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______________Chapter 1

Introduction to Auditing

GENERAL PURPOSE FINANCIAL STATEMENTS

leaning Financial Statements include the following:


a)Profit & Loss Account: Which indicates profit
earned or loss incurred during a particular
financial year.
b)Balance Slteet: Which shows position of assets &
liabilities at a particular date.
c)Cash flow & funds flow Statement: Which shows
movement of cash/ funds during a particular
financial year (However these are not prepared
by all entities).
d)Notes to accounts: i.e. Disclosures or explanatory
notes.
Esers of Owne For evaluating performance of business. For
r
financial evaluating profitability of business.
statements Management For evaluating their own performance. For making
decisions. Forjudging tax liabilities. For estimating
expected future outcomes.
Customers
Lenders
Government & Forjudging credit worthiness of the entity.
creditors Forjudging recoverability of their dues.
Employees For determining general consistency of the business.
For calculation of direct tax. For levying excise duty,
Research VAT, etc.
analysts For determining reasonableness of wages & salaries
etc.
etc. For creating demand for bonus.
For evaluating trends.
Forjudging investment opportunities in the entity.

1 .2 A U D IT IN G

Audit
is an
indep

1
2 Bestword's Auditing and Assurance CM Chap. 2

ende
nt
exam
inatio
n, Of
finan
cial
infor
matio
n,
Of any entity whether profit making or not, irrespective
of its size & legal structure, When such an examination
is conducted with a view to express an opinion thereon.

D e fin itio n as
per
IC A I
Audit has to be conducted in a proper way.
Auditor should be completely objective (unbiased) in his
Features/ Systematic & approach.
Independent He should not be influenced by the
Characteristics
Financial client.
of Audit
statement Auditor's opinion is on financial
s statements including Profit and I
account, Balance sheet & Notes to
accounts. The Preparation of
Entity financial statements is the
responsibility management of
entity.
His Opinion client can be any entity whatever
is the legal form i.e., it may bti
proprietorship, partnership, trust or company etc.
The entity may be profit oriented or a charitable one.
His opinion is on 'true & fair view' of financial
statements. For this, it is necessary that
(i)Financial statement have been prepared using
acceptable policies which are consistently
applied,
(ii)Financial statements have been prepared as per
relevant ^ regulations, &
(iii)There is appropriate disclosure of all material items.
By Whom In India, audit is to be conducted by a
professional having good accc anting &
auditing background. A chartered accountant having
certificate of practice is eligible to conduct audit.

1.3 INDEPENDENT AUDIT


4 Bestword's Auditing and Assurance CM Chap. 2

Meaning of Independence means that the judgement of a person is not subordinate to wishes of another | person.
It requires that he should not act under any influence.
Independence
Thus, he can work in a complete unbiased manner.

Auditor's The need for auditor independence is provided in Standards on Auditing.


Independence THE COMPANIES ACT, 1956 also contains specific provision to ensure auditor's | independence.
Moreover, as per THE CHARTERED ACCOUNTANTS ACT, 1949 as amended by THE 1 CHARTERED
ACCOUNTANTS (AMENDMENT) ACT, 2006, independence of auditor 1 is required.

Why If auditor maintains high degree of independence, credibility of financial statements is 1 enhanced.
Independent audit report will be accepted & respected by all stakeholders.
independence

Advantages of For management a)They can easily judge reasons for losses along with the reasons & try 1 to control
independent it.
b)They can ensure general reliability; of accounting system.
audit
c) For Employees a)It discourages them from committing frauds as it acts as a moral check | on them.
b)They can judge reasonableness of payments w.r.t salary, bonus etc.
introduction to/waning (a) lb)
For lenders Bankers can place reliance on audited financial statements while
14 BASIC ASPECTS TO BE COVERED BY THE AUDITOR / AUDITORS FUNCTIONS
ct audit. (a) Examination making
Of Accounting system & Internal decision
Control abouttocredit
system ensureworthiness
about theirofappropriateness.
loan applicants. ■ Even after
oach.
providing loan, the audited statements of borrower help the lender to judge
(b) Books Checking books of accounts to ensureoftheir
recoverability theirarithmetical
funds. accuracy.
ifit and loss
(c) Evidence For Computing
Examining Tax ■Audited
documentary evidencestatements
to supportenhances
the booksthe
of reliability
accounts. of computation of income earned by
nsibility
of anotherof (d) Full inclusion entity, thus helps in determining income tax.
Checking whether all entries in the books of Accounting have been taken while preparing financial statements.
it may be Auditor also checks computation of excise duty & sales tax etc.
For Owners They get real picture of profits & losses earned.
■From such statements, they come to know about their share in profit (as in
partnership firms) and can expect dividend.
For arbitrationIn case of dispute, audited statements help in settling claims.
C h a>le
p . policies
1 Introduction to Auditing
For insurer 5
In case of loss or damage to property by fire, theft etc. it helps the insurer to settle the
r relevant claim.
For prospective
On basis of past year's audited financial statements, they can devise expected profit trends
auditor's investor for deciding whether to invest in the entity or not.

i by THE of
auditor

;ments is
(e) Properness Examining whether information contained in financial statements is proper and it does not contain any
erroneous or fraudulent entry.
(f) Verification of Checking their completeness, existence, valuation & disclosure in financial statements.
Assets/
liabilities
(g) Statutory In case of audit of banks, General Insurance Companies etc., ensure compliance of financial statements with
compliance relevant statute.
(h) Disclosure Examining whether the information in financial statements is disclosed properly as per accounting principles.

(i) Truth & Cheeking whether financial statements as a whole represent true & fair view of profit /loss and of Assets &
fairness liabilities in the required from.
ins & try

ral check etc.


1.5 QUALITIES OF AUDITOR

(a) Integrity Auditor should be honest, sincere & straightforward while performing his professional duties.

(b) Objectivity He must adopt unbiased & impersonal approach.


6 Bestword's Auditing and Assurance CM Chap. 2
A
(c) Independence He should not subordinate his judgement to the will of others (client orotheil He should be free »w of any interest
ud
apparently as well as in reality. He should audit the financial statements prepared by the F
management in 1 way. or
He should have general knowledge of client's business and economic trends^^H Awareness about laws like Taxation (c) pr
laws & Contract T Computer a) o
(d) Knowledge
Companies Act etc, is also required. jnfornV<*t,(,n b) ha
a )s
(e) Communication He must continuously update his knowledge to conduct audit effectively. system
During conduct of audit, he has to interact with various officers & staff of organisiK^Ti—ggs third
b)Th
skills (c)M
(f) Tact parties, thus he requires goods oral & written communication abilities.
T
He must be able to deal with different person in different situation. He has to dir: supervise his own staff as
(g) Judgement '
well, thus he should be tactful.
He should be capable to taking firm judgement as to which items are to be chedl behavioural what should be (a)
(h) Logical skills the sample size. (b)
He must be able to analyse & interpret problems so that he can accordingly deal wi same. (c
)
(i) Technical skills He must have good hand on accounting & auditing etc. Moreover, he should be a' latest
development in auditing standards so that he can perform audit in effective mi (d

ement
T(
He should not disclose, confidential information acquired during conduct professional a I
(j) Confidentiality +
duties, to any third party except when
■Permitted by client or
■Required by law ,

(k) Caution Whatever he does, he must do with proper skill & care.

RELATIONSHIP OF AUDITING WITH OTHER DISCIPLINES


Accounting
(a)Auditor provides opinion on financial statements. Basis Meaning
(b)For this, he has to review & evaluate the financial statements.
(c)Thus he should have thorough & sound knowledge about Accounting principles & format contents of
financial statements.
(d)It requires complete expertise of accounting concepts.
Mathematics Function
(a)Auditor deals with financial figures & amounts that appear in financial statements.
By whom
(b)It requires knowledge of calculation procedure involved in computing various items fore,™
deprecation, provision for tax etc.
principle
(c)He has to make comparisons & perform ratio analysis. Thus, a good hand on maths is required.
Statistics Primary
(a)Sampling is an important auditing technique. responsibi
(b)For drawing random sample, he requires knowledge of probability theory & various statistical
concepts. Expertise
Economics
(a)Before conducting audit, auditor needs to obtain knowledge regarding business & economic! Time of
environment affecting the client.
occurred
(b)Moreover, accounting records the data regarding economic activities (e.g., purchases, sales,5
income, payments etc).
(c)Thus economic concepts are required to perform auditing in a meaningful way.
(d)
Law Auditor has to check transactions w .r .t conformity with law.
For example, in audit of partnership firm, he has to check if interest on capital has been provided in accounts
even in absence of such a provision in partnership deed. If it is so, he has to mention this in audit report (as
it is in contravention of The Partnership Act).
Thus, he should have sound knowledge of laws affecting the client.
Computer Now a days, most of the clients maintain their accounts in computer information system.
information
Thus working knowledge on computer is required for auditors to conduct audit in an effective way.
system
Business In financial statements of the client, results of various operations / functions are shown.
operations For example finance, purchase, sale, personnel (payroll) etc.
Until auditor has knowledge about basic business operations, he cannot judge their financial results in effective
Chap. 1 way. to Auditing
Introduction 7
BehaviouralAuditor has to deal with many personnel.
science He has to obtain explanation from client's staff & management.
Moreover, he has to direct & supervise his own audit staff.
Thus, he should have tact of getting along with people.
Financial He should have knowledge of financial techniques like ratio analysis, funds flows analysis & working capital
managemen management etc.
This will help him to understand & evaluate the financial statement in a better way.
t
Logic (a) Auditing is a systematic & logical process.
(c) Thus, auditor's procedures must be logical according to given situation.
Language Auditor is required to communicate orally as well as in writing (preparing audit report etc.).
Thus, he should have good command over language, which is in general use.

1.7 DIFFERENCE BETWEEN AUDITING AND ACCOUNTING

Basis Accounting Auditing


MeaningAccounting is the art of Recording, Classifying
It is &
Independent Examination of financial information of an entity
Summarizing financial Information. to express an opinion thereon.

FunctionIt records financial aspects of entity It reviews the accounting system.


By whom Statutory audit can only be conducted by a chartered accountant.
Any person having good knowledge of accounting.

Principles
As per accounting standards. As per auditing standards .
PrimaryTo maintain accounts & prepare financial statements
To conduct audit in an effective way is the responsibility of
responsibilit is the responsibility of management. auditor.
y
Expertise
Accounting expertise. Accounting & auditing Expertise (both).
Time of Accounts are prepared by the management prior Auditing
to get is examination of financial information, thus can't be
occurrence them audited. conducted prior to accounting.
1.8 SA-200 BASIC PRINCIPLES GOVERNING AN AUDIT
9. Audit
8 Bestword's
conclusions a)Auditor
1. Integrity, shouldAuditing and Assurance
be straightforward, CM
honest and sincere in his professional work. Chap. 2
and reporting
objectivity and b)He should be fair and must not be biased.
independence c)He should maintain impartiality. He should be free of any interest.
2. Confidentiality a)He should maintain confidentiality of information acquired during his work.
b)He should not disclose any such information to a third party without specific I permission of
client or legal or professional duty to disclose.

3. Skill and a)He should perform work with due professional care.
competence b)Audit should be performed by persons having adequate training, experience and 1 competence.

4. Work a)The auditor can delegate work to assistants or use work performed by other auditors I and
performed by experts.
others b)But he will continue to be responsible for his opinion on financial information.

c)The Auditor is entitled to rely on work performed by others, provided


•He exercises adequate skills and care and
•There is nothing to doubt.
5. Documentation a)He should document matters relating to the audit (maintain working papers).

b)Working papers are maintained to demonstrate that the audit was carried out in accordance with
the basic principles.
6. Planning a)He should plan his work to conduct audit in effective and timely manner.

b)Plans should be based on knowledge of the client's business.

c)Plans should be further developed and revised during audit if circumstances require so.
7. Audit Evidence a)Auditor should obtain sufficient and appropriate audit evidence by performing compliance and
substantive procedures.
b)Evidences enable the auditor to draw reasonable conclusion.

c)Compliance procedures mean the tests designed to obtain reasonable assurance that internal
controls have been properly designed & operating effectively throughout the
year.
d)Substantive Procedures are performed to obtain evidence as to the completeness, accuracy and
validity of data produced by the accounting system.
8. Accounting system a)Internal control system ensures that the accounting system is adequate and that all the accounting
and internal information has been duly recorded.
control b)The auditor should understand the accounting system and related internal controls adopted by
the management.
c)He should study and evaluate internal controls system to determine the nature, timing and extent
of other audit procedures.
a)The auditor should review and assess the conclusions drawn from the audit evidences obtained through performance of
procedures.
b)The audit report should contain clear written expression of opinion on the financial statements.
c)His report is on whether:
■The financial information has been prepared using acceptable accounting policies which have been consistently applied;
■The financial information complies with relevant regulation and statutory requirements; and
■There is adequate disclosure of all material matters.
(d)The report should be as per legal requirement. When other than clean opinion is given, the audit report should state the reasons
thereof.

1.9 OBJECTIVES OF AUDIT


As per SA-200 Audit is conducted to express an opinion primary objective is Reporting
on
financial
statements
. Thus,
The objective of audit of financial statements is to enable the auditor to express an opinion on such financial statements.
The auditor reports whether financial statements represent true & fair view.

It can be examined by considering whether:


(a) Financial statement have been prepared using consistent & acceptable accounting policies &
(b) Financial statements comply with relevant rules & regulations & Financial statements contain disclosure of all material matters.
(c) Auditor is expected to provide opinion on true & fair view of financial statement as above.
Detection of (b)
(a) He cannot frame such opinion if he is not able to confirm / dispel the possibility of existence of fraud & error in financial
misstatement statements. Thus incidental/ secondary objective is detection of misstatement in financial statements.
(c) (a)Primary responsibility of prevention, detection & correction misstatement is that of management.
(b)However, if there are doubtful situation that some material misstatement may exist, auditor should extent his procedure to
As per SA-240 confirm / dispel the doubt.
(c)Audit may not reveal all the misstatement (due to inherent limitations of audit).
(d)If auditor performs his work in accordance with basic principles governing an audit, he cannot be held liable for non-detection
of
Chap. 1 Introduction to Auditing 9 misstatement
in financial statements of client.
As per SA-200A (e)However, if he notices material misstatement resulting from fraud, he should communicate the same at appropriate level of
management.
Reporting on (f)If misstatements are found, he should ensure their appropriate disclosure either in financial statements by the management or in
what? his audit report.
True & case
As per fair-of (a)Unless doubtful situations are there, auditor is totally justified in relying upon the management / employees of the client.
Meaning
"Kingston cotton (b)He is a watchdog not a blood hound.
mills company "
Chap, t
10 Bestword 's Auditing and Assurance Chip,!
(ii) Compensating a)
Errors b) Which are nullified by the impact of another error. For
1.12 AC:
example.: expenses amounting to Rs. 6 0 0 0 w r o n recorded
g !) f at Meaning -
Rs. 8000 while another expense amounting to R s.2000 | not recorded
at c) all. fl_
Aeeountin
(d
No ) effect on Trial Balance. Why disek
But may affect profits if one error arises in r e v e n u e aother
x i I in a needed
(in) Error of balance sheet item.
Omission (a)Where transaction is not recorded in Accounts, whollyorI partly.
(b)For example: Sales of 1000 to a either not recorded wholly or 1 shown in sales
Accounts but not posted to A's account.
(c)Full omission does not affect trial balance but partial 1 omission does.
(d)May affect profit.
(a)Incorrect recording of a transaction.
(iv) Error of
commission (b)Maybe of following types:
■Posting error: - wrong Account/Amount/ Side. * Casting Error:-
Wrong totalling/balancing.
■Duplication error: - entry recorded twice.
■Carry forward error:- Wrong amount/ side.
(c)For example: - Sales amounting to Rs. 1 0 0 0 /- r e c o r d e d100/-
a s 1or page
total of wage sheets 500/- carried fo r w a r d Rs.
a s 5500/-. Requirem
(d)May or may not affect trial balance. Same is the case of impact on Aeeountin
profit. *
standard
T yp e of errors disclosure
i aeeountin]
As per nature AS-1
As per accounting aspect

r
revealing /not self-revealing Affecting T.B
Unintentional/ Unconcealed/ /not affecting
intentional concealed T.B.
1, 1,13 A(
Self-
Meaning
T I
Error of
Three fundamen aeeountin assumptic
Error of
Compensating
Error of commission
principleomission
error Conditions which increase the risk of misstatement in financial statement
1.Weakness in internal control system.
2.Doubt about competence and integrity of management.
3.Unusual pressure within entity e.g., entity facing problems in getting finance.
4.Unusual transactions e.g., transaction with related parties.
5.Problems in obtaining sufficient & appropriate audit evidence. For example,
management deliberately n o t coperating
o with the auditor.

Disclosur
requirem
per AS-1
Chap. 1 Introduction to Auditing 11

6.
1.12 ACCOUNTING CONCEPT-DISCLOSURE OF ACCOUNTING
Meaning - POLICIES
A c c o u n policies
tin g
It refers to specific accounting principles & methods of applying those principle,
Why disclosure adopted by entity.
is needed In preparation & presentation of financial statements.
(a)There is no single list of Accounting policies that can be applicable in all situations.
(b)Management chooses the appropriate accounting policy.
(c)For e.g., depreciation can be charged as per written down value method or straight-
line method. Same ways, different polices may be adopted for following:-
■Valuation of inventory
■Treatment of expenditure during construction
■Valuation of fixed assets
■Conversion of foreign currency items
■Valuation of investments
■Treatment of research & development expenditure
■Treatment of contingent liability
(d)The profit or loss can be significantly affected by adopting different accounting
policies.
Requirement of a) (e)Thus disclosure of accounting policies followed, becomes necessary so that readers
Accounting of financial statement can properly understand the view presented.
b)
standard All
c)significant accounting policies adopted in financial statements should be disclosed; &
regarding d) Disclosure should usually be made at one place; &
disclosure of Disclosure should from part of financial statement; &
accounting Any change in Accounting policies having material effect should be disclosed along
with amount by which financial statement is affected by such change ( if amount is
policies- AS-1
ascertainable ) If amount is not ascertainable, the fact should be stated; & If any
(e) fundamental accounting assumption is not followed, the fact should be disclosed.

1.13 ACCOUNTING CONCEPT-FUNDAMENTAL ACCOUNTING ASSUMPTION


Certain fundamental accounting assumptions underlie the preparation &
presentation of financial statements. Their use is assumed.
Three (a)Going Concern: The enterprise is viewed as going concern, that is, continuing
fundamental operations for the foreseeable future. It is assumed that the enterprise has neither
accounting the intention nor the necessity of close down.
assumptions (b)Consistency: It is assumed that accounting policies are consistent from one period
to another period.
(c)Accrual: Revenues and costs are accrued, that is, recognized as they are earned or
incurred (and not as money is received or paid) and recorded in the financial
statements of the period to which they relate.
Disclosure (a)If all three fundamental Accounting assumptions are being followed in preparation
requirement & presentation of financial statements, specific disclosure is not needed.
as per AS-1 (b)However, if any fundamental accounting assumption is not followed the fact has to
be disclosed in the financial statements.
(c)Thus disclosure is needed only in case of non-compliance with the fundamental
Chap, t
12 Bestword 's Auditing and Assurance Chip,!

accounting assumption.
Chap. 1 Introduction to Auditing 13

QUESTIONS ON CHAPTER -1

COMMENT ALONGWITH REASONS WHETHER FOLLOWING ARE TRUE OR FALSE.


(1)Financial statements include P&L accounting and Balance Sheet but not notes to accounts.
FALSE Financial statements mean whole set of accounts including P&L account, Balance sheet anf
disclosure i.e., notes to accounts.
(2)Audit is independent examination of operations conducted by management.
FALSE Audit is independent examination of financial statements of an entity to express opinieM
thereon. It is thus examining financial information, not operations of entity.
(3)Auditor's opinion is on True & Fair view of financial statements.
TRUE For reporting on true & fair view, it is seen whether acceptable policies are consistently applied? j,
regulations have been observed & appropriate disclosures have been made in financifl statements.
(4)Auditor needs to be independent.
TRUE Independence means that judgement of a person is not subordinate to wishes of any person f
Independent audit enhances credibility of financial statements of client.
(5)Audited financial statements help the lenders.
TRUE <=> Lenders can rely on audited financial statements while making decision about credit worth® | of loan applicant &
later on, they can judge recoverability of their funds.
(6)Auditor does not need communication skills, as he is concerned only with financial information.
FALSE During conduct of audit, he has to interact with various officers and staff of client .& til
parties, which requires good written & oral communication skills.
(7)Auditor must maintain confidentiality subject to certain exceptions.
TRUE He (Auditor) should not disclose any confidential information relating to client. However,k|
can disclose if it is permitted by client or required by law.
(8)Auditor does not need knowledge of accounting.
FALSE Auditor expresses opinion on financial statements. If he does not have expert knowledge on
accounting, he cannot check whether financial statements prepared by entity's management a itrue t
& fair or not.
(9)Auditor should have knowledge of CIS.
TRUE Now a days, most of the client maintain their accounts in computer information system. T h i s ,
working knowledge on computer is required for auditors to conduct audit in an effective way. f
(10)Audit doesn't require knowledge of business operations on part of auditor.
FALSE In financial statements of client, result of various operations/ functions are shown. Units
auditor has knowledge about basic business operations, he can't judge their financial results in
effective way.
(11)Documentation is required to be kept by auditor.
TRUE => He should document matters relating to the audit (maintain working papers). Working papers ait
maintained to demonstrate that the audit was carried out accordance with the basic principles. |
(12)Auditor is responsible for prevention & detection of misstatements.
FALSE <=> Primary responsibility of prevention, detection & correction of fraud and error is that o!
management. Thus if auditor performs his work in accordance with basic principles governing an
audit, he cannot be held liable for non-detection of misstatement in financial statements.
(13)Financial statements are responsibility of management.
TRUE <=> The management is responsible for maintaining an upto date and proper accounting of various
transactions entered into during the course of the year.
(14)Sampling is a major inherent limitation of audit.
TRUE => Auditor uses sampling during performance of audit. It is not possible for him to conduct detailed checking due to
14 Bestword's Auditing and Assurance Chap.: Chap. 1

time constraints and other practical problems. As he doesn't check each & every item, so it is impossible
for him to detect all fraud & errors.
(15)Disclosure of accounting policy, which is adopted in preparation of financial statements, is not required. FALSE
<=> The profit or loss can be significantly affected by adopting different accounting policies. Thus,
disclosure of accounting' policies followed becomes necessary, so that readers of financial statements can
properly understand the view presented.
(16)As per AS -1 disclosure of fundamental accounting assumptions is needed whether these are followed or not.
FALSE => If all three fundamental accounting assumptions are being followed in preparation & presentation of financial
statements, specific disclosure is not needed. Thus, disclosure is needed only in case of non-compliance
with the fundamental accounting assumption.

THEORETICAL QUESTIONS

%Nov What would be the inherent limitations of an Audit in relation to frauds and errors? % M 01 N
Write short note on Conditions or events, which increase the risk of fraud or error.
98N 0I!M Write short note on Errors of commission.
99May Distinguish between Auditing and Accounting
00May 'An opinion expressed by the auditor is neither an assurance as to the future viability of the enterprise nor the
efficiency or effectiveness with which management has conducted the affairs of the enterprise'. Comment.
01 N 03 M Do you agree with the view that there are inherent limitations of Audit? 05 N
4Nov State briefly the qualities of Auditors. 05Nov Write short
note on General Purpose Financial Statements.
5Nov Write short note on Going Concern Concept.
97May "Independence of auditor must not only exist in fact, but should also appear to exist to all reasonable persons"-
Discuss highlighting the advantages of an independent audit.
97 Nov Briefly describe the Fundamental Accounting Assumptions.
99 May Write short note on Disclosure of Accounting Policies.
99 Nov Write short note on Fundamental Accounting Assumptions.
01 May What is the importance of having the accounts audited by independent professional auditors?
1May Write short note on Fundamental Accounting Assumptions.
1. Nov Write short note on Disclosure of Accounting Policies.
3May Write short note on Disclosure of Accounting Policies. 03 Nov
Write short note on Fundamental Accounting Assumptions.
03 , 06 Nov What are the basic principles governing an audit as laid down in SA200 (AAS 1)? Explain in briet
05 May Discuss the concept of 'True and Fair'.
Chap.J______

__________ Chapter Difference


^^^H Internal &
Basic concepts in Auditil Evidence

2.1 BASICS - AUDIT EVIDENCE Reliability


Audit Evidence refers to any information Evidence
Meaning
obtained by the auditor so that he c^njto 1
conclusions R evprpss npininn on financial
statements.
Sufficient and
Appropriate Consisten
(a)Auditor should obtain sufficient & Appropriate evidences.
Evidence c
(b)Sufficiency refers to quantum of audit evidence.
Evidence
(c)Appropriateness refers to quality of audit evidence.
Factors to (a)Degree of risk of misstatement.
determine (b)The result of audit procedures i.e. any fraud & error detected Procedurt
Sufficiency & by auditor. obtain Ev
Appropriateness (c)Materiality of item.
(d)Type of information available.
Types of Audit (e)Experience gained during previous audit, (d) Trend
Evidence shown by accounting ratios etc.
According to 1. Visual For example, observing stock taking conducted^
nature client's staff.
2. Documentary For example, Having a copy of loan agreejl sales
bills etc.
3. Oral For example, discussion with managers regarding
current trends in business.
According to 1. Internal Which is created within client's organisation. For
source example., copies of bills given to customer
employee's wage sheets etc.
2. External This originates outside client's organisation. For
example, purchase invoice, bank statement etc.

Types of Audit Evidence


I

According to source
According to
nature
I

15
Chap. 2 Basic concepts in Auditing 16

Oral Interna Extern


l al
Documentary

R
Visual
Chap. 2 Basic concepts in Auditing 17

Difference between Basi Internal Originates outside


s Created & retained organisation.
Internal & Meanin withi client'
g client's organisation. n s
External Evidence External
Example Copies of sales invoice, wage Purchase invoice, bank sheet
statements
Sourc Outside the entity
e Inside the entity
Reliability More reliable
Less reliable
(a)External evidence is generally more reliable than internal evidence.
Reliabili of
(b)Evidence obtained directly through auditor is more reliable than that obtained through client.
ty
(c)Written Evidence is more reliable than oral evidence.
Evidenc (d)Internal Evidence is reliable if related internal controls are good.
e
(i)The audit evidences, obtained through different sources or of different nature should be consistent.
Consistenc of (ii)If there is inconsistency among different evidences relating to a single item, auditor should perform
y Evidence additional procedures to resolve inconsistency.
Procedures Compliance procedures are performed to check designing,
operating effectiveness and continuity of I.C. system. Auditor
(i) Compliance performs compliance procedures in respect of the following
to Procedure assertions relating to internal control system :
obtain Evidence
Existence that the internal control exists.
(design)
Operating that the I.C. system is operating effectively.
effectiveness
Continuity that the internal control has been so operated throughout the period.
Substantive procedures are performed to check completeness, accuracy and validity of
(ii) Substantive transactions and balances. Auditor performs substantive procedures in respect of following
procedure assertions relating to data produced by accounting system:
That a transaction is recorded in the proper period at proper amount.
An item is disclosed, classified and described as per recognized accounting polices and relevant statutory
Measurement requirements, if any.
That there is no unrecorded asset or liability or transaction.
That a transaction or event took place which pertains to the entity during the
Presentation
relavant period.
and disclosure
Valuation a
That an asset or liability is n recorded at appropriate carrying value.
Completeness That an asset or a liability exists at a given date.
Existence
Rights and That an asset is a right of the entity and liability is an obligation of the entity at a
Occurrenc given date.
obligations e
t
o
Compliance & substantive procedures are performed by following methods:
1. Inspection Inspection consists of examining records, documents or tangible assets. Four types of documentary evidence
are:
(i)documentary evidence originating from and held by third parties,
(ii)documentary evidence originating from third party and held by the entity;
(iii)documentary evidence originating from the entity and held by third parties; and
(iv)documentary evidence originating from and held by the entity.
2. Observation (i)Observation consists of witnessing a process or procedure being performed by others.
(ii)For example, the auditor may observe the counting of inventories being performed by client's personnel.
(i)Inquiry consists of seeking appropriate information from knowledgeable persons inside or outside the entity.
(ii)Confirmation consists of the response to an inquiry.
3. Inquiry and (iii)For example, the auditor requests confirmation of receivables by direct communication with debtors.
Confirmation
Computation consists of checking the arithmetical accuracy of records or performing independent calculations.
Analytical review refers to studying significant ratios and trends and investigating unusual fluctuations.
It means performing some work which had already been done by management. For Eg.- Preparing Bank
Reconciliation statement.
4. Computation

5. Analytical Review
6. Reperformance
2 .2 SA-500 -AUDIT EVIDENCE (REVISED) w.e.f. April 1, 2009

Definitions Accounting records - The records of initial accounting entries and supporting
records, such as checks and records of electronic fund transfers; invoices;
contracts;etc.
,(j>K Appropriateness (of audit evidence) - The measure of the quality of audit
evidence; that is, its relevance and its reliability in providing support for the
conclusions on which the auditor's opinion is based.
Chap. 2 Basic concepts in Auditing 19

Jpf Audit evidence - Information used by the auditor in arriving at the conclusions on
which the auditor's opinion is based. Audit evidence includes both information
contained in the accounting records underlying the financial statements and
other information.
Jtff Management's expert - An individual or organisation possessing expertise in a
field other than accounting or auditing, whose work in,that field is used by the
entity to assist the entity in preparing the financial statements.
Jpf Sufficiency (of audit evidence) - The measure of the quantity of audit evidence.
The quantity of the audit evidence needed is affected by the auditor's assessment
of the risks of material misstatement and also by the quality of such audit
Sufficient evidence.
The auditor shall design and perform audit procedures that are appropriate in the
Appropriate
circumstances for the purpose of obtaining sufficient appropriate audit evidence.
Audit Evidence Inspection
Inspection consists of examining records, documents or
tangible assets. Inspection involves examining records or
documents, whether internal or external, in paper form,
electronic form, or other media. An example of inspection
used as a test of controls is inspection of records for
evidence of authorisation.
Inspection of tangible assets may provide reliable audit
evidence with respect to their existence, but not necessarily
Inquiry and about the entity's rights and obligations or the valuation of
Confirmation Observation the assets.
Observation consists of witnessing a process or procedure being performed
by others.
For example, the auditor may observe the counting of
inventories being performed by client's personnel.

(i)Inquiry consists of seeking appropriate information from knowledgeable persons


inside or outside the entity.
(ii)Confirmation consists of the response to an inquiry.
(iii)For example, the auditor requests confirmation of receivables by direct
communication with debtors.
Recalculation direct communication with debtors. Recalculation consists of of
checking the mathematical accuracy documents or records. Recalculation or may
be performed manually electronically
Analytical Analytical review refers to studying significant ratios and trends and investigating
Procedures unusual fluctuations.
Reperformance Reperformance involves the auditor's independent execution of procedures or controls
that were originally performed as part of the entity's internal control.
20 Bestword's Auditing and Assurance CM Chap. 2

■The reliability of audit evidence that is generated internally is increased 1related


controls are effective.
■Audit evidence obtained djrectly by the auditor is more reliable than audit eviis
obtained indirectly
■Audit evidence in documentary form, whether paper, electronic, or other mediui more STAGE-3
reliable than evidence obtained orally .
overall r
■Audit evidence provided by original documents is more reliable than audit evidi
provided by photocopies or facsimiles, or documents that have been digitised or the end of1
otherwise transformed into electronic form, the reliability of which ns depend on the
controls over their preparation and maintenance.
When information to be used as audit evidence has been prepared using the workoif Extent ol
management's expert, the auditor shall, onARP
(a)Evaluate the competence, capabilities and objectivity of that expert;
(b)Obtain an understanding of the work of that expert; and
(c)Evaluate the appropriateness of that expert's work as audit evidence for tl relevant
assertion.
2.
When using information produced by the entity, the auditor shall evaluate whether ft
information is sufficiently reliable for the auditor's purposes.
If,
(a)audit evidence obtained from one source is inconsistent with that < btained from anotSi or
(b)the auditor has doubts over the reliability of information to be used as audit evidence. The
auditor shall determine what modifications or additions to audit procedures ai necessary to
resolve the matter, and shall consider the effect of the matter, if any,
Inconsistency in, or on oft aspects of the audit. _ _____________
Doubts over
Reliability of, 2.3 SA- 520 - ANALYTICAL PROCEDURES
Audit Evidence

1 When designing and performing audit procedures, the auditor shall consider the relevance
and reliability of the information to be used as audit evidence. ■ The reliability of audit
evidence is increased when it is obtained from independent sources outside the entity.
Meaning "Analytical procedures" means the analysis of significant ratios and trends, including the
investigation of fluctuations.
Nature of Analytical procedures include comparisons of the entity's financial information with f following:
Analytical ■Comparable information for prior periods.
Procedures ■Anticipated results such as budgets.
■Predictive estimates prepared by the auditor, such as estimation of depreciation.
■Industrial trend.

Chap. 2 Basic concepts in Auditing 21


Use of ARP • Analytical procedures are used -
a)In planning the nature, timing and extent of other audit procedures.
b)As an overall review of the financial statements.
STAGE-1 In Planning •The auditor should apply analytical procedures at the planning stage for understanding the
the audit business and in identifying areas of potential risk.
•It uses both financial and non-financial information.
STAGE-2 As ■He may use ARP at this stage as a mean to obtain extra evidence relating to an item.
Substantive ■When performing analytical procedures as substantive procedures, auditor will need to
Procedures consider whether to rely on results of ARP or not.

STAGE-3 In overall He should apply analytical procedures at or near the end of the audit while concluding as to whether the
review at the end of the financial statements as a whole are consistent with his knowledge of the business.
audit In some cases, the auditor may identify areas where further procedures should be applied before
reporting.

The application of analytical procedures is based on the assumption that relationships


Extent of on reliance
ARP among data exist and continue.
The extent of reliance on the results of analytical procedures depends on the following
factors:
Materiality of the items involved. For example, when inventory balances are material the auditor does
not rely only on analytical procedures in forming conclusions;
Other audit procedures applied for the same audit objectives;
Accuracy with which the expected results of analytical procedures can be predicted. For example, the
auditor will place greater reliance in comparing gross profit margins from one period to another than
in comparing discretionary expenses, such as research or advertising; and
Assessment of inherent and control risks: For example, if internal control over sales order processing is
weak, then auditor would consider adopting more substantive tests rather than ARP only.

Unusual fluctuations
When ARP identify significant fluctuations which are inconsistent' with other information, the auditor
should perform extended procedures.

2.4 SA-320 - AUDIT MATERIALITY


22 Bestword's Auditing and Assurance CM Chap. 2

Materiality Meaning ■Material items are those which may affect the judgement of users of
financial statements.
■It may be quantitative / qualitative.

■ It depends upon ■Size of item;


■Nature of item;
• Statutory provisions, etc.
Materiality to be From both point of views - ■ Individual Account and * Overall financial
considered statements.

Auditor should 1.Determining NTE of audit procedures; and


consider materiality 2.Evaluating effect of misstatements.
while
Relationship between Relation Inverse relationship between Degree of Audit Risk and Materiality level.
Materiality and Audit
Risk
Reason Generally, management / employees don't commit fraud in high value items.
Moreover, as a general practice, auditor examines high value items in detail.
Thus, it is less risky that high value Fraud and Error may not be detected. Thus
high materiality level leaves audit risk at lower degree. Hence, inverse
relation.

Considerations by ■Auditor decides upon materiality level during planning stage which may be c h a n gduring
ed
Auditor progress of audit. It may be increased/ decreased for specific account.
■If ARP indicates misstatements, auditor should adopt other procedures to estimate it.
Aggregate Meaning *Specific misstatements identified by Auditor +
uncorrected *Uncorrected misstatements (not identified) +
misstatement *Net effect of uncorrected misstatements identified during previous
year's audit
If Auditor concludes that aggregate uncorrected misstatement are material

Ask Management to adjust financial statement


Scope of this SA

4 i
Materiality in the O. K. Qualified/ adverse opinion.
Context of an
Audit

2.5 SA 320(REVISED) MATERIALITY IN PLANNING AND PERFORMING


AN AUDIT (on or after April 1, 2010)

This Standard on Auditing (SA) deals with the auditor's responsibility to apply the concept of
materiality in planning and performing an audit of financial statements. SA 450, explains
how materiality is applied in evaluating the effect of identified misstatements on the audit and
of uncorrected misstatements, if any, on the financial statements.
3.The auditor's determination of materiality is a matter of
professional judgment, and is affected by the auditor's
perception nf the financial information needs of users of the
financial statements. In this context, it is reasonable for the
auditor to assume that users:
(a)Have a reasonable knowledge of business and economic
activities and accounting and a willingness to study the
Chap. 2 Basic concepts in Auditing 23

information in the financial statements with reasonable


diligence;
(b)Understand that financial statements are prepared,
presented and audited to levels of materiality;
(c)Recognize the uncertainties inherent in the measurement of
amounts based on the use of estimates, judgment and the
consideration of future events; and
(d)Make reasonable economic decisions on the basis of the
information in the financial statements.
4.The concept of materiality is applied by the auditor both in
planning and performing the audit, and in evaluating the
effect of identified misstatements on the audit and of
uncorrected misstatements, if any, on the financial statements
and in forming the opinion in the auditor's report.
5.In planning the audit, the auditor makes judgments about the size
of misstatements that will be considered material. These
judgments provide a basis for:
24 Bestword's Auditing and Assurance CM Chap. 2

a)Determining the nature, timing and extent of risk assessment procedures;


b)Identifying and assessing the risks of material misstatement; and
c)Determining the nature, timing and extent of further audit procedures.
6. The auditor considers not only the size but also the nature of uncorrected misstatements, when evaluating
their effect on the financial statements.
Effective DateThis SA is effective for audits of financial statements for periods beginning on or after April 1,2010.

Objective The objective of the auditor is to apply the concept of materiality appropriately in planning and performing the
audit.
/Definition For purposes of the SAs, performance materiality means the amount or amounts set by the auditor at less than
materiality for the financial statements as a whole to reduce to an appropriately low level the probability
that the aggregate of uncorrected and undetected misstatements exceeds materiality for the financial
statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by
the auditor at less than the materiality level or levels for particular classes of transactions, account
balances or disclosures.

Determining When establishing the overall audit strategy, the auditor shall determine materiality for the financial
Materiality and statements as a whole. If, there is one or more particular item for which misstatements of lesser amounts
Performance than the materiality for the financial statements as a whole could reasonably be expected to influence the
Materiality when economic decisions of users taken on the basis of the financial statements, the auditor shall also
determine the materiality level or levels to be applied to those particular item.
Planning the
Audit The auditor shall determine performance materiality for purposes of assessing the risks of material
misstatement and determining the nature, timing and extent of further audit procedures.

Revision as the The auditor shall revise materiality for the financial statements as a whole (and, if applicable, the
Audit materiality level or levels for particular classes of transactions, account balances or disclosures) in the
event of becoming aware of information during the audit i that would have caused the auditor to have
Progresses
determined a different amount (or amounts) initially.
If the auditor concludes that a lower materiality for the financial statements as a whole (and, if applicable,
materiality level or levels for particular classes of transactions, account balances or disclosures) than
that initially determined is appropriate, the auditor shall determine whether it is necessary to revise
performance materiality, and whether the nature, timing and extent of the further audit procedures
remain appropriate.

Documentation The audit documentation shall include the following amounts and the factors considered in their
determination:
Materiality for the financial statements as a whole ;
If applicable, the materiality level or levels for particular classes of transactions, account balances or
disclosures;
Performance materiality; and
Any revision of (a)-(c) as the audit progressed.
2.6 SA 580 (REVISED) - WRITTEN REPRESENTATIONS (W.E.F. 1ST
APRIL, 2009)
Scope of this SA This Standard on Auditing (SA) deals with the auditor's responsibility to obtain written representations
from management and TCWG.
Written ■Similar to responses to inquiries, written representations are audit evidence.
Although
Representations as written representations provide necessary audit evidence, they do not provide sufficient
appropriate audit evidence on their own about any of the matters with which they deal.
Audit Evidence
Furthermore, Other
the fact that management has provided reliable written representations does not affect the
nature or extent of other audit evidence that the auditor obtains.
Written
Representatio
Chap. 2 Basic concepts
To obtain written representations frominmanagement
Auditing 25 the
that management believes that it has fulfilled
Objectives of ns
fundamental responsibilities.
auditor
To support other
Date auditof evidence by means of written representations, if determined necessary by the
auditor or required by other SAs; and
and
To respond appropriately to written representations provided by management or absence thereof.
Period(s)
Doubt as to the
Covered
Doubt as to Written A written statement by management provided to the auditor to confirm certain matters or to support
Reliability of Written by
other audit evidence. Written representations in this context do not include financial statements, the
the Reliability representations
Representations Written
assertions therein or supporting books and records.
of Written Representations
from Whom The auditor shall request written representations from management with appropriate responsibilities
Representatio
Formstatements
for the financial ofand knowledge of the matters concerned.
ns and PreparationWritten
and written representation that mgt. has fulfilled its responsibility for the
Written
Requested Representations Presentation of the preparation and presentation of the financial statements
Representatio
Written Financial Statements
about ns
Representatio Management's
ns Not Responsibilities
Provided Information Provided Written representation that mgt. has provided the auditor with all relevant
to the Auditor information agreed in the terms of the audit engagement and that all
transactions have been recorded and are reflected in the financial statements.

Other SAs require the auditor to request written representations. If, in addition to such
required representations, the auditor determines that it is necessary to obtain one or more
written representations, the auditor shall request such other written representations.
The date of the written representations shall be as near as practicable to, but not after, the date
of the auditor's report on the financial statements. The written representations shall be for all
financial statements and period(s) referred to in the auditor's report.

The written representations shall be in the form of a representation letter addressed to the
auditor.
If law or regulation requires management to make written public statements about its
responsibilities, the relevant matters covered by such statements need not be included in
the representation letter.

If the auditor has concerns about the competence, integrity, ethical values or diligence of
management, the auditor shall determine their effect on the reliability of representations
(oral or written) and audit evidence in general. In particular, if written representations are
inconsistent with other audit evidence, the auditor shall perform audit procedures to
attempt to resolve the matter.
If the auditor concludes that the written representations are not reliable, the auditor shall
take appropriate actions, including determining the possible effect on the opinion
If management does not provide one or more of the requested representation, he shall discuss
Requested Written the matter with mgt. and re-evaluate the reliability and integrity of mgt. He shall consider its
Representations Not effect on his audit report as well.
Provided The auditor shall disclaim an opinion on the financial statements if:
(a)The auditor concludes that there is sufficient doubt about the integrity of management such
that the written representations are not reliable; or
(b)Management does not provide the written representations.

2.7 SA-505 - External Confirmations


26 Bestword's Auditing and Assurance CM Chap. 2

External It is the process of obtaining and evaluating audit evidence through a direct communication from a third
Confirmation- party in response to a request for information about a particular item.
Meaning

Process of ■Selecting the items for which confirmations are needed.


External ■Designing the form of the confirmation request.
Confirmations ■Communicating the confirmation request to third party.
■Obtaining response from third party.
■Evaluating the information or absence of confirmation.
Situations where ■Debtor balances;
External ■Creditor balances;
Confirmations may ■Terms of agreement or transactions with third parties;
■Bank Balance and other information from bankers;
be used
■Stock held by third parties;
Evidenc
■Property title deeds held by third parties; e
■Investments purchased but delivery not taken; & TRUE
Chap. 2 ■Bank loans. Basic concepts in Auditing 27
Timing of External confirmation may be requested either at the balance sheet date or as at any mlfl date close to Auditor
External the balance sheet date. Respondents will be more willing to a confimatilf request containing
TRUE
management authorization.
Confirmations
Use of Positive and Positive It asks the respondent to reply to the auditor in all cases either!®! indicating the
confirmation respondent's agreement/ disagreement with the ghfij information, or by asking the 3)Compli
Negative
request respondent to fill in information. FALS
Confirmation
E
Request
Negative It asks the respondent to reply only in the event of disagreement with®
4)Substa
confirmation information provided in thg request. Negative confirmation request shot® be used
request when: TRUE
■inherent and control risk is low;
5)Auditc
■a large number of small balances is involved;
■a substantial number of errors is not expected; and TRUE
■it does not appear to the auditor that respondents will disregard these requests.
6)Mate!
Respondent's competence and independence affect the reliability of evidence. Thus, It confirmation FALS
Characteristics of
Respondents request should be addressed to appropriate individual.
(7Ther
)
The external The auditor should maintain control over selection of third parties to whom a requeip will be sent, the TRU
confirmation preparation and sending of requests and the responses to those requests.®
He should ensure that he directly sends out the confirmation requests, the requests attl properly
process
addressed and that all replies and the undelivered confirmations are delivered directly to him.
considerations by He should perform alternative procedures if no response is received to a positrafi external confirmation Exte
(8
auditor request.
)i
■The auditor should consider whether external confirmations appear to be unreliable. FA
He should also consider the causes of inconsistency revealed by external confirmation^ 1 any. L
(9 )
Rep
Management Meaning If auditor wants to confirm certain information and management 1 requests the !
Requests auditor not to do so, he should consider validity of grounds for such a request. Au
(1
TRl
He should ask the management to submit its request I in a written form, 0)
c
alongwith the reasons for such request. He should! maintain documentation of
TR
the request made by the management along with the reasons given by the
management.
If he agrees If he agrees to management request not to seek external confirmation regarding
a particular matter, then apply alternative procedures to obtain > sufficient
appropriate evidences.
If he doesn 't agree If the auditor does not accept the validity of management's request and is
prevented from obtaining confirmations, there is a limitation on the scope of
the auditor's work. He should consider the possible impact on the audit report.

OBJECTIVE TYPE QUESTIONS

Comment on whether following are True or False


(1)Evidence should be sufficient and appropriate.
TRUE Auditor should obtain sufficient & Appropriate evidence. Sufficiency refers to
quantum of audit evidence. Appropriateness refers to quality of audit
evidence.
(2)Auditor should consider consistency of evidence.
TRUE The audit evidences obtained through different sources or of different nature
should be consistent.
If there is inconsistency among different evidences relating to a single
item ,auditor should perform additional procedures to resolve
inconsistency.
28 Bestword's Auditing and Assurance CM Chap. 2

(3)Compliance procedure is undertaken to check transactions & balances.


FALSE => Compliance procedure is undertaken to check designing, operating
effectiveness and continuity of internal control systems.
(4)Substantive procedures are carried out to check data produced by accounting
system .
TRUE => Substantive procedures are undertaken to check completeness, accuracy and
validity of data produced by accounting system i.e., transactions and
balances.
(5)Auditor may use analytical review procedure at planning stage.
TRUE => The auditor should apply analytical procedures at planning stage for
understanding the business and in identifying areas of potential risk. It
uses both financial and non- financial information.
(6)Material items are only quantitative in nature.
FALSE Material items are those which may influence the judgement of users of
financial statements. It may be quantitative and qualitative as well.
(7)There is inverse relation between materiality & audit risk.
TRUE => Generally management /employees don't commit fraud in high value items.
Moreover, as a general practice, auditor checks high value items in detail.
Thus it is less risky that high value fraud and error may not be detected .
So, high materiality level leaves audit risk at lower degree.
(8)External confirmation means representation from management.
FALSE <=> It 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 particular item.
(9)Reply is required in all cases in positive confirmation request.
TRUE <=> It asks the respondent to reply to the auditor in all cases either by indicating
the respondent's agreement/disagreement with the given information or by
asking the respondent to fill in information.
\ud\tor should carefully plan & control external confirmation.
TYUJE The auditor should maintain control over the process of
selecting those to whom a request will be sent, the

r
preparation and sending of confirmation requests and
the responses to those requests.3.2 SA-210 - TERMS
OF AUDIT ENGAGEMENT

Audit t letter, to avoid any misunderstanding. Reasonable justiftc


Engagement 2.Auditor should send an engagement letter, preferably
before commensi' engagement. (i.e. to change pre
Letter
The objective of the audit; The scope of the audit;
Client and Audito
Management responsibility for the financial
New terms
Principal statements;
contents:
1.Client and Management's responsibility for selection and
Auditor consistent application__________________________________________________
should accounting policies;
agree on Management's responsibility for preparation of the
terms of financial statements onjl concern basis;
engagemen Management's responsibility for making reasonable
t by way judgments and estimate
of■ Management's responsibility for the maintenance of
engagemen adequate accountingj and internal controls;
Unrestricted access to records and documentation;
The fact that due to (1) the test nature of an audit, (2) persuasive rati
conclusive nature of audit evidence, (3) involvement of judgement and (4)ii
limitations of any accounting and internal control system, there is an una1 risk
that even some material misstatements may remain undetected; &
The fact that the audit process may be subjected to peer review.

Additional Matters Planning of the audit.


Expectation of receiving MRL.
Requesting client to confirm the terms of the engagement. Description of any
other letters the auditor expects to issue to the client. Fees and billing
arrangements. Effective
Date
Arrangements w.r.t. the involvement of other auditors and experts and
intti_____________________________________________________________________
auditor.

Objective

Arrangements to be made with the predecessor auditor.

When the auditor of a parent entity is also the auditor of its


subsidiary, division, Auditor should consider Legal
30 Bestword 's Auditing and Assurance
"should consider the reque

requirements, independence of the managemH etc. to decide


whether to stnd a separate engagement letter to the component.
The auditor should consider whether circumstances require revision in terms i
Definition engagement or if there is need to remind existing terms of
engagement to the client. 1

Changes in If before completing the engagement, client requests the auditor to change
Engagement I; engagement to one, which provides a lower level of assurance, he
should consider tit 1 reasonableness of such a request.

Audit of
Component

Recurring Audits
He should consider the request from client to change the terms
I
Ppr 'f Auditor conqludes that there is

Reasonable justification of should continue-with original


change engagement
(i.e. to change previous '4
misunderstanding)
If client doesn't permit him to

Client and Auditor should continue original engagement


agree on New terms I
No reasonable justification Withdraw and consider other
of change i obligation
(i.e. report these circumstances to
He shouldn't agree to a other
change of engagement and «
parties like BOD or shareholders)

3.3 SA 210 (REVISED) AGREEING THE TERMS OF AUDIT


ENGAGEMENTS (on or after April 1, 2010)
__________________________________________________
__________________________________________________________________________
Bestword 's Auditing and Assurance C h a p ,!

Preconditions
Scope of this SA This Standard on Auditing (SA) deals with the auditor's responsibilities in agreeing the terms of the audit
for an Audit engagement with management and, where appropriate, those charged with governance.

Effective Date This SA is effective for audits of financial statements for periods beginning on or after April 1,2010.

Objective The objective of the auditor is to accept or continue an audit engagement only when the basis upon which
it is to be performed has been agreed, through:
a)Establishing whether the preconditions for an audit are present; and
Confirming that there is a common understanding between the auditor and management and, where
appropriate, those charged with governance of the terms of the audit engagement.

Definitions Preconditions for an audit - The use bv management of an acceptable financial reporting framework_in the
preparation of the financial statements and the agreement of management and, where appropriate, those
charged with governance to the premise on which an audit is conducted.
For the purposes of this SA, references to "management" should be read hereafter as "management and,
where appropriate, those charged with governance".

In order to establish whether the preconditions for an audit are present, the auditor shall: (a) Determine whether the financial
reporting framework to be applied in the preparation of the financial statements is acceptable; and
Obtain the agreement of management that it acknowledges and understands its
(b)
responsibility:
(i)For the preparation of the financial statements in accordance with the ai financial reporting framework, including
their fair presentation;
(ii)For such internal control as management determines is necessary to enable the preparation of financial statements that
are free from material misstatement, whethB due to fraud or error; and
(iii)To provide the auditor with: Access to all information such as regords. documentation and other matters; Additional
a. information that the auditor may request from management for the purpose of the audit; and
b.
c Unrestricted access to persons within the entity from whom the auditor;
. determines it necessary to obtain audit evidence.
Limitation on Scope If management or those charged with governance impose a limitation on the scope of the auditor's work in the terms of a
Prior to Audit proposed audit! engagement such that the auditor believes the limitation will result in the auditor disclaiming an opinion on
Engagement the financial statements, the auditor shall not accept such a limited engagement as an audit! engagement. _
Acceptance I
If the preconditions for an audit are not present, the auditor shall| discuss the matter with management. Unless required by law
or regulation to do so, the auditor shall not accept the proposed audit I engagement. J
Other Factors
Affecting Audit The auditor shall agree the terms of the audit engagement with management or those charged with governance, as
Engagement appropriate.
Acceptance the agreed terms of the audit engagement shall be recorded in an audit engagement letter or other suitable form of written
agreement and shall include:
(a)The objective and scope of the audit of the financial statements;
(b)The responsibilities of the auditor;
(c)The responsibilities of management;
(d)Identification of the applicable financial reporting framework for the preparation of the financial statements; and
Bestword 's Auditing and Assurance C h a p ,!

(e)Reference to the expected form and content of any reports to be issued by the auditor and a statement that there may be
circumstances in which a report may differ from its expected form and content.
If law or regulation prescribes in sufficient detail the terms of the audit engagement the auditor need not record them in a
written agreement, except for the fact that such law or regulation applies and that management acknowledges and
understands its responsibilities as above.
On recurring audits, the auditor shall assess whether circumstances require the terms of the audit engagement to be revised and
Recurring whether there is a need to remind the entity of the existing terms of the audit engagement.
Audits

Agreement on
Audit
Engagement
Terms
34 Bestword 's Auditing and Assurance

Acceptance of Thea auditor shall not agree to a change in the terms of the audit engagement where
Knowledge o'
there is no reasonable
Change in the justification for doing so. clients Busines
If, prior to completing the audit engagement, the auditor is requested to change the audit engagement to an
Terms of the
engagement that conveys a lower level of assurance, the auditor shall determine whether there is
Audit reasonable justification for doing so.
Engagement If the terms of the audit engagement are changed, the auditor and management shall agree on and record the
new terms of the engagement in an engagement letter or other suitable form of written agreement.
If the auditor is unable to agree to a change of the terms of the audit engagement and is not permitted by
management to continue the original audit engagement, the auditor shall:
(a)Withdraw from the audit engagement where possible under applicable law or regulation; and
(b)Determine whether there is any obligation, either contractual or otherwise, to report the circumstances to
other parties, such as those charged with governance, owners or regulators.

Additional Financial Reporting If financial reporting standards established by an authorised or recognised


Considerations Standards standards setting organization are supplemented by law or regulation, the auditor
Supplemented by shall determine whether there are any conflicts between the financial reporting
in Engagement Law or Regulation standards and the additional requirements. If such conflicts exist, the auditor shall
Acceptance discuss with management the nature of the additional requirements and shall agree
whether:
J^'The additional requirements' can be met through additional disclosures in the
financial statements; or
^KThe description of the applicable financial reporting framework in
the financial statements can be amended accordingly. If neither of the above
actions is possible, the auditor shall determine whether it will be necessary to
modify the auditor's report.

Auditor's ReportIn some cases, the law or regulation applicable to the entity prescribes the layout or
Prescribed by Law wording of the auditor's report in a form or in terms that are significantly different
or Regulation from the requirements of SAs. In these circumstances, the auditor shall evaluate:
(a)Whether users might misunderstand the assurance obtained from the
audit of the financial statements and, if so,
(b)Whether additional explanation in the auditor's report can mitigate
possible misunderstanding.
If the auditor concludes that additional explanation in the auditor's report cannot
mitigate possible misunderstanding, the auditor shall not accept the audit
engagement, unless required by law or regulation to do so. An audit conducted in
accordance with such law or regulation does not comply with SAs. Accordingly,
the auditor shall not include any reference within the auditor's report to the audit
having been conducted in accordance with SAs.

This letter will be effective for future years unless it is terminated, amended or superseded. Please s i g attached
n copy of this
letter to indicate that it is in accordance with your understanding of the a r r a n g e maudit
e n t sof
| the financial statements. XYZ & Co.
Chartered Accountants
Chap. 3 Preparation for an Audit 35

(Signature)
(Name of the Member) (Designation)

Acknowledged on behalf of ABC Company by

(Signature)
Name and Designation Date

3.5 AUDIT TECHNIQUES


Develops
Audit techniques refer to certain means & methods for collecting evidences.
overall
Example Meaning
1. Posting checking 4. 2. Casting checking 5. Re- 3. Physicalcomputation 8. Bank reconciliation (contents
Inquiry 7. Year end verification • 6. ARP
Difference Between Basic way to handle audit Methods are employed for conduct!^
scrutiny work. procedures.
Audit Procedures &
Many (refer to examples given above);
Audit Two types -
Techniques Compliance and substantive.
Procedures Techniques

In verification of Assets, mam techniques such as physical examination, inquiry and computations ! are needed.

3.6 PLANNING-BASICS

Basis
(i) Meaning

(ii) Types

atureA specific procedure may


require a number of techniques.
36 Bestword 's Auditing and Assurance
PlanningK n o w le d g e o f t h1.The
e c lieauditor
n t s should plan his work to enable him to conduct an effective audit in an efficient
B u s in e s s and timely manner.
2.It should be based on knowledge of the client's business.
Usefulness Audit planning helps to ensure that:
" appropriate attention is devoted to important areas of the audit;
■potential problems are promptly identified;
■the work is complete in time;
■assistants are utilised properly; and
■the work done by other auditors and experts is duly co-ordinated.
The auditor can obtain such knowledge from - Previous Experience. Discussion with
people within entity. Discussion with internal auditor. Discussion with other auditor.
Discussion with knowledgeable people outside entity. Publication relating to industry
in which entity operates. Legislation and Regulation. Visits to entity/plant.
Documents produced by entity (minutes, manuals, plans) etc. Client's annual report to shareholders.
Client's policy and procedure manual. Minutes of meeting of shareholders, BOD etc. Internal periodic
reports.
Consideration of state of economy and its impact on client's business.
The Development of an terms of engagement and any statutory responsibilities. Nature and timing
of overall plan reports or other communication. Applicable legal or statutory requirements.
(contents of plan) Accounting policies adopted by the client and changes in those policies.
Effect of new accounting or auditing pronouncements on the audit. Identification
of significant audit areas. Setting of materiality levels for audit purposes.
Conditions requiring special attention such as the possibility of material error or fraud.
Reliance to be placed on accounting system and internal control.
Rotation of emphasis on specific audit areas.
Nature, timing and extent of audit evidence.
Work of internal auditors and the extent of their involvement.
Involvement of other auditors.
Involvement of experts.
Allocation of work between joint auditors.
Establishing and coordinating staffing requirements.

3.7 SA 300 (REVISED) - PLANNING AN AUDIT OF FINANCIAL STATEMENTS (w.e,f. 1st April
2008)____________________________________________________________________________
Scope of this SA It deals with the auditor's responsibility to plan an audit of financial statements. This SA is framed in the context of recurring
audits. Additional considerations in initial audit engagements are separately identified.
The engagement partner and other key members of the engagement team shall be involved in planning the audit.
Involvement of Key
Engagement Team
Members
Chap. 3 Preparation for an Audit 37

Preliminary
Engagement The auditor shall undertake the following activities at the beginning of the curratp engagement:
Activities a)Performing procedures required by SA 220 regarding the continuance of tht§ relationship;
b)Evaluating compliance with ethical requirements, including independent! required by SA 220; and
^Preliminary
c)Establishing an understanding of the terms of the engagement, as required biB 210. Engagement
Activities, „
The auditor shall establish an overall audit strategy that sets the scope, tiraii direction of the
audit, and that guides the development of the audit plan. In establishing the overall audit
Planning Activities strategy, the auditor shall: U)
Planning
(a)[Tdentify ^e characteristics^ the engagement that define its scope;
(b)Ascertain the reporting objectives of the engagement to plan the timingofi audit and the nature of the communications
required; Str
(c)Consider the factors that are significant in directing the engagement
efforts; a
(d)Consider the results of preliminary engagement activities and, where apf whether knowledge
Use gained on
other engagements performed by the engagf partner for the entity is relevant; and ol
(e)Ascertain the NTE of procedures. Char
The auditor shall develop an audit plan that shall include a description of: a
audit
(a)The nature, timing and extent of planned risk assessment procedui determined under SA 315.
(b)The nature, timing and extent of planned further audit procedures at the assertion! level,
Dir as determined
under SA 330 .
ec
(c)Other planned audit procedures that are required to be carried out so that the $ NT engagement
complies with SAs. E
(iii)Upda deK
The auditor shall update and change the overall audit strategy and the audit plan as t necessary
Documentation during the course of the audit te e
The auditor shall plan the nature, timing and extent of direction and supervision of \ + ReN engagement
team members and the review of their work. po
I. Se\
The auditor shall document: (^The overall audit strategy; tyyf 5 e >
The audit plan; and .
AssV
2 f
[pf Any significant changes made during the audit engagement to the overall audit strategy or the
and the reasons for such changes.
. Ins audit plan,
sta

The auditor shall undertake the following activities prior to starting an initial audit:
(a)Performing procedures required by SA 220 regarding the acceptance of the client relationship and the specific audit
engagement; and
(b)Communicating with the predecessor auditor, where there has been a change of auditors, in compliance with relevant ethical
requirements.

Additional 6
Considerations in
Initial Audit
Engagements .

.
38 Bestword's Auditing and Assurance Chap.: Chap. 1

SUMMARY OF SA 300
Audit

Recurring
(i) Preliminary Continuance (Q.C.)
Engagement
Activities
Ethics (Q.C.)
Terms

1
j (ii) Planning Activities
Initial
Acceptance
(
Q
.
C
.)
+
Commu
nicate
with
previou
s
auditor
+ Strategy

Use of Knowledge
Characteristics of
audit
Direction required
NTE (Broad
determination)
Plan Report (timing
etc)
315-
330-
Other
Plan
315-
330-
Other

(iii)
Updatio
ns, if
required
Chap. 3 Preparation for an Audit 39

3.8
ADVA
NTAG
ES OF
AUDI
T
PROG
RAM

1. Selection of The program helps selecting assistants as per their capability.


Assistants

2. Instructions for staff It contains instructions for staff as to work to be done.

3. Ready check list It provides ready checklist of all the procedures and techniques to be adopted.

4. No ignorance or Due to properly written program, there is no chance of forgetting /overlooking some important
overlooking matter.

5. Responsibility Program clearly set out as to who is required to do a particular work. Thus responsibility can be
fixation fixed.

6. Progress of work The progress of work can be determined on the basis of entries on the program.
done

7. Supervision Work by assistants can be easily supervised by referring the program.

8. Timely completion Time to time, compliance with program is checked so as to complete the work on timely basis.

9. Basis for reporting Program easily sets out procedure - evidence - conclusions chain, to enable the auditor f to
express opinion.

10. Future Audits It serves as a guide for audits to be carried out in succeeding years.

11. Safeguard for auditor In case, auditor faces some case for negligence, he can defend himself by showing it.

3.9 LIMITATIONS OF AUDIT PROGRAM

1. Mechanical Approach Assistants may carry out work mechanically without understanding the whole concept. '

2. Inflexibility The program often becomes rigid & inflexible. Assistants are not able to change it as per
requirements of specific case. .
3. Lack of initiative Hard & fast program hurts the initiative & judgmental skills of hard working assistants.

4. Monotonous Talented & efficient staff becomes frustrated due to anonymity in programs.

5. Shelter for inefficient They think that it contains exhaustive matters. They don't even think of any unusual matter,
assistants which is not listed in program even if its presence can change audit approach.
40 Bestword's Auditing and Assurance Chap.: Chap. 1

3.10 WAYS TO CARRY


OUT SYSTEMATIC &
EFFICIENT AUDIT
1. Regularity Audit must be carried out regularly.

2. Record of time If arrival & departure time of assistants are recorded, it will act as a moral check for them.

3. Completeness Specific portion of work should be completed on daily basis.

4. Documentation Working papers should be maintained regarding all the work done.

5. Confidentiality Audit staff should not discuss the client's affairs with outsiders.

6. Stamping After examination, all vouchers must be stamped.

7. Colour Colored pen/pencils & different ticks should be used to indicate different audit procedures.
differentiation
8. Supervision Audit team manager must periodically review & supervise the work done.

9. Regular During audit, there should be continuous interaction among the members of audit team to discuss
meetings latest findings.

10. Flexibility If need arises, audit program should be revised during the course of audit.

3.11 CLASSIFICATION
OF AUDIT
ACCORDING TO TIME
OF ASSURANCE
Chap. 3 Preparation for an Audit 41

Final/ periodical/ i Audit that begins after the books have been closed at end of accounting period &
Meaning thereafter carried on continually till completion.
completed Audit
Advantages i)Work is carried out in single continuous sitting.
ii)Suitable for small client.
iii)No manipulation in accounts, once closed.
iv)No interruption in regular workflow of client.

v) Limitations i)Excessive workload on auditor at end of accounting year.


ii)May not be suitable for big enterprise.
iii)Misstatements cannot be determined on an early basis.
iv)Less time for detailed examination.
Continuous Audit Meaning >When audit is conducted during the financial year i.e., accounts are examined
the whole year round; it is termed as continuous audit.
>Audit staff is present at clients site almost during entire accounting period.

> Advantages i)Earlier discovery of-misstatements.


ii)Presence of audit staff acts as moral check on client.
iii)Client's accounts are always kept up to date.
iv)Auditor has more time for detailed checking.
v)Auditing work can be completed on a timely basis.
vi)Helpful for client as auditor can provide useful suggestion after detailed
checking.
vii)Routine checking is completed in advance.

viii)Less pressure at year-end.


Limitations i)Records may be altered after being examined by auditor.
ix)
ii)Not suitable for small organisation.
iii)Audit staff may overlook a matter not completely examined on last visit.
iv)Sometimes, client feels that regular presence of auditor interrupts his working.
v)It is very time consuming.

vi) Precautions to i)Work should be completed up to definite stage during each visit.
avoid ii)Important balances should be noted down at end of each visit & compared at
limitations next visit so that any alteration can be detected.
iii)Visits should be on random basis (surprise visits).
iv)Special attention should be given to altered figures, if any.
v)Auditor should try at his level best not to interfere in client's day to day work.

>Documentation refers to
working papers kept
by the auditor in
connection with f
performance of his
audit work.
>It is the record of planning,
procedure performed, evidence
42 Bestword's Auditing and Assurance Chap.: Chap. 1

obtained & conclusions drawn.


>It shows that audit work has
been conducted as per
requirement.

(i)W.P should be designed &

organised according to

circumstances of each audit.

(ii)As far as possible, working

papers should be kept in

standardised form.

(iii)Documentation should be

sufficiently complete, dated &

signed.

(iv)All significant matters

involving judgment should be

documented.
(v)As per ICAI,
documentation is the
property of auditor &
he should maintain it
at least upto 7 years
from date of signing of
audit report,
(previously it was 10
years)
(vi)If it is in electronic
/magnetic media, he should take
proper care for its storage &
retrieval.
(vii)He should maintain
confidentiality ( should not
show his W.P. to outsiders).
Working
paper files In
case of
1.
Permanent
audit file

recurring audit, two type of files


are maintained to avoid
duplicity of documentation.
These are as follows:

It contains matters which don't


change very often. This file is
updated during each &ndit. Its
contents are as follows:-
Chap. 3 Preparation for an Audit 43

Inf
or
ma
tio
n
reg
ard
ing
the
leg
al
an
d
org
ani
zat
ion
al
str
uct
ure
of
the
ent
ity.
Fo
r
e.g
. in
cas
e
of
Co
mp
an
y,
thi
s
inc
lud
es
M
O
A
&
A
O
A.
Legal

docum

ents,

agreem

ents
44 Bestword's Auditing and Assurance Chap.: Chap. 1

and

minute

relevan

t to the

audit.

record

of the

study

and the

evaluat

ion of

the

internal

control

s.

Copies

of

audited

financi

al

stateme

nts, for

previou

s years.

Analysi

s of

signific

ant

ratios

and

trends.
Chap. 3 Preparation for an Audit 45

Copies

of

manage

ment

letters

issued

by the

auditor,

if any.

Record

of

commu

nicatio

n with

the

retiring

auditor.

Notes

regardi

ng

signific

ant

account

ing

policies

.
46 Bestword's Auditing and Assurance Chap.: Chap. 1

Significant 2. Current It contains matters relating to audit of single period. Its contests are as
audit audit file follows:-
observations ■Correspondence relating to acceptance of annual reappointment.
3.12 AUDIT WORKING PAPERS (DOCUMENTATION)
of earlier ■Important matters in the minutes of Board Meetings and General Meetings as
relevant to audit.
years.
Meaning ■Evidence of the planning process of the audit and audit programme.
■Analysis of transactions and balances.
■A record of the nature, timing and extent of auditing procedures.
■Evidence that the work performed by assistants was supervised and reviewed.
■Copies of communication with other auditors, experts and third parties.
Basic
■Letters of representation or confirmation received from the client.
requirements
■Conclusions reached by the auditor concerning significant aspects of the audit.
* Copies of the financial information being reported on and the related audit reports.

Audit note Meaning It is generally a bound book which records large variety of matters observed during
Book audit. ,
Examples of Audit queries not solved immediately. Irregularities observed during audit.
contents
(iUjrImportant information regarding entity not appearing in accounts, (jy)f
Important matters for future reference.

Features / i)It is permanent record of auditor, which can be referred to later on.
usefulness
ii)It contains all details of work carried out. This work can be linked, if concerned
assistant is away.
iii)It contains all workflow of audit in detail.
iv)It can be important defence for auditor if action for negligence is brought against
him subsequently.
v)It shows, weakness in clients system, thus helpful in formulating audit programs in
future.
vi)It helps in follow up of work done.
Chap. 3 Preparation for an Audit 47

Important i)Helps the senior to review work done by assistants.


advantage of
working papers
48 Bestword's Auditing and Assurance Chap.: Chap. 1

Guidance note on Rule of auditor's property. Documentatioi


auditors right if confidentiality As per SA-200 (AAS-1), auditor should not disclose any confidential m a t the Audit
Ownership & relating to client to any 3rd party unless it is
client & others Procedures
custody of
seek access to his working papers Performed an
document or Audit Evidem
rests with
Auditors property auditor. Thus, i his legal /Professional duty to disclose Obtained
Permitted by
3rd parties including other auditors client confidential as above.
Can he show Client (i)Client doesn't have any right to access audi W.P. kept by auditor.
1

working papers No, otherwise it will violate rule of (ii)But auditor may, at his discretion, show s o rncomplete W.P. to client.
to (iii)If he shows W.P. to client itself, rule i confidentially does not arise at all.

3.13 SA 230 (Revised) - AUDIT DOCUMENTATION (w.e.f. 1st April' 2009)

Scope of this SA Other SA and Laws or regulations may establish additional documentation requirements.

Nature and (b)Evidence that the audit was planned and performed in accordance with. S A s a napplicable d legal and
Purposes of Audit regulatory requirements. .
Audit documentation serves a number of additional purposes, including the following:
Documentation 1.Assisting the engagement team to plan and perform the audit.
2.Assisting members of the engagement team responsible for supervision to di r e c t a supervise
nd the audit work.
3.Enabling the engagement team to be accountable for its woyk.
4.Retaining a record of matters of continuing significance to future audits.
5.Enabling the conduct of quality control reviews and inspections.
6.Enabling the conduct of external inspections in accordance with applicable l e g a lregulatory, or other
requirements
(a)Audit documentation - The record of audit procedures performed, relevant a u d ievidence t obtained, and
conclusions the auditor reached (terms such as " w o r k ipapers"
ng or "workpapers" are also sometimes used).
(b)Audit file - One or more folders or other storage media, in physical or e le c tr o nform,
ic containing the records
that comprise the audit documentation for a s p e c ific
engagement.
(c)Experienced auditor - An individual (whether internal or external to the fir m ) w has h o practical audit
Definitions experience, and a reasonable understanding of:
Audit documentation
provides: (i)Audit processes;
(a)F.virlence of the auditor's (ii)SAs and applicable legal and regulatory requirements;
basis for audit report;
and (iii)The business environment in which the entity operates; and
(iv)Auditing and financial reporting issues.

Meaning
Why it is

Example
may
suitable
Chap. enable an experienced auditor to understand:
3
y acc ess audit (a)The nature, timing, and extent of the audit procedures;
(b)The results of the audit procedures performed, and the audit evidence
D o c u m e n t a t io n o f
Chap. 3 Preparation for an Audit 49
u,r
- ThusTJlT t h e A u d it
P roced u res obtained; and
P e r f o r m e d a n d show some/ (c)Significant matters arising during the audit and the conclusions
A u d it E v id e n c e reached thereon.
hernial nmtteT
O b t a in e d
,lf
> rule of Auditor shall also record:
Form, Contain (a)The identifying characteristics of the specific items or matters
and Extent of tested;
Aud.:t (b)Who performed the audit work and the date such work was
isclose The auditor shall completed; and
prepare audit (c)Who reviewed the audit work performed and the date and extent of
documentation that such review.
onfidentialit is sufficient to If the auditor identified inconsistent information, the auditor shall
document how the auditor addressed the inconsistency.
If, in exceptional circumstances, the departs from SA, the auditor shall document the reasons for the departure and alternative procedures
performed.
Departure from a
Relevant If, in exceptional circumstances, the auditor performs new or additional audit procedures or draws new conclusions after the date of the auditor's
Requirement report, the auditor shall document:
1. The circumstances encountered;
sments.
Matters Arising 2. The new or additional audit procedures performed, audit evidence obtained, and conclusions
after the Date of reached, and their effect on the auditor's report; and
the Auditor's 3. When and by whom the changes to audit documentation were made and reviewed.
Report
Assembly of the
SAs The auditor shall assemble the audit documentation in an audit file and complete the administrative process of assembling the final audit file on a
FinnI Audit File timely basis after the date of the auditor's report. After the assembly, the auditor shall not delete audit documentation before the end of its
and ng: retention period.
"ect and
J
egal,
3.14 TEST CHECKING / SAMPLING - BASICS

audit
king

)
nic
ific

Cho
50 Bestword's Auditing and Assurance CM Chap. 2

Meaning Test checking means examining less then 100% of items in the population. T)
St
Why it is required i)Auditor usually doesn't have enough time for detailed 100% examination.
ii)Number of transactions / Balances are generally very high.
iii)Mostly items are identical.
iv)If, on basis of compliance procedures, it is concluded that internal control system is very effective,
there is no need for detailed 100% examination.
Examples where it i)Cheking bank reconciliation statement.
may not be suitable
ii)Few transactions, very high in amount.

iii)Few transactions with related parties.

iv)Few transactions, having unusual nature.


v)Disclosure requirement of accounting standards.
vi)Compliance with statutory provision.
vii)Significant entries near/ at year-end.
viii)Few transactions involving foreign exchange.

Precautions (i)
while Thorough study of The flow of transactions should be completely studied bdl adopting
conducting test accounting system sampling.
cheeking (how to
make sampling
Meaning
Type-I effective)
Judgmental (ii) Thorough study of I.C. Proper study of internal control system helps the auditor to de^i^E
sampling System. further test check plans.

Example (iii) Areas not suitable for Auditor should take care to ensure that detailed complete chedifl is
sampling done for required items (as above).

Advantages (iv) Proper planning Proper plan for test cheking should be devised & explained® audit
staff.
, (v) Classification Transactions & Balances should be classified & statiM,®
The
(vi) number of items in a sample should be appropitj
Sample size
determined.
required.
(vii) No
Sample should bias be chosen in unbiased way.
(viii) Analysis of
Errors found in sample misstatement should be analysed properly.

Sample size & composition are decided on basis of aiiditoj experience.


This is a traditional method of sampling.
He may decide to check entries in July, November & F e b r u a J
ry March during audit of certain year & out of remaining m o n thnext
s ! year (Rotation
of Emphasis).
Simple to operate.
Traditional approach thus understandable by audit s ta f f the
v little expertise.
Rotation of emphasis is done.
Normally year end transactions are checked in detail to whether
s cut off procedures are adequate.
(i)Unscientific method.
Limitations (ii)There may be personal bias.
(iii)Sample may not be true representative of population.
(iv)Not suitable if situations changes materially (d u inadequacy
e of experience of auditor in that particular a re a ) .
Type-2 Meaning ■Sample is chosen by applying certain mathematical & statist] caLde
Statistical vices,^
■It is generally based on ^probability th^qrv.
sampling C h a p . 3 Preparation for an Audit 51
■ Advantages i)More scientific.
ii)No personal bias.
iii)Results of sample can be evaluated & projected in more reliable way.
iv)Widely accepted way of sampling.

Limitations i)Complex to operate.


ii)Not suitable for audit staff having no knowledge of( statistical technique.
iii)It may be time consuming exercise.

3.15 METHOD FOR SELECTING THE SAMPLE


M e a n in g ■Method means the way in which sample is chosen.
52 Bestword 's Auditing and Assurance
■Method should be such that sample can be expected to be true representative of population.
(2) Stratified ■For this, it is necessary that each item in population have equal chance of being chosen.
Random ■There are basically two methods by which sample can be selected.
Sampling Factors
^^^^MEJWOD^^^____________________
1. Tolerable
Random sampling Interval / systematic sampling Simple random Stratified random Block Cluster
Error

2.Expected
M eth o d -I Meaning i)All items have equal chances of selection. Error
ii)It may involve use of random number table. 3.Samplin
R andom
Risk
iii)It can be of two types i.e. simple random or stratified random.
S a m p lin g
iv) (1) Simple Random i)Each item of population (for Eg. :- each debtor) has equal chance of
Sampling selection.
ii)It can be chosen by
use of random number table, help of computer.
Picking up number in a random way.
iii)Suitable for Homogeneous population (population having similar items).
For example:- Debtors ranging from Rs. 5,000 to 15,000.

Stratification means dividing a heterogeneous population »l


more homogeneous sub populations.
Sample is taken from each sub population (stratum).
It is useful for diversified population.
For Eg.:- Debtor in range of 20 Rs. to 5,00,000 Rs. whereitaj
be divided into stratum as following.

Upto A 10,000 10,001 - 1,00,000 B

D C
3,00,001 -5,00,000 1,00,001 -3,00,000

Now, random sample is chosen from each stratum.


Its results are more appropriate in case of population haw
different characteristics.

It is simply an extension of simple random sampling. However,


it requires special attention to judge contents ofead stratum.

Items are chosen in such a way that there is


Preparation for an Audit constant intern 53
between selections.
The first interval has random start.
Interval may be based on
i)Certain number (Eg. :- every 10th sales invoice).
ii)Monetary total (Eg. every increase of Rs. 10,000 ii|
cumulative wage summary)
It is used in case when population does not correspond toil
particular trend.
It can be of two types - block & cluster.

Selection of a definite block of consecutive items. For


Eq. :- first 50 purchase invoice for month of
November. This is a simple method like judgemental
sampling. However, it may be biased at times.
(1)Population is divided into groups called Cluster.
(2)A number of clusters are selected on random basis.
(3)For Eg. :- 1000 sales invoices are divided into 10 clusters
havinf| 100 items each, then 3rd,6th & 9th clusters are
chosen.
(4)Lese effective than random sampling since each item is m il
Meaning randomly chosen.
Method-2
Interval/
systematic
sampling

(1) Block
Sampling

In
Comp
(2) Cluster
sampling In
Substi

Effect
54 Bestword 's Auditing and Assurance
(5)

Nu 316
factq^F^CTIN^IZ^^^MP^
i)Tolerable Error
into ii)Expected Error F a c to rs
iii)Sampling Risk
1.
T o le r a b le
can E r r o r => Maximum Error in population that auditor is ready to
accept for a given sample size. => If smaller tolerable
error, big sample size is needed.
In compliance procedure Maximum rate of deviation from
I E x p e c te destablished procedure of I.C.
E r r o r I In substantive procedure j Maximum monetae error.
S a m p lin g => If auditor expects possibility of error in population,
R is k larger sample size is required. If population is expected to
be free of misstatement, smaller sample size is needed.
1.It arise from possibility that
=> Auditor's conclusion based upon sample,
=> May be different from,
=> Conclusion that would have been reached,
=> If same audit procedures were applied on entire population.
2.It is always in sampling.
3.If acceptable sampling risk is low, large sample is needed.
4.It arises in both compliance procedures & substantive procedure.
In Risk of under Based upon sample, auditor concludes that I.C. system is not
compliance reliance adequate, however actually it is not so.
procedure
Risk of over Based upon sample, auditor concludes that I.C. are very effective &
reliance thus decides to rely on them, however it is not so in reality.

In Risk of incorrect Based upon sample, auditor concludes that transactions/ balances are
substantive Rejection materially misstated, whereas in fact these are not.
procedure
Risk of incorrect Based upon sample auditor concludes that transactions/ balances are
Acceptance not materially misstated while in fact these are misstated.

Sampling Risk (at a glance)


In Procedure In Substantive E ffect
Risk of Under
Compliance Procedure
reliance Risk of
incorrect I reliance
Risk of over
These both leadoftoincorrect
Risk more acceptance y
work to
Preparation for an Audit be These both 55
performed by auditor.
However audit report is may opinion
not erroneous. by auditor.
rejection
1. Financial reporting frameworks
often discuss the concept of
materiality in the context of the
preparation and presentation of
financial statements.
Although financial reporting
frameworks may discuss
materiality in different terms, they
generally explain that:
■Misstatements, including
omissions, are material if they,
individually or in the
aggregate, influence the
economic decisions of users
taken on the basis of the
financial statements;
■Judgments about materiality are
made in the light of
surrounding circumstances,
and are affected by the size or
nature of a misstatement,; and
■Judgments about matters that are
material to users of the
financial statements are based
on a consideration of the
common financial information
needs of users as a group.
2.If the applicable financial reporting
framework does not include a
discussion of the concept of
materiality, the characteristics
referred to in above paragraph
provide the auditor with such a
frame of reference.

lead to
erroneous