company and if such expenses are paid the auditor should disclose the fact in his report. or (ii) Special Account to be opened in the State Bank of India or a Scheduled Bank. Attention in this regard is invited to Section 227(IA)(e) of the Companies Act. however. The deposit is to be made within 45 days of the date of the contribution or of the receipt of or accrual of the interest. in other cases. Personal expenses of directors . in connection with a loan made by any other .

loan. purchase or otherwise the securities of any other body corporate. exceeding sixty per cent. along with the investment. without being previously authorised by a special resolution. 49 (c) acquire. where any term loan is subsisting. the amounts for which guarantee or security so far provided to or in all other bodies corporate. (a) a resolution is passed in the meeting of the Board authorising to give guarantee in accordance with the provisions of this section. the purpose of the investment. the amounts for which guarantee or security so far provided to or in all other bodies corporate. by way of subscription. guarantee or security proposed to be made or given by the Board. specified in sub-section (1). in a general meeting of the company or the annual general meeting held immediately after passing of the Board resolution. (3) No loan to any body corporate shall be made at a rate of interest lower than the prevailing bank rate. if there is no default in repayment of loan instalments or payment of interest thereon as per the terms and conditions of such loan to the public financial institution. is obtained: Provided that prior approval of a public financial institution shall not be required where the aggregate of the loans and investments so far made. any body corporate. (b) there exists exceptional circumstances which prevent the company from obtaining previous authorisation by a special resolution passed in a general meeting for giving a guarantee. or to any other person by.The Company Audit person to. the particulars of the body corporate in which the investment is proposed to be made or loan or security or guarantee to be given. or hundred per cent of its free reserves. (2) No loan or investment shall be made or guarantee or security given by the company unless the resolution sanctioning it is passed at a meeting of the Board with the consent of all the directors present at the meeting and the prior approval of the public financial institution referred to in Section 4A. specific sources of funding and such other details. loan or security or guarantee. and (c) the resolution of the Board under clause (a) is confirmed within twelve months. no investment or loan shall be made or guarantee shall be given or security shall be provided unless previously authorised by a special resolution passed in a general meeting: Provided further that the Board may give guarantee. exceeds the aforesaid limits. whichever is more: Provided that where the aggregate of the loans and investments so far made. if. and 6. guarantee or security proposed to be made or given does not exceed the limit of sixty per cent. along with the investments. loans. being the standard rate made public under Section 49 of the . of its paid-up share capital and free reserves. whichever is earlier: Provided also that the notice of such resolution shall indicate clearly the specific limits.

directly or indirectly: (a) make any loan to any body corporate. or a company established with the object of financing industrial enterprises. (5) (a) Every company shall keep a register showing the following particulars in respect of every investment or loan made. the amount. or to any other person by. any guarantee given or any security provided or any investment made by. terms and purpose of the investment or loan or security or guarantee. (b) give any guarantee. till such default is subsisting. or a housing finance company in the ordinary course of its business.50 Advanced Auditing and Professional Ethics Reserve Bank of India Act. (6) The register referred to in sub-section (5) shall be kept at the registered office of the company concerned and (a) shall be open to inspection at such office. stock. and (b) extracts may be taken therefrom and copies thereof may be required. shall. namely : (i) (ii) the name of the body corporate. (i) a banking company or an insurance company. and on payment of the same fees as in the case of the register of members of the company. purchase or otherwise the securities of any other body corporate. (iii) the date on which the investment or loan has been made. in connection with a loan made by any other person to. . (ii) a company whose principle business is the acquisition of shares. (8) Nothing contained in this section shall apply (a) to any loan made. 1934. and (iv) the date on which the guarantee has been given or security has been provided in connection with a loan. or provide security. debentures or other securities. any body corporate.6. which has defaulted in complying with the provision of Section 58A. guarantee given or security provided by it in relation to any body corporate under sub-section (1). loan. (7) The Central Government may prescribe guidelines for the purposes of this section. or of providing infrastructural facilities. (b) The particulars of investment. (4) No company. guarantee or security referred to in clause (a) shall be entered chronologically in the register aforesaid within seven days of the making of such investment or loan. by way of subscription. or the giving of such guarantee or the provision of such security. and (c) acquire. in the same manner. and the provisions of Section 163 shall apply accordingly. by any member of the company to the same extent.

by way of subscription. Final Accounts Preparation and Presentation 6. (9) If default is made in complying with the provisions of this section. 51 (b) to investment made in shares allotted in pursuance of clause (a) of sub-section (1) of Section 81.The Company Audit (iii) a private company. Explanation: For the purposes of this section. jointly and severally. 6. however. other than sub -section (5). (a) “loan” includes debentures or any deposit of money made by one company with another company. are not applicable to an insurance or banking company or a company engaged in the generation or supply of electricity or to any other class of companies for which a form of balance sheet and profit and loss account has been specified in or under the Act governing such class of .11 Statutory Requirements .Section 211 governs the form and contents of the Balance Sheet and the Profit and Loss Account. or provided by the company. not being a banking company. (10) If default is made in complying with the provisions of sub-section (5). the maximum punishment which may be imposed under this sub-section by way of imprisonment shall be appropriately reduced: Provided further that all persons who are knowingly parties to any such contravention shall be liable. (b) “free reserves” means those reserves which. or (e) to acquisition by a holding company. The provisions thereunder. the company and every officer of the company who is in default shall be punishable with imprisonment which may extend to two years or with fine which may extend to fifty thousand rupees: Provided that where any such loan or any loan in connection with which any such guarantee or security has been given. are free for distribution as dividend and shall include balance to the credit of the securities premium account but shall not include share application money. has been repaid in full. to the company for the repayment of the loan or for making good the same which the company may have been called upon to pay by virtue of the guarantee given or the securities provided by such company. the securities of its wholly owned subsidiary. purchases or otherwise. the company and every officer of the company who is in default shall be punishable with fine which may extend to five thousand rupees and also with a further fine which may extend to five hundred rupees for every day after the first day during which the default continuous. and where such loan has been repaid in part. (c) to any loan made by a holding company to its wholly owned subsidiary. unless it is a subsidiary of a public company. no punishment by way of imprisonment shall be imposed under this sub-section. as per latest audited balance sheet of the company. (d) to any guarantee given or any security provided by a holding company in respect of loan made to its wholly owned subsidiary.

The Central Government is authorised under sub-section (3) to exempt. while preparing the balance sheet. (3C) For the purposes of this section. The provisions that companies.6. (b) the reasons for such deviation. and that the same to be displayed in the manner required. Thus in order that the statements of account of a company may exhibit a true and fair view of the state of affairs of a company. 1999 has inserted following sub-sections in Section 211 namely: (3A) Every profit and loss account and balance sheet of the company shall comply with the accounting standards. should comply with are: (a) That every balance sheet of a company should give a true and fair view of the state of affairs of the company as at the lend of financial year and should be in the form set out in Part I of Schedule VI or as near thereto as circumstances admit or such other form as may be approved by the Central Government either generally or in any particular case. arising due to such deviation. any class of companies from compliance with any of the requirements in Schedule VI if. on the application of or with the consent of the Board of Directors of the company by order modify in relation to that company any of the requirements of the Act as to the matters to be stated in the company’s balance sheet or profit and loss account for the purpose of adopting them to the circumstances of the company. namely: (a) the deviation from the accounting standards. and (c) the financial effect. the expression “accounting standards” means the standards of accounting recommended by the Institute of Chartered Accountants of India . other than those aforementioned. and (b) That every profit and loss account of a company should give a true and fair view of the profit or loss of the company for the financial year and should comply with the requirements of Part II of Schedule VI. so far as they are applicable thereto. it is necessary: (i) (ii) that the information required by law (as specified in Schedule VI to the Act) should be disclosed. it is necessary to grant the exemption in the public interest. the following. if any. The Companies (Amendment) Act. in its opinion.52 Advanced Auditing and Professional Ethics companies. by a notification in the Official Gazette. The exemption may be granted unconditionally or subject to such conditions as may be specified in the notification. The Central Government also may. such companies shall disclose in its profit and loss account and balance sheet. due regard should be had as far as may be to the general instructions for the preparation of balance sheets under heading “Notes” at the end of the Part I. (3B) Where the profit and loss account and the balance sheet of the company do not comply with the accounting standards.

On this ground.The Company Audit 6.Now a days. The Balance Sheet of a company shall be either in horizontal form or vertical form. Schedule VI – Part I of Schedule VI contains the form in which the Balance Sheet of a company should be . Some of the advantages of final statements of account being drawn in a columnar form are as under: (i) (ii) When the final accounts are drawn up in this form. the financial position of the company can be readily comprehended by a layman. As a result. [Students are invited to see the published accounts of any big company]. is not satisfactory. The profit and loss account discloses clearly the amount of trading or non-trading profit earned during the year. by what amount. as may be prescribed by the Central Government in consultation with the National Advisory Committee on Accounting Standards established under sub-section (1) of Section 210A: Provided that the Standards of accounting specified by the Institute of Chartered Accountants of India shall be deemed to be the Accounting Standards until the Accounting Standards are prescribed by the Central Government under this sub-section.that brought forward from the previous year. (iii) The Balance Sheet discloses the amount of debt and shareholders’ equity. 1949. for it does not disclose clearly whether the value of the equity of the share holders has increased or decreased and. (iv) The form is capable of presenting together comparative figures of a number of years. known as the “T” form. constitute an Advisory Committee to be called the National Advisory Committee to be called the National Advisory Committee on Accounting Standards (hereafter in this section referred to as the “Advisory Committee”) to advise the Central Government on the formulation and laying down of accounting policies and accounting standards for adoption by companies or class of companies under this Act. Form of the Balance Sheet . 53 constituted under the Chartered Accountants Act. and the appropriations out of the total profits recommended by the Board of Directors. Constitution of National Advisory Committee on Accounting Standards . by notification in the official Gazettee. the shares in companies are held by a wide variety of persons. (v) The relationship between the various balances (ratios) can be easily worked out.The Central Government may. It further discloses the position of assets held against them segregated into fixed assets and working capital. it has been suggested that instead. if so. a majority of whom are not conversant with the principles of accounting or with the form in which the final statements of accounts are drawn up. there have been complaints from several quarters that the traditional form in which the balance sheet of a company is drawn up. the balance sheet should be drawn up in the columnar form.

‘Capital Reserve’. The former gives the form of balance sheet in traditional horizontal form while the latter introduced in late 1978. From the foregoing provision. At the end of the form. there are general instructions which should be followed in the preparation of the Balance Sheet. ‘Reserve’.54 Advanced Auditing and Professional Ethics drawn up. is in excess should be treated as a reserve and not as a provision. Where. for example. But no form has been prescribed for Profit & Loss Account.6. Significance of True and Fair 6. Part II of the Schedule contains provisions as regards information relating to items of income and expenditure which should be disclosed in the Profit & Loss Account. and states the information as regards different assets and liabilities which should be disclosed therein. . he should disclose further information. ‘Liability’ and ‘Quoted Investment’. the current position of trade investments if their market value is below cost. the auditor is of the opinion that the information disclosed does not show the correct financial position of the company. This part has again two sub-parts (IA) and (IB). It further provides that in the case of a provision of liability which. all the disclosures required by this part are made.12 The words “true and fair” are not defined in the Companies Act. 1956 except in so far as sub-section (5) of Section 211 of the Companies Act states that the balance sheet and profit and loss account of a company shall be deemed as not disclosing a true and fair view of the state of affairs of the company in case any matter which is required to be disclosed by the provisions contained in Schedule VI or by virtue of a notification issued under sub-section (3) or an order under sub-section (4) is not disclosed. The foregoing view is broadly correct in as much as. 1956 and the profit and loss account discloses all the information required by several provisions contained in part II of Schedule VI. however. Part III of the Schedule contains definitions of the expressions ‘Provision’. Part VI of the Schedule VI contains an abstract of the financial statements and general business profile of the company. provided of course. in the opinion of directors. when the balance sheet of a company is drawn up in the form prescribed in Schedule VI to the Companies Act. Companies are therefore free to adopt a form they consider suitable according to their own requirements. the statements of account disclose all material facts which must be considered for studying the profitability of the company and its financial position. provides the vertical form of the balance sheet. it could be construed that so long as the statements of accounts are drawn up in conformity with the provisions contained in Schedule VI they would be deemed to disclose a ‘true and fair’ view of the state of affairs of the company (except in case of companies governed by special Acts). This vertical form can be used by companies without the necessity of any permission.

It is imperative that there should be a clear idea about profit. it may be treated as paying a dividend out of capital which is legally not permissible unless the company is being wound up. does not dwell upon the accounting practices that should be followed in order to generate the information required to be disclosed. For all these. because of a wrong process of computation. The compliance of the practices recommended by the Accounting Standard in prime facie and predominant evidence in deciding whether the accounts represent a true and fair view. no wonder. They concentrate on basic matters. Reserves can be created only when there is profit. Despite the existence of accounting principles. judicial rulings and legal requirements controversy in these respects cannot be considered to have come to an end. determination of correct profit is obviously important and. distributable . The Companies Act.The Company Audit 6. whether to close down. reserves should be maintained. Divisible Profits. Should more profit be distributed than is permissible. some reserves can also be utilised to pay dividends. As per section 211 (3A).e. it is obligatory upon companies to comply with accounting standards laid down by the Institute of Chartered Accountants of India [Section 211(3A)]. i. Decision about the future of the business. The auditor must necessarily have regard to generally accepted accounting practices. expand or modify largely depend on the trend of profits or losses. 1956 apart from prescribing the disclosure requirements in Schedule VI and by way of notes to the Profit and Loss Account. where.13 Profit is the central theme for almost all business activities. still there is large scope of disagreement on whether capital reserves are distributable. 55 It will be important to understand here the role played by the Accounting Standards published under the authority of the Council of the Institute of Chartered Accountants of India and other authoritative publications. While discharging their attest functions. investors’ interest in a business is also dependent upon the yield that they get. it will be the duty of the members of the Institute to ensure that the Accounting Standards are implemented in the presentation of financial statements covered by their audit reports. In addition. It is clear that these standards cannot deal with all nuances of accounting practices. accepted accounting practices suggest situations.. the articles of association of companies generally contain provisions in this respect. The Institute’s Accounting Standards have therefore been formulated with a view to harmonise the diverse accounting policies and practices. even in the absence of any specific law. the management of the business would be depleting capital of the company which may have dangerous results. Apart from the specific law governing creation and maintenance of reserves in certain cases. For example. it is a matter to which accountants attach great importance. Apart from legal consequences. though professional bodies as well as law have tried to distinguish revenue reserves from capital reserves. legal provisions and judicial pronouncements in carrying out his duties. They apply only to items which are material. Dividends and Reserves 6.

within the broad framework of available guidelines. (iii) A mere rise in market value is not a profit. The book value of current assets should be based on their cost or net realisable value whichever is lower.13. It is ascertained by determining the market value on the two accounting dates of all the assets reduced by the amount of liabilities incurred. This state of affairs has given rise to much uninformed criticism of accountants and their work.56 Advanced Auditing and Professional Ethics profit. decline in its market value is a loss. 6. added to this is the difficulty an economist and an accountant differ as to computation of profit of a business. while he agrees that these should be prepared in order that proprietors may have periodical reports of the stewardship. One should be aware of the various possibilities in this regard.Profit is the increase the value of total net assets of a business over a period of time after making an allowance for any withdrawal or introduction of capital. . (iv) No profits are earned unless the product is sold and cash is received or an enforceable obligation against a debtor is created. exercise his own judgement in each case. he is conscious of the fact that a business is a continuing operation and its wheels do not cease to grind. In this regard some of the ideas which have dominated the thinking of accountants in the past are: the necessity of preserving the monetary value of the proprietary capital originally contributed. A special note in this connection should be taken for depreciation and valuation of stocks.6. profit is the margin between operating income and associated expenses as related to a given period of time. Nevertheless. the two major elements influencing the correct determination of profit or loss. he is conscious of their limitations. The increase or reduction in the net worth is the profit or loss for the intervening period.To an accountant. the unpredictable nature of the future course of events and sale as an essential step to the emergence of profit. on its exclusion the accounts may become more accurate and meaningful. These two are related to the valuation of assets of the business which directly and significantly affect the figure of profit or loss. accountants have used the word ‘profit’ for many years without assigning a definite meaning to it. but if the asset is a current asset. dividend and reserves. as is assumed for the purpose of preparing the periodical statements of account. Economist’s concept .1 Concept of profit . The auditor should. Accountant’s concept . It is on this account that he is continually striving to perfect his method to evaluate the expenditure which has not resulted in an income so that. These ideas in due course have developed into a completed fabric of generally “accepted accounting practices” which are stated below: (i) (ii) The book value of fixed assets should be assessed at their historical cost regardless of their market price. This is known as the “Increased Net Worth Theory of Profit”.Like the term “value” in Economics. So.

concept of procedure is gaining importance over the conservatism. (vii) Consistency of accounting policy adopted from year to year should be ensured as far as practicable. the charge for depreciation is made merely to amortize the original cost. The rule that profit must only be taken into account when realised by sale is again responsible for some distortion. immediately.. (vi) In general. its residual scrap. No a day. etc. etc. Less successful ones write them off over a period of years. would provide the necessary guidance. 6. value of obsolescence. There are several elements of estimation involved in its computation. provide for all losses.e. It may or may not at the end of its useful life.g. valuation of stock-in-trade.Again there is no uniformity of treatment of these items. sometimes even in the same industry their treatment at different units is not the same.The charge for depreciation is always approximate.13. Further. when the basis of valuation is altered or a wrong basis is adopted. it affects the amount of profit or loss disclosed by the Profit and Loss Account. (ii) Intangible assets . result in accumulating enough liquid resources to replace the asset on account of the increase which may have taken place in the replacement cost. known expenditure or loss even though not incurred should be provided for. patent rights. (iv) Stock-valuation . (iii) Deferred revenue expenditure and other fictitious assets . On a consideration of the aforementioned practices it would appear that if any of them are disregarded. Therefore. The different bases on which assets are valued are briefly explained below to show that the method conventionally followed for the determination of profits does not necessarily give profit which have been actually earned.Accounting theory so far has not sufficiently developed to prescribe a uniform method of valuation of intangible assets like goodwill. etc. provision for bad and doubtful debts. The likely issuance of Accounting Standard on “Intangible Assets”. the life of the asset. conservatism) is commendable: overstatement is not permissible.2 Valuation of assets . Successful companies write off their preliminary expenses or development expenses.. This is based on the dictum: anticipate no profits. e. This class of assets is thus treated differently by different industries. This is because a lot of estimation enters in determining the value of assets and liabilities: (i) Fixed assets . 57 (v) In general. the practice adopted for writing off fictitious assets such as preliminary expenses.The question of determination of profits is inextricably bound up with the valuation of assets. Its application logically to companies doing long- . underestimation of prospective revenue (i. etc.The Company Audit 6. the manner in which expenditure on research is adjusted in the accounts.There are several senses in which the words “cost” and “net realisable value” may be construed. the argument being that such initial expenditure also benefits future years. the accuracy of profits disclosed by the statements of account would be vitiated and elements of guess work and uncertainty would creep in. technical know how. Some of the significant factors which affect the determination of profit are: rate of depreciation of fixed assets.

Crabtree Thomas vs. This contention was rejected at first but was upheld by the Court of Appeal.13. arising from the business of the company. It was held that depreciation on assets calculated on the straight line. The salary was cumulative. Spanish Prospecting Co.6. Dividend to be paid only out of profits (1) No dividend shall be declared or paid by a company for any financial year except out of the profits of company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2) or out of the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with those provisions and remaining undistributed or out of both or out of moneys provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government. 1988.3 Depreciation under Section 205 of the Companies Act. The company dealt in shares and securities. This case establishes the fundamental nature of profit (impliedly the economist’s profit). but the income tax payable by the company was not to be deducted. Crabtree (1912). reads as under: “Section 205. Ltd. a director of the company was to be paid by way of remuneration 20% of the profit “available” for distribution each year.58 Advanced Auditing and Professional Ethics term construction contracts may involve a great fluctuation in profits from year to year. as amended by the Companies (Amendment) Act. In Re. Any arrears were to be payable out of future profits. 6. But it was ruled out on the ground that depreciation must be charged on the assets of a business to arrive at the amount of profit. AS-2 issued by the Institute deals with uniform approach and practice as regards valuation and presentation of inventories. Judicial rulings on ascertainment of profits . Ltd. to a residuary legatee. The said section.Section 205 prohibits a company from declaring dividend out of its profits before providing for depreciation in the manner laid down in the section. 20% whereof was payable to the director. Saunton Hotel Co. The trustee charged in the accounts depreciation on machinery. 1956 . Edwards vs. method must be deducted from the surplus to arrive at the amount of profit. the testator left his business to be carried on by trustees and to pay thereof to his wife while she lived and on her death. The company went into liquidation and some of the securities held were sold by the liquidator. the company had contracted to pay a certain salary to some of its staff subject to the condition that they shall not be entitled to draw their salary “except only out of profits” if any. Provided that: (a) if the company has not provided for depreciation for any previous financial year or years which falls or fall after the commencement of the Companies (Amendment) . It was contended on behalf of the life tenant that the profits before charging depreciation were paid to her. (1942). (1911). It was contended that the proceeds should be credited to the Profit and Loss Account (their book value was nil) in order to enable the staff to receive their arrears to salary.The fact of the three cases given below should be studied carefully: In Re.

(1C) The provisions contained in sections 205. 1960. if it thinks necessary to do so in the public interest. (1B) The amount of dividend including interim dividend so deposited under sub-section (1A) shall be used for payment of interim dividend. 1960 it will. 205C. (b) if the company has incurred any loss in any previous financial year or years. or (b) in respect of each item of depreciable asset. arrived at in both cases after providing for depreciation in accordance with the provisions of sub-section (2) or against both. allow any company to declare or pay dividend for any financial year out of the profits of the company for that year or any previous financial year or years without providing for depreciation: Provided further that it will not be necessary for a company to provide for depreciation as aforesaid where dividend for any financial year is declared or paid out of the profits of any previous financial year or years which falls or fall before the commencement of the Companies (Amendment) Act. (2) For the purpose of sub-section (1). before declaring or paying dividend for any financial year provide for such depreciation out of the profits of that financial year or out of the profits of any other previous financial year or years. the amount of the loss or an amount which is equal to the amount provided for depreciation for that year or those years whichever is less. then. for such an amount as is arrived at by dividing ninety five per cent of the original cost thereof to the company by the specified period in respect of such asset. 206. also apply to any interim dividend. shall be set off against the profits of the company for the year for which dividend is proposed to be declared or paid or against the profits of the company for any previous financial year or years. or (c) on any other basis approved by the Central Government which has the effect of writing off by way of depreciation ninety five per cent of the original cost to the company of each such depreciable asset on the expiry of the specified period. 205A. (c) the Central Government may. or (d) as regards any other depreciable asset for which no rate of depreciation has been laid down by this Act or any rules made thereunder. (1A) The Board of directors may declare interim dividend and the amount of dividend including interim dividend shall be deposited in a separate bank account within five days from the date of declaration of such dividend. as far as may be. 59 Act. 206A and 207 shall. depreciation shall be provided either: (a) to the extent specified in Section 350. 1960.The Company Audit 6. or such basis as may be approved by the Central Government by any general order published in the Official Gazette or by any special order in any particular case: . which falls or fall after the commencement of the Companies (Amendment) Act.

so long as such failure continues. discarded. not exceeding ten per cent. in the event of the depreciable asset being sold. discarded. then. no dividend shall be declared or paid by a company for any financial year out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2). (2A) Notwithstanding anything contained in sub-section (1). (3) No dividend shall be payable except in cash: Provided that nothing in this sub-section shall be deemed to prohibit the capitalization or profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount. or in the case of joint shareholders to the registered address of that one of the joint shareholders which is first named on the register of members. demolished or destroyed. for the time being unpaid. on any shares held by the members of the company.The amount of depreciation to be deducted in pursuance of clause (k) of sub-section (4) of Section 349 shall be the amount of depreciation assets as shown by the books of the company at the end of the financial year expiring at the commencement of this Act or immediately thereafter and at the end of each subsequent financial year at the rate specified in Schedule XIV. declare any dividend on its equity shares. Ascertainment of depreciation Section 350 . (b) any dividend payable in cash may be paid by cheque or warrant sent through the post directed to the registered address of the shareholder entitled to the payment of the dividend. shall be written off in accordance with the provision to Section 350. as may be prescribed: Provided that nothing in this sub-section shall be deemed to prohibit the voluntary transfer by a company of a higher percentage of its profits to reserves in accordance with such rules as may be made by the Central Government in this behalf. (4) Nothing in this section shall be deemed to affect in any manner the operation of section 208. (2B) A company which fails to comply with the provisions of Section 80A shall not. demolished or destroyed the written down values thereof at the end of the financial year in which the asset is sold. or to such person and to such address as the shareholders or the joint shareholders may in writing direct. except after the transfer to the reserves of the company of such percentage of its profits for that year. 1974. .6. (5) For the purposes of this section: (a) “specified period” in respect of any depreciable asset shall mean the number of years at the end of which at least ninety-five per cent of the original cost of that asset to the company will have been provided for by way of depreciation if depreciation were to be calculated in accordance with the provisions of section 350.60 Advanced Auditing and Professional Ethics Provided that where depreciation is provided for in the manner laid down in clause (b) or clause (c). on and from the commencement of the Companies (Amendment) Act.

e. as the case may be.13. demolished a destroyed for any reason before depreciation of such asset has been provided for in full. Provided that if any asset is sold. 6. Not less than 10% of the current profits. Therefore depreciation in future would be with reference to books of account and which may be on SLM basis. 13. "the amount of depreciation assets". demolished or destroyed.12. its scrap value. 1956 lays down the law relating to distribution of profits by making certain provisions under Section 205. the excess if any of the written down value of such asset over its sale proceeds or.The Companies Act.5% of the current profits. “the amount calculated with reference to the written down value of the assets" by the words.f.The Company Audit 6.5% Exceeding 12.2000 amended section 350 and deleted the words.5% but not exceeding 15% Exceeding 15% but not exceeding 20% Exceeding 20% Percentage of profit required to be transferred to reserves Nil Not less than 2. no company is permitted to declare or pay dividend for any financial year out of the profits of that year without first transferring to reserve so much percentage of profits of the year as is prescribed under the Companies (Transfer of Profits to Reserve) Rules. or (d) out of moneys provided by the Central Government or a State Government for payment of a dividend pursuant to the guarantee given by the Government. discarded.4 Law relating to dividends Sources of dividends . Not less than 5% of the current profits. shall be written off in the financial year in which the asset is sold. The percentage of profits required to be transferred to reserves have been related to the rate of dividend proposed for the year and are given hereunder: Rate of dividend Upto 10% Exceeding 10% but not exceeding 12. or (b) out of the undistributed profits or the company for any previous financial year or years arrived at after providing for depreciation in the manner aforementioned and remaining undistributed. Not less than 7. .In terms of Section 205(2A) of the Companies Act. Accordingly dividend cannot be declared or paid by a company for any financial year except: (a) out of profits of the company for the year arrived at after providing for depreciation in accordance with the provisions of Section 205(2). 61 The Companies (Amendment) Act. or (c) out of the balances of profit mentioned in (a) and (b) above. 2000 w. Dividends out of current profits -Transfer to reserves . 1975.5% of the current profits. discarded.

If the company wishes to transfer a higher percentage and is also contemplating declaration of dividend it is to ensure a rate of dividend for the year equal to the average rate of dividend declared in respect of the immediately preceding three years. (vi) A company is absolutely free to transfer to reserves a higher percentage than is indicated in the slabs in the table above.5% of the current profits. if the net profit after tax for the year is lower at least 20% compared to the average net profit after tax at the immediately two preceding years.6. a minimum distribution sufficient for the maintenance of dividends to shareholders at an amount equal to the average amount (quantum) of dividend declared over the three years immediately preceding the financial years is to be ensured. Where no dividend is declared the amount proposed to be transferred to its reserves from the current profits shall have to be lower than the average amount of the dividends declared over the immediately proceeding three financial years. In other words.The aforesaid requirement of transferring profits to reserve. For doing that it must comply with further conditions laid down in the Companies (Transfer of Profits to Reserves) Rules.5% to 10%. (iii) The profit for the above purpose should be determined after debit for Statutory Development Reserve. (vii) Companies are free to carry the residual profit.5%” the corresponding rate for transfer to reserve is 2. companies are henceforth [i. Transfer to reserves exceeding 10% Conditions .62 (i) (ii) Advanced Auditing and Professional Ethics Arrears of depreciation mentioned in Section 205(1) should also be provided in determining the profit for the purpose of transfer to reserves. The reserves contemplated are only the “free reserve”. after coming into force of the Companies (Amendment) Act. (v) The transfer to reserve contemplated in Section 205(2A) does not include any transfer to Development Rebate Reserve. In a case where bonus shares have also been issued in the financial year in which the dividend is declared. A company can transfer to reserve a percentage. or in the three years immediately preceding the financial year. The ceiling at 10% for transfer to reserve is in accordance with the provision of Section 205(2A) which requires the transfer “not exceeding 10%”. The profit should be after tax for the above purpose.e. provided the rate of transfer does not exceed 10%.. Dividends out of past profits . the company will not be required to ensure the maintenance of the average amount/rate of dividend mentioned earlier.Also. in the Profit and Loss Account. The company would be free to transfer to reserve any percentage from 2. irrespective of the amount. of profits higher than 10%. However. 1975. after dividend and transfer to reserves. Capital or any special reserve. 1974] forbidden from declaring dividends out of past . when the rate of dividend proposed is between “exceeding 10% but not exceeding 12. (iv) The rates of dividend mentioned in the table above relate to the rates of equity dividend and the portion of dividend in excess of the fixed rate of dividend in respect of the participating preference shares. subject to a ceiling of 10% is not a ban on a higher transfer.

(ii) The rates of equity dividend declared and paid by a company are as follows: 2001-2002 2000-2001 1999-2000 15% 12% 12% The company has earned sufficient profit after tax in 2002-03 and wishes to propose a dividend on equity shares at 11% of the current profits and transfer to Reserved 20%. and (ii) (iii) the balance of reserves after such withdrawal shall not fall below 15% of its paid-up share capital. The rules titled “Companies (Declaration of Dividend out of Reserves) Rules.00. 17. In arriving at this profit a deduction was made of Rs. first be utilised to set off the losses incurred in the year before any dividend in respect of preference or equity shares is declared.000 for the year 200203. 1975” provided that in the event of inadequacy or absence of profits in any year.000 and 10% on the preference capital of Rs. (iii) Will it make any difference if the company under (ii) above proposed a rate of equity dividend @ 20%? . The company has proposed a rate of dividend @15% on its equity capital of Rs. The company also proposes to transfer to reserves 10% of the current profit. dividend may be declared by a company for that year out of the accumulated profits earned by it in previous years and transferred by it to the reserves.00. subject to the conditions that: (i) the rate of the dividend declared shall not exceed the average of the rates at which dividend was declared by it in the five years immediately preceding that year or ten per cent of its paid-up capital. the total amount to be drawn from the accumulated profits earned in previous year and transferred to the reserve shall not exceed an amount equal to one-tenth of the sum of its paid-up capital and free reserves and the amount so drawn shall.3.000 in respect of the reserve created on account of Shipping Reserve.000.00. The company has not issued any bonus shares during the last few years. The post-tax profit in 2002-03 is higher than the corresponding profit of each of the previous three years.The Company Audit 6. whichever is less.6.00. 63 profits kept in reserves unless declaration conforms to the rules prescribed for the purpose by the Central Government or Central Government’s prior approval is obtained in case such rules are not complied with [Section 205A(3)]. 6. Illustration (a) Give your views together with reasons on the following proposals: (i) A company had profit after depreciation and tax of Rs.

3.00.000 17.000 18. 17. The Companies (Transfer of Profit to Reserve) Rules.00.00. It issued bonus shares during 2001-02.60.000 8. 8.00.000 on this account. (b) A company has earned a total sum of Rs.000 of the current profits. 18 lakhs.00. 17. Now the company proposes to appropriate a part of this amount for making payment of dividend for the years 2002-03 in which it has earned a profit of Rs.00. The Board proposes a payment of dividend of Rs.00. 1975 issued under Section 205(2A) of the Companies Act provide for a transfer to reserve of “not less than 5% of the current . Solution (a) (i) All the proposals of the company are legally valid.00.00. Since the company is proposing a transfer to reserve of 10% of the current profit.6.000 9.00.) 10.64 Advanced Auditing and Professional Ethics (iv) Will it make any difference if the amounts of net profits after tax of the company under (ii) above are as follows? Rs. Profit of Rs.000 15.000 after tax and depreciation is the profit contemplated in Section 205(2A) of the Companies Act as clarified by the Company Law Board. Reserve on account of shipping reserve of Rs.000 is an item of prior deduction for determination of the figure of Rs. Advise the company.000 15. 2. a transfer not exceeding 10% of the current profits to reserve is required and the question of voluntary higher transfer will arise only if the rate of transfer is higher than 10%.000 16.000 17. there is no problem before the company for declaration of dividend. 85 lakhs during the years from 1997-98 to 2001-02. Under Section 205(2A) of the Companies Act. 2002-2003 2001-2002 2000-2001 1999-2000 10.00.000 14.000 (v) A company’s profits after tax for several years and equity dividends are given below: Years 2002-2003 2001-2002 2000-2001 1999-2000 Net profit after tax (Rs.00.00. 25 lakhs.000 The company wishes to transfer to reserves Rs.00.00.000 Rate of equity dividend 8% (proposed) 14% (paid) 12% (paid) 10% (paid) Amount of dividend (Rs). The company has neither declared any dividend nor transferred any amount to the reserves during these years and kept the amount in the Profit & Loss Account.

the company is allowed to pay a lower dividend. It is a case of voluntary transfer to reserves at a percentage higher than 10% under Section 205(2A) of Companies Act.000. However. on the first-count the company can not make transfer of Rs. the company is free to make voluntary transfer to reserves at more than 10% without being required to maintain the rate of dividend. taking 20012002 and 2000-2001 figure into account is Rs. (ii) The proposal is not legally sustainable. the company’s proposal to pay dividend @11% and transfer to reserve @20% would be valid propositions. Therefore. therefore. it is required to maintain the amount of dividend for 2002-03 at least at the level of the average of the amounts paid during the preceding three years.333. the profit is 2002-03 is lower by more than 20%.00. 65 profits” in respect of the dividend rate exceeding 12. 10. the former is less than the latter by about 37.The Company Audit 6. 11% is less than this rate and. Thereafter transfer to reserve of 5% more up to 10% is valid.5%. compared to the average of corresponding profits to the preceding two years.000 whereas the average post tax profit.5% than the average post-tax profit referred to above. The average aforesaid works out to Rs. it is incumbent on it to at least maintain the average rate of dividend declared by the company in respect of the immediately preceding three years. The current year’s proposed amount. 2 lakhs to reserves.10. It should also be noted that the company’s post-tax profit is not less than the average post-tax profit for the last two years and no bonus shares have been issued by the company during 2002-03 or in the preceding three years which would have permitted transfer to reserves higher than 10% with a reduced rate of dividend. viz. (iv) Yes. Since the current year’s post-tax profits is less by 37. Any voluntary transfer of profits of a percentage higher than 10% to reserve can be made only when the company complies with the requirements laid down by the Companies (Transfer of Profits to Reserve) Rules. As per the clarification of the Company Law Board. 1975. (iii) Yes. 8. as per the Companies (Transfer of Profits to Reserve) Rule.00.00. The company has issued bonus shares within the preceding three years and therefore. Rs. When a company declares a dividend and wishes to transfer profit to reserve at a percentage higher than 10%. therefore the company cannot make a transfer of a higher percentage reserves than 10%. the company’s post-tax profit for the year is less than the average post-tax profit of the company for the preceding two years by more than 20%.53.5% but not exceeding 15%. The post-tax profit for the year is Rs. In the present case the average rate of dividend works out to 13%.16. The dividend proposed in 2002-03. fixed preference dividend is not to be considered in Section 205(2A) of Companies Act. the company’s proposal to transfer to reserves @ 20% would be in order in view of the fact that the current year’s rate of proposed dividend is higher than the average rate of dividend for the preceding three years. Therefore. (v) The proposal is in conformity with law.000 is less than the aforesaid average figure. Because of this overriding situation the company is not obliged to maintain the average .

1975” has no application. the company can freely appropriate past profits towards any insufficiency in the current year.6. A question that arises here is whether the company should transfer profits to reserves and provide depreciation for the whole year before declaring interim dividend. In case of existing companies. Restrictions on dividends when debentures not redeemed . no company is permitted to declare or pay dividend for any financial year out of the profits of that year without first transferring to reserve so much percentage of profit of the year as is prescribed under the Companies (Transfer of Profit to Reserve) Rule. 1975 before . The percentages of profits required to be transferred to reserves have been related to the rate of dividend proposed for the year and are given earlier: According to Section 205A(3) of the Companies Act a company is forbidden from declaring dividends out of the accumulated profits earned by the company in previous years and transferred by it to the reserves. Profit for the purpose of payment of dividend. read with section 205(1C). companies should provide for depreciation as required by section 205 and comply with the Companies (Transfer of Profits to Reserves) Rules. In as much as the given company has not transferred the profit of 1997-98 to 2001-02 amounting to Rs. 85 lakhs for payment of dividend in the current year and also it can utilise the profit of Rs. On an overall basis it may be advised that the company can appropriate any part of Rs. Amendments relating to payments of Dividends . 205 (2) of the Companies Act. dividend has been defined to include interim dividend also. distribution of dividends shall be only with approval of debenture trustees and lead financial institution (c).When debentures are not redeemed. 85 lakhs to reserves. “Companies (Declaration of Dividend out of Reserves) Rules. Based on section 2(14A). 1975. Accordingly.66 Advanced Auditing and Professional Ethics amount of dividend as contemplated in a situation where bonus shares have been issued.As per Section 2(14A). Newly inserted sub-section (1A) of section 205 provides that board of directors may declare interim dividend and the amount of dividend including interim dividend should be deposited in a separate bank account within five days from the declaration of such dividend.18 lakhs profit pertaining to the year 2002-03 and the balance amount of profit from the past accumulated profits. 18 lakhs for the current year for payment of dividend on compliance with the requirement of Section 205(2A). prior permission of lead financial institution will be required if dividend proposed is over 20% or as per loan agreement or if the company does not comply with conditions of financial institutions regarding interest and DSCR (debt service coverage ratio). it can be concluded that since interim dividend is also dividend. following restrictions apply on declaration of dividend: (a) Company can declare dividend out of general reserves. only if residual profits after transfer to DRR are adequate (b) In case of new companies. the rules made under Section 205A(3) viz.. In terms of Section 205(2A) of the Companies Act. (b) Assuming that the profits arrived at are after providing for depreciation in accordance with the provisions of Section. unless such declaration conforms to the rules prescribed by the Central Government. 1956 the company must comply with Section 205(2A) of the Companies Act before it can appropriate Rs.

provision must be made for any unrealised revaluation deficit (Section 264). Capital Receipts .i. has to be considered. and dividends can be paid only if justified by the picture as a whole. As regards the application of revaluation reserve to write off past revenue loses. Capital Reserve and Capital Receipts.e. is that the same can be applied for writing off past capital losses. 1956 does not include any amount regarded as free for distribution through profit and loss account. Examples of capital receipt include share premium amounts transferred to capital redemption reserve on redemption of preference shares. i. provided that it assets are not reduced to less than one and a half times its liabilities (Section 265). Such profits however.The Company Audit 6. does from part of its normal course of business. The company has to provide estimated depreciation for the full year before declaring interim dividend. It seems having regard to the provisions of Section 205 of the Companies Act. An investment company (defined in Section 266) may make a distribution out of the surplus on revenue account only (i. 67 declaration of interim dividend. we have gone over to what is sometimes called the ‘balance sheet surplus’ approach: the company’s cumulative position.By their nature can not be distributed by way of dividend.Defined as per part-III of Schedule VI to the Companies Act. like revaluation reserve. therefore. If the company does not transfer any profit to reserves. Capital Profit . Such surplus remains after evaluation of the whole of the assets and liabilities has been fairly taken. The position in our country.e. 1956 does not make any distinction between capital profits and other profit. may be distributed by way dividends. A public company must allow for any excess of unrealised losses over unrealised profits on the capital account . not including even realised capital profits. Strictly Speaking. involving past years as well as the current year. regulated more by convention than by any law as regards unrealised capital profits. the sale of assets. Distribution of Capital Profit . any profit realized on sale of fixed or on disposal of investments. it has to be contended with an interim dividend not exceeding 10 per cent of the paid-up capital. hence the resultant surplus from the sale of fixed assets would be capital profit.The term Capital profit means these profit which arise from transactions which do not fall within the normal activities of the business.e. that revaluation reserve should not be applied to write off past revenue losses because that will facilitate a distribution of dividend without being required to earn a revenue surplus for the purpose.. Capital Reserve . but at the same time not being bound to take account of unrealised or realised capital losses). Therefore. For example a trading company sells part of its fixed assets at a price which is higher then the original cost of these assets. can not be applied in issuing bonus shares as per the Bonus . As a result. and profit on re-issue of forfeited shares. Following two conditions must be satisfied before capital profit distributed: (i) (ii) The surplus is realized. Special rules apply to public companies and to investment companies. That means the amount in capital reserve can not be used for distribution of dividend. Since the company deals in merchandise.First we should distinguish the three concepts: Capital profit. the Companies Act. the position is to clear. it is not merely a book entry.

both unrealised and realised. . a provision for all the arrears of dividend payable thereon must be first made. It would give rise to an anomalous position. If any company (including a private or a closely held public Co. the statutory auditor of the company should qualify his audit report (vide November ’94. The Articles of Association of a company may also require that a part of the profit should be credited to the general reserve before any dividend is distributed.) utilises the revaluation reserve for issue of bonus shares. On this account. the amount proposed to be distributed will be in excess of the account actually available for distribution in cash or securities readily convertible into cash. and either in the year in which they occur or in convenient instalments out of revenue profits.If any part of the profits has been utilized for meeting a capital expenditure or is invested in book debts or stocks. the Debenture Trust Deed in respect of a debenture issue made by a company may stipulate that a fixed percentage of profits will be credited annually to the Debenture Redemption Reserve Fund. it is not obligatory for them to do so. Appropriation out of the amount available for distribution as dividend Although the whole of the amount standing to the credit of the Profit & Loss Account. the amount of such an appropriation for credit to the Fund would be a prior appropriation of the profits. In such a case. the amount so invested as well as that proposed to be further invested similarly must be credited to the General Reserve Account. provided it represents revenue profits or capital profits which are available for distribution on the conditions aforementioned is distributable as dividend. the Chartered Accountant. (c) Provision for preferential payments .If a company has issued preference capital. p.68 Advanced Auditing and Professional Ethics Issue Guidelines issued by the Securities and Exchange Board of India (SEBI) nor in paying up debentures or loan stock or calls on partly paid shares. For example. the company having stocks which it cannot sell or books debts it cannot realise. on account of which it will not be able to pay dividends within the time allowed (30 days) which shall result in the management being penalized (Section 207). it is often necessary to make appropriations out of the same on various grounds to arrive at the amount which may be distributed as a dividend. Also refer to Accounting Material) Previous losses . Moreover.At times a company. Otherwise. (b) Amortisation of a debt . Some of these grounds are the following: (a) For credit to General Reserve . may undertake that it would create a fund out of its profits for its payment.Though companies do write off capital losses. if the shares are cumulative. 681). while raising a loan. which makes it clear that bonus shares cannot be issued by capitalisation of revaluation reserve. it should not be available for distribution as a dividend. The Institute has also issued a guidance note on availability of Revaluation Reserve for issue of bonus shares. there must be provision to pay the dividend on preference shares at the stipulated rate before any dividend is paid on equity shares. In all such cases it would be necessary for the directors to appropriate proper amounts out of profits to comply with the legal necessity.6.

Legal Decisions . on the basis of provisions contained in clause (d) sub-section (2) of Section 205 it could be held that in respect of any asset for which no rate of depreciation has been laid down by the Income tax Act or has been prescribed by the Central Government depreciation need not be provided. For if this is not done. It could. But. (An English case decided in 1889). 1956 would necessitate provisions of depreciation. also that the Company Law Department of the Government of India has clarified by a notification that in its opinion a company is obliged to provide depreciation on the wasting assets before it can declare dividends. Ltd. it is argued. if a company decides to follow this procedure. It may be noted that with the issuance of accounting standards. but also on leaseholds. that depreciation must be provided not only on building. 69 In addition the directors in any year may decide to appropriate a part of the profits considered extraordinary or excessive to the credit of a Dividend Equalization Reserve so as not to raise the rate of dividend distributed beyond what the company could be expected to maintain in the future. It is the position of law propounded in another English Case Verner vs. In fact. Another view in this matter can be that regardless of the fact that the Central Government has not notified any rate in respect of an asset for which no rate has been prescribed under the Income tax Rules. The Central Government has refrained from issuing the notification presumably on this ground. mines and other similar assets. it could be argued that no depreciation need be provided in respect of goodwill. it would be a fraud on creditors. there is an obligation to provide depreciation on every asset on the ground that it is sound accounting practice. it would be necessary for it to retain assets sufficient to pay its debts. plant and machinery. leaseholds and other similar wasting assets. 239]. In support of this view it has been pointed out that the Institute of Chartered Accountants in England and Wales had recommended to its members as early as January 1945.. cannot be interpreted to support the legal principle emerging out of the English cases. The accounting opinion being in favour of provision of depreciation in respect of every asset.The Company Audit 6.The question of divisible profits has been the subject of several legal decisions. the absence of an order under Section 205(2)(d) specifying the rates at which depreciation should be charged on wasting assets. Neuchatel Asphalte Co. the situations described in the preceding paras do not exist any more. It has been considered above that there is necessity for provision of depreciation on assets under the provisions contained under Section 205 of the Companies Act. even though no depreciation is allowable in respect of these assets under the Income tax Act. However. compliance with accounting standards even as per provisions of the Companies Act. . On this basis. aforementioned. Most of these decisions were arrived at on the basis that unless required by the Articles of Association. therefore. these decisions have little applicability. patents. Application of the principle laid down in the case of Lee vs. Generals and Commercial Investment Trust Ltd [1894 2 Ch. etc. profits earned could be distributed as dividends before providing for depreciation or writing off past losses. be argued that the principle laid down by the decision in the above mentioned case is still applicable in this country. After the amendment of Section 205 in 1960. however.

2. 8. On the other hand. The basic decision about the dividend is that of the management. This can often be very profitably employed to finance expansion or diversification or for setting right the adverse working capital or liquidity position. 6. Dividends and working capital. sometimes auditors are consulted in the matter of deciding upon the quantum of dividend that can be distributed by a company.6. 4. Dividends and market value of shares. Dividends and new capital requirements. Re-investment alternative. Apart from this. It is a source of finance so far as the company is concerned. rationality or feelings of the shareholders and other allied factors. the shareholders do not have the authority to enhance the sum proposed by the directors unless the articles allow such a procedure. 3. Chartered Accountants as such also act as consultants to various companies on a number of matters. As a general proposition the following are determinants of dividend policy: 1. The basis of legality is provided by the Companies Act. 1956 and the related Articles of Association. including dividend. though the aspects of shareholders’ aspirations are also taken into consideration. in the discharge of his duties is not concerned with the policy about dividends. Tax brackets of shareholders. Payment of dividends (1) Dividends once declared become the liability of the company and must be paid within 30 days of the date of declaration. However. He is merely concerned with the legality and actual payment of the dividend. 5. Dividend is a phenomenon involved with the question of financial management of the company. 7. In deciding upon a policy of dividend the financial considerations generally get the place of prominence. Any failure to do so attracts a penalty for the various persons associated with the management [Section 207]. Dividends and liquidity. the management. . A balance is generally struck to bring about compromise and adjustment between these without unduly impairing the financial state of the company. because of its very thorough and intimate knowledge of the financial state of affairs of the company and of the business environment. is considered to be the best equipped to deal with the matter. However. In this context.Normally an auditor. it should be appreciated that the amount of the profit available as dividend has competing claimants. Nature of earnings. it is therefore very difficult to lay down any definite policy in this regard. Stability of dividend.70 Advanced Auditing and Professional Ethics Dividend policy and related financial considerations . as a guiding rule a broad frame of policy has often been adopted by companies for guidance in deciding each year the quantum of dividend having regard to the specific situations faced by the company in the concerned year or situations that are in offing.

the company shall within seven days from the date of expiry of the said period of 30 days.2. the company must furnish to such authority or committee as the Central Government may appoint.. (ii) the name and last known addresses of the rightful recipients. if so authorised by the Articles of Association (Section 93). If nothing has been paid on any of the shares. (4) According to the provisions contained in Clause 85 of Table A. dividend may be declared and paid according to the nominal amount of shares.. (iii) the amount to . Section 205A states that where. after the commencement of the Companies (Amendment) Act..section (1) of Section 205C. to be called “Unpaid Dividend Account of.. But in respect of a share warrant. are entitled to receive dividends along with the holders of shares already issued. The dividends that have remained unpaid upto 1.. surplus obtained on revaluation of asset cannot be applied for the issue of bonus shares. though a dividend can be declared only in a general meeting.2.. the same will be deemed as a part thereof.. to any shareholder entitled to the payment of dividend.. a statement in the prescribed form setting forth in respect of all sums included in such transfer: (i) the nature of sum. Dividend is payable in proportion to the amount paid up or credited as paid up on shares. transfer the total amount of dividend which remains unpaid or unclaimed within the said period of 30 days to a special account to be opened by the company in this behalf in any scheduled bank. The expression “dividend which remains unpaid” means any dividend the warrant in respect thereof has not been encashed or which has otherwise not been paid or claimed.. 71 (2) Dividends are not payable except in cash or by a warrant. the payment can be made only to the bearer or his banker. But the profits or reserves can be capitalised for purpose of issuing fully paid bonus shares subject to the guidelines issued by the SEBI also they may be applied for paying up any amount for the time being unpaid on any share held by the members of the company Section 205(3). It is obligatory for the company to pay interest at the rate of 12% for the benefit of the shareholders concerned on any amount of unpaid dividend which has not been transferred to the aforesaid account with the scheduled bank. Unless the foregoing regulation has been excluded or modified by the articles.1975.The Company Audit 6. (3) Dividends can be paid either to the registered holder of a share or to his order or to his banker. the amount thereof must not exceed the amount recommended for distribution by the Board of Directors. however./Company (Private) Limited. In the case of a fresh issue of capital the holders unless precluded by the terms of issue.. It is permissible. for payment to be made by a cheque. 1974 a dividend has been declared by a company but has not been paid or claimed within 30 days from the date of the declaration. Company Limited. When unclaimed dividends are transferred to the Fund. Any money which has been transferred to unpaid dividend account of a company and which remains unpaid or unclaimed for a period of seven years from the date of such transfer. the amount shall be transferred by the company to the Fund established under sub.1975 shall also have to be transferred to the above mentioned account within six months from 1.

Provided that no such amounts referred to in clauses (a) to (d) shall form part of the Fund unless such amounts have remained unclaimed and unpaid for a period of seven years from the date they became due for payment. 1988.6. (d) matured debentures with companies. State Governments. (4) The Central Government shall.72 Advanced Auditing and Professional Ethics which each person is entitled. and (g) the interest or other income received out of the investments made from the Fund. (c) matured deposits with companies. and (v) such other particulars as may be prescribed. Establishment of Investor Education and Protection Fund – (1) The Central Government shall establish a fund to the called the Investor Education and Protection Fund (hereafter in this section referred to as the “Fund”). (e) the interest accrued on the amounts referred to in clauses (a) to (d). (f) grants and donations given to the Fund by the Central Government. companies or any other institutions for the purposes of the Fund. Explanation: For the removal of doubts. by notification in the Official Gazette specify an authority or committee. added a new Section 206A according to which payment of dividend and allotment of bonus and right shares to the transferee to be held in . (3) The Fund shall be utilised for promotion of investor awareness and protection of the interests of investors in accordance with such rules as may be prescribed. with such members as the Central Government may appoint. to administer the Fund. (2) There shall be credited to the Fund the following amounts. (5) It shall be competent for the authority or committee appointed under sub-section (4) to spend moneys out of the Fund for carrying out the objects for which the Fund has been established. (iv) the nature of his claim thereof.] The Companies (Amendment) Act. The company shall be entitled to a receipt from the authority or committee under sub-section (4) of Section 205C for any money transferred to it to the Fund and such a receipt shall be an effectual discharge of the company in respect there of [sub-section (7)] 205C. namely: (a) amounts in the unpaid dividend accounts of companies. and maintain separate accounts and other relevant records in relation to the Fund in such from as may be prescribed in consultation with the Comptroller and Auditor General of India. it is hereby declared that no claims shall lie against the Fund or the company in respect of individual amounts which were unclaimed and unpaid for a period of seven years from the dates that they first became due for payment and no payment shall be made in respect of any such claims. (b) the application moneys received by companies for allotment of any securities and due for refund.

(iv) a board resolution recommending dividend was passed. This Section requires that where any instrument of transfer of shares has been delivered to the company for registration and the transfer of such shares has not been registered by the company. (xi) there were any complaints regarding non-payment or delay in payment of dividend? If. 3. (ix) permission of Reserve Bank of India was obtained for payment to non-resident shareholders before the dividend was remitted to them.. Reserve Bank of India’s Receipt/Approval. Minutes of Board/General Meeting. Documents Involved . it shall transfer the dividend in relation to such shares to the special account referred to in Section 205A unless the company is authorised by the registered holder of such shares in writing to pay such dividend to the transferee specified in such instrument of transfer. Register of Members. 10. The auditor may take the following steps to ensure that the dividend has been paid only out of profits: (a) Check whether dividend was declared out of profits arrived at after providing for depreciation. Notice of Closure for Register of members. Unpaid Dividend Account/Register. 4. (iii) conditions governing transfer of higher percentage complied with. before declaring any dividend. 5. (v) register of members was closed as per the provisions of Section 154. the minimum prescribed amount had been transferred to reserves according to the Companies (Transfer of Profits to Reserves) Rules. (c) Check whether: (i) (ii) the depreciation was provided according to provisions of Section 205(2). ensure that approval was obtained from the Central Government before declaring dividend [Section 205(1)(c)]. 1975. (vi) the dividend was declared only in the annual general meeting. 6. Dividend payment Register. in case of listed company. . 7. 73 abeyance till the title to shares is decided. 8. (b) If no depreciation was provided. (x) intimation sent to stock exchange. Annual Report. etc. Form 1 of the Unpaid Dividend Rules. Further the company shall also keep in abeyance in relation to such shares any offer of right shares and any issue of fully paid up bonus shares. (viii) Amount of dividend deposited in a separate bank account within five days from the date of declaration of dividend. Dividend warrant.1. 2. 9. so. whether corrective action was taken. Correspondence with Central Government.The Company Audit 6. (vii) dividend has been paid in the prescribed manner within 30 days of time to the registered holder or to their order (Section 207).

created a debt as the Board may subsequently rescind the resolution and cancel the announcement. investment allowance reserves. For example.74 Advanced Auditing and Professional Ethics Interim Dividend . (2) Patents appearing in the balance sheet which in fact are useless. unlike a final dividend declared by the company at the annual general meeting. As stated earlier. the same has to be regularised at the general meeting because interim dividend was a dividend paid by the directors any time between two annual general meeting. Therefore. financial and legal considerations. as indicated above a number of provisions from the Income tax Act have got to be considered. setting off of past losses and transfer to reserves of a prescribed percentage of the profits. A mere resolution of the directors resolving to pay a certain amount as interim dividend did not create a debt enforceable against the company for it was always open to the directors to rescind the resolution before payment of the dividend as decided in the leading case PNB Ltd. the interim dividend could be declared by the Board of Directors only if there was an authorisation in the Articles of Association to do so. Payment of dividend and the Income tax Act . Prior to amendment in the Companies Act.g. with the commencement of the Companies (Amendment) Act. Should all fictitious assets be written off before distribution of dividends? . However.The definition of term dividend has been modified to include interim dividend also. It also provides for the circumstances under which dividend can be paid out of past profits. a final dividend once declared by the company in general meeting was a debt and created an enforceable obligation. 1956. interim dividend stands at par with the final dividend.The Accounting Standards Board of ICAI has issued a guidance note on terms used in financial statements where the term ‘fictitious asset’ has been described as an item grouped under assets in a balance sheet which has no real value. The distinction between interim and final dividend was that unlike interim dividend. all aforesaid requirements applicable in case of final dividend would also apply to interim dividend. Union of India. having direct or indirect relevance to the determination of the amount of dividend. The accounting and legal considerations are highly related. The payment of dividend is a corporate phenomenon based on accounting. We can also give other examples like. December 13. In particular it requires provision for depreciation. 2000 w. 2000. .6. In determining the accounting profit. 1956 has prescribed the manner of determination of the amount of dividend in Section 205. distributable profit of a company gets conditioned by the requirements to create and retain reserves e. It may be pointed out that any departure from the provisions of the Income tax Act will not make the payment of dividend illegal but may increase the tax liability of the company. (1) Goodwill recorded at a particular figure whereas the company may have no goodwill at all in the ordinary commercial sense. vs. The Companies Act. The manner of payment of the dividend is also provided for in the Companies Act.Payment of dividends by a company though basically governed by the provisions of the Companies Act.f. section 205A has been amended to provided for interim dividend as well.e. It was further held that an interim dividend announced by the Board of Directors would not. It may be mentioned that any deviation from these provisions will render the dividend illegal. However. has to reckon with a number of provisions contained in the Income tax Act. The guidance note cites the example of the debit balance of the profit and loss statement.

75 There is no mandatory rule in accounting or any legal requirement that fictitious assets must be written off before declaration of dividend. They represent certain fictitious assets. contained therein should first be set off before declaration of dividend out of current profits. The Statement of Auditing Practices issued by the ICAI opines that only those items of expenditure which can properly be deferred should final a place under the head ‘Miscellaneous Expenditure’. However. In the case of Verner vs. all fictitious assets must be first written off.. depreciation. It is thus evident that the provisions are a charge against profits while reserves are an appropriation of profits. from those appropriated out of profits for credit to revenue reserve. 6.5 Reserves . if capital profit is sought to be distributed as dividend. Also. which in the opinion of directors can not be distributed as a dividend through the Profit and Loss Account are to be credited to such a reserve. This is for the reason that one of the conditions for use of capital profits for dividend purposes is a complete revaluation of all assets and liabilities which should result in a surplus. than were originally made are to be considered as reserve. The distribution is carried further by segregating the reserve which is made up of fortuitous gains.. unconnected with business activity (e. the following points must be noted in this regard: If there exists debit balance in the profit and loss account. Accordingly it may be said that though writing off of fictitious assets on a proper accounting consideration is desirable. Similarly.The term ‘reserves’ is not defined in Part III of Schedule VI except negatively. The language of the provision appears to suggest that directors are vested with an unrestricted right to decide which of the amounts to be credited to the Capital Reserve subject only to provisions of the Act as regards certain .g. However. it is not mandatory. The Companies Act does not specify the categories of accretions to the shareholders funds which are to be credited to the Capital Reserve. provisions that prove to be in excess of amounts required or having been made liberally. also provisions in excess of the amount considered necessary for the purposes. if any. receipts on account of share premiums). there is no instruction in Schedule VI or anywhere in the Companies Act including Section 205 to first write off such miscellaneous items of expenditure. are in addition thereto. These professional and statutory requirements imply that these items need not be fully written off but to the extent they are capable of being deferred can be included under the head ‘Miscellaneous Expenditure’. In this connection if it may be noted that in Schedule VI.13. the first is described as a capital reserve and the second merely as a reserve. Such a distinction is essential for disclosing in the balance sheet the amount by which the equity of the shareholders has increased with the accumulation of undistributed profits. Part I of Schedule VI also requires disclosure under the head Miscellaneous Expenditure of the amounts to the extent not written off. The General Commercial In vestment Trust Ltd. This is more in the nature of preferable practice but is not mandatory in its nature. in the sense that the profits retained in the business not having any of the attributes of a ‘provision’ are to be treated as reserves. except indirectly by providing that the amounts. Part I in the asset side certain items are included under the heading ‘Miscellaneous Expenditure’.The Company Audit 6. appreciation in values of fixed assets. are reserves. it was held that a company may pay dividends if it is solvent and is acting within its articles that distribution of dividend is permissible if there exists revenue surplus even though some portion of the value of the assets disclosed in the balance sheet may turn out to be fictitious.

76 Advanced Auditing and Professional Ethics funds not being available for distribution as dividend. It is also generally different from the income shown in the tax-return submitted to tax authorities’.13.7 Non-provision of proposed dividend . (5) General Reserve built up for the future developments of business (Revenue Reserve). Attention of the students is drawn to the provisions of Section 205(A) of the Companies Act. if subsequently conditions arise. discussed earlier. for they cannot violate the accepted principles of accountancy which determine whether or not an item of income is capital or revenue.13. 6. (4) Amounts retained for equalisation of dividends (Revenue Reserve). Therefore. For instance. 1949 do not require proposed dividends to be shown in respective balance sheets. The following are examples of amounts retained in the business that are credited to one reserve account or another: (1) Securities Premium Account (Capital Reserve). 6. requires proposed dividend to be shown under “Current Liabilities and Provisions” it does not mean that in fact the proposal for the dividend becomes a liability or is necessarily a provision. nor does it amount to a provision. accounted for on accrual basis. Since. Consequently the taxation liability that is provided for in the accounts does not bear any direct relationship to the profit disclosed and readers of such account are left to guess the reasons. The Council of the Institute of Chartered Accountants of India has considered the issues involved and is of the view that proposed dividend does not represent a liability. it is not so.6.It has been noticed that a large number of companies do not provide for the proposed dividend but either carry forward the balance on the Profit and Loss Account or transfer an amount to the general reserve and charge the dividend to the profit and loss account or to the reserve when payment is made. It may also be remembered that an appropriation once made can be revoked. (3) Profit on reissue of forfeited share (Capital Reserve). AS-22 on “Accounting for Taxes on Income” now requires that tax should be treated as an expense. (2) Capital Redemption Reserve Account created in pursuance of provision contained in Section 80 of the Companies Act (Capital Reserve). about restrictions in the utilisation of past profit kept: in reserves for dividend purposes.e. income tax should be treated on the same footing as is done in case of other expenses i.. which show that amounts appropriated earlier to the Capital Reserve are distributable as dividends. .6 Deferred Taxation . pending the approval of the shareholders in the general meeting. But. The form of accounts laid down under the Insurance Act. as given in the Schedule VI of the Companies Act. Students are advised to go through AS-22 on “Accounting for Taxable Income”.It is a common experience that the profit or loss as per the Profit and Loss Account will be different from the income ultimately assessed to income tax. 1938 and the Banking Regulation Act. From a management point of view income tax is an item of expense rather than an appropriation of pre-tax profit. directors can alter their earlier decision. and this does not impair the true and fair view of such balance sheets. The Council is further of the opinion that merely because the form.

the amount in respect of which should be specified. nonprovision for tax (where a liability is anticipated’ would amount to contravention of the provisions of Sections 209 and 211 of the Companies Act..Section 350 provides that the amount of depreciation should be the amount of depreciation shown as per books of account... the reserves of the company appearing in the said balance sheet have been over-stated and the current liabilities and provisions appearing in the said balance sheet have been understated”....13.. the Council is of the opinion that though on correct accounting principles. has recommended that the fact that the provision for proposed dividend has not been made should be disclosed by means of a note in the accounts and that the auditor should refer to the note in his report and make his report subject thereto.. Depreciation 6. It has expressed the view that on an overall consideration of the relevant provisions of law.Section 205(2) of the Companies Act.The Company Audit 6...The Council of the Institute of Chartered Accountants of India has taken note of the fact that there is a practice prevalent whereby companies do not make provision for tax even when such a liability is anticipated... including Rs... An example of the manner in which the report on the balance sheet and the Profit and Loss Account may be qualified in this respect is given below: “The company has not provided for taxation in respect of its profits and the estimated aggregate amount of taxation not so provided for is Rs .... The Council. specified period of any depreciable asset is “the number of years at the end of which at least 95% of the original cost of that asset to the company will have been provided for by way of depreciation if depreciation were to be calculated in accordance with the provision of Section 350”. the attention of the shareholders would have to be drawn to the fact that no appropriation has been made for the proposed dividend.... (b) Straight line method .. 1956 lays down the following alternatives for providing the depreciation: (a) To the extent specified in Section 350 . the proposed dividend does not become a liability. it is necessary for the auditor to qualify his report and such qualification should bring out the manner in which the accounts do not disclose a “true and fair” view of the state of affairs of the company and the profit or loss of the company..14..... the profits of the Company for the financial year under report have been overstated and to the extent of such aggregate non provision.Alternatively depreciation may be calculated by dividing 95% of the original cost of the asset to the company by its specified period. According to Section 205(5)(a). Part I-A requires. Schedule XIV to the Companies Act also provides the straight line .. “proposed dividends” to be shown under Provisions at paragraph 3(XIV) of Part II of the same Schedule requires the “proposed dividends” to be disclosed.To the extent of such non-provision for the year. Accordingly.1 Method of providing for depreciation . 77 however the form of the balance sheet prescribed under Schedule VI.. therefore.. for the Year ended on ... 6..14 There are different methods for charging depreciation: 6.8 Non-provision of tax in the accounts ... ...

double shift and triple shift working. Similarly where an asset is sold. This has set at rest the controversy that whether or not depreciation has to be provided on multiple shift working. The amendments to Section 205 and Section 350 have been notified to come into force from 15th June. demolished or destroyed. The rates of depreciation prescribed in Schedule XIV for various categories of depreciable assets implicitly recopied that the rates of depreciation represent true commercial depreciation. 1987. Department of Company Affairs specifies depreciation rates both on the written down value basis and the straight line basis. 1988 and as altered by GSR 756(E). The WDV rates prescribed in Schedule XIV are relevant in the context of Section 350 which can also be followed by a company for providing depreciation under Section 205 for the purpose of declaration or payment of dividends. Ministry of Law. In respect of depreciable assets for which no rate has been prescribed under Schedule XIV to the Companies Act. As straight line depreciation rates have been specified in Schedule XIV to the Companies Act. For example. Justice and Company Affairs. 95/by 28. Schedule XIV to the Companies Act. Thus the corresponding SLM rates for the factory buildings would be 3. provided that Schedule XIV shall be deemed to have been inserted in the principal Act from 2nd April. It has been specifically provided that in case any addition is made to any asset during the financial year. 1988. depreciation should be provided upto the date on which the asset is sold.43) per annum.34% (i. The straightline method of depreciation permitted under Section 205 is one of the bases for charging depreciation. It also list 23 items of plant and machinery falling within the general category in respect of which no extra shift depreciation is allowed. there would be no need for a company to calculate these rates.e. 1956 . depreciation should be calculated on prorata basis from the date of such addition. in the case of factory buildings (for which the WDV depreciation rate prescribed in Schedule XIV is 10%). (c) Any other basis . discarded. These rates have the effect of writing-off 95% of the original cost of an asset on straight line basis over the same period in which the aforesaid percentage of the original cost would be written off if depreciation were provided on writing down value basis. discarded. . The Companies (Amendment) Act.6. Schedule XIV provides rate of depreciation for extra shift working for only certain categories of plant and machinery. depreciation is to be provided on a basis approved by the Central Government.78 Advanced Auditing and Professional Ethics depreciation rates in respect of various categories of assets. The SLM rates of depreciation have been worked out by dividing 95% of the original cost of an asset by its specified period. Schedule XIV also provides separate depreciation rates for single shift. the specified life is 28.Depreciation can also be charged on any other basis provided it has effect of writing-off 95% of the original cost of the asset on the specified period and it is writing-off 95% of the original cost of the asset on the expiry of the specified period and it is approved by the Central Government. demolished or destroyed during the financial year.43 years.Schedule XIV which has been inserted by the Companies (Amendment) Act. 1988.

A suffered a loss on the shares held by him X Ltd. Mr. Z a chartered accountant is often consulted by Directors of Y Ltd. Mr. Gower has been appointed as the Office Master of a Jute Mill at a salary of Rs. Sylvester. 3. Ltd. (vi) Mr. a Director of a public company.. Will A succeed? (b) Shri C. It is usual practice of a manufacturing company to hold shares in the name of its banker which is a nationalised bank. a manufacturing company having a capital of Rs. K. 8. which is a subsidiary to Y Ltd. at a remuneration of Rs. attended and exercised voting powers on behalf of the President. on specific financial problems.500 p... The company says that the visit is unnecessary since the branch has been audited by a chartered accountant. a director of X Ltd. is being appointed as retainer in Z Pvt. Gower happens to be the maternal uncle of Mr. a subsidiary of the company. (vii) Mr. 250. 79 Self-examination Questions 1. (a) Mr. .. mentioning the provisions that have been violated.2. of Industries. is found in the Register of members maintained by the company. however. (v) In a general meeting of a company which has the President of India as a shareholder. (ii) (iii) A subscriber to the memorandum paid no money towards the shares agreed to be taken by him. was private company? 2. Examine the following acts and state which of them you consider to be in violation of the provisions of the Companies Act. 2 lakhs to B Ltd. (i) The auditor’s report of a company contained significant qualifications. His name.200.m. as the Chief Accountant at a monthly salary of Rs.P.000 has advanced a loan of Rs. has been appointed by U Ltd. wishes to visit Pune branch of the company..A. A sues Mr Z.The Company Audit 6. The Managing Director of the two companies is one and the same person. the Secretary of the Deptt.. The Directors of A Ltd. the auditor of X Ltd.00. it was noticed that some of the shares were transferred pursuant to transfer deeds submitted to the company which did not bear any endorsement. S. Can the company do so? 3. a director of the Mill. Is the company’s contention valid ? (c) A company wishes to issue debentures on the condition that these would be redeemed only when the free reserves accumulate to 25% of the paid up capital. (iv) While conducting a share capital audit. (viii) Mr..M. the Board’s report circulated amongst the shareholders did not contain any reference to the auditor’s qualifications. It is contended that this facilitates speedy transfers. Has the investment been validly made? Would it have any difference if B Ltd. Z.

80 Advanced Auditing and Professional Ethics (ix) A Pvt. (x) Extent of shares issued against claims not due can not be so described Section 227(IA). . The company. A portion of the claim so settled was overdue while for the balance the normal credit period was not over. Ltd. the rates quoted were absolutely competitive. in its published accounts. company composed of two shareholders entered into contract with a public limited company for supply of certain materials against cash consideration. Z. has shown the issue as issue for cash consideration. company happened to be the wife & son of Mr. a director of the other company. (x) Certain shares were issued to a creditor of the company in settlement of his claims.6. The members of the Private Ltd. No sanction of the Board was sought for this contract. Answers to Question 1: 2: 3: No (a) No (b) No (c) No The actions that are in violation of the provision of the Companies Act: (i) 217 (iii) 108.

P. when he is in practice. that at all events he shall gain his case.1 A member of the accounting profession. the auditor is expected to discharge his duties according to “generally accepted auditing standards” obtaining at the time when the professional work is carried out. he is appointed under a statute or under an agreement to carry out some professional work it is to be presumed that he shall carry them out completely and with the care and diligence expected of a member of the profession. The implications of a professional engagement have been explained in the case Lanphire v. only a few of which have been mentioned above. offers to perform a larger variety of professional services. however. as follows: “Every person who enters into a learned profession undertakes to bring to the exercise of it a reasonable degree of care and skill. when one offers his services. may from time to time undergo change. if he is an attorney.Eddy. He does not undertake. In view. But no man. There may be persons who have a higher education and greater advantages than he has.7 LIABILITIES OF AUDITORS Nature of Auditor’s Liability 7.” To the same effect are the undermentioned observations in Cooly’s “Torts” an outstanding American Authority (cited in “Accountant’s Legal Responsibility’ by Saul Levy): “In all these employment’s where peculiar skill is requisite. therefore. he is understood as holding himself out to the public as possessing the degree of skill company possessed by others in the same employment and if his pretentions are unfounded. nor does he undertake to use the highest degree of skill. whether skilled or unskilled undertakes that the task he assumes shall be performed successfully and without fault or error. 475 cited in “Professional Negligence” by J. When. but not for . of the fact that the standards of competence may vary from individual to individual and also the concept of the function of an audit and that of its technique. he also holds himself out to the public as an accountant qualified to undertake these assignments. he commits a species of fraud upon every man who employs him in reliance on his public profession. but he undertakes to bring a fair. reasonable and competent degree of skill. Phipos (1838) & Case & P. nor does a surgeon undertake that he will perform a cure. he undertakes for good faith and integrity.

in order that such of them as are qualified may discharge their duties. therefore. no bar to assistance being taken in the performance of a duty or engagement.1 Taking assistance in the discharge of his duties . It.7. v. or other personal qualifications normally cannot be assigned. 7. it must be performed either by him or by his persons under his supervision since he himself remains finally responsible. An auditor who does not personally look into the accounts but merely delegated it to his assistants cannot be said to be acting with due skill and care. however. Hinds Musgrave Stevens). Rajamany : “No auditor can escape from personal liability by taking shelter under the misconduct of his own employees. clause (13) of Part I of First Schedule to the Chartered Accountants Act. however. Only to ensure that this scheme shall be adhered to in all cases. in the discharge of his professional obligations had relied on the report or statement of his. subsequently found to be false. M. quite common for the auditors to engage persons some of whom are professionally qualified.’ Despite the fact the principal is responsible for the misdemeanour and misdeeds of his employees. Ball Baker & Co. The principals. follows that the work of an auditor being of a personal character. v.” The decision in the Rajamany’s case also places a limitation on the extent to which an auditor may delegate his duties to his assistants: “Callousness and irresponsible abdication of his (auditor’s) work can never be regarded as anything but misconduct . to assist them in their work.” Either absence of the requisite skill or failure to exercise reasonable skill can give rise to an action for damage for professional negligence. which of the two persons discharges it. bad faith or dishonesty. but not losses consequent upon mere errors of judgement. are expected to guide and supervise their work and are personally responsible for any dereliction of duty or absence of care or skill in performance of an audit or any other professional engagement.2 Advanced Auditing and Professional Ethics infallibility.: “The principal must not excuse himself for his clerk’s negligence by saying that he employed a clerk. therefore.” (2) In the Superintendent of Police v. which are . They cannot ordinarily shift any part of this liability to their employees. he is liable to his employer for negligence. while others are not. It is. 1949 makes it obligatory that reports on financial statements would be signed either by the member or his partner. This is. cannot be held liable in a criminal action brought against him (Rex. But contracts involving personal skill. Such legal position is clearly borne by the following extracts from the judgements in two celebrated cases: (1) In Henry Squire (Cash Chemists) Ltd.1. An auditor who.It is a well accepted legal principle that duties under a contract can be assigned only in cases where it does not make any difference to the person to whom the obligation is owed.

disciplinary action for professional misconduct under section 21 of the Chartered Accountants Act can also be taken against a Chartered Accountant for failure to discharge his professional duties competently or diligently. shall be deemed to be guilty of professional misconduct. the liability may be civil or criminal. the Council of the Institute of Chartered Accountants of India is pleased to specify that a member of the Institute. if he is grossly negligent in the conduct of his duties. The Council has also issued a Notification bearing No.Liabilities of Auditors 7. generally consists of undermentioned three elements: (a) existence of duty or responsibility owed by one party to another to perform some act with certain degree of care and competence. The above Notification safeguards the interest of members who engage Chartered Accountants and issue reports on the basis of the work carried on by them. This Notification was issued because the Council felt the need to create public confidence in such members since they had certain responsibilities as members of the Institute as against other employees who were not members.The liability for professional negligence may arise either under a statute or an agreement.3 assigned to them with adequate skill and care. which is culpable.2 Basis of liability .1-CA (7)/65 November.” In the absence of this clause. or Government concern. 1965. reproduced below: “No 1-CA (7)/65: In exercise of the powers conferred by Clause (ii) of Part II of the Second Schedule to the Chartered Accountants Act.2 Negligence. 1960 in as much as it applied not only to a member in service with a Chartered Accountant in practice or a firm of Chartered Accountants but also to those in service with a commercial. Professional Negligence 7. (b) occurrence of a breach of such duty. industrial. who is employed by a Chartered Accountant in practice or by a firm of such Chartered Accountants. 1949. the Council has issued the following notification in the exercise of powers vested in it by Part II of Schedule II to the Act : “In exercise of the powers conferred by Clause (ii) of Part II of the Second schedule to the Chartered Accountants Act. only the Chartered Accountant who had signed the report would be liable and it would not be possible to reach the employee chartered accountant on grounds of misconduct. whether in practice or not. and . 7.” This Notification is much wider in scope than the previous Notification issued on 12th November. the Council of the Institute of Chartered Accountant of India specifies that a member of the Institute who is an employee shall be deemed to be guilty of misconduct if he is wilfully and grossly negligent in the conduct of his duties as such employee.1. 1949.

being suffered by the party to whom the duty was owed as a result of negligence. There are users who have direct economic interest in the concerned business enterprise like the owners. it will be highly instructive to analyse the situation under the following three heads: (1) English Scene. If responsibility is to be imposed where specific users are identified. professional negligence would constitute failure to perform duties according to “accepted professional standards”. Usually. potential owners. In this context. resulting in some loss or damage to a party to whom the duty is owed. employees and customers. then to what extent will it be imposed and what criteria will be used to determine the specific user to whom the auditor should be responsible? Liability imposed should have some relation to the responsibility reasonably assumed and the fees charged. Under what circumstances should these parties not in privity with the auditor be allowed to recover from the auditor losses that they incur as a result of the auditor’s dereliction of duty? The solution seems difficult. This will be apparent from the summary of legal decisions discussed hereinafter. on which the auditors report.4 Advanced Auditing and Professional Ethics (c) loss or detriment. these parties are not in priority with the auditor.7. When a loss has been suffered by a third party who is not privy to the arrangement between the clients and the auditor for determining whether he is liable. are designed to serve the needs of a variety of users. English scene . (2) American Scene. The evolution of law in this regard varies widely in England and the United States. regulatory authorities. stock exchanges. So far as our country is concerned. (3) Indian Scene.The general rule in England is that only parties to a contract may enforce the rights under the contract. The financial statements.A professional man is deemed to have been negligent only when he owed a duty to a person or persons and he had failed to perform or had performed it negligently. To hold a negligent auditor liable “in an indeterminate amount for an indeterminate time to an indeterminate class” will be stretching the limit too far. trade associations and labour unions . management. (A) To whom is the duty owed? . If a loss had been suffered by a client through the action of the auditor. particularly owners and creditors. We cannot at the same time brush aside the whole concept of auditors’ liability to those parties with whom he has no privity of contract. lawyers. it is necessary to find out whether the auditor owed any duty to him. creditors and suppliers. Hence. we should say that much headway has not been made. There are also others who have indirect interests like financial analysts and advisers. taxation authorities. his liability would be determined on the basis of the contract of engagement according to which the auditor had undertaken to provide service. . financial press.

B. English courts continued to follow Derry v. the most absurd and outrageous consequences. 1842) it was held that an injured passenger. and unless he intended to deceive. It was held that a false statement made through carelessness and without reasonable ground for believing it to be true could be evidence of fraud. He said: “But the law of England does not go to that extent.The question of Accountant’s liability to third parties directly came up for consideration in England in the case of Candler v.) that an architect who negligently gave certificates of progress for the construction of a building was not liable to a lender for losses incurred in relying on the certificates. During this period there was no liability to third parties for negligent misrepresentation except when a special duty to be careful was imposed by contract a fiduciary relationship or likelihood of physical damage to person or property. every passenger.152 Eng. a duty arises to use ordinary care and skill to avoid such danger. to which I can see no limit. limb or health. in the absence of contract. Crane Christmas & Co. although liability to third parties could be established if the negligent misrepresentation resulted in loss of life.Liabilities of Auditors 7. 491 (C. the law does not. Thus. who was not a party to a contract to maintain a stage coach. However.” The formula is very broad and could justify auditor’s liability to users of financial statements having direct or indirect economic interests. Peek until 1963. 402 Ex.5 In Winberbottom v. Lord Esher observed as follows: “Whenever one person is by circumstances placed in such a position with regard to another that every one of ordinary sense who did think would at once recognise that if he did not use ordinary care and skill in his own conduct with regard to those circumstances he would cause danger of injury to the person or property of the other. the suppliers of a scaffold for the painting of a ship was held liable to the painter even in the absence of privity of contract. Lord Esher in Le Lievre v. and if the plaintiff can sue. Unless we continue the operation of such contracts as this to the parties who entered into them. it was not fraudulent and could not render the person liable in deceit. could not sue on the contract. C 337. hold him responsible for drawing his certificates carelessly. The fact to the case were that a firm of accountants had been engaged by a company to prepare the company’s accounts. The accountants knew that the statements of account would be shown to third parties. Peek (1889) 14 A. might bring a similar action. it was held that there is no liability to third parties for negligent language that resulted only in pecuniary loss. Relying on the statements of account . Wright (10M & W 109. it does not consider that what man writes on paper is like a gun or other dangerous instruments. however.” Direct case on an Accountant’s liability to third parties . if it was made in the honest belief that it was true.A. Learned Judge observed as follows: “There is no privity of contract between these parties.” In 1883. Gould (1893) LQ. would ensue. or even any person passing along the road who was injured by the upsetting of the coach. In Derry v. However. this decision was the subject of great controversy.

in the ordinary course of business or professional affairs. the subject of liability to third parties for negligence of a professional person has been comprehensively reviewed.. The one man who gives them wrong information will not complain if they do not verify it.. for it means that the accountant’s certificate which should be a safeguard. Though the Hedley Byrne case did not directly concern an Accountant. In my opinion Accountants owe a duty of care only to their own clients.J. investors.... and for failure to exercise that care an action for negligence will lie if damage result. It is just what he wants so as to gain his own ends. and he is required to do this not so much for the satisfaction of his own client but more for the guidance of shareholders. would know that he was being trusted. who certifies the accounts of his client is always called upon to express his personal opinion whether the accounts exhibit a true and correct view of his client’s affairs. though acted on by that other to his detriment was not action in the able absence of any contractual or fiduciary relationship between the parties Lord Denning.. becomes a share for those who rely on it. The House of Lords unanimously overruled the majority decision in Candler v. then the person replying accepts a legal duty to exercise such a care as the circumstances require in making his reply. v. If we should decide this case in favour of the Accountants there will be no reason why Accountants should ever verify the word of the man in a one man company.. Christmas & Co. the principle laid down in the case is applicable to Accountants.” A turning point .7. Ltd.Hedley Byrne & Co. or that his skill or judgement was being relied on.. so asked. the plaintiff had invested money in the company and it was lost. and said: “ . the House of Lords. Cohen and Asquith L. In the case. and others who may have to rely on the accounts in serious matters of business. I do not myself think it is the law. I think it is to be regretted.J. a person seeks information or advice from another.R.6 Advanced Auditing and Professional Ethics reported upon by the accountants. If such be the law. revenue authorities. who is not under contractual or fiduciary obligation to give the information or advice. The statements in question had been prepared negligently but there was no fraud. 14.. dissenting). because there will be no one to complain about it. Therefore. Heller & Partners Ltd.. (1963) All E. in circumstances in which a reasonable person may..” .. He wanted their backing for misleading information he gives them and he can only get it if they accept his word without verification. the following extracts from the headnotes are reproduced : “If. dissented... Crane. and upheld Lord Denning’s dissenting opinion in that case. held that a false statement made carelessly. 575: (1964)... and the person asked chooses to give the information or advice without clearly so qualifying his answer as to show that he does not accept responsibility. as contrasted with one fraudulently made by one person to another. however.. the Accountant... LJ. (Denning.. but also to those who they know will rely on their accounts in the transactions for which these accounts are prepared. I Camp L. And the persons who are misled cannot complain because the accountants owe no duty to them.

and Twomax Ltd. 1983.. and that the auditors had a duty of care to persons whom they could have reasonably foreseen would rely on their audit report. Marks. the House of Lords in England decided that there is no immunity from third party liability to an accountant unless he is acting judicially. Bloom and (1981). Justice Woolf ruled that such a duty of care did exist. and that a purchase would probably have taken place on the same basis even had the true financial position been known.000 resulting in overstated income and balance sheet figure. London Borough of Merton. directors. and had discussions with Jeb Fasteners. Jeb Fasteners subsequently purchased the company.G. the defending firm of auditor reported on the annual financial statements of B. 1975). carelessness on his part may be likely to cause damage to the latter. the plantiffs. However for recent cases have suggested a break away from the Hedley Byrne ‘special relationship principle’-Jeb Fasteners Ltd. ‘Second. it is necessary to consider whether there are any considerations which ought to negate. in the reasonable contemplation of the former. as opposed to the ‘special relationship test of Hedley Byrne. Dickson. Immunity stemmed from the origin of the appointments and not from the way the duties were performed (Arenson v.. In the context of accountant’s liability to third parties recently. for the year ended 31 October.7 The Council of the English Institute has taken legal advice on the question of accountants’ liability for negligence in the light of the decision aforementioned.G. or reduce or limit the scope of the duty .Liabilities of Auditors 7. Justice Woolf applied a ‘reasonable foresight’ test. Stock had been valued at net realisable value of £2. The auditors were aware of the company’s liquidity problems.In 1975. Mcfarlane and Robinson (1982). The judge ruled that the primary purpose of the takeover appeared to be the acquisition of the services of the two B. as between the alleged wrongdoer and person who has suffered damage there is a sufficient relationship of neighbourhood such that. in which it was hold that : ‘First. Beckman Rutley & Co. held that even if the auditors had acted as arbitrators. they could not claim immunity in negligence. The Times. One of the Judges Lord Kilbrandon. The contention of the auditors that using as arbitrators. but the auditors escaped liability on the grounds that the alleged negligence was not the cause of the loss. Casson. Marks. In this case the auditors of a company valued certain shares of the company as per the agreement between the parties selling and buying the shares. Jeb Fasteners . if the first question is answered affirmatively. It was later established that the valuation was a gross undervaluation. v. 1974. but the takeover was not a success. It has issued a statement “Professional liability of accountants and auditors” in November. Negligence was alleged against the auditors. at the time of takeover negotiations. one has to ask whether. and Goode v. This was based on a judgement by Lord Woolf force in the 1977 case of Anns v. 12th November. Bloom and Co. Consequently Jeb sued the auditors on the grounds that they were made into purchasing the company by the mis-stated financial statement. fasteners Ltd. instead of at cost of £11. in which case a prima facie duty of care arises.

Twomax Ltd and Goode v. Lord Steward relied on the Jeb case. were not aware of reliance by the plaintiffs or even of the fact that a takeover was contemplated. Bloom and Co. The Court of Appeal agreed that there was a lack of causal connection between the auditor’s negligence and Jeb’s loss. they were aware of the fact that Kintyre needed capital. .’ In Jeb Fasteners. The auditors did not attend the stock take and this contributed towards their being regarded as negligent. it would appear unwise for an auditor or accountant to rely on Hedley Byrne to restrict his liability. the judge decided that the events leading to the takeover of B. . Justice Woolf’s ruling has some authority but leaves the extent of third party liability still unconfirmed. insurers should be well able to cover this risk.’ And auditor’s. particularly those for 1973. if the auditors have made some very significant ‘goof. Accordingly. for it is hard to imagine a situation where accounts which are true and fair to members will be sufficiently misleading to others to provide the basis of a claim for negligence. It would appear safest to assume that negligently prepared or audited financial statements can result in liability to clients and third parties alike. Consequently. This latter is not a powerful argument. for the purposes of stewardship only. although it agreed by all parties that at the time of the audit Marks. and the judge accordingly ruled in favour of the plaintiffs. McFarlane and Robinson was a 1982 case decided in Scotland (where the law of negligence is the same as in England). was within the contemplation of Mr. the plaintiffs claimed they would not have been interested in the company. This made the situation foreseeable. Justice Woolf ruled that the auditors were aware of the liquidity problems of B. Dickson. and had they been aware of the true position. It further stated that it was not necessary for it to decide on the extent of liability to confirm in favour of the defendant. A usual argument against the extension of liability to third parties is that company law requires the auditor to report to the existing shareholders. stated that they had relied on the audit opinion of Dickson et al.7. Mcfarlane and Robinson were the auditors. And that the accounts have not necessarily been prepared with others in mind. Twomax Ltd. in purchasing their respective interest in Kintyre. Twomax Ltd. and decided that although the auditors were not aware of the specific intention of the plaintiffs. which could otherwise unfairly result in individuals bearing the loss. were foreseeable. acquired a controlling interest in Kintyre Knitware Ltd. Although the extent of liability is still by no means certain. and that financial assistance would become necessary and that a takeover was certainly one method which.G.8 Advanced Auditing and Professional Ethics of the class of person to whom it is owed or the danger to which any breach of it may give rise. Financial loss to creditors or other third parties will normally only occur as a result of the auditor’s default. of which Dickson. There were various mistakes in the audited financials.G. Marks (the auditor). Twomax and joint plaintiffs Gordon and Goode.

Furthermore. But should we have to entirely bear this heavy burden.. Yes so often they are ‘men of straw’ so there is no point in pursuing them.. It was not for individual speculation with a view to profit.. On the facts. The purpose of annual accounts so far as members are concerned..9 On the other hand. He would be liable to contract and tort for losses his client might suffer from breach of the duty.Liabilities of Auditors 7... as a requirement of holding office.. The amounts involved could indeed be almost infinite. and the fact of reliance very difficult to prove projectively (herein would lie the auditors’ the greatest safeguard). via our insurance premiums.”.. And tort should not be used as a backdoor approach for creating such a liability. ... Touche Ross. The House of Lords observed that where a statement was put into general circulation and might forcibly be relied on by strangers for anyone of a variety of different purposes which the makers of the statement had no specific reason to anticipate. whereas directors can often escape with a suspended jail sentence. CAPARO Industries V. was to enable them to question past management. The learned judges disclosed that for a duty to exist the following conditions must be satisfied: (i) the defendant would need to be fully aware of the nature of the transaction the plaintiff had in mind. a public company. The House of Lords opined that in advising his clients. the duty to use care did not exist. it would be wrong for accountants to be exposed ‘to liability in an indeterminate amount for an indeterminate time to an indeterminate class’.... The auditors owed no duty of care to the members of the public who relied on the accounts in deciding to buy shares. if the true accounts were known.. it is the directors who should really take primary responsibility for loss through misleading accounts. it should clearly say so. A purchaser of additional shares stood in the public to whom the auditors owed no duty.. it can be strongly argued that if the company law wants auditors to report to creditors.M/s. to exercise voting rights and to influence future policy management. It was also held that the purpose of the auditor’s certificate was to provide those entitled to the report with in information to enable them to exercise their proprietary powers. In the words of Cardozo in the famous American case of the Ultramares Corporation v. the auditors. a firm of accountants had appealed to the House of Lords from a decision of the Court of Appeal which held that auditors could be sued by an investing shareholder for inaccuracy in accounts or misleading accounts by which a pre-tax profit should have been shown as a loss. with their insurance cover.. Touche. will prove a much better bet. and their illgotten spoils? Perhaps directors should also carry a mandatory indeminity insurance. Touche Ross . although on grounds of equity one can question whether the auditor should in fact be held responsible for the financial loss of every potential investor and every creditor who seeks to rely on his report... It was difficult to visualise a situation in which individual shareholders could claim to have sustained loss in respect of existing shareholdings referable to auditors’ negligence which could not be recouped by the company. the professional owed a duty to exercise the standard of skill and care appropriate to his professional status.. and others. it was alleged that CAPARO would not have bid for the takeover of Fidelity.

and Goloo and others v Bright Grahame and Murray (1993) which would not extend the classes of persons to whom the accountant might be liable and which reinforced the view that it must be proved that an auditor’s negligence must be the “effective and dominant cause” of loss for a liability to exist. In Possfund v. They are James Mc Naughton Paper Group Ltd v Hicks Anderson and Co (1991). The case was settled out of court. the relationship to the client was not deemed to be sufficiently close.10 Advanced Auditing and Professional Ethics (ii) he must know that his advice or information would be directly or indirectly communicated to the plaintiff. Adams and others (1992). Berg Sons and Co and others v. a position they have maintained throughout the case. and could not support a duty of care to a finance house that had discounted Berg’s bills.35m in July. Morgan Crucible Co PLC v Hill Samuel and Co Ltd (1991) has threatened to dilute the effects of the Caparo decision. it applied to shareholders as a class not as individuals. the opinion had been relied upon for the purpose for which it was issued. supported by a letter from the auditors and the auditors’ opinion was issued after the takeover had commenced. and thus the plaintiff was not relying solely on the accounts but also on these further representations. The fact that a potential lender could foreseeably come to possess statements was not enough to create the necessary relationship. Clearly these recent cases have upheld the principles established in the Caparo judgement. Only one case. The degree of proximity was such that the defendant could well be liable. because the auditor had not directly sent a copy of the audited statements to a bank about to grant a loan to his client. 1994 to avoid any further legal action. Similarly in Columbia Coffee and Tea Party Ltd v. it is being argued that a duty of care is . They denied any negligence. and (iii) he must know that the plaintiff was likely to rely on the advice or information in deciding on the transaction that he had in mind. The facts of the case work that company taking over another. Thus. three more cases have endorsed its doctrine. Diamond (1996). It is interesting to note that Touche Ross. made an out of court settlement with Caparo of £1. relying on information provided by the auditor of the target company. it was held the auditor had a duty of care in that. in this case. as in Caparo. In Al Saudi Bank and others v Clark Pixley and another (1990). whereas in the Caparo case the audited accounts had been drafted for one purpose but had been relied upon for a different purpose. and had not been aware that the statements had been distributed. Subsequent to the Caparo case. the auditors in the case. which showed that the auditor’s work had been performed only to satisfy the statutory audit requirement and no more. the Court held that a third party investor was owed a duty of care on the basis of an assumption of responsibility flowing from statements in the defendant’s auditor manual which brought a potential purchaser of shares within the ambit of persons to whom a duty of care was owed. the Caparo principles were applied and.7. where a duty of care was denied again because. Since the directors of the target company circularised all their shareholders forecasting a sizeable increase in pre-tax profits. Churchill and others (1992).

. Ultramares upheld the privity of contract doctrine under which third parties cannot sue auditors for ordinary negligence. other beneficiaries are unnamed third parties. Ultramares Corp. Liability to Primary Beneficiaries . the judge recognized that extending liability for ordinary negligence to any third part might discourage individuals from entering the accounting profession. Ultramares sued the CPA firm for negligence and fraud.000 in the audit of Fred Stern & Co. First. the decision reaffirmed the auditor’s liability to any third party for gross negligence or fraud. Ultramares as a primary beneficiary could sue and recover for losses suffered because of the auditor’s ordinary negligence. In contrast. Hence. An analysis of the decision reveals several significant environmental factors that are particularly interesting in view of the current legal environment. stockholders. the bank becomes a primary beneficiary. the client informs the auditor that the report is to be used to obtain a loan at the city national bank. if at the time the engagement letter is signed. A third party may be defined as an individual who is not in privity with the parties to a contract. However. A primary beneficiary is anyone identified to the auditor by name prior to the audit who is to be the primary recipient of the auditor’s report. thus depriving society of a valuable service. v. failed to discover fictitious transactions that overstated assets and stockholders equity by $700. judge Cardozo’s decision extended to primary beneficiaries the rights of one in privity of contract. For example. American Scene . Ultramares loaned Stern large sums of money that Stern was unable to repay because it was actually insolvent.The privity of contract doctrine extends to the primary beneficiary of the auditor’s work. Third. In contrast. he feared the impact that a broader encroachment on the privity doctrine might have on other professionals such as lawyers and doctors. Touch. the auditor’s liability for ordinary negligence has traditionally been different between the two classes of third parties.Liabilities of Auditors 7. The landmark case. The auditor is liable to all third parties for gross negligence and fraud under tort law. The defendant auditors. Second. In essence. The court found the auditors guilty of negligence but ruled that accountants should not be liable to any third party for negligence except to a primary beneficiary.The common law liability of the auditor to third parties is important in any discussion of the auditor’s legal liability. and its major findings are as follows.11 assumed and owed to these investors who (as intended) rely on the contents of the prospectus in making subsequent purchases. On receiving the audited financial statements. Touche (now deloitte and Touche). and potential investors. such as creditors. there are two classes of third parties: (1) a primary beneficiary and (2) other beneficiaries. From a legal stand-point.

Foreseeable Parties . it was insolvent. Rusch Factors Inc v. In this case. The certified statements indicated that the potential borrower was solvent when.The leading cases that extended the accountant’s liability for ordinary negligence to foreseen parties and to foreseeable parties are as follows: In Rush Factors Inc. this means that the accountant would not be liable if the audit report was used by a bank to invest capital in the client’s business in exchange for common stock instead of granting a loan. since 1968. the court instead said. Foreseeability is used extensively by the courts in cases involving physical injury. This concept was first applied in an audit negligence case in the early 1980s. Court decisions have not required that the injured party be specifically identified.The first shift away from Ultramares occurred in the form of judicial acceptance of the specifically foreseen class concept.12 Advanced Auditing and Professional Ethics Liability to Other Beneficiaries . The defendant asked for dismissal on the basis of lack of privity of contract. Stock holders and present and future investors. The plaintiff had asked the defendant accountant to audit the financial statements of a corporation seeking a loan. In the above instance. Levin (1968) Cases Illustrating Liability to Other Beneficiaries . Rush Factors sued the auditor for damages resulting from its reliance on negligent and fraudulent misrepresentations in the financial statements. However. The foreseen class concept does not extend to all present and future investors. For example. all banks are foreseen parties. stockholders. in fact. the defendant knew that his certification was to be used for potential financial of the …. corporation (emphasis added). but the class of persons to which the party belonged had to be limited and known at the time the auditor provided the information. The liability is limited to losses suffered through reliance on the information in a transaction known by the auditor or a similar transaction. The accountant should be liable in negligence for careless financial misrepresentation relied upon by actually foreseen and limited classes of persons.7. but trade creditors and potential stockholders would not be part of the foreseen class. .The Ultramares decision remained virtually unchallenged for 37 years. foreseeablility is almost universally used in product liability cases when the manufacturer’s negligence causes the physical injury. Ths concept extends the auditor’s duty of due care to any foreseeable party who suffers a pecuniary loss from relying on the auditor’s representation. The court ruled in favour of the plaintiff. This concept is explained as follow: If the client informs the CPA that the audit report is to be used to obtain a bank loan. several court decisions have served to extend the auditor’s liability for ordinary negligence beyond the privity of contract doctrine.. and it still is followed today in many jurisdictions. Foreseeable parties include all creditors’. vs.Individuals or entities whom the auditor either knew or should have known would rely on the audit report in making business and investment decisions are foreseeable parties. or creditors. While the decision could have been decided on the basis of the primary benefit rule set forth in ultramares. A Foreseen Class . Levin (1968).

Dandekar had forwarded the statements of account to the Income-Tax Officer and. all the weekly entries in the separate sets of books of account were to called up and were entered in the regular books of account. When the matter was subsequently considered by the Madras High Court it was held that “he (Mr. therefore. Madras and had prepared the statements of account and Income-tax Return on the basis of account produced to him.” In view of the English decision (Hedley Byrne’s Case) mentioned earlier. the decision in this case may any more be considered to be good law. the Indian Courts may hereafter follow the decision in the Hedley Byrne case and hold that the auditor is responsible to all those persons for negligence who had relied on a financial accounts or statement prepared by him which is incorrect. if he did that. be considered to have undertaken to apply that skill for the assistance of another person and thereby to have accepted a duty of care to that person. Dandekar and filed a complaint with the Institute of Chartered Accountants of India. of course. Mohamad & Co. quite irrespective of a contract. Dandekar had been engaged by Messrs A. On examination. he is under no duty to investigate whether the accounts prepared by the assesses are correct or not. Dandekar) was under an obligation to perform auditing with due skill and diligence. Mr. All the statements were signed by him and there was also endorsement at the foot of the Balance Sheet that it had been verified and found to be correct. . For.M. it would be difficult to see what further obligations he had in the matter and in the favour of whom. relative to daily transactions.regular Day Books and ledgers for the open market transactions and a separate book for the black market transactions.Commissioner of Income Tax v. if he knows or ought to have known that it has been prepared for a particular person or class of persons or may be relied on by the person. the statements of account having been found to be wrong. We do not agree that the respondent is under any such duty to the Department and. neither suggest or assist in the preparations of false accounts. or class of persons in that particular connection. Dandekar had examined only the regular books of account of the assessee and prepared the statements of account and the Income-tax Return on the basis of these units. made at the end of the week of the transactions of that week. The facts of the case are: Mr. the Income-tax department took up the matter against Mr. Mohamad & Co. While the former contained detailed entries.Liabilities of Auditors 7. very likely. A negligent though honest. At the end of the financial year.13 The Indian Scene . the latter contained only consolidated entries.. Dandekar : This is the only decision on the auditor’s liability to a third party by an Indian Court. The charge is that he owed a duty to the Department to himself investigate the truth and correctness of the accounts of the assessee and not merely to act as their Post Office in transmitting them. misrepresentation which causes financial loss to another may thus. no question of negligence arises. it was discovered that Messrs. The Accountant is under a duty to prepare and resent correct statements of account of the assessee and he should. The effect of the Hedley Byrne decision is that some one possessed of a special skill may. G. while doing so had stated particulars of books of account that he had examined. But. Mr. had maintained two sets of account. During the course of assessment.

This doctrine is of particular concern to practising accountants. it is expected that the auditor would carry out the checking of accounts and verification of statements according to ‘standard audit practices’. If there is any default or failure in the conduct of an audit or in carrying out any other engagement judged by professional standards the person responsible. The auditor being an expert. On this account. But. He also must exercise the same degree of prudence. an important part of whose work consists of preparing. the implications should not be overlooked by any accountant who knows that his professional skill. The auditor.To charge a professional man with breach of duty or negligence. as any other professional person. . is not expected to be a detective nor is he required to approach his work with a suspicious or pre-conceived notion that there is something wrong. where a detailed audit has been carried out. (B) Breach of Duty or Negligence . A professional man does not guarantee the success of his professional effort. where a detailed audit is not required the scope and extent of routine checking that must be carried out is determined.7. Nevertheless. it is necessary to prove that there has been a deviation from the standard of care which he was expected to exercise in the performance of his duties. he should delve deep into the matter. However. whether gratuitously or not. however. he must carry out the audit according to ‘accepted professional standards’ (the implications of these words are explained hereafter) and having regard to all facts known to him about the financial solvency of the client. give rise to an action for damages at the suit of a person with whom no contract exists. if there is any thing that excites suspicion in him. For example. skilled in the techniques of accounting and auditing. skill and care. he is only required to be reasonably cautious and careful.14 Advanced Auditing and Professional Ethics in certain circumstances. on the ground that it was not agreed upon. in similar circumstances. the auditor who verifies the books of account of client by the application of test checks. In other words. is expected that he would be in possession of certain standards of knowledge and experience. He is a watch dog but not a ‘blood hound’. exercised in an independent capacity. in a case where a complete audit should have been carried out. would be expected to do. in the absence thereof. therefore. In the case of non-company audit. Nevertheless he is expected to posses a certain amount of knowledge and experience and he must exercise a reasonable degree of care and skill for the performance of duties. the fact should be brought to the notice of the client by the nature of checking carried out being stated in the report and area of accounts which have been covered being specified. on a consideration of the nature of engagement. examining or expressing an opinion on financial statements of various kinds which may be relied on by persons other than those for whom they were originally intended. would be guilty of negligence. will be relied on by others. would be held guilty of professional negligence if subsequently it is found that a mistake or fraud had remained undetected which would have been unearthed if a detailed audit had been carried out.

Arthur E. London Oil Storage Co. It may be observed that in general the defence was that the frauds were such that reasonable diligence and careful audit would have failed to reveal them or they were caused by lack of efficiency of the management. under the general principles of law. Armitage v. (1936): The charge in this case was that due to failure on the part of the auditor to verify the amount recorded and received for cash sales. Ltd. Green & Co.15 Likewise. all of whom happen to be the sole directors and the 2. (1904): In this case. The auditor was found guilty of negligence in not verifying the petty cash balance as part of the audit. which was shown by the petty cash book at 799 but in fact was only 30. the auditors were held responsible for the amount of defalcations which arose subsequent to their failure to detect frauds in an earlier period. succeeded. i. (1901): The auditors in this case had accepted the schedule of bad debts supplied to them by the Managing Director although it was inaccurate and they were far from satisfied with it. v. or in its supervision over the accounts. but in considering whether or not he has displayed reasonable care one must apply rules of common sense. six or seven hundred and a company which has only three shareholders. v. on the ground that the damages suffered were not due to the conduct of the auditor but that of directors who were guilty of gross negligence in allowing the balance in the hands of the Petty Cashier to increase to such a large amount. it has been alleged would have been discovered by the auditors.3 In the series of cases considered below. Cases Concerning the Civil Liability Of Auditors For Negligence 7. Despite the fact.Liabilities of Auditors 7. 3. The claim filed by the liquidator of the company against the auditors for negligence therefore. . the auditors have been called upon to pay compensation to their clients for the losses suffered by them through their negligence. the auditors were charged with negligence for failure to discover the misappropriation of the petty cash balance.5 sh. the fraud of the cashier had not been discovered. they had failed to qualify their report. action was brought against the auditors for damages sustained through defalcation of employees or otherwise which. In the course of judgement. Brewer and Knott. 1.e. but the damages awarded were limited to £5. Seear Hasulk & Co. Only in one case. if they had carried out their duties with the required degree of care and skill. The plaintiffs in some cases were individuals or partners and in the other companies but action was not brought under misfeasance proceedings of the Companies Act. Pendleburys Ltd. this he must do with reasonable care. The Central Advance and Discount Co. Eills Green & Co. But the charge did not succeed since the auditors have repeatedly brought the lack of internal check on ‘cash receipts to the attention of the three directors who were the only shareholders and debenture holders of the company. There is all the world of difference between a company which has a large body of shareholders numbering say. the learned judge observed: “He (the auditor) is there to see that the shareholders get a true representation of the finances of the company as disclosed by its books. v.

had misappropriated a large sum of money. but to enquire into its substantial accuracy. it transpired that the auditors had not examined the books of account with sufficient care as a result whereof the frauds committed by the cashier had remained undetected Mr.. A special fee was demanded and paid for this work. The prospectus contained. 5. if the auditor has. 4. In the course of the judgement. Justice Talbot. that the cashier of the plaintiff. Ferguson & Co. A. Tri-Sure India Ltd. v. Brewer & Knot (1942) ACTC (P 836): In this case. inter alia. by altering systematically figures on vouchers of petty cash and making fraudulent entries on time sheets.: Tri-Sure India Limited issued a prospectus of February 75 inviting public to subscribe its share. Joseph Armitage for alleged negligence in auditing the plaintiff’s books by reason of which defalcations aggregating to £1440 were not detected.. The auditor was found negligent by the Court... During the course of the hearing.F. observed that “Accountants undertaking duties of that kind could not be heard to excuse themselves on the ground that this or that was small matter. reported to the directors. Shepherd (1887): In this case action was brought by the liquidators against the auditors not under misfeasance proceedings. the report of the auditors (the defendants) on the accounts of the company for the year 1973-74 which showed that there was an abnormal rise in the rate of profits for the year 1973-74. check totals of wages sheets into wages book and check weekly totals with other detailed provisions.. the auditor had not considered the provision in the Articles and the balance sheet was not properly drawn up. but under a civil action for the recovery for amounts paid as dividend out of capital. check calculations and additions of wages sheets. Artmitage v. action was brought by Mr. 6.” The auditors were held guilty of negligence and a damage of £1259 was awarded against them. during the course of his judgement.. the learned judge observed that it was the duty of the auditor in auditing the accounts of the company not to confine himself to verifying the arithmetical accuracy of the balance sheet.. The defalcations consisted in fraudulent alterations of time sheets and petty cash vouchers.. and to ascertain that it contained the particulars specified in the Articles of Association.7. Such a detailed audit had been called for since the plaintiff wanted protection against his staff. in fact.. and was properly drawn up so as to contain a true and correct representation of the company’s affairs. In examining the balance sheet. An investigation later revealed that sales figures for 1973-74 had been manipulated by a whole time director of the company with the active co-operation of .. Leads Estate and Investment Society Ltd. what more could he be expected to do?”. Where the interests of a small company are confined to a very few persons and there are no outside people because all the interests in the company are held by the directors themselves.. The public issue was over-subscribed and the company proceeded to allot the shares as per the term of the issue. v. But it transpired after the audit had been in progress for some two and half years. The plaintiff had arranged with the auditor that they would vouch all payments with the receipts entered in the Petty Cash Account.16 Advanced Auditing and Professional Ethics sole debenture holders.

the company offered to refund all moneys which were subscribed by the allottees and also proceeded to sue the auditors for damages of Rs. Action in this case can be brought by a person who has sustained a loss or damage as a result of subscription to the shares or debentures. What is reasonable care and skill must depend upon the circumstances of each case. and (vii) whether the production for the year was adequate to support the volume of sales and closing stock for the year. . (v) whether there was any improvement/deterioration in the usage of material. The suit was. 63.Under section 62 for making an untrue statement in the report (as an expert forming a part of the prospectus). unless some information has reached which excites suspicion or ought to excite suspicion in a professional man of reasonable competence. less care and less scrutiny may be considered reasonable.” Thus. An auditor’s duty is to see what the state of the company’s affairs actually is. but he is not required to begin with suspicion and to proceed in the manner of trying to detect a fraud or a lie. dismissed. The other charges levelled against the auditors were (i) whether the consumption of raw material was commensurate with the sharp increase in sales/production. based on the record of continued success in financial matters.4 A civil action against the auditor may either take the form of claim for damages on account of negligence or that of misfeasance proceeding for breach of trust or duty: (a) Damages for negligence . the Court held that “the auditor is required to employ reasonable skill and care. Civil Liabilities under the Companies Act 7. The company alleged that the auditors failed to examine and ascertain any satisfactory explanation for steep increase in the rate of gross and net profits. therefore. but he is not required to perform the functions of a detective. and whether it is reflected truly in the accounts of the company. on the faith of the prospectus containing an untrue statement. Regarding the duties of the auditor. (ii) the reasons for disproportionate ratio of the total debts due by trade debtors to turnover as compared to the previous years. The Court held that the plaintiffs were not able to prove that the auditors were negligent in the performance of their duties. (iii) the reason for material variation in the ratio of the value of stock on hand to the cost of turnover for the year 1972-73 and for the year 1973-74. The practice of resorting to selective verification where internal controls are found to be satisfactory by an auditor has also been upheld in his judgement. upon which the balance sheet and the profit and loss account are based. On discovery of this.Liabilities of Auditors 7.85 lakhs.17 other top officials of the company. (iv) whether there was any change in the prices of prime raw material. the judgment has re-emphasised that an auditor need not proceed with suspicion unless the circumstances are such as to arouse suspicion or ought to arouse suspicion in a professional man of reasonable competence. Where there is nothing to excite suspicion and there is an atmosphere of complete confidence. (vi) whether the company had got new customers and/or there was any change in the terms of credit to customers.

or (c) that he was competent to make the statement and that on reasonable ground he believed and had continued to believe up to the time of allotment of shares or debentures that the statement was true. The words in his report. The Court observed that the duty of the auditor was to convey information and . however. to the shareholders the facts of the case. is guilty of misfeasance.The auditor who does not report. due to professional negligence of the auditor. The action. an accountant and “any other person whose profession gives authority to a statement made by him.The term “misfeasance” implies a breach of trust or duty. when the balance sheet is not properly drawn up. The charge against the auditor in this case was that though he had submitted a detailed report to the directors. Some of these have been illustrated above by the decision in cases on civil liability of auditor due to professional negligence.” Also that under Section 55 of the Act a statement may be considered to be untrue. the same was withdrawn before any copy of the prospectus was delivered for registration. including the report purporting to have been made by him as an “expert” has been obtained. A few cases in which action has been brought the auditors against under misfeasance provisions of the Companies Act are summarised below: 1. (1895). not only because it is so but also if it is misleading in the form and context in which it is included. would not succeed if the auditor is able to prove: (a) that after he had given his consent in writing. in respect of which the security lodged was wholly insufficient and had expressed his misgivings as regards recovery/ of interest on these accounts. he had neither disclosed the position to the shareholders nor he had made any reference to the report which he had laid before the directors. “the value of assets as shown on the Balance Sheet is dependent upon realisation etc.held .18 Advanced Auditing and Professional Ethics It may be noted that the term “expert” under section 58(2) includes. The liability would arise if the written consent of the auditor to the issue of the prospectus. on realising that the statement was untrue. or (b) that after registration of the prospectus but before any allotment was made thereunder. included in the Profit and Loss Account. In Re: The London and General Bank. he. as regards loans and overdrafts granted to customers. had withdrawn his consent in writing and had given reasonable public notice of the withdrawal and of the reasons therefore.7. Liability also arises in the circumstances where some loss or damage has been suffered by a client or a third party. (b) Liability for misfeasance . among others. The auditor of a company would be guilty of misfeasance if he has been guilty of any breach of trust of negligence in the performance of his duties which has resulted in some loss or damage to the company or its property.” did not contain any warning to shareholders and the mere presence of these words was not enough to excite suspicion.

As regards the first dividend (declared in 1891). though he was guilty of an error of judgement. 2. careful and cautious auditor ordinarily would use. the auditor was required to conduct a monthly audit. In Re: Kingston Cotton Mills Co. the profits of the company had been inflated fictitiously by the deliberate manipulation of the quantities and values of stock-in-trade. and had compared them with ledger balance. care and caution which a reasonably competent. also. In this case. The auditors had certified the balance sheet on the basis of the certificate of the manager as to the correctness of the stock-in-trade without checking the stock in detail and this fact was shown on the fact of the balance sheet. the profit disclosed by the profit & loss account was found to have been inflated by the suppression of certain purchase invoices outstanding at the date of the balance sheet though the goods received in respect thereof had been included in the closing stock. exonerating the auditors of the charge of negligence. despite the fact. If any matter is observed which is calculated to excite suspicion. by way of damages. The learned judge hearing the case found that the suppression of invoices would have been detected if the auditor had called for the creditors’ statements of account on the basis of which payment had been ordered. but not a blood hound’.R. he concluded that if due . cautious and careful. What is reasonable skill.Liabilities of Auditors 7. was liable to refund the amount of the second dividend (declared in 1892) on the ground that he was aware of the critical position of the affairs and thus had acted negligently in not reporting the facts to the shareholders although he had reported them to directors. Tyson and others (1900) Act L. but in the absence of anything of that kind he is only bound to be reasonable. He must. if the entries in the ledger accounts were checked with relevant invoices. 23. The Irish Woolen Co. Lopes L.J. believing them to be honest and truthful.19 not to arouse enquiry and held that the auditor. under a special agreement with the company. in the period subsequent to the audit.held . made remarks to the following effect : It is the duty of an auditor to bring to bear on the work he has to perform the skill. ‘He is a watch dog. care and caution is a matter which must be judged on consideration of the special circumstances of each case. take reasonable care to find that the representations made by them are not palpably false. however. He is entitled to rely on the representation made to him by the tried servants of the company in whom confidence has been placed by the company. Ltd. 3. in the course of judgement. it would have been discovered that these had not been posted on the true dates.That an auditor is liable for any damages sustained by a company by reasons of falsification of accounts which might have been discovered by the exercise of reasonable care and skill in the performance of the audit.That it is not the duty of the auditor to take stock and that he is not guilty of negligence if the certificate of a responsible official is accepted in the absence of suspicious circumstances. An auditor is not bound to act as a detective. In this case. as it was of the opinion that the evidence was not sufficiently strong to establish a case of misfeasance against him. the auditor was not held liable. held . On these facts. (1896). or as had been said to approach his work with suspicion or with a foregone conclusion that there is something wrong. he should probe it to the bottom. Limited v.

at all material times.That when there is time lag between the incurring of a liability and receipt of bills and at the time of audit. In this case. the company’s stock brokers who. The auditor had relied on the certificate of Ellis & Co. held . (1913). Negligence was alleged in respect of over valuation of work in progress. and holding securities. on reasonable grounds.. “I think he (the auditor) must take a certificate from a person who is in the habit of dealing with.7.held . rightly believes to the exercise of the best judgement a trustworthy person to give such a certificate. In Re: Westminster Road Construction and Engineering Co. The chairman of the company was also the senior partner in the firm of Ellis & Co. though the payments had not been made by the company in consequence of any report or audit by the auditors. In this case. the suppression of the invoices would have been discovered and held the auditor liable for the damages which the company had suffered due to understatement of liability in the Balance Sheet. It was contended that they had failed in their duty in passing the accounts without drawing attention to such payments and that in consequence the Balance Sheet did not show the true financial position. on a consideration of the evidence led in this case. action had been brought against the auditor by the liquidator of the company in respect of payment of dividend when there were in fact no profits of which it could be paid.That the auditors of a company in liquidation may be held liable for failure to detect ultra vires payments.That an auditor is not justified in omitting to make personal inspection of securities that are in the custody of a person or a company with whom it is not proper that they should be left.” 6. which were in the custody of Ellis & Co. 5. He made the following obiter dicta which is of great significance to auditors. a claim was brought against the auditor to make good certain payments which were held to be wrong and ultra vires. In Re : City Equitable Fire Insurance Co. were heavily indebted to the company. The principal charge against the auditors was that they had failed to detect and report to the shareholders that a number of company’s securities. were being pledged by the firm to its customers. The master of Rolls. In Re : Republic of Bolivia Exploration Syndicate Ltd. but only in extreme cases will the liability be fully enforced. Ltd. Ltd. 4. omission of .20 Advanced Auditing and Professional Ethics care and skill had been exercised.. an action had been brought by the Official Receiver as liquidator of the company against the directors and auditors for damages arising out of misfeasance. and who he. a fact which had put the company to loss. (1932). sufficient time had not elapsed for the invoices relating to such a liability to have been received it was the duty of auditor to make specific enquiries as to the existence of such liabilities. He also must check the valuation of the work in progress at which it is included in the Balance Sheet. that these securities were held by them. showed that it was customary for the auditor to obtain certificate from banks in respect of securities lodged with them and that the certificates were not accepted from brokers. In this case.held.

Though the fact that the defalcation had occurred was accepted.This is a significant case in as much as it seeks to provide guidelines for the exercise of auditor’s judgement and discretion where conclusive accounting and auditing principles are not available to guide the auditor. In the case. etc. For instance. day to day. held . the Courts have held that the amount of loss should be made good by the auditor. it will be observed that when an auditor has been found guilty of professional negligence and a loss has been suffered. The test that the Court applied was not whether the balance sheet was in accordance with generally accepted accounting principles but whether the balance sheet fairly represented the financial position. 7. at the time money was duly handed over. (ii) known dishonesty by a high official. under . The Court held that the auditor was liable to refund to the company the amount of dividend wrongly declared. The judgement is significant for what it says about the weight the law will attach to the standards of accounting profession and for what it says about obligations of an auditor over and above those imposed by the standards themselves. Also.In the various cases considered. Catterson and Sons Ltd. Ltd. with interest and costs. notwithstanding this. This was not reported and since the amount advanced by this company became irrecoverable. the auditor was held guilty of not having reported a known fact. The Court held that though in ordinary case disposition of funds advanced by the client to its affiliates need not be disclosed by the auditor.. 8. which had become irrecoverable. the system had been continued.Liabilities of Auditors 7. In Re: Continental Vending Machine Corporation (1970) An American Case . in the case of Leeds Estate Building and Investment Co. Thus the Court laid down a special rule for disclosure and emphasised that an auditor’s approach should not necessarily be limited to the mere compliance with the accepted standards but should primarily be governed by the objective to establish an honest and fair representation of financial facts.e. The President of the Continental Vending Machine Corporation caused the diversion of a substantial sum of money of the Corporation to his benefit by canalising it through an associated concern the audit of which was conducted by another. an application had been made by the liquidator that the auditor of the company had been negligent in the performance of his duty and thus was liable to compensate the company in respect of amounts misappropriated by an employee of the company.That the primary responsibility for the accountant of a company is of those who are in control of the company i. the auditor contended that he had drawn the attention of the directors to the weakness of the system of recording cash and credit sales and had recommended its alteration. v. A substantial part of the security for this accommodation consisted of securities of the Continental Vending Co. In Re: S.P. itself. the auditors were held guilty of gross negligence. the directors. (iii) corporation being operated to a material extent for the private benefit of its President. In this case. by the manager. (1947). and (iv) dishonest diversion of funds. Shephered. such a disclosure becomes necessary in cases of : (i) looting. that the directors had failed to check adequately the cash records. Damages must be suffered .21 liabilities.

000/-. Ltd. the loss has been occasioned through negligence of directors. Brewer and Knot. The charge may also fail if he is able to prove that the statement complained of is either immaterial or that he had reasonable ground to believe. He incurs such a liability as auditor of the company. Seear Husluck and Co. the auditor would be liable both for the original loss which he had failed to detect and the subsequent loss suffered by the employer. the fault of the auditor in failing to verify the asset has been considered to be only technical and only nominal penalty has been imposed. In the case of Artmitage v. prospectus. Apart from the liability for professional negligence. jointly with directors. But he can be so charged only if he has authorised the issuance of the prospectus. v. certificate. in the discharge of duties an auditor also may be penalised under section 233 of the Companies Act for failure to comply with any of the provisions contained in sections 221 and 229. Where. on the ground that professional negligence had not occasioned the loss. statement or other document required by or for the purpose of the Act. the auditor was held liable to make good. Criminal Liability under the Companies Act 7. embezzles a larger sum. Under section 628 an auditor is liable for criminal prosecution.5 The circumstances in which an auditor can be prosecuted under the Companies Act. the auditors were held responsible even for the amount of defalcations which has taken place subsequent to their failure to detect fraud with regard to petty cash in an earlier period. the dividend paid out of capital. 1. if he in any return. and the penalties to which he may be subjected are briefly stated below: (i) Under section 63 an auditor is criminally liable for making any misstatement (untrue statement in a prospectus) and can be sentenced to a term of imprisonment extending to two years or a fine of Rs. balance sheet. The punishment in this case is fine which may extend to Rs. however. 50. and in fact he did believe up to the time of issue of the prospectus. the employee emboldened by the non-detection of the defalcation. It penalises the making of a false statement in any document required by or for the purposes of complying with the provisions of the Act. 5sh was awarded as damages against the auditor. or (b) which omits any material fact knowing it to be material.£5. is applicable only to false statements which are not specifically punishable under any section of the Act. that the statement was true. in the following year. If convicted. in the case of London Oil Storage Co.000 or to both.22 Advanced Auditing and Professional Ethics a civil action by the liquidator. presumably. For instance.7. i. he can be punished with imprisonment for a term extending to two years and also with a fine.e. It is the only case in which the principle of consequential damages has been applied to audit claims. if an auditor omits to detect a defalcation by an employee and. . (ii) This section. makes a statement (a) which is false in any material particular knowing it to be false. before there is a chance of any further audit. although the loss was much more.

000 from excess Profit Duty. and dividends on both the preference and ordinary stocks. there had been a considerable writing up of assets. £2. In 1927. it was clear that the accounts were not only false but materially false. The facts of the case briefly were that the Profit and Loss Account for the year 1926 showed. (1921) . 3. and (b) of publishing an annual report for the year 1927. The auditor was in the company’s regular employment as its accountant and was convicted on various charges of conspiracy and fraud in connection with the published accounts of the bank.000 from Income tax Reserve and £25. and sentenced to 12 months’ imprisonment.776 from investment Profit.37. it was making a trading loss. .75.30. 1956. (1900) . in fact.386. in fact.The directors and auditors. Lord Kylsant and Another (1931) . which he knew to be false in a material particular.Morland the auditor.5. 2. The contention of the crown was that such item. for having joined in the issue of false balance sheets.(Known as the Royal Mail Steam Packet Company’s Case) This was a criminal prosecution in which Lord Kylsant who was Chairman of the Board of Directors of Royal Mail Steam Packet Company was charged on two counts (a) of publishing an annual report for 1926. Dambell Banking Co.12.50. ‘Balance for the year. though Lord Kylsant was found guilty and convicted on a separate charge of publishing false prospectus for the issue of fresh debenture stock.1 Cases in which an auditor has been held to have incurred criminal liability - 7.907 was raised to £4. with intent to deceive the shareholders Mr. Rex v. Ltd. a surplus of £2. H. knowing them to be false in material particulars. and with the intent to deceive and defraud shareholders of the company. If this was not done there would have been a considerable deficit. Both the accused were acquitted of respective charges.J. had been drawing upon its secret or hidden reserves from 1921 to 1927. were prosecuted under section 221 of the Criminal Code of 1872 which is similar to Section 227 of the Companies Act.212.000.23 1. in the case. adjustment of taxation reserves. with intent to deceive the shareholders. but did not state those views in their certificates to the shareholders.” The company. Actually this apparent surplus had been arrived at on including undisclosed credits of £5.293 by similar credits totalling £2.24. It must be added that almost the entire amounts of these credits had no relation to the trading of the respective years 1926 and 1927. in the accounts conveyed “a deliberate false representation to the shareholders that the company was making a trading profit when.500 was written up to £7. From the facts provided. with practically identical wording.In this case. They had told the managers that they held strong’ views about the overdraft. In one case a piece of property that cost £5. letters from the auditors to the managers showed that they (the auditors) thought that overdrafts were bad although taken in as good. was charged with aiding and abetting Lord Kylsant to commit these offences.Liabilities of Auditors 7. Farrow’s Bank Ltd.80. The adjustment of these special credits enabled the company to pay its debenture interest. including dividends on shares in allied and other companies. The jury found all the defendants (including the auditors) guilty. less depreciation of fleet £4. obviously to show profits available for dividends. which he knew to be false in a material particulars and that the said report concealed from the shareholders the true position of the company. and they were sentenced to various terms of imprisonment.

) the auditor of Richard Critical and Co.24 Advanced Auditing and Professional Ethics N. adjusted in the Profit and Loss Account. connection with a prospectus issued by the company inviting applications for shares. in assets. In the course of summing up Mr. The case was brought in England under Section 12(l) of the Prevention of Fraud (Investment) Act (1930). It. almost similar to Section 68 of the Companies Act.214. together with the figure of profit for the year 1946. therefore. Musgrave.This was a prosecution of Mr.P. on this charge but Mr. an engineering concern. as an accountant. The balance sheet. (1932) . A. Ltd. 15. which did not involve the auditor. Musgrave. manager and the auditors for an offence under section 232 of the Indian Companies Act. an amount held in suspense for bad or doubtful items of interest. The decision in the case has been principally responsible for the change in the phraseology of the auditor’s report from ‘true and correct’ to ‘true and fair’ requiring a fuller disclosure of any non-trading income or that not belonging to the year. Rex v. was a misleading statement and that the two directors and the auditor were guilty of making it recklessly. were made against the two Directors. no doubt. Hinds Musgrave and Steven (1950) .746. Wild J.The directors of the Bank made a statement in the balance sheet that the profit earned by the bank in 1927 amounted to Rs. Hinds. Steven handed that matter over to his partner and Us partner having in fact made tests and satisfied himself at the time as an honourable man.” The contention of the prosecution was that this item. The amount of profit had been arrived at on taking credit for a sum of Rs. Steven was reckless in accepting Mr. Justice Humphries said: “It seems to me a very serious matter for your consideration whether you can possibly say that Mr.B. 1913 (now section 628) of the Act.L. 4. one of the directors. The Directors. The auditor. Two of the aforenamed directors and the auditors were charged with inducing people to apply for shares in the company by recklessly making misleading statements in the prospectus. It was held that the official Liquidator should prosecute the managing directors. Steven was acquitted so also was Mr. in fact represented “expenditure in connection with development and expansion of export trade of newly formed subsidiary and associated companies carried forward.E. the other director was convicted.C. two directors and of Mr. when the expenditure was actually incurred. Mr. This is the one thing that is said to be against him. J.608. contains a false statement and a very material one and I am unable to see how it can be argued that it was not intended to be misled.45. said “What the Directors of the bank have done is to show a cash profit for the year by adding in a sum which is due. Other charges.” 5. There is plenty of evidence that in others parts he took meticulous care in . The charge against the auditor was in respect of inclusion of a sum of £39. Morton’s (the partner’s ) explanation. 1956. Cenneth Forbes Steven (of Singleton Fabian and Co. The auditor was prosecuted on the basis of the auditor’s report set out in the prospectus. but was never paid and was never likely to be paid. Hinds and Mr. and a careful accountant that the document was right can you say that Mr.7. of Karachi Bank Ltd. Official Liquidator Karachi Bank v. etc.

The learned judge observed. he had not stated the position clearly. Authorities both legal and professional are unanimous that in a bank audit the cash balance claimed by the management must be verified by the auditor because otherwise the management might remove the greater part of the funds and show them falsely as lying in hand in cash and thereby relieve themselves of the necessity of making up accounts showing the disposition of money. Dass Gupta. instead.N.” In the matter of the second charge against the auditor that though he had some doubts and misgivings as regards certain losses which might be suffered by the bank due to certain overdrafts accounts proving to be irrecoverable. But on this particular point his evidence is relied upon Mr.000 although the actual balance on the date was a little over Rs. action was brought against Shri S.In this case. it is no defence for him to say in disciplinary proceedings started under Chartered Accountants Act that he had told the shareholder that he had not done it. One of the charges was that in 1944 the bank has shown in its Fixed Deposit Ledger certain large sums as having been received on fixed deposit from certain concerns in which the Managing Director was interested but the Cash Book of the bank did not show any corresponding entries on the relevant dates.000. the decisions in a number of cases can be referred to. The auditor in defence submitted that he had not verified the cash balance in hand and had mentioned this fact in his Special Report. are considered below: Deputy Secretary of the Government of India. S.Liabilities of Auditors 7. 5. 1. It was also alleged that on a certain date in 1944 the Cash Book showed a cash balance of Rs. In the matter of cash the auditor is not entitled to rely on the certificate of the manager of accepted integrity. in respect of alleged negligence in the audit of accounts of Aryan Bank Limited. according to the principles laid down in the case Re: City Equitable Fire Insurance Co.” Cases Concerning the Misconduct of Auditors under the Chartered Accountants Act 7. It was alleged that the bank had resorted to manipulation of accounts on an extensive scale. The learned judge in this regard observed: “If an auditor does not do what it is his duty to do. “Either he knew that some of the debts were bad and some of the so called secured loans were not genuine.6 The code of conduct for an auditor should be taken into consideration and the different circumstances under which disciplinary action can be taken against a member. Dass Gupta . however for students to understand what constitutes ‘gross negligence’ in terms of Clauses 5 to 8 of Part I of the Second Schedule to the Chartered Accountants Act. Ministry of Finance v. for the years 1942 to 1944. It being important. a member of the Institute.00. he had failed to qualify the report in certain terms indicating the true position of the debits and. N.25 trying to ascertain whether the books of this company were reliable or whether they were not. The lapse is constituted by his failure to verify a duty without which an audit is meaningless and it is not excused by giving information of the omission to the shareholders. Another charge was that though the auditor had certain doubts as regard loans advanced against fixed deposits. but he did . Morton. had made some cryptic remarks about them in his special report. two decisions by Indian Courts which have become legal classics.

contained. but also whether the books of the company themselves exhibit a true and fair state of the company’s affairs.26 Advanced Auditing and Professional Ethics not wish to inform the shareholders of that fact but wanted at the same time to provide for his own safety and. In this regard the dictum. with the result that the auditor did not have access to it. if disclosed. All matters which are capable of direct verification should generally be verified directly. The learned judge in his judgement also made the following observation as regards the duties of auditor and methods they should follow for discharging them satisfactorily: (a) Ascertaining reporting. he is not responsible for its non disclosure to the shareholders. . or he was careless and neglected to give the shareholders the information which it was his duty to give. they would show the balance sheet in a different way. pronounced by Rigby L. (e) Verifying the existence of assets and liabilities. therefore. to the fact that he is not in possession of any information which excites suspicion or ought to excite suspicion of a professional man of reasonable competence. Director but only if he is satisfied that the representations made by him appear to be an honest and truthful. But matters which require investigation rather than checking may be verified on the basis of representation of officers of accepted competence and integrity provided there is nothing unusual in the accounts. If any matter has been kept out of the books. (b) Verifying not merely the arithmetical accuracy of the statements of account but also their substantial accuracy by confirming that they include all the particulars requiring disclosure by the Articles or the Companies Act and otherwise represents true and fair state of affairs of the company.7. (f) Making a report to the shareholders as would give them information and not merely means of information. that the words as shown by the books of the company. For the purpose. in the report which the auditors make on the statements of account relieve them the responsibility as regards disclosure of the affairs of the company kept out of the books can be followed. as shown by the books of the company.J. the auditor may properly rely on the statements of the director-incharge or the Mg. (c) Checking the accounts and verifying the financial statements with reasonable care and skill. in the case Re : London & General Bank. in order that the shareholders may judge the position of the company for themselves. however. he inserted certain cryptic remarks in his Special Report. If the auditor is not satisfied as to the accuracy of entries in the balance sheet or they are such that.” It was held that the respondent has committed a grave wrong and in consequence he was suspended from the membership of the institute for two years. not only whether the balance sheet exhibits a true and fair state of affairs of the company. (d) Examining the books of the company and obtaining such information or explanation which he considers necessary but not with suspicious mind or by proceeding in a manner he would adopt for detecting a fraud or a lie subject. these facts must be conveyed to the shareholders.

as we find to our regret to have been the position here. a positive danger to them. The principal defence of the auditor in respect of the charges was that he had relied on statements of the management in regard to matters included in the statements certified by him. but only says that he has taken all possible care and exercised reasonable skill and having done so has arrived at the conclusions which are recorded in his certificate. His liabilities under the Income Tax Act of 1961 are as below: (i) Under Section 288 .” The auditor was held guilty of gross negligence. but only relies upon statements made to him by the management. the learned judge made the following observation: “As has been said..7 In connection with proceedings under the Income Tax Act 1961. On the appointment of the administrator subsequently under Section 52A of the Insurance Act. as his own case find it impossible to hold that he exercised any skill or care of any kind. instead of a source of security to the shareholders. statement. but he is not also an insurer.27 Controller of Insurance vs H. can not act as an authorised representative (for any matter within the definition of a member in practice) for such time that the order of the Council disqualifies him from practising. A Chartered Accountant found guilty of professional misconduct in his professional capacity by the Council of the Institute of Chartered Accountants of India. a Chartered Accountant often acts as the authorised representative of his clients and attends before an Income Tax Authority or the appelate tribunal. or . 1938. Dass & Co. C. But if. a number of irregularities were discovered.Any person who acts or induces... in any manner another person to make and deliver to the Income Tax Authorities a false account. He does not certify the absolute accuracy of the accounts which he audits and approves of..Liabilities of Auditors 7.. During the course of the judgement. an auditor is not only blood hound.C.A person who has been convicted of any offence connected with any Income Tax proceeding or on whom a penalty has been imposed under the said Act (except under clause (ii) of sub section (1) of Section 271) is disqualified from representing an assesses. Das . (ii) Under Section 278 . “An auditor who construes his duty to shareholders or policy holders too narrowly and who passes and approves of whatever is stated to him by the management of the corn any whose accounts he audits does not serve the shareholders with the loyalty or efficiency expected of him and constitutes.In this case. an auditor does nothing at all in the way of scrutinising the books of the company. The auditors had audited the accounts of the company from 1936 until 1951 and had issued the certificate required under Regulations 7(c) and 7(d) of Part I of the First Schedule to the Insurance Act.. Liabilities Under Income Tax Act 1961 7. The Chief Commissioner/Commissioner of Income Tax has been given powers to determine the period of such disqualification of a person. action was brought against Messers H. by the Central Government in the matter of audit of accounts of Bhagya Laxmi Insurance Limited.

. he has also to submit a report on the scope and results of such examination.28 Advanced Auditing and Professional Ethics declaration. Where the Chartered Accountant has conducted an examination of such records. the particulars of accounts. statements and other documents supplied to him by the assessee for the preparation of the return. (iii) Under Rule 12A of the Income Tax Rules .7. he would be liable to rigorous imprisonment which may extend to seven years and to a fine. Thus if this report contains any information which is false and which the Chartered Accountant either knows or believes to be false or untrue. The report to be submitted will be a statement within the meaning of Section 277 of the Income Tax Act. has to furnish to the Assessing Officer.Under this rule a Chartered Accountant who as an authorised representative has prepared the return filed by the assessee. relating to any income chargeable to tax which he knows to be false or does not believe to be true.

In case of statutory appointments. clear and objective in the matter of preparation of the report. This is imperative to avoid disputes on the contents of the report. where an auditor finds that a reference to certain facts is necessary in the report in order to render his opinion meaningful. In case of a non-statutory appointment. between the auditor and the client that determines the scope of the auditor’s work and consequently. The auditor in his interest should endeavour to get the terms of appointment reduced in writing so that possibilities of ambiguities or different interpretations of the terms can be eliminated. Accordingly.8 AUDIT REPORT Auditor’s opinion 8. often the duties to be performed by the auditor and matters to be reported upon are specified by the concerned legislation. By expressing views in the report. He is to verify the books of account and the resulting statements and state his findings in the report. The report is the medium of communication of the auditor’s expert views on the financial statements and it has a significant bearing on the credibility of such statements. An opinion can be formed by a process of examination. written or otherwise. It must be appreciated that what is sought from an auditor is his informed opinion about the credibility of the financial statements which summarise the year’s transactions. he is to report within the terms of his appointment as agreed upon by him and the client. The report should also be as simple as the circumstances permit. besides other matters considered necessary by the auditor. the scope of the report. It is necessary to emphasise that an auditor’s report is directly linked with the task entrusted to him. . he is necessarily to be careful. Naturally. Therefore. he should state such facts in the report. Consequently. inter alia. The facts should be stated as they are and any attempt to interpret them should be avoided and they should be distinguished from the opinion part of the report. students may refer to sub-sections (2) and (3) of Section 227 of the Companies Act. 1956 which provide for. the auditor takes upon himself a great responsibility because a large number of people are likely to put reliance on the financial statements.1 At the end of every audit. In this context. the report will have a fact paragraph and an opinion paragraph. it is the agreement. The auditor’s task is basically verificatory in nature: that is why auditing is called an “attest” function. the auditor issues a report. Verification and evaluation are the steps that provide the very basis of the opinion to be expressed. a few factual statements to be made by the auditor.

The nature of the audit examination carried out also has a very great bearing on the value of the audit opinion. The auditors cannot be expected to know all the technicalities and the complexities of the business deals.1 Significance of the nature of audit examination . the auditor indicated that he had not carried out certain procedures. to be self-contained.N. The scope of part is as important as the opinion part because the opinion is very much conditioned by the scope of the work and the examination carried out.2 Advanced Auditing and Professional Ethics The report. if any. This ultimately resulted in his being charged with professional misconduct and being found guilty. under the requirement contained in Section 227 of the Companies Act. 8. if in a report on the accounts of a partnership firm it is stated that the stock records were not subject to audit. should also devote a part to the scope and limitations. the auditor in our country is required to state certain facts like whether he has obtained all the information and explanations considered necessary by him and whether the balance sheet and the profit and loss account are in agreement with the books of account.2 Significance of obtaining information and explanation from the management . the readers of the report will be in a position to assess the implications of the opinion more clearly.Section 227 (3) of the Companies Act. 1956 casts a duty on the auditor to state whether the information and explanations considered necessary by him for the purpose of his audit has been obtained. 8. apparently to disown responsibility. The requirement simultaneously serves the purpose of indicating to a limited extent. provided grounds for much litigation and. it is necessary that a reference is made in the audit report itself about the scope and nature of the work performed. However. often we come across reports stating that the audit has been carried out by reference to the “books of account and the vouchers produced” This is a very significant statement highlighting the nature of audit carried out. In this case. Ministry of Finance v. In the audit report of partnerships and sole traders. also the relevant papers and documents to explain the transactions may not be really available to the . This is a significant requirement in as much as recognition is accorded to the process of obtaining information as part of the whole auditing process. This has another positive aspect if the scope and nature are spelt out in the report. Das Gupta. 1956. S.1. obviously the opinion will be subject to the limitations and is likely to be different from what it would have been if the auditor had the authority to check and verify whatever he considered necessary. How significant is the disclosure of nature of examination carried out can be appreciated from the famous case of Deputy Secretary to the Govt.8. it will suggest proper evidence collection and arithmetic agreement. The recitation of the scope of the audit has the advantage of limiting and defining the responsibility assumed by the auditor. For example. The misunderstanding about the scope of the work and the nature of the work to be performed in the past.1. AASs issued by the AASB constitute auditing standards within which framework the auditor carries out his responsibility. then naturally the opinion ultimately expressed cannot be taken to be the opinion based on a complete audit including the audit of the stock records. of the work done and the examination carried out in a broad manner. of India. The statement in the report that he had not carried out certain procedures suggested the nature of examination actually carried out by him and that established the meaninglessness of the opinion. the nature of examination carried out. therefore. and can be expected to exercise their judgement on how far to act on the basis of the opinion expressed. If the scope of the work was limited by the client.

Students may recall that an auditor may write “letter of weaknesses” to communicate weaknesses in the internal control system to the management. the overall view that an auditor is able to take of the business and his intimate knowledge of the internal organisations. if any vital information is deliberately withheld from the auditor in the ordinary course of audit. and he had no means to know the existence of such information. He should also make it obvious by prefixing the expression “in my opinion” to the opinion part of the report. If they have been specially formulated the auditor should exercise a little more care to examine them for any apparent unreasonableness or inconsistency. should not reject the information and explanations as fabricated unless he has noticed something suspicious about them. having regard to the circumstances. in case the accounts turn to be wrong for that reason. the auditor should insist on its production before him. it is very much within his rights to make in the report or in a separate report suggestions for improvements. and therefore auditors have been given the right to ask for information and explanations from the management. he will issue an opinion that will lend credibility to the financial statements. no information and explanations should be accepted as reliable without subjecting that a scrutiny.About the opinion which is the central focus of an auditor’s report. if the auditor is not satisfied about the proper presentation of facts in the accounting statements or is of the opinion that inappropriate classification.3 auditor and. etc. The management of the company. he would be held guilty on that account. The auditor should also see whether the information and explanations made available to him have come from the company’s records or they have been specially formulated. It has to state that his opinion on true and fair character of the balance sheet and the profit and loss account is based on the information received.1. even if they are available they may still need to be explained so that one can clearly understand the impact of the transactions on the accounts. If the auditor is satisfied that the statements of account under report correctly summarise the year’s transactions and are truthfully and fairly presented. have been used or important information has been withheld. the auditor’s report is greatly valued on account of objectivity. The information and explanations made available to the auditor by the management should be relied upon when the auditor is satisfied that they are prima facie reliable. Apart from the scope. in particular. Thereby he will be able to draw a line between facts and opinion. it would not be uncommon to find a part devoted to recommendations. Therefore. In this connection. the auditor should not be held guilty or negligent. 8. On the other hand. which actually enters into transactions on behalf of the company is expected to have thoroughly understood the implications of all material transactions. based on available evidence and common sense. Where some basic documentary evidence is available. the auditor has to be highly discreet in using words and phrases.Audit Report 8.3 Nature of Auditor’s Opinion. however. If an auditor feels that certain improvements in the accounting control or in the records are called for. However. If. In fact. however. the auditor has means to know of the existence of such vital information but he ignored it. students should refer to the provision of Section 221 of the Companies Act. aggregation. He. 1956 in which the officers of the company have been made responsible to provide information to the auditor on matters pertaining to the payments. he cannot issue . fact and opinion parts of an audit report.

4 Advanced Auditing and Professional Ethics an unqualified opinion.8. (8). It is also a presumption in our country that the accounting statements contain relevant informative disclosures unless an exception is made. ordinarily.2. The review and assessment involves considering whether the financial statements have been prepared in accordance with an acceptable financial reporting framework applicable to the entity under audit. 1949 have a direct bearing on the reports of the chartered accountants in India. also he checks whether consistency in accordance with the principles has been maintained. In case he finds the accounting principles are not being followed properly and consistently. and fails to invite attention to any material departure from the generally accepted procedure of audit applicable to the circumstances. 3. the auditor should review and assess the conclusion drawn from the audit evidence obtained. With a view to express an opinion. 8. In the following paragraph the requirements as laid down in AAS 28 are elaborated. The very fact that these acts are not considered as desirable professional practices has its own effect of indirectly setting standards of reporting for the chartered accountants in India. Clauses (5). He may qualify or express reservation about the truth and fairness of the accounting statement either on an overall basis or as to the aspects specified in the report. fails to report a material misstatement known to him to appear in a financial statement with which he is concerned in a professional capacity. . The standard replies that auditor’s report should contain a clear written expression of opinion on the financial statements taken as a whole. and (9) of Part I.2 The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the form and content of the auditor’s report issued as a result of an audit performed by an auditor of the financial statements of a n entity. It is also necessary to consider whether the financial statements comply with the relevant statutory requirements.The auditor’s report includes the following basic elements. from allegation of professional misconduct or negligence against him. A chartered accountant in practice shall be deemed to be guilty of professional misconduct. This will put the readers of his report on guard and the auditor will remain protected to the extent he has qualified. An act of a chartered accountant in practice in India falling under the aforesaid clauses. if he: 1. Second Schedule to the Chartered Accountants Act. fails to obtain sufficient information to warrant the expression of an opinion or his exceptions are sufficiently material to negate the expression of an opinion. 2.1 Basic Elements of the Auditor’s Report . fails to disclose a material fact known to him which is not disclosed in financial statement but disclosure of which is necessary to make the financial statement not misleading. he takes care to see whether the financial statements are prepared and presented in accordance with the principles of accounting. The Auditor’s Report on Financial Statements 8. can result in his being held to have committed a professional misconduct. 4. in the following layout: (a) Title. he qualifies the report. (6). In the course of audit.

Audit Report (b) Addressee. (c) Opening or introductory paragraph (i) (ii) identification of the financial statements audited. Ordinarily. a reference to the financial reporting framework used to prepare the financial statements. A measure of uniformity in the form and content of the auditor’s report is desirable because it helps to promote the reader’s understanding of the auditor’s report and to identify unusual circumstances when they occur.The auditor’s report should identify the financial statements of the entity that have been audited.The auditor’s report should describe the scope of the audit by stating that .5 a statement of the responsibility of the entity’s management and the responsibility of the auditor. This determination will be made in the context of the financial reporting framework that management chooses. and an expression of opinion on the financial statements. a description of the work performed by the auditor. Financial statements are the representations of management. The report should include a statement that the financial statements are the responsibility of the entity’s management and a statement that the responsibility of the auditor is to express an opinion on the financial statements based on the audit. 8. Title -The auditor’s report should have an appropriate title. Addressee. It may be appropriate to use the term “Auditor’s Report” in the title to distinguish the auditor’s report from reports that might be issued by others. Opening or Introductory Paragraph . the board of directors. Scope Paragraph . (g) Place of signature. and (h) Auditor’s signature. the auditor’s responsibility is to audit these financial statements in order to express an opinion thereon. or is required to use. or from the reports of others. (d) Scope paragraph (describing the nature of an audit) (i) (ii) (i) (ii) (f) (e) Opinion paragraph containing Date of the report. the auditor’s report is addressed to the authority appointing the auditor. The preparation of such statements requires management to make significant accounting estimates and judgments. In contrast. as well as to determine the appropriate accounting principles and methods used in preparation of the financial statements.The auditor’s report should be appropriately addressed as required by the circumstances of the engagement and applicable laws and regulations. such as by the officers of the entity. a reference to the auditing standards generally accepted in India. including the date of and period covered by the financial statements.

The date of an auditor’s report on the financial statements is the date on which the auditor signs the report expressing an opinion on the financial statements. evidence to support the amounts and disclosures in financial statements. The terms of engagement cannot. The date of report informs the reader that the auditor has considered the effect on the financial statements and on the report of the events and transactions of which the auditor became aware and that occurred up to that date. “Scope” refers to the auditor’s ability to perform audit procedures deemed necessary in the circumstances.The report should name specific location. on a test basis. indicates. amongst other things. “give a true and fair view”. Date of Report . Place of Signature . The report should include a statement by the auditor that the audit provides a reasonable basis for his opinion. the auditor should not date the report earlier than the date on which the financial statements are signed or approved by management. the requirements of relevant legislation and the pronouncements of the Institute. with regard to the determination of the “scope” states (paragraph 5): “The scope of an audit of financial statements will be determined by the auditor having regard to the terms of the engagement. The auditor’s report should describe the audit as including: (a) examining. “Objective and Scope of the Audit of Financial Statements”. which is ordinarily the city where the audit report is signed. that the auditor considers only those matters that are material to the financial statements.6 Advanced Auditing and Professional Ethics the audit was conducted in accordance with auditing standards generally accepted in India. whether the financial statements comply with the statutory requirements. and (d) evaluating the overall financial statement presentation. restrict the scope of an audit in relation to matters which are prescribed by legislation or by the pronouncements of the Institute. (b) assessing the accounting principles used in the preparation of the financial statements.” The Auditing and Assurance Standards issued by the Institute of Chartered Accountants of India establish the auditing standards generally accepted in India. The report should include a statement that the audit was planned and performed to obtain reasonable assurance whether the financial statements are free of material misstatement. The term used to express the auditor’s opinion. .8. Since the auditor’s responsibility is to report on the financial statements as prepared and presented by management. however. Opinion Paragraph .The opinion paragraph of the auditor’s report should clearly indicate the financial reporting framework used to prepare the financial statements and state the auditor’s opinion as to whether the financial statements give a true and fair view in accordance with that financial reporting framework and. where appropriate. Auditing and Assurance Standard (AAS) 2. (c) assessing the significant estimates made by management in the preparation of the financial statements.

2. and the effects thereof. an auditor’s report may be modified by adding an emphasis of matter paragraph to highlight a matter affecting the financial statements which is included in a note to the financial statements that more extensively discusses the matter. that any changes in the accounting principles or in the method of their application. Accordingly.An unqualified opinion should be expressed when the auditor concludes that the financial statements give a true and fair view in accordance with the financial reporting framework used for the preparation and presentation of the financial statements. The auditor should modify the auditor’s report by adding a paragraph to highlight a material matter regarding a going concern problem where the going concern question is not resolved . The addition of such an emphasis of matter paragraph does not affect the auditor’s opinion. An unqualified opinion also indicates that(a) the financial statements have been prepared using the generally accepted accounting principles. Matters That Do Not Affect the Auditor’s Opinion In certain circumstances. (b) the financial statements comply with relevant statutory requirements and regulations. The paragraph would preferably be included preceding the opinion paragraph and would ordinarily refer to the fact that the auditor’s opinion is not qualified in this respect.Audit Report 8. and (c) there is adequate disclosure of all material matters relevant to the proper presentation of the financial information. implicitly. An unqualified opinion indicates. The partner/proprietor signing the audit report should also mention the membership number assigned by the Institute of Chartered Accountants of India.3 Modified Report .An auditor’s report is considered to be modified when it includes: (a) Matters That Do Not Affect the Auditor’s Opinion ♦ ♦ ♦ ♦ emphasis of matter qualified opinion disclaimer of opinion adverse opinion (b) Matters That Do Affect the Auditor’s Opinion Uniformity in the form and content of each type of modified report will enhance the user’s understanding of such reports. have been properly determined and disclosed in the financial statements. subject to statutory requirements. where applicable. 8. this AAS includes suggested wordings to express an unqualified opinion as well as examples of modifying phrases for use when issuing modified reports.7 Auditor’s SignatureThe report should be signed by the auditor in his personal name.2. Where the firm is appointed as the auditor. which have been consistently applied. the report should be signed in the personal name of the auditor and in the name of the audit firm.2 The Auditor’s Report . 8.

A qualified opinion should be expressed as being ‘subject to’ or ‘except for’ the effects of the matter to which the . such as situations involving multiple uncertainties that are significant to the financial statements.8. In our opinion ………. in the auditor’s judgment. The auditor should consider modifying the auditor’s report by adding a paragraph if there is a significant uncertainty (other than going concern problem). However. Matters that Do Affect the Auditor’s Opinion An auditor may not be able to express an unqualified opinion when either of the following circumstances exists and. The ultimate outcome of the matter cannot presently be determined. The circumstances described in (a) could lead to a qualified opinion or a disclaimer of opinion. “Going Concern. the resolution of which is dependent upon future events and which may affect the financial statements. and no provision for any liability that may result has been made in the financial statements. the method of their application or the adequacy of financial statement disclosures.8 Advanced Auditing and Professional Ethics and adequate disclosures have been made in the financial statements. or (b) there is a disagreement with management regarding the acceptability of the accounting policies selected. A qualified opinion should be expressed when the auditor concludes that an unqualified opinion cannot be expressed but that the effect of any disagreement with management is not so material and pervasive as to require an adverse opinion.” The addition of a paragraph emphasising a going concern problem or significant uncertainty is ordinarily adequate to meet the auditor’s reporting responsibilities regarding such matters. we draw attention to Note X of Schedule …… to the financial statements. – An illustration of an emphasis of matter paragraph relating to going concern is set out in AAS 16. The circumstances described in (b) could lead to a qualified opinion or an adverse opinion.. in extreme cases. An uncertainty is a matter whose outcome depends on future actions or events not under the direct control of the entity but that may affect the financial statements. An illustration of an emphasis of matter paragraph for a significant uncertainty in an auditor’s report is as follows: “Without qualifying our opinion. and preliminary hearings and discovery proceedings on both actions are in progress. the effect of the matter is or may be material to the financial statements: (a) there is a limitation on the scope of the auditor’s work. The entity is the defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. or limitation on scope is not so material and pervasive as to require a disclaimer of opinion. the auditor may consider it appropriate to express a disclaimer of opinion instead of adding an emphasis of matter paragraph. The entity has filed a counter action.

the auditor would attempt to carry out reasonable alternative procedures to obtain sufficient appropriate audit evidence to support an unqualified opinion. In circumstances where it is not practicable to quantify the effect of modifications made in the audit report accurately. Ordinarily. when the terms of the engagement specify that the auditor will not carry out an audit procedure that the auditor believes is necessary.Audit Report qualification relates. in a note to the financial statements. When there is a limitation on the scope of the auditor’s work that requires expression of a qualified opinion or a disclaimer of opinion. An adverse opinion should be expressed when the effect of a disagreement is so material and pervasive to the financial statements that the auditor concludes that a qualification of the report is not adequate to disclose the misleading or incomplete nature of the financial statements. Also. the auditor should ordinarily not accept such a limited engagement as an audit engagement. for example. accordingly. if any. individually and in aggregate. in the opinion of the auditor. Whenever the auditor expresses an opinion that is other than unqualified. It may also arise when. when the timing of the auditor’s appointment is such that the auditor is unable to observe the counting of physical inventories. on the financial statements should be mentioned in the auditor’s report. unless impracticable. 8. the auditor may do so on the basis of estimates made by the management after carrying out such audit tests as are possible and clearly indicate the fact that the figures are based on management estimates. for example.4 Circumstances That May Result in Other Than an Unqualified Opinion Limitation on Scope A limitation on the scope of the auditor’s work may sometimes be imposed by the entity.9 A disclaimer of opinion should be expressed when the possible effect of a limitation on scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and is. unable to express an opinion on the financial statements. However. A scope limitation may be imposed by circumstances. when the limitation in the terms of a proposed engagement is such that the auditor believes the need to express a disclaimer of opinion exists. a quantification of the possible effect(s). unless required by statute. the entity’s accounting records are inadequate or when the auditor is unable to carry out an audit procedure believed to be desirable. a statutory auditor should not accept such an audit engagement when the limitation infringes on the auditor’s statutory duties. the auditor’s report should describe the limitation and indicate the possible adjustments to the financial statements that might have been determined to be necessary had the limitation not existed. this information would be set out in a separate paragraph preceding the opinion or disclaimer of opinion and may include a reference to a more extensive discussion. 8.2. a clear description of all the substantive reasons should be included in the report and. In these circumstances. .

This has other implications also from the point of view of professional responsibility. For those who practise as a partnership. Had this accounting policy been followed. or the adequacy of disclosures in the financial statements. the reports are made by others. This short provisioning for depreciation has resulted into the profit for the year..2. the auditor should express a qualified or an adverse opinion. the department is of the view that putting the signature in the firm name is not contemplated by Section 229..founded.5 Signature on Audit Report . (introductory paragraph). In a profession. even . Under Section 229 of the Companies Act. to the financial statements. it would be clear that the view of the Government is not well. where a firm is so appointed. Government of India. any of the partners can sign the report. the particular skill and reputation of the practitioner counts considerably and if anybody else is allowed to make the report on behalf of the person appointed. This is contrary to Accounting Standard (AS) 6 on “Depreciation Accounting”. is of the view that there cannot be a firm name in case of sole practitioners. 8. gradually the goodwill of the practitioner will end and the clients may shift to the person actually making the report. otherwise the very essence of the appointment of a particular man or firm will be lost. the Department of Company Affairs.. If in respect of appointments held by him. However. Illustrations of these matters are set out below: Disagreement on Accounting Policies-Inappropriate Accounting Method—Qualified Opinion “We have audited …….. As stated in Note X of Schedule ……. (scope paragraph). fixed assets and reserves and surplus being overstated by Rs………. it is usual for them to sign in the firm name..The report is to be signed by the maker of the report.. On a closer scrutiny.………. the method of their application. only a partner in the firm practising in India.. This is also recognised by the aforesaid Section 229.10 Advanced Auditing and Professional Ethics Disagreement with Management The auditor may disagree with management about matters such as the acceptability of accounting policies selected. It has also implications from the standpoint of the practitioner. 1956 only the person appointed as auditor of the company or. it may be his individual name or the firm name of which he is the sole proprietor... no depreciation has been provided for the period in the financial statements. If he is an individual. We conducted our audit in accordance with .. issued by the Institute of Chartered Accountants of India and the accounting policy being followed by the entity according to which depreciation is provided on straight line basis. It is obvious that the person appointed makes the report.. In the case of practice as a partnership firm.. may sign the auditor’s report or sign or authenticate any other document of the company required by law to be signed or authenticated by the auditor. In case of chartered accountants practising in partnership. the provision for depreciation for the period would have been Rs. it will create an unusual legal situation. Normally.. a chartered accountant in practice signs the report in the name he is registered as a practitioner. then this confidence in the person will cease to be a factor. If such disagreements are material to the financial statements..8.

1956. Students may recall that the long standing practice was to sign in the firm name. as the case may be. and (ii) opinions. (3).6 Audit Report under the Companies Act. But now in view of the objection raised by the Department of Company Affairs to this practice. The provision is intended to safeguard the professional purity by excluding non-chartered accountants from signing the aforesaid documents. The former requires the auditor to “inquire into” specific matters stated in the sub-section and pursuant to the authority contained in the latter the Manufacturing and other Companies (Auditor’s Report) 1 Partner or Proprietor.The auditors of a company are required to report to its members in terms of Section 227 of the Companies Act. 1956 referred to above.” in his own hand. The auditors reporting requirements are contained in sub-sections 1(A). “The Auditor’s Report on Financial Statements” has recommended to the members who are in practice in partnership that signature on or authentication of the auditor’s report or any other document required to be signed or authenticated by the auditor should be made in the following manner.2. For ABC and Co. 8. . (2). if A. It may be recalled that sub-sections (1A) and (4A) were introduced in 1965.11 though the name has been signed by a partner. The matters which the auditors have to report could be classified into two categories. For example. Chartered Accountants.Audit Report 8. B and C were in practice as ABC & Co. Partners are mutual agents and therefore. to sign on his behalf or on behalf of his firm. (i) statement of fact. The concerned partner should invariably sign his own name in his own hand for and on behalf of the firm appointed to audit a company’s accounts. (4). 1956 . profit & loss account. 1949 provides that a chartered accountant in practice shall be deemed to be guilty of professional misconduct if he allows a person. allowing a partner to sign does not interfere with the clarity of responsibility. it seeks to keep the line of professional responsibility clear. report or financial statements. not being a member of the Institute or a member not being his partner. Clause (13) of Part I of the First Schedule to the Chartered Accountants Act. any of A or B or C could sign as “ABC & Co. By excluding chartered accountants who are not partners. any balance sheet. the Council of the Institute in the AAS28. Chartered Accountants Signature (Name of the Member Signing the Audit Report) (Designation)1 In addition to the provision of the Companies Act. and (4A).

in the case of balance sheet. In effect. are complementary to the opinion. On the face of adverse facts. of the state of the company’s state of affairs. if any of the matters required to be stated pursuant to sub-sections (2) and (3) are subject to qualification or . the details of amount of cess not so paid. The 1975 Order was superseded by the order issued in 1988 which is also superceded now by Companies (Auditor’s Report) Order. no favourable opinion can be given.12 Advanced Auditing and Professional Ethics order was issued in 1975.8. It should be appreciated that only certain very important and basic facts about the accounts are required to be stated under the provisions of sub-sections (2) and (3). the auditor's report shall state in thick type or italics. (iii) Whether the company’s balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and the returns. (iv) Whether the accounts give a true and fair view. 2003. the profit and loss account and balance sheet complied with the accounting standards referred to in sub-section (3C) of Section 211. the reliability of the accounting information under the report would be seriously impaired. It may be noted that as per section 227(3)(e). Whether the accounts give the information required by the Act in the manner so required. However. The opinions which the auditor is required to express are: (i) Whether proper books of account as required by law have been kept by the company so far as it appears from the examination of the books and proper returns adequate for the purposes of the audit have been received from branches not visited by him. distinct disclosure. If the auditor states that he has not been able to obtain all the information and explanations considered necessary by him. (iv) whether any director is disqualified from being appointed as director under clause (g) of sub-section (1) of section 274. the facts. Whether the report on the accounts of any branch office audited under Section 228 by a person other than the company’s auditor has been forwarded to him as required by Section 228 (3) (c) and how he has dealt with the same in preparing the auditor’s reports. these observations or comments of the auditors which have any adverse effect on the functioning of the company. and in the case of the profit and loss account. The statement of facts by the auditor is a very significant pointer to the credibility of the accounts. it should not be understood that a distinct statement of a fact makes it unnecessary to consider the same for the purpose of opinion formation. When we analyse subsections (2) and (3) of Section 227. of the profit or loss for the year. (ii) (iii) Whether in his opinion. (v) Whether the cess payable under section 441A has been paid and if not. apart from their own significance which probably account for their. we find that the auditor has to make statements of fact in his report on the following: (i) (ii) Whether he has obtained all the information and explanation which to the best of his knowledge and belief were necessary for the purposes of his audit. Sub-section (4) provides for reasons to be given in the auditor’s report.

If the loan has been given for business considerations. or by way of security for the performance of the depositor’s obligations.Audit Report negative statement or denial of opinion. The clause applies to all loans and advances made “on the basis of the security’. etc. Loans and advances have not been defined anywhere in the Act. “Security” for this purpose would include any movable or immovable property. of which either physical possession or over which a legally effective charge is given to lender. It should however be noted that the auditor is required to make only enquiries on the matters specified in the sub-section and is not to investigate into the matters referred to therein.. A. The inquiry should be made in the light of conditions prevailing when the loan or advance was made. If he is satisfied as a result of the enquiries. or even. in the last case deposit being with a party who customarily accepts deposits. Where the loan or advance is made to a company. and obtaining information and explanations. or for the purpose of earning interest. unless he has any special comments to make on any of the items referred to therein. 1956 8. etc. e.. would have to be taken into account. any charge on the assets of such a company should have been registered under Section 125 of the Act in order to constitute an effective security. having regard to the requirement of clause (d) of the sub-section. Report under Section 227 (1A) of the Companies Act. a distinction is obviously intended to be made between “loans and advances” and “deposits”. Any item required to be disclosed under the head “Loans and Advances” in Part I of the Schedule VI to the Act which do not fall within the above definition of a “deposit” should be construed for the purpose of this clause as “loans and advances”. Various considerations.13 Section 227(1A) requires the auditor to make certain specific enquiries during the course of his audit. such as the position and standing of the borrower. prevailing market rate of interest. he has no further duty to report that he is so satisfied. purpose of the loan.” This clause applies to loans and advances made by the company during the financial year under audit. The loan agreement or correspondence in regard to the terms of the loan or advance should be seen. Clause (a) requires the auditor to inquire: “Whether loans and advances made by the company on the basis of security have been properly secured and whether the terms on which they have been made are not prejudicial to the interests of the company or its members. either for safe keeping. powers and duties regarding access to books etc.. A “deposit” may be defined as the placing of money or money’s worth with a third party. the interest charged and the terms of repayment. in . whether they are outstanding on the date of the Balance Sheet or not. there may be justification for interest being charged at a rate lower than the market rate. houses. However. type of security.g. The “terms” on which the loan or advance is made would primarily include the security. It would be difficult to lay down any general principles regarding the rate of interest which may be charged on loans and advances. loans to suppliers of raw materials or other goods. This requirement is without prejudice to his general rights. He is however not required to report on the matters specified in this sub-section. whether belonging to the borrower or not. loans to staff for purchase of cars.

However.8. the auditor is satisfied that the sale is bonafide and the price realised is reasonable. Obviously. if book entries are passed purporting to record “transactions” which have. is the entry regarding the transactions in the books of account. This clause requires the auditor to inquire in all cases where shares. Under Clause (b) the auditor has to inquire: “Whether transactions of the company which are represented merely by book entries are not prejudicial to the interests of the company. The reference to “members” should therefore be construed as a reference to the members of a company as a class. The question whether the terms on which a loan or advance has been made are “prejudicial to the interests of the company or its members” is a difficult one. The members of the company would be primarily interested in a reasonable return on their investment and in the safety of their capital. Again. no interest being charged at all. in fact. If loan or advance has been approved by the members of the company and/or the Government as required by Section 370 of the Act (now 372A). or is contrary thereto.” The transactions of a company are ordinarily matters of fact. debentures or other securities have been sold at a price less than their cost. when a loan is given only with a view to earning interest. this should be set right or reported upon by the auditor. In such cases. The purpose of book entries is to correctly record transactions which have. if so. he has no further duty to report on the matter. taken place. the auditor is not to inquire as to how such transactions of the company affect the interests of individual members in their personal capacities. or the principal evidence. having regard to the circumstances of the case. the auditor should inquire whether such transactions have in fact taken place and. the interest charged would be at the commercial rate. Particular attention should be paid to loans or advances to concerns in which the directors of the company or their associates are interested. this would be a prima facie evidence to show that it is not prejudicial to the interests of the company or its members. debentures and other securities have been sold at a price less than that at which they were purchased by the company”. in fact. The question whether a loan is prejudicial to the interests of the members should therefore be considered from this angle. not taken place. A reference is invited to the definition of a “deposit” in contradistinction to that of a loan or . whether they are prejudicial to the interests of the company. If. If a book entry is passed which is not in accordance with the facts of the transaction.14 Advanced Auditing and Professional Ethics appropriate circumstances. Under Clause (d) the auditor has to inquire: ‘“Whether loans and advances made by the company have been shown as deposits”. similar considerations would apply. whether so much of the assets of the company as consist of shares. Under Clause (c) the auditor has to inquire: “Where the company is not an investment company within the meaning of Section 372 or a banking company. as a result of his inquiries. The clause is therefore intended to cover transactions of the company for which the only evidence. in their capacity as members.

or in accordance with accepted business practice.Audit Report 8. The provisions of the order are supplemented to the existing provisions of the Companies Act. It should be noted that the inquiry to be made is whether loans and advances have been shown as deposits. Report under the Companies (Auditor’s) Report Order. Where.” B. etc. the Order requires a statement on each of the matters specified thereunder. the Central Government has the power to direct by a general or special order that in the case of specified companies the auditor’s report shall include a statement on such matters as may be specified in its order. and if no cash has actually been so received. 2003 dated June 12. if it finds necessary or expedient to do so. Clause (e) requires the auditor to inquire: “Whether personal expenses have been charged to revenue account. Firstly the provision of sub-sections (2). medical expenses. Certain points of distinction may. either on the basis of the company’s contractual obligations. (3) and (4) of Section 227 are applicable to all companies while the Order is not applicable to the classes of companies specified in the Order. however. maternity benefits. be noted. consult the Institute of Chartered Accountants of India. it would be the duty of the auditor to report thereon. The Central government may before making any such order. whether cash has actually been so received in respect of such allotment. canteen facilities. however. Whether the position as stated in the account books and the balance sheet is correct. 2003 which has now been amended by way of Companies (auditor’s Report) (Amendment) order. is perfectly normal and legitimate and does not call for any special comment by the auditor. 2004.15 advance given in the comments on clause (a) above. 1956 regarding the auditors report as contained in Section 227. the provisions of sub-section (1A) only require an auditor to enquire into the matters specified in the sub-section and as such he will report only if the comment is necessary in the light of enquiry. 1956. conveyance for personal use. Illustration of such expenses are the provision of rent-free quarters. whereas. personal expenses not covered by contractual obligations or by accepted business practice are incurred by the company and charged to revenue account. In accordance with these provisions. expenses on leave travel. The provision of this order is in addition to the directions given by the Comptroller & Auditor General under Section 619 of the Companies Act. and not vice versa. the Central Government had issued the Companies (Auditor’s Report) Order. .” The practice of meeting certain types of personal expenses of employees is normal and is recognized both by the Income tax Authorities and the Company Law Board. Secondly. The charging to revenue of such personal expenses. regular and not misleading. 2003. Clause (f) requires the auditor to inquire: “Where it is stated in the books and papers of the company that any shares have been allotted for cash. Under Section 227(4A) of the Companies Act.

but . to answer any of the statutory affirmations in the negative or with a qualification. 1956 which have a bearing on the accounts. With the issuance of the AAS 28 “The Auditor’s Report on Financial Statements”. the principles of modification of auditor’s report have been laid down herein. 8. such as the directors’ remuneration whether material or not. In 1970. (iii) establish whether the matters in question are so material as to affect the presentation of a true and fair view of the whole of the affairs of the company. in their opinion. In such cases. It is. We discuss below the important principles laid down in the “Statement on Qualifications in the Auditor’s Report. The result is that the auditor of a company is in a position to persuade the management of the company to accept his views and modify the accounts or make such disclosures as are required by the law. According to the statement. However. in their report.1 Aspects to be considered in qualifying report . and (iv) see whether the matters constituting the qualification involve a material contravention of any requirements of the Companies Act. it is possible for the auditor to report that. and prevents the management of companies from resorting to accounting practices and methods of disclosure which are not in accordance with the law. as in the absence of these he would qualify his report. Beyond this. This is due to the fact that the right of a statutory auditor to make a qualified report is a great deterrent. have to be specifically disclosed. for lack of adequate information about an item.” The Statement points out that in a majority of cases the auditor’s report on the accounts examined by them is found to be unqualified. form and manner of qualifying the audit report. In a majority of cases.3. the Companies Act. items which are the subject matter of qualification are not material as to affect the truth and fairness of the whole of the accounts but merely create uncertainty about a particular item.While qualifying a report.8. therefore.3 The statutory provisions in the Companies Act. it is the duty of the auditor to qualify his report.16 Advanced Auditing and Professional Ethics Statement on Qualifications in the Auditor’s Report 8. or are of such a nature as to affect only a particular item disclosed in the accounts. 1956 does not mention anything about the. If this is not done. say. the Council of the ICAI published the “Statement on Qualifications in the Auditor’s Report” which attempted to enumerate some principles regarding the purpose and manner of any qualifications in the Auditor’s Report and thereby improving the standards of reporting by the Chartered Accountants in regard to the audits undertaken by them. realise whether the auditors are in active disagreement with something which has been done by the company or are merely unable to form an opinion. a qualified report is not necessary unless the issues involved are material. necessary for the auditor to give the reason for any qualifications or reservations in this report. 1956 relating to qualifications in the auditors report are contained in Section 227 (4) of the Act which provides that where the auditors are required. it is important to (i) (ii) ascertain the various items (the statement of fact and opinion referred to above) that require a qualification. their report shall state the reasons for such an answer. items requiring disclosures under the law.

The distinction between “information” and “means to information” made in the London and General Bank’s case is still valid. the accounts disclose a true and fair view.g. The practice has also grown recently of having a large number of notes to accounts some of which are subject matter of qualification in the auditor’s reports and some of which are merely clarificatory. Another example would be where the auditors were not able to examine a substantial part of the books of account. It enumerates the following principles regarding manner of qualification with a view to ensuring certain degree of uniformity and to assist the public in evaluating the contents of auditors’ reports. however.2 Manner of qualifying reports .Audit Report 8.explanatory statement may be sufficient. In circumstances where it is not possible to quantify the effect of the qualifications accurately the auditor may do so on the estimates made by the (ii) . it is not necessary to reproduce verbatim such a note in the audit report. subject to the qualification. e. 8. In such a case. the accounts present a true and fair view. where a note is already given in detail by the management.. For this purpose. Finally. the auditor should state all qualifications independently in his report in an adequate manner so that a reader can assess the significance of these qualifications.. the statement reminds the auditors of a well established principle that they must give full information about the subject matter of the qualification and not merely create grounds for suspicion or inquiry and leave it to the shareholders to cull out the facts by diligent inquiry.It is a general principle that the qualifying remarks should be placed in such a manner as to make it very clear as to the particular item of the auditors’ report to which the qualification relates. The principles are follows: (i) All qualifications should be contained in the auditor’s report.3. Where notes of a qualificatory nature appear in the accounts. including where the profit is converted into a loss or vice versa.g. it should not be placed in such a manner as to give an impression that the auditors have not obtained all the information which has been required in the performance of their work. the auditor should state that the profit or loss account does not reflect a true and fair view of profit or loss for the period. It is necessary that the auditors should “reproduce” the notes of a qualificatory nature in their report to enable the reader to know the importance to these qualifications. they were in police custody. the effect of individual as well as the total effect of all qualifications on profit or loss and/or state of affairs these qualifications on the financial statements in a clear and unambiguous manner. Sometimes. The Auditing and Assurance Standards Board of the ICAI has clarified that the use of the word ‘reproduce’ does not imply verbatim reproduction. wherever possible. An example would be where all the qualifications taken together substantially affect the profit or loss as shown in the profit and loss account. the items which are the subject matter of qualifications are so material that it would be meaningless to state that.17 subject to the specific qualification mentioned. It is also necessary that the auditor should quantify. The notes to accounts normally represent explanatory statements given by the Directors of the company and should not contain the opinion of the auditors. a brief self. e. if the qualification is of such a nature that it affects truth and fairness of the accounts.

. This is contrary to Accounting Standard (AS) 6. the following additional qualification appears at Serial No. We further report that had the observations made by us in paragraphs (1) and (2) above been considered..66. The amount of provision required in this behalf could not be ascertained.41 lacs (as against the reported figure of Rs. It is customary for qualifications to be made by the use of expressions..." In the above situation..781. the overall-effect paragraph would appear as follows: "We further report that.. in our opinion.07 lacs).. issued by the Institute of Chartered Accountants of India and the policy being followed by the company according to which depreciation is provided on straight line basis. Had this accounting policy been followed.... "No provision has been made in respect of product warranties outstanding at the year end. profit for the year. Accordingly. the auditors reported as under: Some Examples (a) Where all qualifications are quantifiable "We report that: (1) No provision for Minimum Alternative Tax amounting to Rs. Depreciation Accounting.29.05 lacs)..500.229.61 lacs has been made due to which the profit during the year has been overstated and the provisions have been understated to that extent.09 lacs) and total fixed assets would have been Rs. the provision for depreciation for the period would have been Rs... that the auditors should use such recognised terminology which clearly implies a qualification... It is therefore important when seeking to qualify a report....8.05 lacs.685.43 lacs (as against the reported figure of Rs. without considering item mentioned at 3 above the effect of which .. (iii) The use of the word “subject to” is essential to bring out the qualifications. The expressions “read with the notes thereon” or “together with the notes thereon” are of an explanatory nature and do not constitute qualifications. In a case where the treatment of underwriting commission was not in accordance with accepted accounting practice.3. "Subject to the above. It is not a correct practice to merely make a factual statement in the auditors’ report without taking exception thereto..18 Advanced Auditing and Professional Ethics management after carrying out such audit tests as are possible and clearly indicate that the figures given are based on the estimates of the management. For instance. the profit for the year would have been Rs." (b) Where all the qualifications are not quantifiable Where it is not possible to quantify the effect of certain qualifications in the auditor's report. 596... reserves and surplus would have been Rs. “subject to” or “except that”. suppose in the illustrations at (a) above. in the overall-effect paragraph. (2) No depreciation has been provided for the period in the financial statements. such as.200 lacs (as against the reported figure of Rs.. fixed assets and reserves and surplus are over-stated to that extent.. reference should be made to such qualifications.

. Accounting for Fixed .. As a result of this change. the accounts will fail to show a true and fair state of affairs. from this year. for example. should be made in the auditor’s report in a manner that it is clear to the reader that the disclosure does not constitute an audit qualification.596. It may be clarified that these examples are aimed only at illustrating the manner of making qualifications/ disclosures and are not intended in any way to be exhaustive. 8.229..200. The paragraph containing the auditor’s opinion on ‘true and fair view not includes a reference to the paragraph containing the aforesaid disclosure.. Examples of qualifications (a) Where proper disclosures regarding changes in accounting policies have not been made by a company: “The company has not disclosed in its accounts the fact of change..Audit Report 8.3. (as against the reported figure of Rs.Given below are some examples which illustrate the manner of making qualification/ disclosure in the audit report in case of deviations from the requirements of mandatory Accounting Standards..” (b) Where a company has capitalised financing costs related to certain fixed assets for periods after such assets were ready to be put to use. reserves and surplus would have been Rs... he may so state in his report... straight-line method to written-down value method as also the effect of this change.3 Manner of making qualification/disclosure in the audit report .In making a qualification/disclosure in the audit report.. It should be understood that a qualification can also arise in consequence of an adverse finding by the auditor in respect of the matters covered under sub-sections (1A)and (4A) of Section 227 of the Companies Act.. the auditor need not make qualification/disclosure in respect of items which. the auditor should consider the materiality of the relevant item. .19 could not be determined.each as compared to the position which would have prevailed had this change not been made. Examples of qualifications/disclosures in the audit report . But.07 lacs).43 lacs) and total fixed assets would have been Rs. in his judgement. the auditor should follow the requirements of the ‘Statement on Qualifications in Auditor’s Report’ issued by the Institute. Thus. the net profit for the year the net block as well as the reserves and surplus are lower by Rs. While making a qualification. “Interest payable on borrowings related to the acquisition of fixed assets has been capitalised for the periods during which the assets were in use for commercial production. This is contrary to Accounting Standard (AS) 10.00 lacs (as against the reported figure of Rs.05 lacs)".685. are not material. in the method of providing depreciation on plant and machinery from. therefore..500.. If. A disclosure which is not a subject matter of audit qualification.. if the amount involved is considerable. an auditor is of the view that personal expenses have been charged to business.. Subject to the above.41 lacs. the profit for the year would have been Rs. had the observation made by us in paragraphs (1) and (2) above been considered. we report that. he must then qualify his report.

the net profit for the year. ‘Accounting for Fixed Assets’ issued by the Institute of Chartered Accountants of India. the method adopted to compute the revalued amounts has not been disclosed.. We.” Examples of Disclosures (a) Where a company has not disclosed all significant accounting policies and has also not disclosed the accounting policies at one place. The auditors should take special care to ensure that it is clearly identified by reference to numbers. and the total effect thereof on the accounts. If the circumstances are such that a separate detailed report cannot be avoided. We report that. Consequently. which is contrary to Accounting Standard (AS) 1. viz. be avoided. report that. The practice of making report. the auditor should take care to ensure that the separate report is also addressed to the shareholders.. which is contrary to Accounting Standard (AS) 10.. date. The revalued amounts of land and buildings are adequately disclosed in the balance sheet. However.4 Use of separate reports . etc.3. and attached to the main report. . In the opinion of the Council of the Institute of Chartered Accountants of India. in a clear and unambiguous manner.. each as compared to the position which would have prevailed if the company had complied with the requirements of AS 10. the net block and the reserves and surplus have been overstated by Rs . “During the year.20 Advanced Auditing and Professional Ethics Assets’. those relating to treatment of research and development costs and treatment of exchange gains and losses have not been disclosed nor have all the policies been disclosed at one place...” 8. ‘Disclosure of Accounting Policies’ issued by the Institute of Chartered Accountants of India. It is desirable that the report should be comprehensive and brief. we report that.The Institute of Chartered Accountants of India has also recommended in its “Statement on Qualification in Auditor’s Report” that the use of separate reports which are referred to in the report of the auditors to the shareholders should as far as possible. the enterprise revalued its land and buildings.. Other significant accounting policies.. (b) Where a partnership firm does not make adequate disclosures regarding the revaluation of its fixed assets.. and the amounts involved. It should specify the matters in respect of which the auditors have reservations or qualifications.8.…. running into several pages is not desirable as the lay shareholder is not in a position to appreciate a mass of fact and information. it is the duty of the directors to publish such other report together with the accounts of the company. 1956. issued by the Institute of Chartered Accountants of India.. Subject to the above.. rather than to the directors or the management and the main report to the shareholders is made subject to such a report. subject to a detailed report or a special report addressed to the directors of the company. where an auditor makes a qualifying report by reference to another report. “The company has disclosed those accounting policies the disclosure of which is required by the Companies Act.

The following illustration of a qualification will explain the point. no scope should be left for any misinterpretation.. and explain the matters.…… was gutted by fire and extensive damage was caused to the fixed assets of the company in that location. It is desirable to give as much information as possible. Where the auditors of a company have decided to give a qualified report.. “During the year one of the four factories of the company (none of which is insured) situated at ……………..21 It has been emphasised earlier that the auditor’s report should be brief.. It is sometimes believed that by discussing their proposed qualifications with the management and thereby giving the management all opportunity to meet the auditor’s objections or offer their explanations.. Although normally full information should be given in the report.. it is desirable that they should discuss the contents of the report with the company’s management and make their views clear. But if the qualification involves a point where two opinions are possible. the treatment followed by it is correct. In many cases.. However the auditor in view of the Institute’s pronouncement on the subject may feel otherwise. so that an opportunity may be afforded to the Board of Directors to consider the issues involved. The auditors may prejudice their independence. When full information with regard to the monetary effect on Profits & Loss A/c and/or Balance Sheet of a qualification or a comment is not available. the auditor’s report should either indicate the approximate monetary effect or should state that it is not possible to ascertain the monetary effect.. an auditor should not include the directors’ explanations in his report in respect of qualifications made by him. ……………………………….Audit Report 8. the company may contend that according to legal opinion obtained by it. the auditor should qualify his report giving his interpretation of the fact and should also refer to the contrary legal opinion obtained by the company and the company’s contention. In the ultimate analysis... Subject to the above we report that the balance sheet shows a true and fair view”..... The same consideration applies in making qualification also. In such a case.. For example.. The extent of the loss has not been ascertained and no provision has been made in the accounts against such loss. Normally. but the total written down value of the fixed assets installed at the factory amounted to Rs. The duty of the auditors is to exercise independent judgement and express their opinion regardless of the views held by the directors and without regard to financial or other standing of the company.... this procedure is likely to result in the presentation of a true and fair view of financial accounts.. However. this discussion may throw new light and the auditor may be able to view the matter in a clearer perspective. it will always be a good practice to discuss the proposed qualifications with the company’s management so that an opportunity may be afforded to the Board of Directors to consider the issues involved.. as the case may be. where full information is not available.. At the same time. it may be appropriate for the auditor not only to state his own opinion in his report but also to point out that a contrary opinion is held by the management or the company’s legal advisers as the case may be. The auditor has the final right and duty of deciding whether or not a qualification . The statement should be as precise as possible bringing out clearly the items affected and their effect on the accounts. This is not at all true.. if a company has capitalised the amount of interest on long-term funds borrowed for acquiring fixed assets. it may also be possible to convince the management of the auditor’s viewpoint...

. by a prior discussion of their proposed qualifications with the management. under Section 227 (1A) of the Companies Act. whether resulting in a qualification in the auditor’s report or not should fully be explained by the Board in its report. it is rather difficult on the part of the auditors to see that Board’s report does not contain any fact that is at variance from the facts stated in the accounting statements . or explanation by the Board is called for. separate information. For this reason also prior discussion between the management and the auditors of proposed qualifications in the auditors’ report is necessary. e. Nevertheless. Audit Report Vis-a-vis Board’s Report . If.Can the auditor refer to any paragraphs in the Directors’ Report in his own report to the members? This aspect. However. an adverse comment. he has to state this fact in his report and obviously. In the context of our country. it is not necessary to give a separate explanation provided the note is comprehensive and fully explanatory.5 Directors’ comments on qualifications . However. it is an. the auditors are able to convince the management of their view point a much more useful purpose is served thereby than if the auditors’ were to give a qualified report on financial statements prepared by the management which do not give a true and fair view. there exists no mandatory requirement for the Board of a government company to provide explanations on adverse comments made in the C & AG’s audit report. 1956 an auditor is to inquire whether shares held as investment have been sold by the company at a price less than the price paid for them. 1956 it appears that the Board’s report is prepared subsequent to the receipt of the auditors’ report. his report or the accounts under his report are not at variance with any statement in the Board’s report. 1956 simply because it is an adverse statement in the auditor’s report. 8. where the qualification is contained only in the auditor’s report. In this connection it should be clearly understood that the scope of the provisions of Section 217 (3) is quite wide and therefore. the subject matter of the auditor’s report is the books of account and the financial statements including notes thereon and not the contents of the Board’s report. reservation or adverse remark in the auditor’s report.22 Advanced Auditing and Professional Ethics is called for. having regard to the provisions of Sections 227 and 217 of the Companies Act. Finally. this will not be a qualifying statement if the transaction is correctly reflected in the accounting statements. Therefore. adverse statement.” When the auditors have qualified their report and a similar note to the accounts is given by the directors also.Under Section 217 (3) of the Companies Act. it will be a matter on which the Board will have to give its explanation under Section 217 (3) of the Companies Act. According to the Department of Company Affairs. The directors have a statutory duty to comment in their report on every qualification conducted in the auditors’ report. The explanation given by the management may also assist the auditors in framing their qualifications more accurately when drafting their final report to the shareholders. If the auditor finds such a situation.8. it seems. 1956 the directors of a company are required to give the fullest information and explanations “on every qualification. Since the Board’s report is supposed to be prepared after the auditor’s report has been received.g. However. the auditor should ensure that on questions of fact.3. Naturally it seems that the auditor cannot refer to any paragraph of the Board’s report in his report on the accounts examined by him. has not received much attention of the professional bodies in India and abroad. it should not be forgotten that the most important and fundamental purpose of a company’s financial statements is to present a true and fair view of the state of the company’s affairs.

An example of qualification under this head is as follows: Owing to the destruction by fire during the war. the statutory auditors of the company should normally include it in their own report unless they are satisfied that either: (i) (ii) the objections of the branch auditor have been met while preparing the accounts of the company’s or during the conduct of the company’s audit. absence of vouchers in respect of material payments made by the company. or (iii) in the light of the information and explanations given to them. of the company’s old records. it has not been possible to ascertain the original cost of and the total depreciation written off from the Fixed . it is advisable that the auditor. or the matter on which the qualification is made is not material in the context of the company’s account as a whole. The circumstances under which auditors are obliged to qualify their reports are numerous. It should be appreciated that in the majority of cases a qualification on this aspect of the report is likely to be a qualification to the true and fair aspect also. such as. non-availability of books and records owing to unavoidable circumstances. some of them have general relevance also. If an honest difference about facts is there. before signing his report. should request the management to draft the paragraph concerning accounts to be included in the Board’s report. Section 228 (3) (c) requires that the branch auditor shall prepare a report on the accounts of the branch office examined by him and forward the same to be company’s auditor who shall deal with the same in such manner as he considers necessary. Examples which arise under this head are the absence of satisfactory documentary evidence of the existence of ownership of the material assets. Therefore. Section 217(2AA) provides for Director’s Responsibility Statement.3. they are satisfied that the qualification is not called for.In the case of a branch audit carried out by a person other than the statutory auditor. The Institute of Chartered Accountants of India in the Statement on Qualifications in Auditors’ Report has indicated by way of illustration certain occasions that may give rise to the necessity of qualification in the auditor’s report. title deeds in respect of land. practices. 8. destruction of books and records by fire or accident. Though these illustrations are based on the report on company accounts. the facts presented be allowed