Adcanced Auditing and Professional Ethics Vol. 2

FINAL COURSE STUDY MATERIAL

PAPER

3

Advanced Auditing and Professional Ethics Volume – 2

BOARD OF STUDIES THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

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

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

SYLLABUS PAPER 3 : ADVANCED AUDITING AND PROFESSIONAL ETHICS (One Paper- Three hours - 100 marks) Level of Knowledge: Advanced knowledge Objectives: (a) To gain expert knowledge of current auditing practices and procedures and apply them in auditing engagements, (b) To develop ability to solve cases relating to audit engagements. Contents: 1.

Auditing Standards, Statements and Guidance Notes Auditing and Assurance Standards (AASs); Statements and Guidance Notes on Auditing issued by the ICAI; Significant differences between Auditing and Assurance Standards and International Standards on Auditing.

2.

Audit strategy, planning and programming Planning the flow of audit work; audit strategy, planning programme and importance of supervision: review of audit notes and working papers; drafting of reports; principal’s ultimate responsibility; extent of delegation; control over quality of audit work; reliance on the work of other auditor, internal auditor or an expert.

3.

Risk Assessment and Internal Control Evaluation of internal control procedures; techniques including questionnaire, flowchart; internal audit and external audit, coordination between the two.

4.

Audit under computerized information system (CIS) environment Special aspects of CIS Audit Environment, need for review of internal control especially procedure controls and facility controls. Approach to audit in CIS Environment, use of computers for internal and management audit purposes: audit tools, test packs, computerized audit programmes; Special Aspects in Audit of E-Commerce Transaction.

5.

Special audit techniques (a) Selective verification; statistical sampling: Special audit procedures; physical verification of assets, direct confirmation of debtors and creditors (b) Analytical review procedures (c) Risk-based auditing.

6.

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

7.

Rights, duties, and liabilities of auditors; third party liability.

8.

Audit reports; Qualifications, notes on accounts, distinction between notes and qualifications, detailed observations by the statutory auditor to the management vis-a-vis obligations of reporting to the members.

9.

Audit Committee and Corporate Governance

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

VOLUME – 2 CONTENTS ADVANCED AUDITING AND PROFESSIONAL ETHICS

CHAPTERS 1 -17 of Advanced Auditing And Professional Ethics are in Volume -1. CHAPTER 18: AUDIT OF CO-OPERATIVE SOCIETIES 18.1

Introduction ................................................................................................. 18.1

18.2

Framework for Government Audit ................................................................. 18.1

18.3

Objective and Scope of Public Enterprises Audit ........................................... 18.4

18.4

Audit of Government Companies .................................................................. 18.5

18.5

Comprehensive Audit of Public Enterprises................................................... 18.6

18.6

Audit Report of the Comptroller and Auditor General ..................................... 18.8

18.7

Propriety Audit ............................................................................................ 18.9

18.8

Performance Audit ......................................................................................18.15

18.9

Performance Audit: Indian Scenario ............................................................18.16

18.10

Planning for Performance Audit...................................................................18.18

CHAPTER 19: INTERNAL AUDIT, MANAGEMENT AND OPERATIONAL AUDIT 19.1

Internal Audit .............................................................................................. 19.1

19.2

Management functions and scope of Internal Auditing ................................... 19.2

19.3

Independence of Internal Auditor.................................................................. 19.6

19.4

Qualifications of Internal Auditor .................................................................. 19.6

19.5

Internal Audit Report ................................................................................... 19.6

19.6

Relationship between Internal and External Auditors ..................................... 19.8

19.7

Management Audit......................................................................................19.11

19.8

Operational Audit .......................................................................................19.28

19.9

Review of Systems and Procedures.............................................................19.39

19.10

Management Audit Questionnaires ..............................................................19.42

CHAPTER 20: INVESTIGATIONS AND DUE DILIGENCE 20.1

Introduction ................................................................................................. 20.1

20.2

Audit versus Investigation ............................................................................ 20.1

20.3

Steps in Investigation .................................................................................. 20.3

20.4

Special Issues in Investigations ................................................................... 20.6

20.5

Special Aspects in Connection with Business Investigations .......................... 20.8

20.6

Types of Investigation.................................................................................20.14

20.7

Due Diligence.............................................................................................20.33

CHAPTER 21: PEER REVIEW 21.1

Introduction ................................................................................................. 21.1

21.2

Objectives of Peer Review ........................................................................... 21.1

21.3

Scope of Peer Review ................................................................................. 21.2

21.4

Applicability................................................................................................. 21.3

21.5

Peer Review Board...................................................................................... 21.4

21.6

The Peer Review Process ............................................................................ 21.4

21.7

Review Procedures.....................................................................................21.11

21.8

Developments in the field of Peer Review………………………………………….21.22

CHAPTER 22: THE SARBANES-OXLEY ACT OF 2002 22.1

Introduction ................................................................................................. 22.1

22.2

Summary of Sarbanes Oxley Act of 2002 ...................................................... 22.2

22.3

Overview of PCAOB’s requirements for Auditor Attestation of Control Disclosures ..................................................................................... 22.4

22.4

Information Technology and SOX 404 .......................................................... 22.5

22.5

Difference between Disclosure Controls and Procedures and Internal Control over Financial Reporting ...................................................... 22.7

22.6

Implementation of Disclosure and Controls Procedures ................................. 22.7

22.7

Precaution to be taken by CEO and CFO before Signing the Certifications ....22.10

ii

22.8

Purpose of Internal Control over Financial Reporting....................................22.11

CHAPTER 23: PROFESSIONAL ETHICS 23.1

Introduction ................................................................................................. 23.1

23.2

Objectives ................................................................................................... 23.1

23.3

Fundamental Principles ............................................................................... 23.2

23.4

The Chartered Accountants Act, 1949 .......................................................... 23.3

23.5

Schedules ................................................................................................... 23.7

23.6

Members who are deemed to be in Practice.................................................. 23.7

23.7

Significance of the Certificate of Practice.....................................................23.10

23.8

Disabilities for Purpose of Membership ........................................................23.12

23.9

Disciplinary Procedure ................................................................................23.12

23.10

Professional Misconduct .............................................................................23.17

23.11

Penalty for falsely claiming to be A Member Etc. ..........................................23.19

23.12

Maintenance of Branch offices ....................................................................23.19

23.13

Schedules to the Act...................................................................................23.21

23.14

Recommended Self-Regulatory Measures ...................................................23.94

23.15

Important Notifications ................................................................................23.95

23.16

Guidelines Issued By the Institute ...............................................................23.97

23.17

Self Regulatory Measures ......................................................................... 23.101 AUDITING AND ASSURANCE STANDARDS AND GUIDANCE NOTES

PART I : AUDITING AND ASSURANCE STANDARDS……................................ I.1–I.219 Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services .......... ..................................................................I.1 Preface to the Statements on Standard Auditing Practices ............................................I.5 Basic Principles Governing an Audit (AAS 1) ........ ...................................................... I.6

iii

Objective and Scope of the Audit of Financial Statements (AAS 2) .. .............................I.9 Documentation (AAS 3) .............................................................................................I.12 The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements (AAS 4 Revised).. ..................................................................... I.14 Audit Evidence (AAS 5) ..............................................................................................I.38 Risk Assessment and Internal Control (AAS 6 Revised) ...............................................I.42 Relying upon the Work of an Internal Auditor (AAS 7).. ................................................I.54 Audit Planning (AAS 8) ..............................................................................................I.57 Using the Work of an Expert (AAS 9) ..........................................................................I.61 Using the work of Another Auditor (AAS 10 Revised) ...................................................I.65 Representations by Management (AAS 11) .................................................................I.69 Responsibility of Joint Auditors (AAS 12) ....................................................................I.75 Audit Materiality (AAS 13) ........... ...............................................................................I.78 Analytical Procedures (AAS 14) ..................................................................................I.81 Audit Sampling (AAS 15).............................................................................................I.84 Going Concern (AAS 16) .. ..........................................................................................I.90 Quality Control for Audit Work (AAS 17)... ...................................................................I.94 Audit of Accounting Estimates (AAS 18) .. ...................................................................I.97 Subsequent Events (AAS 19) ...................................................................................I.102 Knowledge of the Business (AAS 20) ........................................................................I.103 Consideration of Laws and Regulation in an Audit of Financial Statements (AAS 21) ................................................................... I.109 Initial Engagements – Opening Balances (AAS 22). ...................................................I.115 Related Parties (AAS 23) ..........................................................................................I.117 Audit Consideration Relating to Entities Using Services Organisations (AAS 24) ........I.122 Comparatives (AAS 25).............................................................................................I.125 Terms of Audit Engagement (AAS 26) .......................................................................I.134 Communications of Audit Matters with those Charges with Governance (AAS 27) .......I.139 The Auditor’s Report on Financial Statements (AAS 28) . ...........................................I.143

iv

Audit in a Computer Information Systems Environment (AAS 29) .. .............................I.157 External Confirmations (AAS 30) ..............................................................................I.162 Engagements to Compile Financial Information (AAS 31) ..........................................I.171 Engagements to Perform Agreed upon Procedure Regarding Financial Information (AAS 32) ............ .....................................................................I.183 Engagements to Review Financial Statements (AAS 33). ...........................................I.190 Audit Evidence – Additional Considerations for Specific Items (AAS 34).................... I.208 General Clarification: (GC)–AASB/1/2002 on AAS 9 Auditing and Assurance Standard (AAS) 9, Using the Work of an Expert ....................I.217 General Clarification: (GC)–AASB/3/2004 on AAS 16 Auditing and Assurance Standard (AAS) 16, Going Concern. . ....................................I.217 General Clarification: (GC)–AASB/2/2002 on AAS 26 Auditing and Assurance Standard (AAS) 26, Terms of Audit Engagement...................I.218 PART II : GUIDANCE NOTES ………................................................................II.1–II.172 1.

Provision for Proposed Dividend ........................................................….........II.1

2.

Independence of Auditors ........................ .......................................................II.2

3.

Guidance Note on Auditor’s Report on Revised Accounts of Companies before Circulation to Shareholders......................................…......II.13

4.

Guidance Note on Audit Reports and Certificates for Special Purposes ..........II.14

5.

Revision/ Rectification of Financial Statements ..............................................II.22

6.

Clarification on the Auditor’s Rights Where Clients and other Auditors Seek Access to their Audit Working Papers .............................II.24

7.

Guidance Note on Section 227(3) (e) and (f) of the Companies Act, 1956(Revised) ......................................................................II.26

8.

Guidance Note on Revision of the Audit Report ..............................................II.43

9.

Guidance Note on Audit of Miscellaneous Expenditure (Revised)....................II.46

10.

Guidance Note on Computer Assisted Audit Techniques (CAATS) ..................II.53

11.

Guidance Note on Audit of Capital and Reserves ...........................................II.66

12.

Guidance Note on Audit of Payment of Dividend . ...........................................II.84

13.

(Revised) Guidance Note on Reports in Company Prospectuses ...................II.103

QUESTION BANK........................................................................................... III.1–III.44

v

18 AUDIT OF PUBLIC SECTOR UNDERTAKINGS

Introduction 18.1 The public enterprises in India have been assigned a key role in the socio-economic development of the country. These enterprises are industries supplying basic inputs to industry and agriculture, such as coal, oil, steel, minerals and metals, cement, chemicals and fertilizers and heavy equipment. Public utilities like the railways, postal and telecom services, electricity generation and supply, road transport, etc. constitute another class of public enterprises. Thus in India the public sector has achieved a dominant role in the national economy. Public sector enterprises are organised through any one of the following modes: (a) Departmentally managed undertakings which form part and parcel of Government activities, for example Indian Railways, Postal Services, Security Printing Press , Canteen Stores Department ; (b) Government companies and deemed Government companies set up under the Companies Act 1956, where Government or Government-owned and controlled institutions own 51 percent or more of the paid up capital; (c) Corporations set up under the specific Acts of legislature e.g., Life Insurance Corporation, Unit Trust of India, etc. Framework for Government Audit 18.2 In India, government audit is performed by an independent constitutional authority, ie. Comptroller and Audit General of India (C&AG), through the Indian Audit and Accounts Department. The Constitution of India gives a special status to the C&AG and contains provisions to safeguard his independence. Article 148 of the constitution provides that the C&AG shall be appointed by the President and can be removed from the office only in a like manner and on the like grounds as a judge of the Supreme Court. Thus, the C&AG can be removed only on the ground of proven misbehaviors or incapacity and only through an order of the President’s after each house of Parliament has

18.2

Advanced Auditing and Professional Ethics

recommended the removal by the required majority. The salary and other conditions of service of the C&AG are determined by the Parliament. Article 151 of the Constitution requires that the audit reports of the C&AG relating to the accounts of the Central/State Government should be submitted to the President/Governor of the State who shall cause them to be laid before Parliament/State Legislative. The Comptroller and Audit General’s (Duties, Power and Conditions of Services) Act, 1971, prescribes that the C&AG shall hold office for a term of six years or upto the age of 65 years, which is earlier. He can resign at any time through a resignation letter addressed to the President. The Act also assign the duties regarding the audit to be followed by C&AG. The organisations subject to the audit of the Comptroller and Auditor General of India are: All the Union and State Government departments and offices including the Indian Railways and Posts and Telecommunications. About 1200 public commercial enterprises controlled by the Union and State governments, i.e. government companies and corporations. Around 400 non-commercial autonomous bodies and authorities owned or controlled by the Union or the States. Over 4400 authorities and bodies substantially financed from Union or State revenues. Audit of Government Companies (Commercial Audit) - There is a special arrangement for the audit of companies where the equity participation by Government is 51 percent or more. The primary auditors of these companies are Chartered Accountants, appointed by the Union Government on the advice of the Comptroller & Auditor General, who gives the auditors directions on the manner in which the audit should be conducted by them. He is also empowered to comment upon the audit reports of the primary auditors. In addition, he conducts a supplementary audit of such companies and reports the results of his audit to Parliament and State Legislatures. Audit Board Setup in Commercial Audit - A unique feature of the audit conducted by the Indian Audit and Accounts Department is the constitution of Audit Boards for conducting comprehensive audit appraisals of the working of Public Sector Enterprises engaged in diverse sectors of the economy. These Audit Boards associate with them experts in disciplines relevant to the appraisals. They discuss their findings and conclusions with the managements of the enterprises and their controlling ministries and departments of government to ascertain their view points before finalisation. The results of such comprehensive appraisals are incorporated by the Comptroller and Auditor General in his reports.

Audit of Public Sector Undertakings

18.3

Action on Audit Reports - The scrutiny of the Annual Accounts and the Audit Reports thereon by the Parliament as a whole would be an arduous task, considering their diverse and specialised nature, besides imposing excessive demands on the limited time available to the Parliament for discussion of issues of national importance. Therefore the Parliament and the State Legislatures have, for this purpose, constituted specialized Committees like the Public Accounts Committee (PAC) and the Committee on Public Undertakings (COPU), to which these audit Reports and Annual Accounts automatically stand referred. Public Accounts Committee - The Public Accounts Committee satisfies itself : a.

that the moneys (shown in the accounts) were disbursed legally on the service or purpose to which they were applied.

b.

that the expenditure was authorised.

c.

that re-appropriation (i.e. distribution of funds).

It is also the duty of the PAC to examine the statement of accounts of autonomous and semiautonomous bodies, the audit of which is conducted by the Comptroller & Auditor General either under the directions of the President or by a Statute of Parliament. Committee on Public Undertakings - The Committee on Public Undertakings exercises the same financial control on the public sector undertakings as the Public Accounts Committee exercises over the functioning of the Government Departments. The functions of the Committee are a.

to examine the reports and accounts of public undertakings.

b.

to examine the reports of the Comptroller & Auditor General on public undertakings.

c.

to examine the efficiency of public undertakings and to see whether they are being managed in accordance with sound business principles and prudent commercial practices.

The examination of public enterprises by the Committee takes the form of comprehensive appraisal or evaluation of performance of the undertaking. It involves a thorough examination, including evaluation of the policies, programmes and financial working of the undertaking. The objective of the Financial Committees, in doing so, is not to focus only on the individual irregularity, but on the defects in the system which led to such irregularity, and the need for correction of such systems and procedures. CAG's Role - The Comptroller & Auditor General of India plays a key role in the functioning of the financial committees of Parliament and the State Legislatures. He has come to be recognised as a 'friend, philosopher and guide' of the Committee. His Reports generally form the basis of the Committees' working, although they are not precluded from examining issues not brought out in his Reports. He scrutinises the notes which the Ministries submit to the

18.4

Advanced Auditing and Professional Ethics

Committees and helps the Committees to check the correctness submit to the Committees and helps the Committees to check the correctness of facts and figures in their draft reports. The Financial Committees present their Report to the Parliament/ State Legislature with their observations and recommendations. The various Ministries / Department of the Government are required to inform the Committees of the action taken by them on the recommendations of the Committees (which are generally accepted) and the Committees present Action Taken Reports to Parliament / Legislature. In respect of those cases in Audit Reports, which could not be discussed in detail by the Committees, written answers are obtained from the Department / Ministry concerned and are sometimes incorporated in the Reports presented to the Parliament / State Legislature. This ensures that the audit Reports are not taken lightly by the Government, even if the entire report is not deliberated upon by the Committee. Objective and Scope of Public Enterprises Audit 18.3 Under the Act of 1971, the scope and extent of audit is determined by the Comptroller and Auditor General. Audit of public enterprises in India is not restricted to financial and compliance audit; it extends also to efficiency, economy and effectiveness with which these operate and fulfil their objectives and goals. Another aspect of audit relates to questions of propriety; this audit is directed towards an examination of management decisions in sales, purchases, contracts, etc. to see whether these have been taken in the best interests of the undertaking and conform to accepted principles of financial propriety. One of the purposes of setting up a company/corporation form of enterprise was to give their managements autonomy and flexibility within overall control and accountability, to run on competitive and commercial terms. Audit does not interfere with their autonomy or inhibit their decision-making authority. Being an ex-post-facto activity, audit does not affect either the authority to take decisions or the decisions themselves. In examining the decisions of a management, the auditor examines that these were taken by the competent authority after examination of all aspects (economic, technological, public interest) on the basis of all the relevant information available at that time and taking into consideration the different alternatives available to management and that the decisions were consistent with the aims and objectives of the enterprise. Audit is an instrument of accountability. But an equally important purpose of audit of public enterprises in India is to help the Government and the enterprise managements improve their efficiency and effectiveness. This is achieved by bringing out financial and operational deficiencies, inadequacies or ineffectiveness of systems, shortfalls in performance, etc. and by analysing the causes of shortfall from acceptable standards of performance. Financial performance is linked with physical performance and issues of efficient and economic operations and management of resources are highlighted. There is an increasing emphasis on audit being an instrument of improvement. But the Comptroller and Auditor General does not make specific recommendations for improvement

Audit of Public Sector Undertakings

18.5

though the areas and needs for improvement are highlighted in his reports. In the broader context, Government audit encompasses two main elements, viz., (a) Fiscal Accountability: It includes audit of provisions of funds, sanctions, compliances and propriety; and (b) Managerial Accountability: It includes audit of efficiency, economy and effectiveness (This is often referred to as efficiency-cum-performance audit). Audit of Government Companies 18.4 The following steps involved in the audit of government companies (a) Appointment of Auditors Under Section 619(2) of the Companies Act, 1956 - Statutory auditors of Government Company are appointed or re-appointed by the Comptroller and Auditor General of India. There is thus a departure from the practice in vogue in the case of private sector companies where appointment or re-appointment of the auditors and their remuneration are decided by the members at the annual general meetings. (b) Supplementary audit under section 619(4) of the Companies Act, 1956 - In the case of a Government company, audit is conducted by professional auditor appointed by the C & AG and the latter is authorised under section 619(4) of the Companies Act, 1956 to conduct supplementary or test audit. He is also empowered to comment upon or supplement the report submitted by the professional auditors. The C & AG may also issue directives to the auditors in regard to the performance of their function. C & AG directions are reproduced in Annexure at the end of this unit. The observations of the Committee on Public Undertakings in its 15th Report on Financial, Management in Public Undertakings explain the rationale behind the test audit etc. thus: “The statutory auditors are responsible for accuracy of the accounts and for certifying that the balance sheet and profit and loss account give a true and fair view of the affair of the company. The committee finds that the scope of normal audit by statutory auditors has been considerably enlarged by the directions issued to them by the C & AG. Normally, therefore, there may be no need for the C & AG to examine the initial accounts and go over the ground already covered by the statutory auditors. The committee are of the view that the supplementary audit of the Comptroller and Auditor General should concentrate more on efficiency-cum-propriety audit so that his reports to the Parliament give an overall appraisal of the financial working of the undertakings”. The C & AG has power to conduct a supplementary or test audit of the company’s accounts by such person as he may authorise in this behalf and for the purposes of such audit require information or additional information to be furnished to any person or persons so authorised on such matters by such person or persons and in such form as the C & AG may by general or special order, direct.

18.6

Advanced Auditing and Professional Ethics

The question is whether C & AG can call for a supplemental or special audit report under section 619 of the Companies Act. Under clause (b) of sub-section (3) of that section, the C & AG has the power to conduct a supplementary or test audit of the company’s accounts by such person or persons as he may authorise in this behalf. The person to be so authorised may well be the auditors appointed under sub-section (2) of that section. It is not necessary to rely on the powers of the C & AG under clause (a) of sub-section (3) for the purpose in view. (c) Right to comment on Auditors’ Report - The statutory auditors shall submit a copy of their audit report to the C & AG who shall have a right to comment upon or supplement the audit report submitted by the statutory auditors in such manner as he may think fit. Section 217(3) of the Companies Act, 1956 imposes a duty on the Board of Directors of a company to give the fullest information and explanations in the Directors’ Report regarding every reservation, qualification or adverse remarks contained in the auditors’ report. The’ Board’s remarks on the auditors’ report are to be given as an addendum to the report and are to form part of the main body of the report as per Section 217(3). In the absence of similar provisions requiring the company to give their reply on the reservations made by the C & AG, the board of directors of such a company is not bound to give information or explanation in respect of such comments. Even the C & AG’s comments would not have been required to be placed before the annual general meeting of a Government company but for the express provisions contained in Section 619(5) of the Act. Similar express provision would be necessary in the Act if it were intended that the provisions of Section 217(3) should also apply in the case of a Government company. Comprehensive Audit of Public Enterprises 18.5 The areas covered by comprehensive audit are those of investment decisions, project formulation and management, organisation, delegation of powers and management information systems, organisational effectiveness, capacity utilisation, management of equipment, plant and machinery, production performance, use of materials, productivity of labour, idle capacity, costs and prices, development of complementary ancillary small scale industries, materials management, sales and credit control, budgetary and internal control systems, etc. The areas covered in comprehensive audit will naturally vary from enterprise to enterprise depending on the nature of the enterprise, its objectives and operations. Some of the issues examined in comprehensive audit are: (a) How does the overall capital cost of the project compare with the approved planned costs? Were there any substantial increases and, if so, what are these and whether there is evidence of extravagance or unnecessary expenditure? (b) Have the accepted production or operational outputs been achieved? Has there been under-utilisation of installed capacity or shortfall in performance and, if so, what has caused it?

Audit of Public Sector Undertakings

18.7

(c) Has the planned rate of return been achieved? (d) Are the systems of project formulation and execution sound? Are there inadequacies? What has been the effect on the gestation period and capital cost? (e) Are cost control measures adequate and are there inefficiencies, wastages in raw materials consumption, etc.? (f)

Are the purchase policies adequate? Or have they led to piling up of inventory resulting in redundancy in stores and spares?

(g) Does the enterprise have research and development programmes? What has been the performance in adopting new processes, technologies, improving profits and in reducing costs through technological progress? (h) If the enterprise has an adequate system of repairs and maintenance? (i)

Are procedures effective and economical?

(j)

Is there any poor or insufficient or inefficient project planning?

(k) Has there been undue waste, unproductive time for men and machines, wasteful utilisation or even non-utilisation of resources? If so, why? The efficiency and effectiveness audit of public enterprises is conducted on the basis of certain standards and criteria. Profit is not the key criterion on performance; management’s performance in the economical and efficient use of public funds and in the achievement of objectives is more relevant. Public enterprises have been set up with certain socio-economic purposes and for fulfilment of certain objectives. The objectives vary from enterprise to enterprise. Audit appraisal analyses the performance of an enterprise to bring out the extent to which the objectives for which the enterprise was set up have been served. Admittedly this is a complex task but basic to effectiveness appraisal. The feasibility/detailed project reports give the basis of investment, capacity, costs, time schedules, gestation period, etc. and are built up of capacities, parameters and norms of consumption, yields, productivity, costs, rate of return, etc. These provide yardsticks by which the performance is measured. Some of the parameters may change due to external or internal factors subsequent to the setting up of the enterprise/project. In conducting efficiency audit due account is taken of the changes effected. Then enterprises are required to have their long and short term capital and operational plans and these provide another set of reference points for assessment of performance. Rated capacity of the unit provides an acceptable benchmark against which physical performance is evaluated. However, utilisation of the rated capacity is assessed along with norms for consumption of raw materials and utilities, yields and rejections as well as requirements for proper maintenance and servicing of equipment. Cost efficiency is another important basis in appraising performance. Standard or target costs are determined on the basis of norms of capacity utilisation, consumption, productivity, yield etc. given in the detailed project reports, moderated in many cases by expert studies to take care of later

18.8

Advanced Auditing and Professional Ethics

constraints and changes. The Bureau of Public Enterprises has issued guidelines to be followed by the public sector enterprises in respect of general management, financial management, materials management, production management, construction management, etc. and these guidelines provide another basis for appraising enterprise performance and its systems. Another source of criteria is industrial engineering and other technical studies by internal and external experts and the standards given in these. Then there are standards of financial propriety. This is a broad indication of the criteria and sources of criteria for conducting efficiency and effectiveness audit of public enterprises. A basic task in audit is to carefully identify the acceptable criteria for assessing the efficiency and effectiveness of an enterprise so that the appraisal by audit is valid and meaningful. The starting point of a comprehensive appraisal of a public enterprise, which covers aspects of economy, efficiency and effectiveness, is the preparation of an audit programme based on the study of decisions relating to the setting up of the enterprise, its objectives, the areas of operation, organisation, financial and operational details available in the annual reports and accounts, capital and operational budgets, deliberations of the board of directors, material in the earlier audit inspection reports on the enterprise and other relevant available papers. These audit programmes (or guidelines) identify the areas/aspects which require further detailed audit analysis and criteria, the data required for such analysis and the sources of such data, the extent of the audit analysis including the test checks to be applied and the Instructions to the audit parties assigned to the work. Audit Report of the Comptroller and Auditor General 18.6 For facility of consideration, the reports of the Comptroller and Auditor General on the public sector undertakings of the Central Government are presented to the Parliament in several parts consisting of the following: (a) Introduction containing a general review of the working results of Government companies, deemed Government companies and corporations. (b) Results of comprehensive appraisals of selected undertakings conducted by the Audit Board. (c) Resume of the company auditors’ reports submitted by them under the directions issued by the Comptroller and Auditor General and that of comments on the accounts of the Government companies. (d) Significant results of audit of the undertakings not taken up for appraisal by the Audit Board. The Comptroller and Auditor General submits separate audit report (commercial) to the legislature in the case of 13 States. In the case of other States/Union Territories with

Audit of Public Sector Undertakings

18.9

legislature, there is a commercial chapter in the main audit report. The State audit reports, contains both the results of audit appraisal of performance of selected companies/corporations as well as important individual instances of financial irregularities, wasteful expenditure, system deficiencies noticed by the statutory auditors, comments noticed in Government audit in the audit functions of certification of accounts and a general review of the working results of Government companies and corporations. Propriety Audit 18.7 Auditing, as a composite concept, looks into accounting and arithmetical accuracy, adherence to rules and regulations, propriety and the end result. According to the varied Requirements, the emphasis on each of the aforesaid factors differs between various types of audit. Students should carefully go through Sections 227 and 227(1A) of the Companies Act. All the requirements of these two Sections are applicable to a Government company and the analysis that will follow will show that some of the provisions of Section 227(1A) really are propriety based. Besides, the Companies (Auditor’s) Report Order, issued under Section 227(4A) of the Companies Act, is also applicable to a Government Company, provided the Government company belongs to any of the categories of companies to which the Order applies. Finally, the Comptroller and Auditor General has issued a set of detailed directions under authority of Section 619(3)(a) of the Companies Act which are to be complied with by the independent professional auditor in carrying out the audit of Government companies or companies concerned by Section 619B of the Companies Act. Propriety already exists in the audits carried on by the Comptroller and auditor General of India. 18.7.1 Definition and Principles - Propriety audit stands for verification of transactions on the tests of public interest, commonly accepted customs and standards of conduct. E.L. Kohler has defined the term propriety as “that which meets the tests of public interest, commonly accepted customs, and standards of conduct, and particularly as applied to professional performance, requirements of law, Government regulations and professional codes”. On an analysis, the tests boil down to tests on economy, efficiency and faithfulness. Instead of too much dependence on documents, vouchers and evidence, it shifts the emphasis to the substance of transactions and looks into the appropriateness thereof on a consideration of financial prudence, public interest and prevention of wasteful expenditure. Thus, propriety audit is concerned with scrutiny of executive actions and decisions bearing on financial and profit and loss situation of the company, with special regard to public interest and commonly accepted customs and standards of conduct. It is also seen whether every officer has exercised the same vigilance in respect of expenditure incurred from public money, as a person of ordinary prudence would exercise in respect of expenditure of his own money under similar circumstances. Propriety requires the transactions, and more particularly expenditure, to conform to certain general principles. These principles are:

18.10 Advanced Auditing and Professional Ethics (i)

that the expenditure is not prima facie more than the occasion demands and that every official exercises the same degree of vigilance in respect of expenditure as a person of ordinary prudence would exercise in respect of his own money;

(ii)

that the authority exercises its power of sanctioning expenditure to pass an order which will not directly or indirectly accrue to its own advantage;

(iii) that funds are not utilised for the benefit of a particular person or group of persons and (iv) that, apart from the agreed remuneration or reward, no other avenue is kept open to indirectly benefit the management personnel, employees and others. 18.7.2 Relevant provisions in the Companies Act, 1956 - The Parliament and Government, with a view to knowing the standards of efficiency, propriety, cost consciousness and economy, have already come up with some provisions in the Companies Act, having direct or indirect bearing on propriety; some of these have been referred to earlier. These provisions are: 1.

Section 209(1)(d) relating to Cost Accounting Records.

2.

Section 227(1A) requiring enquiry into certain specified matters.

3.

Section 227(4A) requiring a supplementary statement on matters specified in the Companies (Auditor’s) Report Order.

4.

Section 233B relating to requirements of Cost Audit.

5.

Section 619(3)(a) requiring a supplementary statement in respect of the Government companies on matters specified.

6.

Additional information in Schedule VI, Part II.

All these are applicable to Government companies. The requirement of the provisions of section 227(1A) is essentially propriety-oriented as much as some specific dubious practices are required to be looked into by the auditor. Areas of propriety audit under the provisions of Section 227(1A) may be following: (a) Whether the terms on which secured loans and secured advances have been made are not prejudicial to the interests of the company or its members. It may be appreciated that the terms of loans include such matters as security, interest, repayment period and other business considerations. The auditor has to inquire whether the terms are such that they can be adjudged as prejudicial to the legitimate interest of the company or of its shareholders. This is a process of judging a situation by reference to certain objective standards or reasonableness whether the terms entered into are prejudicial or not, not only to the company but also to the shareholders. (b) Whether transactions of the company which are represented merely by book entries are not prejudicial to the interests of the company. This proposition has got to be inquired

Audit of Public Sector Undertakings 18.11 into by reference to the effects of the book entries, unsupported by transactions, on the legitimate interests of the company. The auditor has to exercise his judgment based on certain objective standards. It is also possible that some transactions may not adversely affect the interests of the company. The auditor has to judiciously consider what does and does not constitute the interest of the company. (c) Whether investment of companies, other than a banking or an investment company, in the form of shares, debentures and other securities have been sold at a price lower than the cost. Apparently, this is a matter of verification by the auditor. The intention, however, is not know whether loss has occurred due to the sale. The auditor is required to inquire into circumstances of sale of investments that resulted in loss. Obviously, the duty cast on him is propriety based, i.e., reasonableness of the decision to sell at a loss. It involves exercise of judgment having regard to the circumstances in which the company was placed at the time of making the sale. (d) Whether loans and advances made by the company have been shown as deposits. Again, considering the propriety element, rationalizing the proper disclosure of loans and advance given by company is made. (e) Whether personal expenses have been charged to revenue. It is an accepted principle that expenses which are not business expenses should not be charged to revenue. The effect of charging personal expenses to the business is to distort the profitability of the company and to secure a personal gain at the cost of the company. Obviously, propriety is involved in this; charging personal expenses to business account is highly improper and abusive hence this provision. (f)

In case it is stated in the books and papers of the company that shares have been allotted for cash, whether cash has actually been received in respect of such allotment, and if no cash actually received, whether the position in books of account and balance sheet so stated is correct, regular and not misleading. A control has been set up to verify the receipt of cash in case of allotment of shares for cash. Further, if cash is not received, the books of accounts and statement of affairs shows the true picture.

Cost records and the provisions of cost audit are designed to inculcate cost consciousness in the management and to know whether productivity is of acceptable order and whether undue wastage or loss etc. has occurred. It would be useful to go into some of the specific requirement of cost audit report in this context. The cost audit report requires the cost auditors to report, inter alia on: (a) matters which appear to him to be clearly wrong in principle or apparently unjustifiable; (b) cases where the company’s funds have been used in a negligent or inefficient manner; (c) factors which could have been controlled, but have not been, resulting in increase in the cost of production.

18.12 Advanced Auditing and Professional Ethics These are clearly enquiries into propriety and the cost accounting records prescribed to facilitate these enquiries. Some of the matters in the additional sought through the Profit and Loss Account (i.e., Part II, Schedule VI) provide making more searching enquiries into such vital matters as facility utilisation, employment of highly paid staff members, inventory, etc.

have been information a basis for production,

The implications of the Companies (Auditor’s) Report Order 2003, and the provisions of the 619(3) (a) and the directions issued by the Comptroller and Auditor General also contain significant elements of propriety. 18.7.3 Propriety elements in CARO, 2003– (a) If the company has given or taken loans, secured or unsecured, to/from companies, firms or other parties listed in the register maintained under section 301 of the Companies Act, whether the rate of interest and other terms and conditions of such loans are prima-facie prejudicial to the interest of the company. In this case, the auditor will have to look into the reasonableness of the rate of interest and the terms and conditions of such loans. In other words, he will have to see whether the terms and conditions, including the rate of interest are apparently adverse to the interests of the company, having regard to the circumstances of the company at the time of taking the loans and the terms normally available. He is to exercise his judgment based on commercial considerations like urgency, security offered etc. (b) If the overdue amount of the loan given to or taken from companies, firms or other parties listed in the register maintained under section 301 of the Companies Act is more than rupees one lakh, what reasonable steps have been taken by the company for recovery/payment of the principal and interest. In making this examination, the auditor would have to consider the facts and circumstances of each case, including the amounts involved. It is not necessary that steps to be taken must necessarily be legal steps. Depending upon the circumstances, period of delay and other similar factors, issue of reminders or sending of advocate’s or solicitor’s notice may amount to reasonable steps. The auditor should ask the management to give in writing the steps which have been taken. The auditor should arrive at his opinion only after consideration of the management’s representations. (c) Whether the transactions needed to be entered in a register in pursuance of section 301 of Companies Act have been made at prices which are reasonable having regard to the prevailing market prices at the relevant time. Section 301 requires that every company shall keep one or more registers in which it shall be entered separately the particulars of all contracts or arrangements to which sections 297 and 299 of the Companies Act apply. As regards the reasonability of prices, the auditor is not expected to make a roving market inquiry but to examine price lists, quotations, prices for other parties etc. He should also take into account the factors such as delivery period, quality, quantity involved, credit terms etc.

Audit of Public Sector Undertakings 18.13 (d) Is the company regular in depositing undisputed statutory dues including Provident Fund, Investor Education and Protection Fund, Employee State Insurance, Income-Tax, Sales Tax, Wealth Tax, Custom Duty, Excise Duty, cess and any other statutory dues with the appropriate authorities and if not, the extent of the arrears of outstanding statutory dues as at the last day of the financial year concerned for a period of more than six months from the day they became payable, shall be indicated by the auditor. (c) Whether the company has made any preferential allotment of shares to parties and companies covered in the register maintained under section 301 of the companies Act and if so whether the price at which shares have been issued is prejudicial to the interest of the company. From the above analysis, it is somewhat clear that under the Companies Act, we already have tools which bring about a blending of propriety to the professional audit of Government companies. However, a word of caution is necessary in this context. The audit conducted by the Comptroller and Auditor General is a rule, procedure and propriety-based one; and often it is said that the desired flexibility is lacking in the system and this has contributed in a large measure to the lack of rapport between the auditor and the audit-units. Honesty is open to question, if that honesty has deviated from laid down rules and procedures. In turn, this has tended to foster a tendency amongst Government officials to just conform to the rules and provide a show of compliance with the standards of propriety. This is not intended to be little the contribution of this audit in ensuring appropriate use of fund of the Government. In Government, because of the enormous amounts involved and the massive volume of transactions and in view of public interest, it is but necessary that compliance with rules should be insisted upon and non-compliance enquired into. But the benefit derived is at least partly offset by the element of distrust and often the truth remains buried. One distinguishing feature should be observed; excepting the directions of the Comptroller and Auditor General issued under Section 619 (3)(a) of the Companies Act, the rest of the provisions are applicable equally to government and non- government companies. Whatever elements of propriety are discernible in them are also present in the audit of non-government companies. The directions under Section 619 (3)(a), generally known as Comptroller and Auditor General’s directions, however, are exclusively applicable to the audit of Government companies and such of the companies in private sector as are covered by Section 619B. Propriety Audit-Problems - Problems in propriety audit, however, arise mainly because of its distinct nature. The expression “propriety” is a moral term and can be understood by reference to the concept of morality accepted by the society at a given time. In any auditing, the essential test lies in formulation of auditing propositions. In the audit of financial accounts by reference to financial and legal requirements, propositions are built up about happening of events, existence, accuracy, title, ownership, compliance with law and internal regulations etc., which are all verifiable. In propriety audit the formulation of verifiable auditing propositions poses the problem. Propriety audit has an inherent element of subjectivity

18.14 Advanced Auditing and Professional Ethics because it is very difficult to establish standards of public interest, commonly accepted customs, standards for conduct which are not firm basis for audit evaluation. To take care of this situation, the C & AG has developed the norms of propriety for expenditure of public funds in our country and this has been discussed in the study above. By laying down the standards of propriety for Government expenditure the C & AG has really tried to tackle in a practical way the complex problem of subjectivity inherent in a situation calling for propriety consideration. The norms so developed provide the basis of verifying expenditure incurred by various Government departments. It has also been mentioned that so far as private sector is concerned, limited elements of propriety has been introduced through the provisions of Section 227 (1A) and 227(4A) of the Companies Act, with a verification base. It may, however, be appreciated that the norms of propriety applicable to governmental transactions may not ipso facto apply to transactions of private sector which have distinct and more limited, objectives suited to them. Each private sector entity may have its unique objectives related, to its management philosophy and the transactions should be geared to achieve those. For example, a management which is operating for maximization of profits without infringing, any legal regulations may follow certain policies while another management believing in a wider measure of social justice may follow different policies. Despite these clear angularities, certain commonness can also be discerned in the policies and approaches of different managements. They include efficient operations, higher productivity and higher profit, reduction of wasteful expenditure etc. Above all, each entity has its impact on the society and building up propriety audit propositions becomes of paramount importance. It is felt that if the management of each entity, irrespective of any legal requirements, formulates norms of propriety for the entity, taking full note of wider social repercussions inherent in its operations, a formidable hurdle in the way of wider introduction of propriety audit can be removed. The element of subjectivity in propriety evaluation will get reduced. Another dimension of the problem noticed in the application of propriety norms in the Government sector needs also to be taken into account. The norms are applied often too mechanically and create problems for expeditious and efficient working. In private sector, this attitude may prove counter-productive. Propriety as a moral element should be a matter of evaluation based on objectives and prevailing circumstances. For example, a travel by air as such should not be considered wasteful unless it is proved that a travel by rail would have been feasible in the circumstances and would have brought the same results brought by the air travel. The element of subjectivity has caused proper discharge of duty very delicate and demands discretion, but wisdom of taking commercial decisions under dynamic environment (the economic, social and political) must be evaluated with reference to the circumstances in which these were taken and therefore, the auditor in his field must reconstruct such circumstances. The judgment of the auditor must be objective as otherwise it would dampen the initiative of

Audit of Public Sector Undertakings 18.15 management and others in taking commercial decisions and propriety audit would prove itself to be counter productive. Performance Audit 18.8 A performance audit is an objective and systematic examination of evidence for the purpose of providing an independent assessment of the performance of a government organization, program, activity, or function in order to provide information to improve public accountability and facilitate decision-making by parties with responsibility to oversee or initiate corrective action [Reference : Government Auditing Standards , US , www.gao.gov ] Performance audits include economy and efficiency and program audits: a.

Economy and efficiency audits include determining (1) whether the entity is acquiring, protecting, and using its resources (such as personnel, property, and space) economically and efficiently, (2) the causes of inefficiencies or uneconomical practices, and (3) whether the entity has complied with laws and regulations on matters of economy and efficiency.

b.

Program audits include determining (1) the extent to which the desired results or benefits established by the legislature or other authorizing body are being achieved, (2) the effectiveness of organizations, programs, activities, or functions, and (3) whether the entity has complied with significant laws and regulations applicable to the program.

Economy and efficiency audits may, for example, consider whether the entity a.

is following sound procurement practices;

b.

is acquiring the appropriate type, quality, and amount of resources at an appropriate cost;

c.

is properly protecting and maintaining its resources;

d.

is avoiding duplication of effort by employees and work that serves little or no purpose;

e.

is avoiding idleness and overstaffing;

f.

is using efficient operating procedures;

g.

is using the optimum amount of resources (staff, equipment, and facilities) in producing or delivering the appropriate quantity and quality of goods or services in a timely manner;

h.

is complying with requirements of laws and regulations that could significantly affect the acquisition, protection, and use of the entity's resources;

i.

has an adequate management control system for measuring, reporting, and monitoring a program's economy and efficiency; and

18.16 Advanced Auditing and Professional Ethics j.

has reported measures of economy and efficiency that are valid and reliable.

Program audits may, for example a.

assess whether the objectives of a new, or ongoing program are proper, suitable, or relevant;

b.

determine the extent to which a program achieves a desired level of program results;

c.

assess the effectiveness of the program and/or of individual program components;

d.

identify factors inhibiting satisfactory performance;

e.

determine whether management has considered alternatives for carrying out the program that might yield desired results more effectively or at a lower cost;

f.

determine whether the program complements, duplicates, overlaps, or conflicts with other related programs;

g.

identify ways of making programs work better;

h.

assess compliance with laws and regulations applicable to the program;

i.

assess the adequacy of the management control system for measuring, reporting, and monitoring program's effectiveness; and

j.

determine whether management has reported measures of program effectiveness that are valid and reliable.

Performance Audit : Indian Scenario 18.9 Performance audit is PSUs in conducted by the Comptroller and Auditor General of India(Supreme Audit Institutions) through various subordinate offices of Indian Audit and Accounts Department (IAAD). In conducting performance audit, the subordinate offices are guided by manual and auditing standards prescribed by CAG. 18.9.1 The mandate and objectives of performance auditing - According to Section 19(1) of the Comptroller and Auditor General (Duties, Powers, and Conditions of Service) Act, 1971: “The duties and powers of the Comptroller and Auditor General in relation to the audit of the Accounts of Government companies shall be performed and exercised by him in accordance with the provisions of the Companies Act, 1956”. Section 619(3) of Companies Act empowers Comptroller and Auditor General of India to conduct supplementary audit or test audit of Government companies. Under Section 619(3) (b) of the Companies Act, the CAG shall have power “to conduct supplementary or test audit of the (Govt) company’s accounts by such person or persons as he may authorize in this behalf; and for the purposes of such audit to require information or additional information to such person or persons and in such form as the Comptroller and/ Auditor General may, by general or special order, direct.”

Audit of Public Sector Undertakings 18.17 Section 619 (4) of Companies Act requires the statutory auditor (chartered accountant appointed by CAG under section 619 (2) of the Act) to submit a copy of his audit report on the accounts of the Govt. company to CAG, who shall have the right to comment upon or supplement the audit report in such manner as he may think fit. Thus while section 619(3) of the Companies Act empowers CAG to conduct test audit (transactions audit) of a Govt. company, section 619(4) empowers CAG to conduct supplementary audit of annual accounts of a Government company. In so far as statutory corporations are concerned the respective Statutes provide for audit by CAG. The scope includes conducting performance audit of these corporations also though specifically not stated so. 18.9.2 Objectives of performance auditing - The objectives are evaluation of economy, efficiency, and effectiveness of policy, programmes, organization and management. Policy is usually defined as an effort to achieve certain aims with certain resources and perhaps within a certain time. A programme can be described as a set of interrelated means-legal, financial, etc. to implement a given policy. Organisation can be defined in different ways, but mostly it is taken to mean the aggregate of people, structures and processes that have the aim of achieving particular objectives. In an organized set up or entity, the entity’s goal and objectives are governed by its constitution. As well known to us, the Memorandum and Articles of Association of a company forms the constitution of the company as also the basic document for entering into a contract with that entity. Authority is delegated to the management. Management generally refers to a person or group person(s), like Board of Directors in a company, vested with powers to take all decisions, actions and framing rules for the steering, accounting and development of human, financial and material resources. Management decisions are mainly internal to the operations of an organization. Policies and programmes decided by the legislature, the executive or executive official, relating to a specific organization (and its internal activities and performance) are the broad guidelines or parameters within which the management is supposed to function. The management is accountable in so far as public sector enterprises are concerned to the legislature and the executives in the Govt. The basic principle of public finance, which not only applies to Govt. expenditure but also forms part of prudential norms of finance in any organization, is that the delegated authority shall observe that care and due diligence in sanctioning of any expenditure as an ordinary man of average prudence of his caliber would have had. Management’s action is watched by other statutory authorities like CAG, CVC, etc. as to utilization of the money sanctioned for the purpose of sanction and also within the sanction especially from the angle of reasonability and the benefits flowing from such expenditure. Efficiency is the input-output ratio and in the case of public spending efficiency is achieved when the output is maximized at the minimum of expenditure. These two aspects mainly relates to economy and efficiency while efficacy is measured by the benefits

18.18 Advanced Auditing and Professional Ethics flowing from such spending. Whilst performance auditing does not question political goals, it can point out the consequences of a given policy. Take for example the audit of performance of enforcement mechanism for administering the provision of Minimum Wages Act which is a social welfare legislation. The auditors, who undertake performance audit of a program or unit, must posses knowledge of the industries or labor contracts where these provisions are applicable and also identify the population thereof before carrying out audit program. The auditor shall evaluate, as part of performance audit, the standard of living before implementation and after implementation of the Act. Further he shall have to evaluate the evidence available before him as to nature of returns prescribed and obtained for taking appropriate action. Auditor shall also have to evaluate the economy, efficiency and effectiveness in the welfare systems to be audited. The performance auditor can then study the shortcomings in the coordination between different agencies like labor department, EPF and ESI organization and the control systems and point out a set of relevant problems. Auditor shall also point out lacuna, if any in the existing legal frame work or enforcement mechanism to strengthen the objective of leglislation. Another possible area of critical audit may be to study actual level of compensation required in each area keeping in mind the local living conditions and where the minimum wages prescribed in the statute is demonstrably different from this level he may report the same to the Govt. for taking appropriate action. In this manner, the performance audit can not only examine the reasons for such vagaries but also ensures that the legislation serves the intended purpose. By reporting the same to the legislature, the corrective is made possible. [Interested students may refer to CPE Background Material on Performance Audit of Public Sector Enterprises in India published by the ICAI for further reference]. Planning for Performance Audit 18.10 The following steps are suggested to the auditors for planning while conducting the performance audit: (A) Work is to be adequately planned - In planning, auditors should define the audit's objectives and the scope and methodology to achieve those objectives. The objectives are what the audit is to accomplish. They identify the audit subjects and performance aspects to be included, as well as the potential finding and reporting elements that the auditors expect to develop. Audit objectives can be thought of as questions about the program that auditors seek to answer. Scope is the boundary of the audit. It addresses such things as the period and number of locations to be covered. The methodology comprises the work in data gathering and in analytical methods auditors will do to achieve the objectives.

Audit of Public Sector Undertakings 18.19 Auditors should design the methodology to provide sufficient, competent, and relevant evidence to achieve the objectives of the audit. Methodology includes not only the nature of the auditors' procedures, but also their extent (for example, sample size). In planning a performance audit, auditors should: a.

Consider significance and the needs of potential users of the audit report.

b.

Obtain an understanding of the program to be audited.

c.

Consider legal and regulatory requirements.

d.

Consider management controls.

e.

Identify criteria needed to evaluate matters subject to audit.

f.

Identify significant findings and recommendations from previous audits that could affect the current audit objectives. Auditors should determine if management has corrected the conditions causing those findings and implemented those recommendations.

g.

Identify potential sources of data that could be used as audit evidence and consider the validity and reliability of these data, including data collected by the audited entity, data generated by the auditors, or data provided by third parties.

h.

Consider whether the work of other auditors and experts may be used to satisfy some of the auditors' objectives.

i.

Provide sufficient staff and other resources to do the audit.

j.

Prepare a written audit plan.

Planning should continue throughout the audit. Audit objectives, scope, and methodologies are not determined in isolation. Auditors determine these three elements of the audit plan together, as the considerations in determining each often overlap. (B) Significance and User Needs - Auditors should consider significance in planning, performing, and reporting on performance audits. The significance of a matter is its relative importance to the audit objectives and potential users of the audit report. Qualitative, as well as quantitative, factors are important in determining significance. Qualitative factors can include: a.

visibility and sensitivity of the program under audit,

b.

newness of the program or changes in its conditions,

c.

role of the audit in providing information that can improve public accountability and decision-making, and

d.

level and extent of review or other forms of independent oversight.

18.20 Advanced Auditing and Professional Ethics One group of users of the auditors' report is government officials who may have authorized or requested the audit. Another important user of the auditors' report is the auditee, which is responsible for acting on the auditors' recommendations. Other potential users of the auditors' report include government officials (other than those who may have authorized or requested the audit), the media, interest groups, and individual citizens. These other potential users may have, in addition to an interest in the program, an ability to influence the conduct of the program. Thus, an awareness of these potential users' interests and influence can help auditors understand why the program operates the way it does. This awareness can also help auditors judge whether possible findings could be significant to these other users. (C) Understanding the Program - Auditors should obtain an understanding of the program to be audited to help assess, among other matters, the significance of possible audit objectives and the feasibility of achieving them. The auditors' understanding may come from knowledge they already have about the program and knowledge they gain from inquiries and observations they make in planning the audit. The extent and breadth of those inquiries and observations will vary among audits, as will the need to understand individual aspects of the program, Government Auditing Standards such as the following. a.

Laws and regulations - Government programs usually are created by law and are subject to more specific laws and regulations than the private sector. For example, laws and regulations usually set forth what is to be done, who is to do it, the purpose to be achieved, the population to be served, and how much can be spent on what. Thus, understanding the laws establishing a program can be essential to understanding the program itself. Obtaining that understanding may also be a necessary step in identifying provisions of laws and regulations significant to audit objectives.

b.

Purpose and goals - Purpose is the result or effect that is intended or desired, and can exist without being expressly stated. Goals quantify the level of performance intended or desired. Legislatures set the program purpose when they establish a program; however, management is expected to set goals for program efforts, operations, outputs, and outcomes. Auditors may use the purpose and goals as criteria for assessing program performance.

c.

Efforts - Efforts are the amount of resources (in terms of money, material, personnel, and so forth) that are put into a program. These resources may come from within or outside the entity operating the program. Measures of efforts can have a number of dimensions, such as cost, timing, and quality. Examples of measures of efforts are dollars, employee-hours, and square feet of building space.

d.

Program operations - Program operations are the strategies, processes, and activities the auditee uses to convert efforts into outputs. Program operations are subject to management controls.

Audit of Public Sector Undertakings 18.21 e.

Outputs - Outputs are the quantity of goods and services provided. Examples of measures of output are tons of solid waste processed, number of students graduated, and number of students graduated who have met a specified standard of achievement.

f.

Outcome - Outcomes are accomplishments or results that occur (at least partially) because of services provided. Outcomes can be viewed as ranging from immediate outcomes to long-term outcomes. For example, an immediate outcome of a job training program and an indicator of its effectiveness might be the number of program graduates placed in jobs. That program's ultimate outcome and test of its effectiveness depends on whether program graduates are more likely to remain employed than similar persons not in the program. Outcomes may be intended or unintended, and they may be influenced by cultural, economic, physical, or technological factors external to the program. Auditors may use approaches drawn from the field of program evaluation to isolate the effects of the program from those of other influences.

One approach to setting audit objectives is to relate the elements of a program to the types of performance audits. For example, audits concerned with economy could focus on efforts: Were resources obtained at an optimal cost and at an appropriate level of quality? Audits concerned with efficiency could focus on the program operations or the relationship between efforts (resources used) and either outputs or outcomes to determine the cost per unit of output or outcome. Program audits could be concerned with determining whether program outcomes met specified goals or whether outcomes were better than they would have been without the program. Any type of performance audit could encompass program operations if auditors are looking for reasons why the program was successful or not. (D) Criteria - Criteria are the standards used to determine whether a program meets or exceeds expectations. Criteria provide a context for understanding the results of the audit. The audit plan, where possible, should state the Government Auditing Standards criteria to be used. In selecting criteria, auditors have a responsibility to use criteria that are reasonable, attainable, and relevant to the matters being audited. The following are some examples of possible criteria: a.

purpose or goals prescribed by law or regulation or set by management,

b.

technically developed standards or norms,

c.

expert opinions,

d.

prior years' performance,

e.

performance of similar entities, and

f.

performance in the private sector.

(E) Audit Follow-Up - Auditors should follow up on significant findings and recommendations from previous audits that could affect the audit objectives. They should do this to determine whether timely and appropriate corrective actions have been taken by auditee officials. The audit report should disclose the status of uncorrected significant findings and recommendations from prior audits that affect the audit objectives.

18.22 Advanced Auditing and Professional Ethics Much of the benefit from audit work is not in the findings reported or the recommendations made, but in their effective resolution. Auditee management is responsible for resolving audit findings and recommendations, and having a process to track their status can help it fulfill this responsibility. If management does not have such a process, auditors may wish to establish their own. Continued attention to significant findings and recommendations can help auditors assure that the benefits of their work are realized. (F) Considering Others' Work - Auditors should determine if other auditors have previously done, or are doing, audits of the program or the entity that operates it. Whether other auditors have done performance audits or financial audits, they may be useful sources of information for planning and performing the audit. If other auditors have identified areas that warrant further study, their work may influence the auditors' selection of objectives. The availability of other auditors' work may also influence the selection of methodology, as the auditors may be able to rely on that work to limit the extent of their own testing. If auditors intend to rely on the work of other auditors, they should perform procedures that provide a sufficient basis for that reliance. Auditors can obtain evidence of other auditors' qualifications and independence through prior experience, inquiry, and/or review of the other auditors' external quality control review report. Auditors can determine the sufficiency, relevance, and competence of other auditors' evidence by reviewing their report, audit program, or working papers, and/or making supplemental tests of their work. The nature and extent of evidence needed will depend on the significance of the other auditors' work and on whether the auditors will refer to that work in their report. Self -examination Questions 1.

Briefly explain the framework for Government audit?

2.

What is Comprehensive Audit ? State objective and scope of Comprehensive Audit of public enterprises?

3.

What are the special issues to be examined in Comprehensive Audit ?

4.

What is Propriety Audit?

5.

Briefly explain the Propriety Audit elements in the CARO 2003 as well as in the Companies Act, 1956?

6.

What is Performance Audit? States its objectives. Explain the role of the Comptroller and Auditor General of India in respect of Performance Audit?

7.

Explain the steps to be followed for planning Performance Audit in public enterprises?

8.

State the nature and purpose of Supplementary Audit under Section 619(4) of the Companies Act, 1956?

9.

What is the role of Public Accounts Committee and Committee on Public Undertakings in respect of audit of public sector undertakings?

Audit of Public Sector Undertakings 18.23 Annexure I Specimen Performance Audit Report issued by the Comptroller and Auditor General of India [Source : www.cag.gov.in] Electronics Corporation of India Limited Computer Education Division -

Electronics Corporation of India Limited started the business of computer education without conducting any objective and detailed assessment of the business potential or its own strengths and weaknesses. The Company did not formulate any policy with regard to appointment of franchisees and as a result faced problems in implementing the franchisee agreements. It had to cancel as many as 63 franchisee agreements during the first five years of operation ending March 2005. There was lack of effective internal control due to which the franchisees worked on their own and exploited the name and repute of the Company. In one agreement alone, the Company had to suffer a loss of Rs. 67.13 lakh during 2001-02 and 2002-03. The Company also undertook school projects in different States wherein too, it worked through the franchisees. Due to problems in controlling the functioning of these franchisees, the Company had to take a decision to not undertake such projects in future. The Company failed to achieve the target turnover and also suffered losses during the years 2001-02, 2002-03 and 2004-05 in this business segment.

Air India Limited Fleet Utilisation and Maintenance -

Air India Limited had a fleet of 36 aircraft as on 31 March 2005, out of which 18 were owned by the Company and remaining were on dry lease. No aircraft was purchased after 1996. The Company resorted to taking aircraft on dry lease for augmentation of fleet since the year 2000 due to absence of an effective fleet replacement policy.

-

The Company cancelled/rescheduled the flights in 3.05 to 12.04 per cent cases and delayed it by more than 20 minutes in 17.35 to 21.87 per cent cases during the last three years ended 2004-05, but it did not maintain the industry data in regard to adherence to flight schedules for evaluation of its own performance vis a vis the other airlines. The utilisation of the available fleet, however, was more than the industry average as well as the planned hours in most cases.

Overview Department Of Atomic Energy Ministry Of Civil Aviation -

The Company incurred expenditure of only Rs. 6.14 crore in creation of repair and maintenance facility as against the capital budget of Rs. 99.98 crore for the last three years ended 2004-05. As a result of non-setting up facilities and non-procurement of equipment as per the capital plan, it had to incur avoidable expenditure of Rs. 8.21 crore on outside repairs in three cases.

-

The Company had prescribed norms for completing various checks prescribed by the Director General of Civil Aviation, but the actual time taken for completion of the checks far exceeded the

18.24 Advanced Auditing and Professional Ethics norms. This resulted in excess grounding of aircraft and consequent loss of potential contribution amounting to Rs. 93.04 crore based on the loss of flying hours. -

The Company sent 13 aircraft for overseas repairs and spent Rs. 57.37 crore on major maintenance such as ‘C’ and ‘D’ checks during the last three years ended March 2005, on grounds of capacity constraints and lessor’s requirement, despite having the in-house capability to carry out these checks. There was shortage of technical manpower but no comprehensive study was conducted to assess the long term requirements of the technical manpower.

-

No case of accident was noticed during the last three years but there was scope for reduction in number of incidents. The Company did not have industry data for benchmarking its performance on the air safety aspects.

Mahanadi Coalfields Limited Project Implementation, Performance of HEMM, Manpower Analysis, Fund Management and Environmental Planning -

The Company could not complete the implementation of advance action plan of seven projects even after time over run of one to 10 years leading to cost overrun of Rs. 66.29 crore as on March 2005. Due to resistance from land oustees, the Company could not produce coal valued at Rs. 118.25 crore during 2004-05 in six projects of Talcher Coalfields.

-

The Company incurred avoidable extra expenditure of Rs. 4.46 crore in 2002-03 by awarding the contract of hiring of surface miner at a higher rate.

-

There was no scientific assessment of manpower requirement. The Company had a workforce of 21298 out of which 66 per cent was in unskilled category at the end of March 2005. The Company’s control on overtime remained ineffective and despite the negative growth in OB removal, there was increase in overtime by Rs. 8.73 crore and Rs. 13.96 crore in 2003-04 and 2004-05 respectively.

-

Despite holding huge surplus fund ranging between Rs. 29.37 crore and Rs. 97.10 crore per month from April 2002 to February 2004, the Company did not invest the same with Coal India Limited (CIL) and lost an interest of Rs. 4.04 crore.

Department of Coal -

The Company could not recover loading charges of Rs. 17.34 crore up to March 2005 in the absence of any agreement with the customers. Further, crushing charges of Rs. 8.12 crore could not be recovered from customers in the absence of a notification for revision of prices of coal produced through surface miner for the period from June 2000 to January 2001.

Neyveli Lignite Corporation Limited Neyveli Lignite Corporation Limited (Corporation) was incorporated in November 1956 with the main objective of excavating lignite in the Neyveli area and generating power therefrom. The Corporation has three mines with lignite excavating capacity of 24 million tonne per annum and three lignite based Thermal Power Stations (TPS) with generating capacity of 2490 MW. Each TPS has a dedicated mine to meet its fuel requirement.

Audit of Public Sector Undertakings 18.25 Performance of Bucket Wheel Excavators -

The Hanumantha Rao Committee appointed by the Government of India determined the norms in 1983 for operation of Bucket Wheel Excavators based on the data available for the period 1969 to 1982. The Company subsequently procured new Bucket Wheel Excavators with upgraded technology but adopted the norms already fixed for the old machines and thus ignored the technical superiority, which enhanced the designed capacities of the Bucket Wheel Excavators.

-

Neither the Hanumantha Rao Committee nor the Corporation fixed achievable capacities for the Bucket Wheel Excavators (BWEs) deployed in the lignite bench/bottom bench.

-

The BWEs worked for more hours than norms but the output rate was lower than the achievable capacity resulting in short removal of overburden of 21.55 million cubic metres and short extraction of 12.22 MT lignite in Mine I and II during the five-year period ending March 2005.

-

There was excess consumption of power and teeth in operating the Bucket Wheel Excavators amounting to Rs. 17.73 crore and Rs. 10.43 crore in Mine I and II respectively during the period under review.

-

The stoppages under the planned and breakdown categories exceeded the norms and led to short extraction of 24.27 MT lignite during the five-year period ending March 2005.

HMT Limited Marketing activities of Tractor Business Group -

The Tractor Business group (Group) comprises the tractor manufacturing division at Pinjore set up in 1971, (with a licensed capacity of 25,000 tractors and an installed capacity of 18,000 tractors per annum), marketing division at Chandigarh

Department of Heavy Industry and Area Offices. Marketing of tractors is done through a net work of dealers who are the only link with the customers. • The Company’s market share of tractors declined from 6.1 per cent (1999-00) to 2.9 per cent (2004-05) due to working capital constraints resulting from slow recovery of funds locked up in the market and production constraints. -

The Group resorted to aggressive marketing techniques through advance of tractors to dealers through Area offices. Dealers in turn advanced most of the tractors to customers to show higher sales. The unsold tractors with dealers were taken back irrespective of their physical condition and credit was given to the dealers accounting the same as sales return. The sales returns, thus, amounted to Rs. 3.68 crore, Rs. 17.25 crore, Rs. 9.42 crore and Rs. 1.18 crore representing 1.28 per cent, 6.66 per cent, 5.76 per cent and 0.58 per cent of sales in 2001-02, 2002-03, 2003-04 and 2004-05 respectively. Thus, the aggressive marketing practice of the Group ended up in huge sales returns.

-

The mounting Sundry debtors to turnover of the Group (43.55 per cent in 1999- 00 to 89.59 per cent in 2002-03) were due to the injudicious practice of dumping tractors on dealers resulting in cash crunch and subsequent low volume of production/sales.

18.26 Advanced Auditing and Professional Ethics GAIL (India) Limited Telecom business -

The Company started its GAIL-Tel project with an investment of Rs. 262.95 crore without preparing Detailed Project Report. It also implemented Phase IIB of the project without considering the actual unsatisfactory performance of the previous phases. The project could not achieve its targets in terms of capacity sales or sales revenue during any of the four years of its operations till March 2005. The project had been incurring losses since 2003-04 and the cumulative loss of the project till September 2005 was Rs. 9.03 crore.

-

The Company also lost projected revenue of Rs. 442.19 crore due to delays ranging from nine to 19 months in the completion of various phases of the project. Internal delays in the processing of tenders and placement of orders contributed to the project delay.

-

An investment of Rs. 36.66 crore on Dense Wavelength Division Multiplexing equipment, Rs 11.48 crore on the Optical Fibre cables and Rs. 12.99 crore on second duct made by the Company could not be put to fruitful use.

Oil and Natural Gas Corporation Limited Availability and utilization of critical equipment of offshore installations in Mumbai Region -

The production of Mumbai High Offshore of ONGC comprising three fields (assets) made a sizeable portion of the country’s hydrocarbon production. For

Ministry of Petroleum and Natural Gas -

ensuring uninterrupted production, ONGC had fixed targets of 100 per cent system availability and 95 per cent equipment availability of critical equipment engaged in production in the offshore fields.

-

ONGC achieved the targeted system availability of critical equipment in Mumbai Offshore but could not achieve the targeted equipment availability due to maintenance related problems.

-

There did not exist any policy in regard to maintenance, revamping and replacement of critical equipment, though the Management had since initiated corrective actions in this regard.

-

Non-adherence to overhaul and preventative maintenance schedule of critical equipment caused high tripping, unplanned shutdown and pre-mature failure of the quipment. Deferment of production/revenue in Mumbai High due to maintenance reasons amounted to Rs.61 crore in 2003-04. The delay in procurement of spares and shortages of maintenance manpower further led to high down time of equipment and consequent lower availability of critical equipment.

-

The utilisation of most of the equipment was below the minimum run hours requirements due to changing behaviour and depletion of fields but the equipment requirements were not reassessed in time to ensure its optimum utilisation. The utilisation of turbine generators on low load factor revealed excessive fuel gas consumption as compared to norms.

Audit of Public Sector Undertakings 18.27 -

In Neelam field, the installed capacity of gas compression was below the actual gas production since inception and delayed action for enhancement of gas compression facility resulted in flaring of gas valued at Rs.126.39 crore for the period 1998 to 2005.

NTPC Limited Gas Based Power Stations -

The Company commissioned six gas-based plants at Anta, Auraiya, Kawas, Dadri, Gandhar and Faridabad with generating capacity of 3657.64 MW. Though 14.17 MCMD of gas was required to utilize this capacity, the actual commitment from GAIL (India) Limited was for 12.75 MCMD only, which was sufficient to operate the plants at 66 per cent of the capacity. Thus, even at the initial stage, there was a mis-match between the requirement of gas for generating capacity and the quantity tied up by the GOI. Further, GAIL did not supply gas even up to the committed level. The GOI, which was primarily responsible for assignment of requisite gas for power stations, did not ensure availability of requisite gas.

-

As the quantity of gas supplied by GAIL declined, the plants increasingly depended on generation through alternate fuel of naphtha/ high speed diesel. As the variable cost of generation of power on alternate fuel was four to five times the

Ministry of Power -

cost of generation on gas, the beneficiaries were reluctant to purchase costlier power resulting in impairment of the efficient working of the power stations.

-

In the agreement entered into with GAIL, the Company was required to pay for the minimum guaranteed quantity of gas in the event of short lifting of gas, while there was no corresponding compensating clause in case of short supply of gas by GAIL. The Company’s financial interests were not, thus, guarded.

-

The tariff fixation policy of Central Electricity Regulatory Commission allowed the Company to recover full fixed charges based on declared capacity, even when actual generated units were below the declared capacity. As a result, the beneficiaries had to bear an excessive charge of fixed cost for Rs. 123.45 crore during 2003-04.

-

Despite underutilization of the existing capacity due to inadequate gas supply, the Company planned to expand the capacity of four gas-based plants in the IX Five Year Plan. As the beneficiaries declined to take costlier power generated on naphtha, it deferred the expansion after incurring an expenditure of Rs. 23.68 crore, out of which the sum of Rs. 17.56 crore was not likely to be utilized till the end of 2011-12.

North Eastern Electric Power Corporation Limited Gas Based Power Stations -

The gas supply agreements with GAIL (India) Limited /Oil and Natural Gas Corporation Limited did not provide for waiver of Minimum Guaranteed Offtake (MGO) payment due to lower generation in Agartala Gas Turbine Project (AGTP) arising out of grid failure and no/low grid demand over which the Corporation could not exercise any control. As AGTP failed to

18.28 Advanced Auditing and Professional Ethics draw/consume even the MGO quantity of gas due to evacuation constraints and low drawal of power by the beneficiaries, the project had to incur infructuous expenditure of Rs. 3.16 crore. -

The Management failed to take timely initiative to enhance the quantity of gas to be supplied keeping in view the availability and future requirement. While working out the gas requirement, the impact of steadily falling calorific value of gas over the years and a higher actual heat rate higher as compared to the norm was not considered.

-

The Assam Gas Based Power Project (AGBPP) could not achieve the target availability because of lack of tie-up for supply of gas in requisite quantities. As a result, there was under-recovery of fixed charges of Rs. 9.94 crore.

-

Main causes for lower generation in AGBPP were transformation and transmission limitations in the North-Eastern Region (NER), lower generation schedule given by North Eastern Regional Load Dispatch Centre and priority given to maximization of hydel generation during monsoon period.

-

Under-utilisation of capacity of AGBPP and AGTP was also due to non-availability of associated transmission line and weak state-owned transmission system, import of power by Assam State Electricity Board from Eastern Region due to high cost of AGBPP power and commissioning of gas based power stations by Government of Tripura during 2002-03.

-

Despite the gas-based stations not achieving the normative auxiliary consumption as well as Gross Station Heat Rate, the Corporation had not conducted any Energy Audit since the commissioning of the plants in July 1998.

-

The Corporation had not developed any documented maintenance policy incorporating its own inspection schedules and associated procedures as well as defining responsibility of various functions even after seven years from the date of commissioning of the plants.

-

Manufacturer’s recommended periodicity of preventive maintenance of the machines was not adhered to in AGBPP and AGTP.

-

Non-commissioning of the fire protection system and De-mineralised plant resulted in noncompliance of mandatory environmental requirements stipulated by various statutory authorities.

Bharat Refractories Limited Working of Bharat Refractories Limited -

Bharat Refractories Limited (BRL) was incorporated in July 1974 as a Government Company. BRL and India Firebricks and Insulation Company (a subsidiary of BRL) were referred to Board of Industrial and Financial Reconstruction (BIFR) in 1992. The BIFR and the Government of India sanctioned three revival schemes during the period January 1997 to June 2002 under which, apart from other concessions, the Company received cash assistance of Rs. 234.60 crore in the shape of loan and equity. Despite these concessions, the Company did not achieve the targets of manpower reduction, production, sales and profitability set forth in the Techno-Economic Viability Report prepared by MECON Limited and it continued to incur losses. The accumulated losses on 31 March 2005 were Rs. 352.56 crore.

Audit of Public Sector Undertakings 18.29 -

The overall production of refractories was only 39 and 87 per cent of the reassessed capacity during 2001-02 to 2004-05 and the shortfall in production was 1.19 lakh tonnes due to underutilisation of capacity, non-availability of working capital leading to shortage of raw materials and excess manpower leading to increased labour cost of Rs. 9 crore annually.

-

The Company was supplying magnesia carbon bricks and slide gate refractory under performance guarantee clause to Bokaro Steel Plant, who recovered/received materials free of cost amounting to Rs. 6.33 crore and Rs. 1.97 crore respectively due to non-achievement of the committed heats under the guarantee clause.

-

As against the re-assessed capacity of 12,000 tonnes of silica bricks at BRP, the plant actually produced only 1790 tonnes during 1999-2000 to 2004-05 and there was no production during 2003-04, though the product had good contribution margin and market demand. The management was silent on the issue and had not examined the reasons for negligible/nil production.

Ministry of Steel -

The actual rejection of bricks in the process of manufacture from green bricks (unburnt bricks pressed in Presses) to saleable bricks was much higher than 10 per cent considered in TEV report. The management neither fixed norms for rejection nor analyzed the reasons.

-

The utilisation of a 2500 tonne Sacmi Press procured at a cost of Rs. 7.53 crore was only 37 per cent during 2000-01 to 2004-05. A press of lower capacity of 2000 tonne, which was considered earlier, could have well served the purpose.

-

The Company could not implement the technology for manufacturing continuous casting refractories purchased from Japan in October 1991 at a fee of Rs. 1.12 crore, rendering the expenditure infructuous.

MSTC LTD Performance Audit of High Seas Sale Activity -

The Company’s International Market Division was primarily engaged in ‘back to back’ sales and despite being planned in the MOU, failed to meet the target of ensuring that at least 20 per cent of the imports were for non-captive buyers.

-

Specific profit contribution of High Seas sale to the overall financial performance could not be ascertained as no separate cost records for or allocation of overheads made to High Seas sale transactions were maintained by the Company.

-

During the last five years ending 31 March 2005 maximum business was derived from four to five items. Growth in overall sales of the Company had been price driven and not volume driven. Concentration of sales on limited number of products and reliance on a single customer i.e. HPL involved attendant risk of loss of flexibility and sudden decline in volume of business in future. It also indicated that the Company had failed to widen its market base and product basket despite the same being planned in the strategic plan.

-

The Company frequently failed to ensure adherence to the condition of the MOA by the customers. Due to deviation and relaxation given in the terms and condition of MOA to the parties, the Company had suffered a loss of Rs. 4.85 crore.

18.30 Advanced Auditing and Professional Ethics Steel Authority of India Limited Import of Coking Coal -

Steel Authority of India Limited (SAIL) does not have captive coking coal mines and is dependent on outside suppliers. Its main suppliers of indigenous coking coal are the subsidiaries of Coal India Limited. In order to improve the technical parameters through blending with indigenous coal and meeting the gap between actual requirement and availability of indigenous coal, the Company had been importing coking coal since 1978-79. Such procurement was made through Long Term Agreements, Spot Tenders and Term Agreements.

-

Due to the shortage of imported coking coal, there was a decline of 12 per cent (0.31 million tonnes) in SAIL’s production of saleable steel for the first quarter of 2004-05.

-

Failure by SAIL to take adequate and timely action through properly planned purchase of hard coking coal resulted in avoidable expenditure of Rs. 344 crore.

-

In view of SAIL’s current time frame for spot tendering, its poor past record in tendering whereby only one per cent of the quantity tendered between November 2000 and December 2004 was actually received and lack of adequate testing and quality assurance, it should consider spot tendering as the least preferred option for SAIL for meeting its planned or urgent requirements of coking coal.

-

SAIL incurred avoidable additional expenditure of Rs. 87 crore and Rs. 89 crore, by signing term agreements for hard and soft coking coal with two foreign suppliers while simultaneously keeping deliveries under the Long Term agreements with them in abeyance.

-

Failure by SAIL to exercise the mutual option quantity of 0.150 million tonnes of soft coking coal in the LT agreement with a supplier for 2003-04 resulted in a loss of Rs. 32 crore.

-

Failure by SAIL to take advantage of existing offers for hard coking coal and acquire 0.46 million tonnes of hard coking coal in 2003-04, resulted in excess expenditure of Rs. 232 crore on spot purchases of hard coking coals.

19 INTERNAL AUDIT, MANAGEMENT AND OPERATIONAL AUDIT

Internal Audit 19.1 Many modern enterprises have become huge and sophisticated. This has resulted in decentralisation of their activities and consequently the top management is remotely concerned with the day-to-day activities of the concern. In this context internal auditing has acquired a great deal of significance. Considering the increasing importance of internal auditing, the Institute of Chartered Accountants of India has constituted a Committee on Internal Audit (CIA) as a non-standing committee on February 5, 2004. The CIA was constituted with the object of formulating Standards and Guidance Notes on Internal Audit. As defined in scope of the standards on Internal Audit, Internal Audit means “An independent management function, which involves a continuous and critical appraisal of the functioning of an entity with a view to suggest improvements thereto and add value to and strengthen the overall governance mechanism of the entity, including the entity’s strategic risk management and internal control system. Traditionally internal auditing has been viewed as confined merely to ensure that the accounting and allied records have been properly maintained; that the assets of the enterprise have been properly safeguarded and that the policies and procedures laid down by the management have been complied with. The modern concept suggests that internal auditing need not be confined to financial transactions and that its scope may be extended to the task of reviewing whether the resource utilisation of the enterprise is efficient and economical. This would necessitate a review of all operations of the enterprise as also an evaluation of the effectiveness of management. We should not however lose sight of the fact that internal auditing is basically a service activity. The internal auditor has to review and report; he is not expected to take upon himself functions of the operational managers. The Research Committee of the Institute of Chartered Accountants of India has brought out “General Guidelines on Internal auditing”. The following discussion is based upon the above publication.

19.2

Advanced Auditing and Professional Ethics

Management functions and scope of Internal Auditing 19.2 Management is a process by which the affairs of an enterprise are conducted in such a manner that its goals and objectives are attained through optimum utilisation of all available resources, within the legal, social, economic and environmental constraints. To achieve optimum utilisation of resources management should determine the goals and objectives of the concern, quantify them to the extent possible, develop major policies and plans, implement them and exercise control over such implementation. Each of the aforesaid managerial functions should be constantly be viewed by the internal auditor. Translated into more concrete terms, the scope of internal auditor’s work should include a review of (i)

internal control system and procedures.

(ii)

system regarding the custodianship and safeguarding of assets - monetary and nonmonetary of enterprise.

(iii) compliance, by the various segments with the policies, plans and procedures of the enterprise as well as with the relevant regulations and laws. (iv) system of collecting data both monetary and non-monetary - to ensure that the information given to management and to external agencies is relevant and reliable. (v) organisational structure of the enterprise and its congruence with its objectives. (vi) efficient and economical use of available resources tangible as well as intangible. (vii) various operations. On the basis of such review, the internal auditor should in his report, highlight the weaknesses observed and give suggestions for improvement. We may now have a brief description on each of the above areas of review : (i)

Review of internal control system and procedures (a) The internal auditor should determine whether the internal control system is in consonance with the organisational structure. As far as possible, controls should be inbuilt in the operating functions, if they are to be cost effective. For example, the establishment of a separate credit control department would not be justified if the objective of reducing credit risk and minimising debt recovery period could be met through controls in-built in the accounting and sales systems especially in smaller and medium sized concerns. (b) Each control should be reviewed and analysed in terms of its costs and benefits. It should also be seen whether the internal controls were in use throughout the period of intended reliance. A break-down in internal controls for a specific portion of intended reliance would need special attention.

(ii) Review of custodianship and safeguarding of assets - The objective of the management is to ensure that the assets are reasonably and adequately protected against loss and that they are properly managed and accounted for. In this context the

Internal Audit, Management and Operational Audit

19.3

internal auditor should review the control systems to ensure that all assets are accounted for fully. He should review the means used for safeguarding assets against losses e.g. fire, improper or negligent activity, theft and illegal acts etc. He should review the control systems for intangible assets e.g. the procedures relating to credit control. Where an enterprise uses electronic data processing equipment, the physical and systems control on processing facilities as well as on data storage should be examined and tested fire should review the adequacy of the insurance cover for the various risks involved. He should also verify the existence of the assets. (iii) Review of compliance with policies, plans, procedures and regulations - It is essential that the various functional segments of an enterprise comply with the relevant policies, plans, procedures, laws and regulations so that the operations are carried out in coordinated manner. The internal auditor should examine whether the management has a system by which its policies, plans and procedures are communicated to all concerned. The information given to each person should be appropriate to his responsibility and authority. It should be in adequate detail to enable him to programme and conduct his own work within the framework of the relevant policies and in accordance with the prescribed procedures in order to achieve that part of the enterprise plan with which he is concerned. The system by which operating personnel are kept informed of amendments to laws and statutory regulations as these affect their decision making and accounting policies is laid down. He should examine whether management formulates the major accounting policies after due regard to their effect on the financial statements both present and future. He should also examine the system of periodical review of existing policies particularly when there is a change in the method and nature of operations of the enterprise. By combining the results of his review of the adequacy of the systems with the result of his compliance tests, the internal auditor should be able to evaluate the effectiveness of the former. He should point out specific weaknesses and suggest remedial action. (iv) Review of relevance and reliability of information - The internal auditor should review the information systems to evaluate the reliability and integrity of financial and operating information given to management and to external agencies such as governmental bodies, trade organisations and labour unions. For the purpose the internal auditor should review the means used for measuring, classifying and reporting information including the records from which the information is extracted. He should examine the accuracy and reliability of financial and operational records. He should review the frequency and timeliness of reports keeping in view the statutory time limits in the case of reports to governmental agencies. He should examine whether the information contained in the reports is meaningful to the users. This involves a study of formats and contents of the reports. It also requires discussions with users to ascertain whether they understand the information correctly. The usefulness of the reports as well as of the records should be evaluated with reference to their costs. The internal auditor should examine whether the reporting is by exception i.e. the reports highlight the significant and distinctive features. (v) Review of the organisation structure - The internal auditor should conduct an appraisal of the organisation structure to ascertain whether it is in harmony with the objectives of

19.4

Advanced Auditing and Professional Ethics the enterprise and whether the assignment of responsibilities is in consonance therewith. For this purpose he should review the manner in which the activities of the enterprise are grouped for managerial control. It is also important to review whether responsibility and authority are in harmony with the grouping pattern. The internal auditor should examine the organisation chart to find out whether the structure is simple and economical and that no function enjoys an undue dominance over the others. He should see whether the lines of authority and responsibility are clearly defined and communicated to all the organisational levels. He should particularly see that the responsibilities of managerial staff at headquarters do not overlap with those of chief executives at operating units. This situation often results in organisational confusion. He should examine whether there is a satisfactory balance between authority and responsibility of important executives i.e., the authority of each executive should be commensurate with the responsibility assigned to him. This can be evaluated by discussing the problems of operations and implementation what various executives. The internal auditor should examine the reasonableness of the span of control of each executive (the number of sub-ordinates that an executive controls). There should be a proper balance between the span of control of different executives at different levels. He should examine whether there is a unity of command i.e., whether each person reports only to one superior. Where dual responsibilities cannot be avoided, the primary one should be specified and the specific responsibility to each senior fixed. This must be made known to all concerned. He should examine whether there is a sufficient flexibility in the day to day working of the organisation and that initiative is not being stifled by a strict adherence to rules. One way of reducing organisational rigidity without sacrificing control is to have a quick and free flow of information within the enterprise. Finally he should evaluate the process of managerial development in the enterprise. This is a vital aspect in a fast growing enterprise. Unless executives are properly groomed to take over positions of responsibilities when senior people retire, there is bound to be organisational chaos.

(vi) Review of utilisation of resources - Management is interested in ascertaining the efficiency and economy with which the resources of an enterprise have been managed and used. Resources are generally tangible production capacity, cash, internal or brought out services etc. In addition, there are certain intrinsic intangible resources of an enterprise e.g. its goodwill in the supplier and customer markets, its standing with government agencies, its reputation with financiers and bankers and its access to new technology. Another vital resource is trained manpower. Tangible resources are depleted through use and in this case management is interested in knowing whether the use has been optimal. On the other hand, intangible resources like goodwill are not depleted through use but may be lost due to bad management or enhanced by good management. The internal auditor should check whether proper operating standards and norms have been established for measuring economical and efficient use of resources. They should be detailed enough to be identifiable with specific operating responsibilities and should be capable of being used by operating personnel for monitoring and evaluating their performance. The internal auditor should review the methods of establishing the operating standards and norms. He should carefully examine the assumptions made

Internal Audit, Management and Operational Audit

19.5

while setting the standards to ensure that they are appropriate and necessary. The variances should be examined to evaluate whether or not the standards and norms are practical. Where there is a wide divergence between actual performance and the corresponding standards, reasons may be looked into. The system of identification and analysis of deviations from standards should be examined. The internal auditor should examine whether analysis of variances is communicated to those concerned in time. He should also examine whether in communicating the variances serious matters are high lighted and whether exceptional variances are communicated more expeditiously than is done in the normal course. As a part of evaluating resources utilisation, identifying the facilities which are under-utilized is an important function of the internal auditor. Such instances may consist of under-utilized machines, unoccupied storage space, huge cash or bank balances, idle man power etc. The internal auditor may also identify understaffing and overstaffing in various areas as these prevent optimum use of resources. While commenting on staffing, the internal auditor should pay special attention to nonproductive work being performed. This would require an enquiry into the job descriptions of employees combined with an intelligent observation of the work being done. Finally the internal auditor should review all procedures with reference to their costs and benefits. One of the factors resulting in inefficiency is that in many cases procedures become hindrance to operations. (vii) Review of accomplishment of goals and objectives - The success of management can be judged by the extent of achievement of goals and objectives of the enterprise. The objectives and goals can be different in different enterprises. Since the entire enterprise should be working toward the accomplishment of its common objectives, management is interested in knowing the extent of lack of contribution of each of them. The internal auditor serves as a medium through which this contribution is evaluate and communicated to the management. He should review the overall objectives of the enterprise to evaluate whether they are clearly stated and are attainable. The translation of such overall objectives into specific objectives for each department and programme should be reviewed. It should be examined whether the objectives are revised periodically in the light of changes in internal and external environment. The internal auditor should examine whether to the extent possible, objectives are expressed in precise quantifiable terms (both monetary and non-monetary) to facilitate detailed planning to be made for achieving them. Budgeting forms an important part of such planning. Line managers who are to implement the plans should fully participate in framing them. This will ensure that plans anticipate the problem areas. There should also be sufficient flexibility in the plans to permit such improvements in their implementation, as would benefit the enterprises as a whole. The responsibility for achieving specific facets of a plan should be clearly identified with the concerned person or department. Apart from these, the internal auditor should examine whether departmental plans are supported by top management. The departmental plan summaries should be sent to concerned managers. These should be discussed and communicated at meetings at which all managers participate.

19.6

Advanced Auditing and Professional Ethics

Independence of Internal auditor 19.3 The definition of internal audit given earlier states that it is an independent appraisal activity. However, we have to carefully note that the import of the word ‘independent’ is largely neutralized by the words ‘within an organisation’. The implication is that since the internal auditor is an appointee, his independence at least with respect to that entity cannot be complete. It may be carefully noted in this connection that the internal audit function is part of the entity and irrespective of the degree of its autonomy and objectivity cannot meet the prime criterion of independence. Yet it cannot be denied that independence of an internal auditor is crucial for effective discharge of his duties. The reporting relationship of an internal auditor can influence his independence. This can be considerably enhanced when the head of the internal audit function reports directly to the highest level in the enterprise and individual audit reports are signed by internal audit personnel who are at a level in the enterprise which is at least equal to the level of the auditor. The internal auditor should be free to communicate fully with the external auditor. As far as possible he should not be involved in operations. Qualifications of Internal Auditor 19.4 The internal auditor should have the special expertise necessary for evaluating management control systems, especially financial and accounting controls. Accounting and finance function continue to be of importance to an internal auditor because they evaluate the activities of the enterprise in terms of a common denominator. Ultimately the success or failure of each function or operation and of the enterprise as a whole is dependent on its ability to maintain its financial viability in the long run. Accounting and finance functions provide basic data for management control of an enterprise. Therefore the internal auditor must have accounting and financial expertise to be able to discharge his duties. The internal auditor is also expected to evaluate operational performance and non-monetary, operational controls. This requires a basic knowledge of the technology and commercial practices of the enterprise. He should also have a basic knowledge of commerce, laws, taxation, cost accounting, economics, quantitative methods and EDP systems. An understanding of management principles and techniques is another essential qualification of an internal auditor as also the ability to deal with people. He should be able to put across criticism in such a manner as would make it acceptable even to the person being criticised. Above all, the internal auditor should have the integrity and detachment of a professional. He often comes across confidential and sensitive information. By his conduct the internal auditor should provide an assurance to the management that confidentiality of such information would be maintained. Internal Audit Report 19.5 The internal auditor’s report contains conclusions and recommendations on the activities audited which are expected to be accepted and acted upon by the management. The management may also use the report to evaluate the performance of the internal auditor. 19.5.1 Essential features of a good internal audit report - The contents of an internal audit

Internal Audit, Management and Operational Audit

19.7

report are influenced by various factors such as the nature of internal auditing function in the organisation, level of reporting, degree of management support and capabilities of internal audit staff. However, for preparing a good internal audit report, the following general rules may be observed. (i)

Objectivity - To maintain the credibility of internal audit function the comments and opinions expressed in the report should be as objective and unbiased as possible.

(ii) Clarity - The language used should be simple and straight-forward. As far as practicable use of technical terms and jargon should be avoided. Each draft of the report should be reviewed by a senior who should attempt to read it from the point of view of the users of the report. (iii) Accuracy - The information contained in the report, whether quantified or otherwise, should be accurate. Where approximation or assumptions have been made the fact should be clearly stated along with reasons, if material. (iv) Conciseness - Brevity is vital subject, of course, to the condition that important information should not be omitted. (v) Constructiveness - Destructive criticism should carefully be avoided in the report. The report should clearly demonstrate that the internal auditor is trying to assist the auditor in an effective discharge of his responsibilities. (vi) Readability - The reader’s interest should be captured and retained throughout. For this, appropriate paragraph heading may be used. (vii) Timeliness - The report should be submitted promptly because if the time lag between the occurrence of an event and its reporting is considerable, the opportunity for taking action may be lost or a wrong decision may be taken in the absence of the information. (viii) Findings and conclusions - These may be given either department-wise or in the order of importance. All the facts and data pertaining to the situation should be assembled, classified and analysed. Each conclusion and opinion should normally follow the findings. Tables or graphs may be used for the presentation of statistical data in appendices; (ix) Recommendations - An internal audit report usually includes recommendations for potential improvements. In order to enable the management to accept and implement the recommendations, the internal auditor should be able to convince the management that the conclusions are logical and valid and the recommendations represent effective and feasible ways of taking action. (x) Auditee’s views - The auditee’s views about audit conclusions or recommendations may also be included in the audit report in appropriate circumstances. (xi) Summary - A summary of conclusions and recommendations may be given at the end. This is particularly useful in long reports.

19.8

Advanced Auditing and Professional Ethics

(xii) Supporting information - The internal auditor should supplement his report by such documents and data which adequately and convincingly support the conclusions. Supporting information may include the relevant standards or regulations. (xiii) Draft Report - Before writing the final report, the internal auditor should prepare a draft report. This would help him in finding out the most effective manner of presenting his reports. It would also indicate whether there is any superfluous information or a gap in reasoning. (xiv) Writing and issuing the Final Report - The final report should be written only when the auditor is completely satisfied with the draft report. The head of the internal auditing department, may review and approve the final report. Before issuing the final report, the auditor should discuss conclusions and recommendations at appropriate levels of management. The report should be duly signed. 19.5.2 Follow-up - The internal auditor should review whether follow-up action is taken by the management on the basis of his report. If no action is taken within a reasonable time he should draw the management’s attention to it. Where the management has not acted upon his suggestions or not implemented his recommendations, the internal auditor should ascertain the reasons therefor. In cases where he finds that non-implementation is due to a gap in communication, he should initiate further discussion in the matter. Where the management has accepted his recommendations and initiated the necessary action, the internal auditor should periodically review the manner and the extent of implementation of the recommendations and report to the management highlighting the recommendations which have not been implemented fully or partly. Relationship between internal and external Auditors 19.6 According to AAS 7, the scope and objective of internal audit are dependent upon the size and structure of the entity and the requirements of its management. As stated earlier the internal auditor operates in various areas such as review of accounting system and internal control; examination of financial and operating information for the benefit of management, examination of the economy, efficiency and effectiveness of operations including non-financial controls of various tangible assets of the entity. While operating in these areas, there is lot of overlapping between the work of internal auditor and external auditor. The work done by internal auditor has an important bearing on the work performed by the statutory auditor as evaluation done by the internal auditor in respect of internal controls, reliability of financial information, verification of assets etc. is also required to be done by the external auditor. The statutory auditor appointed under the Companies Act, 1956, is also required to examine in specified cases of companies, whether the internal audit is commensurate with the size and nature of its business in terms of CARO, 2003 issued under Section 227-4A of the Companies Act, 1956. It should, however, be remembered that while external auditor holds responsibility for his report and for the determination of the nature, timing and instant of the audit procedures, much of the work of the internal audit function may be useful to him in his examination of financial information. AAS-7 on “Relying upon the work of an Internal Auditor”

Internal Audit, Management and Operational Audit

19.9

deals with the relationship between internal and external auditors which is discussed in following paragraphs. The role of the internal audit function within an entity is determined by management and its prime objective differs from that of the external auditor who is appointed to report independently on financial information. Nevertheless, some of the means of achieving their respective objectives are often similar and thus much of the work of the internal auditor may be useful to the external auditor in determining the nature, timing and extent of his procedures. The external auditor should, as part of his audit, evaluate the internal audit function to the extent he considers that it will be relevant in determining the nature, timing and extent of his compliance and substantive procedures. Depending upon such evaluation, the external auditor may be able to adopt less extensive procedures than would otherwise be required. By its very nature, the internal audit function cannot be expected to have the same degree of independence as is essential when the external auditor expresses his opinion of the financial information. The report of the external auditor is his sole responsibility, and that responsibility is not by any means reduced because of the reliance he places on the internal auditor’s work. 19.6.1 General evaluation of internal audit function - The external auditor’s general evaluation of the internal audit function will assist him in determining the extent to which he can place reliance upon the work of the internal auditor. The external auditor should document his evaluation and conclusions in this respect. The important aspects to be considered in this context are : (a) Organisational Status - Whether internal audit is undertaken by an outside agency or by an internal audit department within the entity itself, the internal auditor reports to the management. In an ideal situation his reports to the highest level of management and is free of any other operating responsibility. Any constraints or restrictions placed upon his work by management should be carefully evaluated. In particular, the internal auditor should be free to communicate fully with the external auditor. (b) Scope of Function - The external auditor should ascertain the nature and depth of coverage of the assignment which the internal auditor discharges for management. He should also ascertain to what extent the management considers, and where appropriate, acts upon internal audit recommendations. (c) Technical Competence - The external auditor should ascertain that internal audit work is performed by persons having adequate technical training and proficiency. This may be accomplished by reviewing the experience and professional qualifications of the persons undertaking the internal audit work. (d) Due Professional Care - The external auditor should ascertain whether internal audit work appears to be properly planned, supervised, reviewed and documented. An example of the exercise of due professional care by the internal auditor is the existence of adequate audit manuals, audit programmes and working papers. 19.6.2 Co-ordination - Having decided in principle that he intends to rely upon the work of the internal auditor, it is desirable that the external auditor ascertains the internal auditor’s

19.10

Advanced Auditing and Professional Ethics

tentative plan for the year and discusses it with him at as early a stage as possible to determine areas where he considers that he could rely upon the internal auditor’s work. Where internal audit work is to be a factor in determining the nature, timing and extent of the external auditor’s procedures, it is desirable to plan in advance the timing of such work, the extent of audit coverage, test levels and proposed methods of sample selection, documentation of the work performed, and review and reporting procedures. Co-ordination with the internal auditor is usually more effective when meetings are held at appropriate intervals during the year. It is desirable that the external auditor is advised of, and has access to relevant internal audit reports and in addition is kept informed, along with management of any significant matter that comes to the internal auditor’s attention and which he believes may affect the work of the external auditor. Similarly, the external auditor should ordinarily inform the internal auditor of any significant matters which may affect his work. 19.6.3 Evaluation of specific internal audit work - Where, following the general evaluation as described above, the external auditor intends to rely upon specific internal audit work as a basis for modifying the nature, timing and extent of his procedures, he should review the internal auditor’s work, taking into account the following factors: (a) The scope of work and related audit programme are adequate for the external auditor’s purpose. (b) The work is properly planned and the work of assistants is properly supervised, reviewed, and documented. (c) Sufficient appropriate evidence is obtained to afford a reasonable basis for conclusions reached. (d) Conclusions reached are appropriate in the circumstances and any reports prepared are consistent with the results of the work performed. (e) Any exceptions or unusual matters are disclosed by the internal auditor’s procedures. The external auditor should document his conclusions in respect of the specific work which he has reviewed. The external auditor should also test the work of the internal auditor on which he intends to rely. The nature, timing and extent of the external auditor’s tests will depend upon his judgement as to the materiality of the area concerned to the financial statements taken as a whole and the results of his evaluation of the internal audit function and of the specific internal audit work. His tests may include examination of items already examined by the internal auditor, examination of other similar items, and observation of the internal auditor’s procedure. Finally, in India even the statute has now recognised that internal audit is necessary for efficient running of companies. The order under Section 227 (4A) now requires the statutory auditor to state in case of list companies and/or other companies with a paid-up capital and reserves exceeding Rs. 50 lakhs or having an average annual turnover exceeding Rs. 5 crores, whether the company has an internal audit system commensurate with its size and nature of business. Thus a review of the internal audit function in large companies has become a statutory responsibility for the statutory auditor.

Internal Audit, Management and Operational Audit

19.11

Refer to Annexure I for Internal Audit Standard 1” Planning of Internal Audit”. Students are advised to study Preface to the Standards and Guidance Notes on Internal Note for reference. Management Audit 19.7 There have been many calls in recent years for a more pluralistic approach to financial reporting to incorporate comments on the efficiency with which the company has conducted its affairs. As directors’ comments on the company efficiency are not likely to be entirely objective, this task, it is proposed will fall on the company auditors; or on additional auditors appointed specially for this purpose. Proposals for such audits have been made under various titles like, ‘management audit’, ‘management efficiency audit’, efficiency audit or ‘operations audit’. The authors of these proposals often try to draw subtle distinction between these terms. This is largely semantic; however the only practical distinction is whether the audit should be confined to the efficiency of the management team in pushing through the company objectives, or whether it should intend to include the objectives themselves, and hence the effectiveness of directors. Not surprisingly most directors concur with the former view. But a review of the efficiency of the management team would have to be both ongoing and in considerable detail to be meaningful, and it is therefore much more suited to a internal audit function. Indeed many companies already have management audit as part of their internal audit procedures. But such audits are for the directors’ information. So they are a far cry from an evaluation of the efficiency of directors themselves such as is currently being demanded. 19.7.1 Evolution - Auditing like any other social discipline is basically evolutionary in character and shapes itself according to the needs of the time and the occasion. The influences that have left their mark on the evolutionary development of auditing can be ascribed to a number of factors, like development of accounting principles, industrialisation, corporate form of business, separation of business ownership and management, laws, rules and regulations framed by the legislatures and government, formation and development of accounting professional bodies throughout the world and their pronouncements and the judgements of various courts in cases involving accountants and auditors duties, responsibilities, rights, and privileges. In recent years, the world has witnessed a rather new type of revolution viz. managerial revolution. Management of enterprises is itself a science and techniques and principles have been formulated for practising this science; a proper practice of this science will ensure an objective and efficient management of the affairs of any economic activity. This revolution has considerably changed the composition and outlook of management. Auditing has come to be viewed as an essential management tool, among others, for the efficient running of business and other economic activities. When we speak of auditing as a management tool, we give an extended coverage to the term auditing without, however, altering its basic concept. This extended concept of auditing includes operational auditing. Auditing is generally associated with accounting activities or events. These activities or events are expressed in monetary terms. For this reason, we sometime try to take a narrow view of matters, that auditing is concerned with only the monetary accounting data. When we take this narrow view we lose sight of the fact that auditing basically and conceptually concerns itself

19.12

Advanced Auditing and Professional Ethics

with collection and appraisal of evidence underlying transactions that are quantifiable and not necessarily expressed in monetary figures. Auditing naturally looks to fields far more extensive than merely monetary accounts. Traditionally, auditing has been financially oriented, focusing on the correctness of accounting records and the propriety of activities contained in the records. However, its emphasis has been changing over the years. It is now responding to a demand for more useful information that cannot be found solely in financial statements. In the late 1940’s, for example, financial analysts and bankers showed a desire for information suitable for managerial appraisal. Today, stock holders, investors, government bodies, and the general public are seeking information by which the “quality of management” can be judged. As a result of this awakened interest of outsiders in judging the merits of organisations, there has arisen a similar movement from within organisations to judge the results of operations and their managers. However, one fact must be accepted in extending the field of auditing. The attitude and approach of the auditor and his mental training have to undergo a change so as to be able to understand, become familiar with and appraise data and events that are not expressed in rupees. In other words, auditors have to acquire management attitudes and should be able to view matters as management may view them. 19.7.2 Management and Operational Audit - The concept of operational audit is discussed in detail later in the chapter. Operational audit is an audit for the management; it is undertaken at the instance of the management for providing it with information and appraisal of operations and activities. A parallel development in auditing is getting shaped as management audit. In fact some of the authors do not see any difference between operational auditing and management auditing. They probably see that both these audits are for the management and cover operational areas that do not come under the review of the traditional audit. They are correct also to this extent. But they miss one important aspect of management audit, which has made it distinct from operational audit, i.e., management audit is an “audit of the management” also. According to T.G. Rose, “The management audit would therefore concern itself with the whole field of activities of the concern, from top to bottom, starting, as always where management control is concerned, from the top, because we are primarily concerned with whether the general management is functioning smoothly and satisfactorily. If it is not, it may be due to the functional management being faulty and, therefore, we pass on to examine that in its turn, in order to find the missing or faulty link which is causing the trouble.” From the very able conceptualisation contained in the above quoted passage, it is somewhat clear what should be the scope and content of management audit. It should definitely cover everything that we know as operational audit and, in addition it should also include review of the adequacy and competence of the objectives, plans, policies and decisions of the top management. However, as has been indicated above, unanimity is lacking on this aspect and management audit has become a subject of debate. John C. Burton, in the article “Management Auditing” (The Journal of Accountancy, May 1968) commented as follows: “In a management audit, the auditor will look to see whether management is getting information relevant to the decisions and actions which it must take. This will require a much more intensive analysis of information needs and the efficiency of the existing system in

Internal Audit, Management and Operational Audit

19.13

meeting them. The auditor will not have to decide whether management is making the right strategic and operative decisions but rather whether management has available to it and is using the relevant information and techniques necessary to evaluate rationally the various alternatives that exist”. Management audits are concerned with appraising management’s accomplishment of organisational objectives; the management functions of planning, organising, directing, and controlling; and the adequacy of management’s decisions and actions in moving towards its stated objectives. Hence, the accent is on evaluating managers’ ability to manage. 19.7.3 Scope - From the authorities quoted above, it seems that the preponderant view about management audit is that it is wider in scope compared to operational audit. However, a distinction should be made between management audit and operational audit. Management audit is concerned with the quality of managing, whereas operational audit centres on the quality of operations. The basic difference between the two audits, then, is not in method, but in the level of appraisal. As will be noted in the comprehensive management questionnaire presented in this text, some of the questions may appear to be of an operational nature. Actually, these questions are meant to appraise the manager’s ability to perform his or her assigned tasks. Thus, the two audits are complementary and supplementary to one another. In management audit, the auditor is to make his tests to the level of top management, its formulation of objectives, plans and policies and its decision making. It is not that he just verifies the operations of control and procedures and fulfilment of plans in conformity with the prescribed policies. He is to reach the root i.e., the functions of top management which lay down objectives and policies, provide means and procedures of implementation and control and which actually engage in direction and control on a continuous basis. In addition to what would normally be covered in an operational audit, management audit would also encompass the relevance and effectiveness of the aims, duties and decisions of management at various levels. Every aspect of the functions of Board of Directors should be in conformity with the objects set out in the constituting document. Similarly the managing director, if any, should act not only in accordance with the mandate he has received but he should ensure that the decisions he takes are in conformity with the objects of the company and the policies formulated by the Board. The effectiveness of management under the control of managing director and the various members of the Board including those incharge of finance, production, sales etc., should be subject to review of the management auditor. From the point of view of the management auditor, knowledge about the following is essential: (i)

Purpose for which the organisation has been created. For example, purpose of a steel mill in the state sector may include: (a) production of steel to reduce imports of steel. (b) creation of reasonable employment opportunities. (c) development of backward areas. (d) providing staff welfare consistent with the needs for a proper living.

19.14

Advanced Auditing and Professional Ethics

It should not be understood that such steel mill will not work for profit. Profit being one of the objects, should be properly balanced with other objects so that the purposes for which the organisation was created can be achieved. (ii)

Management structure including delegation of authority, planning and budgeting.

(iii) Reports required for a proper management and the reports actually received. (iv) Internal controls. (v) Nature of production of the business concerned in the broad way so that he can understand the flow and content of work leading to production and their mutual relationships. Some ideas about the techniques, formulas, raw materials and personnel requirement would be of direct assistance to the management auditor. (vi) Production planning (vii) Factory layout, design and installed capacity (viii) Personnel policy and personnel management including requirements, training, welfare, incentives and disincentives. (ix) Materials management including sources of important raw materials, receipt of materials of the quality and quantity needed, storage, supervision and safe custody, insurance and the procedure for issue of materials. (x) Sales management and sales planning including advertisement policy. (xi) Decision making process. (xii) Books and records including cost accounting records, cost accounting system and financial accounting policies. (xiii) Financial management of the organisation. In view of the analysis made above which recognises management audit and operational audit as two identifiable exercises having a large area of overlapping jurisdiction, it may be convenient to consider them together to avoid duplication; and for this purpose the expression “management and operational audit” may be acceptable as a management audit which includes within its scope all the elements of operational auditing. 19.7.4 Desirability of Management Audit - Management Audit is a tool to improve management performance by recognising facts and information about management presented after appropriate examination, verification and evaluation, by professionally qualified and competent people. Naturally, any organisation of a reasonable size may be able to derive benefit from this form of audit which is distinctly different from annual statutory financial auditing and deeper and broader than the conventional internal auditing. Management audit focuses attention on a comprehensive and constructive examination of the organisational structure, its components such as, divisions, departments, ventures, plans, policies, its financial control system, its method of operation, its appropriate use of human, physical and financial resources. The principal reason for undertaking a management audit is the need for detecting and

Internal Audit, Management and Operational Audit

19.15

overcoming current managerial deficiencies (and resulting operational problems) in ongoing operations. Unlike the annual review by outside accountants, which focuses on financial results of the past year and thus is backward-looking, a management audit represents a more positive, forward-looking approach that evaluates how well management accomplishes its stated organisational objectives; how effective management is in planning, organising, directing, and controlling the organisation’s activities; and how appropriate management’s decisions are for reaching stated organisation objectives. This evaluation of managerial performance is achieved with the aid of a management audit questionnaire. Whether management evaluation through use of the questionnaire is performed by an outside auditing or consulting firm, the consulting staff within the organisation, or selected members of the organisation is immaterial. The important point is, that some group is charged with the responsibility to undertake this evaluation process periodically. One benefit of the management audit, then, is that managerial problems and related operational difficulties can be spotted before the fact rather than after the fact as with a financial audit. This forwardlooking approach is analogous to the preventive maintenance concept found in production; that is, periodic management audits can pinpoint problems as they are developing from a small scale. In comparison, detecting the same problem at a later time, when they have generally increased in scope, results in higher costs to the organisation. A second important benefit of management auditing is that it represents another management tool to assist the organisation in accomplishing desired objectives. The capability of the management audit questionnaire to pinpoint important problem areas that are related to managing an organisation is a real plus factor for its use. Business failures are caused largely by poor management. What better way can this important problem be overcome than by employing management audit in an objective manner? If certain managers are ineffective in their present positions, appropriate corrective action should be taken. Obviously, management auditing would be clearly helpful in the case of ailing industries, to isolate the problems and account for their ailments. It is specially important if such industries are either to be taken over by the government or to be heavily financed by financial institutions with a view to bring back vigour in them. Before committing public funds, like government funds or the institutional funds, it is important to properly diagnose the financial health and possibilities of a business undertaking and know the specific reasons that have caused or contributed to the decline of the business. Given bad management, any amount of money pumped in may go waste; similarly, without proper knowledge of the causes of sickness, government takeover may not cure the ills. Even a sound entity may also benefit from a periodical management audit; further improvement in its operations can be effected, the brewing or latent problems may be detected and analysed and opportunities or difficulties created by changing circumstances can be known. 19.7.5 Organising the Management Audit -The establishment of a general programme for management audit requires management’s approval to the plan. Unless the management’s full support is available for the proposal, there may be lot of difficulties at later stages. Therefore, it is imperative to give consideration to a statement of policy which indicates therein the objectives and which reflects a definite plan to achieve the objectives while organising for management audit. The plan should also include the statement on personnel requirements,

19.16

Advanced Auditing and Professional Ethics

establishment of staff training programmes to improve the effectiveness of work and the basis of control over time and cost. These, being the basic features are discussed below at length with related matters. Devising the statement of policy - The management’s support must be reflected clearly and categorically in the company’s highest policy statement. The policy statement should be quite specific. It should spell out clearly the scope and status of the management/operational auditing within the enterprise, its authority to carry out audits, issue reports, make recommendations, and evaluate corrective action. The statement of policy should lay down in clear terms the scope of activities to be performed by the management auditor. The scope of activities is the most basic requirement for building up a successful management audit programme both for small as well as a large organisation. Thus, a comprehensive statement of policy provides definite understanding to management concerning the nature of audit to be performed and the scope and details of audit work to be carried out. This then will become the charter under which the management auditor should operate. In this charter, will be set forth, for the rest of the company to see, how executive management regards the purpose, mission and authority of the function of management auditor within the company. The statement must afford the auditor all the authority he needs yet does not assign responsibility which he cannot conceivably carry out. The statement must categorically say that the management auditor is capable of reviewing administrative and management controls over any activity within the company. However, he should not be expected to extend his activities to the evaluation of performance of professional and technical activities calling for specialised knowledge and skills and suggest remedies unaided by people competent to undertake such evaluation. Location of audit function within the organisation - Some organisations depending upon their size and nature of have established a separate department of audit specialists where the head of the department reports directly to the top executive. In certain cases, the audit group may be a part of the activities of management services department, administrative control department or some other unit of organisation. The more important question, however, is that the function should be as entirely independent as possible of pressure from various groups in the enterprise. The greater the independence, greater is the freedom to work effectively. Therefore, it is better to place the auditing function quite high in the organisation. The minimum requirement for the auditing organisation is to report to an officer whose status is such that he can command prompt and proper consideration of the auditor’s opinion and recommendations. Preferably that officer should be a member of the Board. One of the controversies that is usually raised is whether the management auditor should report to the finance director, to whom he may be administratively responsible or to the managing director where the has no administrative responsibility. A third opinion would like the auditor to report to an audit committee, comprising of senior executives of the company who are preferably Board members. A different school of thought would like auditors to report to both the finance director and the audit committee. Though the controversy rages and no definite solution can be arrived at, it is felt that the controversy regarding which of these persons the management auditor should report to is not much substance where independence exists. Independence of the management auditor is not necessarily related to the person/persons he reports. His independence is entirely dependent on the management’s attitude towards audit, the

Internal Audit, Management and Operational Audit

19.17

credibility the management auditor has with the management and the management’s positive will to listen to criticism for self betterment. Allocation of personnel - Whatever be the size of the enterprise, it is important that all persons selected and assigned to audit possess a good understanding of auditing theory, a thorough knowledge of the fundamentals of both organisation and management, the principles and effective methods of control, and the requirements for conducting scientific appraisal. “General Guidelines on Internal Auditing” issued by the Institute also emphasise these qualifications for an auditor whose area extends beyond the review of financial controls. As the management auditor is expected to evaluate operational performance and non-monetary operational controls, he should possess basic knowledge of the technology and commercial practices of the enterprise, an enquiring, analytical, pragmatic and imaginative approach and a thorough understanding of the control system. The management auditor should also have a basic knowledge of commerce, law, taxation, cost accounting, economics, quantitative methods and EDP systems. Knowledge in these areas would be adequate for him to identify problems and to determine steps to be taken when a problem is identified. It does not mean that management audit should be assigned to engineers, computer experts and others. Rather persons having sound accounting background alongwith general knowledge of other relevant disciplines are best suited to perform this job. Because the profession of accountancy basically teaches a systematic and analytical approach to a problem, it is this methodical approach which is the guiding note to an audit function of review of controls. In personal characteristics individuals assigned to the job should have an inclination towards analysis, a high degree of imagination and an ability to write and express themselves clearly and logically. Staff training programme - A continuous training programme is necessary to achieve quality in performing audit assignments because the management auditor must keep a breast of new ways to improve auditing standards. An effective training programme enables staff to assume additional responsibilities and advancements in the organisation. Thus the programme acts as an incentive for drawing capable people into the department and keeping them. Time and other aspects - The time required to carry out a management audit will vary, depending upon the extent and nature of assignment. For example, the time required to perform an audit of the entire activities of an organisation’s purchasing department might take a few weeks, while an audit of the entire business could take several months. Much depends upon the size of the activity. An appraisal of a plant’s standard cost system might also simultaneously include an appraisal of the departmental budgetary control system. In a study of the results of sales contacts and selling efforts in the field, one might find it feasible to study the expense reports and other costs incurred in making contacts. In the evaluation of the method of scheduling production in a plant, one might well take a good look at the sales department’s method of compiling and preparing the sales forecast. The time and cost will vary for each assignment, depending upon the nature of the assignment, the number of auditors assigned to perform the work, and whether or not more specialists in a particular field are required. An audit of a production planning and control department, for example because of its size and other factors, could require an audit staff of several persons and, in addition, a specialist in production planning and one in production control. If an assignment is one which requires technical assistance of a nature unavailable within the audit group, it might be

19.18

Advanced Auditing and Professional Ethics

advisable to seek a qualified outside consultant to perform the work. Frequency - Having specified various approaches to management audit, including its scope and its staffing requirements the last item that should be considered before undertaking such an audit is its frequency. Prime consideration should be given to the nature of the organisation. Is the company in a fast-changing industry where there is great accent on the latest technology in the company’s products and/or services? When the organisation is subject to rapid change or the total resources utilised are expensive, the frequency of management auditing should be greater than when it does not undergo rapid changes or the resources employed are not high in value. In essence, management audits should be made often enough to provide protection against growing problems. On the other hand, they should not be so frequent as to lead to repetitious results of questionable value. To get an idea of the optimum frequency of such an audit, it might be worthwhile to look at financial audits. Customarily, financial audits are conducted annually. They are highly programmed, since an internal control questionnaire is utilised to attest to accounting methods and procedures. By contrast, a management audit should be considered from a longer time frame. For an organisation, that is subject to rapid changes or consumes a great amount of high-cost resources, a two-years basis might be adequate to protect it from managerial and operational problems becoming entrenched or too large. For those organisations in a relatively stable industry, the frequency of audit can be every three years. In no case should the interval be allowed to exceed three years. 19.7.6 Conducting a Management Audit - Once top management has decided on the scope, the staffing, and the frequency of the management audit, the next phase is the undertaking of actual audit. This involves investigating and analysing the present facts through interviews as well as completing a management and questionnaire so as to determine the problems confronting the organisation. Getting the facts through interviews - To avoid waste of time and effort, adequate preparation is necessary in management auditing just as in financial auditing. The management auditors should know what information is desired, and they should be prepared to ask a number of direct questions to get the desired information. Reference can be made to the management audit questionnaire for specific questions. Care must be taken in selecting the proper managers to interview so as to obtain pertinent information. Needless to say, the persons to be interviewed must be notified beforehand, and they should be informed what reports, records, or other documentation should be available at the time of the interview. Following the foregoing interview procedures will provide the management auditors with pertinent information that is necessary for a successful management audit. In the interview itself, the auditors should begin by stating the purpose of the audit. Emphasis should be placed on getting the facts that are essential to review and appraise the functional area(s) under study. The exchange between auditor and manager should be friendly and conducted in an open atmosphere so as to encourage a free exchange of ideas. The manager’s opinions on different items should be allowed to free expression. Of course, they may be disregarded in the report and in subsequent discussions with other company managers if so desired by the manager. It is important that the auditors be tactful and

Internal Audit, Management and Operational Audit

19.19

diplomatic at all times. Failure on this one point may result in the management auditors getting only part of the desired information. It is always wise to listen to tentative solutions set forth by the manager for problems that confront him or her. Many times these solutions can be made an integral part of final recommendations, and when the manager sees that his or her solutions are included in the final report, the individual is more apt to support the recommendations. Thus, management auditors will experience less opposition at the end of the engagement by utilising this approach. Also, during the interview, management auditors should not commit themselves, nor should any recommendations be set forth at this time. Once all pertinent information has been extracted from the interview, it is advisable to verify the accuracy of information by requesting the person interviewed to read the notes taken and place his or her initials thereon. This extra step makes the individual feel an important part of management audit. Measuring performance through the Management Audit Questionnaire - During the interview, the management auditors make a careful inquiry into important facts. The next step is to analyse this information, with the aim of measuring current performance. The best way to perform such an analysis is to utilise the sections of the management audit questionnaire that apply to the areas under study. By way of review, a management audit questionnaire aims at a comprehensive and constructive examination of an organisation’s management and its assigned tasks. Overall, the questionnaire is concerned with the appraisal of management actions in accomplishing organisation objectives. Its primary objective is to highlight weaknesses and deficiencies of the organisation for possible improvements. More specifically, it includes a review of how well or badly the management functions of planning, organising, directing, and controlling are being performed. In addition, it evaluates how effective the decision-making process is in accomplishing stated organisation objectives. Within this framework, the questionnaire provides a means for evaluating an organisation’s ongoing operations by examining its major functional areas. Before discussing the benefits and problems of undertaking a management audit, it is important to understand what the questionnaire is designed to accomplish. It does not provide answers; it simply asks questions. The questions are asked to help bridge the gap between management theory and practice. Every manager must deal with a specific situation when involved in managerial problem solving. Hence, the questions that are asked within the various sections of management audit questionnaire are designed to aid the manager to sort out those factors, forces, and effects that are relevant to the situation being studied. From this viewpoint, the questionnaire is designed to evaluate management practices. There are three possible answers to the management audit questions: “yes”, “no”, and “N.A.” (not applicable). A “yes” answer indicates that the specific area, function, or aspect under study is functioning in an acceptable manner; no written explanation is needed in that case. On the other hand, a “no” answer indicates unacceptable performance and should be explained in writing. Questionnaire comments on negative answers not only provide documentation for future reference, but, more important, provide background information for undertaking remedial action. Those questions that are not applicable and should be ignored in the audit are checked in the “N.A.” column.

19.20

Advanced Auditing and Professional Ethics

In any case, these questions are designed to help an individual evaluate real world situations. As such, the questions should be approached from a research-oriented frame of reference. If all questions are answered with a ‘yes’, operations are proceeding as desired. On the other hand if there are one or more ‘no’ answers, difficulties are being experienced and must be explained in writing. If the question does not apply, the N.A. (not applicable) column is checked. Thus management audit questionnaire for this part of the audit not only serves as a management tool to analyse the current situation; more importantly, it enables the management auditors to synthesise those elements that are causing organisational difficulties and deficiencies. To state it another way, a synthesis (a process of combining separate elements) can be used for determining the problem. The capability to assess all negative answers goes a long way towards defining the real problem-not just stating its symptoms. 19.7.7 Concluding a Management Audit - The preparation of the management audit report that covers the details of the management auditor’s findings and recommendations represents an important part of concluding an audit assignment. To assist in the preparation of the final report, the management auditors normally meet with management and other concerned personnel for the purpose of discussing freely any aspect or finding of the audit. This approach assists the independent third party in bringing together the important elements of audit as well as determining appropriate recommendations. Also, it will disclose any “hangups” that organisation personnel may have towards a particular solution. It is far better to discuss alternative recommendations and feel out the possible consequences of recommended action. In this way, when corrective actions are undertaken, the resulting consequences can be predicted, thereby avoiding unworkable solutions. Because of the importance of the oral presentation of recommendations and the final report to management, these areas are covered in some depth below. However, it should be noted that the type of report required varies with the level of investigation. Thus, a comprehensive investigation involves a report that is very broad in scope, while a smaller-scale investigation of one or two functional areas will result in a less comprehensive report. Oral recommendations for improvement - From the management viewpoint, the main focus of audit is recommendations. Generally, there is an oral presentation of specific recommendations to members of the top management team who approved the audit. In some cases, the approval may have come from the board of directors, which then becomes the recipient of the auditors’ oral recommendations. Upon completion of the presentation, oral recommendations become an integral part of the final report- the subject matter for the next section. In the oral presentation, recommendations representing feasible solutions that will be accepted without too much difficulty are discussed initially. This gives the management auditors an opportunity to establish their credibility. The auditors should back these recommendations with a cost/benefit analysis that indicates the expected return to the organisation from implementing them. Where implementation may be difficult because of personality problems, organisational changes, and the like, the auditors should still push their proposals if their benefits exceed their costs. In essence, those recommendations that are necessary to assist in fulfilling organisation objectives in a more efficient and economical manner should be presented for implementation. However, it should be noted that if certain

Internal Audit, Management and Operational Audit

19.21

recommendations are not, accepted during the oral presentation, it is wise to offer alternatives. In the consulting profession, this is known as the “escape route”. In other words, “cover your tracks” and “be prepared at all times.” An integral part of the oral presentation is determining when and where the recommendations can be put into operation. The interchange of ideas among management and the auditors allows for a logical development of appropriate dates for implementation. Additionally, it assists management auditors in drawing up an implementation time-table for inclusion in their final report. 19.7.8 Management Audit Reports - The written report is the medium by which the comments, criticisms and recommendations of a management audit department are conveyed to the Board, to functional directors and to management in general. It follows, therefore, that audit reports crystallise the work of the management auditor and merit the closest consideration of all audit staff engaged in their preparation. Reports must be written with very great care after full consideration of the subject matter and with full regard to the fact that it is imperative that the report conveys exactly the right impressions on the reader. Management audit reports will inevitably cover a wide variety of subjects, reflecting as hey do the many and ever increasing ramifications of management audit departments. Broadly, however, reports may be divided into four main categories: 1.

Reports prepared by the management audit staff after their visits to a unit.

2.

Periodical reports prepared by senior members of management audit department which summarise the main audit findings and recommendations for the period under consideration and which afford a concise review of the department’s activities for that period.

3.

Reports on the results of special investigations and inquiries.

4.

An annual audit report.

The right of the management auditor to report to the highest level is now well established in many organisations but in all cases responsible officials of the different units which have been subjected to audit should be afforded the opportunity of discussing matters in the report concerning their departments before this is passed in final form to a higher level. Types of Reports - The reporting of results covers a wide spectrum of types. We can describe the more important ones as follows: Oral reports - In many situations, the reporting of results will be on an oral basis. To some extent, this is inevitable since a part of the actual audit effort is carried on in conjunction with company personnel. In other cases, it is a result of emergency action needs. It may also be a prelude to more formal written reports. To some extent, there will always be oral reporting as a means of later supplementing written reports, especially when individuals being served have special needs. Oral reporting therefore, serves a useful and legitimate purpose. It is recognised that it has a major limitation that there is no permanent record. As a result there are more likely to be later misunderstandings. What is important, therefore, is that this type of reporting be used carefully and for all significant matters, specially the matters covered by emergency oral reporting, should be followed up immediately by a written report giving reference to oral reporting. For example, a management auditor, if he has come across any

19.22

Advanced Auditing and Professional Ethics

embezzlement, should immediately inform the concerned management orally, so that steps may be immediately taken to prevent further embezzlement. Interim written reports - In situations where it is deemed advisable to inform management of significant developments during the course of the audit, or at least preceding the release of the regular report, there may be some kind of interim written report. This report may pertain to especially significant problems where there is a need for early consideration. or the report may be of a progress nature. In either case, they may be quite formal in nature or of the more informal type of current memoranda. They can be reserved for very exceptional developments, or issued on a more extensive basis. Often, their distribution is limited to this auditee management, but this is not necessarily the case. Normally interim reports are full, covered in the final regular reports unless certain matters included in the interim report have been cleared/ rectified to the auditor’s satisfaction. All in all, interim reports represent a type of reporting which, when used with judgement, can be a good device to improve the total reporting process. Regular written reports - In the typical situation, the particular audit assignment will include the preparation of a formal written report. The form and content of such written reports will vary widely, both as between individual audit assignments and individual companies. They may be short or long. They may be presented in many different ways, including the extent to which quantitative or financial data are re-included. We will in the later pages discuss in more detail the organisation and planning of this type of report. Summary written reports - These summary reports are also referred to as ‘flash’ reports. In a number of companies the practice has developed of issuing an annual (or sometimes more frequent) report summarising the various individual reports issued, and describing the range of their content. These summary reports in some cases are primarily for audit committees of Boards of Directors, but in other cases for higher level management. They are especially useful to top level managers who do not actively review the individual reports. They are also useful to the general auditor in seeing his total reporting effort with more perspective and on an integrated basis. Organisation of the written report Format - Though it is difficult to lay down a format applicable to all situations, yet the following general guidelines may be observed: (i)

Title - The management audit report should have a short but descriptive title so that its subject matter can be easily identified.

(ii) Objectives - The management auditor may describe the objectives of the audit assignment. (iii) Scope - The management auditor may give a brief description of the activities audited by him. (iv) Findings, conclusions and opinions - These may be given either department wise or in the order of importance. All the facts and data pertaining to the, situation should be assembled, classified and analysed. Each finding should be discussed comprehensively

Internal Audit, Management and Operational Audit

19.23

and correlated with other findings. Conclusions and opinions should normally follow the findings. Tables or graphs may be used for the presentation of statistical data in appendices. (v) Recommendations - A management audit report may include recommendations for potential improvements. However, care should be taken in making recommendations in order that the auditor’s own objectivity may not become subject matter of question. He may point out defects and make recommendations in a broad manner on how to overcome them. He should avoid providing detailed procedures in the capacity of an auditor. Normally specifying procedures etc. should rest with consultants. (vi) Auditee’s views - The auditee’s views about audit conclusions or recommendations may also be included in the audit report in appropriate circumstances. (vii) Summary - A summary of conclusions and recommendations may be given at the end. This is particularly useful in long reports. Planning the Audit Report - Before starting the report, the auditor should ask himself, “What do I want to tell the reader about this audit? The answer will enable him to communicate effectively. Supporting information - The management auditor should supplement his report by such documents and data which adequately and convincingly support the conclusions. Supporting information may include the relevant standards or regulations. Preparing draft report - Before writing the final report, the auditor should prepare a draft report. This would help him in finding out the most effective manner of presenting his report. It would also indicate whether there is any superfluous information or a gap in reasoning. Writing and issuing the final report - The final report should be written only when the auditor is completely satisfied with the draft report. The head of the management auditing department may review and approve the final report. Before issuing the final report, the auditor should discuss conclusions and recommendations at appropriate levels of management. The report should be duly signed and dated. Follow-up of the audit report - The management auditor should review whether follow-up action is taken by management on the basis of his report. If no action is taken within a reasonable time, he should draw management’s attention to it. Where management has not acted upon his suggestions or not implemented his recommendations, the auditor should ascertain the reasons therefor. In cases where he finds that non-implementation is due to a gap in communication, he should initiate further discussions in that matter. Where management has accepted his recommendations and initiated the necessary action, the management auditor should periodically review the manner and the extent of implementation of the recommendations and report to the management highlighting the recommendations which have not been implemented fully or partly. Any nonimplementation of the management auditor’s report in continuing assignments, after having convinced that the communication of the report was complete should be earnestly taken up because on this the credibility and usefulness of the audit function largely depends. It also

19.24

Advanced Auditing and Professional Ethics

reflects management’s attitude to audit. In any case, the auditor to retain the usefulness of audit function should ascertain from the management, preferably in writing, the reasons for non- implementation. It is possible that because of change in circumstances, the audit observation did not require any action on the part of the management. 19.7.9 Behavioural aspects encountered in a Management Audit - It has been experienced that one of the biggest difficulties involved during the course of management audit is that people working in the organisation do not wish to accept any change. While at the time of conducting interviews, it seems that people working in the organisation are amenable to change but at the time of actual implementation they come up with stiff resistance to proposals on account of various behavioural problems arising on this account. Such an unfortunate situation can be avoided by building up a positive approach to management audit and involving the various organisation personnel right from the initiation of the management audit. Another fear which haunts executives working in the organisation is that the management auditors’ recommendations may lead to their removal or reshuffling in the process. This problem may also be overcome by explaining to these executives that the management auditor is there to help them in achieving the results rather acting against their interests. Various problems arising on account of behavioural attitudes and solutions to overcome them during the process of management audit are discussed in the following paragraphs. Financial auditors deal mainly with figures. Management auditors deal mainly with people. Management auditors in the normal discharge of their duty will come into contact with the following: (a) Colleagues in their own department, (b) Staff of the department whose functioning they audit. (c) “Top management” who authorise them to perform audits. Therefore, management auditors must develop and maintain good relations with auditees to gain information and to ensure corrective action on audit findings. Yet, the general image that the auditor seemed to create is that he is a critic, fault finder or private spying authority of the top management. It is an ‘occupational risk’ of management auditor to come across very often ruffled feelings, hostile relationship and unwelcome atmosphere. While the position of management auditor is not of any recent origin, it is still true that the behavioural problems connected with a management auditor’s role have existed for a long time and continue to exist. There are many causes for behavioural problems arising in the review function of management / operational audit. Particularly, when management/operational auditors performs comprehensive audit of operations, they cannot be as well informed about such operations as a financial auditor in a financial department. Operating processes may be unfamiliar and complex. The operating people may be speaking a language and using terms that are foreign to the auditor’s experience. However it must be emphasised that other departments which have only staff function to perform do have similar behavioural problems. Any suggestions made by them either may not be accepted or if forcibly implemented attempts are like to be made to make them a failure. In the following paragraphs, the nature and causes of behavioural problems that the management auditor is likely to face in the discharge of the review function that is expected of him and possible solutions to overcome these problems are discussed.

Internal Audit, Management and Operational Audit

19.25

(1) Staff / line conflict - The staff/line relationship is inherently prone to conflict. Management auditors are staff. And line people in the sense all members of other departments of the organisation are likely to regard the management auditor the same way as they regard other staff people. Management auditors being specialists in their field may think that their approach and solutions are the only answers. They tend to discount the difficulty people may face if called on to act on their ideas. And they may feel that they must point out defects to prove themselves to top management. Line personnel, under such circumstance, will most likely regard staff with antagonism. (2) Control - As the management auditor is expected to evaluate the effectiveness of controls, there is an instinctive reaction from the auditee to have certain amount of fear that his actions when reported are likely to cause adverse effect on those who receive the auditor’s report, viz., top management. There is a certain amount of justified fear that top management’s opinion of their performance or implementation of control procedures is likely to be affected by the auditor’s report. Therefore, the management auditor, being the part of control system and thorough evaluation of controls, leads to breeding of antagonism on the part of the auditees. According to a research study, the causes of antagonism are as follows: ♦

Fear of criticism stemming from adverse audit findings.

♦

Fear of changes in day-today working habits because of changes resulting from audit recommendations.

♦

Punitive action by superiors prompted by reported deficiencies.

♦

Insensitive audit practices - reports which are overly critical, reports which focus on deficiencies only, the air of mystery cloaking some audits, and the perception that auditors gain personally from reporting deficiencies.

♦

Hostile audit style - a cold and distant aspect is a lack of understanding of the auditee’s problems, an absence of empathy, an air of smugness or superiority, an excessive concentration on insignificant errors, a prosecutional tone when asking questions, and a greater concern with parading defects than helping constructively to improve conditions.

The other significant cause is that auditor’s study of existing systems and procedures may give room for recommendations for changes of such systems, There is a certain built-in resistance to change. When a change is recommended by the auditor the resistance to change is transferred to the auditor’s recommendations and the auditor. The auditor is looked upon as a likely instrument for recommending changes and auditees do not welcome the visits of auditors and much less their studies and their reports thereafter. In view of the above, the fear of evaluation of their performance and the possibility of changes suggested in the existing familiar systems form the major causes for behavioural problems between the auditor and the auditee. It should not, however, be overlooked that in addition to the above cause the auditor’s general approach to his role and his behaviour add yet another dimension to the nature of behavioural problems. Solution to behavioural problems - The auditors, if they were to adopt the role of accuser or secret agency of the management to try upon the happenings of the auditee division, they

19.26

Advanced Auditing and Professional Ethics

would be unwelcome. Their presence will give rise to problems of personal relationship. Relations between the auditor and the auditee may improve if the auditor acts and is perceived as a professional advisor and consultant. In any event, there is a need to demonstrate to the extent possible that: 1.

the audit is part of an overall programme mandated by higher- level authority to meet higher-level organisational needs for both protection and maximum constructive benefit.

2.

the objective of the review is to provide maximum service in all feasible managerial dimensions.

3.

the review will be conducted with minimum interference with regular operations of the operating personnel.

4.

the responsible officers will be kept fully informed and have an opportunity to review findings and recommendations before any audit report is formally released.

It is essential to create an atmosphere of trust and friendliness so that audit reports will be understood in their proper perspective. Davis and Scott in their book on “Human Relations and Organisational Behaviour” had suggested that being effective does not merely consist of being extremely polite. “Effectiveness... is a difficult task requiring the highest mental ability and sound framework for analysing human situations”. In view of the delicate role of the auditor, it is inevitable that he has to face complex situations. The skill that is needed is of a high order warranting “sophisticated understanding based on sound philosophy”. Constructive criticism - It is essential that the auditor should concentrate only on constructive criticism. He should also make obvious in his report the value of his comments in tangible terms. Only then would suggestions carry weight with the auditees and they will feel convinced that the auditor has been objective in his remarks in the report. T.J. Krien in his article on “People assets that talk back” has strongly advocated the view that once the auditor is able to convince the auditees that his approach is one of mutual problem solving rather than one of fault finding, then it would produce positive results and the chances of auditors’ recommendations being considered in an objective fashion would be better, If the auditors were to adopt a “fault finding role”, the auditees would be constrained to become defensive and would bend backwards to justify their position. A few other authors also have strongly advocated the view that the success of the auditor’s role would to a great extent depend upon whether the auditee were made to feel convinced that the auditor’s role was one of being helpful rather than that of a fault finder. Reporting methods - To achieve this objective, the auditor has to make a concerted effort to convey effectively his role by adopting a friendly but firm tone in his report. It is always possible to disagree without being disagreeable, to criticise without being critical. The reports should concentrate on areas which need improvement rather than listing inefficiencies and deficiencies in performance of the auditee. The mistaken notion that the greater the number of deficiencies reported the higher would be the rating of his performance should be erased or given up. This is an outdated notion and does not in any way contribute to the effectiveness of the auditor.

Internal Audit, Management and Operational Audit

19.27

Participative approach - It is well established that auditor’s reports have, better acceptability if the improvements suggested are discussed with those who have to implement them and made to feel that they have participated in the recommendations made for improvements. Harmeyer W.J. in his article on “Operational audit: You too can be a Consultant” has reasoned that by adopting a participative approach the chances of improvements being accepted and implemented successfully with conviction area very good. In his work, be has effectively described the concept as follows. “By utilising this participation you end up with coordinated suggestions for improvement not with the auditor’s recommendations”. W.T.Jerome also voiced the same view in his article in Harward Business Review long back. He very correctly pointed out that “auditors must candidly recognise that they are appraising many deficiencies from the distorting vantage point of hindsight. If they recognise this limitation by soliciting the views of operating personnel, internal auditing becomes a co-operative enterprise ......... it will not then be regarded as the “secret police” of the home office.” Instances are not uncommon where when auditors recognising the state of conflict between themselves and the auditees adopted a positive approach and in most of the organisations auditors play the role of trouble shooters and are expected to play an important role on very many occasions, If the auditors were to straightaway reject all proposals, whether good or not, made by departmental heads without appreciating the auditee’s contribution and accomplishments an atmosphere of hatred and hostility created. On the other hand, it has been observed that either oral or written appreciation of the auditee’s achievements not only encourages the auditees to develop a friendly attitude towards the auditors but look forward to their guidance in a more receptive fashion. The participative approach to the internal audit process has proved to be success. Well-known authorities in the field have proved by means of research they have conducted that resistance to change is absent if not minimal when participative method is adopted. Feelings of hostility disappear giving room to feelings of mutual trust. Team spirit is developed and the auditors and the auditee endeavour to achieve the common goal. Proposed recommendations are discussed with the auditee and such modifications as may be mutually agreed upon are incorporated. With this attitude of the auditors and auditees, it becomes absolutely easy to implement the proposed suggestions as the auditees themselves take initiative for implementation and auditors do not have to force any changes on the auditees. Finally, it needs hardly any emphasis that there should be right management culture, enlightened auditees and auditors of the right calibre. May be to expect a combination at all times of all the three is asking for the impossible. But, a concerted effort by the management, auditors and auditees to achieve a more acceptable climate would go a long way to achieve the goal. Three cases are given hereunder to illustrate the practical aspects of behavioural problems. Case-1: Auditor objective: Auditee offensive: Management’s apathy - In Professional Organisation Ltd., the Management Auditor as part of his duty was expected to perform the audit function of the Consultancy Division of the organisation. The auditor in the normal functioning discovered lack of control and a further study revealed suppression of information regarding illegal procedures being followed by the department. His further in-depth

19.28

Advanced Auditing and Professional Ethics

examination of the books revealed that the division has been overstating profits, to justify its existence. These facts which had been in existence with the knowledge of manager of the Division had been left undetected. The auditor was totally professional. His attitude was not one of “policing”. He had discussed the contents of his proposed report with the auditee. The auditee had to be defensive and hence decided to be offensive. Management had to face the predicament of appreciating the good job done by the management audit department without openly decrying the Divisional Manager. There was open “cold war” of hatred and hostility declared by the divisional Manager. The behavioural problems arose in spite of auditor’s professional role. The auditee’s reaction was instinctive as a corollary to being self-defensive. The management had a tough time. The problem was sorted out and the atmosphere of illfeeling and hatred generated by the auditee could be smoothened. Case-2 Auditee progressive: Auditor cantankerous: Management indifferent - In a large organisation, there was a long-standing problem of lack of coordination between marketing and production. The pressures of day-to-day problem, made the situation worse. Production and Marketing Managers were happy to have the services of the management, auditor to streamline procedures and monitor the implementation. It would have been ideal for the auditor to evolve a good system after a detailed study of the problems, have the key personnel of production and marketing departments participate in the discussion and to have introduced the proposed system with their co-operation. Instead the auditor took on his duty as a mission for fault finding and started submitting secret reports on the malfunctioning of the Production and Marketing departments. Management, having already the heavy load of coordination would seek explanations from Production and Marketing departments. The auditor’s cantankerous behaviour and management’s indifferent attitude inspite of auditee’s very cooperative approach gave room for a series of behavioural problems. A participative approach, with the total curtailment of “policing” reports, with the correct guidance from the management would have avoided all behavioural problems. Case-3 Auditor progressive- Auditee appreciative: Management objective - In a large organisation with operations spread all over the country the management faced sudden problems of lack of financial control, inspite of high levels of production and remarkable market demand. The organisation had an efficient and progressive management auditor with a good team. The auditees were individuals with professional attitude. Management was progressive and dynamic. Management called for meetings, explained the special assignment being given to management auditor of aiding management to get a grip over the situation. The auditee welcomed the auditor as an expert consultant. The auditor adopted an attitude of friendliness without descending to levels of too much familiarity. There was coordinated effort between the auditor and auditee. Management was kept informed of the problems and solutions being jointly worked out by the auditors and the auditees. Within a very reasonable time, what seemed an “out of control” situation was streamlined and the management got back the grip over the entire organisation. Operational audit 19.8 Operational auditing is a systematic process involving logical, structured and organized series of procedures.

Internal Audit, Management and Operational Audit

19.29

19.8.1 Internal Auditing and Operational Auditing - To understand what operational auditing is, it would be better if we first understand internal auditing. It may be recalled that internal auditing is an activity carried on by the internal staff of an organisation to meet the management requirements of information. The definition of internal auditing given by the Institute of Internal Auditors, New York, in fact equals internal auditing with operational auditing. According to this definition, internal auditing is an independent appraisal activity within an organisation for the review of operations as a service to organisation. Naturally, when an auditor is concerned with the appraisal of operations, he be comes an operational auditor. Another important point that this definition throws up is that operational auditing is essentially a function of internal auditing staff. According to the Institute of Internal Auditors, “the overall objective of internal auditing is to assist all members of management in the objective discharge of their responsibilities, by furnishing them with objective analysis, appraisals, recommendations and pertinent comments, concerning the activities reviewed. The internal auditor, therefore, should be concerned with any phase of business activity wherein he can be of service to managements.” A IIA publication defines operational auditing as - Operational auditing is a systematic process of evaluating an organisation’s effectiveness, efficiency and economy of operations under management’s control and reporting to appropriate persons the results of the evaluation along with recommendations for improvement1. On the basis of above definition operational auditing is a systematic process involving logical, structured and organized series of procedures. Operational auditing concentrates on effectiveness, efficiency and economy of operations and therefore it is future oriented. It does not end with the reporting of the findings but also recommends the steps for improvement in future. At this stage it must be conceded that operational auditing is a newly emerged term and therefore liable to be understood according to individual perceptions about what it is or should be. It may, therefore, take some time to have a generally accepted conceptualisation on this. However there probably may not be much of difference in viewing operational audit as a review and appraisal of operations of an organisation carried on by a competent independent person. The question of competence is implicit in any auditing situation; unless one is wellconversant with the philosophy, techniques and procedures of audit, one cannot do justice to the work of audit. Similarly auditing whether carried on by an internal staff or by an external person, should necessarily be an independent activity to maintain its objectivity and usefulness. According to Cadmus “Operational Auditing is not different from internal auditing, it is merely an extension of internal auditing into operational areas. And it is characterised in both financial and operational areas - by the auditor’s approach and state of mind”. The difference in the approach of both these audits is illustrated below: Perception - Traditionally, internal auditors have been engaged in a sort of protective function, deriving their authority from the management. They view and examine internal controls in the financial and accounting areas to ensure that possibilities of loss, wastage and 1 Darwin J. Casler and James R. Crockett, operational Auditing. An Introduction (Altamonte Springs, FL: The Institute of Internal Auditors, Inc., 1982). P 14.

19.30

Advanced Auditing and Professional Ethics

fraud are not there; they check the accounting books and records to see, whether the internal checks are properly working and the resulting accounting data are reliable. They also look into the aspect of safety of the assets and properties of the company. Some element of operational auditing can be found even in these traditional functions of internal auditors, specially in the context of fraud, wastage and loss. Internal auditors emboldened by their ability to appraise financial and accounting control, gradually started extending their field to cover nonaccounting control as well. They, however, had to condition their mind and approach so as to examine the results from the management point of view. This is a sort of expertise which they also utilise in appraising financial data from the management point of view. To a traditional internal auditor, a loss of Rs. 1,000 caused by a wrong totalling of invoice is important and this is that he looks for. But for an auditor engaged in the review of operations, carrying out of a proper maintenance programme of the machines is of greater importance because considerable production loss due, to machine breaks down can thus be prevented. In both the cases, the auditor’s objective is to see that the business and its profitability do not suffer from avoidable loss, but, nevertheless, there is a distinct difference in approach. Take another instance - when the auditor looks into the vouchers to see whether they corroborate the entries in the cash book or physically examines the cash in hand he is doing his traditional protective function. The moment be concerns himself to see whether customers’ complaints are duly attended to or whether cash balance is excessive to the need, he comes to the operational field. It should not be assumed, that, since an operational auditor is concerned with the audit of operations and review of operating conditions, he is not concerned with the financial aspects of transaction and controls. A point has already been made that the special expertise acquired by the operational auditor, that enables him to view the controls and operations from the management point of view, can be carried back to his review of the financial areas. In the matter of cash transactions, the operational auditor will look into such aspects as the quantum of cash in hand (by relating it to the requirement of cash to be held) carried generally or the use of cash not immediately required. Also he will review the operational control on cash to determine whether maximum possible protection has been given to cash. Similarly, in the audit of stocks, he would be interested in such matters as reorder policy, obsolescence policy and the overall inventory management policy. In pure administrative areas on stock, he will see whether adequate security and insurance arrangements exist for protection of stocks. Issues - According to Lindberg and Cohn, two facts about operational audit must be understood - the area of operational audit is young and it is still, uncertain of direction. As has been indicated earlier these authors confirm that there exist two opposing views about the nature and role of operation audit. One view holds that operational auditing is only a fact gathering tool that will help management appraise performance and identify areas in which additional investigations may yield improvement. The other view seems to extend the scope of operational audit further to recommendation of specific changes intended to correct the short comings observed by the auditor. It may be observed here that Lindberg and Cohn prefer to use the expression “Operations Audit” instead of the more common practice of denoting it as “operational auditing” with a view to distinguishing the former from the latter, which according to the authors, is generally understood to convey the second type of meaning

Internal Audit, Management and Operational Audit

19.31

associated with the expression. These authors have defined “operations auditing” as a technique for regularly and systematically, appraising unit or function effectiveness against corporate and industry standards by utilising personnel who are not specialists in the area of study with the objective of assuring a given management that its aims are being carried out and in identifying conditions capable of being improved. It seems that the basic difference that exists in conceptualisation of the technique of operational auditing is in the auditor’s role in recommending corrections or in installing systems and controls. According to Lindberg and Cohn, such a situation would be in conflict with the role of operational auditor. One cannot objectively review an operation, control or a system recommended by him and in fact this should be left to be dealt by methods and procedures people. In this connection, the views of the Institute of Internal Auditors, in the context of internal audit are relevant. According to that Institute, “the internal auditor should be free to review and appraise policies, plans, procedures and records; but his review and appraisal does not in any way relieve other persons in the organisation of the responsibilities assigned to them. The Institute has further held that “since complete objectivity is essential to the audit function, internal auditors should not develop and install procedures and systems, prepare records or engage in any other activity which they normally would be expected to review and appraise”. It may be remembered that the definition of internal auditing given by this Institute is same as operational auditing. Therefore, the views quoted above equally apply to operational audit per se and Lindberg and Cohn’s views are not different from these in this respect. Also there does not appear to be much conflict of views in understanding operational auditing as an extension of internal auditing with a definite work content which stretches beyond the traditional field of internal auditors i.e. financial accounting. However, a further distinction should be observed between traditional internal auditing and operational auditing this lies in the attitude and approach to the whole auditing proposition. Every aspect of operational auditing programme should be geared to management policies, management objectives and management goals. Objectives - The main objective of operational auditing is to verify the fulfilment of plans and sound business requirements as also to focus on objectives and their achievement objectives; the operational auditor should not only have a proper business sense, he should also be equipped with a thorough knowledge of policies, procedures, systems and controls, he should be intimately familiar with the business, its nature and problems and prospects and its environment. Above all, his mind should be open and active so as to be able to perceive problems and prospects and grasp technical matters. In carrying out his work probably at every step he will have to exercise judgement to evaluate evidence in connection with the .situations and issues; he will have to get the assistance of norms and standards in every operating field to be able to objectively judge a situation. The norms and standards should be such as are generally acceptable or developed by the company itself. Performance yardsticks can be found in the management objectives, goals and plans, budgets, records of past performance, policies and procedures. Industry standards can be obtained from the statistics provided by industry, associations and government sources. It should be appreciated that the standards may be relative depending upon the situation and circumstances; the operational auditor may have to apply them with suitable adjustments. For

19.32

Advanced Auditing and Professional Ethics

example, the standards relating to objectives for a government company are quite different from those of a private sector company. Similarly standards of performance of a well equipped company which also adequately looks after the well-being of employees may be significantly different from a company which offers scanty welfare facilities or is ill-equipped. Today, however, the concept of modern internal auditing suggests that there is no difference in internal and operational auditing. In fact, the scope of internal auditing is broad enough to embrace the areas covered by operational auditing as well. The modern internal auditing performs both protective as well as constructive functions. 19.8.2 Qualities of Operational Auditor - The operational auditor should possess some very essential personal qualities to be effective in his work. He should have sufficient curiosity so as to know clearly every aspect of the matter under audit. In areas beyond accounting and finance, his knowledge ordinarily would be rather scanty and this is a reason which should make him even more inquisitive. He should ask the who, why, how of everything. He should try to visualise whether simpler alternative means are available to do a particular work. He should try to see every thing as to whether that properly fits in the business frame and organisational policy. He should be persistent and should possess an attitude of skepticism. He should not give up or feel satisfied easily. He should imbibe a constructive approach rather than a faultfinding approach and should give a feeling that his efforts are to help attaining an improved operation and not merely fault finding. He should consider a fault or mistake found in the course of audit more as a guide to effect improvement than to treat the fault as a sort of crime. If the auditor succeeds in giving a feeling of help and assistance through constructive criticism, he will be able to obtain co-operation of the persons who are involved in the operations. This will itself be a tremendous achievement of the operational auditor. He should also be equipped with business sense in good measure. He should view every action or operation in relation to the profit objective or other objectives, if any of the organisation. He should be able to view every action in its segmental relevance as also its relevance to the interrelated operations. He should not be obsessed by narrow protective view point that may naturally come to him. His attitude should be to encourage and appreciate good work and to extend a helping hand to those found deficient. The operational auditor should try to develop a team comprised of people of different backgrounds. Involvement of technical people in operational auditing is generally helpful. 19.8.3 Why Operational Audit? - The need for operational auditing has arisen due to the inadequacy of traditional sources of information for an effective management of the company where the management is at a distance from actual operations due to layers of delegation of responsibility, separating it from actualities in the organisation. Specifically, operational auditing arose from the need of managers responsible for areas beyond their direct observation to be fully, objectively and currently informed about conditions in the units under control. Operational audit is considered as a specialised management information tool to fill the void that conventional information sources fail to fill. Conventional sources of management information are departmental managers, routine performance report, internal audit reports, and periodic special investigation and survey. These conventional sources fail to provide information for the best direction of the departments all of whose activities do not come under

Internal Audit, Management and Operational Audit

19.33

direct observation of managers. The shortcomings of these sources can be stated as under: (i)

Executives and managers are too preoccupied with implementation of plans and achieving of targets. They are left with very little time to collect information and locate problems. They may come across problems that have come to surface but they are hardly aware of problems that are brewing and potential. Even when a department is working well and smoothly, one cannot rule out some crack or gap in operations or in controls, which is not interrupting the work now but will assume big proportions and seriously hinder the working at some future date.

(ii)

Managers or their aides are generally relied upon for transmitting information than for booking for information or for analysing situations.

(iii) The information that is transmitted by managers is not necessarily objective - often it may be biased for various reasons. (iv) Conventional internal audit reports are often routine and mechanical in character and have a definite leaning towards accounting and financial information. They are also historical in nature. (v) Other performance reports contained in the annual audited accounts and the routine reports prepared by the operating departments have their own limitations. The annual audited accounts are good insofar as an overall evaluation is concerned in monetary terms. But they may not bring to light specific problems in different operational areas so readily. Sales may be shown at a higher monetary value compared to the previous year and this may apparently suggest that the functioning of the sales department is satisfactory. But this may have been caused by a number of factors inspite of a really bad performance on the sales front. This fact may not be readily known unless one cares to analyse the sales data by reference to notes and explanations to the accounts and other related accounting data. Even a study of this nature may not fully reveal the weakness. It is quite possible that the established market for sales has been lost partly while some fortuitous sales have compensated the loss. The other routine departmental reports definitely serve a purpose of more or less currently informing the management about the departmental performance. But the reports are not always objective and have a definite tendency to colour the departmental performance favourably. For example, the routine weekly production report may include production ‘that is subsequently rejected by the quality control staff, or to avoid showing a bad production performance; even the partly produced goods may also be included. Remember, all this can happen inspite of specific management instructions about the basis on which the production report is to be made out. Another important point may be noticed in the matter of routine departmental reports. The despatch section, to show a good performance, may show goods handed over to the transport section which, even within its knowledge, may not be really despatched within the next several days, because of accumulation of goods at the transport shed or because of non-availability of wagons or shipping space. It may be appreciated that those reports may or may not contain a falsehood; but, definitely, they do not show performance in the proper light in relation to allied activities and thereby the problems of

19.34

Advanced Auditing and Professional Ethics

one area are merely shifted to the next. They fail to provide insight into particular problems that may be growing elsewhere in the organisation. The busy management people, who can afford time only to glance over the performance reports, cannot be expected to make an integrated reading of several reports or to undertake an analysis of such reports. What they need is reliable, unmanipulated and objective report which they would like to look into understand the situation. (vi) Operations of controls in a satisfactory manner cannot be relied upon to bring to light the environmental conditions. Controls are specific and their satisfactory operation is related to the specific situation under control. Also monitoring of the breakdown or non-operation of controls is a periodic phenomenon. (vii) Surveys and special investigations no doubt are very useful but these are at the best occasional in character. Also, they are costly, time consuming and keep the departmental key personnel busy during the period they are on. They are undertaken mostly to find causes of certain state of affairs or to fix responsibility for certain undesirable happenings. These are basically an attempt to carry out a post-mortem rather than to enlighten the management about the ways on improvement or for better performance or to give a signal for dangers and disasters to come. Operational auditing has filled a very significant vacuum; it has come to provide the management with inexpensive, continuous and objective appraisal of activities, operations and controls to inform the management about achievement of standards and, if otherwise, to inform the management about what has gone wrong and how it has gone wrong. Also, it enlightens the management about possible dangers, constraints and opportunities that may be of immense value to the management. 19.8.4 Type of Operational Audits2 - There are three broad categories of operational auditors: functional, organizational, and special assignments. In case, part of the audit is likely to concern evaluating internal controls for efficiency and effectiveness. Functional Audits - Functions are a means of categorizing the activities of a business, such as the billing function or production function. There are many different ways to categorize and subdivide functions. For example, there is an accounting function, but there are also cash disbursements, cash receipt, and payroll disbursement functions. There is a payroll function, but there are also hiring, timekeeping, and payroll disbursement functions. As the name implies, a functional audit deals with one or more functions in an organization. It could concern, for example, the payroll function for a division or for the company as a whole. A functional audit has the advantage of permitting specialization by auditors. Certain auditors within an internal audit staff can develop considerable expertise in an area, such as production engineering. They can more efficiently spend all their time auditing in that area. A disadvantage of functional auditing is the failure to evaluate interrelated functions. The production engineering function interacts with manufacturing and other functions in an organization.

2

Auditing and Assurance Services by Arens, Elder & Beasley; prentice hall publication, 2003 edition, page 740.

Internal Audit, Management and Operational Audit

19.35

Organizational Audits - An operational audit of an organization deals with an entire organizational units, such as a department, branch, or subsidiary. An organizational audit emphasizes how efficiently and effectively functions interact. The plan of organization and the methods to coordinate activities are especially important in this type of audit. Special Assignments - In operational auditing, special assignments arise at the request of management. There are a wide variety of such audits. Examples include determining the cause of an ineffective IT system, investigating the possibility of fraud in a division, and making recommendations for reducing the cost of a manufactured product. 19.8.5 Objectives of Operational Audit - Like internal auditing, the scope and quality of operational auditing is predominantly dependent upon management attitudes. An open minded management with broad vision, can appreciate the need of operational auditing and to give it the necessary freedom and sanction to perform what it is capable of performing. Also, the qualities and the sense of perspectives of the operational auditor can mould operational audit in the right shape. Without a combination of these two, operational auditing may not be able to show its distinctively and advantages to the organisation. Therefore, there is a possibility of operational auditing having different objectives to fulfil in different organisations. Generally, operational audit objectives include: (i)

Appraisal of controls.

(ii)

Evaluation of performance.

(iii) Appraisal of objectives and plans, and (iv) Appraisal of organisational structure. The most significant gain an organisation can derive from operational auditing is probably in the area of appraisal of controls. Internal controls, because of their unobtrusive omnipresence in the organisation, provide the essential hinges to ensure proper performance in each functional or organisational area for accomplishing the desired organisational objective. If the hinge of a machine is weak or broken however costly or good that machine may be, it will not perform with any degree of efficiency. Similarly, if controls are weak or breaking down, however well equipped or well-manned the organisation may be, it will fail to operate effectively. Operations and the results in which management is interested are largely a matter of control. If controls are effective in design and are faithfully adhered to, the result that can be attained will be subject to the other limiting constraints in the organisation. According to Lawrence B. Sawyer, “One widely accepted view of operational auditing holds that it is directed toward control rather than performance and hence avoids technical involvement”. This view suggests that operational auditing deals with administrative controls exercised over all phases of the business and its purpose is to determine whether the controls are adequate and are proving effective in accomplishing management’s objectives or plans or operations. It seems there is considerable validity in the views stated above. It is also to be conceded that appraisal of performance necessarily requires an appropriate technical background. In the task of performance evaluation, an operational auditor is heavily dependent upon

19.36

Advanced Auditing and Professional Ethics

availability of acceptable standards. Apart from this, the operational auditor cannot be expected to possess technical background in so many diverse technical fields obtaining even in one enterprise. Even when examining or appraising performance or reports of performance, the operational auditor’s mind is invariably fixed on control aspects. For example when he walks through the factory floor, amongst others, he observes whether machines are idle or workmen not present in the post assigned to them or the accumulation of stores on the floors All these have a bearing on the operation of controls. He can then go into the reasons of the failure of controls and bring these to the attention of the management for verification in the interest of proper working in future. He reviews internal control reports to ascertain whether they bring the performance, qualitatively and quantitatively to the notice of the management; also weather the organisation’s policies and plans are being carried out. In performance appraisal, the operational auditor is basically concerned not so much with how well technically the operations are going on, but with accumulating information and evidence to measure the effectiveness, efficiency and economy with which the operations are being carried on. He prepares his evaluation programme in such a manner that it will show how well or how poorly the department has fared by reference to applicable standards, procedures, rules, policies and plans. The principal basis of performance evaluation can be productivity, personnel, workload, cost and quality. In the area of productivity, the operational auditor can undertake such tests as input-output ratios for materials and labour in quantitative terms. Alternatively or in conjunction with the above, the auditor may also study the extent of labour and material expended per unit of output in physical terms. In the sphere of physical production the auditor will, in most cases, get the advantage of having some acceptable norms or standards. He also has to review the aspects of production loss and rejections in appraising performance, For other spheres, such measures as man-hours per customer or man- hours per application processed can be adopted. What measure is appropriate on what occasion is a matter to be judged by the auditor and he can evaluate performance by reference to the selected measure. Apart from these, the auditor has to consider the following broader aspects also in performance evaluation: (i)

How does productivity compare with the prior period?

(ii)

At what level should productivity be to meet the target?

(iii) What are the factors affecting productivity? (iv) Is the level of production commensurate with the flow of orders received? (v) Is unsatisfactory production performance the result of : (a) non-availability of raw materials? (b) inadequate or unskilled personnel? (c) lack of proper supervision? (d) lack of proper machine maintenance? (e) strikes and/or lockout? (f)

problem of power supply?

Internal Audit, Management and Operational Audit

19.37

(g) non-availability of essential machine spares? (h) poor quality of raw materials? (i)

other causes like, fire, earthquake?

(j)

lack of proper quality control?

(vi) Can the work methods be improved? (vii) Are the machines utilised to their capacity? (viii) Can the work be further mechanised with advantage? Personnel is perhaps the most important factor in performance evaluation. Unless the organisation has a sound personnel policy consistent with its requirements, the facilities, materials and equipment that are available in the organisation may not be utilised properly to obtain optimum performance. There may even be clearly negative factors like excessive overtime or excessive spoilage of materials, sub-standard production, indiscipline amongst workers, etc. that may retard the performance qualitatively and quantitatively. The operational auditor in his appraisal of personnel can make use of the quantitative data readily available to him like number of employees, personnel turnover, total regular and overtime hours worked ratio of direct employees to indirect employees and so on. He should also take into account the undernoted broad aspects involving personnel: (i)

Whether the organisation has properly qualified and experienced personnel for the various levels of work?

(ii)

Is the number of people employed at various work centres adequate, excessive or inadequate?

(iii) Does the organisation provide facilities for staff training so that employees and workers keep themselves abreast of current techniques and practices? (iii) Is the organisation unable to obtain staff possessing requisite qualifications? (iv) If yes, what are the reasons: (a) Low wages? (b) Bad working conditions? (c) Management attitude? (d) Status of the organisation in the industry? (v) Is the rate of staff turnover high? If yes, what are the causes? (vi) Is the ratio of overtime to regular man-hours excessive or normal? (vii) Why is the need for overtime? (viii) If the ratio of overtime is high, what is being done to reduce it? ‘Work load measurement can be another significant area where operational auditor can be of use because of ready availability of quantitative data. There can be measures like volume or quantity of work handled and/or performed volume of new work, backlog of work, etc. The

19.38

Advanced Auditing and Professional Ethics

propositions that would usually arise in this area may be as follows: (i)

Is there any backlog of work? If yes, is it due to increasing volume of new work on the existing work itself is heavy by reference to the staff and facilities available?

(ii)

Is the new work volume increasing or decreasing?

(iii) How to meet the increasing work load? Would it be worthwhile to employ more staff or get the work done by overtime? (iv) Is the current work done in time? (v) Is the backlog increasing or decreasing? Quality of work is a matter which is not directly amenable to operational audit scrutiny Nevertheless, it is an important aspect of performance of an organisation. Therefore, some quantitative measures are often devised to judge the quality of work. These can be number of customers’ complaints, rejections by quality control department, number of workers’ grievances, number of errors in invoicing or recording transactions, quantity of scrap and wastages, etc. The auditor may comprehend the quality aspect by reference to certain objective questions like: (i)

Is the present work quality satisfactory in so far as customers, suppliers, bankers, workers and the quality standards followed are concerned?

(ii)

If not, what are the factors that account for unsatisfactory quality? Is it the workload, lack of equipment, bad quality of raw materials or other materials in use, unsatisfactory working conditions giving rise to workers’ grievances or the methods?

(iii) Is the quality of work getting better or worse? (iv) Is the quality of work responsive to training imparted to workers? (v) How can the quality be improved whether by changing the work methods or boosting the workers’ morale by adding more technical facilities, by improving supervision or by enforcing stricter control on quality of materials that go into the work? Cost is perhaps the most cogent indicator of performance. Costs are classified and recorded for a proper assimilation of their implications on performance. The operational auditor may be concerned with such matters as: (i)

Is the cost break-up realistic so as to serve as a basis for performance evaluation?

(ii)

Are the costs collected under various heads and sub- heads showing an increasing trend per unit of output?

(iii) Do costs conform to forecasts? If not on what count? (iv) Are the costs of various departments or divisions justified? (v) Are all the activities necessary? (vi) Would it be better if the company buys some of the components or output from outside instead of producing them? (vii) Are the people cost conscious?

Internal Audit, Management and Operational Audit

19.39

Though controversial, a school of thought holds that operational auditing can be stretched to evaluate management objectives and plans. This view stems from the fact that everything in an organisation is the product of basic plans and objectives set by the management. If the management policy favours installation of controls or specifies the extent of controls whether satisfactory or not, controls would have to stay within the policy frame. Therefore, the basic thing that should be evaluated is management policies, plans and objectives. We will discuss this aspect further when dealing with management audit. However, it should be noted that there exists considerable opposition to the aforesaid view. The other viewpoint holds that operational auditing by its nature should be confined to operations and related controls. The aim of operational auditing is to appraise operations and controls and their adherence to prescribed or laid-down policies and not to go into the question of appropriateness of plans and objectives. However, the operational auditor may look into the aspects like whether objectives are clearly spelt out and properly communicated to the personnel responsible for implementation and whether the personnel have understood the objectives in the sense meant by the management. Also, he can take note of any apparent conflict in the objectives for its effect on operations. Organisational structure provides the line of relationships and delegation of authority and tasks. This is an important element of the internal control design. Therefore, this is also another important area for appraisal by the operational auditor. In evaluating organisational structure, the aspects that may be considered by the operational auditor may be as follows: (i)

Is the organisational structure in conformity with management objectives?

(ii)

Whether the organisational structure is drawn up on the basis of matching of responsibility and authority?

(iii) Whether the line of responsibility from the top to the bottom is clearly discernible from the structure? (iv) Whether the delegation of responsibility and authority at each stage is clear and overlapping are avoided? 19.9

Review of Systems and Procedures

19.9.1 Systems -Systems are so fundamental to an understanding of responsibilities of managers and the environment in which they operate that management auditors should get a clear understanding of what systems are and how they operate. The word system is commonly defined as “a set of objects, together with relationships between the objects and their attributes, connected or related to each other and to their environment in such a manner as to form an entire or integral whole.” The definition can be better understood with reference to a complex biological system of human beings which consists of various sub-systems, e.g. nervous system, digestive system, respiratory system, blood circulation system, reproductive system, etc. The physical objective of human life is to live and grow. Each sub-system contributes to this overall objective by performing specific functions. Each sub-system in turn, may be treated as a complete system in itself. For instance, digestive system consists of various organs, say stomach, esophagus, intestines, etc. which are interdependent and interrelated, so that failure of any part will lead to failure of the digestive system. Thus, the

19.40

Advanced Auditing and Professional Ethics

essence of a system lies in the inter- relationship and inter-dependence of various parts and processes. Unrelated and independent parts can never constitute a system. Similarly, it can be said that a business organisation also does not operate in a vacuum. Its various operations - manufacturing, purchasing, marketing, accounting and finance, research and development, personnel - comprise a system. All of these functional departments are combined into a complex unified, whole. The overall system i.e. a business organisation is made up of many interacting and related sub-systems, e.g. the various functional departments. These operation have to take into account and needs and operating modes of all the people, enterprises and governments that make up the environments in which it operates. It is essential that managers accept this hard fact that their organisational units do not operate in a vacuum. Each unit is dependent upon/related with some other unit in the organisation. Thus, the production department does not go ahead and produce articles for which the marketing department does not see a market. Conversely, the marketing department does not take orders for sales which the production department is not geared to produce. In another business function, we see that operations of a purchasing department must satisfy the needs of departments requesting materials. To accomplish an objective by means of a system entails three main steps: 1.

Design a system to achieve the main objectives.

2.

Operate the system.

3.

Check that the system is operating and producing as intended by its design, i.e. that the stated objective is being achieved.

19.9.2 Procedures - Procedures are the means by which policies are implemented. Most often, procedures entail the use of documents in accordance with precise instructions or methods to be used. At lower levels in an organisation, formalised and authorised procedures become more numerous and of specific nature because of following factors: 1.

There exists economic advantage of specifying precise uniform action to be taken by a large number of people and for repetitive jobs.

2.

The need for more precise control over employees’ activities which can only be achieved if there are detailed prescriptions of how things are to be done.

3.

The element of discretion has to be reduced as far as possible.

Standard procedures go a long way towards making sure that pertinent information flows to the people who need it and that each person understands what he is to do with it. In addition, standard procedures, when expressive of policy guidelines established by management, facilitate control of business operations. The purpose of establishing procedures is also to ensure consistent interpretation of policies. That eliminates the need to make the same decisions over and over and leaves more time for creative planning, thoughtful analysis and productive effort. 19.9.3 Review of Systems and Procedures - The purpose of systems and procedures is to help management in the planning and accomplishment of organisational purpose, in communicating their requirements, and in assisting the personnel in carrying out the requirements. The review of systems and procedures is to improve the methods, to get away

Internal Audit, Management and Operational Audit

19.41

from the old ways and traditional routines and to reduce the cost in completing and processing the paper work - eliminating waste, duplication and inefficiencies. In reviewing any system or procedure, the management auditor must concern himself with its purpose as well as its design and then he must decide on its merits as the best serving the interests of the enterprise. A poor system or procedure may prevent the carrying out of the policy for which it was intended. A system may have outgrown its usefulness. The end result of a system or a procedure may be loose and may require improvement. In the study of the systems and procedural functions, the auditor should ask himself: 1.

Is the function properly located in the organisation?

2.

Do the staff personnel have the necessary training and experience to perform the work?

3.

Has a definite programme been established and has been taken for its attentive accomplishment?

4.

Is productivity satisfactory?

The evaluation of a system or a procedure actually includes three separate considerations. First, is the system or procedure meeting all of the current requirements? Second, is it operating effectively? And third, what is the degree of effectiveness? To determine whether system or procedure is meeting current requirements, the following among other things, should be considered: 1.

Is the system or procedure designed to promote achievement of the company’s objectives, and is it accomplished effectively?

2.

Does the system or procedure operate within the framework of the organisational structure?

3.

Does the system or procedure adequately provide methods of control in order to obtain maximum performance with the least expenditure of time and effort?

4.

Do the routines designated in the system or procedures indicate performance in logical sequence?

5.

Does the system or procedure provide the means for effective coordination between one department and another?

6.

Have all required functions been established?

7.

Has the necessary authority been designated to carry out responsibilities?

8.

Can any changes be made to improve effectiveness?

The important thing is to make sure that the system or procedure is designed to meet the desired results. One must determine what is actually done, as well as where, how, when, and by whom. Each individual step in the process must be studied and its effectiveness considered. At the same time, one must be constantly alert for possible improvements. While it may be difficult to determine a precise measurement of how effectively a system or procedure operates, the degree of effectiveness can be somewhat ascertained by checking on the activities from the standpoint of speed, accuracy and orderly flow of paper work. Do

19.42

Advanced Auditing and Professional Ethics

bottlenecks and delays occur from time to time the schedules, reports, or end results promptly completed and furnished on time? Are operations proceeding well or better than expected? What is the relationship between the volume of work and the number of employees performing the work, and how does it compare from month to month? The auditor must always be on the alert for possible defects and irregularities. He must check the activities with the instructions, to see if the instructions are properly complied with. All deviations must be called to the attention of the supervisor who is responsible for the proper adherence to instructions, and necessary corrective action taken. On occasions, due to some unusual circumstances, the auditor may find that good judgement often dictates some deviation from an instruction possibly to better achieve a desired objective. Management must be constantly alerted to the importance of systems and procedural function as an element of good organisation and management. No business can continuously achieve success without considering the maintenance of systems of control and of current, written procedures to guide all concerned in performing their work assignments. Systems and procedural work render aid and constructive service to management in order to assist them in the planning and accomplishment of desired results. The basic objective of the systems person is to develop the most ideal system that will meet the organisation’s specific requirements or needs, coordinating the essential managerial functions, eliminating the unnecessary, preserving the important and incorporating modern, practical and efficient methods and equipment. Differences between Financial and Operational Auditing - The major differences between financial and operational auditing can be described as follows: (i) Purpose - The financial auditing is basically concerned with the opinion that whether the historical information recorded is correct or not, whereas the operational auditing emphasizes on effectiveness and efficiency of operations for future performance. (ii) Area - Financial audits are restricted to the matters directly affecting the appropriateness of the presented financial statements but the operational auditing covers all the activities that are related to efficiency and effectiveness of operations directed towards accomplishment of objectives of organization. (iii) Reporting -The financial audit report is sent to all stock holders, bankers and other persons having stake in the Organisation. However the operational audit report is primarily for the management. (iv) End Task - The financial audit has reporting the findings to the persons getting the report as its end objective, however, the operational auditing is not limited to reporting only but includes suggestions for improvement also. Management Audit Questionnaires 19.10 The Management Audit Questionnaires highlights important manufacturing problems confronting the organisation. 19.10.1 Manufacturing including purchasing function - Evaluation of the manufacturing function through the management audit questionnaire tends to be complex for most industrial organisations, since the manufacture of finished products usually involves many operations. Not only must plant, equipment and tools be provided in the manufacturing process, but

Internal Audit, Management and Operational Audit

19.43

appropriate personnel must also be hired and trained to utilise the manufacturing facilities. Raw materials and goods in process must be available when needed. Production must be planned, scheduled, routed, and controlled for producing the desired finished goods that meet specific customer deadlines. Hence, a management audit questionnaire in this area must be comprehensive to pinpoint any ongoing managerial and operational deficiencies. For a complete evaluation of the manufacturing function, the manufacturing management questionnaire is sub-divided in five sections: I.

Manufacturing Overview

II.

Production Planning

III.

Production

IV. Inventory V.

Purchasing.

From this broad viewpoint, the questionnaire will highlight important manufacturing problems confronting the organisation. Manufacturing overview - In a manufacturing environment, purchased materials and manufactured materials for stock flow into the various stages of the production process. As they do, the materials take on a variety of forms and shapes until they become finished goods. Next, the finished products flow through the distribution system until they reach the customers. From this view, the focus is on the materials flow. Coupled with the materials flow is the corresponding information flow, a most important factor in coordinating the diversified manufacturing activities. Information must be comprehensive so as to allow integrated decision making throughout the entire materials-flow process. With this integrated flow of essential information, management and operating personnel can make adjustments swiftly and effectively in response to the ever -changing business environment. Production Planning - The evaluation of the production planning group (See Section II) starts with examining the competency of its management. Important questions relating to long-range production plans are set forth for evaluation, followed by analogous questions on short to medium-range plans. Ultimately, these short to long-range planning questions evaluate the caliber of the production planning group and their ability to undertake their assigned tasks. In the next subsection of the questionnaire, the production planning organisation structure is review. Is it flexible enough to meet changing conditions as well as to ensure efficient and economical manufacturing operations? Building upon these sub sections, the adequacy of leadership by the production planning group is assessed. Specifically, questions are asked to determine if production planning management provides the necessary leadership to achieve desired production goals. Complementary to the leadership subsection is the capacity of the group to communicate important information to manufacturing departments for economy and efficiency in ongoing operations. The last subsection examines the degree of control over manufacturing operations. Not only is there a need for reviewing the adequacy of production planning schedules, but also there must be a means of determining if current schedules are below expectations so that corrective

19.44

Advanced Auditing and Professional Ethics

action can be taken. Production - In the third section of the manufacturing management audit questionnaire, the production function is examined. Initially it is evaluated in terms of its long-range plans. The focus is on the capability of manufacturing facilities to meet the long-term needs of the organisation. Similarly, attention is paid to the human element with great emphasis on providing capable managers to control future ongoing operations. These same types of questions are asked on a short-term basis, namely, for short-to medium-range plans. The main focus of the next subsection of the questionnaire is on the effectiveness of the organisation structure for meeting production goals. For the most part, questions are asked that relate to the capabilities of the production facilities to provide efficient and economical manufacturing. Going beyond the organisation structure, leadership, or lack thereof, in the production function is analysed in the next subsection. Questions relating to the degree, of team-work between production management and its subordinates are asked. Overall, leadership of production supervisors focuses on the economy and efficiency of operations within the various production work centres. For effective leadership, there is need for open channels of communication, the subject of the next subsection. The accent is on communicating efficient methods and processes, as well as on communicating worker-related problems to the proper management level for resolution. In the last subsection, the control factors over production are assessed. Specifically, questions relate to the comparing of actual manufacturing times to standard times, undertaking, corrective action if deemed necessary, utilising efficient production methods and techniques employing quality control techniques at strategic control points, and so forth. Overall, the accent is on evaluating how well ongoing manufacturing operations are controlled as goods in process move from one work station to another. Inventory - Evaluation of an organisation’s inventory system through the management audit questionnaire (see Section IV) starts with determining the degree of integration of inventory management plans with other functional areas. Additional questions focus on such areas as the adequacy of inventory management to plan in the long run for optimum inventory levels. Translating the long-range inventory plans into a shorter time frame, typical questions are raised concerning the adequacy of short-to medium-range inventory plans to meet the requirements of purchasing and manufacturing as well as the need for protection against inventory stockouts. In addition, there are questions evaluating the compatibility of the inventory structure with short- to long-range plans. Building upon the foregoing subsections of the questionnaire, the capability of inventory management to exert the necessary leadership to minimize inventory investments is assessed. Complementary to this subsection is one on communication, whose purpose is to determine if proper information is forwarded to management for keeping inventory under control. In the final subsection, the degree of control over inventory is examined. If an out-ofcontrol condition exists, appropriate management action can be undertaken so as to restore the inventory situation to normal. Purchasing - The purchasing section concludes the manufacturing management audit questionnaire. An all-inclusive long-range purchasing plan should include close coordination

Internal Audit, Management and Operational Audit

19.45

with Production, inventory, and finance. Questions relating to the utilisation of managerial methods by purchasing are stressed for the long run. In turn questions that assess the degree of the current year’s (or intermediate years’) purchasing plans are set forth. Next, questions that focus on the structure found in the purchasing department are used for evaluation. The main focus of this subsection relates ‘to the competency of purchasing management to carry out its assigned activities. In the next subsection, purchasing leadership is examined from many managerial viewpoints. Does purchasing management exercise sufficient control over its suppliers, and does it try to minimize costs of purchased materials and supplies? Even though purchasing management may be progressive in its approach to buying from outside, there must be an open atmosphere for passing on important purchasing information to the appropriate managers and operating personnel. Questions relating to this area are covered in the subsection on communication. The final subsection on control evaluates purchasing control, whereby the accent is on keeping overall costs or purchased goods and services at a minimum. Questionnaire Yes 1.

MANUFACTURING OVERVIEW A.

Long-range plans: 1.

2.

3.

Are long-range manufacturing plans in agreement with: a.

long-rang organisational objectives?

b.

long-range plans of other functional areas ?

c.

medium-range manufacturing plans?

d.

short-range manufacturing plans?

Are long-range manufacturing plans reviewed by: a.

the board of directors?

b.

Top management

Do long-range manufacturing plans include the following functional areas: a.

production planning?

b.

production?

c.

inventory?

d.

purchasing?

4.

Is there an official planning committee to develop long-range manufacturing plans?

5.

Does

manufacturing

management

accept

and

No

N.A.

19.46

Advanced Auditing and Professional Ethics understand these long- range plans?

B.

6.

Are manufacturing management efforts directed toward accomplishing these long-range plans?

7.

Is performance against long-range manufacturing plans measured periodically?

8.

Are long-range manufacturing periodically so as to stay current?

9.

Is the management by exception principle an integral part of long-range manufacturing plans?

plans

reviewed

Short- or medium-range plans: 1.

2.

3.

Are short- or medium-range manufacturing plans in agreement with: a.

short- or medium-range organisation objectives?

b.

short- or medium-range plans of other functional areas?

c.

long-range manufacturing plans?

Are short- or medium-range manufacturing plans reviewed by: a.

top management?

b.

middle management?

c.

lower management?

Do short - or medium-range manufacturing plans include the following functional areas: a.

production planning?

b.

production?

c.

inventory?

d.

purchasing?

4.

Are there procedures for developing short- or medium-range manufacturing plans?

5.

Does manufacturing management accept and understand these short- or medium-range plans?

6.

Are manufacturing management efforts directed toward accomplishing these short- or medium –range plans?

Internal Audit, Management and Operational Audit

C.

7.

Is performance against short - or medium-range plans measured periodically?

8.

Are short- or medium range manufacturing plans reviewed periodically to stay current?

9.

Is the management by exception principle an integral part of short- or medium-range manufacturing plans?

Organisational structure : 1.

Is the manufacturing organisation chart compatible with other functional organisation charts?

2.

Is it clear who is charged with responsibility and who has authority over: a.

production?

b.

production planning?

c.

inventory?

d.

purchasing?

3.

Does each person in manufacturing know his or her job well?

4.

Is it clear what the superior-subordinate relationships are in the manufacturing departments?

5.

Are there adequate job descriptions for each manufacturing position?

6.

Is a competent employee assigned to each manufacturing position?

7.

Is the level of manufacturing training adequate for:

8.

9.

a.

managers?

b.

employees?

Can the quality of manufacturing personnel be assessed for: a.

management?

b.

employees?

Are the manufacturing departments adequately staffed?

10. Are reporting relationships clearly defined and understood by manufacturing personnel? 11. Is manufacturing management held accountable for

19.47

19.48

Advanced Auditing and Professional Ethics its actions? 12. Is there provision within departments for periodic organisational structure?

D.

E.

the manufacturing review of their

Leadership: 1.

Does manufacturing management provide the necessary leadership so that workers have a feeling of responsibility for accomplishing production goals?

2.

Is effective leadership evident in these manufacturing areas: a.

production?

b.

inventory?

c.

production planning?

d.

purchasing?

3.

Does manufacturing management provide the necessary leadership so that company workers have favourable attitudes towards the organisation and their fellow workers?

4.

Does manufacturing management provide a feeling of freedom for workers to discuss job-related problems with their supervisors?

5.

Does manufacturing management support its workers, that is, is there supportive behaviour toward workers?

6.

Does manufacturing management utilise some type of rewards and incentives to motivate workers?

Communication: 1.

Are manufacturing goals well communicated to production personnel?

2.

Are fluctuations in current sales reflected immediately in manufacturing operations in order to increase or decrease productive capacity?

3.

Are downward and communication evident : a.

production?

b.

production planning?

upward

channels

of

Internal Audit, Management and Operational Audit

F.

c.

inventory?

d.

purchasing?

4.

Have more efficient methods and processes of manufacture been communicated from engineering or purchasing personnel to production management?

5.

Has the company’s programme to obtain improvement, simplification, and economies in the following areas been well communicated to the appropriate personnel: a.

materials?

b.

Iabour?

c.

overhead?

6.

Is an effective information system being used to relay important managerial production reports on a timely basis?

7.

Does the company employ some type of communications package programme to keep employees informed and satisfied on the job?

Control : 1.

Is there adequate control over manufacturing goals so that they are in conformity with overall organisation objectives?

2.

Are there effective control reports, methods and techniques utilised for the following manufacturing areas: a.

production?

b.

production planning?

c.

inventory?

d.

purchasing?

3.

Is close control maintained over manufacturing costs?

4.

Are predetermined standards compared to actual results (budget versus actual) on a timely basis?

5.

Is corrective action undertaken when significant manufacturing deviations are detected?

19.49

19.50 II.

Advanced Auditing and Professional Ethics

PRODUCTION PLANNING A.

B.

Long-range plans: 1.

Is production planning management of sufficient calibre to meet long-range manufacturing objectives?

2.

Is there a continuous and sound programme for production planning and scheduling?

3.

Is production planning and scheduling an integral part of an information, system ?

4.

4. Are production plans made as far in advance as possible to : a.

ensure availability of materials?

b.

level machine loading?

c.

minimize movement of workers?

5.

Is there an effort to level out production over time?

6.

Have there been adequate production planning and scheduling in the past to meet customer delivery dates ?

Short- or medium-range plans : I.

Is there a centralised production planning group whose focus is on current or short-range manufacturing operations ?

2.

Is production planning management of sufficient calibre to meet short-or medium-range manufacturing objectives?

3.

Do manufacturing plans provide for meeting, scheduled completion dates?

4.

Are current production plans possible in advance to: a.

ensure availability of materials?

b.

level loading of equipment?

c.

minimize movement of workers?

5.

Are mathematical techniques, such as MRP (Materials requirements Planning, linear programming, And simulation, employed to plan production efficiently and effectively?

6.

Is there ample provision for locating customer orders during the manufacturing process?

Internal Audit, Management and Operational Audit 7.

Are backlog figures charted as a guide for future production planning?

8.

Does the production panning group consider work in process so as to keep costs at a minimum?

C. Organisational structure:

D.

1.

Is the production planning department under the direction of a qualified manager?

2.

Is the production planning department organised so that it can respond to changing conditions?

3.

Is the production planning department organised so that production schedules are made as far as possible in advance to ensure efficient and economical manufacturing operations?

4.

Are production schedules an integral part of an information system?

5.

Are production schedules sufficiently comprehensive to include all customer orders (small to large size)?

Leadership: 1.

Is the production planning manager a leader, i.e., does he or she exert the necessary leadership to accomplish established production quotas as well as deadlines?

2.

Is leadership evident in the production planning function, that is, do production personnel look to this group as an effective source of information on production scheduling and control?

3.

Is there appropriate interaction with a high degree of confidence and trust between the production planning group and production personnel?

4.

Does the production planning group enlist the necessary co- operation of all manufacturing units to realise production goals?

5.

Does the production planning group avoid wasted production time through effective planning and scheduling methods?

6.

Is the production planning group flexible enough to meet demands placed on it by the sales department?

19.51

19.52 E.

F.

Advanced Auditing and Professional Ethics Communication: 1.

Are downward and upward communication channels used effectively to keep appropriate production personnel abreast of pertinent production schedule?

2.

Does the production planning group communicate a sufficient flow of current manufacturing information to production personnel to achieve economy and efficiency in ongoing operations?

3.

Are production schedules communicated far enough in advance to ensure: a.

availability of materials?

b.

leveling of machine loading?

c.

keeping of overtime to a minimum?

4.

Is production planning flexible enough to meet unanticipated changes that are transmitted periodically from different functional areas of the company?

5.

Is feedback of deviations from production plans an essential part of the production planning process?

Control : 1.

Is close control exercised by the production planning manager over production schedules?

2.

Is there a periodic schedule manufacturing operations?

3.

Is this periodic schedule:

for

a.

understood by operating personnel?

b.

followed by operating personnel?

controlling

4.

Are production planning goals compared to actual production schedules so that corrective action can be undertaken if results are below expectations?

5.

Are standard setup and run time used for loading the manufacturing (management control) centers?

6.

Does the machine loading system effectively balance the amount of machine capacity available?

7.

Are delinquent production loads effectively rescheduled?

8.

Are there enough production expediters to control

Internal Audit, Management and Operational Audit ongoing manufacturing operations effectively? 9.

Is there adequate control over production order backlogs?

10. Are the latest mathematical techniques, such as MRP (materials requirements planning) and simulation, employed to control ongoing manufacturing operations in an efficient and economical manner ? 11. Are jobs scheduled by the production planning manager contained in the production schedules? III.

PRODUCTION A.

Long-range plans: 1.

Are manufacturing facilities adequate to meet longrange company objectives?

2.

Are manufacturing facilities well laid out to provide efficiency in: a.

production ?

b.

materials handling?

c.

related manufacturing functions?

3.

Have production bottlenecks?

4.

Are manufacturing facilities capable of meeting longrange customer demands?

5.

Are long-range manufacturing plans directed toward acquiring new:

6.

a.

plant ?

b.

equipment?

c.

tooling?

operations

been

free

from

Does manufacturing management have a set procedure for replacing inefficient: a.

plant?

b.

equipment?

c.

tooling?

7.

Is factory automation utilised to the fullest extent?

8.

Are long-range manufacturing plans directed toward

19.53

19.54

Advanced Auditing and Professional Ethics manufacturing facilities that are:

9.

a.

well lighted?

b.

well ventilated?

c.

well maintained?

Does production have a long range preventive maintenance (PM) programme?

10. Can present capacity be expanded to meet longrange production needs? 11. Do manufacturing facilities lend themselves to: a.

a quality control programme?

b.

utilisation of minicomputers to control automated machines and processes?

c.

numerical control machine tools.

12. Does production have capable managers as: a.

plant superintendents?

b.

work centre supervisors?

c.

foremen?

13. Are manufacturing methods subject to constant scrutiny for improvement? 14. Does the company employ an effective wage incentive system to keep costs at a minimum? 15. Have the company’s manufacturing facilities been operating at a desired level of capacity? B.

Short- or medium-range plans: 1.

Do short- or medium-range manufacturing plans call for leveling out production?

2.

Do short- or medium-range manufacturing plans reduce or eliminate production bottlenecks?

3.

Do short- or medium-range manufacturing plans include a preventive maintenance (PM) programme?

4.

Is there adequate provision for repairs and service of equipment that has high downtime?

5.

Is there ample provision for: a.

expanding production?

Internal Audit, Management and Operational Audit b. 6.

contracting production?

Is there an effective programme to remedy: a.

high scrappage rate?

b.

high rejection rate?

7.

Is there a programme to train employees who are not working efficiently?

8.

Is there a programme for promoting factory personnel?

9.

Do short- or medium-range manufacturing plans provide a method for comparing actual times to standard times?

10. Are manufacturing methods subject to constant scrutiny for improvement? 11. Are manufacturing methods designed for economy of manufacture? 12. Do short- or medium-range manufacturing plans call for increasing worker productivity? 13. Do short- or medium-range manufacturing plans call for good health and safety practices in the manufacturing process? 14. Are current quality control techniques adequate? C. Organisational structure: 1.

Are production facilities well laid out to provide efficient and economical manufacturing?

2.

Are production facilities organised so that materials handling is kept to a minimum?

3.

Are production facilities organised so that there is an effective preventive maintenance (PM) programme?

4.

Are production facilities flexible enough to:

5.

a.

accommodate shifts in product demand?

b.

expand production?

c.

contract production?

Is there a definite production programme to obtain improvement, simplification, and economies in: a.

equipment and machinery?

19.55

19.56

Advanced Auditing and Professional Ethics b.

manufacturing processes?

c.

raw materials?

d.

direct and indirect labour?

e.

manufacturing overhead?

6.

Do productive operations employ some type of wageincentive system for manufacturing efficiency?

7.

Are production facilities geared to utilise the latest technological developments, such as automatic machines, mechanical robots, and minicomputers?

8.

Are production facilities well maintained so as to be safe and free from fire, explosion, and the like?

9.

Is the plant well lighted and ventilated?

10. Is there security against strikes, sabotage, and the like? D.

Leadership: 1.

Is there leadership evident in the production function, that is, do production personnel feel a real responsibility for production goals and behave in ways to implement them?

2.

Do production personnel feel free to discuss their jobs and related problems with their supervisors?

3.

Is there a friendly interaction between management and personnel with a degree of confidence and trust?

4.

Is the appropriate style of leadership used for, various types of production workers: a.

autocratic (no participation in decisions)?

b.

consultative (some degree of participation in decisions)?

c.

participative (large degree of participation in decisions)?

5.

Is there a high degree of team work, encouraged by effective leadership at the production level?

6.

Do production supervisors give the necessary leadership to initiate improvements in work methods?

7.

Do production supervisors give the necessary leadership to provide economy and efficiency of

Internal Audit, Management and Operational Audit performance within the production work centres? 8.

Do production supervisors back up their workers in conflict situations?

9. Do production supervisors maintain an open atmosphere to keep labour grievances and complaints to a minimum? E.

F.

Communication: 1.

Do production workers feel free to communicate their problems, whether they be job-related or personal, to their superiors?

2.

Have the most efficient manufacturing methods and processes been communicated to production personnel?

3.

Is the feedback concept utilised to hold production personnel accountable for their operations?

4.

Have the detailed aspects of the incentive system been fully explained to production personnel?

5.

Has a preventive maintenance programme been communicated to all production personnel?

6.

Have good safety practices been communicated to all production personnel for their protection?

7.

Have good “housekeeping” procedures been communicated to all production personnel for increasing productivity?

Control: 1.

Are production operations integrated with major input sources: a.

engineering?

b.

inventory?

c.

purchasing?

2.

Are actual manufacturing times compared to standard times as quickly as possible’

3.

Is immediate corrective action undertaken once the deficiency is detected?

4.

Do production reports, methods, and techniques lend themselves to economy and efficiency in ongoing

19.57

19.58

Advanced Auditing and Professional Ethics manufacturing operations? 5.

Is there adequate control over manufacturing operations to reduce or eliminate production bottlenecks?

6.

Does effective control over production include a preventive maintenance (PM) programme?

7.

Are modern handling methods utilised for transportation of in- process manufactured items?

8.

Is there effective control over the movement of inprocess manufactured items?

9.

Is the plant well laid out so as to permit materials flow in the most direct route from receiving through produaction to shipping?

10. Is the quality control mechanism adequate for producing products of uniform quality? 11. Are statistical quality control techniques used to monitor products at strategic control points? 12. Is there control over production rejects and rework? 13. Is there adequate review of product quality reports with the view of improving operational manufacturing performance? IV. INVENTORY A.

Long-range plans: 1.

Is inventory management sufficiently qualified to meet long-range company objectives?

2.

Are long-range inventory management plans coordinated with:

3.

4.

a.

production?

b.

purchasing?

c.

finance?

Is inventory properly and efficiently stored so as to provide a minimum of: a.

obsolescence?

b.

deterioration?

c.

pilferage?

Is there an adequate inventory system under

Internal Audit, Management and Operational Audit management control to plan inventory in the long run at optimum levels?

B.

5.

Is there an effective physical inventory system to obviate any surprises in loss or value?

6.

Are inventory plans and procedures audited periodically by: a.

internal auditors?

b.

external auditors?

Short- or medium-range plans: 1.

Is inventory management sufficiently qualified to meet short- or medium-range company objectives?

2.

Are short-range inventory management plans an integral part of-

3.

4.

5.

a.

production?

b.

purchasing?

Are inventories under control as to: a.

type?

b.

amount?

Is there an adequate inventory system to: a.

plan current inventory at optimum levels?

b.

compare physical to perpetual inventories?

c.

detect theft?

Are lead times figured into inventory levels for: a.

purchasing?

b.

manufacturing?

6.

Is the concept of safety stock employed as a protection against stock-outs?

7.

Are inventory levels coordinated with reorder points?

8.

Are bills of materials utilized to determine inventory requirements?

9.

Do short-range inventory plans include “make” versus “buy” decisions to lower costs?

10. Is receiving and inspection of inventory items adequate?

19.59

19.60 C.

Advanced Auditing and Professional Ethics Organisational structure: 1.

Is the inventory department under the direction of a capable manager?

2.

Are inventories and their in-plant movements organised and reported by their basic types:

3.

D.

a.

raw materials?

b.

work in process?

c.

finished goods?

Are inventories maintained at their optimum level by their basic types: a.

raw materials?

b.

work in process?

c.

finished goods?

4.

Is there an effective system of physical inventory to disclose any irregularities or losses?

5.

Is inventory organised around the ABC method of classifying materials, i.e., by high, medium, and lowvalue items?

6.

Is inventory integrated within an information system?

7.

Are modern materials-handling methods used for transportation and storage of materials?

Leadership: 1.

Does inventory management exert the necessary leadership to keep inventory under control?

2.

Is inventory management capable of giving the leadership necessary to minimise the investment in: a.

raw-materials inventories?

b.

work-in-process inventories?

c.

finished-goods inventories?

3.

Is inventory kept at a minimum that is consistent with efficient production planning?

4.

Does inventory management have the necessary clout to store inventories properly in order to minimize losses caused by spoilage, obsolescence, or depreciation?

Internal Audit, Management and Operational Audit 5.

E.

F.

Is inventory management sufficiently progressive to employ the most modern materials-handling methods for transportation and storage of inventories?

Communication: 1.

Is there an information system utilised that employs efficient management, methods and techniques to control inventories and to prepare periodic inventory reports that are of great value to management?

2.

Is there an effective communication system designed to assist in, keeping the inventory turnover rate high?

3.

Is there good managerial control over movement of work-in-process materials so that this inventory is kept at a minimum?

4.

Is the level of work-in-process materials consistent with an efficient manufacturing cycle?

5.

Is there a procedure for highlighting excess inventory quantities and bringing this condition to management’s attention in order to return them to their proper levels?

6.

Is there an effective inventory system for keeping any surprises in inventory losses to minimum?

Control: 1.

2.

3.

4.

Are inventory management control reports, methods, and techniques integrated with: a.

production?

b.

purchasing?

Are inventories effectively controlled as to: a.

type?

b.

amount?

Are inventories properly stored to provide a minimum of. a.

obsolescence?

b.

deterioration?

c.

pilferage?

Have inventory levels been reduced by profitable disposition of obsolete or excess items?

19.61

19.62

Advanced Auditing and Professional Ethics 5.

Is inventory control integrated with: a.

economic order quantities?

b.

reorder points?

6.

Is the concept of safety stock employed to protect against stockouts?

7.

Are lead times figured into inventory levels?

8.

Have steps been taken to balance the cost generated by too small an inventory against the cost of carrying excessive inventories to determine an optimum inventory turnover?

9.

Are bills of materials utilised to determine what items should be retrieved from inventory?

10. Is there adequate management control over the receipt of raw materials and parts from vendors? 11. Is there adequate management control over the receipt of work-in- process items for the manufacturing departments? 12. Is there adequate inspection of items received into inventory as to: a.

type?

b.

number?

13. Are inventory items physically counted to make sure that perpetual inventory records are accurate? 14. Is inventory controlled through the use of the ABC concept (A = high-value items, B = medium-value items, C = low-value items)? 15. Is there an effective management control system for receiving materials that are not on a purchase order, i.e., products returned by customers? 16. Are materials available when needed for the start of production? V.

PURCHASING A.

Long-range plans: 1.

Is purchasing management sufficiently qualified to meet long- range company objectives?

Internal Audit, Management and Operational Audit 2.

a.

production?

b.

inventory?

c.

finance?

3.

Are managerial methods employed to keep routine purchasing tasks at a minimum?

4.

Are appropriate management planning methods employed by purchasing?

5.

Is there a purchasing performance program to measure the long- term performance of:

6.

B.

Are long-range purchasing plans coordinated with:

a.

vendors?

b.

buyers?

c.

purchased parts?

Do company buyers (over the long run) search for: a.

new sources of supply?

b.

new and better materials and methods?

c.

lower prices?

Short- or medium-range plans: 1.

Is purchasing management sufficiently qualified to meet short- or medium-range company objectives?

2.

Are short- or medium-range purchasing plans an integral part of: a.

production?

b.

inventory?

c.

finance?

3.

Do purchasing models employ the economic order quantity (EOQ) concept?

4.

Are bids obtained on large quantity purchases?

5.

Do purchasing plans include provision for taking advantage of quantity discounts?

6.

Does purchasing evaluate several sources of supply before issuing purchase orders?

7.

Is there a set policy for ordering through purchasing requisitions?

19.63

19.64

C.

D.

Advanced Auditing and Professional Ethics

Organisational structure: 1.

Is the purchasing department under the direction of a capable manager?

2.

Are purchasing searching for:

procedure

organised

around

a.

new sources of supply?

b.

new materials?

c.

better manufacturing methods?

d.

lower prices (in the manufacturing process)?

3.

Are purchasing procedures integrated within an information system?

4.

Is the quality of goods considered when purchasing?

5.

Are delivery times considered when purchasing?

6.

Is there a managerial approach to measuring purchasing performance of buyers?

7.

Do purchasing procedures take into account automatic checks and balances (internal control) for matching orders and invoices?

Leadership: 1.

Does purchasing management exert the necessary leadership to require that materials and supplies be in on time from suppliers?

2.

Does the purchasing group provide the necessary leadership to take advantage of special buying Opportunities that will lower overall product costs?

3.

Does the purchasing group keep abreast of technological developments so as to alert the company’s engineering department to the existence of raw materials and processes?

4.

Does the purchasing group search for newer and lower-cost sources of supply?

5.

Does the purchasing department employ low-cost methods of preparing purchase orders?

Internal Audit, Management and Operational Audit E.

Communication: 1.

F.

Is there an open atmosphere in which the purchasing group wants to keep abreast of technological developments and is constantly searching for: a.

new sources of supply?

b.

new and better materials?

2.

Do purchasing agents spend ample time talking to sales-persons in order to acquire sufficient information about new products and processes that may be beneficial to the company?

3.

Do purchasing agents communicate information about new products and processes to the proper authorities. Such as inventory and engineering management, in order to keep manufacturing operations as efficient and economical as possible?

4.

Are the results of purchasing performance communicated to the purchasing agents and their superiors?

Control : 1.

Are production control reports, methods, and techniques integrated with purchasing?

2.

Is purchasing of large amounts under the control of economic ordering formulas?

3.

Does purchasing take advantage of quantity discounts?

4.

Are there set managerial policies for buying from the outside?

5.

Is purchasing performance by the company’s purchasing agents under the control of a purchasing manager?

6.

Is there adequate control exercised by purchasing management to ensure that: a.

low prices are being paid for purchased items?

b.

new and better materials and parts are being bought?

c.

new sources of supply are being used?

19.65

19.66

Advanced Auditing and Professional Ethics 7.

Are there adequate controls, that is, checks and balances, for: a.

issuing purchase orders?

b.

inspection of receipts?

c.

matching of orders, invoices and reports?

receiving

19.10.2 Marketing Function - The marketing function tends to be more difficult to evaluate by utilising a management audit questionnaire than most other functional areas. The principal reason is that marketing is highly dependent upon external environmental factors that are not under the control of marketing management. Typical examples include the prices of competitors, the general level of economic activity, and the rate of inflation. Similarly, marketing is often dependent upon human judgement, involved with complex relationships, and beset with imperfect knowledge, resulting in decisions being made by sheer intuition rather than by some type of scientific analysis. Although experience and intuition are vital ingredients in marketing, they can be greatly enhanced by computer analysis and quantitative techniques. No matter what view-point, or what combination of the two approaches intuitional and quantitative- is found within an organisation, the five sections of the marketing management audit questionnaire, namely: I.

Marketing Overview

II.

Sales

III.

Market Research

IV. Advertising V.

Physical Distribution.

Marketing Overview - No matter what type of business organisation, marketing generally starts the information flow from customers desiring specific goods and/or services. Not only does marketing receive orders from customers, but also marketing efforts are focused on them. The Company’s marketing executives derive their information about customers and the market place through marketing intelligence, formal market research, and company accounting information. Marketing intelligence activity represents the continuous effort to keep informed about current developments among customers, competing products, and the marketing environment. In a similar manner, market research centres on a more formal approach to current developments in particular, project-oriented research. The company’s accounting system generates sales and cost information to complement marketing intelligence and research. Overall, marketing management needs an effective information flow to relate its efforts to constantly changing conditions. The purpose of this initial section of the marketing management audit questionnaire is twofold. First, this section concentrates on the ability of marketing management to meet changing environmental factors, both external and internal. The manner in which marketing management relates to changing environmental factors is one way of determining how well it is prepared to meet the challenges of changing times. The proper meshing of the external and

Internal Audit, Management and Operational Audit

19.67

internal environments with an Organisation, s business functions, particularly marketing, leads to efficiency and economy of organisational operations for accomplishing Predetermined objectives. Second, this section determines the degree of integration of the marketing function with other functional areas that relate to marketing. Sales - Evaluation of an organisation’s sales effort through the management audit questionnaire (Section II) starts with examining the capabilities of sales management. Questions on long-range marketing plans with respect to such items as products, services, policies, and sales-person compensation are set forth. Similar questions are asked about short- or medium-range marketing plans. As with long-range sales plans, these questions ultimately evaluate the ability of an organisation’s sales management to perform its assigned tasks. Specifically, emphasis is placed on the ability of sales managers to meet sales quotas that not only result in profitable operations, but also increase customer satisfaction and keep salespersons sufficiently motivated to meet new sales goals. Enlarging upon this last point, the sales organisation structure should be flexible enough to meet both short- and long-term sales growth objectives and changing business conditions. Likewise, the sales compensation plan should encourage both immediate and longer-term sales. Building upon the above subsections of the questionnaire, questions relating to sales management leadership are developed. Emphasis is placed on the effectiveness of sales management in getting the sales staff to achieve specific sales goals. Also, the degree of confidence and trust between sales managers and sales-persons is assessed. Complementary to leadership is an evaluation of sales management’s communication skills, with particular emphasis on critical information needed to keep sales persons abreast of important organisational activities. In the final subsection, the degree of sales control exercised by sales management is reviewed - that is, how well sales goals are related to actual sales so that corrective action can be undertaken if results are below expectations. Market Research - Before extensive new product development is undertaken, it is helpful to initiate a market research study to determine the feasibility of bringing a new product to the market place. The first subsection of the market research section (See Section III) evaluates the effects of long-range plans on market research. In like manner, the relationships of shortor medium-range plans to market research are set forth. The focus of both subsections is on the effectiveness of market research management and its staff to fulfill its assigned tasks in researching new products. Underlying these questions is the next subsection, which evaluates market research structures for undertaking specific studies. More specifically, question relating to emerging and shifting markets are asked. In the leadership subsection, the capabilities of the market research manager are examined. Also, the effectiveness of market research communication from sources outside the group, especially from customers, is evaluated. Similarly, the exchange of ideas between the market research group and its management is examined for determining communication effectiveness. Within the control subsection, market research costs are reviewed to determine the degree of management control over ongoing projects. In most cases, costs are compared to budgeted amounts, which form the basis for corrective action. Advertising - The advertising section of the marketing management audit questionnaire (See

19.68

Advanced Auditing and Professional Ethics

Section IV) is an extension of the sales section. An all-inclusive sales plan should include long-range as well as short- to medium-range advertising plans. From that perspective, questions relating to such areas as the adequacy of the advertising budget and the tie-in of regular and special promotions to advertising are evaluated. Next, questions relating to the advertising structure are evaluated. The central focus of this subsection is on the competency of advertising management to meet current sales objectives during upswings and downswings of the economy. The management-by-exception principle is employed to compare actual advertising costs to budgeted amounts. Also, advertising management’s ability to integrate its own area with personal selling and promotion is evaluated. Within the next subsection, advertising leadership is examined from several managerial viewpoints. For instance, is the organisation an innovator in advertising, does it keep with the times, and does it have a well-thought-out advertising program? Although it may well be progressive in advertising, its methods of communication must be compatible with the message directed at its customers. In essence, there must be a balance in the overall advertising programme to reap its full benefits. Also, there must be adequate managerial control over the advertising effort. In the final subsection, advertising control is therefore evaluated, with the accent or keeping advertising costs within the budgeted amounts. Physical Distribution - As with the prior sections, the physical distribution (PD) section (See Section V) of the marketing management audit questionnaire is an integral part of marketing activities. To ensure proper distribution of an organisation’s products (services), the first subsection of long-range plans centres on questions that are oriented toward the future. Fundamentally, these questions on distribution assess the value received for cost incurred. In the next subsection, the physical distribution structure is evaluated from several viewpoints, namely, their number, their efficiency, and the ability to meet changing conditions. Within the leadership subsection, distribution channels under PD management are assessed in terms of their ability to move a large volume of merchandise to customers at a low cost and, at the same time, achieve a high rate of inventory turnover. Complementary to this subsection is one on communication. These questions highlight physical distribution effectiveness or lack thereof, particularly in relaying essential managerial and operational information. In the last subsection, physical distribution control is reviewed, particularly in the areas of costs and inventories. Yes I.

MARKETING, OVERVIEW A.

Long-range plans: 1.

Are long-range marketing plans in agreement with: a.

long-range organisations objectives?

b.

long-range plans of other functional areas?

c.

medium-range marketing plans?

No

N.A.

Internal Audit, Management and Operational Audit d. 2.

3.

short-range marketing plans?

Are long-range marketing plans reviewed by: a.

Board of directors?

b.

Top Management ?

Do long-range marketing plans include the following functional areas: a.

Sales ?

b.

Market research ?

c.

Advertising ?

d.

Physical distribution ?

4.

Is there an official Planning Committee to develop long-range marketing plans?

5.

Does marketing management, accept and understand these long-range plans?

6.

Are marketing management efforts directed towards accomplishing these long-range plans?

7.

Is performance against long-range marketing plans measured periodically?

8.

Are long-range marketing reviewed periodically so as to stay current?

9.

Have forecasts been sufficiently accurate to develop long-range marketing plans?

10. Is the management by exception principle an integral part of long-range marketing plans? B.

Short- or medium-range plans: 1.

2.

Are short- or medium-range marketing plans in agreement with: a.

short- or objectives?

medium-range

b.

short- or medium-range functional areas?

c.

long-range marketing plans?

organisational plans

of

other

Are short- or medium-range marketing plans reviewed by:

19.69

19.70

Advanced Auditing and Professional Ethics

3.

a.

top management?

b.

middle management?

c.

lower management?

Do short- or medium-range marketing plans include the following functional areas: a.

Sales ?

b.

Market research?

c.

Advertising ?

d.

Physical distribution?

4.

Are there procedures for developing short- or medium-range marketing plans?

5.

Does marketing management accept and understand these short- or medium-range plans?

6.

Are marketing management efforts directed towards accomplishing these short- or medium range plans?

7.

Is performance against short- or medium-range plans measured periodically?

8.

Are short- or medium-range marketing plans reviewed periodically to stay current?

9.

Have forecasts been sufficiently accurate to develop short- or medium-range marketing plans?

10. Is the management by exception principle an integral part of short- or medium-range marketing plans? C.

Organisational structure: 1.

2.

Is the marketing organisation structure adequate to fulfill stated marketing: a.

objectives?

b.

plans?

c.

strategies?

d.

programs?

e.

policies?

Is the marketing organisational chart compatible with

Internal Audit, Management and Operational Audit other functional organisational charts? 3.

Is it clear who is charged with responsibility and who has authority over: a.

Sales ?

b.

market research?

c.

advertising?

d.

physical distribution?

4.

Does each marketing person know his or her job well?

5.

Is it clear what the superior-subordinate relationships are in the marketing department?

6.

Are there adequate job descriptions for each marketing position?

7.

Is there a competent employee assigned to each marketing position?

8.

Can the quality of marketing personnel be assessed for :

9.

a.

management?

b.

employees?

Is the marketing department adequately staffed?

10. Are reporting relationships clearly defined and understood by marketing personnel? 11. Is marketing management held accountable for its actions? 12. Is there provision within the marketing department for periodic review of its organisation structure? D.

Leadership: 1.

2.

Does marketing management provide the leadership to develop: a.

new product opportunities?

b.

new market segments?

c.

new promotional ideas?

Is some form of leadership evident in these

19.71

19.72

Advanced Auditing and Professional Ethics marketing areas:

E.

a.

sales?

b.

market research?

c.

physical distribution?

3.

Is marketing management sufficiently progressive to take a chance on a new product?

4.

Is the organisation’s marketing program geared to leadership in the market-place?

5.

Does marketing management provide the know-how to meet competition head on?

Communication: 1.

Have short-to long-range marketing objectives and plans been communicated to the proper marketing personnel ?

2.

Have the organisation’s marketing strategies and programmes been communicated to the proper marketing personnel.

3.

Have the organisation’s marketing policies been communicated to the proper marketing personnel?

4.

Are communication channels adequate for the coordination of marketing activities, in regard to:

5.

a.

new product introduction?

b.

pricing policies?

c.

personal selling practices?

d.

special promotions?

e.

market research studies?

f.

advertising programmes?

g.

physical distribution methods?

Is there effective feedback of important marketing information to the proper personnel?

F. Control: 1.

Do the managers of marketing activities exercise sufficient control to achieve desired marketing objectives in these areas:

Internal Audit, Management and Operational Audit

2.

Sales?

b.

Market research?

c.

Advertising?

d.

Physical distribution?

Are effective control reports, methods, techniques utilised for these marketing areas: a.

Sales?

b.

Market research?

c.

Advertising?

d.

Physical distribution?

and

3.

Is close control maintained over marketing activities and their costs?

4.

Are marketing goals compared to actual results (budget versus actual):

5. II.

a.

a.

on a periodic basis?

b.

on a timely basis?

Is corrective action undertaken when significant marketing deviations are detected?

SALES A.

Long-range plans: 1.

Is sales management of sufficient caliber to meet long-range sales objectives?

2.

Have sales been adequate over the long run to meet organisational objectives?

3.

Has the organisation maintained its past share of the total market?

4.

Does the organisation have a strategy for maintaining its future share of the total market?

5.

Do long-range plans include the leveling out of sales peaks and valleys?

6.

Are sales forecasting techniques: a. used? b. adequate?

19.73

19.74

Advanced Auditing and Professional Ethics 7.

8.

9.

Does the organisation calculate long-range data for products by: a.

sales volumes?

b.

contribution factors?

c.

breakeven points?

Are long-range sales quotes established for: a.

products or product lines ?

b.

sales or geographical areas?

c.

salespersons?

Are the organisations products or product lines diversified?

10. Does the organisation have a policy on developing new products? 11. Is this policy adequate for developing future growth? 12. Is there an adequate long-range programme for developing the sales force in the future? 13. Are sales service policies adequate for future growth? 14. Are the organisation’s products relevant to the times? 15. Does the organisation have advantages over its competitors in the long run? 16. Are there adequate incentive programmes to keep sales at a desired level? 17. Does the sales compensation plan encourage long-range sales as well as immediate sales? B.

Short- or medium-range plans: 1.

Do the organisation’s short - or medium-range plans highlight its advantages over its competitors in: a.

product innovation?

b.

merchandising capabilities?

c.

advertising effectiveness?

d.

personal selling expertise?

Internal Audit, Management and Operational Audit e. 2.

3.

other marketing factors deemed necessary?

Are there well-defined policies included within the organisation’s marketing short- or medium-range plans on : a.

sales?

b.

returns?

c.

allowances?

d.

commissions?

Are short-or techniques : a.

used ?

b.

adequate

medium-range

sales

forecasting

4.

Are there short-or medium-range sales quotas?

5.

Are sales performance records maintained by: a.

products or product lines ?

b.

sales or geographical areas ?

c.

sales persons?

d.

advertising effectiveness?

6.

Are selling efforts directed towards those products with high unit contribution?

7.

Are short- or medium-range plans directed toward a sales mix that maximizes: a.

satisfaction of customer needs?

b.

customer service ?

c.

profits ?

8.

Is the short- or medium-range sales program the directed toward, at least, maintaining the company’s share of the market?

9.

Do the short- or medium-range sales plans include a programme to maintain or improve its customer relations?

10. Are selling prices established on a sound financial basis?

19.75

19.76

Advanced Auditing and Professional Ethics 11. Does the pricing mechanism provide a satisfactory return for the: a.

manufacturer?

b.

distributor?

c.

retailer?

12. Does the pricing mechanism provide for: a.

inflationary or deflationary times?

b.

volume variations?

c.

unforeseen contingencies?

13. Is there adequate sales supervision to accomplish short- or medium-range sales goals? 14. Are there adequate salespersons to meet short- or medium-range sales goals? 15. Do short- or medium-range sales plans include an effective sales training programme? C. Organisational structure: 1.

Are sales quotas established for each: a.

sales area?

\

b.

product or product line?

c.

salesperson?

2.

Are sales and service policies structured for short and long-term growth?

3.

Are sales and service policies sufficiently flexible to meet short-to long-term growth?

4.

Are sales and service policies sufficiently flexible to meet changing business conditions?

5.

Are there individual product-line sales managers?

6.

Is there adequate sales personnel in the field?

7.

Is the organisation’s sales compensation plan structured so that it encourages: a.

immediate sales?

b.

intermediate sales?

Internal Audit, Management and Operational Audit c. 8.

D.

E.

long-term sales?

Is the organisation’s sales compensation plan structured so that it is effective as to the: a.

amount?

b.

incentive?

c.

method?

Leadership: 1.

Does sales management spend ample time in the field to provide advice and support to sales personnel?

2.

Does sales management instill in its salespersons a sense of being sales- oriented?

3.

Are salespersons sufficiently motivated by sales management to reach their sales quotas?

4.

Does sales management solicit ideas and opinions about new products from its salespersons and make constructive use of them?

5.

Do salespersons feel completely free to discuss their problems with sales management?

6.

Is there a friendly interaction, with a high degree of confidence and trust, between sales management and salespersons?

7.

Are salespersons involved in important decisions that affect their sales efforts?

8.

Are salespersons adequately trained to meet the challenge presented to them?

Communication: 1.

Are downward and upward communication channels used effectively to keep salespersons abreast of overall organisational activities that may have some effect on their sales efforts?

2.

Have sales quotas been communicated to all salespersons?

3.

Are weekly sales reports communicated from the field to sales management?

19.77

19.78

F.

Advanced Auditing and Professional Ethics 4.

Are sales and service policies communicated to salespersons?

5.

Are salespersons bulletins, issued on a periodic basis, an effective means of communication, i.e., are they read and is appropriate action taken when required?

6.

Are new methods and techniques of selling communicated to salespersons?

7.

Are salespersons kept abreast of finished-goods inventories that need to be sold before they spoil, deteriorate, or lose their value?

8.

Are salespersons kept abreast of excess finished goods inventories that need to be sold?

Control: 1.

2.

3.

4.

Does sales management exercise effective control over: a.

personal selling?

b.

advertising?

c.

regular promotions?

d.

special promotions?

Is close control exercised by sales management over these areas: a.

sales goals?

b.

sales prices?

c.

sales returns?

d.

sales allowances?

Is sales performance controlled by: a.

products or product lines?

b.

sales or geographical areas?

c.

salespersons?

Are sales control reports, methods and techniques: a.

used?

b.

adequate?

Internal Audit, Management and Operational Audit 5.

Where there are deviations between sales goals and actual sales, does sales management undertake corrective action when deemed necessary?

6.

Is there adequate sales supervision in the field to control ongoing sales activities?

7.

Are adequate field sales reports forwarded to sales management for better control of the organisation’s sales efforts?

8.

Is there effective control by sales management over product selling prices?

9.

Does sales management exercise sufficient control to at least maintain the organisation’s share of the market?

10. Does sales management exercise adequate control to maintain or improve customer relations? 11. Is there sufficient control exercised over the sales compensation programme to ensure equitable: a.

sales commissions?

b.

sales bonuses?

12. Do controls exist for monitoring the quantity and dollar value of customer orders that are behind schedule? III. MARKET RESEARCH A.

Long-range plans: 1.

Are long-range market research plans compatible with overall marketing plans?

2.

Is there a clear-cut division of responsibility between sales and market research?

3.

Is market research management capable of handling long-term research projects?

4.

Are long-term market research projects adequately funded?

5.

Is the market research department for long-term projects adequately: a.

supervised?

b.

staffed?

19.79

19.80

Advanced Auditing and Professional Ethics 6.

B.

Are markets studied in depth before new product development? a.

geographical trends?

b.

market potential?

c.

disposable income?

7.

Are the organisation present products or product lines studied to indicate their relations to continual shifting

8.

Are long-range statistics available for the following characteristics of the population that form the potential market for the organisation’s products: a.

buying habits?

b.

number in family?

c.

type of housing”

d.

type of transportation?

Short- or medium-range plans: 1.

Are short- or medium-term market research projects an integral part of the current year’s budget?

2.

Are short- or medium-term market research projects for reliable results adequately: a.

supervised?

b.

staffed?

3.

Is the market research group sufficiently flexible to make changes in its ongoing projects?

4.

Is the market research group consulted in the planning of: a.

sales quotas?

b.

product distributions?

c.

retail promotions?

5.

Does ongoing market research utilize current data in evaluating new products?

6.

Are new market research methods and techniques employed by market research management and its

Internal Audit, Management and Operational Audit staff? C.

D.

Organisational structure: 1.

Are market structures studied before new product development?

2.

Are the changing structural characteristics of markets studied, such as trends back to cities and shifts of markets from one income level to another?

3.

Are statistics generated regarding the characteristics of population comprising potential customers for the organisation’s products, such as income, number in the family, and buying habits?

4.

Are market areas analysed on the basis of sales potential and desired market share?

5.

Are market structures checked periodically for weak and strong areas?

Leadership: 1.

Is the market research group under the direction of capable and progressive management?

2.

Does market research management make its presence felt in planning: a.

sales quotas?

b.

advertising?

c.

physical distribution?

3.

Does market research management require that the dynamics of the market-place, i.e., trends to the suburbs, shifts of market potential, be incorporated in market research studies?

4.

Is market research management capable of exerting influence to get desired market statistics regarding characteristics of the population, i.e., income, number in the family, and buying habits?

5.

Is market research management capable of exerting sufficient influence to analyse market areas on the basis of sales potential and desired market shares?

19.81

19.82

Advanced Auditing and Professional Ethics 6.

E.

F.

Does market research management exert sufficient influence to make new statistical tools available to its staff?

Communication: 1.

Does market research management communicate new ideas on marketing projects to its staff?

2.

Are long-range marketing plans communicated to the market research group so that they may be incorporated as a part of specific market research projects?

3.

Are the latest product sales data communicated to the market research group through the organisation’s information system?

4.

Within the market research group, is there a free exchange of ideas: a.

among peers?

b.

with their superiors?

5.

Do organisation personnel communicate information on ideas for possible new product development to the market research group?

6.

Do sales personnel communicate important changes in the market place to market research personnel?

7.

Are important market research data compiled by government and/or private agencies communicated to market researchers?

Control: 1.

Are market research studies adequately controlled by market research management?

2.

Are adequate controls established over market research projects?

3.

Is there an effort to keep market research costs under control?

4.

Are deviations from budgeted market research costs analysed by market research management?

5.

Are weak sales areas researched adequately so as to uncover their deficiencies?

Internal Audit, Management and Operational Audit 6.

Are weak products researched adequately so as to uncover their deficiencies?

IV. ADVERTISING A.

B.

C.

Long-range plans: 1.

Is the advertising programme an integral part of long-range marketing plans?

2.

Is the advertising budget adequately managed to meet long-range plans?

3.

Are regular promotions, salespersons contests, etc. an integral part of the long-range advertising programme?

4.

Are seasonal promotions integrated with long-range plans?

Short or medium-range plans: 1.

Is the advertising budget adequately managed to meet short- or medium-range plans?

2.

Is there a well-planned advertising programme for the short or medium run?

3.

Are regular promotions, salespersons contests, etc. an integral part of the short- or medium-range advertising programme?

4.

Are there seasonal promotions to overcome sales fluctuations?

Organisational structure: 1.

Is the advertising budget adequate to meet current sales objectives?

2.

Are advertising budgets established for: a.

each products or product line?

b.

each sales area?

3.

Are advertising policies structured for short- to longterm growth?

4.

Can the advertising budget be adjusted to reflect constantly changing economic conditions?

5.

Is there provision for correction by advertising management when advertising costs exceed the budget?

19.83

19.84

Advanced Auditing and Professional Ethics 6.

D.

E.

Is advertising integrated with personal selling and promotion?

Leadership : 1.

Is the organisation recognised as a leader in innovative advertising?

2.

Is advertising management capable of developing a well-thought-out and well-integrated advertising programme?

3.

Is advertising management capable of developing regular promotions and salespersons’ contests that are an integral part of the organisation’s total advertising programme?

4.

Does advertising management develop seasonal promotions to overcome seasonal sales fluctuations?

5.

Is advertising management progressive enough to relate its advertising message to the current times?

Communication : 1.

Is advertising management communicating advertising messages that are relevant to the times?

2.

Are the advantages of the organisation’s products over its competition adequately communicated to its customers?

3.

Is the organisation’s advertising programme effective in communicating its intended messages on: a.

regular promotions?

b.

special promotions?

4.

Are advertising and special promotion expenses in line with personal selling expenses so that there is a balance in the overall marketing programme?

5.

Are salespersons’ contests integrated with overall advertising efforts so that maximum effectiveness is derived from these marketing efforts?

6.

Are quantitative and statistical techniques employed to determine the best means of reaching specific market segments for certain products?

Internal Audit, Management and Operational Audit F.

V.

Control : 1.

Is there an effort made by advertising management to eliminate ineffective advertising?

2.

Is there an effort made by advertising management to keep advertising costs within the budget?

3.

Is corrective action undertaken by advertising management when advertising costs exceed budget amounts?

4.

Is advertising sufficiently controlled so that erratic sales fluctuations are kept to a minimum?

5.

Are the latest quantitative and statistical techniques employed to make sure that the organisation gets the most out of its advertising expenditures?

PHYSICAL DISTRIBUTION A.

B.

Long-range plans : 1.

Is physical distribution an integral part of long-range marketing plans?

2.

Is physical distribution management active in the preparation of its long-range plans?

3.

Are distributors large enough to handle anticipated future volume?

4.

Is there a periodic evaluation of distributors to assess their contribution to the physical distribution system?

5.

Have distribution costs been in line with the industry?

6.

Will there be thorough retail coverage in the future, particularly, in key market areas?

7.

Are there continuing educational programs to aid distributors in moving larger volumes in the future?

Short- or medium-range plans : 1.

Is physical distribution management aware and capable of solving its short- or medium-range problems?

2.

Do short- or medium-range plans include provision for meeting scheduled delivery dates?

19.85

19.86

Advanced Auditing and Professional Ethics 3.

Are distribution centers staffed by properly trained personnel?

4.

Are distribution centres strategically located near large population centres?

5.

Do current policies and programs aid the distributors in managing their operations effectively with respect to:

6.

C.

a.

sales promotion?

b.

advertising?

c.

dealer aids?

Do short-or medium-range plans include continuing programs to assist distributors and retailers in moving products?

Organisational structure : 1.

Is there an adequate number of distribution centers to handle : a.

present volume?

b.

anticipated future volume?

2.

Are key marketing areas structured so that they are adequately serviced by efficient distribution centres?

3.

Is the distribution system organised so that there is a thorough retail coverage, particularly in key areas?

4.

Is the organisation structured so that there are continuing programmes to aid distribution centers and retailers in having a high turnover of inventory?

5.

Is the organisation structured so that there are policies and programmes designed to aid distribution centres and retailers with respect to:

6.

a.

sales promotion?

b.

advertising?

c.

profitability?

Are physical distribution programmes sufficiently flexible to accommodate changing conditions?

Internal Audit, Management and Operational Audit D.

E.

F.

Leadership : 1.

Does physical distribution management assist its distribution channels in achieving a high merchandise turnover?

2.

Are distribution channels utilised that keep physical distribution costs at a minimum?

3.

Is the organisation sufficiently flexible to change distribution channels when they no longer serve its needs?

4.

Does distribution management recognise current and imminent changes affecting distribution channels?

5.

Does the organisation have programmes to aid its distribution channels in their management?

6.

Does distribution management require that company-owned goods be handled and stored properly for fast shipment to customers?

Communication : 1.

Does distribution management communicate coming distribution changes to the organisation’s planning group?

2.

Are inadequacies of the present physical distribution system communicated to top management for correction?

3.

Are organisational policies and programmes to aid distributors communicated to them in an effective manner?

4.

Do distribution channels feed back essential information for maintaining an effective physical distribution system?

5.

Are there effective procedures to alert distribution management that certain products are not being moved as fast as planned?

Control : 1.

Is there an effort by physical distribution management to keep distribution costs under control?

2.

Is there adequate control over programme to aid retailers in promoting the organisation’s products?

19.87

19.88

Advanced Auditing and Professional Ethics 3.

Is there adequate control over finished-goods inventory: a.

on hand?

b.

in the hands of distributors?

4.

Does control over finished goods include a programme to aid retailers in increasing inventory turnover?

5.

Is corrective action undertaken by physical distribution management when exceptions are uncovered?

19.10.3 Personnel Function - Evaluating the personnel Function by utilising a management audit questionnaire can be a difficult task, because the “people factor” can rarely be assessed completely. For one thing, the needs of the individuals who comprise the company’s work force change continuously. Additionally, it should be noted that the personnel function does not operate alone, but rather is a most important part of each functional area. For an objective evaluation of the personnel function in a typical organisation, the following sections are presented in this chapter: I.

Personnel Overview

II.

Manpower Planning

III.

Industrial Relations

Personnel Overview - The personnel area has the capability to make or break any company. To succeed, the company requires a productive group of people who are highly motivated to accomplish organisational objectives. Similarly, it needs a work force that is capable of handling current and future work volumes. Implied in this is the need for flexibility: a permanent work force must be maintained for normal operations and supplemented with an auxiliary force when there are peak work loads or emergency conditions to be met. In this manner, management can keep personnel costs at a minimum while servicing the required business functions and sub functions necessary to accomplish predetermined objectives. The main purpose of this first section of the personnel management audit questionnaire is to focus on the capabilities of management to meet changing personnel conditions. The manner in which managers respond to these change factors is one way to evaluate their capabilities in handling organisation personnel. In a few words, this beginning section evaluates not only how well the personnel function itself is operating, but also how effectively it is operating in the various functional areas of the organisation. Manpower Planning - To evaluate the manpower planning function through the management audit questionnaire (See Section II) it is necessary to start assessing capabilities of personnel management. Key questions relating to long-range manpower plans are set forth, followed by those relating to a shorter time frame-short-and medium-range. Fundamentally, these questions examine the adequacy of plans to meet manpower needs from the short run to long

Internal Audit, Management and Operational Audit

19.89

run. Building upon this background, the manpower planning structure is examined. Such questions as whether the organisation structure lends itself to on-the-job training and whether personnel replacements are trained for continuity of operations are asked. In the next subsection, questions relating to leadership by personnel management, in such areas as training programme and wage and salary rates, are developed. The emphasis here is on the quality of personnel management to achieve specific manpower plans. Supplementary to the leadership subsection is an evaluation of the company’s communication process with its personnel. In the final subsection, the degree of control over manpower planning is reviewed. In effect, the main concern of these questions is to determine if qualified personnel, including managers, are available to keep the organisation operating in an efficient and economical manner to meet predetermined objectives. If actual results are different from manpower plans, corrective action needs to be undertaken. Industrial Relations - The industrial relations (IR) section of the personnel management audit questionnaire (See Section III) is to a large degree an extension of the prior two sections. An all-inclusive personnel programme should include a provision for maintaining as well as improving industrial relations. Questions relating to short-range and long-range industrial relations plans are initially asked. They centre on determining if the company provides adequate employee and fringe benefits that compete favourably with firms in the same area and if there is a sufficient degree of harmony between management and its Subordinates. Where the company does not meet established wages, benefits, and the like, questions are asked regarding the plans to improve them. Next, questions are asked regarding the wage and salary structure as related to encouraging high productivity as well as efficiency and economy of operation. Also, the relationship of this structure to other firms of comparable size is examined. In the next subsection, industrial relations leadership is evaluated from several points of view. Is there harmony and co-operation in the company from effective IR management? Is top management interested in good industrial relations? And are good industrial relations evidenced by high morale and positive attitudes of employees? The next subsection examines the degree to which employees feel free to communicate their personnel and job-related problems to their supervisors. Within last subsection, control over industrial relations programme is evaluated, that is, does management exert sufficient control over employee wages, benefits and working conditions to promote harmony and co-operation among its employees and, ultimately, to meet organisation objectives? Yes 1.

PERSONNEL OVERVIEW A.

Long-range plans: 1.

Are long-range personnel plans in agreement with: a.

long- range organisational objectives?

b.

long-range plans of other functional areas?

No

N.A.

19.90

Advanced Auditing and Professional Ethics

2.

B.

c.

medium-range personnel plans?

d.

short-range personnel plans?

Are long-range personnel plans reviewed by: a.

Board of directors?

b.

Top management?

3.

Is there an official Planning Committee to develop long-range personnel plans?

4.

Does personnel management accept and understand these long-range plans?

5.

Are personnel management efforts directed toward accomplishing these long-range plans?

6.

Is performance against long -range personnel plans measured periodically?

7.

Are long-range personnel plans reviewed periodically so as to stay current?

8.

Is the management by exception principle an integral part of long-range personnel plans?

Short- or medium-range plans: 1.

Are short- or medium-range personnel plans in agreement with: a. short- or medium-range organisational objectives? b. short- or medium-range plans of other functional areas? c.

2.

long-range personnel plans?

Are short- or medium-range personnel plans reviewed by: a.

top management?

b.

middle management?

c.

lower management?

3.

Are there procedures for developing short- or mediumrange personnel plans?

4.

Does personnel management accept and understand these short- or medium-range plans?

Internal Audit, Management and Operational Audit

C.

5.

Are personnel management efforts directed toward accomplishing these short- or medium-range plans?

6.

Is performance against short- or medium-range plans measured periodically?

7.

Are short- or medium-range personnel plans reviewed periodically to stay current?

8.

Is the management by exception principle an integral part of short- or medium-range personnel plans?

Organisational structure: 1.

Is the personnel organisation chart compatible with other functional organisation charts?

2.

Is it clear who is charged with responsibility and who has authority over: a.

personnel?

b.

manpower planning?

c.

industrial relations?

3.

Does each person in personnel know his or her job well?

4.

Is it clear what the superior-subordinate relationships are in the personnel department?

5.

Are there adequate job descriptions for each personnel position?

6.

Is a competent employee assigned to each personnel position?

7.

Is the level of personnel training adequate for:

8.

9.

a.

management?

b.

employees?

Can the quality of company personnel be assessed for: a.

management?

b.

employees?

Is the personnel department adequately staffed?

10. Are reporting relationships clearly defined and understood by personnel?

19.91

19.92

Advanced Auditing and Professional Ethics 11. Is personnel management held accountable for its actions? 12. Is there provision within the personnel department for periodic review of its organisation structure?

D.

Leadership : 1.

Does personnel management provide the necessary leadership to have a formal programme of personnel selection and evaluation before hiring new employees?

2.

Does personnel management give the leadership necessary to have an annual review of present personnel for the purpose of :

3.

E.

a.

improving their performance?

b.

determining their promotions?

c.

determining their remuneration?

Is personnel management sufficiently progressive to have an ongoing training program for developing a.

management personnel

b.

non-management personnel?

4.

Does management exert its influences in seeing that company personnel are effectively employed in their jobs?

5.

Does management exert its influence to have an effective programme that enlightens employees on the economic “facts of life”, i.e. relationship of their pay to the cost-of-living index and the impact of ‘cost increases on the company’s operations?

Communication : 1.

Do the downward channels of communication facilitate the accomplishment of company objectives and activities in an efficient and economical manner?

2.

Do the upward channels of communication facilitate the accomplishment of company objectives and activities in an efficient and economical manner?

3.

Are there downward and upward channels of communication to provide for an efficient flow of information on:

Internal Audit, Management and Operational Audit

4.

F.

a.

company programmes and projects?

b.

company policies and directives?

c.

work methods and procedures?

d.

matters affecting employee morale?

e.

matters affecting employee needs?

Are the general methods of communication effectively utilised: a.

spoken or written words?

b.

numbers, including mathematics?

c.

pictures?

d.

actions?

5.

Are there organisational policies to encourage employees to express their views and recommendations through formal communication channels?

6.

Are informal communications channels, i.e., the grapevine are used to supplement the formal communication channels?

7.

Do communication channels provide the necessary information that motivates employees to take pride in their work?

8.

Do communication channels provide the necessary information that affects the employees’ well-being, i.e. opportunity for advancement and seniority in a union?

Control : 1.

Is there adequate control exercised over personnel so that their objectives are in conformity with overall organisational objectives?

2.

Are employees who are positively motivated given adequate control over their work environment to realise more of their needs on the job?

3.

Are effective control methods and, techniques used in : a.

personnel?

b.

manpower planning?

c.

industrial relations?

19.93

19.94

II.

Advanced Auditing and Professional Ethics 4.

Is close control maintained over personnel costs?

5.

Are predetermined personnel standards compared to actual results (budget versus actual) on a timely basis?

6.

Is corrective action undertaken when significant deviations are detected?

MANPOWER PLANNING A.

B.

C.

Long-range plans : 1.

Is manpower planning management qualified to meet long-range objectives?

sufficiently

2.

Are manpower needs an integral, part of the company’s long-range plans’?

3.

Are manpower planning methods used to predict future personnel needs?

4.

Are key position protected with trained replacements?

5.

Is there an effective training programme for key (executive) personnel?

6.

Is the company’s training programme geared to handle future expansion?

Short- or medium-range plans : 1.

Is manpower planning management sufficiently qualified to meet short- or medium-range objectives?

2.

Do short, or medium-range plans include a programme for evaluating manpower requirements for the coming year?

3.

Are there procedures for recruitment or selection of personnel to fill vacancies or new positions?

4.

Do personnel plans include a provision for labour turnover?

5.

Do personnel plans include a review of current wages to ensure compatibility with other companies in the area?

6.

Do personnel plans, regulate employee overtime so that it does not become excessive?

7.

Is there an effective training programme, for plant personnel?

Organisational structure :

Internal Audit, Management and Operational Audit

D.

1.

Is the manpower planning group under the direction of a capable manager?

2.

Is manpower planning integrated with the corporate planning function?

3.

Does the organisation structure lend itself to one the job training to satisfy immediate and future job openings?

4.

Are personnel replacements being training for continuity of operations?

5.

Does the company enjoy stable employment levels that minimise the problem of manpower replacement?

6.

Is manpower turnover acceptable to the company’s management?

Leadership : 1.

Does personnel management feel a real responsibility for company goals and react in a way to implement them through effective manpower planning?

2.

Does personnel management exert the necessary influence to protect all key positions with trained replacements?

3.

Does the personnel department maintain an effective training programme for all key personnel?

4.

Is the personnel department training new personnel for the expansion of its operations?

5.

Does the personnel department exert the required influence to see that first-line supervisors are:

6.

a.

functioning effectively?

b.

paid adequately?

Is personnel management progressive enough to make sure that wage and salary rates plus fringe benefits compare favourably with: a.

the area in which the company is located ?

b.

its competitors?

7.

Does personnel demand of top management fringe benefits that will attract top-notch employees?

8.

Does personnel management know and understand

19.95

19.96

Advanced Auditing and Professional Ethics the problems of company employees well enough to realise their future impact on manpower planning?

E.

F.

III.

Communication : 1.

Are recommendations for advancement communicated to the appropriate personnel?

2.

Does the company actively communicate new job openings internally before going to the outside?

3.

Does the company state in its job openings the opportunities for learning new skills through company sponsored training programmes?

4.

Does the company have a policy of publicizing promotions: a.

within the company?

b.

outside the company?

Control : 1.

Is there adequate control over manpower planning so that ample personnel are available to handle the current work load?

2.

Is there adequate control over the recruitment and selection of personnel to fill vacancies or new positions?

3.

Is an effort made to keep labour turnover to a minimum?

4.

Is there effective control of employee overtime ?

5.

Is there effective managerial control over company training programmes?

6.

Are manpower plans related to actual results where possible so that corrective action can be undertaken if results are below expectations?

INDUSTRIAL RELATIONS A.

Long-range plans : 1.

Is personnel management of a sufficient calibre to meet long- range industrial relations objectives?

2.

Do personnel long-range plans include provision for improving relations with employees?

Internal Audit, Management and Operational Audit 3.

4.

5. B.

Does the company have a long-range programme for providing adequate: a.

training ?

b.

medical care?

c.

vacations ?

d.

insurance?

e.

pensions ?

f.

sick pay?

Does the company continue to compete favourably with other firms in the area in terms ofa.

wage rates ?

b.

fringe benefits?

c.

layoff benefits ?

Has the company had good relationships with its union(s)?

Short- or medium-range plans : 1.

Is personnel management of a sufficient calibre to meet short- or medium-range industrial relations objectives?

2.

When employee relations are marginal or bad, do personnel plans call for improving them?

3.

Do plans call for an employee review programme?

4.

Is there an annual job evaluation and review programme?

5.

Do plans call for improving working conditions?

6.

Do plans call for improving employee fringe benefits?

7.

Do plans call for an effective health and safety programme?

8.

Do plans include a programme for improving employee morale and attitude toward the company if needed?

9.

Do plans call for formal procedures to resolve unionmanagement conflicts about: a.

Wages?

19.97

19.98

C.

Advanced Auditing and Professional Ethics overtime?

c.

production rates?

d.

work rules?

Organisational structure : I.

Is the industrial relations department under the direction of a capable manager?

2.

Does the company enjoy favourable relations with its: a.

unionised employees?

b.

ununionised employees?

3.

Does the company’s wage and salary structure compare favourably with other firms?

4.

Does the company’s fringe benefits structure compare favourably with other firms?

5.

Does the company’s incentive system encourage:

6.

D.

b.

a.

high productivity?

b.

greater efficiency and economy of operation?

Are employee handbooks used to reduce possible management- employee conflicts by having policies set forth in writing?

Leadership : 1.

Does top management exert its influence in maintaining good industrial relations with its employees?

2.

Is top management’s interest in good industrial relations reflected in its:

3.

4.

a.

wage and salary structure?

b.

fringe benefits?

Is there harmony and co-operation evident in the company among its: a.

employees?

b.

departments?

Are good industrial relations evidenced by high morale and positive attitudes of employees toward the firm?

Internal Audit, Management and Operational Audit 5. E.

F

19.99

Do subordinates feel free to discuss important matters concerning themselves with their superiors?

Communication : 1.

Does the company actively relationship with its union(s)?

promote

a

good

2.

Does the company actively promote harmony and cooperation among its employees and departments through appropriate communication channels?

3.

Do company employees feel free to communicate their personal and job-related problems to their superiors?

4.

Does the company promote on-the-job and off-the job training as a part of its overall educational programme?

5.

Does the company participate actively in worthy community projects?

Control : 1.

Does management exercise sufficient control over its industrial relations programme so that it has a good relationship with its employees?

2.

Is there an industrial relations programme to maintain or improve the company’s image in the eyes of its employees?

3.

Does management exercise sufficient control over : a.

employee wages?

b.

employee fringe benefits?

c.

employee working conditions?

4.

Does management promote harmony and cooperation among its employees?

5.

Are industrial relations programmes

Self-examination questions 1. 2. 3. 4. 5. 6. 7.

What is management audit? How far is it different from internal audit? What are the steps involved in conducting management audit? What are the objectives of operational audit? How is a management audit normally conducted? Give a brief write up on management audit reports. What are the difficulties encountered in the course of a management audit? Prepare an illustrative management audit questionnaire for the manufacturing function of a typical organisation?

19.100 Advanced Auditing and Professional Ethics Annexure I Standard on International Audit (SIA) 1 Planning an 'Internal Audit The following is the text of the Standard on Internal Audit (SIA) 1, "Planning an Internal Audit", issued by the Council of the Institute of Chartered, Accountants of India. This Standard should be read in conjunction with the Preface to the Standards and Guidance Notes on Internal Audit, issued by the Institute. In terms of the decision of the Council of the Institute of Chartered Accountants of India taken at its 260th meeting held in June 2006, the following Standard on Internal Audit shall be recommendatory in nature in the initial period. The Standard shall become mandatory from such date as notified by the Council. Objectives of Planning 1. The purpose of this Standard on Internal Audit is to establish standards and provide guidance in respect of planning an internal audit. An internal audit plan is a document defining the scope, coverage and resources, including time, required for an internal audit over a defined period. The internal auditor should, in consultation with those charged with governance, including the audit committee, develop and document a plan for each internal audit engagement to help him conduct the engagement in an efficient and timely manner. Adequate planning ensures that appropriate attention is devoted to significant areas of audit, potential problems are identified, and that the skills and time of the staff are appropriately utilised. Planning also ensures that the work is carried out in accordance with the applicable pronouncements of the Institute of Chartered Accountants of India. 2. The overall objectives of an internal audit, as defined in the Preface to the Standards and Guidance Notes on Internal Audit are:

to suggest improvements to the functioning of the entity; and to strengthen the overall governance mechanism of the entity, including its strategic risk management as well as internal control system. 3.

Internal audit, therefore, helps inter alia in:

(i)

Understanding and assessing the risks and evaluate the adequacies of the prevalent internal controls.

(ii)

Identifying areas for systems improvement and strengthening controls.

(iii) Ensuring optimum utilisation of the resources of the entity, for example, human resources, physical resources etc. (iv) Ensuring proper and timely identification of liabilities, including contingent liabilities of the entity. (v)

Ensuring compliance with internal and external guidelines and policies of the entity as well as the applicable statutory and regulatory requirements.

(vi) Safeguarding the assets of the entity.

Internal Audit, Management and Operational Audit 19.101 (vii) Reviewing and ensuring adequacy of information systems security and control. (viii) Reviewing and ensuring adequacy, relevance, reliability and timeliness of management information system. 4. The internal audit plan should be comprehensive enough to ensure that it helps in achieving of the above overall objectives of an internal audit. The internal audit plan should, generally, also be consistent with the goals and objectives of the internal audit function as listed out in the internal audit charter as well as the goals and objectives of the organisation. An internal audit charter is an important document defining the position of the internal audit vis a vis the organisation. The internal audit charter also outlines the scope of internal audit as well as the duties, responsibilities and powers of the internal auditor(s). In case the entire internal audit or the particular internal audit engagement has been outsourced, the internal auditor should also ensure that the plan is consistent with the terms of the engagement. 5. Planning involves developing an overall plan for the expected scope and conduct of audit and developing an audit programme showing the nature, timing and extent of audit procedures. Planning is a continuous exercise. A plan once prepared should be continuously reviewed by the internal auditor to identify any modifications required to bring the same in line with the changes, if any, in the audit environment. However, any major modification to the internal audit plan should be done in consultation with those charged with governance. Further, the internal auditor should also document the changes to the internal audit plan. 6. The internal auditor may also discuss the significant elements of his overall plan, including important procedures, with those charged with governance. This would help the internal auditor as well as the client to assess whether the internal audit is directed to achieve the objectives as set out in the terms of engagement. The discussion would also help the internal auditor to gauge whether the client's perception of the role and responsibilities of the internal auditor is appropriate. The internal auditor should also assess the client expectations as to the assurance level on different aspect of entity's operations and controls. For instance, the client may feel assured if inventories are verified once in a quarter, while for cash verification, monthly interval may be specified. This will enable the auditor to plan the frequency and extent of audit procedures to be adopted. Factors Affecting the Planning Process 7. The internal audit plan should be based on the knowledge of the entity's business. While developing the internal audit plan, the internal auditor should have regard to the objectives of the internal audit engagement as well as the time and resources required for conducting the engagement. In addition, the internal audit plan should also reflect the risk management strategy of the entity. Planning an internal audit involves establishing the overall strategy for the engagement so as to keep the risks associated with the assignment at the acceptable level. Therefore, the planning process is also influenced by the internal auditor's understanding and assessment of: The objectives of the activity being subjected to internal audit. The significant risks associated with the above activity.

19.102 Advanced Auditing and Professional Ethics The risk management and internal control system instituted in the organisation to reduce the above risks to an acceptable level. The possible areas in which the internal audit can suggest improvement to the risk management andl or internal control system associated with the concerned activity. The selection of engagement team (including, where necessary, the engagement team quality control reviewer) and the assignment of audit work to the team members, including the assignment of appropriately experienced team members. Business developments affecting the. entity, including changes in information technology and business processes, changes in key management, and acquisitions, mergers and divestments. Industry developments such as changes in industry regulations and new reporting requirements. Changes in the financial reporting framework, such as changes in accounting standards. Other significant relevant developments, such as changes in the legal environment affecting the entity. Scope of Planning 8.

Internal audit plan should cover areas such as:

Obtaining the knowledge of the legal and regulatory framework within which the entity operates. Obtaining the knowledge of the entity's accounting and internal control systems and policies. Determining the effectiveness of the internal control procedures adopted by the entity. Determining the nature, timing and extent of procedures to be performed. Identifying the activities warranting special focus based on the materiality and criticality of such activities, and their overall effect on operations of the entity. Identifying and allocating staff to the different activities to be undertaken. Setting the time budget for each of the activities. Identifying the reporting responsibilities. The internal audit plan should also identify the benchmarks against which the actual results of the activities, the actual time spent, the cost incurred would be measured. 9.

The scope of an internal audit is normally affected by factors such as:

Terms of the engagement. Nature of accounting system - manual or IT-based - and the degree of reliance placed by the auditor on the same. Accounting policies adopted by the entity. Nature of information technology system used by the client in the various business processes and the exception reports generated by the system.

Internal Audit, Management and Operational Audit 19.103 Authorization and delegation of authority in the systems environment and data entry checks and data security measures including generation of day end logs of security and authorisation violations. The nature of management information system in vogue and the extent to which the management information system reports are used by the client in establishing and reviewing internal controls. Expected audit coverage, including identification of areas of audit requiring special attention, number and locations to be included, nature of business segments to be audited and the need, if any, for specialized knowledge. Materiality thresholds established in respect of various areas of audit especially, those areas requiring special attention. Nature and extent of audit evidence to be obtained. Experience and skills of the staff and the need for supervising, directing, coordinating and reviewing their work. Requirements of the applicable pronouncements of the Institute of Chartered Accountants of India. Statutory or regulatory framework in which the entity operates. Planning Process Obtaining Knowledge of the Business 10. The internal auditor should obtain a level of knowledge of the entity sufficient to enable him to identify events, transactions, policies and practices that may have a significant effect on the financial information. Following are some of the sources wherefrom the internal auditor can obtain such knowledge: Previous experience, if any, with the entity and the industry. Legislation and regulations that significantly affect the entity. Entity's policy and procedures manual. Minutes of the meetings of the shareholders, board of directors, and important committees of the board such as the audit committee, remuneration committee, shareholders' grievances committee. Management reports/ internal audit reports of prior periods. Newspaper/ industry journals. Discussion with client's management and staff. Visits to entity's plant facilities etc., to obtain first hand information regarding the production processes of the entity. Visits to the entity's department where the accounting and other documents are generated, maintained, and the administrative procedures followed.

19.104 Advanced Auditing and Professional Ethics Other documents produced by the entity, for example, material sent to the shareholders and the regulatory authorities, management policy manuals, manuals relating to accounting and internal controls, organizational charts, job description charts, etc. Knowledge of the entity's business, among other things, helps the internal auditor to identify areas requiring special focus, evaluate the appropriateness of the accounting policies and disclosures, accounting estimates and management representations. Knowledge of the business would also help the auditor to identify the priorities of the business, critical factors or constraints in the smooth running of the business as also understand the trends in respect of various financial and operating ratios, etc. Establishing the Audit Universe 11. The next step in audit planning is establishment of the audit universe or the audit territory. Audit universe comprises the activities, operations, units etc., to be subjected to audit during the planning period. The audit universe is designed to reflect the overall business objectives and therefore includes components from the strategic plan of the entity. Thus, the audit universe is affected by the risk management process of the client. The audit universe and the related audit plan should also reflect changes in the management's course of action, corporate objectives, etc. 12. As discussed in paragraph 4, planning is a continuous exercise. The internal auditor should periodically, say half yearly, review the audit universe to identify any changes therein and make necessary amendments, to make the audit plan responsive to those changes. Establishing the Objectives of the Engagement 13. The next stage in planning is establishing the specific objectives of the internal audit engagement. The establishment of such objectives should be based on the auditor's knowledge of the client's business, especially a preliminary understanding and review of the risks and controls associated with the activities forming subject matter of the internal audit engagement. The preliminary understanding and review involves gathering necessary information by means of a combination of the following procedures: Observation of the activity being performed. Inquiry of the staff associated with performing the activity. Discussion with the client. Reading through the internal audit reports, management reports etc., of previous periods. Performing analytical procedures. Performing actual walk-through tests. 14. The internal auditor would use the information so gathered to determine the objective(s) of the engagement as also to decide the nature, timing and extent of his procedures. The internal auditor should also document the results of his preliminary review so conducted. The documented results would, normally, cover aspects such as:

Internal Audit, Management and Operational Audit 19.105 Preliminary assessment and understanding the risks and controls associated with the activity, viz., sufficiency and appropriateness of the control-s, procedures for identification and management of risks associated with the activity. Significant issues thrown up by such a review, for example, significant errors, non-compliance with any significant law. Procedures proposed to be adopted by the internal auditor to resolve the above issues. Preliminary time budget for completing the engagement. Establishing the Scope of the Engagement 15. The next stage in planning an internal audit is establishing the scope of the engagement. The scope of the engagement should be sufficient in coverage so as to meet the objectives of the engagement. The internal auditor should consider the information gathered during the preliminary review stage to determine the scope of his audit procedures. The nature and extent of the internal auditor's procedures would also be affected by the terms of the engagement. In case the internal auditor is of the view that circumstances exist which would restrict the auditor from carrying out the procedures, including any alternative procedures, considered necessary by him, he should discuss the matter with the client to reach a conclusion whether or not to continue the engagement. The scope of his engagement should documented comprehensively to avoid misunderstanding on the areas covered for audit. The internal auditors are often confronted with a situation where client denies access to certain information or has a negative list of areas where internal audit is not desired. There are also situations where while the client requires internal audit procedures to be carried but findings are not to form part of the report but to be reported separately. 16. Further, in case of information technology based environment, the scope of engagement would include the extent to which internal auditor are permitted to access the system and reports which can be viewed and those which can be exported. Further, system based audit tools that an internal auditor can use to draw and analyze the data should be clearly understood in the scope of his engagement. Deciding the Resource Allocation 17. Once the scope of the internal audit procedures is established, the next phase is that of deciding upon the resource allocation. Efficient resource allocation is essential to achieve the desired objective, within the constraints of time and cost as well as optimum utilization of resources. For this purpose, the internal auditor should prepare an audit work schedule, detailing aspects such as: Activities / procedures to be performed; engagement team responsible for performing these activities/procedures; and time allocated to each of these activities! procedures. 18. While preparing the work schedule, the internal auditor should have regard to aspects such as:

19.106 Advanced Auditing and Professional Ethics any significant changes to the entity's missions and objectives, business processes, and management's strategies to counter these changes, for example, changes in the entity's controls structure or changes in the risk assessment and management structures any changes or proposed changes to the governance structure of the entity composition of the engagement team in terms of skills and experience and any changes thereto The engagement work schedule should, however, be flexible enough to accommodate any unanticipated changes as well as professional judgment of the engagement team in the components of the audit universe as discussed above. The work schedule should also reflect the internal auditor's assessment of risks associated with various areas covered by the particular internal audit engagement and the priority attached thereto. Preparation of Audit Programme 19. The internal auditor should also prepare a formal internal audit programme listing the procedures essential for meeting the objective of the internal audit plan. Though the form and content of the audit programme and the extent of its details would vary with the circumstances of each case, yet the internal audit programme should be so designed as to achieve the objectives of the engagement and also provide assurance that the internal audit is carried out in accordance with the Standards on Internal Audit. As a corollary, the audit plan developed by the internal auditor would need to be a risk-based plans, appropriately reflecting and addressing the priorities of the internal audit activity, consistent with the organisation's goals. The internal audit programme should also be finalized in consultation with the appropriate authority before the commencement of the work. The internal audit programme identifies, in appropriate details, the objectives of the internal audit in respect of each area, the procedures to be performed to achieve those objectives, the staff responsible for carrying out the particular activity, the time allocated to each activity as also the sufficiently detailed, instructions to the staff as to how to carry out those procedures. The internal audit programme may also have provision for information such as the procedures actually performed, reasons for not performing the originally identified procedures, actual time consumed in carrying out the relevant procedure, reasons for deviations from budgeted time etc. A well prepared, comprehensive audit programme helps proper execution of the work as well as of the proper supervision, direction and control of the performance of the engagement team. Effective Date 20. This Standard on Internal Audit Is applicable to all internal audits commencing on or after Earlier application of the SIA is encouraged.

20 INVESTIGATIONS AND DUE DILIGENCE

Introduction 20.1 The term investigation implies a systematic and in-depth examination or inquiry to establish a fact or to evaluate a specific situation. In other words, investigation means inquiry into facts". Professional accountants are often required to investigate the accounts or the related matters and records of the enterprise. The term investigation may be defined as an examination of books and records preliminary to financing or for any other specified purpose, sometimes differing in scope from the ordinary audit. Thus, investigation covers areas of financing decisions, investment decisions, fraud or profitability determination or cost determination etc,. Audit versus Investigation 20.2 Investigation differs substantially from an audit assignment. Audit aims at collection of sufficient appropriate audit evidence to enable the auditor to form a judgement and express an opinion on the financial statements or other data under examination. An investigation ,on the other hand, requires special in-depth examination of the particular records or transaction with the objective of establishing a part or happening or assessing a particular situation. The scope of audit is broad based and general in nature whereas investigation is narrow and specific. The difference is tabulated below: Basis of Difference

Investigation

Audit

(i) Objective

An investigation aims at establishing a fact or a happening or at assessing a particular situation.

The main objective of an audit is to verify whether the financial statements display a true and fair view of the state of affairs and the working results of an entity.

(ii) Scope

The

The scope of audit is wide

scope

of

investigation

20.2

Advanced Auditing and Professional Ethics may be governed by statute or it may be non- statutory.

and in case of statutory audit the scope of work is determined by the provisions of relevant law.

(iii) Periodicity

The work is not limited by rigid time frame. It may cover several years, as the outcome of the same is not certain.

The audit is carried on either quarterly, half-yearly or yearly.

(iv) Nature

Requires a detailed study and examination of facts and figures.

Involves tests checking or sample technique to draw evidences for forming a judgement and expression of opinion.

(v) Inherent Limitations

No inherent limitation owing to its nature of engagement.

Audit suffers from inherent limitation.

(vi) Evidences

It seeks conclusive evidences.

Audit is mainly concerned with prima- facie evidence.

(vii) Observance of Accounting Principles

It is analytical in nature and requires a thorough mind capable of observing, collecting and evaluating facts.

Is governed by compliance with generally accepted accounting principles, audit procedures and disclosure requirements.

(viii) Reporting

The outcome is reported to the person(s) on whose behalf investigation is carried out.

The outcome is reported to the owners of the business entity.

The approach to an investigation is different from that followed in an audit. An investigation involves a more detailed examination of the selected areas than what is required in an audit. An investigation seeks substantive and in some case even conclusive evidence as compared to audit which mainly relies on persuasive evidence. An investigator does not accept a stated fact as correct until it is substantiated. An auditor, in the absence of suspicious circumstances, relies on stated facts or figures. An auditor has to see whether the method of valuation and other accounting policies have been properly made in the financial statements or not. An investigator, however, is not by accounting conventions, policies and disclosure requirements. An auditor does not suspect unless circumstances are there to arouse suspicion, while an investigator approaches the work with a frame of mind to suspect, verify and satisfy.

Investigation and Due Diligence

20.3

Steps in Investigation 20.3 As investigation involves a variety of situations, it is not possible to lay down any standardised procedure. However, usually, an investigation requires the following steps in order of sequence: ♦

Determination of objectives and establishment of scope of investigation.

♦

Formulation of the investigation programme.

♦

Examination and study of various records by reference to appropriate evidence.

♦

Analysis, processing and interpretation of findings.

♦

Preparation of report and drawing up of conclusions.

Now let us study each of these steps in detail. 20.3.1 Determination of objectives and establishment of scope of investigation - Investigation should be a systematic function and must be methodically planned. At the stage of acceptance of the assignment, the investigator should be absolutely clear about what is sought to be achieved by the investigation. If instructions from the client leave matters vague and nonspecific, it would be proper for the investigator to have the matters discussed and obtain clearly written instructions covering the object and the scope of investigations and the issues incidental thereto. Detailed instructions on the objectives and scope of investigation enable the investigator to plan the work purposefully and to determine the extent, manner aid the area of checking. Unless clear instructions are received from the client, it may not be advisable for the investigator to undertake the work because the investigator may face problems later either from the client himself or from any other interested party. Even he may be charged with negligence for failure to do the work properly. Considering the need and requirement the area of investigation may be extended. But if, however, permission is not granted, he should while submitting his report, state how the conclusions reached have affected by investigation not having been extended to other areas. The period which the investigation should cover should be clearly specified. The results of investigation are often seriously affected owing to change in circumstances which have occurred since it was contemplated, e.g., devaluation, import restrictions, starting of a new division, etc. Therefore, the purpose of the investigation should be borne in mind while determining the period which an investigation should cover. 20.3.2 Formulation of the investigation programme - It is not possible to draw up one programme to serve different types of investigations which a professional accountant is called upon to carry out, for their scope and content have to be determined on a consideration of circumstances peculiar to each business or situation. The investigation programme should be drawn up having regard to the nature of the business, the structure of business, the instructions from the client embodying the objectives, the consequent scope and depth and the necessity to extend the investigation into books and records belonging to others. The

20.4

Advanced Auditing and Professional Ethics

programme should also be flexible so that knowledge gained with the progress of work can be used to extend, reduce or modify the extent and areas of checking. In programming the verification, the investigator should concentrate on areas considered relevant rather than to undertake a wide-ranging verification. For example, in an investigation on suspected payment of wages to ghost workers, the investigator should scan the areas having a bearing on the determination of wages and payments thereof. He should concentrate on time and job cards, appointment and termination of workers, attendance records, internal controls, internal checks, and preparation of wage sheets, withdrawal of money from bank for payment of wages and the actual disbursement of wages. He may not see anything else. There may be a different situation when an investigator is confronted with valuation of business. Though the scope is wide, the investigator may only pick up the relevant and material items that influence the valuation of a business as for example, profit, depreciation, stock valuation, material income and expense items and the valuation of assets including the question of writing down of intangible and fictitious assets. He may not except for a general review, undertake any detailed study of other matters. A conscious effort in investigation programming should be devoted to localise the enquiry into the relevant areas and, for that purpose, the initial wider base of inquiry should be gradually narrowed and fixed at a level that is meaningful. Matters not found to have a bearing on the subject matter of investigation should be gradually and progressively eliminated. This procedure alone will enable an in-depth examination of the matters relevant to the investigation. Actual examination of books, records and other documents should be carried out in accordance with the programme. As indicated earlier, if needed, the programme may be modified in the light of knowledge and experience gained. It is possible that while investigating into overtime payments, the investigator may come across evidence of workers not actually present in the factory in the normal hours. When such a situation is confronted, he should immediately write to the client for instructions for extending the scope of investigation. This will necessitate a re-casting of the investigation programmes and new areas would require to be covered. 20.3.3 Collection of evidence - Through examination, the investigator would be gathering relevant evidence connected with the matters to be investigated. In the course of examination of the documents and records, the investigator may require to obtain oral explanations from various personnel of the concerned business. In case his client is a person external to the business, it may be necessary for the investigator to get the matter formally agreed to by the business through the client. The investigator should look for the most convincing evidence; he should seek and examine all the available evidence and by a process of elimination and corroboration, should endeavour to reach at the truth of the matter. He, unlike the auditor, is not to restrict himself to prima facie evidence ordinarily available. He should examine it and if circumstances demand should try to obtain evidence that may have to be specifically procured. For example, in the matter of valuation of land, he should definitely have regard to the available evidence as per records of the business and records of any bid received for the land. In addition, he should have regard to the prices at which land was sold or purchased in the neighbourhood around the same time. This may require him to obtain evidence even by going to the land registration office. He may also call for the report of experts in land valuation.

Investigation and Due Diligence

20.5

20.3.4 Analysis and interpretation of findings - Careful analysis and correlation of facts and figures will be necessary before the investigator can reach his conclusion. The conclusion should be well reasoned and backed by established facts and data. He must analyse the data objectively on the basis of evidence gathered by him and should not draw conclusions according to pre-conceived notions. While interpreting the figures, the investigator must keep in mind various factors e.g. the political and economic considerations, competition faced by the business, historical pattern of the data, nature of the business, etc. 20.3.5 Reporting of findings - Like all other work of an accountant, an investigation results in a report. It is submitted and addressed to the party at whose instance the investigation has been carried out. The nature of the report is governed mainly by two factors. First, the instructions given by the client as regards the special aspects of the business which are required to be investigated; and second, the findings of the investigating accountant. The important issues to be kept in mind by the investigator while preparing his report are as follows: (i)

The report should not contain anything which is not relevant either to highlight the nature of the investigation or the final outcome thereof.

(ii)

Every word or expression used should be properly considered so that the possibility of arriving at a different meaning or interpretation other than the one intended by the investigator can be minimized.

(iii) Relevant facts and conclusions should be properly linked. (iv) Bases and assumptions made should be explicitly stated. Reasonableness of the bases and assumptions made should be well examined and care should be taken to see that none of the bases and assumptions can be considered to be in conflict with the objective of the investigation. For example, in an investigation into over-stocking of raw materials, stocks and spares etc. it should not be assumed that the ordering levels indicated on bin cards provide fair guidance about acquisition of further materials. Also, since investigation is a fact finding assignment, assumptions should be made only when it is unavoidably necessary. (v) The report should clearly spell out the nature and objective of the assignment accepted, its scope and limitations, if any. (vi) The report should be made in paragraph form with headings for the paragraphs. Any detailed data and figures supporting any finding may be given in Annexures. (vii) The report should also state restrictions or limitations, if any, imposed on the instructions given by the client. Preferably the reasons for placing such restrictions and their impact on the final result should also be stated. (viii) The opinion of the investigator should appear in the final paragraph of the report. Due to non-availability of standardised procedure and lack of professional guidance, investigation calls for extreme care, caution and circumspection on the part of the investigator in exercising his judgement and discretion. Investigation often has a characteristic of very intimate and direct involvement of parties whose interest may be affected. Therefore, unlike

20.6

Advanced Auditing and Professional Ethics

auditing, chances of one or the other of the parties challenging the finding of the investigation are far greater. Special Issues in Investigations 20.4 Investigations broadly range between two extremes; on the one hand there are those in respect of which complete accounts, documents, records and other information are available, and on the other, those in respect of which little information, besides published accounts and statistical data, is available. Then again, investigation may cover the whole of accounting or may relate to only a part or parts of accounting as may be specified. Some more issues often arise in investigation. They are stated below: (a) Whether an investigator is required to undertake a cent per cent verification approach or whether he can adopt selective verification - The answer to this question depends on the exact circumstances of the case under investigation. If the investigator has to establish the amount of cash defalcated by the cashier, he has probably no option but to carefully examine all the cash vouchers and related transactions. On the other hand, if he is to arrive at the profitability of a concern, he may verify constituent transactions on a selective basis taking extreme care to see that no material transaction that affects profit has remained concealed from his eyes. In investigation, it is always safer to go by statistically recognised sampling methods than to depend on the so-called “test checks” where circumstances permit selective verification. (b) Whether the investigator can put reliance on the already audited statement of account - Here also no dogmatic views are possible. If the investigation has been launched because of some doubt in the audited statement of account, no question of reliance on the audited statement of account arises. However, if the investigator has been requested to establish value of a business or a share or the amount of goodwill payable by an incoming partner, ordinarily the investigator would be entitled to put reliance on audited materials made available to him unless, in the course of his test verification, he finds the audit to have been carried on very casually or unless his terms of appointment clearly require to test everything afresh. It was held in the case of Short & Compton v. Brackert (1904) that an accountant, when making an investigation for an incoming partner, was entitled to assume that the figures appearing in the books were correct. In another case, Mead v. Ball Baker & Co. (1911), it was held that an accountant, when acting as an adviser to a proposed investor in a limited company, was not expected to check errors in stock sheets and the omission of liabilities. These cases were decided long time ago. Therefore, much reliance cannot be placed on them. It is, therefore, desirable for the investigator to ascertain from the client, in advance, in writing, whether the audited statements of account produced to him should be taken as correct. If the statements of account produced before the investigator were not audited by a qualified accountant, then of course there arises a natural duty to get the figures in the accounts properly checked and verified. However, when the accounts produced to the investigator have been specially prepared by a professional accountant, who knows or ought to have known that these were prepared for purposes of the investigation, he could

Investigation and Due Diligence

20.7

accept them as correct relying on the principle of liability to third parties settled in the famous Hedley Byrne’s case. Nevertheless, it would be prudent to see first that such accounts were prepared with objectivity and that no bias has crept in to give advantage to the person on whose behalf these were prepared. (c) Whether an investigator necessarily requires assistance of expert - Often an investigator may feel the necessity of obtaining views and opinions of experts in various fields to properly conduct the investigation. It would be therefore, proper for the investigator to get the written general consent of his client, to refer special matters for views of different experts; at the beginning it and he should settle the question of costs for obtaining the views and other related implications. (d) Investigation out of disputes and conflicting claims - Cases for investigation sometimes arise out of disputes and conflicting claims. It is needless to emphasise that the investigator should remain above disputes or conflicting claims and be alert to the possibilities of the information or documents made available to him to be prejudiced. Even the client, overtly or covertly, may try to influence his reports. A seller of a business or controlling shares may request him to see that he gets the most favourable price. Similarly, if he is appointed by the buyer, he may be requested to deliberately depress the value. The investigator should keep him scrupulously professional and should keep the interest of all the involved parties in view. This is a challenging task and probably no other professional work offers this much of challenge. This work is exciting too and requires not only the best of skill but of a high degree of maturity and experience. (e) Basis of opinion of an investor - The investigator should refrain from issuing speculative opinion. He should confine his opinion to the established facts and nothing more. If the facts, as conveyed through the books, records, papers and other evidence, are not capable of being properly established, he should not express an opinion or, if at all he expresses any opinion, he should qualify the opinion appropriately. This problem may particularly arise in cases where incomplete books and records are produced for investigation. (f)

Whether an investigator can make futuristic statements - The investigator should refuse to be futuristic. He may assume that the established trend in the business will continue in the near future, in the absence of any contrary evidence, in arriving at the present value of a business. He, however, should not project the trend into any future years to establish a value.

(g) Whether to retain working papers or not - Another important precaution is that the investigating accountant should retain, on his files full notes of the work carried out, copies of schedules and all working papers, record of conversations and the like. Also the working papers should link up the figures shown by the books of business with the final figures produced by the accountant. In the absence thereof, he would not be able to explain the figures when he is called upon to give evidence in a court of law to support his figures; for quite often the conclusions of the accountant are challenged by parties whose interest is adversely affected by his findings, for example, when the value of shares of a company taken over by the Government has been determined by him. This

20.8

Advanced Auditing and Professional Ethics will also be of immense help to the investigator in correlating facts and events and later in drafting the report.

Special Aspects in Connection with Business Investigations 20.5 We discuss below the factors to be considered by a professional accountant while carrying out the investigation for attaining satisfactory results: (a) Studying the overall picture - In such a business investigation, it is of utmost importance first to have an overall picture of the position of the business which is being investigated before the details are gone into. This is because figures are only symbols; and it is impossible to interpret them intelligently without knowledge of the background in which they have emerged. For instance, for investigating the accounts of a group of companies, it would not be possible to know the manner in which the profits had emerged in the past unless a chart is prepared, showing the relationship of different companies comprising the group; whether as subsidiaries or not, the nature of transactions entered into by one unit in the group with another or others and the terms on which this has been done. It may be noted here that Section 212 of the Companies Act, 1956 requires every holding company to furnish a statement along with its annual accounts showing certain financial and non-financial information in respect of its subsidiaries. Further, it is important to know whether the business is engaged in the manufacture of one or two important lines of products, is principally processing materials or is concerned only with the sale of a single product. Also, whether it is a business which depends for its success on imported raw materials or supply of parts and components from ancillary businesses or uses indigenous materials and parts which are manufactured locally. If the business is labour - intensive, its future profitability would be dependent on availability of skilled labour and relations of the management with the trade unions. Labour relations thus can affect the future profitability of the business. The method of distribution of products, either through wholesalers or retailers also must be examined. Apart from these preliminary enquiries, the investigating accountant should study: (i)

the character of management;

(ii)

the economic and political forces to which the business is subject; and

(iii) the position it enjoys in trade. The question of management is important since a good business, when badly managed, may be ruined while, on the other hand, a good management may make a success of what in itself is not a good business. The study of the impact of economic forces is important for determining factors that have been responsible for the rise or fall in the sales and profits of the business. At times, political or economic factors also may affect the fortunes of a business; for example, labour disturbances, changes in government policies in the matter of levy of excise and custom duties, imports, etc. It is, therefore necessary that the impact of all these factors should be studied and their effect on the business judged on a consideration of the profits in the past. For studying the economic and financial position of the business, the following should be considered:

Investigation and Due Diligence

20.9

(i)

The adequacy or otherwise of fixed and working capital. Are these sufficient for the growth of the business?

(ii)

What will be the trend of the sales and profits in the future? The success of a business in the future will depend on the position enjoyed by it in the past in relation to its competitors. A business may be successful because it enjoys a monopoly. In such a case, the possibility of emergence of competition must be examined. This may be ascertained on the basis of the trend in market share of the product and the licensing policy followed by the government. Establishing the trend of sales, product-wise and area-wise will ordinarily help in drawing a conclusion on whether the trend will be maintained in the future.

(iii) Whether the profit which the business could be expected to maintain in the future would yield an adequate return on the capital employed? For finding answers to all these questions, the Profit and Loss Account and the Balance Sheets of the concern for the past several years should be examined. (b) Profit and Loss Account - To study the Profit and Loss Account of a concern, it is necessary to consider each item, included therein, in relation to the corresponding items in the Profit and Loss Account of the previous years. It is therefore, necessary that a summary, in a columnar form, should be prepared of the balances included in the Profit and Loss Accounts of the business for a period, say of 5 to 7 years. For preparing such a summary the figures of the latest year should be put in first, either on the right hand side of the summary or on the left hand side. In this way, it will be possible to ensure that classification of items included in all the accounts conforms to the classification of items in the latest Profit and Loss Account, on suitably adjusting, where necessary, the figures in the earlier years account at the foot of the summary, the balances of the Profit and Loss Accounts, year by year, should be entered and reconciled with the audited accounts. In the foregoing summary, in the place of figures of opening and closing stocks, the figures of stock consumed in different years should be entered. It should also be verified that the stocks and work-in-progress have been valued on a consistent basis throughout the period under review. If there has been a change, the values of stocks should be adjusted. Further, in the summary, the gross profit ratios and the ratios showing the relationship between various items of expenses and sales should be entered. The trend of these ratios should be examined and, if there is a wide divergence in them, an explanation for the same should be sought. In the preparation of the summary attention should also be paid to the following matters: Turnover - The figures of sales should be broken down between the various products sold to show variations in turnover of individual products from year to year. In this way, it would be possible to find out the products the sales of which have been increasing and those the sales of which have been falling. Further, by reference to the list of customers, in the Order Books, it should be ascertained whether the business has a very large turnover with a few customers or a small turnover with several customers. The Order Books should also be examined to find out if fictitious sales have been centered in any year to boost up profits. If so, the figures of sales of the year or years should be adjusted. If the business consists of activities which are dissimilar in operation, like manufacturing and agency, then apart from splitting the income

20.10

Advanced Auditing and Professional Ethics

between the two sources, expenses should also be apportioned between them to separately arrive at the figures of profit from each of the activities. Wage structure - The method of computing wages and the rates of wages should be examined. On occasions a business may have to pay higher wages than those prevailing in other business in the same neighbourhood in pursuance of an industrial award. Another factor which is important to consider in this connection is the relationship of the business with its workers. A business which has suffered several industrial disputes, strikes, etc. and has had its working interrupted by them frequently cannot be expected to prosper unless a proper settlement is reached with workers’ unions. Depreciation - The charge on account of depreciation and maintenance of machinery and other assets included in the accounts of different years should be compared to verify that depreciation has been provided from year to year on a consistent basis and that it is adequate. Also, the necessary adjustment in the depreciation charge should be made if it is the practice of the company to write off the assets on a renewal basis. Further, if assets have been revalued, it should be confirmed that depreciation on the increased valuation has been adjusted. In this respect it may be noted that Para 26 of AS-6 ‘Depreciation Accounting’ states that in case of revaluation of depreciable assets, the provision for depreciation should be based on the revalued amount and on the estimate of the remaining useful life of the assets. If the annual maintenance charge has been fluctuating from year to year, it may indicate that the plant or the building has not been regularly repaired. Generally, with age, the cost of maintenance of assets should increase. If it has not, the reason thereof should be ascertained. In case of leasehold property, it should be ascertained whether an adequate provision has been made for the dilapidation charge which may be payable at the end of the lease. Managerial Remuneration - It should be verified that the remuneration payable to various members of managerial personnel is not excessive in relation to the profits of the business after taking into account the time devoted by each of them. However, it could also be that no or only a nominal remuneration has been charged in the accounts. In either case, an adjustment should be made to arrive at true profitability of the concern. Further, in case of company, requirement of relevant section of Companies Act, 1956 is to be seen. It has to be assured that calculation of profit for arriving at the remuneration is correct. Exceptional and non-recurring items - It is customary to adjust exceptional items in the summary of Profit and Loss Account in order that they may not obscure the trend of the profits. In the matter of non-recurring items, it is necessary to remember that adjustments are to be made in respect of exceptional items which do not recur from year to year or can be considered exceptional having regard to their materiality or periodicity. In this connection, it is worthwhile to examine the income tax assessment orders of the business to find out the items which have been treated as revenue but have been regarded by the taxing authority as inadmissible. Where the effect of these has been abnormal on the tax paid by the company from year to year, suitable adjustments should be made in the figures of taxes paid, as well as in the assets amounts. Likewise, adjustments should be made in respect of exceptional profits and losses.

Investigation and Due Diligence

20.11

Repairs and maintenance - It is one of the recurring expenses of a business. Occasionally it is noticed that this expenditure is unduly heavy in some of the years, while quite low in some others. Generally, companies, as a matter of routine undertake major repairs, overhauls and maintenance programme at an interval of 3 or 4 years while running repairs and maintenance continue in the usual manner which gives rise to fluctuating charges in the accounts unless periodic major expenses are treated as deferred expenditure. Besides, due to wrong allocation of expenses between capital and revenue, repair charges may appear to be heavy or low. If fluctuating and abnormal charges for repairs is noticed, it would be the duty of the investigating accountant to scrutinise this head thoroughly to establish correct and normal charge for repairs. Unusual year - A company’s record of profitability may show a trend of increasing or decreasing profit or loss or it may be highly erratic and fluctuating. Where a definite trend is discernible, the job of the investigating accountant is somewhat simplified. He can adopt recent years’ record of profitability as the basis for estimating future maintainable profit having regard to the inflationary state in the economy. But if the same is fluctuating, there would be more demand on judgement of the accountant in selecting the period to be covered for estimation of profitability. In such cases it may even be necessary to take into consideration results of past 9 to 10 years with a view to iron out the fluctuation. If, however, it is noticed that results of one or more years under scrutiny were materially vitiated by exceptional factors like a long term industrial dispute, natural calamities, fire, war, ravage etc., the investigating accountant should eliminate such year/years from consideration altogether since they do not reflect the results obtained through normal business. (c)

Balance Sheet -

Fixed Assets - Fixed assets, usually, are shown in accounts at cost less depreciation but the accounts do not show the ages of different assets. It is desirable, therefore, to obtain age analysis of various items of fixed assets. Assets which are old or are obsolete would naturally have to be replaced. It should be seen that their values are not in excess of the value of service that they could be expected to render to the business during the balance period of their active life and the amount they would fetch on sale as scrap. In addition, from a study of the maintenance expenses incurred from year to year, it should be judged whether the assets have been properly maintained. If not, it might be necessary to incur heavy expenditure on repairs to put them in a proper working order. In such a case, an allowance for this factor should be made in the value of assets. More particularly, it should be seen that if assets have been revalued, the increased depreciation charge has been adjusted against profit. Para 10 of the Guidance Note on ‘Treatment of Reserve created on Revaluation of Fixed Assets’ states that when a company has created revaluation reserve by revaluation of fixed assets and the company has charged the additional depreciation to Profit and Loss Account, it is possible to transfer an amount equivalent to accumulated additional depreciation from the revaluation reserve to Profit and Loss Account or General Reserve as the case may be. Further, investigator has to assure whether assets whose recoverable amount is less than carrying amount are impaired and requirement of AS 28, “Impairment of Asset”, has been complied.

20.12

Advanced Auditing and Professional Ethics

Investments - Investments should be broadly classified into long term investments and current investments. A current investment is by its nature readily realisable and is intended to be held for not more than one year. All other investments are long term investments. Current investments are valued on the basis of lower of cost and fair value determined either on an individual investment basis or by category of investment but not on an overall basis. Longterm investments are usually carried at cost. However, when there is a permanent decline in the value of long-term investments, the carrying amount should be reduced to recognise the decline. The carrying amount of long term investments is determined on an individual investment basis. Interest, dividends and rentals receivable in connection with investment are generally regarded as income. However in some cases, such receipts represent recovery of cost and should therefore be reduced from, the cost of investment (e.g. dividend out of preacquisition profits). Stock and work-in-progress - It should be seen that stocks have been valued consistently and that the basis of valuation was such that the value placed on stocks did not include any element of profit. Also, there should be due allowance for damaged, obsolete and slow moving stocks. Debtors - In assessing their value, the following should be taken into account: (i)

Whether bad debts have been adjusted in the years in which the relevant sales took place instead of in the year in which they have been written off. Normally, such an adjustment should be made but not when debts have had to be written off on account of a slump or a fall in international prices, during a period subsequent to the period in which sales had taken place.

(ii)

The length of the credit period allowed throughout the period under investigation, to determine whether it has been necessary to increase continually the credit period in order to effect the sales. If it has been so, it would indicate that the demand for the goods manufactured by the concern in the market has been diminishing gradually.

(iii) Debts should be classified according to their age. This would disclose the character of the parties with whom the company trades and the amount of working capital that will be necessarily blocked on this account in the course of business. Other liquid assets - It should be ascertained that the assets so described are readily realisable. Money with a bank in liquidation should be taken only to the extent guaranteed by Deposit Insurance Scheme. Idle assets - On a scrutiny, it may appear that certain assets are remaining idle and are not being properly applied in the business. These may come from all sections of assets. For example, certain plant and machinery may have been put to use after a considerable period of time after acquisition. Some of the fixed assets may be awaiting installation even at the valuation time. The company may hold large cash and bank balances, not warranted by the need of the business. Then again, there may be instances of obsolete and slow moving stocks of large value in the accounts of the company. It would be the duty of the investigating accountant to eliminate these idle assets, if any, after proper identification from the net worth

Investigation and Due Diligence

20.13

of the business. However, proper value of these assets may be separately added to the value of the business. Liabilities - The important matter to investigate in this regard is whether those are stated fully or understated or overstated. In other words, whether the profits of the business have been inflated by suppression of liabilities or there are any free reserves included in the liabilities. In either case, an adjustment would be necessary. Secondly, it should be ascertained that liabilities are not unduly large or are not outstanding for a long time, in such cases, it would be necessary to pay off some of them which would cause a drain on the liquid resources of the concern. The fact should be stated in the report. Taxation - Orders in respect of assessments completed should be studied and it should be verified that an adequate provision has been made in respect of liabilities for taxes which have not been assessed. Also, it should be seen that in the past there has been no reopening of assessments. If so, the company may be liable for an undisclosed sum of taxes plus penalties. Any temporary tax benefit should also be disregarded. Capital - In this regard, it is necessary to ascertain: (i)

Whether the capital is well balanced. This would not be the case if the amount of debentures and preference share capital are disproportionately large as compared to the equity capital, for this would be a handicap to the company in raising further equity capital, on favourable terms for financing the business or to pay off capital commitment. Further, when the capital is highly geared, it would affect the value of the equity capital;

(ii)

that the amount of capital is reasonable compared to the value of fixed assets and the amount of working capital required. The terms associated with the issue of the capital should also be studied; restriction on transferability of shares usually depresses the value of share and of the business.

(d)

Interpretation of figures -

Fixed Assets - The amount of capital expenditure which would be necessary in the future for the continuation of the business, in its existing stage, should be assessed having regard to the undermentioned factors: (i)

the amount required for the replacement of assets when these would become worn out or obsolete;

(ii)

the expenditure which will be necessary to replace obsolete machinery by more sophisticated machinery for manufacturing different types of goods for which there is demand.

Turnover - In assessing the turnover which the business would be able to maintain in the future, the following factors should be taken into account: (i)

Trend: Whether in the past sales have been increasing consistently or they have been fluctuating. A proper study of this phenomenon should be made.

(ii) Marketability: Is it possible to extend the sales into new markets or that these have been fully exploited? Product wise estimation should be made.

20.14

Advanced Auditing and Professional Ethics

(iii) Political and economic considerations: Are the policies pursued by the Government likely to promote the extension of the market for goods to other countries? Whether the sales in the home market are likely to increase or decrease as a result of various emerging economic trends? (iv) Competition: What is the likely effect on the business if other manufacturers enter the same field or if products which would sell in competition are placed on the market at cheaper price? Is the demand for competing products increasing? Is the company’s share in the total trade constant or has it been fluctuating? Working Capital - In making assessment of the working capital requirements in the future, the following matters should be taken into account: (i)

Has the ratio of stock to turnover been increasing and if so, is it a continuing or only a temporary trend?

(ii)

Are the creditors being paid promptly or is there a backlog which will have to be dealt with?

(iii) What will be the effect on stock, debtors and creditors, if the turnover is increased or if new products are introduced? Estimating future maintainable profits - Fluctuations in profits during the years under review should be examined after adjusting the profits for extraneous factors, if any, that had given rise to fluctuations to determine whether the factors responsible for the fluctuations were temporary or was likely to recur in future. A statement should be prepared showing separately the profits after depreciation earned in each of the years during the period under review, after making adjustments therein, if considered necessary, as regards factors which have been responsible for any extraordinary increase in profits. If the percentage of profits before taxation to capital has been stable or has been increasing, it would indicate that the business would continue to earn the same rate of profit as it has done in the past. If, on the other hand, the percentage has been falling, and there is no evidence that the factors responsible therefore have ceased to operate, investment of further capital in the business would not be commercially advisable. Types of Investigation 20.6 The different types of investigation that a chartered accountant is usually called upon to carry out are given hereunder: Statutory - As an inspector under Sections 235 to 251 of the Companies Act, 1956. Non-statutory - These are listed as under: (a) Investigation on behalf of an incoming partner. (b) Investigation for valuation of shares in private companies. (c) Investigation on behalf of a bank proposing to advance loan to a company. (d) Investigation of frauds. (e) Investigation on behalf of an individual or a firm proposing to buy a business.

Investigation and Due Diligence (f)

20.15

Investigation in connection with review of profit/financial forecast.

20.6.1 Investigation under the Companies Act, 1956 - Investigation under the Companies Act, 1956 may broadly be classified into: (A) Investigation into the affairs of a company and (B) Investigation of ownership of a company. (A) Investigation into the affairs of a company - In the following situations, the Central Government may appoint one or more competent persons as inspectors to investigate the affairs of a company and to report thereon in the manner directed by it: (i)

If the registrar of the Companies makes a written report, under Section 234(6) of the Companies Act, 1956, to the Central Government that certain information or explanation are not supplied to him by the Company or that the books, documents or other information and explanations are not supplied to him disclose an unsatisfactory state of affairs or that they do not make a full and fair disclosures [Section 235 (1)].

(ii)

If in the opinion of the Central Government or that of Company law Board, National Company law Tribunal, there are circumstances suggesting: (a) That the business of the company is being conducted with intent to defraud its creditors, members or any other persons or otherwise for a fraudulent or unlawful purpose, or in a manner oppressive of any of its members, or that the company was formed for any fraudulent or unlawful purpose; (b) That the persons concerned with the formation of the Company, or the management of its affairs have in connection therewith been guilty of fraud, misfeasance or other misconduct towards the company or towards any of its members; or (c) that the members of the company have not been given all the information with respect to its affairs they might reasonably expect, including information relating to the calculation of the commission payable to a managing director or the manager of the company [ Section 237 (b)]. (d) In the case of Barium Chemicals Ltd. V. Company Law Board", it was held that one of the circumstances mentioned above must exist before the Central Government can order an investigation. If it is shown that the circumstances do not exist or that they are such that it is impossible for anyone to form an opinion there from suggestive of the aforesaid things, the opinion is challengeable on the ground of non-application of mind or perversity or on the ground that it was formed on collateral grounds and was beyond the scope of the statute.

In the following situations, the Central Government has to appoint an inspector to investigate the affairs of the company: (i)

Where the Company Law Board /Tribunal orders such an investigation on an application made by the following:

20.16

Advanced Auditing and Professional Ethics

(a) In the case of a Company having share capital, not less than 200 members or members holding not less than 1/10th of the total voting power [ Section 235 (2) (a) ]. (b) In case of a company not having share capital, not less than 1/5th in number of the members of the company [Section 235(20 (b) ]. Section 236 provides that the application should be supported by evidence showing that the applicants have good reasons for requiring the investigation. The Central Government can also ask the applicants to give security up to Rs. 1,000.00 towards payment of the investigation (ii)

Where the company by special resolution, or by Court order, declares that the affairs of the company aught to be investigated by an inspector appointed by the Central Government.

Section 238 provides that a firm, body corporate or other association cannot be appointed as an inspector. Thus, a firm of professional accountant cannot be appointed as inspector but an individual accountant can be so appointed. Investigation into the affairs of related companies and other - Section 239 of the Companies Act, 1956 provides that an inspector appointed under Section 235 or 237 can also, with the prior approval of Central Government in appropriate cases, and if he thinks it essential, investigate the affairs of the following bodies corporate and others: (a) Any other body corporate which is or has at any relevant time been the subsidiary of the company under investigation or holding company or subsidiary of its holding company or a holding company of its subsidiary. (b) any other body corporate which is, or has at any relevant time been managed by any person as managing director or as manager, who is, or was, at the relevant time, the managing director or the manager of the company; or (c) Any other body corporate which is, or has at any relevant time been, managed by the company under investigation or whose board of directors comprises of nominees of the company under investigation or is accustomed to act in accordance with the directions or instructions of the said company or any of its director or of any company any of whose directorships is held by the employees or nominees of those having the control and management of the company under investigation. (d) any person who is or has at any relevant time been the company's managing director or manager. The objective of these investigations, fundamentally, is to determine whether any provision of the Act has been violated or there has been a breach of duty on the part of a director or an officer of the company resulting in a loss to shareholders or a class of them. It has been held in the case Narayanlal Bansilal v. Maneck Phiroze Mistry and another (1960 comp. Cases, p. 62) that an investigation into the affairs of a company under the Companies Act was not a criminal proceeding. It was also held that the report of the inspector is just an expression of his opinion in the manner in which affairs of the company was conducted.

Investigation and Due Diligence

20.17

The term “affairs of a company” was considered in R.V. Board of Trade Ex. parte St. Martin Preserving Company Ltd. (1964 E.R. 561). It was held that it can cover investigations into all aspects of its business; its assets including goodwill, profits and losses, contracts and transactions, investments and rather property interests and control of subsidiary companies and transactions of a receiver and manager of a company. In another case, S.L. Verma v. Delhi Flour Mills Co. Ltd. (1975, 45 company cases), it was held that to order investigation under Section 237, at least prima facie evidence should exist showing circumstances which would lead to the conclusion that an investigation was necessary. The simple fact that subsidiary company had not shown any profit would not justify an order for investigation. Powers of the Inspector - Section 240 of the Companies Act, 1956, directs all officers, other employees and agents of the company or of the related bodies corporate under investigation to preserve and to produce all books and papers in their custody before the inspector. They are also required to give all reasonable assistance to the inspector in connection with the investigation. With the previous approval of the central government, the inspector can also ask any other body corporate to furnish such information or to produce such books and papers before him as are considered necessary for his investigation into the affairs of the company. The inspector can keep in his custody any such books or papers for six months. The inspector also has the power to examine on oath any officers, employees or agents of the company under investigation or of the related bodies’ corporate .With the previous approval of the central government; he can also summon and examine any other person on oath. Penalties have been prescribed for persons who do not give information or books and papers to the inspector or who do not appear before the inspector when required to do so. The expression “Officers" in the case of investigations includes the trustees for debenture holders. Similarly, the expression “agents" includes all persons acting or purporting to act on behalf of the company under investigation or the related bodies corporate or persons and includes the bankers, legal advisors and auditors. Further, the expression “officers and other employees and agents" includes both past and present officers, other employees and agents. Section 240A gives powers to inspector, if he is so authorized by a First Class Magistrate, to seize the books and papers of the company under investigation or of any related body corporate or of the managing director or the manager of the company or other body corporate, if he has reasonable ground to believe that such books or papers may be destroyed, falsified, altered, mutilated or secreted. The Magistrate can, after considering the inspector’s application on their behalf, authorize him to enter and search the places where such books and papers are kept and cease them, if considered necessary. The inspector can retain the ceased books and papers till the conclusion of the investigation. Before returning them, he can put appropriate identification marks on them. Inspector’s Report - Under Section 241 of the Companies Act, 1956, the inspector has to make interim (if so required) and the final report to the Central Government. The Central Government forwards a copy of the final report to the company and the related bodies corporate under investigation. Copies of the final report to the company are to be furnished by

20.18

Advanced Auditing and Professional Ethics

the central government to the applicants for investigation on a request being made in their behalf and to the court and the Company Law Board / Tribunal in relevant cases. The central government may also publish the report and may furnish copies thereof to certain other persons. Section 242 to Section 244 of the Companies Act, 1956, deal with follow -up of the inspectors" report and gives power to the central government to launch prosecution or apply for winding up of the company or for an order under Section 397 or Section 398 or institute proceedings for recovery of damages regarding fraud or other misconduct or for recovery of the misapplied property. Section 245 provides that the expenses of investigation shall be defrayed by the central government in the first instance. However, it can recover the same from the persons specified in their behalf to the extent so specified. Section 246 provides that the inspector’s report shall be admissible in any legal proceedings as evidence of the inspectors" opinion on matters contained in the report. General approach for investigation - The general approach for investigation under Sections 235 and 237 of the Companies Act, 1956 is conditioned by the legal requirements in these regards. From the foregoing requirements of law, it is apparent that investigations under these requirements may encompass a wide field. As pointed out earlier, the affairs of the company may include everything such as goodwill, profit and loss, contracts, investments, assets, shareholding in subsidiaries, decision making, etc. Also the specific circumstances mentioned in these sections like fraud, mismanagement, oppression of any shareholder etc. come within the term “affairs of the company.” Investigation under Sections 235 and 237 do not call for any special approach. The approach to any investigation is determined on a consideration of the nature of the investigation and the terms of reference. However, the inspector should ensure that the terms of reference are clear, unambiguous and in writing. If he has any doubt about any item in the terms, he should obtain clarification in writing. It should also be, seen that the terms of reference are not too general, because that may frustrate the whole objective of the investigation; the scope of the investigation will become unwieldy and ill defined. An investigation order to investigate into the affairs of the company would be an instance at point. Affairs would mean anything and everything that the company is involved in. The thrust and sharpness of the investigation would get diffused and blunted and important distortions in the company may be overlooked in the generalities of the scope. Therefore the inspector should ask for reframing of the order specifying the exact matters to be investigated. He should also take into consideration the possible effect of limitations, if any, put in the terms of reference and should keep the Central Government informed in writing about their effect on the investigation. The next point for consideration of the inspector would be the determination of the scope of the investigation on the basis of the terms of reference. At this stage, it may be useful for the inspector to go into the history of the company and its affiliates or associates. He should evaluate the terms of reference in sketching the scope of investigation; this will enable him to locate the limitation, if any, in the terms of reference, not clearly mentioned. For a purposeful investigation, he may need to stretch his inquiry into the books and records of allied and associated persons and concerns and may require to arm himself with the powers given under

Investigation and Due Diligence

20.19

Section 239 of the Companies Act. He should also have regard to the period over which the investigation should stretch. The evaluation of terms of reference and the consequential determination of the scope of investigation are the twin props on which the entire investigation would rest and, therefore, the inspector appointed under Sections 235 or 237 should devote careful attention to these. Thereafter, he should frame his programme for investigation in a systematic manner. He should keep adequate working notes and papers with references and cross references in a proper and methodical way to aid him in the preparation of the report. The actual process of investigation would be essentially an evidence gathering procedure and, at every step, he should have regard to the procedures laid down in these sections regarding production of documents and evidence, examination on oath and seizure of documents. He should also keep his mind open to the revelations he comes across in the process of evidence collection and should assess whether the programme of investigation needs amendment or modification. He should also consider whether assistance of other experts like engineers, lawyers, etc., is necessary in the interest of a comprehensive and fool proof examination of the documents and information. Only after he has completed the steps in the investigation programme and has marshaled all the information that he needed should he prepare his report. He, however, can make interim report also as provided under Section 241 of the Companies Act. The findings should be completed and exhaustive. Before he makes his final report he should obtain and keep on record the evidences relied upon by him. By the nature of things, such evidence should be as conclusive as possible depending on circumstances of the case. He should make his report in accordance with the provisions of Section 241 of the Companies Act. However, the overriding consideration that he should at every stage of investigation and especially in the report framing stage bear, is to remain fair and thoroughly unbiased. The general approach for investigations under Sections 235 and 237 should, therefore, be formulated having regard to the terms of reference, scope, the period, the programme and procedure of the investigation and the attending legal requirements specified above. (B) Investigation of ownership of a company - Section 247(l) enables the Central Government, if it thinks fit, to appoint inspector(s) to investigate and report on the membership of any company and other matters relating to the company, for the purpose of determining the true persons who are or have been financially interested in the success or failure, whether real or apparent, of the company or who are or have been able to control or materially influence the policy of the company. Also if the Company Law Board declares by an order that the ownership of a company should be investigated, the Central Government shall appoint inspector(s) for the same purpose as mentioned in Section 247(l). Section 247(1A) without prejudice to its powers under this section, the Central Government shall appoint one or more inspectors under sub-section (1), if the [Tribunal], in the course of any proceedings before it, declares by an order that the affairs of the company ought to be investigated as regards the membership of the company and other matters relating to the company, for the purpose of determining the true persons – (a) who are or have been financially interested in the success or failure, whether real or apparent, of the company; or

20.20

Advanced Auditing and Professional Ethics

(b) who are or have been able to control or materially to influence the policy of the company. While appointing an inspector under Section 247(l), the Central Government normally defines the scope of his investigation. The power of the investigator shall extend to the investigation of any circumstances suggesting the existence of any arrangement or understanding which, though not legally binding, is or was observed or is likely to be observed in practice and which is relevant for the purposes of his investigation. For the purposes of any investigation under Sections 247, 239, 240 and 241 shall apply with necessary modifications. However under Section 247, the Central Government is not bound to furnish the company under investigation or any other person with a copy of the inspector’s report. But it has to keep with the Registrar of companies, a copy of the report or of those parts which may be divulged. Section 250 of the Companies Act empowers the Tribunal, on a reference made to it by the Central Government in connection with any investigation under Sections 247, 248 or 249 or on a complaint made by any person in this behalf, to impose restrictions upon issue and transfer of shares and debentures of a company under investigation. Such a restriction is valid for a period not exceeding three years. Section 250A provides that investigation proceeds initiated against a company will not be stopped even if the company has passed a special resolution for voluntary winding up or it has made an application for relief in cases of oppression or mismanagement. Finally, Section 251 safeguards the legal advisers and bankers of a company under investigation from furnishing certain privileged communication in respect of the company or any information as to the affairs of any of the customers other than such company to the Central Government or Tribunal or the inspector. Scope and extent of investigation - When a chartered accountant is appointed to carry out an investigation under any of the aforementioned provisions, the extent of enquiry, the objective of the investigation and the various matters referred to for investigation are specified in the order of investigation issued by the appointing authority. On a consideration thereof, the investigating accountant should determine the areas of accounts which require investigation and the extent to which the enquiry is to be made as well as his general approach to the enquiry. For example, if the allegation is that certain transactions have been entered into in contravention of the provisions of the Companies Act, the nature of transactions, the persons who were parties thereto, the amount or amounts involved and the circumstances under which these were entered into must be examined. If the contravention was deliberate and willful and was made with some ulterior motive, it would attract greater penalty as compared to the one which was inadvertent. The enquiry therefore should show the motive, if any, of the contravention. If the loss suffered by the company has given rise to a gain by a director and other managerial personnel or its associates, the manner in which the benefit has accrued and the amount thereof shall have to be investigated. In case of a company having subsidiaries or where one or more directors are interested in one or more concerns, all the dealings with these concerns should be examined for these may have been entered into with the intention of transferring profit. Generally, all sales and purchases of goods and assets from directors and their associated concerns should be scrutinised since these also can be a vehicle of illicit transferring of profits.

Investigation and Due Diligence

20.21

Any breach of duty or abdication of responsibility for purposes of investigation would be material only if it has resulted in a loss to the company. In such a case, the factors responsible for the loss or losses, besides the amount thereof, shall have to be investigated. Negligence would be culpable only if it was in relation to a duty cast by the Act, Articles of Association or by a resolution of the shareholders or that of the Board of Directors. Any negligence in the discharge of duty of a director or any other managerial personnel must be construed very broadly, for apart from being the agents of the company, they are trustees of its property. As such, it is their duty to safeguard the property of the company and protect the interest of the shareholders. It must be remembered, however, that it is not the duty of a director to attend to the business of a company continuously and, therefore, so long as the decisions of the Board at which the director was present were taken on a proper consideration of the evidence available and in the best interest of the company, he would not be responsible for any losses suffered by the company. It may be necessary for an investigator to interrogate directors, officers, agents, and others concerned with matters under his enquiry. Before drawing up his brief in this regard as well as for framing his conclusions, he should, if necessary, take legal assistance. If the Investigating accountant is required to report on the efficiency of the management, he should be discreet in expressing his opinion. Usually, it is sufficient if he merely indicates the general limitations of the management. The inspector must ensure that the persons who figure in the investigation get the fullest opportunity to explain their action and conduct. However, the inspector can not hold out any assurance to anybody except the assurance of fairness implicit in the job. It is necessary to note that according to the provisions contained in clause (b) of Sub-section (vi) of Section 240 of the Companies Act, auditors also are considered agents of the company. As such, they are expected to give to the inspector all assistance in connection with the investigation which they are in a reasonable position to give. They also can be required to produce their working papers and notes for examination by the investigator. 20.6.2 Investigation on behalf of an incoming partner - The general approach of the investigating accountant in this type of investigation would be more or less similar, irrespective of the nature of business of the firm-manufacturing, trading or rendering a service. Primarily, an incoming partner would be interested to know whether the terms offered to him are reasonable having regard to the nature of the business, profit records, capital distribution, personal capability of the existing partners, socio-economic setting, etc., and whether he would be capable of deriving continuing benefit in the shape of return on capital to be contributed and remuneration for services to be rendered, which can be justified by the overall economic conditions prevailing and other considerations considering his own personality and achievements. In addition, he would be interested to ascertain whether the capital to be contributed by him would be safe and applied usefully. Broadly, the steps involved are the following: (a) Ascertainment of the history of the inception and growth of the firm.

20.22

Advanced Auditing and Professional Ethics

(b) Study of the provisions of the deed of partnership, particularly for composition of partners, their capital contribution, drawing rights, retirement benefits, job allocation, financial management, goodwill, etc. (c) Scrutiny of the record of profitability of the firm’s business over a suitable number of years, with usual adjustments that are necessary in ascertaining the true record of business profits. Particular attention should, however, be paid to the nature of partners’ remuneration, which may be excessive or inadequate in relation to the nature and profitability of the business, qualification and expertise of the partners and such other factors as may be relevant. (d) Examination of the asset and liability position to determine the tangible asset backing for the partner’s investment, appraisal of the value of intangibles like goodwill, know how, patents, etc. impending liabilities including contingent liabilities and those for pending tax assessment. In case of firms rendering services, the question of tangible asset backing usually is not important, provided the firm’s profit record, business coverage and standing of the partners are of the acceptable order. (e) Position of orders at hand and the range and quality of clientele should be thoroughly examined, which the firm is presently operating. (f)

Position and terms of loan finance would call for careful scrutiny to assess its usefulness and implication for the overall financial position; reason for its absence should be studied.

(g) It would be interesting to study the composition and quality of key personnel employed by the firm and any likelihood of their leaving the organisation in the near future. (h) Various important contractual and legal obligations should be ascertained and their nature studied. It may be the case that the firm has standing agreement with the employees as regards salary and wages, bonus, gratuity and other incidental benefits. Full import of such standing agreements would be gauged before a final decision is reached. (i)

Reasons for the offer of admission to a new partner should be ascertained and it should be determined whether the same synchronises with the retirement of any senior partner whose association may have had considerable bearing on the firm’s success.

(j)

Appraisal of the record of capital employed and the rate of return. It is necessary to have a comparison with alternative business avenues for investments and evaluation of possible results on a changed capital and organisation structure, if any, envisaged along with the admission of the partner.

(k) It would be useful to have a first hand knowledge about the specialisation, if any, attained by the firm in any of its activities. (l)

Manner of computation of goodwill on admission as also on retirement, if any, should be ascertained.

(m) Whether any special clause exists in the deed of partnership to allow admission in future of a new partner, who may be specified, on concessional terms.

Investigation and Due Diligence

20.23

(n) Whether the incomplete contracts which will be transferred to the reconstituted firm will be a liability or a loss. It would always be worthwhile to remember that, in a partnership, personal considerations count predominantly over other considerations and assessment of standing of the firm, standing and reliability of other partners, their personal reputation and the goodwill enjoyed by the products/services are important. On the basis of the broad frame of considerations as given above, the investigating accountant should devise his own considerations in each case which may be quite diverse. Additional considerations may come up in the case of service-rendering firms where profit and business record, goodwill of the firm and of individual partners would assume greater significance. Again, in the case of industrial firms, the network of customers, their scatter, size, etc., would be relevant for consideration. 20.6.3 Investigation for valuation of shares in private companies - The importance should be given on various purposes for which such a valuation is necessary, the different bases on which valuation is possible and the variety of economic factors, on a consideration whereof the price so determined needs to be adjusted. The necessity for valuation of shares of a private company arises, for under the Companies Act, a private company must restrict the transfer of its shares. In consequence, the shares of a private company do not have a free market in which their prices could be determined by interaction of the forces of supply and demand. In respect of equity shares, there are two main methods of valuation. According to the first method, value is determined on the basis of net worth of the company. The amount of net worth is divided by the number of shares comprising the equity capital to arrive at the value for one share. When this method is followed, goodwill of the business, based on the estimated future maintainable profit, is included among the assets to arrive at the amount of net worth. According to the second method, the average profit earned by the business during the preceding 5 to 7 years is computed. Afterwards, on the assumption that the same would continue to be earned in the future, the value of business is calculated by capitalising it at a reasonable rate of interest. If the rate assumed is high, the value of the business would be smaller. Correspondingly, it would be high if the rate of interest applied is low. A provision of the risk factor and restriction on transfers in the value of shares is made by varying the rate of interest applied. The rate of return that an investor expects to earn in a business of the type in which the company is engaged, is ascertained from the prices of the shares of companies engaged in a similar business quoted on the stock exchange. The value of preference shares is estimated on the basis of the yield on preference shares of companies engaged in a similar trade or industry after making allowance for factors like restriction on transferability, average rate of earnings as compared to the rate of dividend, etc.

20.24

Advanced Auditing and Professional Ethics

Special features Net worth basis (a) Each asset should be revalued on taking into account its utility to the business as a going concern. The value of different assets, on a revaluation, may be either more or less in comparison to their book values. For example, the book value of safes and furniture in the case of a bank is usually much less as compared to their utility. On the other hand, the book value of intangible assets, e.g., leasehold rights, patents, goodwill, etc., in case of an industrial concern may be higher in comparison with the advantage which accrues to it from these assets. In both the cases, the assets should be revalued at their replacement cost i.e., the cost of similar assets at the prevailing market price, reduced by the amount of depreciation which they would have suffered, if they were in use during the period that the corresponding assets have been in use. But the cost adopted, in cash, should be the cost of the assets as were originally purchased or that of their substitutes considered more suitable in the circumstances of the case. (b) The value of goodwill of a business is primarily dependent on its capacity to earn superprofit and the period over which these are expected to arise. The super profits that the business would earn in the future are estimated on the basis of profits earned in the past, after making an allowance therein for the continuation or otherwise of favourable factors, which in the past had enabled the business to earn super-profits. This is usually a difficult matter since, for the purpose, it is necessary to analyse the trend of economic, social and political forces which have an impact on the profitability of the business. For instance, the installed capacity must be viewed against future national requirements on taking into account the government’s licensing policy. Again, government policies like controls over selling price or advantages of marketing through its own organisations will have to be considered since any change therein might seriously affect the profit structure. Therefore, to determine the impact of these factors, the accountant must have knowledge of the company’s working and experience of the business in general. Yield basis (a) The value of shares on yield basis is arrived at on the basis of present value of the right to receive dividends in the future. Since dividends can be paid only out of profits, in this case also, it is necessary to determine the amounts of profits which the company would be earning in future as well as the amounts thereof which would be distributed as dividend from year to year. In short, it is an exercise in projecting the trend to profits and predicting the policy that the company might follow in the matter of declaration of dividends. (b) The rate at which the amount of dividends should be capitalised is decided on taking into account the risk that shareholders are taking in the matter of declaration of dividends being continued in future, assessed in the background of past history of the company, the amount of reserves the company possesses, both secret and those disclosed in its books, future prospects of the line of manufacture or trade in which the company is

Investigation and Due Diligence

20.25

engaged and the impact of various social and political factors that are likely to emerge on the company’s profitability. Since the effect of these factors is reflected in the prices at which the shares of companies engaged in similar trades and businesses are quoted on the Stock Exchange, the investigating accountant should consider them. These would show to him the rate at which their dividends were being capitalised. He should adopt the average rate of return expected by investors in the shares of such companies but it should be applied only after making due allowance for the factors peculiar to the case, such as restrictions on transfer of shares, majority holding, etc. In any valuation of shares, with the transfer of shares control is also to pass, a separate value should be ascertained for the control and added to the value otherwise obtained either on net worth basis or yield basis. 20.6.4 Investigation on behalf of a bank proposing to advance loan to a company - A bank is primarily interested in knowing the purpose for which a loan is required, the sources from which it would be repaid and the security that would be available to it, if the borrower fails to pay back the loan. On these considerations, the investigating accountant, in the course of his enquiry, should attempt to collect information on the undermentioned points: (i)

The purpose for which the loan is required and the manner in which the borrower proposes to invest the amount of the loan.

(ii)

The schedule of repayment of loan submitted by the borrower, particularly the assumptions made therein as regards amounts of profits that will be earned in cash and the amount of cash that would be available for the repayment of loan to confirm that they are reasonable and valid in the circumstances of the case. Institutional lenders now-adays rely more for payment of loans on the reliability of annual profits and loss on the values of assets mortgaged to them.

(iii) The financial standing and reputation for business integrity enjoyed by directors and officers of the company. (iv) Whether the company is authorised by the Memorandum or the Articles of Association to borrow money for the purpose for which the loan will be used. (v) The history of growth and development of the company and its performance during the past 5 years. (vi) How the economic position of the company would be affected by economic, political and social changes that are likely to take place during the period of loan. To investigate the profitability of the business for judging the accuracy of the schedule of repayment furnished by the borrower, as well as the value of the security in the form of assets of the business already possessed and those which will be created out of the loan, the investigating accountant should take the under-mentioned steps: (a) Prepare a condensed income statement from the Profit and Loss Accounts for the previous five years, showing separately therein various items of income and expenses, the amounts of gross and net profits earned and taxes paid annually during each of the five years. The amount of maintainable profits determined on the basis of foregoing

20.26

Advanced Auditing and Professional Ethics

statement should be increased by the amount by which these would increase on the investment of borrowed funds. (b) Compute the under-mentioned ratios separately and then include them in the statement to show the trend as well as changes that have taken place in the financial position of the company: (i)

Sales to Average Stocks held.

(ii)

Sales to Fixed Assets.

(iii) Equity to Fixed Assets. (iv) Current Assets to Current Liabilities. (v) Quick Assets (the current assets that are readily realisable) to Quick Liabilities. (vi) Equity to Long Term Loans. (vii) Sales to Book Debts. (viii) Return on Capital Employed. (c) Enter in a separate part of the statement the break-up of annual sales product-wise to show their trend. Steps involved in the verification of assets and liabilities included in the Balance Sheet of the borrower company which has been furnished to the Bank - The investigating accountant should prepare schedules of assets and liabilities of the borrower and include in the particulars stated below: (a) Fixed assets - A full description of each item, its gross value, the rate at which depreciation has been charged and the total depreciation written off. In case the rate at which depreciation has been adjusted is inadequate, the fact should be stated. In case any asset is encumbered, the amount of the charge and its nature should be disclosed. In case an asset has been revalued recently, the amount by which the value of the asset has been decreased or increased on revaluation should be stated along with the date of revaluation. If considered necessary, he may also comment on the revaluation and its basis. (b) Stock - The value of different types of stocks held (raw materials, work-in-progress and finished goods) and the basis on which these have been valued. Details as regards the nature and composition of finished goods should be disclosed. Slow-moving or obsolete items should be separately stated along with the amounts of allowances, if any, made in their valuation. For assessing redundancy, the changes that have occurred in important items of stock subsequent to the date of the Balance Sheet, either due to conversion into finished goods or sale, should be considered. If any stock has been pledged as a security for a loan the amount of loan should be disclosed. (c) Sundry debtors, including bills receivable - Their composition should be disclosed to indicate the nature of different types of debts that are outstanding for recovery; also

Investigation and Due Diligence

20.27

whether the debts were being collected within the period of credit as well as the fact whether any debts are considered bad or doubtful and the provision if any, that has been made against them. Further, the total amount outstanding at the close of the period should be segregated as follows: (i)

debts due in respect of which the period of credit has not expired;

(ii)

debts due within six months; and

(iii) debts due but not recovered for over six months. If any debts are due from directors or other officers or employees of the company, the particulars thereof should be stated. Amounts due from subsidiary and affiliated concerns, as well as those considered abnormal should be disclosed. The recoveries out of various debts subsequent to the date of the Balance sheet should be stated (d) Investments - The schedule of investments should be prepared. It should disclose the date of purchase, cost and the nominal and market value of each investment. If any investment is pledged as security for a loan, full particulars of the loan should be given. (e) Secured Loans - Debentures and other loans should be included together in a separate schedule. Against the debentures and each secured loan, the amounts outstanding for payments along with due dates of payment should be shown. In case any debentures have been issued as a collateral security, the fact should be stated. Particulars of assets pledged or those on which a charge has been created for re-payment of a liability should be disclosed. (f)

Provision of Taxation - The previous years up to which taxes have been assessed should be ascertain. If provision for taxes not assessed appears in be inadequate, the fact should be stated along with the extent of the shortfall.

(g) Other Liabilities - It should be stated whether all the liabilities, actual and contingent, are correctly disclosed. Also, an analysis according to ages of trade creditors should be given to show that the company has been meeting its obligations in time and has not been depending on trade credit for its working capital requirements. (h) Insurance - A schedule of insurance policies giving details of risks covered, the date of payment of last premiums and their value should be attached as an annexure to the statements of assets, together with a report as to whether or not the insurance-cover appears to be adequate, having regard to the value of assets. (i)

Contingent Liabilities - By making direct enquiries from the borrower company, from members of its staff, perusal of the files of parties to whom any loan has been advanced those of machinery suppliers and the legal adviser, for example, the investigating accountant should ascertain particulars of any contingent liabilities which have not been disclosed. In case, there are any, these should be included in a schedule and attached to the report.

Advanced Auditing and Professional Ethics

20.28

Finally, the investigating accountant should ascertain whether any application for loan to another bank or any other party has been made. If so, the result thereof should be examined. 20.6.5 Investigation of frauds - Frauds are of two classes, viz. defalcations involving misappropriation, either of money or that of goods, and manipulation of accounts not involving a defalcation. The detections of manipulations of accounts being one of the objects of an audit, For the detection of frauds perpetrated for misappropriating either money or goods, knowledge of the various circumstances under which these may be committed and that of different forms they take is essential. On this account, a brief description thereof is given below. The various situations in which money may be embezzled and the various forms that such frauds usually take include the following: (a) Cash receipts - In cases like holding back cash sales, collections by travelling salesmen, V.P.P receipts, or casual receipts, e.g., sales of scrap, recoveries out of debts written off earlier, etc., the amount or amounts of receipts embezzled may be subsequently covered up by the perpetrator adopting one or other of the undermentioned devices: (i)

Issuing a receipt to the payee for the full amount collected and entering only a part of the amount on the counterfoil.

(ii)

Showing a larger cash discount than actually allowed.

(iii) Adjusting a fictitious credit in the account of a customer for the value of goods returned by him. (iv) Adjusting a cash sale as a credit sale, and raising a debit in the account of the customer. (v) Writing off a good debt as bad and irrecoverable to cover up the amount collected which has been misappropriated. (vi) Short-debiting the customer’s account in the ledger with an intention to withdraw the difference when the full amount payable by him is collected. (vii) Under-casting the receipts side of the Cash Book or over-casting the payment side; carrying over a shorter total of the receipts from one page of the Cash Book to the next or over-carrying the total of the payment from one page of the Cash Book to the next with a view to covering up misappropriation; either short banking of cash collection or apart of the amount withdrawal from the bank. (b)

Inflating cash payment (i)

Making double payment of an invoice or paying a false invoice.

(ii)

Paying personal expenses out of the business by falsifying details. e.g., showing betting losses as advertisement charges.

Investigation and Due Diligence

20.29

(iii) Withdrawing unclaimed credit balances of customers or amounts falsely credited in the accounts of parties. (iv) Falsely adjusting a refund in the account of a customer and withdrawing the credit balance. (v) Wrong totalling of the wage sheets and misappropriating the excess amount withdrawn from the bank for payment of wages. (c) Frauds through suppliers’ ledger (i)

Adjusting fictitious or duplicate invoices as purchases in the accounts of suppliers and subsequently misappropriating the amounts when payments are made to the suppliers in respect of these invoices.

(ii)

Suppressing the Credit Notes issued by suppliers and withdrawing the corresponding amounts not claimed by them.

(iii) Withdrawing amounts unclaimed by suppliers, for one reason or another by showing that the same have been paid to them. (iv) Accepting purchase invoices at prices considerably higher than their market prices and collecting the excess amount, paid in cash, from the suppliers. (d) Customers’ ledger (i)

By the ‘teeming and lading’ method, i.e., misappropriating the amount collected from a customer and crediting his account by the amount paid by him only when an amount is subsequently collected from another customer; repeating this practice with several items collected and depositing back the amount or amounts so misappropriated before the close of the year.

(ii)

Misappropriating the amount collected from a customer and subsequently adjusting his account by crediting the amount on account of allowance or a rebate for excess price charged.

(iii) Crediting the amount received from a customer to the account of another customer and subsequently withdrawing the amount wrongly credited. (e) Stock frauds - Stock frauds are many and varied but here we are concerned with misappropriation of goods and their concealment. (i)

Employees may simply remove goods from the premises.

(ii)

Theft of goods may be concealed by writing them off as damaged goods, etc.

(iii) Stock records may be manipulated by employees who have committed theft so that book quantities tally with the actual quantities of stocks in hand. Before proceeding to investigate frauds of the type afore-mentioned, the investigating accountant should ascertain the exact duties of the person concerned who is suspected to have committed a fraud; his relationship to the general routine of the office, and the circumstances in which any known instances of defalcation have come to light. Such an enquiry would give a clue to promising avenues of investigation. Greater the authority of the

20.30

Advanced Auditing and Professional Ethics

individual suspected of a fraud, wider would be the field which would have to be covered by the investigation. At times, an accountant is called upon to investigate a suspected fraud, the details or the nature whereof is not known. In such a case, for localising the source of the fraud, the investigating accountant will have to study the financial and accounting structure of the organisation. As a first step, he should examine the line of responsibility between the various members of the staff. He should have a look at the system of internal control in operation for spotting out the weaknesses, if any, that may exist in it. Relying on the above study, he should direct his enquiry towards those aspects of the business where there as been excessive control in the hands of single persons, without any supervision by any other person or any other inherent weakness that may be in existence in the system. Procedure for Investigation Cash receipts - On the assumption that some of these may have been diverted before being entered in the books, evidence as regards income received from different sources should be scrutinised, e.g., stock, sales summaries, rental registers, correspondence with customers, advices of travelling salesmen and counterfoils or receipts. Carbon copies of receipts marked ‘duplicate’, should be scrutinised to confirm that they are in fact copies of receipts issued earlier. In addition, by recalling paying-in-slips from the bank the details of cash deposited on each day should be compared with those shown in the Cash Book. The record of sales of scrap of waste paper, that of collection of rents from labourers temporarily accommodated in the company’s quarters, that of refunds of amounts deposited with the electric supply co., and other Government authorities should be examined for finding out if any of these amounts have been misappropriated. Cash sales should be vouched in detail. Recoveries from customers and sundry parties should be checked with the copies of receipts issued to them; deductions made on account of cash discounts should be reviewed. All withdrawals from the bank should be checked by reference to corresponding entries in the bank pass book. Cash payments - All the evidence as regards cash payments made, including acknowledgement by parties for payments shown to have been made to them, should be carefully scrutinised. In the case where a figure appears to have been erased or altered on the receipts issued by the party, on reference to the party concerned, the actual amount paid to him should be confirmed. The same procedure should be adopted in respect of amounts acknowledged on blank papers. All payments by bearer cheques should be examined. The system of recording of wages should be reviewed, specially as regards possible over-totalling of wage sheets, and entries in them of dummy workmen. The system of ordering and receiving goods should be reviewed so as to confirm that no payment has been made in respect of supplies which have not been received. Confirmations should be obtained from partners or Directors in respect of amounts shown to have been paid to them. The Petty Cash Book should be vouched and totalled. Special attention should be paid to payments made on account of salaries and wages; confirmation should be obtained from the management that all payments of such salaries and wages were made to persons who were actually in the service of the company. All the withdrawals from the bank should be checked by reference to entries in the bank’s pass book. All the bills receivable or payable should be checked by reference to the Bills Books.

Investigation and Due Diligence

20.31

Verification of balances in customers’ ledger - Special attention should be paid to allowances adjusted on account of goods returned or difference in price or on any other account as well as to amounts written off as bad debts. To confirm that the accounts of customers have been debited in respect of goods supplied to them, entries in the Order Book should be tested with those in the Sales Day Book where one is kept. The investigating accountant should obtain confirmation of customers in respect of the amounts standing in their accounts. Those of them who have no balance in their accounts should be requested to confirm the statement of their account (which should be sent to them) for ascertaining that the entries shown therein were genuine. Verification of balances in suppliers’ ledger - The Bought Journal should be vouched by reference to entries in the Goods Inward Book and the suppliers’ invoices to confirm that amounts credited to the accounts of suppliers were in respect of goods, which were duly received and the suppliers’ accounts had been credited correctly. All the suppliers should be requested to furnish statements of their accounts to see whether or not any balance is outstanding or due so as to confirm that allowances and rebates given by them have been correctly adjusted. Defalcation of stock - It may be of trading stock, raw materials, manufacturing stores, tooks or of other similar items (readily) capable of conversion into cash. The loss may be the result of a theft by an employee once or repeatedly over a long period, when the same have not been detected. Such thefts usually are possible through collusion among a number of persons. Therefore, for their detection, the entire system of receipts, storage and despatch of all goods, etc. should be reviewed to localise the weakness in the system. The determination of factors which have been responsible for the theft and the establishment of guilt would be difficult in the absence of: (a) a system of stock control, and existence of detailed record of the movement of stock, or (b) availability of sufficient data from which such a record can be constructed. The first step in such an investigation is to establish the different items of stock defalcated and their quantities by checking physically the quantities in stock held and those shown by the Stock Book. Afterwards, all the receipts and issues of stock recorded in the Stock Book should be verified by reference to entries in the Goods Inward and Outward Registers and the documentary evidence as regards purchases and sales. This would reveal the particulars of stock not received but paid for as well as that issued but not charged to customers. Further, entries in respect of returns, both inward and outward, recorded in the financial books should be checked with corresponding entries in the Stock Book. Also, the totals of the Stock Book should be checked. Finally, the shortages observed on physical verification of stock should be reconciled with the discrepancies observed on checking the books in the manner mentioned above. In the case of an industrial concern, issue of raw materials, stores and tools to the factory and receipts of manufactured goods in the godown also should be verified with relative source documents. Defalcations of stock, sometimes, also are committed by the management, by diverting a part of production and the consequent shortages in production being adjusted by inflating the wastage in production; similar defalcations of stocks and stores are covered up by inflating

Advanced Auditing and Professional Ethics

20.32

quantities issued for production. For detecting such shortages, the investigating accountant should take assistance of an engineer. For that he will be more conversant with factors which are responsible for shortage in production and thus will be able to correctly determine the extent to which the shortage in production has been inflated. In this regard, guidance can also be taken from past records showing the extent of wastage in production in the past. Similarly, he would be able to better judge whether the material issued for production was excessive and, if so to what extent. The per hour capacity of the machine and the time that it took to complete one cycle of production, also would show whether the issues have been larger than those required. 20.6.6 Investigation on behalf of an individual or firm proposing to buy a business Scope of investigation - The objective of such an investigation is to collect such information as would enable the purchaser to decide whether it is worth while to buy the business and if so, for what amount. The investigation should proceed broadly on the same lines as for valuation of shares. Additional matters which must receive the attention of the investigating accountant on which, if appropriate, information to the client should be given. (A)

In case of proprietary concerns or partnerships (i)

Reasons for the sale of the business and the effect on turnover and profits that there would be on retirement of the present proprietor (or partners).

(ii)

The length of lease under which the premises are held; the prospects of its renewal or extension.

(iii) The unexpired period of any patents owned by the vendors. (iv) The age of the present managerial staff and the prospects of continuing in service under the new proprietorship and the possible liability, not already provided for that would arise as regards payment of pensions or gratuities in case of old and aged employees and those retrenched. (v) If the bulk of sales are made to customers whose number is small, the profitability of the business would be greatly shaken on withdrawing their support. This would be an element of weakness which should be investigated as it might affect future profitability. (vi) The valuation that could be placed on goodwill to determine whether that appearing in the book is less or more; if none is included to determine the amount that should be included, if at all. (B) If the business belongs to a limited company - The vendors’ interest in this case will be purchased by the acquisition of shares. On that account, the following additional matters would also require consideration: (i)

The authorised and issued capital of the company.

(ii)

Whether there is any uncalled liability on the shares.

Investigation and Due Diligence

20.33

(iii) If the capital is divided into different classes of shares - the rights that are attached to each class. (iv) Particulars of dividends paid in the past and the amounts thereof which are in arrear (on cumulative preference shares). (v) If there are any mortgages created on the assets appearing in the company’s books, a search should be made in the Register of Charges in the office of the Registrar of Companies. (vi) The price at which the shares are being offered. If the company is a public company, the price will usually be in excess of market price quoted on the Stock Exchange, but in the case of unquoted shares particularly where the company whose shares are being acquired is a private company, a valuation will have to be placed on the shares for the purpose of purchase. 20.6.6 Investigation in connection with review of profit/financial forecasts - There are many investigations which involve an examination of future profits. Profit reports can be required as part of a general investigation into the purchase of a business or by banks and financial institutions with regard to project cash flow and profitability statements for appraisal of loan applications submitted by the intending borrowers. All forecasts depend, to a large extent, on the nature of the business with its numerous and substantial uncertainties. Therefore, such forecasts are not capable of verification by the reporting accountants in the same way as financial statements which present the results of a completed accounting period. Normally, such situations involve special review as these depart from the auditor’s traditional role of expressing an opinion in relation to past events. For quite a long time, professional accountants have been involved in the preparation or review of profit forecasts to be submitted by intending borrowers to banks and financial institutions. These institutions place a greater reliance on such statements if they are prepared or reviewed by chartered accountants. As a large number of chartered accountants are undertaking the preparation and review of profit and financial forecasts for submission to banks and financial institutions, the ICAI has issued a guidance note on this subject. The guidance note discusses various considerations and important matters to which the accountants should direct their attention in reviewing the forecasts. It also contains guidelines for preparation of the report. Due Diligence 20.7 'Due Diligence' is a term that is often heard in the corporate world these days in relation to corporate restructuring. The term 'corporate restructuring' normally includes internal reconstruction, amalgamations, spin-offs, divestiture, mergers, joint ventures, split-off, etc. Certain corporate restructuring exercises are not within the group (also known as external corporate restructuring exercises), for example, a joint venture between two parties where one party hives off an existing unit or division into another company into which the joint venture partner then acquires an interest or has acquired an interest. These are all corporate restructuring exercises that involve more than one party. For such a corporate restructuring exercise to succeed, it must be planned properly. A key element in such an exercise, where it

20.34

Advanced Auditing and Professional Ethics

involves the acquisition of another entity, unit or assets of an entity, is the performance of a “due diligence” review. Due Diligence may also required to be performed in cases of venture capital financing, lending, leveraged buyouts, public offerings, disinvestment, coporatisation, etc. Sometimes, in a restructuring exercise, while the unit may remain within a group, it may pass from under the charge of one management team to that of another team. This situation also gives rise to the need for a due diligence review. Purpose of Due-Diligence - The purpose of due diligence is to assist the purchaser or the investor in finding out all he reasonably can about the business he is acquiring or investing in prior to completion of the transaction including its critical success factors as well as its strength and weaknesses. In addition, it may expose problems or potential problems that can be addressed in the price negotiations or by dealing suitable clauses in the contractual documentation, in particular, warranty and or indemnity provisions. Due Diligence can be sub-classified into discipline-wise exercises be as follows: ♦

Commercial or Operational Due Diligence

♦

Financial Due Diligence

♦

Tax Due Diligence

♦

Information Systems Due Diligence

♦

Legal Due Diligence

♦

Environmental Due Diligence

♦

Personnel Due Diligence

20.7.1 Commercial or operational Due Diligence - Operational due diligence is generally performed by the concerned acquirer enterprise (due diligence may also be commissioned by the enterprise for the sale of its business or part of a business), and involves an evaluation from a commercial, strategic or operational perspective. For example, whether proposed merger would create operational synergies. On the other hand, financial due diligence review would be performed after the commercial valuation. Accordingly, while a preliminary review might be performed during initial stages of the restructuring exercise and may, in fact, be performed simultaneously with the commercial evaluation, at a later stage, financial due diligence may be performed on the books of account and other information directly pertaining to the financial matters of the entity. In addition, a legal due diligence may be required where legal aspects of functioning of the entities are reviewed; for example, the legal aspects of property owned by the entity or compliance with various statutory requirements under various laws. Like other due diligence exercises, environmental and personnel due diligence are also carried out in order to establish whether various propositions with regard to environment and personnel of the enterprise under review are appropriate. 20.7.2 Financial Due Diligence - At times, the financial due diligence review is interpreted as complete due diligence review since it is supposed to ascertain the financial implications of all the other due diligence reviews. This is, however, not appropriate. The term 'financial due

Investigation and Due Diligence

20.35

diligence' should be used with caution. Unless the scope of financial due diligence to be performed is wide enough to cover all the aspects, it should not be confused with overall due diligence review. It can be understood from the foregoing that the role of financial due diligence commences after a price has been agreed for the business. The initial price and other decisions are taken on the basis of net worth as well as trend of profitability of the target company, with an assumption that all contingent liabilities that may impact the future of the business have been recorded. The principal objective of financial due diligence, therefore, is usually to look behind the veil of initial information provided by the company and to assess the benefits and costs of the proposed acquisition/merger by inquiring into all relevant aspects of the past, present and future of the business to be acquired/merged with. In order to achieve its objective, the due diligence process can include any or all of the following objectives for individual areas of the verification: ♦

Brief description of the history of business

♦

The background of promoters

♦

Accounting policies and practices

♦

Management information systems

♦

Details of management structure

♦

Trading results both past and the recent past

♦

Assets and liabilities as per latest balance sheet

♦

Current status of Income tax assessments including appeals pending against tax liabilities assessed by tax authority.

♦

Cash flow patterns

♦

The projection of future profitability

If a full fledged financial due diligence is conducted, it would include the following matters, inter alia, in its scope: (a) Brief history of the target and background of its promoter (b) Accounting policies (c) Review of financial statements (d) Taxation (e) Cash flow (f)

Financial Projection

(g) Management and employees (h) Statutory Compliance.

20.36

Advanced Auditing and Professional Ethics

(a) Brief history of the target and background of its promoters - The accountant should begin the financial due diligence review by looking into the history of the company and the background of the promoters. The details of how the company was set up and who were the original promoters has to be gone into, before verification of financial data in detail. An eye into the history of the target may reveal its turning points, survival strategies adopted by the target from time to time, the market share enjoyed by the target and changes therein, product life cycle and adequacy of resources. It could also help the accountant in determining whether, in the past, any regulatory requirements have had an impact on the business of the target. Broadly, the accountant should make relevant enquiries about the history of target's business products, markets, suppliers, expenses, operations. This could, inter alia, include the following: ♦

Nature of business(es) (for example, manufacturer, wholesaler, financial services, import/export)

♦

Location of production facilities, warehouses, offices

♦

Employment (for example, by location, supply, wage levels, union contracts, pension commitments, government regulation)

♦

Products or services and markets (for example, major customers and contracts, terms of payment, profit margins, market share, competitors, exports, pricing policies, reputation of products, warranties, order book, trends, marketing strategy and objectives, manufacturing processes)

♦

History of the business with important suppliers of goods and services (for example, long-term contracts, stability of supply, terms of payment, imports, methods of delivery such as "just-in-time")

♦

Inventories (for example, locations, quantities)

♦

Franchises, licenses, patents

♦

Important expense categories

♦

Research and development

♦

Foreign currency assets, liabilities and transactions

♦

Legislation and regulation that significantly affect the entity

♦

Information systems

(b) Accounting policies - The accountant should study the accounting policies being followed by the target and ascertain whether any accounting policy is inappropriate. The accountant should also see the effects of the recent changes in the accounting policies. The target might have changed its accounting policies in the recent past keeping in view its intention of offering itself for sale. The overall scope has to be based on the accounting policies adopted by the management. The accountant has to look at the main effect of accounting policies on the overall profitability and their correctness. It is reiterated that the

Investigation and Due Diligence

20.37

accountant should mainly look at all material changes in Accounting Policies in the period subjected to review very carefully. The accountant's report should include a summary of significant accounting policies used by the target, that changes that have been made to the accounting policies in the recent past, the areas in which accounting policies followed by the target are different from those adopted by the acquiring enterprise, the effect of such differences. (c) Review of Financial Statements - Before commencing the review of each of the aspect covered by the financial statements, the accountant should examine whether the financial statements of the target have been prepared in accordance with the Statute governing the target, Framework for Preparation and Presentation of the Financial Statements and the relevant Accounting Standards. If not the accountant should record the deviations from the above and consider whether it warrant an inclusion in the final report on due diligence. After having an overall view of the financial statements, as mentioned in the above paragraphs, the accountant should review the operating results of the target in great detail. It is important to make an evaluation of the profit reported by the target. The reason being that the price of the target would be largely based upon its operating results. The accountant should consider the presence of an extraordinary item of income or expense that might have affected the operating results of the target. It is advisable to compare the actual figures with the budgeted figures for the period under review and those of the previous accounting period. This comparison could lead the accountant to the reasons behind the variations. It is important that the trading results for the past four to five years are compared and the trend of normal operating profit arrived at. The normal operating profits should further be benchmarked against other similar companies. Besides the above, and based on the trend of operating results, the accountant has to advise the acquiring enterprise, through due diligence report, on the indicative valuation of the business. In the case of many enterprises, the valuation is mainly based on the value of net assets only. For valuation of immovable properties and plant, if required, the assistance of expert valuers could also to be taken. The exercise to evaluate the balance sheet of the target company has to take into consideration the basis upon which assets have been valued and liabilities have been recognised. The net worth of the business has to be arrived at by taking into account the impact of over/under valuation of assets and liabilities. The accountant should pay particular attention to the valuation of intangible assets. The objective of the Due Diligence exercise will be to look specifically for any hidden liabilities or over valued assets. Certain examples of hidden liabilities are: ♦

The company may not show any show cause notices which have not matured into demands, as contingent liabilities. These may be material and important.

♦

The company may have given “Letters of Comfort” to banks and Financial Institutions. Since these are not “guarantees”, these may not be disclosed in the Balance sheet of the target company.

20.38

Advanced Auditing and Professional Ethics

♦

The Company may have sold some subsidiaries/businesses and may have agreed to take over and indemnify all liabilities and contingent liabilities of the same prior to the date of transfer. These may not be reflected in the books of accounts of the company.

♦

Product and other liability claims; warranty liabilities; product returns/discounts; liquidated damages for late deliveries etc. and all litigation

♦

Tax liabilities under direct and indirect taxes

♦

Long pending sales tax assessments

♦

Pending final assessments of customs duty where provisional assessment only has been completed.

♦

Agreement to buy back shares sold at a stated price.

♦

Future lease liabilities

♦

Environmental problems/claims/third party claims

♦

Unfunded gratuity/superannuation/leave salary liabilities; incorrect gratuity valuations.

♦

Huge labour claims under negotiation when the labour wage agreement has already expired.

Examples of over valued assets could be: ♦

Uncollected/uncollectable receivables

♦

Obsolete, slow non-moving inventories or inventories valued above NRV; huge inventories of packing materials etc. with name of company

♦

Underused or obsolete Plant and Machinery and their spares; asset values which have been impaired due to sudden fall in market value etc.

♦

Assets carried at much more than current market value due to capitalization of expenditure/foreign exchange fluctuation, or capitalization of expenditure mainly in the nature of revenue

♦

Litigated assets and property

♦

Investments carried at cost though realizable value is much lower

♦

Investments carrying a very low rate of income / return

♦

Infructuous project expenditure/deferred revenue expenditure etc.

♦

Group Company balances under reconciliation etc.

♦

Intangibles of no value

(d) Taxation - Tax due diligence is a separate due diligence exercise but since it is an integral component of the financial status of a company, it is generally included in the financial due diligence. It is important to check if the company is regular in paying various taxes to the Government. Generally taxes are levied both by the Central Government as well as by the State Government. Further taxes may be direct or indirect. Most of the tax laws require the

Investigation and Due Diligence

20.39

enterprise to register itself with the government and it is important to check if all necessary registrations have been made. The accountant has to also look at the tax effects of the merger or acquisition. (e) Cash Flow - A review of historical cash flows and their pattern would reflect the cash generating abilities of the target company and should highlight the major trends. It is important to know if the company is able to meet its cash requirements through internal accruals or does it have to seek external help from time to time. It is necessary to check if a) Is the company able to honour its commitments to its creditors, to the banks, to government and other stakeholders b) How well is the company able to turn its debtors and stocks c) How well does it deploy its funds d) Are there any funds lying idle or is the company able to reap maximum benefits out of the available funds? (f) Financial Projections - The accountant should obtain from the target company the projections for the next five years with detailed assumptions and workings. He should ask the to give projections on optimistic, pessimistic and most likely bases. Ordinarily, it would be desirable that the accountant evaluates the appropriateness of assumption used in the preparation and presentation of financial projections. If, the accountant is of the opinion that as assumption used by the target is unrealistic, the accountant should consider its impact on the overall valuation of the company. He should offer his comments on all the assumption, highlighting those which, in his opinion are not inappropriate. In case he feels the projections provided by the target are not achievable or aggressive he has to mention this in his report. He should thoroughly check the arithmetic of the calculations made for financial projections. (g) Management and Employees - In the Indian context, the status of work force, staff and employees and their demands is a complex problem. In most of the companies which are available for take over the problem of excess work force is often witnessed. It is important to work out how much of the labour force has to be retained. It is also important to judge the job profile of the administrative and managerial staff to gauge which of these match the requirements of the new incumbents. Due to complex set of labour laws applicable to them, companies often have to face protracted litigation from its workforce and it is important to gauge the likely impact of such litigation. It is important to see if all employee benefits like Provident Fund (P.F.), Employees State Insurance (E.S.I), Gratuity, leave and Superannuation have been properly paid/ provided for/funded. In case of un-funded Gratuity, an actuarial valuation of the liability has to be obtained from a reputed actuary. The assumptions regarding increase in salaries, interest rate, retirement etc. have to be gone into to see if they are reasonable. It is also necessary to see if the basic salary /wage considered for the valuation is correct and includes all elements subject to payment of Gratuity. In the case of PF, ESI etc. the accountant has to see if all eligible employees have been covered. It is very important to consider the pay packages of the key employees as this can be a crucial factor in future costs. One has to carefully look at Employees Stock Option Plans; deferred compensation plans; Economic Value Addition and other performance linked pay; sales incentives that have been promised etc. It is also important to identify the key employees who

20.40

Advanced Auditing and Professional Ethics

will not continue after the acquisition either because they are not willing to continue or because they are to be transferred to another company within the 'group' of the target company. (h) Statutory Compliance - During a due diligence this is one aspect that has to be investigated in detail. It is important therefore, to make a list of laws that are applicable to the entity as well as to make a checklist of compliance required from the company under those laws. If the company has not been regular in its legal compliance it could lead to punitive charges under the law. These may have to be quantified and factored into the financial results of the company. 20.7.2 Contents of a Due Diligence Report - The contents of a due diligence report will always vary with individual circumstances. Following headings are illustrative: ♦

Executive Summary

♦

Introduction

♦

Background of Target

♦

Objective of due diligence

♦

Terms of reference and scope of verification

♦

Brief history of the company

♦

Share holding pattern

♦

Observations on the review

♦

Assessment of management structure

♦

Assessment of financial liabilities

♦

Assessment of valuation of assets

♦

Comments on properties, terms of leases, lien and encumbrances.

♦

Assessment of operating results

♦

Assessment of taxation and statutory liabilities

♦

Assessment of possible liabilities on account of litigation and legal proceedings against the company.

♦

Assessment of net worth

♦

Interlocking investments and financial obligations with group / associates companies, amounts receivables subject to litigation, any other likely liability which is not provided for in the books of account.

♦

SWOT ANALYSIS Comments on future projections

♦

Status of charges, liens, mortgages, assets and properties of the company.

Investigation and Due Diligence

20.41

♦

Suggestion on ways and means including affidavits, indemnities, to be executed to cover unforeseen and undetected contingent liabilities.

♦

Suggestions on various aspects to be take care of before and after the proposed merger / acquisition.

Self-Examination Questions 1.

Distinguish between the terms audit and investigation?

2.

What are the major considerations involved in the determination of the scope of an investigation? Can the investigating accountant accept the audited statements of account of the concern, as a basis for his investigation?

3.

How are maintainable profits of a concern estimated? Indicate five different counts in respect of which adjustments are necessary to determine the trend of profits?

4.

State the major considerations involved in the verification of undermentioned assets included in the Balance Sheet of the concern which is proposed to be taken over by a company: (a) Fixed Assets (b) Stocks (c) Book Debts (d) Patents (e) Investments?

5.

What are the different ways in which cash may be defalcated? How would you detect such defalcations?

6.

How would you organize the investigation of accounts in a case where a fraud is expected to have been committed by the “teeming and lading” method?

7.

The directors of Super Bazar in Calcutta find that a large number of customers’ balances are overdue for payment. They appoint you to investigate the matter and to recommend the steps that should be taken to expedite collections from customers. Give an outline of the programme that you will adopt to carry out such an investigation. Also, give a proforma of the report you will submit after the investigation?

8.

Your client is contemplating joining an established firm of architects as a partner. He supplies you with the draft of the proposed terms and desires that you should investigate the affairs of the business of the firm to advise him. State the matters you will investigate to carry out his instructions?

9.

Why is it necessary to determine the value of shares of a private company? What are the different bases on which such shares are valued? Mention the special considerations involved in each case?

10. (i)

List the important precautions which an investigator should take before commencing the review of profit forecasts?

(ii)

What are the important factors which you will consider while conducting the review of profit forecasts?

20.42

Advanced Auditing and Professional Ethics

Annexure I I. EXCESS CLAIM FOR LOSS OF STOCKS This is a case study of an investigation in respect of a major insurance claim where an investigator was appointed by surveyors for evaluation of stocks. Introduction An investigator (for that matter even an auditor, whether statutory, Internal, or Concurrent) has to be attentive to deficiencies or weaknesses in internal controls. Such deficiencies or weaknesses expose the client to possibilities of errors and frauds. The significant difference between the two is that errors are a result of either inefficiency or oversight, while frauds are the result of shrewd planning by the fraudster. Further, errors can be more easily located since they would have been inadvertently committed without any intention of concealment, while camouflaging of frauds would be deliberate and intelligent. Therefore, the investigator (or auditor) has to modify his approach in circumstances where fraud is suspected. It is always advisable for an investigator (or auditor) to review all his findings objectively towards the completion of the assignment, just before finalizing his report. This would enable him to have an overview of all his observations. He must ask himself “Do all the facts and pieces of evidence fit in logically? Is there any indication of mismatching of facts? Do the data tie up with the current, circumstances? Is there any unusual or strange pattern?” A study of the findings is likely to give him a wealth of information. This exercise may reveal latent errors or frauds. The following case study explains how an investigator was able to detect a major insurance fraud. Facts of the case ABC was a partnership firm trading in television sets. It stocked several models of television sets of various companies. The stocks were kept at a warehouse. After an outbreak of fire in the warehouse, ABC lodged a claim with the insurance company. The claim was for Rs. 200 lacs for about 1550 television sets. Stock records which were maintained at the warehouse included the following: 1.

Goods Inward Notes

2.

Delivery Challans.

3.

No Charge Invoices for free replacements

4.

Stock Ledger (ledger page for each model of television)

A parallel stock, ledger was maintained at the office also. The insurance company sent an investigator to assess the claim of ABC. Since the warehouse was completely reduced to cinders, the only quantitative record available was the stock ledger at the office. The investigator went about his task meticulously. First he gathered all the routine information — list of books of account, purchase and sales procedures, levels of authorities in force, and list of suppliers and customers. He also documented, in brief, the nature of the business and the background of the owners. Since his focus was on the insurance claim. He concentrated his efforts on the examination of stock ledger, purchases and sales.

Investigation and Due Diligence

20.43

Investigator’s approach and plan The investigator conducted the investigation with two broad objectives in mind: (a)

To assess the correctness of the quantities of the stock-on-hand as on the date of fire.

(b)

To satisfy himself that the valuation was fair and reasonable.

As regards (a), he adopted the following procedure: (i)

He traced the opening balances from the last audited physical verification statement.

(ii)

He checked the castings of the stock ledger for all the quantities received and sold.

(iii)

He traced quantities of goods received from the Purchase Register and suppliers’ challans (since GRNs were lost).

(iv)

He traced quantities of goods sold form the sale register.

(v)

He traced the free replacements from the Claims Register and obtained confirmations in writing from the partners that barring those shown in the register, there were no other free replacements.

(vi)

He listed damaged or defective stock on the basis of the Claims Register.

(vii) He traced quantities of returns from both credit notes and debit notes into the stock register. (viii) He could not get any feedback from the storekeeper since the latter had been hospitalised after the fire and had subsequently gone back to his village. As regards the findings, he had nothing unusual to report. Everything seemed to be correct. All the checks detailed above did not reveal any discrepancy. As regards (b), the procedure was fairly simple since it was only a trading firm. The firm had adopted the FIFO basis of valuation and, therefore, the cost of stock was derived from the latest purchase bill. The insurance company was satisfied with this because, as per the policy, it had to reimburse the claimant at the ‘replacement value’. The investigator then decided to examine all the facts collectively before finalising his report. Results and findings Though he did not have any specific query, the following observations were unusual: ♦

The past audited physical verification statement as well as the earlier balance sheets of the firm disclosed stocks which were less than 50 % of the stocks value as on the date of the fire.

♦

Faxed orders-on-hand as on the date of fire did not even add up to 15 % of the stocks claimed to have been lost.

♦

Some of the purchases during the last few days before the fire were made without any advance being paid. In the past, by and large, purchases were made with 50% advance to suppliers. The payments were made after the date of fire.

♦

Suppliers’ challans for the purchases stated above did not bear the usual godown keepers’ signature.

All these facts led the investigator to believe that the stocks had been overstated in the claim. However, none of these observations were really sufficient for him to conclusively prove that stocks were overstated. He asked the firm for explanations which were given in respect of each of the above observations as follows:

20.44

Advanced Auditing and Professional Ethics

(a)

The increase in the quantum of stocks was due to major sales drive which the firm was proposing to launch shortly. They had been negotiating a major order with a new client, which was in the process of finalisation.

(b)

A lot of verbal and telephonic orders were received as on the date of fire.

(c)

Due to growing competition, some of the suppliers were willing to favour the Firm by not insisting advance payments.

(d)

Due to heavy traffic, a large consignment of stocks came late at night when the usual warehouse keeper was not there and one of the partners had himself come and accepted the stocks.

Obviously, some concrete evidence was required to disprove the claim. The investigator decided to visit the warehouse to see if any more evidence was available. It was at the warehouse that he hit upon the solution to the problem of proving the absurdity of the claim. The dimensions of the warehouse apparently did not seem to practically permit more than 1000 television sets to fit in. He called for the layout of the warehouse and took the actual measurements of the smallest television set stocked by the firm. Even if these had been the only sets stocked by the firm, not more than 1200 sets could be fitted in the godown without even providing for space for human movement. Also, stacking norms permitted only 3 television boxes in a column, further restricting the number of sets, which could be stored. When these queries were raised, the firm accepted that there seemed to be an ‘error’ and reduced the claim unconditionally. Lessons to be learnt Dimensional limits of storage of assets can be the most important consideration in determination of an asset quantification. It is logical to presume that the inventory cannot be more than : (a)

The physical limits of space available.

(b)

The permissible storage facility. The storage facility limits may not merely be on account of dimensions. For instance, stocks may be governed by stocking norms for safety or prevention of damage. To illustrate a godown having stacks of pressure cookers may have a height to accommodate 15 pressure cookers, but storage may not be permitted over 10 cookers cartons vertically since the cookers may not be able to withstand the weight of more than 9 cartons on top.

(c)

Legal constraints.

(d)

Certain items of plant and machinery may technically require certain open space or clear area surrounding it or on top thereby restricting the number of such assets in a given area.

Wherever the investigator (auditor) deems fit, he should obtain technical guidance on the storage and custody of the assets as per the plan and layout furnished by the client. This would give the investigator (auditor) the upper limit of the asset quantification with suitable. Modifications and adjustments for stocks lying with third parties and third party stocks lying with the client. The point that this case study highlights is that an effective investigation warrants all the examination and review procedures are adopted in harmony and objectively. The findings have to be viewed both individually and collectively and the results must ring true. Illogical trends, patterns or mismatches of facts are the significant pointers to the investigator or auditor, as the case may be. It is up to him to examine them and draw his conclusions appropriately.

Investigation and Due Diligence

20.45

Annexure II II. EMBEZZLEMENT OF CASH This is a case study where an investigator was appointed by an insurance company to assist the surveyors in investigating into a major insurance claim involving embezzlement of cash. Introduction Man has been known to exploit situations of crisis and disaster, because human, nature is frail and easily susceptible to temptation. Accordingly, an investigator needs to be alert to the increased probability of fraud in circumstances of disaster and crisis. The following is a case, which amply illustrates this point. Facts of the case A supermarket, having a very large turnover in cash sales of all kinds of items such as groceries, foodstuffs, sweets, chocolates, meat, and other related items, was severely looted during an outbreak of riots and was literally reduced to shambles. Foodstuffs, sweets, and other traded items were looted or strewn all over. The supermarket remained shut for a few days after the riots since the stocks and scraps could not be disposed of until permitted by the Police and the insurance company. A police complaint was filed but the stolen goods and cash could not be recovered. The insurance company started making preparations for assessment of the claim. As per the standard approved procedure, insurance surveyors were appointed to assess the claim for: Loss of stocks: Rs.1.25 crores. Loss of cash : Rs. 1.5 lacs. An amount of Rs. 8 lacs was left back in the cash box which had been forcibly broken open. Investigator’s approach and plan The surveyors appointed a chartered accountant as an investigator to help them in evaluating the claim. The following procedures were performed by him: (a)

Photographs and a video film of the site evidencing the actual damage were examined.

(b)

Copy of the police complaint was obtained and kept on record.

(c)

Books of account and stock records were asked for. It was explained that these were fully destroyed and found to be in a torn, damaged or mutilated condition in the inner accounts office which was also not spared by the rioteers.

(d)

Monthly physical stock statements sent to the bank till the date of damage were also compared with the estimate of the claim to assess the reasonableness of the claim.

(e)

In respect of the ‘A’ category items (top 70% in value), investigator derived the quantities of items of closing stock using the last audited physical verification stock sheet as the starting point and adjusting subsequent receipts (from statements submitted by vendors) and issues (from statements submitted to sales tax consultant).

(f)

Both the cash on hand and the stocks were tested for ‘goodness of fit’ in the trends seen for the relevant periods. As far as the cash balance was concerned, it was actually estimated on the basis of the average daily balance for the previous year which seemed reasonable, considering that sales during the current period were at least 12% higher. Stock value was compared with the average stock value for the last three years and fitted reasonably it, the trend.

20.46 (g)

Advanced Auditing and Professional Ethics Routine statements were taken from the cashiers and the salesmen. Apparently, when the supermarket was opened the day after the riots the entire promises were found ransacked. The manager had designated the person in-charge to assess the damage in his individual department and report on its status after taking note of the physical condition and quantity of the inventory. On the basis of these reports, made informally initially, an estimate of the loss was made.

Results and findings General symptoms did not seem to point out anything adverse or extraordinary. It seemed as if the claim was reasonable and acceptable under the circumstances. However, the investigator decided to probe further. He asked for routine, but essential information such as the list of books and records maintained and documents in use and the system of accounting in force. In addition to the analysis of historical data of cash, sales and stocks as above, the investigator even asked for assistance in gathering and preserving documents in whatever condition they appeared to be in and expressed a desire to examine each scrap of paper himself. The investigator, eventually, came across the proof. He found some torn faxes dated three days subsequent to the date of the riots! Obviously, the rioteers had not come back to damage the papers. It had to be someone else who would benefit from the destruction of papers. Moreover, it had to be someone who had been the first to visit the cash department immediately after the date of the riots. The cashier, on being confronted with the faxes, confessed that in order to take advantage of the situation, he had taken out the money and destroyed all the papers in the cashier’s office to make it seem as if the cash box had also been broken open and looted. He admitted that there was indeed no damage in the inner account office. This also gave him an opportunity to cover up his earlier embezzlement by destroying all the records. How then did the investigator guess that something was wrong when all other tests did not’ indicate so? Partly it was his experience. He had seen a case where an income tax assessee had deliberately taken advantage of a fire in his office to destroy certain records for avoiding disconcerting tax queries. He saw a similar opportunity here for a typical cash fraud. Secondly, it was unlikely that rioteers would leave 8.5 lacs in the cash box and destroy each and every document in the office. The normal psychology of any human being would be to take off with money rather than go on rampage where no material gain was likely. Lessons to be learnt The case study highlights: (a)

Disaster and crisis can provide unbelievable opportunity for perpetrating frauds, and

(b)

a fraud can be very easily camouflaged and it is very easy to fall into a trap of believing what one sees.

Thus, in situations of disaster and crisis, the investigator must not fall into the trap of believing and depending only on what is apparent, unless he has eliminated every other possibility. In such situations, he can effectively adopt the principle of ‘mistrust the obvious’. He should leave no stone unturned and satisfy himself that all evidence is reliable and, if not, must clearly state in his report the extent of gap or insufficiency in the evidence. The management must be informed of all possible consequences of damage/ loss through such gaps in the evidence.

Investigation and Due Diligence

20.47

Annexure III III. MISUSE OF A DISCOUNT SCHEME This is a case study highlighting the use of the technique of “Investigator’s Bluff’ to detect misuse of a discount scheme. Introduction Investigation goes beyond a mere exercise of examining books and records produced before an investigator. Application of skill and expertise by the investigator is essential to get meaningful and useful results. In this context, inspection, physical verification, or visit to place of manufacturing, trading, marketing or any other place of activity assumes immeasurable importance in collection and gathering of evidence. The following case study highlights the importance of inspection and use of the technique of “Investigator’s Bluff”. Facts of the case A trading concern, dealing in chocolates and sweets and having a chain of retail outlets in all the metro cities, decided to have an incentive scheme to induce shoppers to visit its shops again. The scheme required shoppers to make a purchase of more than Rs. 1,000 to entitle them to get a 10% discount coupon for their next visit. A placard was prominently displayed at each of the shops to advertise the discount scheme. Appropriate internal controls in the form of pre-numbered receipt books and discount coupons were also introduced. Pursuant to the scheme, sales of all the metros, showed an upswing as expected, except in one city where even after the introduction of the discount scheme, the sales had not increased, though large values of discounts had been availed of the management was intrigued by this and appointed an investigator to look into the matter. Investigator’s approach and plan The investigator’s plan covered examination of the following: ♦

Sales

♦

Purchases

♦

Cash and bank transactions

♦

Salaries

♦

Journal entries

♦

Other books of account

Results and findings The investigator did not notice anything untoward and the financial statements and the books of account seemed to be in order. The serial numbers controls, cash totals and cash registers appeared to be satisfactory. The investigator then decided to personally visit the concerned metro to look into the matter. On a personal visit, the first thing he noticed was that the placard regarding the scheme was not displayed. Obviously, shoppers could have had no other way of knowing whether such a scheme was in force unless the cashier was, as a matter of routine, informing shoppers purchasing chocolates worth Rs. 1,000 or more, of the discount entitlement and furnishing discount coupons. He went through all the past discount coupons

20.48

Advanced Auditing and Professional Ethics

encashed by customers and found that most of the shoppers who had purchased chocolates and sweets over Rs. 1,000/- had purchased chocolates or sweets worth much more on their next visit. This perhaps was understandable, but even more intriguing was the fact that a lot of shoppers had visited the shop again on the same or the very next day to purchase chocolates. This was certainly unusual because normally chocolates are not ‘stocked and a shopper would generally buy his required quantity on the first visit itself. This led the investigator to believe that the discounts claimed were not genuine. However, since the names and addresses of the shoppers were not available, proving any foul play was difficult. The investigator decided to adopt “Investigator’s bluff’ technique. He decided to test the scheme by sending a decoy customer who purchased chocolates worth Rs. 2,500. As expected, the customer did not get the discount coupon. He was given a receipt of Rs. 2,500, numbered 20026. The spaces relating to information of discount coupon as well as the net payment amount were left blank in the receipt. At the end of the day, the cashier reported his total cash sales for the day and a statement of account coupons issued, which showed that discount coupon number 2113 had been issued against the receipt 20026. The investigator confronted the cashier about the discount coupon, who confessed that he had fraudulently retained the discount coupon himself, explained how he went about encashing such discount coupons, as follows Step 1:

Receipt say 20001 was issued to XYZ for Rs. 2,500/-

Step 2:

Daily Cash Receipt and Discount Coupons Statement would disclose: A discount coupon say 2001 issued to the shopper XYZ against Receipt 20001, though the discount coupon 2001 was actually in possession of the cashier himself.

Step 3:

When another customer making a purchase of Rs. 1,500/- did not ask for a cash receipt, the cashier would make out a receipt for Rs. 1,500/ with Rs. 150/- entered in the discount column, and attach coupon 2001 to that receipt as if that customer was XYZ who had returned to purchase chocolates again with the discount receipt 2001.

Step 4:

The cashier would pocket Rs. 150/- and put Rs. 1,350/- In the cash box.

In this manner, he had siphoned off an average of almost Rs. 20,000 per week. This would never have come to light if the investigator had not visited the shop and learnt that the discount scheme, infact, had never been in operation at all. This explained why the sales at the concerned metro had not increased even after the introduction of the scheme. Lessons to be learnt Very often the conventional procedures applied by the investigator do disclose weaknesses in controls and anomalies in findings. However, these procedures may, at times, fail to discover or bring to light the actual damage done and the nature of deceit or trickery. It is, therefore, essential for an investigator to adopt effective fact-finding techniques to determine whether all policies and control procedures are being implemented or not. That is also why personal inspection, visits and ‘walk-through tests’ are very meaningful, and where situation so demands, an “investigator’s bluff”, as shown above, can be used.

Investigation and Due Diligence

20.49

Annexure IV IV. DUPLICATE DOCUMENTARY EVIDENCE USED TO RAISE FALSE CLAIMS This is a case study wherein duplicate documentary evidence used to support a payment was detected by an investigator. Introduction In spite of various controls in an organisation, it is difficult to rule out the possibility of a payment being made on the basis of a duplicate supporting evidence. It is not easy to lay down a plan applicable in all situations regarding the steps to be taken to prevent such payments. The following case study illustrates this point. Facts of the case A Company was spending several lacs of rupees on advertising through hoardings at prominent places in the city. The usual evidence of such an expenditure was in the form of: ♦

Agreement with the owner of the hoarding site, specifying the details of the size of the hoarding, the subject matter with a description of the hoarding, location, rate, and the period for which the hoarding was to be kept.

♦

Agreement regarding the maintenance of the hoarding, i.e., touching-up and cleaning periodically for removal of dust, erasures due to rain, etc.

♦

Photograph of the hoarding.

♦

Bill for rent charged by the owner of the site.

♦

Certification by an independent agency as regards verification and compliance of the terms and conditions of the agreement with the owner of the hoarding site.

Investigator’s approach and plan 1.

Compliance with agreement: The investigator verified the compliance of the terms of agreements, as per the checklist prepared by him.

2.

Vouching of bills: The bill for rent charged by the site owner was checked to ensure that it was supported by a ‘physical inspection report’ and photographs.

Results and findings At a first glance, the evidence stated above appeared to be sufficient. There was nothing in the inspection report to suggest any non-compliance of any of the terms of the agreement. However, one small detail in the photograph attached to the bill caught the investigator’s attention. The photograph showed the hoarding next to a small poster of a film running at a particular cinema hall. He knew that particular cinema hall had been demolished well over a year ago. Just to satisfy himself, the investigator asked for the previous year’s file and on examining it he found that the photographs of the hoardings attached were duplicates of those in the previous year. The investigator notified the management and suggested that a physical verification be carried out immediately to ascertain whether the hoarding was satisfactorily displayed at the site. An independent check was carried out and the results were startling. Not only had the company’s hoarding been removed from its designated place on the date of verification, but its competitor was given the hoarding site for which the rent was being collected from the company. On making further inquiries with local residents, it was learnt that the hoarding of the company had been removed many months ago. The company took legal action

20.50

Advanced Auditing and Professional Ethics

against the owner of the hoarding site and the agency, which was responsible for carrying out the physical inspection. Lessons to be learnt It is necessary to minutely examine the evidence particularly where the investigator is dependent on another agency for physical inspection or verification. In this case though there was no real necessity for the investigator to call for the previous year’s records, yet, on a suspicion as mentioned above, he called for the previous year’s photographs and a comparison provided the clue as to the possibility of existence of a foul play. Keen examination of photographs revealed that they were identical and thus, the investigator decided to launch a further inquiry and on physical inspection at the site, the actual fraud came to light. Therefore, it is advisable that, in all areas requiring physical verification or inspection, the investigators must include in their checklist, comparison with previous periods’ records. For example: 1.

Physical verification of investments and comparison with investments which existed in the previous period will disclose bonus shares received or investments stolen or lost.

2.

Stock verification statements compared with those related to previous period will indicate the comparative status of old, damaged, unserviceable and obsolete stocks.

3.

Similar procedures will be applicable to all assets of the-client lying with third parties.

4.

Physical verification or inspection is also likely to enable an investigator to verify the reasonableness and sanctity of expenses incurred. Annexure V V. ABSENCE OF A CASH RECEIPT – AN INDICATION OF A FRAUD

This is a case of investigation of embezzlement of cash sought to be concealed by not producing a cash receipt. Since the service was received, the absence of the cash receipt was not considered too important. Introduction In the process of an investigation, investigators often encounter resistance from the investigates as regards furnishing of details, documents, records and other requirements. Since investigation is an activity which comments on work done by others, naturally, there is some degree of reluctance to furnish information. Such reluctance may or may not emanate from fraudulent or mala fide intentions. Accordingly, the investigator has to be practical and keep his approach to the investigation open to such possibilities. For example, where the investigator is satisfied that the material purchased has been received, even though there is no bill or supporting evidence for the same, he does not take the matter very seriously except to report that documentary evidence was missing. Though the investigator may ask for evidence of payment, the explanation often given is “the material has been purchased in a hurry and the receipt was not available”, or “forgotten to be collected”. The importance of the supporting evidence is considerably minimised because the material or service has actually been received. It is with regard to such situations that investigators should be more careful. The following case study is one such example. Facts of the case A travel agent was offering several services such as obtaining visas. Passport renewals, fresh passport applications etc., in addition to the main service of booking tickets. The agent levied service charges for such services rendered. In all such services the client had to pay two amounts - (a) the charges payable to the

Investigation and Due Diligence

20.51

authorities such as the embassies, passport office etc.; and (b) the agency service fees. The agency itself was concerned with the service, fees receivable from the client and more often than not, did not bother about the correctness of the charges payable to the authorities. In the given case study, a large corporate conference was to be held in Melbourne, with a one day halt in Singapore on the way from Mumbai in respect of which visas for 35 participants had to be arranged for Singapore. The travel agent was asked to do the needful. The company was informed that normal charges for Singapore visa were about Rs. 3,000 and accordingly, Rs. 1,05,000 were given to the travel agent. The travel agent sent his assistant to the embassy with the money and, in due course, he got the passports back with visas. The assistant informed the agent that he had forgotten to collect the receipt. Since the visas had been obtained and since, in the past, the agent had paid Rs. 3,000 per visa, he did not press the matter further. He raised a bill on the company for the entire amount of visa charges and his own service charges. No questions, are raised since the visas were in order. It was known to the company that some embassies did not issue receipts for visas. Results and findings The fact was that there was no visa charge payable for that month for transit passengers having confirmed return tickets in an effort to promote tourism in Singapore. The assistant, of the travel agent had conveniently pocketed the amount of Rs. 1,05,000 and got away with the indifferent attitude of the travel agent. Recommended approach and plan for investigation The following steps may be taken by an investigator to carry out an investigation in a situation similar to the above: ♦

Insist upon and obtain will the circulars from all embassies where receipts were not available to verify visa fees paid for the period under review.

♦

Make a note of dates from which each revision in fees, both for single as well as multiple entry visa was applicable. This information may be presented in a tabular form where register as suggested below is not maintained by the travel agent.

♦

Inquire whether any special concessions or free visas were given to any class of travellers during the period under review and check visa fees paid during such periods.

♦

As a control procedure, the travel agent may be requested to maintain the following register to enable monitoring of visa fees in force throughout the year:

1. COUNTRY : Singapore Period

Circular/ notification

1.1.98 to 31.3.98

Sing/1/56/98 of 31.12.97

1.4.98 to 31.5.98

Sing/1/126/98 of 31.3.98 Sing/1/155/98 of 31.5.98

June 1998

Foreign Currency: $ Single Multiple entry entry $65 $75

$85

$100

Free

$50

Special and Other Concessions For senior or handicapped citizens $10 As above Special festival bonanza for all

20.52

Advanced Auditing and Professional Ethics

Similarly, passport renewals or even fresh applications attract fresh which undergo revision from time to time. Receipts are always issued but often not insisted upon. The importance of receipts cannot be understated. Similar controls, as in the case of visa fees explained earlier, should be exercised in these cases also, Lessons to be learnt Documentary proof is essential. More often than not, queries relating to missing receipts for cash or bank payments are brought to the notice of the management but not given much importance. It is deemed that if the material or service purchased has been received the problem is merely one of the documentation and nothing serious. However, the above case amply proves the contrary.

21 PEER REVIEW

Introduction 21.1 The term "peer" means a person of similar standing. The term "review" means conduct of re-examination or retrospective evaluation of the subject matter. In general, for a professional, the term "peer review" would mean review of work done by a professional, by another professional of similar standing. ‘Peer Review’ is defined as, a regulatory mechanism for monitoring the performances of professionals for maintaining quality of service expected of them for enhancing the reliance placed by the users of financial statements for economic decision-making. As per the Statement of Peer Review (ICAI, 2002) “Peer Review” means an examination and review of the systems and procedures to determine whether they have been put in place by the practice unit for ensuring the quality of attestation services as envisaged and implied/mandated by the Technical Standards and whether these were effective or not during the period under review". The examination and review of a practice unit would be carried out by a "reviewer", i.e., a member, selected from a panel of reviewers maintained by the Board. The term "practice unit" means members in practice, whether practising individually or as a firm of Chartered Accountants. Objectives of Peer Review 21.2 The main objectives of peer review are as discussed below: (i)

To ensure that members while performing attestation services comply with technical standards laid down by the Institute;

(ii)

To ensure that such a member has in place proper system (including documentation system) for maintaining the quality of attestation services performed by him;

(iii) To ensure adherence to various statutory and other regulatory requirements; and (iv) To enhance the reliance placed by the users of financial statements for economic decision making.

21.2

Advanced Auditing and Professional Ethics

Thus the primary objective of peer review is not to find out deficiencies but to improve the quality of services rendered by members of the profession. The Statement of Peer Review also makes it clear that the peer review, "does not seek to redefine the scope and authority of the Technical Standards specified by the Council but seeks to enforce them within the parameters prescribed by the Technical Standards". The peer review is directed towards maintenance as well as enhancement of quality of attestation services and to provide guidance to members to improve their performance and adherence to various statutory and other regulatory requirements. Such an objective of the peer review process makes it amply clear that the reviewer is not going to sit on the judgement of the practice unit while rendering attestation services but to evaluate the procedure followed by the practice unit in rendering such a service. Accordingly, where a practice unit is not following technical standards, the reviewers are expected to recommend measures to improve the procedures. To elaborate further, the key objective of peer review exercise is not to identify isolated cases of engagement failure, but to identify weaknesses that are pervasive and chronic in nature. For instance, absence of formal planning of an audit represents a serious deficiency that needs to be remedied by the practice unit. An instance of the auditor not carrying out physical verification of furniture and fixture may not attract the same comment. However, certain items of assets are best verified through the physical verification process and not adopting the same procedure may rightly be viewed as a systemic failure. The conclusion, therefore, is that the peer review seeks to identify and address patterns of non-compliance with quality control standards. Scope of Peer Review 21.3 The Statement on Peer Review (ICAI, 2002) lays down the scope of review to be conducted as under: The peer review process is directed at the attestation services of a practice unit: (1) Once a practice unit is selected for review, its attestation engagement records pertaining to the immediately preceding three completed financial years shall be subjected to review. However, records of audit reports/attestation services relating to years prior to the accounting year beginning 1.04.2002 shall not be subjected to review. (2) The Review shall focus on: (i)

Compliance with Technical Standards.

(ii)

Quality of Reporting.

(iii) Office systems and procedures with regard to compliance of attestation services systems and procedures. (iv) Training Programs for staff (including Articled and Audit Assistants) concerned with attestation functions, including appropriate infrastructure. As it is clear from the above, that the Statement of Peer Review aims to confine the scope of review to preceding three years since this would establish the consistency or deviations, if any, in respect of procedures followed by the practice unit. The tenure of immediately three financial years, perhaps, has been envisaged since all practice units would not be subjected to

Peer Review

21.3

mandatory annual review. However in the first year of its implementation, it provides clearly that records of attestation services relating to the accounting year beginning on or after April 1, 2002 shall only be subjected to review. The Statement defines the scope of peer review which revolves around compliance with technical standards; quality of reporting; office systems and procedures with regard to compliance of attestation engagements; and, training programmes for staff including articled and audit assistants involved in attestation engagements. A Practice Unit means members in practice, whether practicing individually or a firm of Chartered Accountants. The entire peer review process is directed at the attestation services which may be used interchangeably as audit services, attestation function or audit functions of a practice unit. The attestation services which shall be subjected to peer review include auditing or verification of financial transactions, books, accounts or records and verification or certification of financial accounting and related statements as defined under section 2(2)(ii) of the Chartered Accountants Act, 1949. Thus, the term attestation services include all those services such as internal audit, concurrent audit etc., which involve provisions of some kind of element of assurance to users. Specifically, the services which have been excluded from the scope of attestation services are all management consulting engagements, representing a client before the authorities, preparing tax returns and providing tax advice, compilation services, testifying as expert witness and providing expert opinions based on facts. It may be noted that while reviewing office systems and procedures and training programmes for the staff, the reviewer shall focus on such areas which may affect the quality of attestation services performed. It is also quite important for a reviewer to understand the scope of review with reference to compliance with technical standards because the said term has been defined in an inclusive manner in the Statement on Peer Review. As per the Statement, the term "Technical Standards" includes accounting standards; auditing standards; framework in respect of accounting and auditing; statements; guidance notes; self-regulatory measures; and, relevant legislation in the context of specific engagement. Therefore, the reviewer shall have to concentrate on compliance with all standards, statements, guidance notes, notifications and relevant legislative requirements in respect of services rendered by the practice unit while performing a particular attestation engagement. Applicability 21.4 ‘Practice units’ (PU) covered under Peer review during the first year i.e., April 1, 2003 are: i)

contractual statutory auditors of banks (excluding regional rural banks and co-operative banks);

ii) insurance companies and public financial institutions; iii) central statutory auditors of central and state public sector undertakings and central cooperative societies meeting specific criteria; iv) auditors of companies meeting specific criteria;

21.4

Advanced Auditing and Professional Ethics

v) auditors of asset management companies and mutual fund schemes; Coverage with effect from April 1, 2004 includes: (a) practice units conducting statutory audit of regional rural banks; (b) cooperative banks, branches of public or private or foreign banks; (c) non-banking financial companies meeting specified criteria; (d) concerns which have raised funds from public or financial institutions and satisfy other specified criteria; Coverage with effect from April 1, 2005 includes: i)

all other practice units

Stage wise implementation shall proceed on the basis of random selection. Peer Review Board 21.5 The Council of the institute of Chartered Accountants of India in March 2002 established the ‘Peer Review Board’ for maintaining Quality of Service as well as enhancing the quality of service of professional members engaged in attestation function. The Board shall consist of maximum of 11 members to be appointed by the Council, of whom at least 6 shall be from amongst the Members of the Council. The balance members of the Board shall be drawn from amongst prominent individuals of high integrity and reputation, including but not limited to, former public officials, regulatory authorities, bankers, senior professional chartered accountants, security industry executives, educators, economists and business executives. The Chairman and Vice-Chairman of the Peer Review Board is appointed by Council from amongst the members of the Council. At least 2/3rd of Council members on the Board shall hold Certificate of Practice. Casual vacancies on the Board shall be filled in by the council. The term of a member shall be for one year or such period as may be prescribed by the Council. The members of the Disciplinary Committee or the Committee on Ethical Standards and Unjustified Removal of Auditors of the Institute of Chartered Accountants of India shall not concurrently be members of the Peer Review Board as well. Presently, the Peer Review Board consists of 9 members of which 6 members are members of the Council. 21.5.1 Qualifications of Reviewer – The Peer review board would maintain a panel of reviewers. To be a panel member, an individual should be: a) a member of ICAI; b) possessing at least 15 years experience of audit; and c)

currently active in the practice of accounting and auditing.

The Peer Review Process 21.6 The Peer Review process has three stages – planning, execution and reporting.

Peer Review

21.5

Stage I: Planning - Planning includes the following steps: 1. Empanelment of Reviewers - The process begins with the empanelment of an individual to act as the reviewer. A panel of reviewers is maintained by the Peer Review Board, satisfying the qualification requirement set by the Board i.e, a) an individual should be a member of the Institute; b) member should possess at least 15 years experience of audit; c) member is currently active in the practice of accounting and auditing. 2. Selection of the Practice Unit - PU’s are selected for Peer Review on a random basis, as per applicability. 3. Intimation to the Practice Unit - Once a practice unit has been selected for Peer Review, an intimation in writing is sent by the Board to the practice unit informing of its selection for peer review. Along with the intimation, the following documents shall also be sent to the practice unit. i)

A copy of the statement on Peer Review.

ii) A panel of three reviewers suggested by the Board or Sub-Committee constituted by it for this purpose, iii) A copy of the questionnaire. 4. Initial Communications by the Practice Unit - After receipt of the intimation from the Board, as mentioned in paragraph above, the practice unit is required to communicate to the Board, its choice of the reviewer from the above mentioned panel within a period of 15 days from the receipt of intimation. The practice unit is also required to complete and send the questionnaire to the reviewer selected by it within one month of the receipt of the intimation, alongwith a complete list of its attestation service engagement clients. It may, however, be noted that the practice unit may not provide the names of all such clients but instead provide code numbers alongwith other relevant details provided the practice unit has been maintaining register allotting the code numbers to all its clients. It is quite possible that a practice unit may have more than one office and its branch office(s) may spread over more than one State/Region. In that eventuality, the reviewer is expected to take cognizance of the same and obtain additional information from the practice unit. Ascertaining such information would be quite crucial while selecting sample of attestation services in an objective manner. It may be noted that apart from the information given in the questionnaire, the reviewer is entitled to seek such other information as the reviewer considers necessary to facilitate selection of sample of attestation services engagements, which appropriately represents the practice unit's client portfolio. 5. Selection of Sample Attestation Service Engagements - The reviewer, on the basis of the information given in the questionnaire or after seeking other information, selects a sample of attestation service engagements on random basis for review. It is clarified that the selection of a sample for review out of the complete list of attestation service clients is

21.6

Advanced Auditing and Professional Ethics at the discretion of the reviewer. However, the reviewer is required to select a sample that is representative of the practice unit's client portfolio.

6. Communication of Sample Selection - After the selection of sample of attestation service engagements for review, the reviewer sends a written intimation to the practice unit about the sample selected by the reviewer, two weeks in advance, from the date the reviewer intends to begin the review. The intimation also contains a request for ready availability of that relevant records relating to the attestation service engagements selected for review. 7. Confirmation of Visit - The reviewer, in consultation with the practice unit, is required to fix the date(s) for on-site review. While fixing the date for on-site review, both the practice unit and the reviewer should bear in mind that date(s) are to be fixed in a manner so that the peer review process is completed within four months of the receipt of intimation by the practice unit. Stage II: Execution - At the execution stage, it is important for the reviewer to note that such visits will be conducted at the practice unit's head office. Therefore, it is suggested that the reviewer at the planning stage should identify the sample clearly. However, it may also be possible that if a practice unit happens to be quite a big outfit and has several branches, the reviewer may have to visit more than once. The Board decided to clarify that the reviewer may not visit a branch (outside the city/ town limits from head office) of practice unit unless the turnover of attestation functions of that branch is more than one million rupees. In such a case, he may instruct the practice unit to get documents and relevant records in respect of attestation engagement performed by such branch office to the head office. Where the Reviewer decides to visit a branch/ office whose turnover from attestation engagements is more than one million rupees, the rate of TA/DA of the reviewer for both the stages shall be as per RBI guidelines (Refer Notification No. PRB/Notn./004/04-05, dated 23rd July, 2004 Execution includes the following steps: 1. Initial Meeting - Before the commencement of the review, an initial meeting should be held between the reviewer and the partner (designated by the practice unit for the purpose) or the sole proprietor of the practice unit. The primary purpose of the meeting is to confirm the accuracy of responses to the questionnaire. The reviewer should be able to understand the system prevailing at the practice unit in order to form a preliminary evaluation of its adequacy. 2. Compliance Review - The reviewer should carry out the compliance review of the five general controls, i.e., independence, maintenance of professional skills and standards, consultation, staff selection and supervision and office administration. The reviewer should review these general controls to gain an understanding of the working of the practice unit and specific control procedures existing at the practice unit. This helps the reviewer in making an identification and evaluation of those control procedures on which it might be effective and efficient to rely in conducting the review. The review of these general controls would consist mainly of inquiries from the partner (designated by the practice unit for the review) or the sole proprietor of the practice unit

Peer Review

21.7

with reference to the responses by the practice unit to the questions given in the questionnaire. Apart from making inquiries with the personnel concerned, the reviewer may adopt other procedures to establish the fairness of the responses by the practice unit to the questions. Selection of other procedures or techniques is a matter of the reviewer's judgement. 3. Selection of Attestation Service Engagements - The number of attestation service engagements to be reviewed depends upon, inter alia, the number of practising members involved, degree of reliance to be placed on general controls and the total number of engagements undertaken by the practice unit during the period under review. The reviewer may modify the initial sample selected for review in consultation with the practice unit at the execution stage. The further refinement of initial sample is done by the reviewer on the basis of information and knowledge that he gains during the course of initial meeting and by performance of compliance review of the key controls within the practice unit. It may, however be noted that, the reviewer should neither review those attestation services engagements of the practice unit which have been the subject matter of disciplinary proceedings nor should the practice unit, in any way, influence the reviewer to select such engagements for review. 4. Review of Records- Compliance and substantive Approach - The reviewer may adopt the compliance approach that helps in determining the nature, timing and extent of the substantive review procedures to be applied in review. The reviewer should conduct adequate compliance procedures to gain an evidence that those general controls on which the reviewer intends to rely operate generally as identified by the reviewer and they have been functioning effectively throughout the period of reliance. Based on the results of compliance procedures, the reviewer concludes either to rely or not to rely on the general controls. In case the reviewer decides to rely on the general controls, he would also need to determine the extent of reliance to be placed on such controls. In such a situation, the nature, timing and extent of substantial procedures would be, normally, less extensive and vice-versa. The compliance approach may not be warranted if the size of the firm is small or medium or the kind of attestation services rendered by the practice unit does not warrant elaborate controls within the firm. In such a case, the reviewer may adopt only substantive approach for conduct of review. The substantive approach involves application of such review procedures that provide the reviewer evidence as to the appropriateness of the factors on which the review is required to be focussed on (refer paragraph 7 of the Statement on Peer Review). The reviewer establishes the appropriateness of factors by reviewing the documentation available within the practice unit. For example, review of working papers related to an attestation engagement would provide the reviewer an evidence that the attestation services have been undertaken in accordance with the prescribed technical standards. The details of the execution of the peer review are given in the Statement on Peer Review. Reviewers are also advised to refer to the Statement for a detailed description of the execution stage of the peer review. 5. Obligations of the Practice Unit - In order to carry out the compliance and substantive procedures, the reviewer is required to access the records or documents related to

21.8

Advanced Auditing and Professional Ethics attestation services of the practice unit. The Statement as per paragraph 12.1 requires the practice unit to produce to the reviewer or afford him access to, any record or document which contains or is likely to contain information relevant to the peer review. The practice unit is also expected to provide all assistance by way of providing explanations and further particulars as may be required with reference to documentation. If the information or matter recorded is not in a legible form, the practice unit shall provide and present to the reviewer a reproduction of such information or matter, or of the relevant part of it in a legible form, with a suitable translation in English if the matter is in any other language. The reviewer may inspect all the documents relevant to his review in one or more offices of the practice unit but under no circumstances he shall communicate with or visit the client of the practice unit. The Board decided to clarify that the reviewer may have access to, or take the abstracts of the records and documents maintained by the practice unit in order to carry out the review work at practice unit's office, but in order to ensure the confidentiality of client's file with the practice unit, the reviewer shall not carry extracts of the client's files or records acquired by him while conducting peer review, as part of his working papers.

Stage III : Reporting - Reporting includes the following steps: 1.

Preliminary Report of Reviewer - At the end of the on-site review, the reviewer is required to send a preliminary report to the practice unit before making any report to the Board on the areas in case systems and procedures of the practice unit reviewed have been found to be deficient or where non-compliance with reference to any other matter has been noticed by the reviewer during the course of review. The reviewer has to take care that the report does not contain name of any individual of the practice unit. However, no preliminary report is required in case no deficiencies or non- compliance are noticed by the reviewer. The reviewer while preparing the preliminary report should review and assess the conclusions drawn from the review that indicates the deficiencies to be reported upon. The preliminary report is addressed to the practice unit. The report, apart from mentioning the areas where systems and procedures of the practice unit have been found to be deficient, should also contain a paragraph that discusses the scope of the review performed by the reviewer. If the reviewer draws a conclusion that there existed a limitation on scope of review, the fact, alongwith such limitation on the scope of the review, should also be communicated to the practice unit through the preliminary report. The reviewer should prepare the report on his letterhead. The report should be dated and also contain the reviewer's signature and membership number and reviewer's code number allotted by the Board.

2. Reply to Preliminary Report - The practice unit has to send its submissions or representations, in writing, to the reviewer, on the areas mentioned in the preliminary report. The reply to the preliminary report should be sent by the practice unit within a period of 21 days from the receipt of the preliminary report from the reviewer. 3. Interim Report of the Reviewer - If the reviewer is not satisfied with the reply of the practice unit, the reviewer has to submit an interim report to the Board. The report so submitted should clearly indicate that it is an "interim report". It may be noted that the Board may then give

Peer Review

21.9

recommendations to the practice unit and instruct the reviewer to carry out a further review after minimum six months in case of any weakness in the compliance of technical standards is reported by the reviewer or follow up review after twelve months in case of any weakness in the internal control system of the concern is reported by the reviewer and to verify whether the systems and procedures of the practice unit have been modified appropriately. The reviewer is then required to submit a report to the Board. 4. Final Report of the Reviewer - If the reviewer is satisfied with the reply of the practice unit, the reviewer shall submit his final report to the Board. The final report should incorporate the findings as discussed with the practice unit. 21.6.1 Qualified Assistant - The reviewer may take the help of a qualified assistant while carrying out peer review. In this context, the Board decided to clarify that a reviewer is permitted to take the assistance of only one assistant who shall be a chartered accountant and a person who does not attract any of the dis-qualifications prescribed under Section 8 or Section 21 of the Chartered Accountants Act, 1949. The name of the qualified assistant which the reviewer would like to assist him shall be identified and intimated to the Board as well as the practice unit before the commencement of the peer review. Such a qualified assistant shall also have to sign the declaration of confidentiality as annexed to the Statement. He shall have no direct interface either with the practice unit or the Board. Further the person chosen for assisting the reviewer shall be from the firm of the reviewer and should have been working with him for at least one year as a member in practice. 21.6.2 Confidentiality - Strict confidentiality provisions shall apply to all those involved in the peer review process, namely, reviewers, members of the Board, the Council, or any person who assists any of these parties. Those persons subject to the secrecy provision: (1) Shall at all times after his/ their appointment preserve and aid in preserving secrecy with regard to any matter coming to his/ their knowledge in the performance or in assisting in the performance of any function, directly or indirectly related to the process and conduct of peer reviews; (2) Shall not at any time communicate any such matter to any other person; and (3) Shall not at any time permit any other person to have any access to any record, document or any other material in any form which is in his/their possession or under his/their control by virtue of his/their being or having been so appointed or his/their having performed or having assisted any other person in the performance of such a function. Non-compliance with the secrecy provisions in the above clause shall amount to professional misconduct as defined under Section 22 of the Chartered Accountants Act, 1949. A statement of confidentiality shall be filled in by the persons who are responsible for the conduct of peer review i.e., reviewers, the members of the Board and others who assist them.

21.10 Advanced Auditing and Professional Ethics 21.6.3 Approach of the Reviewer - Briefly, the stepwise approach which may be adopted by the reviewer is discussed in the following paragraphs: (a) The reviewer should gain an understanding of the engagement letter since an attestation engagement or for that matter any other kind of engagement should begin with an engagement letter. Engagement letter is an important document as it defines the nature and scope of the attestation engagement, practice unit's responsibilities with regard to the engagement. This understanding would help him in planning the review of documentation. The reviewer should focus the review primarily on the key engagement matters. The reviewer should also consider the materiality of the matter while planning the review. (b) The number of attestation engagements to be selected requires the exercise of judgement by the reviewer based on the evaluation of replies given in the questionnaire and the size of the practice unit. The objective is to obtain a reasonable cross-section of the practice unit's clients although greater weight may be given to large clients. (c) The practice unit may have policies and procedures for accepting a particular engagement. These policies and procedures may not exist in the form of records in each practice unit. In such a case the reviewer should consider enquiring from the concerned persons about such policies and procedures. The reviewer should, wherever possible, examine that the policies and procedures for acceptance of audit have been complied with and necessary documentation with regard to the same exists. (d) The reviewer may follow a combination of compliance procedures and substantive procedures throughout the peer review process. The mix of compliance and substantive procedures depends upon the professional judgement of the reviewer. The reviewer may consider the following: -

In carrying out the compliance tests, the reviewer may evaluate whether the policies and procedures of the practice unit are sufficient to ensure compliance of technical standards and whether these policies and procedures are adequately communicated to all staff who are involved in carrying out the attestation work.

-

In performing substantive tests, the reviewer should evaluate whether the practice unit's working papers relating to the client adequately document the findings and conclusions and whether the report of practice unit is in consonance with the findings and conclusions drawn.

(e) Finally, the reviewer while evaluating records may consider the following: -

determine that any significant issues, matters, problems that arose during the course of the engagement have been appropriately considered, resolved and documented;

-

determine that adequate audit evidence or other relevant evidence in relation to the engagement is obtained to support the reasonableness of the conclusions drawn; and

Peer Review 21.11 -

determine that significant decisions relating to the engagement, use of professional judgement, resolution of significant matters have been properly documented.

21.6.4 Inherent Limitations of Review - The reviewer conducts the review in accordance with the Statement on Peer Review. The review would not necessarily disclose all weaknesses in compliance of technical standards and maintenance of quality of attestation services since it would be based on selective tests. As there are inherent limitations in the effectiveness of any system of quality control which happens to be subject-matter of review, departure from the system may occur and may not be detected. Review Procedures 21.7 A reviewer, based on the information and explanation obtained during the course of review, has to assess the evidence obtained and formulate his opinion on the compliance with technical standards and the internal controls within the practice unit that contribute towards maintenance of the quality of reporting. This chapter outlines the procedures that may be adopted by the reviewer in achieving the very object of the review. The word "should" used in this Chapter could be read as "would" also, wherever the context so requires. 21.7.1 Off-Site Procedures - The reviewer would start his review procedures as soon as response of the practice unit to the questionnaire is received. The reviewer should examine the response given by the practice unit. This examination is done with a view, among other things: -

to determine initial sample of the clients to whom attestation services have been rendered; and

-

to obtain basic understanding of the broad framework of quality control policies and procedures under which the practice unit operates.

The above examination would provide the reviewer with the knowledge about the practice unit, which would ultimately help the reviewer in developing an appropriate plan for the review. Accordingly, the reviewer would be able to conduct the review in an effective, efficient and timely manner. The reviewer may also, based on his evaluation of the responses given in the questionnaire, frame further questions to seek replies from the practice unit or determine the additional information that may be required for the review. The reviewer would also determine the relevant records/ documentation that may be required to be examined during the course of the review. While conducting off-site reviews, the reviewer would select an initial sample from the complete list of attestation services. This initial assessment of selection of sample may either be further reduced or increased at the execution stage in consultation with the practice unit. 21.7.2 On-Site Procedures - The on-site procedures would begin with the initial meeting with the practice unit. The Statement makes it abundantly clear that a reviewer must fix the date(s) for on-site review in consultation with the practice unit. While flexibility is built-in in this process, the reviewer must fix-up the date by mutual consent so that he can conduct the review within specified time.

21.12 Advanced Auditing and Professional Ethics The primary purpose of the initial meeting with the practice unit is to determine the accuracy of the responses given in the questionnaire and seek additional information in respect of those questions which fail to explain all relevant procedures. For example, the reviewer, in order to verify the accuracy of particulars filled in Part A of the questionnaire (Profile of the Practice Unit) examines the file containing the particulars. Similarly, the practice unit may have written policies and procedures which may corroborate the responses given in the questionnaire. It may, however, be noted that absence of such written policies and procedures does not necessarily mean that the policies and procedures followed by the practice unit are not adequate for maintaining the quality of service being rendered. The reviewer should obtain sufficient appropriate evidence to ensure that the responses to the questions are accurate. The manner of obtaining the evidence is discussed later in this chapter. Based on the above procedures, i.e., initial examination of the responses given in the questionnaire, additional information sought by the reviewer on inspection of internal manuals, if any, in case of large practice units, responses to further questions posed by him and after establishing the accuracy of the responses, the reviewer should be able to have a thorough understanding of the policies and procedures followed by the practice unit. Once the reviewer identifies the policies and procedures followed by the practice unit, the reviewer's next task is to perform compliance testing or compliance review. The primary purpose of the compliance review is to make an evaluation and identification of those control procedures on which it might be efficient to rely upon. Then the reviewer applies substantive procedures. The reviewer should obtain sufficient appropriate review evidence through the performance of compliance and substantive review procedures to enable him to draw reasonable conclusion that the policies and procedures adopted by the practice unit under review have been designed to carry out professional attestation service engagements in a manner that ensure compliance with the technical standards as defined in paragraph 3.7 of the Statement on Peer Review. The reviewer obtains sufficient appropriate review evidence by applying one or more of the following methods: -

Inspection;

-

Observation; and

-

Inquiry; Inspection mainly consists of examination of documentation (working papers) and other records maintained by the practice unit. Observation consists of witnessing a procedure or process being performed by others. For example, while conducting on-site review, the reviewer may review the performance of internal control. Inquiry consists of seeking appropriate information from the partner (designated by the practice unit for the purpose)/sole proprietor or other knowledgeable persons within the practice unit. The inquiries may originate from the responses to the questions given in

Peer Review 21.13 the questionnaire. The inquiries may also arise from the inspection of documentation maintained by the practice unit. While observation and inquiry may be considered as external independent sources of review evidence, inspection remains the most significant method for confirming the effective observance of control procedures in the practice unit. Observation and inquiry may also corroborate the evidence provided by inspection. The reviewer, in order to carry out the review effectively, should have an understanding of the documentation maintained by the practice unit. 21.7.3 Compliance Review Procedures - It is the first stage of applying review procedures to ascertain whether the practice unit has been observing the systems as contemplated by it in the questionnaire. The Statement requires the reviewer to consider the 'general controls' which comprise of five controls, viz., Independence, Maintenance of Professional Skills and Standards, Outside Consultation, Staff Supervision and Development and Office Administration. The Statement makes it imperative that all practice units are expected to address each of the five key control areas. However, the reviewer shall have regard to the size of the practice unit while evaluating such controls. It also envisages that the reviewer may have certain supplementary questions to consider and evaluate whether such controls are installed and are operational within the practice unit. A checklist which is illustrative in nature for the guidance of reviewers in respect of each five general controls is given hereunder: A.

Independence -

-

Does the practice unit have a policy to ensure independence, objectivity and integrity, on the part of partners and staff? Who is responsible for this policy?

-

Does the practice unit communicate these policies and the expected standards of professional behaviour to all staff?

-

Does the practice unit monitor compliance with policies and procedures relating to independence?

-

Does the practice unit periodically review the practice unit's association with clients to ensure objectivity and independence?

B.

Professional Skills and Standards-

-

Does the practice unit have an established plan for personnel needs at all levels, based on current and anticipated clientele, business growth, impending retirements, etc.?

-

Does the practice unit have an established recruitment policy?

-

Are applicants and new personnel informed of the personnel policies and procedures relevant to them?

-

Does the practice unit have continuing education programmes for partners and staff?

-

How easily are current and relevant professional literature, including accounting and auditing standards and pronouncements by professional bodies, available to partners and staff?

21.14 Advanced Auditing and Professional Ethics -

Does the practice unit conduct programmes for developing expertise in specialised areas and industries?

C.

Outside Consultation -

-

Is there any policy for consulting experts (both internal and external)?

-

Has the practice unit built up a network of other accountants, solicitors and advocates, and technical consultants in industries in which its clients operate?

D.

Staff Supervision and Development -

-

Does the practice unit have written guidelines on the responsibility at each level, and on the expected performance and qualifications necessary for advancement to the next level?

-

Does the practice unit have a system for gathering and evaluating information on the performance of personnel?

-

Does the practice unit have a system of periodically counselling personnel on performance and career opportunities?

-

Does the practice unit have a system of assigning an audit to the most appropriate personnel? Are requirements of specialised expertise and personnel skills given due consideration?

-

Does the practice unit have written guidelines for maintaining working papers (form and content)?

-

Does the practice unit have standardised forms, checklists, and questionnaires to assist in the conduct of audit?

E.

Office Administration -

-

Does the practice unit have established procedures for record retention, including security aspects?

-

Does the practice unit maintain a record containing particulars such as client name, nature of engagement, particulars regarding date of commencement of audit, date of audit report, billing, etc?

-

Does the practice unit maintain staffs register?

-

Does the office have a proper library containing relevant books and all publications of Institute of Chartered Accountants of India?

Evaluation of general controls by the reviewer would help him in determining the appropriate selection of sample. It is expected that the reviewer shall aim to draw a sample comprising of clients of varying size representing cross-section of the industry so that it reflects the overall performance of a practice unit. 21.7.4 Review of Records - Compliance/Substantive Review Procedures - After evaluating general controls by performing compliance procedures, the Statement envisages that a reviewer should actually review the records of the practice unit. Such review may either be

Peer Review 21.15 conducted by compliance approach or substantive approach or a combination of both. At the first stage, the records in respect of following key controls are to be reviewed to ensure compliance with technical standards: -

Audit Record Administration

-

Financial Statements Presentation

-

Review and Evaluation of System of Internal controls

-

Substantive Tests

-

Audit Conclusion

-

Audit Report

The above key controls required to be evaluated by the reviewer actually represent the logical sequence in which an audit ought to have been conducted by the reviewer. At this stage, as far as reviewer is concerned, the documentation aspect shall be of critical importance. Accordingly, the Statement makes it amply clear that "members in smaller practices may find some of the documentation too elaborate for most of their clients and so should tailor their attestation services documentation to suit their particular circumstances with justification for doing so provided to the reviewer". Reviewers are expected to take note of this while reviewing records of smaller-sized practice units. 21.7.5 Illustrative Checklist of Audit Programme of a Reviewee - A checklist which illustrates the contents of the audit programme of a reviewee for the guidance of the reviewer is given hereunder: -

Appointment and the relevant resolution about the appointment.

-

Terms of the engagement including reports required and manner of determining audit fees.

-

System of book-keeping and the list of the books of accounts maintained by the entity.

-

Particulars of the promoters, directors and their powers.

-

Names of persons who write the books of accounts and other authorised officers.

-

Memorandum and Articles of Association, Partnership Deed as applicable. Details of business of client and its accounting systems by reviewing and assessing information on:

-

nature of business of the entity; and

-

the internal control system including owner/manager controls.

-

Profit and loss account, balance sheet, auditor's and directors' reports of the previous year and the reports of internal auditor. Analytical review procedures in order to:

-

identify areas of accounts which are important because of their size;

-

highlight unusual or unexpected figures or relationships in the accounts;

21.16 Advanced Auditing and Professional Ethics -

design audit test which concentrates on important and unusual items; and

-

obtain sufficient audit assurance to allow the reduction or even elimination of detailed testing in some areas.

-

Assessment of audit risk by using the professional judgement and audit procedures to ensure that it is reduced to an acceptably low level.

-

Preliminary estimates of materiality for the audit as a whole.

-

Class of accounting transactions which are relevant and to decide the type of testing and samples.

-

Selection of representative samples.

-

Compliance tests to evaluate the reliability of key controls.

-

Material weaknesses in the operation of key controls to management.

-

Performance of analytical review procedures, substantive tests of detail to obtain sufficient, relevant and reliable audit evidence for each audit objective.

-

Fundamental accounting assumptions i.e., consistency, going concern and accrual basis of accounting are followed by the client in the preparation and presentation of financial statements.

-

Any change in an accounting policy which has a material effect have been disclosed.

-

Audit report is received from all the Branch Auditors and any reservation made by the branch auditor is appropriately dealt with in the finalisation of accounts.

-

Working papers contain all audit evidence, and are cross-referenced.

-

Summary of work done, problems, important judgements and audit conclusions.

-

Review by senior incharge of work of all assistants, audit programme followed and work performed as per time schedule.

-

Permanent file updated throughout the audit.

-

Review of unadjusted errors to determine whether individual and aggregate effect is material.

-

Compliance with Companies Act, 1956 and other relevant statutory requirements.

-

Compliance of all mandatory Accounting Standards issued by the Institute.

-

Post balance sheet events.

-

Formulation of draft audit opinion.

-

Comparison of budgeted time to actual and reasons for major variations.

-

Complete staff evaluation forms.

-

Planning of next year's audit and including it in the permanent audit file.

Peer Review 21.17 Finally, the reviewer may decide to employ substantive procedure only in case he is unable to place reliance in specific control procedures. The application of substantive review procedures would involve inspection of working papers of the attestation engagement. 21.7.6 Compliance with Technical Standards - The Statement identifies the following components to be part of technical standards: -

Accounting Standards issued by the Institute of Chartered Accountants of India;

-

Auditing and Assurance Standards issued by the Institute of Chartered Accountants of India;

-

Framework for the Preparation and Presentation of Financial Statement and Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services issued by the Institute of Chartered Accountants of India;

-

Statements issued by the Institute of Chartered Accountants of India;

-

Guidance Notes issued by the Institute of Chartered Accountants of India;

-

Notification/Directions issued by the Institute of Chartered Accountants of India; and

-

Compliance of the provisions of the various relevant Statutes and/or Regulations which are applicable in the context of the specific engagement being reviewed.

A complete list of Statements, Guidance Notes, notifications/ directions issued by the Institute of Chartered Accountant of India is given as Annexure to this chapter. 21.7.7 Quality of Reporting - The reviewer should verify whether the practice unit has policies and procedures to provide reasonable assurance that the reports issued are supported by conclusions reached at each stage of audit and are adequately referenced. The quality of report encompasses, apart from what is stated in the preceding sentence, the form and contents of the report also. This section aims at providing some procedures that should be followed by the reviewer to verify that the reporting done by the practice unit is of desired quality. The reviewer should determine the level of supervision of the engagement under review. In determining the level(s) of supervision required for a particular engagement, the reviewer should examine the following: -

Complexity of the subject matter;

-

Qualifications of persons performing the work;

-

Extent of consultation available and used;

-

Degree of authority delegated to assistants on an engagement;

-

Performance of personnel assigned to an engagement; and

-

Risk inherent in the engagement.

The working papers of the practice unit must contain adequate evidence to support the audit opinion including full information on work carried out by other auditors. This will normally include copies of the audit programme, particulars of audit tests carried out, copies of the

21.18 Advanced Auditing and Professional Ethics principle working papers and a letter of representation or copy, if addressed to the other auditors. The reviewer should examine the working papers from this angle also. When preparing the auditor's report, the practice unit should comply with the reporting standards prescribed under the Companies Act, 1956 or other applicable laws, Auditing and Assurance Standards, Statement on Qualifications in Auditor's Report and other relevant reporting guidance issued by the Institute. The auditor's report should contain a clear written expression of opinion on the financial information and if the form or content of the report is laid down or prescribed under any agreement or statute or regulation, the audit report should comply with such requirement. The following specific circumstances should be referred to in the report issued by a practice unit: -

The scope of the auditor's examination is affected by conditions that preclude the application of one or more auditing procedures considered necessary in the circumstances.

-

The financial statements are affected by a departure from acceptable accounting principle.

-

Inadequate disclosure in the financial statements of a material nature.

-

The financial statements are affected by material uncertainties concerning future events, the outcome of which is not reasonably determinable at the date of the auditor's report.

-

The auditor wishes to emphasize a matter regarding the financial statements.

The auditor's report includes the following basic elements, ordinarily in the following layout: a)

Title: The auditor's report should have an appropriate title.

b)

Addressee: The auditor's report should be appropriately addressed as required by the engagement and regulations, if any.

c)

Opening or Introductory Paragraph:

d)

i)

The auditor's report should identify the financial statements of the entity that have been audited, including the date of and period covered by the financial statements.

ii)

The report should include a statement that the financial statements are the responsibility of the entity's management and a statement that the responsibility of the auditor is to express an opinion on the financial statements based on the audit.

Scope paragraph: i)

The auditor's report should describe the scope of the audit by stating that the audit was conducted in accordance with AASs issued by the Institute.

ii)

The report should include a statement that the audit was planned and performed to obtain reasonable assurance about whether the financial statements are free of material misstatement.

Peer Review 21.19 iii)

The auditor's report should describe the audit as to include the examination of evidence on test basis, assessing the accounting principles used, assessing the significant estimates made by the management and evaluating the overall financial statement presentation.

iv)

The report should also include a statement by the auditor that the audit provides a reasonable basis for the opinion.

e)

Opinion Paragraph: The opinion paragraph of the auditor's report should clearly indicate the financial reporting framework used to prepare the financial statements and state the auditor's opinion as to whether the financial statements give a true and fair view in accordance with that financial reporting framework and, where appropriate, whether the financial statements comply with statutory requirements.

f)

Date of Report: The auditor should date the report on which the auditor signs the report expressing an opinion on financial statement.

An unqualified opinion indicates the auditor's satisfaction in all material respects with the following matters or as may be laid down or prescribed under the relevant agreement or statute or regulation, as the case may be: -

The financial information has been prepared using acceptable accounting policies, which have been consistently applied;

-

The financial information complies with relevant regulations and statutory requirements; and

-

There is adequate disclosure of all material matters relevant to the proper presentation of the financial information, subject to statutory requirements, where applicable.

When a qualified opinion, adverse opinion or a disclaimer of opinion is to be given or reservation of opinion on any matter is to be made, the audit report should state the reasons there for. The reviewer should, particularly, ascertain that principles relating to manner of qualifying the audit report as laid down in the Statement on Qualifications in Auditor's Report and other relevant pronouncements of the Institute have been complied. 21.7.8 Office Systems and Procedures - The reviewer should focus on it that an assistant is wasting time on non-essentials. Again, a senior may lose control by failing to compare the schedule with the complete item of work. In the olden days, such lapses would be covered up by night work but nowadays client's staffs are generally not too happy to keep the office open at nights to accommodate the auditors. Staffing: The requirement of proper staff is a critical component of the practice unit. In this context, the following may be noted:

21.20 Advanced Auditing and Professional Ethics -

The practice unit should have laid down qualifications deemed necessary for various levels of responsibility. This is to ensure that the firm is staffed by personnel who have attained and maintain the Technical Standards and professional competence required, to enable them to fulfil their responsibilities with due care.

-

There should be introductory procedures for the new employees like orientation programme, discussion of office procedures, etc.

-

The performance of each staff should be evaluated and communicated to the staff on periodical basis and should be filed in the staff file.

Professional development of staff: All big or medium size practice units or progressive small practice units should have the system of continuous professional development of its staff: -

Laid down policies and procedures of the practice unit relating to independence and the system to communicate them to the staff at the time of joining and subsequently on periodic basis.

-

In-house mechanism for continuous professional development education.

-

Provide access to libraries and other authoritative sources to its staff; provide copies of Technical material issued by the Institute, from time to time, thereby ensuring that they are aware of changes taking place in Accounting and Auditing and Assurance Standards.

-

Designating the expert/experienced individuals as available for consultation and their area of expertise.

21.7.9 Training and Office Administration - The training programme of the articled/audit clerk is a significant component to ensure the availability of a proper manpower. The objectives of such training programme implementation of these systems and procedures during the course of review. The reviewer may, however, note that applicability of these may vary with the size and level of practice unit. Practice Unit's policies may include -

The implementation of quality control policies and procedures by the practice unit, designed to ensure that all audits are conducted in accordance with Auditing and Assurance Standards.

-

The practice unit's general quality control policies and procedures communicated to its personnel in a manner that provides reasonable assurance that the policies and procedures are understood and implemented.

-

The implementation of those quality control procedures which are, in the context of the policies and procedures of the firm, appropriate to the individual audit.

Peer Review 21.21 Office procedures include -

The organisation of the field work of audit and delegation of the work to assistants in a manner that provides reasonable assurance that the work would be performed with due care by the person having the degree of professional competence required in the circumstances.

-

The auditor while performing supervisory responsibilities should consider the professional competence of assistants performing work delegated to them when deciding the extent of direction, supervision and review, appropriate for each assistant.

-

Assistants to whom work is delegated should be given appropriate directions. Direction involves informing assistants of their responsibilities and the objectives of the procedures they are to perform.

-

The audit programme is an important tool for communication of audit directions.

-

The partner should monitor the progress of audit to consider whether the assistants have necessary skill and competence, they understand the audit directions and the work is carried out in accordance with the overall audit plan and audit programme.

-

The work performed by each assistant should be reviewed by personnel of at least equal competence.

21.7.10 Time Budget - Time is of vital importance in all audit work. The partner must control it firmly, as assistants are generally liable to take up more time than originally scheduled. Many precious man-hours are lost if a busily occupied senior staff member fails to note that include: -

Acquisition of adequate theoretical knowledge.

-

Developing skills in applying theoretical knowledge to practical situations.

-

Inculcating a disciplined attitude.

-

Imbibing due professional orientation.

-

Developing ethical values.

While designing the training programme of articled/audit clerks, the practice unit should consider the following elements: -

Assigning progressive work experience commensurate with the expanding abilities of the trainees.

-

Designing a study plan to ensure that trainees are fully prepared to take examinations at the earliest opportunity for which they are eligible.

21.22 Advanced Auditing and Professional Ethics -

Ensuring that work experience is preceded and backed by practical instructions, including briefing before each assignment to ensure that the application of practical techniques to the circumstances of individual clients is properly understood.

-

Ensuring in-house theoretical training is integrated with practical work experience.

-

Assigning higher levels of technical and supervisory responsibility and client contact designed to ensure that personal and managerial skills are developed.

-

Ensuring that professional attitude and an understanding of professional ethics are developed.

21.7.11 Audit working papers - The working papers are the property of the auditor and the auditor should adopt reasonable procedures for custody and confidentiality of his working papers and should retain them for a period of time sufficient to meet the needs of his practice and satisfy any pertinent legal or professional requirement of record retention. 21.7.12 Filing of working papers - The working papers should be properly filed in order to ensure that they are easily retrievable. In case of recurring audits, some working paper files may be classified as permanent audit files and the current file. To the extent possible the records related to permanent files should be kept in bound manner, duly numbered. Attention is invited to AAS-5 on "Documentation" in this context. Developments in the field of Peer Review 21.8 Recently the American Institute of certified Public Accountants (AICPA) has constituted a task Force which has recommended the following to enhance transparency and effectiveness of the Peer Review: 1. Peer review reports should be as concise as possible and written in “plain English.” The “grading” terminology should be simplified and the report should be a stand-alone document that discloses the significant matters affecting the type of report issued. 2. The current peer review administrative oversight processes should be made more transparent by communicating the objectives, procedures, and results of oversight to the public through annual, and in certain cases biannual, reports issued by the AICPA and the state CPA societies that administer the program. 3. To ensure a level playing field for all practitioners, all state boards of accountancy should require peer review as a condition of licensure. 4. The AICPA should conduct a comprehensive peer reviewer recruitment campaign to attract new, quality peer reviewers and to educate firms on the benefits of having its owners and staff members involved in performing peer reviews. 5. The AICPA’s Peer Review Board should continue to ensure the high quality of peer reviewers, establishing additional minimum requirements to be a peer reviewer, and consider

Peer Review 21.23 requiring additional minimum criteria such as the number of accounting and auditing hours spent by a reviewer in his or her own firm. 6. The AICPA should provide a mechanism for members to comply with state board licensing requirements by allowing any AICPA firm to post voluntarily its peer review results in the AICPA’s current public file regardless of membership in a specific AICPA section or audit quality center. The task force recommendations resulted from a great deal of deliberation and recognition that the ultimate beneficiary of the peer review process has broadened over time, from benefiting the firm exclusively to now including the broader regulatory community and the public. The recommendations are being submitted to the Peer Review Board for consideration, analysis and possible execution. The Board decided that if the recommendations are successfully implemented, a broad based campaign to educate members and users about the significant changes would be warranted. Forty-one state CPA societies now administer the AICPA Peer Review Program and the AICPA Peer Review Board oversees the forty-one administering bodies. Thirty-nine states require peer review as a condition of licensure; about half of which require some form of disclosure of the results. Thousands of AICPA firms currently place the results of their peer reviews in a public file as an enrollment requirement in the Center for Public Company Audit Firms peer review program or as a membership requirement of AICPA audit quality centers and the Private Companies Practice Section. In addition, thousands of firms provide their peer review results to clients to comply with governmental or regulatory requirements. Many firms take pride in the results of their peer review and use them as a marketing tool. This all contributes to the high public expectations of peer review. [Source: AICPA Board of Directors Peer Review Task Force Report: Recommendations for Enhancing the AICPA Peer Review Programs in a Transparent Environment February 9, 2006. Also refer to Peer Review: An Era of Transparency at www. aicpa.org AICPA Peer Review Standards & Guidance: Standards for Performing & Reporting on Peer Reviews (effective 1/1/2005) incl. Interpretations Additional Guidance Re: Standards effective 1/1/2005] Self-examination Questions 1.

Explain the meaning of the term Peer Review. Do you think that the process of Peer Review will enhance the quality of audit work? Explain with a detailed reference to the objectives and scope of the Peer Review?

21.24 Advanced Auditing and Professional Ethics 2.

The peer review does not seek to redefine the scope and authority of the Technical Standards specified by the Council but seeks to reinforce them within the parameters prescribed by the Technical Standards – explain the statement.

3.

Explain the composition of role of the Peer Review Board?

4.

Explain different stages of Peer Review Process?

5.

What should be the Peer Review Procedures?

6.

Briefly explain the reporting requirement of the Reviewer under the “Peer Review”?

7.

What is a Practice unit for the purpose of Peer Review? How is a Practice Unit selected?

8.

What documents should be sent to the Practice Unit along with the intimation of selection and what should be the duty of the Practice Unit in response to initial communication?

9.

Explain the process to be followed by the reviewer after initiation communications is made by the Practice Unit of the Peer Review Board?

10. How should the reviewer execute the Peer Review function? 11. Briefly explain approach to be adopted by the reviewer for the purpose of peer review? 12. Write short notes on : (i)

Offsite Procedures of Peer Review

(ii)

On site Procedures of Peer Review

(iii) Compliance Review Procedures. 13. Develop an illustrative check list of audit programme of a reviewee for the guidance of the reviewer under the Peer Review Process? References 1. Statement on Peer Review, ICAI March, 2002 2. Peer Review Manual, ICAI, March, 2003 3. Training Modules for Peer Reviewers, ICAI, August, 2005

22 THE SARBANES-OXLEY ACT OF 2002

Introduction 22.1 The Sarbanes–Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called SOX or Sarbox; is a United States federal law passed in response to a number of major corporate and accounting scandals including those affecting Enron, Tyco International, and WorldCom. These scandals resulted in a decline of public trust in accounting and reporting practices. Named after sponsors Senator Paul Sarbanes (D–Md.) and Representative Michael G. Oxley (R–Oh.), the Act was approved by the House by a vote of 423-3 and by the Senate 99-0. The legislation is wide ranging and establishes new or enhanced standards for all U.S. public company boards, management, and public accounting firms. The Act contains 11 titles, or sections, ranging from additional Corporate Board responsibilities to criminal penalties, and requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the new law. In view of the importance of the Act in the globalised environment of financial reporting, auditing and corporate governance, this has been included in the Final New Course. This Chapter intends through light on the basic requirements of the Act. The first and most important part of the Act establishes a new quasi-public agency, the Public Company Accounting Oversight Board, which is charged with overseeing, regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies. The Act also covers issues such as auditor independence, corporate governance and enhanced financial disclosure. The Sarbanes-Oxley Act's major provisions include the following: ♦

Creation of the Public Company Accounting Oversight Board (PCAOB);

♦

A requirement that public companies evaluate and disclose the effectiveness of their internal controls as they relate to financial reporting, and that independent auditors for such companies "attest" (i.e., agree, or qualify) to such disclosure;

♦

Certification of financial reports by chief executive officers and chief financial officers;

♦

Auditor independence, including outright bans on certain types of work for audit clients and pre-certification by the company's Audit Committee of all other non-audit work;

22.2

Advance Auditing and Professional Ethics

♦

A requirement that companies listed on stock exchanges have fully independent audit committees that oversee the relationship between the company and its auditor;

♦

Ban on most personal loans to any executive officer or director;

♦

Accelerated reporting of insider trading;

♦

Prohibition on insider trades during pension fund blackout periods;

♦

Additional disclosure;

♦

Enhanced criminal and civil penalties for violations of securities law;

♦

Significantly longer maximum jail sentences and larger fines for corporate executives who knowingly and willfully misstate financial statements, although maximum sentences are largely irrelevant because judges generally follow the Federal Sentencing Guidelines in setting actual sentences;

♦

Employee protections allowing those corporate fraud whistleblowers who file complaints with OSHA within 90 days to win reinstatement, back pay and benefits, compensatory damages, and congressional page abatement orders, and reasonable attorney fees and costs.

Summary of Sarbanes Oxley Act of 2002 22.2 The Sarbanes Oxley Act of 2002 established corporate accountability and civil and criminal penalties for white – collar crimes. The act contains eleven titles, the summary of which is given hereunder: Title I - Public Company Accounting Oversight Board (PCAOB) Established in an independent private board, to regulate the accounting profession, to be dominated by executives and experts from outside the accounting profession (a self-regulatory body so far). This setup aims at establishing Public confidence in the ‘Report of independent Registered Public Accounting Firm’ and to protect the interest of investors. The PCAOB requires the Public Accounting Firms to register with the Board and to follow certain regulations for audit of Public Companies Title II – Auditor Independence The auditors of Public Companies to follow: ♦

Regulatory authorities –Securities Exchange Board (SEC) as SEC was entrusted to issue rules implementing several of the provisions of Sarbanes Oxley Act.

♦

To comply with the PCAOB rules and regulations.

♦

To enhance the rights, duties and responsibilities of the Audit Committee.

Title III – Corporate Responsibility ♦

The Audit Committee to be more independent through enhancement of their Oversight responsibilities and one of the Audit Committee member to be “Financial Expert”

♦

Requires the Chief Executive Officer (CEO) and Chief Financial Officer(CFO) to issue certification of quarterly financial results and annual reports to SEC as part of compliance

The Sarbanes-Oxley Act of 2002

22.3

with form 10-K quarterly Report under Section 13 or 15(d) of the Security and Exchange Act of 1934 or Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934. ♦

Provides rules of conduct for companies management and their officers regarding pension matters.

♦

To comply with the Securities and Exchange Board rules requiring attorneys to report violations of securities laws to the company’s CEO or Chief Legal Counsel and to Audit Committee if no action is taken.

Title IV – Financial Disclosure ♦

Obligatory for the companies to provide objective and transparency in disclosure of financial results having established effectiveness of internal control systems for financial reporting and disclosures covering off balance sheet transactions.

♦

Disclosure the corporate mission statement and corporate ethics and their implementation.

♦

Disclosure by CEO, directors, management of the company and principal stockholders involving company securities.

Title V- Conflict of Interest ♦

Declaration by Securities Exchange Committee (SEC) of rules to address conflicts of interest arising when securities analysts recommend equity securities buying and selling in their Research Report and announcement to public.

Title VI – Commission Resources and Authority ♦

To provide additional funding to SEC.

♦

Power to SEC and federal courts to censure and impose prohibitions on persons and corporate entities.

Title VII – Studies and Reports ♦

Federal regulatory bodies to conduct studies regarding Accounting firms, Credit Rating Agencies, violation of laws, rules and regulations by various agencies concerning corporate affairs and action involving securities laws.

Title VIII – Corporate and Criminal Fraud Accountability ♦

To enforce tougher civil and criminal penalties for fraud and accounting scandals, securities fraud and certain other forms of obstruction of justice.

♦

In case of violation of securities laws there may be debts non-dischargeable.

♦

Protect employer against corporate whistle blowers (person who provide evidence of fraud in the company) .

22.4

Advance Auditing and Professional Ethics

Title IX – White- Collar Crime ♦

Tougher practices for CEO’s guilty of wrong doing and other fraud such as mail and wire fraud and ERISA violations.

♦

Chief Executive Officer (CEO) and Chief Financial Officer (CFO) to issue certification in their quarterly, Half-yearly and Annual Reports to SEC forming part of Form 10 K and 10 Q under Section 13 or 15(d) of the Securities Exchange Act of 1934 and impose penalties for certifying a misleading or fraudulent report.

Title X – Corporate Tax Reforms ♦

CEO should sign company’s federal tax returns.

Title XI – Corporate Fraud and Accountability Provide regulatory bodies and courts to take various actions –civil and criminal proceedings in connection of misstatements amounting to accounting scandals and fraudulent financial reports, other frauds on securities matters, obstruction of justice and retaliating against corporate whistleblowers. Overview of PCAOB's requirements for auditor attestation of control disclosures 22.3 Auditing Standard No. 2' of the Public Company Accounting Oversight Board (PCAOB) has the following key requirements: ♦

The design of controls-relevant assertions related to all significant accounts and disclosures in the financial statements ;

♦

Information about how significant transactions are initiated, authorized, supported, processed, and reported ;

♦

Enough information about the flow of transactions to identify where material misstatements due to error or fraud could occur ;

♦

Controls designed to prevent or detect fraud, including who performs the controls and the regulated segregation of duties ;

♦

Controls over the period-end financial reporting process ;

♦

Controls over safeguarding of assets ;

♦

The results of management's testing and evaluation.

22.3.1 Internal controls - Under Sarbanes-Oxley, two separate certification sections came into effect – one civil and the other criminal. Section 302 of the Act mandates a set of internal procedures designed to ensure accurate financial disclosure. The signing officers must certify that they are “responsible for establishing and maintaining internal controls” and “have designed such internal controls to ensure that material information relating to the company and its consolidated subsidiaries is made known to such officers by others within those entities, particularly during the period in which the periodic reports are being prepared.” The officers must “have evaluated the effectiveness of the company’s internal controls as of a date within 90 days prior to the report” and “have presented in the report their conclusions about the effectiveness of their internal controls based on their evaluation as of that date.”

The Sarbanes-Oxley Act of 2002

22.5

Moreover, under Section 404 of the Act, management is required to produce an “internal control report” as part of each annual Exchange Act report. The report must affirm “the responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting.” The report must also “contain an assessment, as of the end of the most recent fiscal year of the Company, of the effectiveness of the internal control structure and procedures of the issuer for financial reporting.” Id. To do this, managers are generally adopting an internal control framework such as that described in COSO. Under both Section 302 and Section 404, the US Congress directed the SEC to promulgate regulations enforcing these provisions. [ Refer to Final Rule: Management’s Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, Release No. 33-8238 (June 5,2003), available at http://www.sec.gov/rules/final/338238.htm. ] The June 5th Final Rules require annual reports to contain (i) management’s report on the company’s internal controls including management’s assessment of their effectiveness as of the end of the fiscal year (ii) a statement identifying the framework used by management to evaluate internal controls and (iii) an independent auditor’s attestation report on management’s assessment. They also require management to evaluate, on a quarterly basis, material changes in the company’s internal controls. In addition, the June 5th Final Rules also make certain revisions to the Section 302 certification requirements and forms of certification. It is important to note at the outset that in the June 5th Final Rules, the SEC changed the term “internal controls and procedures for financial reporting” previously used to describe the internal controls required by Section 404 of the Act to “Internal Control over Financial Reporting.” The outside auditors for companies must, for the first time, attest to managers' internal control assessment, pursuant to SEC rules, which currently require only large public companies comply with this part of SOX. This presents new challenges to businesses, specifically, documentation of control procedures related to information technology ("IT"). Public Company Accounting Oversight Board (PCAOB) has issued guidelines on how auditors should provide their attestations. Information Technology and SOX 404 22.4 The PCAOB suggests considering the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework in management/auditor assessment of controls. Auditors have also looked to the IT Governance Institute's "COBIT: Control Objectives of Information and Related Technology" for more appropriate standards of measure. This framework focuses on information technology (IT) processes while keeping in mind the big picture of COSO's "control activities" and "information and communication". However, these certain aspects of COBIT are outside the boundaries of Sarbanes-Oxley regulation. Refer to the Study Material of Information System Control and Audit for a detailed discussion on COBIT.

22.6

Advance Auditing and Professional Ethics

The financial reporting processes of most organizations are driven by IT systems. Few companies manage their data manually and most companies rely on electronic management of data, documents, and key operational processes. Therefore, it is apparent that IT plays a vital role in internal control. As PCAOB's "Auditing Standard 2" states: "The nature and characteristics of a company's use of information technology in its information system affect the company's internal control over financial reporting." Chief information officers are responsible for the security, accuracy and the reliability of the systems that manage and report the financial data. Systems such as ERP (Enterprise Resource Planning) are deeply integrated in the initiating, authorizing, processing, and reporting of financial data. As such, they are inextricably linked to the overall financial reporting process and need to be assessed, along with other important process for compliance with Sarbanes-Oxley Act. So, although the Act signals a fundamental change in business operations and financial reporting, and places responsibility in corporate financial reporting on the chief executive officer (CEO) and chief financial officer (CFO), the chief information officer (CIO) plays a significant role in the signoff of financial statements. The SEC identifies the COSO framework by name as a methodology for achieving compliance. The COSO framework defines five areas, which when implemented, can help support the requirements as set forth in the Sarbanes-Oxley legislation. These five areas and their impacts for the IT Department are as follows: Risk Assessment - Before the necessary controls are implemented, IT management must assess and understand the areas of risk affecting the completeness and validity of the financial reports. They must examine how the company's systems are being used and the current level and accuracy of existing documentation. The areas of risk drive the definition of the other four components of the COSO framework. Control Environment - An environment in which the employees take ownership for the success of their projects will encourage them to escalate issues and concerns, and feel that their time and efforts contribute to the success of the organization. This is the foundation on which the IT organization will thrive. Employees should cross train with design, implementation, quality assurance and deployment teams to better understand the entire technology lifecycle. Control Activities - Design, implementation and quality assurance testing teams should be independent. ERP and CRM systems that collect data, but feed into manual spreadsheets are prone to human error. The organization will need to document usage rules and create an audit trail for each system that contributes financial information. Further, written policies should define the specifications, business requirements and other documentation expected for each project. Monitoring - Auditing processes and schedules should be developed to address the high risk areas within the IT organization. IT personnel should perform frequent internal audits. In addition, personnel from outside the IT organization should perform audits on a schedule that is appropriate to the level of risk. Management should clearly understand and be held responsible for the outcome of these audits.

The Sarbanes-Oxley Act of 2002

22.7

Information and Communication - Without timely, accurate information, it will be difficult for IT management to proactively identify and address areas of risk. They will be unable to react to issues as they occur. IT management must demonstrate to company management an understanding of what needs to be done to comply with Sarbanes-Oxley. U.S. and non-U.S. public companies have been subject to the disclosure controls and procedures and the internal accounting controls certification requirements of Section 302 of the Act since August 29, 2002, when the SEC published its final rules regarding Certification of Disclosure in Companies’ Quarterly and Annual Reports (the “August 29th Final Rules”). U.S and non-U.S. Public Companies have also been subject to the certification requirements of Section 906 of the Act since July 30, 2002. Difference between Disclosure Controls and Procedures and Internal Control Over Financial Reporting 22.5 Because both the August 29th Final Rules and the June 5th Final Rules deal with “Disclosure Controls And Procedures” and “Internal Control Over Financial Reporting,” it is important to understand the basic difference between them. ‘Disclosure Controls and Procedures’ are meant to ensure, as far as possible, that all the information required by law to be included in the periodic reports filed with the SEC is made available to those responsible for preparing them in a complete and timely fashion. ‘ Internal Control Over Financial Reporting’ is meant to ensure the integrity of the financial statements and guard the assets of the company. At the bookkeeping level, these procedures are designed to enforce the proper recording of income and expenditure so that revenues are deposited into the company’s bank account and unauthorized expenditures do not leave the company’s bank account. At the executive level, these procedures are designed to prevent manipulation of revenues and expenses, such as illegal transfers from expense accounts to capital accounts, in which management may be tempted to engage in order to hit the end of the period “whispered numbers”. Because most periodic reports contain financial statements, there is some inevitable overlap between the two sets of controls. Considering the accounting lapse in the US , this overlap is considered as a good procedure. The Disclosure Controls and Procedures and The Internal Control Over Financial Reporting are sometimes collectively referred to in this advisory as “the Controls And Procedures.” Implementation of Disclosure and Controls Procedures 22.6 While contemplating the implementation of these procedures, companies should focus on the purpose of the Disclosure and Control Procedures rather than on their form. Each company has a different business and there is no “one size fits all” solution. Thus for example, it may not be appropriate for all companies to establish a disclosure committee. Each company should consider which methods of gathering information would be best for acquiring the necessary information. The Disclosure Controls and Procedures should be crafted in such a way that they are easy to follow and practical to implement. They should be in writing and should be customized to

22.8

Advance Auditing and Professional Ethics

reflect the operations of the company and its particular risk profile. Given below is a list of suggestions, some recommended by the SEC and others and which are considered as a good practice, for the implementation of Disclosure Controls and Procedures : (i) Disclosure Committee - A disclosure committee may be established charged with assisting the CEO and CFO in developing, writing and overseeing Disclosure Controls and Procedures. The disclosure committee should be made up of the general counsel, the principal accounting officer, the chief investor relations officer, the principal risk manager or persons with different titles but with similar responsibilities, heads of major business units and the head of the human resources department. (ii) Inventory of Current Procedures - A good starting point for the disclosure committee in developing Disclosure Controls and Procedures is to take an inventory of the company’s existing practices and weaknesses with regard to: ♦

preparing annual reports on Forms 10-K, 10-KSB, 20-F or 40-F, quarterly reports on Form 10-Q, 10-QSB, current reports on Form 8-K, foreign issuer reports on Form 6-K, proxy and information statements, earnings press releases, rating agency reports, schedules 13D and 13G, reports on Forms 3, 4 and 5 to the extent that the company prepares them for their executive officers and directors, and website disclosure;

♦

the handling of whistle blower complaints with respect to the company’s disclosure;

♦

the review of any matters raised by the company’s independent auditors in their management letter or in connection with any information included in the reports and

♦

the retention of relevant documents.

(iii) Identification of personnel - The disclosure committee should identify persons both inside and outside the company whose input is critical to the disclosure process and set deadlines for the time they have to gather, verify and report the information to those preparing the disclosure. (iv) Preparation of Controls and Procedure Timetable and Check List - The disclosure committee should disseminate internally a Controls and Procedures check list which fills in any gaps and fixes any weaknesses discovered by the inventory. The check list should state that it has been adopted as part of the Disclosure Controls and Procedures required by the Act. The check list should be prepared in consultation with the company’s internal and independent auditors and outside counsel with a view to blending, as far as possible, the Disclosure Controls and Procedures with the company’s Internal Control Over Financial Reporting. Content Check List The check list should assign responsibility to designated individuals with deadlines i.

for gathering the documentation and information needed by each section of the relevant report under the relevant SEC rules and regulations, (i.e. Regulation S-X, S-K etc.);

ii.

for providing responses to any follow up questions arising out of the gathered information;

The Sarbanes-Oxley Act of 2002

22.9

ii.

for assessing risks the company may be facing in its business or in its operational, technology, or financial areas;

iv.

for taking a closer look at areas of disclosure that have raised questions in the past and for reviewing other hot button issues such as related party and off balance sheet transactions, revenue recognition policies, reserves or asset impairment;

v.

for reviewing any alternative accounting treatments and why the company chose the one it did and whether it provides a fair presentation of the company’s financial condition;

vi.

for communicating and meeting with the outside auditors and outside counsel in connection with their audit or review of the reports;

vii. for reviewing any employee complaints regarding disclosure and bringing them to the attention of the audit committee; viii. for convening due diligence meetings with the participation of the disclosure committee and outside advisors to discuss the comprehensiveness of the material gathered and any disclosure issues; ix.

for convening management meetings to evaluate any management letters received by the company from their independent accountants and to consider the adequacy of operating and information technology systems;

x.

for preparation and revision of draft reports and the conducting of compliance checks of the pertinent SEC, exchange and Nasdaq regulations;

xi.

for gathering of back-up certifications for the Sections 302 and 906 certifications if the company decides to implement back-up certifications ;

xii. for convening meetings with the CFO and CEO, the board and the audit committee at which the reports can be carefully reviewed and any disclosure issues discussed; and xii. for signing off on drafts and final versions of the reports. (v) Back-up Certifications - Companies may wish to consider obtaining “back-up” support certifications from certain officers that confirm the certifications of the CEO and CFO. Back-up certifications may not be appropriate for all companies. One consideration, among others, is whether asking for back-up certificates will cascade down through the company and create an unmanageable bureaucratic structure. 22.6.1 Evaluation of Disclosure Controls and Procedures - The disclosure committee may plan to review and evaluate the check list at least quarterly in the case of U.S. companies and annually in the case of non-U.S. companies for the following: ♦

staffing inadequacies in the disclosure process;

♦

the level of experience of those drafting the reports;

♦

the reliability of the information systems used;

♦

whether those preparing the reports have access to the persons that have the information required and whether such persons are responsive to requests for information;

22.10

Advance Auditing and Professional Ethics

♦

whether sufficient time was allowed for review, comment and Q&A on drafts; whether transaction files were complete or were missing documents;

♦

whether material transactions and issues were included in early drafts and how long did it take for issues to surface;

♦

whether disclosures were accurate; whether form checks revealed any problems and if so whether they were corrected;

♦

whether there are adequate controls over related party transactions; and

♦

Whether there was sufficient time to discuss issues and maintain a sufficient dialog between the gatekeepers of the information. The results of this periodic evaluation should be discussed with the CEO, CFO, the board of directors and the audit committee.

22.6.2 Other Functions of the Disclosure Committee - Other functions of the disclosure committee would include overseeing and coordinating the collection of information, resolving questions about the materiality of a development, reviewing and advising on the content of disclosure, drafting of disclosure and communication with the investing public, and recommending to the board, the audit committee, the CFO and the CEO, the filing of the report. Precaution to be taken by CEO and CFO Before Signing the Certifications 22.7 Assuming that the steps described above in Para 22.6 in connections with the implementation of the Controls and Procedures have been taken, the CEO and CFO should ask themselves the following questions before signing the certification. 1.

Did you participate in the design, maintenance and evaluation of your company’s Controls and Procedures as they apply to all of the company’s public disclosures and reports?

2.

Did you make it clear to employees that adherence to the Controls and Procedures is on top of your list of priorities and should be taken very seriously?

3.

Did you read the report and does it provide an accurate picture of the company’s financial condition as you know it?

4.

Have you asked for explanations of anything you did not understand and were you satisfied with the answers?

5.

Did you evaluate the Controls and Procedures and are you satisfied that they are adequate to ensure that they capture all potential matters for disclosure in a timely manner?

6.

Did the Disclosure Controls and Procedures leave enough time to prepare a good first draft and give sufficient time to you, the board and the audit committee to review it and discuss any issues?

7.

Does the disclosure of the evaluation of the Controls and Procedures in the periodic report you are signing conform with your own evaluation of the Controls and Procedures?

The Sarbanes-Oxley Act of 2002

22.11

8.

Did you talk to the critical people preparing the report? Did you ask them how comfortable they are with the contents of the disclosure and if they would sign the certification under oath, if the law were to require them to?

9.

Did you take a second critical look at those areas most likely to raise issues with the SEC?

10. Did you talk with the independent auditors about the report? Did you ask them whether they was anything in the report they would have recorded differently than the internal auditors recorded it? 11. Did you ask the independent auditors if they are satisfied with the Controls and Procedures and with their communication with the inside auditors? 12. Did you ask the independent auditors whether they had any disagreements with the internal auditors or senior management regarding the contents of the financial statements or the report? 13. Did you ask the independent accountants if the company’s accounting was aggressive? 14. Did you discuss with the audit committee the certifications and the Controls and Procedures evaluation made? 15. Did you keep a record of all steps taken to give you the comfort necessary to sign the certification? Purpose of Internal Control Over Financial Reporting 22.8 The establishment, maintenance and periodic evaluation of Internal Control Over Financial Reporting required by Section 404 of the Act is important in view of the fact that in auditing financial statements, outside accountants conduct and rely upon samplings and random checks rather than upon an exhaustive review of each transaction. This method of sampling and spot checking is justified if a reliable system of Internal Controls Over Financial Reporting is in place because it provides a level of comfort that there are checks and balances which monitor the day to day financial operations of the company. If on the other hand, no reliable Internal Control Over Financial Reporting exists, the accountant would have to conduct tests of transactions and perform additional analyses in order to accumulate sufficient evidence to support its opinion on the financial statements. 22.8.1 Procedures To Be Included In the Internal Control Over Financial Reporting - Internal Control Over Financial Reporting should include policies and procedures that provide reasonable assurance that (i) records are maintained that fairly reflect purchase and sales of the company’s assets,(ii) that transactions are properly recorded so as to permit the preparation of GAAP financial statements, (iii) receipts and expenditures are being made in an authorized fashion and (iv) unauthorized use of company assets that could have a material effect on the financial statements will be timely detected. 22.8.2 Extent of Management’s Duty to Assess and Report on the Company’s Internal Control Over Financial Reporting - In order to ensure the reliability of the Internal Control Over Financial Reporting at all times, management is required to evaluate the effectiveness of

22.12

Advance Auditing and Professional Ethics

those controls on a periodic basis and to include a report of such evaluation in the annual report, which evaluation must be attested to by the company’s outside accountants. Under the Section 404 proposed rules, management would have been required to evaluate the effectiveness of the internal controls quarterly. Recognizing that this would be too burdensome, the June 5th Final Rules only require quarterly evaluation of changes that have materially affected, or are reasonably likely to materially affect, the Company’s Internal Control Over Financial Reporting. Whereas a U.S. public company would have to report these changes quarterly, a non-U.S public company would only have to report them in its annual report. If, in the course of the evaluation, management discovers any deficiency in the design or operation of Internal Control Over Financial Reporting that could adversely affect a company’s ability to record, process, summarize and report financial data consistent with the assertions of management in the company’s financial statements, then management must disclose this material weakness in the report. 22.8.3 Procedures To Be Followed by Management in Preparing the Report of the Effectiveness of Internal Control Over Financial Reporting - The June 5th Final Rules do not specify the method or procedures to be performed in an evaluation and such method will vary from company to company. They do, however, require management to maintain the documentation that supports its assessment of the effectiveness of the company’s Internal Control Over Financial Reporting. The documentation regarding the design of internal controls and the testing process should provide reasonable support (i) for the evaluation of whether the control is designed to prevent or detect material misstatement or omissions, (ii) for the conclusion that the tests were appropriately planned and performed and (iv) that the results of the tests were appropriately considered. In performing their evaluation of the design and effectiveness of the Internal Control Over Financial Reporting, management should review (i) the company’s controls over initiating, recording, processing and reconciling account balances, classes of transactions and disclosures and related assertions included in the financial statements; controls related to the initiation and processing of non-routine and nonsystematic transactions; controls relating to the selection and application of appropriate accounting policies and controls relating to the prevention, identification and detection of fraud. 22.8.4 Location in the Annual Report of the Management’s Report on the Effectiveness of Internal Control Over Financial Reporting - Form 10-K for annual reports of U.S. public companies has been amended by adding Item 9A entitled “Controls and Procedures” to the annual report on Form 10-K. Form 20-F for annual reports for non-U.S. public companies has been amended by revising Item 15 of Part II. After the Second Compliance Date, these amendments will require a company’s annual report to include an internal control report of management that contains (i) a statement of managements responsibility for establishing and maintaining internal controls over financial reporting for the company, (ii) a statement identifying the framework used by management to conduct the required evaluation (iii) managements assessment of the effectiveness of the company’s Internal Control Over Financial Reporting as of the end of the company’s most recent fiscal year, which assessment must include disclosure of any material weakness in the company’s Internal Control Over

The Sarbanes-Oxley Act of 2002

22.13

Financial Reporting identified by management and (iv) a statement that the accounting firm that audited the financial statements included in the annual report has issued an attestation report on management’s assessment of the company’s internal control over financial reporting, which report must be filed as part of the company’s annual report with the SEC. For public companies that are Accelerated Filers, including non-U.S. public companies that are Accelerated Filers, the Second Compliance Date by which they must comply with the internal control report requirement is the date that the company files its first annual report for fiscal years ending on or after June 15, 2004. For public companies that are not Accelerated Filers, the Second Compliance Date by which they must comply with the internal control report requirement is the date that the company files its first annual report for fiscal years ending on or after April 15 2005. 22.8.5 Framework To Be Adopted by Management in Evaluating the Internal Control Over Financial Reporting - Although the SEC has not mandated any particular framework for the evaluation of the effectiveness of the Internal Control Over Financial Reporting, the framework used must be free of bias, permit qualitative and quantitative measurements, be sufficiently complete to include factors that would alter a conclusion about the effectiveness, and be relevant to an evaluation of internal control. 22.8.6 What Must the Outside Accountant’s Attestation on Management’s Internal Control Report Include and What Accounting Standards Will Be Used For Such Attestation?- The June 5th Final Rules require each annual report to include an attestation by the company’s outside accountants in which the accounting firm expresses an opinion, or states that an opinion cannot be expressed and if not, why not, about management’s assessment of the effectiveness of the company’s Internal Control Over Financial Reporting in accordance with standards on attestation engagements. The Act requires the new Public Company Accounting Oversight Board to establish standards for these attestation reports. 22.8.7 Can Management Delegate the Evaluation of the Internal Control over Financial Reporting to the Company’s Outside Accountants? - Management cannot delegate the evaluation of the Internal Control Over Financial Reporting to the company’s outside accountants because under the SEC’s rules of auditor independence (see Carter Ledyard & Milburn’s LLP client advisory dated May 2003 on Audit Committee and Financial Reporting for U.S. and non-U.S companies under the Sarbanes Oxley Act), one of the prohibited non-audit services that an outside accountant may not provide to its audit client is the monitoring of internal controls. Nevertheless, because under Section 404 of the Act, the outside accountant must attest to the effectiveness of management’s evaluation of the internal controls, the outside accountant must be involved in the assessment. Accordingly, management must be actively involved in the evaluation of the internal controls by the outside accountants and coordinate the process with them. 22.8.8 Do the Periodic Report Certification Requirements and the Controls and Procedures Apply to Non U.S Public Companies and to Current Reports on Form 8-K, Proxy Materials and Information Statements? - It should be noted that the certification and Controls and Procedures apply to annual reports filed by Foreign Private issuers on Forms 20-F and 40-F. Although the certification is not required for reports of Foreign Private Issuers on Form 6-K,

22.14

Advance Auditing and Professional Ethics

the Disclosure Controls and Procedures for generating a 6-K, especially those incorporating financial data, must be in place. These Controls and Procedures should be designed to ensure timely filing of Form 6-K reports via EDGAR (required since November 4, 2002) and to ensure that all information included in a Form 6-K is complete and accurate in all material respects. Current reports such as reports on Forms 8-K, 6-K, proxy materials and information statements are not covered by the Section 302 certification requirement. Disclosure Controls and Procedures for these reports however, are required to be designed, maintained and evaluated to ensure full and timely disclosure even though there is no certification requirement. In this connection, companies should build in to their Disclosure Controls and Procedures the mechanisms necessary to allow them to comply with a proposed amendment of the SEC which would require them to report on Form 8-K, 22 categories of events within two days of their occurrence. [Certain materials of this section are sourced from Carter , Ledyard and Milburn LLP for which we acknowledge them with thanks]

23 PROFESSIONAL ETHICS

Introduction 23.1 The International Federation of Accountants (IFAC), in its guidelines on Professional Ethics for the Accountancy Profession, has stated: “Persons who pursue a vocation in which they offer their knowledge and skills in the service of the affairs of others have responsibilities and obligations to those who rely on their work. An essential pre-requisite for any group of such persons is the acceptance and observance of professional, ethical standards regulating their relationship with clients, employers, employees, fellow members of the group and the public generally.” Objectives 23.2 The Code recognizes that the objectives of the accountancy profession are to work to the highest standards of professionalism, to attain the highest levels of performance and generally to meet the public interest requirement. IFAC in its Code of Ethics for Professional Accountants has also stated as under: 23.2.1 The Public Interest - A distinguishing mark of a profession is acceptance of its responsibility to the public. The accountancy profession’s public consists of clients, credit grantors, governments, employers, employees, investors, the business and financial community, and others who rely on the objectivity and integrity of professional accountants to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on the accountancy profession. The public interest is defined as the collective well-being of the community of people and institutions the professional accountant serves These objectives require four basic needs to be met: Credibility - In the whole of society there is a need for credibility in information and information systems. Professionalism - There is a need for individuals who can be clearly identified by clients, employers and other interested parties as professional persons in the accountancy field Quality of Services - There is a need for assurance that all services obtained from a professional accountant are carried out to the highest standards of performance

23.2

Advanced Auditing and Professional Ethics

Confidence - Users of the services of professional accountants should be able to feel confident that there exists a framework of professional ethics which governs the provision of those services Fundamental Principles 23.3 In order to achieve the objectives of the Accountancy profession, professional accountants have to observe a number of prerequisites or fundamental principles. The fundamental principles are: Integrity - A professional accountant should be straightforward and honest in performing professional services. Objectivity - A professional accountant should be fair and should not allow prejudice or bias, conflict of interest or influence of others to override objectivity. Professional competence - A professional accountant should perform professional services with due care, competence and diligence and has a continuing duty to maintain professional knowledge and skill at a level required to ensure that a client or employer receives the advantage of competent professional service based on up-to-date developments in practice, legislation and techniques Due Professional Care - It dose not require ultimate expert but does extend to every aspect of the audit including the evaluation of audit risk, the formulation of audit objective, the establishment of audit scope, the selection of audit tests and the evaluation of test result. It requires an individual to exercise the Skill of a level commonly possessed by practioners of that specialty Confidentiality - A professional accountant should respect the confidentiality of information acquired during the course of performing professional services and should not use or disclose any such information without proper and specific authority or unless there is a legal or professional right or duty to disclose Professional Behaviour - A professional accountant should act in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession. The obligation to refrain from any conduct which might bring discredit to the profession requires IFAC member bodies to consider, when developing ethical requirements, the responsibilities of a professional accountant to clients, third parties, other members of the accountancy profession, staff, employers and the general public Technical Standards - A professional accountant should carry out professional services in accordance with the relevant technical and professional standards. Professional accountants have a duty to carry out with care and skill, the instructions of the client or employer in-so-far as they are compatible with the requirements of integrity, objectivity and in the case of professional accountants in public practice, independence. In addition they should conform with the technical and professional standards promulgated by: ♦ ♦

IFAC (e.g. International Standards on Auditing); International Accounting Standards Board;

Professional Ethics ♦ ♦

23.3

The Member’s professional body or other regulatory body; and Relevant legislation.

The Chartered Accountants Act, 1949 23.4 The Chartered Accountants Act, 1949 (No. 38 of 1949) came into force on the 1st day of July, 1949. Later in the year 1959, certain amendments were made therein through the Chartered Accountants (Amendment) Act, 1959 (No.15 of 1959). After about 47 years extensive changes have been made in the Act through the Chartered Accountants (Amendment) Act, 2006 (No.9 of 2006) which have been notified by the Central Government in the Gazette of India (Extra Ordinary) dated 23rd March, 2006. The entire Act is divided in nine chapters [Including chapter VIII A inserted by Chartered Accountants(Amendment) Act, 2006] The Complete enumeration of Contents is given below: Chapter I - Preliminary 1.

Short title, Extent and Commencement

2.

Interpretation

This Chapter contains preliminary aspects of the Act like applicability of the Act, definition of various terms like, Chartered Accountant, Council, holder of a restricted certificate, Registered Accountant etc Chapter II - The Institute of Chartered Accountants of India 3.

Incorporation of the Institute

4.

Entry of names in the Register

5.

Fellows and Associates

6.

Certificate of Practice

7.

Members to be known as Chartered Accountants

8.

Disabilities

This chapter deals with various things like who shall be entitled to have his name entered in the register of members of the institute, who shall be deemed to have become an associate member of the Institute, who shall be entered in the Register as a fellow of the Institute. This Chapter also deals with issues relating to certificate of practice and disabilities of a person for having his name entered in the Register. Chapter III - Council of the Institute 9.

Constitution of the Council of the Institute

10. Re-election or re-nomination to Council [Substituted by Chartered Accountants (Amendment) Act, 2006]

23.4

Advanced Auditing and Professional Ethics

10A. Settlement of dispute regarding election [Inserted by Chartered Accountants (Amendment) Act, 2006] 10B. Establishment of Tribunal [Inserted by Chartered Accountants (Amendment) Act, 2006] 11. Nomination in default of election or nomination 12. Presidents and Vice-President 13. Resignation of Membership and casual Vacancies 14. Duration and dissolution of the Council 15. Function of the Council 15A. Imparting education by Universities and Other bodies [Inserted by Chartered Accountants (Amendment) Act, 2006] 16. Officers and employees, salary, allowances etc.[substituted by Chartered Accountants (Amendment) Act, 2006] 17. Committees of the Council 18. Finances of the Council This Chapter deals with various issues like composition of Council of the Institute, manner of conducting election to the Council, mode of tendering resignation from the membership of the Council mode of filling a casual vacancy, various duties o the Council.. This Chapter also deals with the permission accorded to any University established by law or any body affiliated to the Institute to impact education on the subjects covered by the academic courses of the Institute etc. Chapter IV - Register of Members 19. Register of Members 20. Removal from the Register This chapter deals with the matter relating to register of members and removal from the register the name of any member. The Council has to maintain a Register of Members of the Institute. This Register shall include name, date of birth, domicile, residential and professional address, qualification etc. Also the Council may remove from the Register the name of any member in certain circumstances like in case of death of the member or if the member does not pay the prescribed fees, or when a member has become subject to any of the disabilities mentioned in section 8 etc Chapter V - Misconduct 21. Disciplinary Directorate [Substituted by Chartered Accountant (Amendment) Act, 2006] 21A. Board of Discipline [Inserted by Chartered Accountants (Amendment) Act, 2006] 21B. Disciplinary Committee [Inserted by Chartered Accountant (Amendment) Act, 2006] 21C. Authority, Disciplinary Committee, Board of Discipline and Director (Discipline) to have powers of civil court [Inserted by Chartered Accountants (Amendment) Act, 2006]

Professional Ethics

23.5

21D. Transitional provisions [Inserted by Chartered Accountants (Amendment) Act, 2006] 22. Professional or other misconduct defined [Substituted by Chartered Accountants (Amendment) Act, 2006] 22A. Constitution of Appellate Authority [Substituted by Chartered Accountants (Amendment) Act, 2006] 22B. Term of office of Chairperson and members of Authority [Inserted by Chartered Accountants (Amendment) Act, 2006]. 22C. Allowances and conditions of service of Chairperson and Members of Authority (Inserted by CA (Amendment) Act, 2006) 22D. Producer to be regulated by Authority [Inserted by Chartered Accountants (Amendment) Act, 2006] 22E. Officers and other staff of Authority [Inserted by Chartered Accountants (Amendment) Act, 2006] 22F. Resignation and removal of Chairperson and Members [Inserted by Chartered Accountants (Amendment) Act, 2006)] 22G. Appeal to Authority [Inserted by Chartered Accountants (Amendment) Act, 2006] In this chapter professional and other misconduct has been defined. As per section 22 of the Act, the expression " professional or other misconduct " shall be deemed to include any act or omission provided in any of the Schedules. In this chapter, Section 21, 22 and 22A have been substituted by new sections 21, 22 and 22A. Other sections (Section 21A, 21B, 21C, 21D, 22B, 22C, 22D, 22E, 22F and 22G) have been inserted by Chartered Accountants (Amendment) Act, 2006. These Sections along with the Schedules deal with the new Disciplinary Mechanism Chapter VI - Regional Councils 23. Constitution and Functions of Regional Councils The Councils may constitute such Regional Councils for the purpose of advising and assisting it on matters concerning its functions. The Regional councils shall exercise prescribed functions. Chapter VII - Penalties 24. Penalty for falsely claiming to be a member etc. 24A. Penalty for using name of the Council, awarding degree of Chartered Accountancy etc. 25. Companies not to engage in accountancy 26. Unqualified persons not to sign documents 27. Maintenance of branch offices 28. Sanction to prosecute This chapter lists penalties in version cases like, if a person who is not a member of the institute and he represents himself as a member of the Institute or he uses the designation Chartered Accountant, he shall be punishable with fine which may extend to one thousand rupees (on first

23.6

Advanced Auditing and Professional Ethics

conviction) and with imprisonment which may extend to six months or with fine which may extend to five thousand rupees or with fine which may extend to five thousand rupees or with both (on subsequent conviction). Other provisions regarding penalties that are included in this chapter provide that a Company (Incorporated in or outside India) shall not practice as Chartered Accountant, a person other than a member of the Institute shall not sign any document an behalf of a Chartered Accountant in practice or a firm of such Chartered Accountants in his or its professional capacity etc Chapter VII A Quality Review Board [Inserted by Chartered Accountants (Amendment) Act, 2006 28A. Establishment of Quality Review Board 28B. Functions of Board 28C. Procedure of Board 28D. Terms and conditions of services of Chairperson and Members of Board and its expenditure After Chapter VII, the Chapter VIIA has been inserted by the Chartered Accountants (Amendment) Act, 2006. It empowers the Central Government to constitute a Quality Review Board outside the framework of the Institute. It will perform the functions like, to make recommendations to the council with regard to the quality of services provided by the members of the Institute, to review the quality of services provided by the members of the Institute including audit services and to guide the members of the institute to improve the quality of services and adherence to the various statutory and other regulatory requirements. Chapter VIII – Miscellaneous 29. Reciprocity 30. Power to make regulations 30A. Powers of the Central Government to direct regulation to be made or to make or amend regulations 30B. Rules, Regulations and notification to be laid before Parliament [Substituted by Chartered Accountants (Amendment) Act, 2006] 30C. Power of Central Government to issue directions [Inserted by Chartered Accountants (Amendment) Act, 2006)] 30D. Protection of action taken in good faith [Inserted by Chartered Accountants (Amendment) Act, 2006)] 30E. Members etc to be public servants [Inserted by Chartered Accountants (Amendment) Act, 2006)] 31. Construction of References 32. Act not to affect right of accountants to practice as such in Acceding States.

Professional Ethics

23.7

This Chapter contains miscellaneous provisions. It empowers the Council to prescribe the conditions subject to which foreign qualifications relating to accountancy shall be recognized for the purpose of entry in the Register. It also empowers the Council to make regulations for the purpose of carrying out the objects of this Act. It also empowers the Central Government to direct the Council to make any regulations or to amend or revoke any regulations already made. Section 30C, 30D, and 30E have been inserted by Chartered Accountants (Amendment) Act, 2006. Section 30C empowers the Central Government to issue directions in the event of noncompliance by the Council of any provisions of the Act. Section 30D protests Central Government, Council, Authority Disciplinary Committee, Tribunal, Board, Board of Discipline, Disciplinary Directorate or any officer thereof, for anything which is in good faith done or intended to be done under this Act or any rule, regulation, notification, direction or order made there under. Section 30E says that The Chairperson, Presiding officer, Members and other officers and employees of the Authority, Disciplinary Committee, Tribunal, Board, Board of Discipline or the Disciplinary Directorate shall be deemed to be public servants within the meaning of Section 21, of the Indian Penal Code. Schedules 23.5 There are two schedules: 23.5.1 The First Schedule - The First Schedule has four parts [Including part IV inserted by Chartered Accountants (Amendment) Act, 2006]. Part 1 of first Schedule deals with the professional misconduct in relation to Chartered Accountant in practice. Part II deals with the professional misconduct in relation to members of the Institute in service. Part III deals with the professional misconduct in relation to members of the Institute generally. Part IV deals with other misconduct in relation to members of the institute generally. 23.5.2 The Second Schedule - The Second Schedule has three parts [Including Part III insulted by Chartered Accountants (Amendment) Act, 2006], Part 1 of Second Schedule deals with the professional misconduct in relation to Chartered Accountants in practice. Part II deals with the professional misconduct in relation to member of the Institute generally. Part III deals with the other misconduct in relation to members of the Institute generally. Members who are deemed to be in practice 23.6 Every member of the Institute is entitled to designate himself as a Chartered Accountant. There are two classes of members, .those who are in practice and those who are otherwise occupied. In Section 2(2) of the Act, the term “to be in practice” has been defined as follows: “A member of the Institute shall be deemed “to be in practice” when individually or in partnership with Chartered Accountants in practice, he, in consideration of remuneration received or to be received(i)

engages himself in the practice of accountancy; or

(ii)

offers to perform or performs service involving the auditing or verification of financial transactions, books, accounts or records, or the preparation, verification or certification of financial accounting and related statements or holds himself out to the public as an accountant; or

23.8

Advanced Auditing and Professional Ethics

(iii) renders professional services or assistance in or about matters of principle or detail relating to accounting procedure or the recording, presentation or certification of financial facts or data; or (iv) renders such other services as, in the opinion of the Council, are or may be rendered by a Chartered Accountant in practice: and the words “to be in practice” with their grammatical variations and cognate expressions shall be construed accordingly. Explanation - An associate or a fellow of the Institute who is a salaried employee of a Chartered Accountant in practice or a firm of such Chartered Accountants shall, notwithstanding such employment, be deemed to be in practice for the limited purpose of the training of Articled Clerks”. Pursuant to Section 2(2) (iv) above, the Council has passed a resolution permitting a Chartered Accountant in practice to render entire range of “Management Consultancy and other Services”. The definition of the expression “Management Consultancy and other Services” is given below: The expression “Management Consultancy and other Services” shall not include the function of statutory or periodical audit, tax (both direct taxes and indirect taxes) representation or advice concerning tax matters or acting as liquidator, trustee, executor, administrator, arbitrator or receiver, but shall include the following (i) Financial management planning and financial policy determination.* (ii) Capital structure planning and advice regarding raising finance.* (iii) Working capital management.* (iv) Preparing project reports and feasibility studies.* (v) Preparing cash budget, cash flow statements, profitability statements, statements of sources and application of funds etc. (vi) Budgeting including capital budgets and revenue budgets. (vii) Inventory management, material handling and storage. (viii) Market research and demand studies. (ix) Price-fixation and other management decision making. (x) Management accounting systems, cost control and value analysis. (xi) Control methods and management information and reporting. (xii) Personnel recruitment and selection. (xiii) Setting up executive incentive plans, wage incentive plans etc. (xiv) Management and operational audits.

* Consideration of “ tax implications” while rendering the services at (i), (ii), (iii) and (iv) above will be considered as part of “ Management Consultancy and other services”.

Professional Ethics

23.9

(xv) Valuation of shares and business and advice regarding amalgamation, merger and acquisition. (xvi) Business Policy, corporate planning, organisation development, growth and diversification. (xvii) Organisation structure and behaviour, development of human resources including design and conduct of training programmes, work study, job-description, job evaluation and evaluation of work loads. (xviii) Systems analysis and design, and computer related services including selection of hardware and development of software in all areas of services which can otherwise be rendered by a Chartered Accountant in practice and also to carry out any other professional services relating to EDP. (xix) Acting as advisor or consultant to an issue, including such matters as: (a) Drafting of prospectus and memorandum containing salient futures of prospectus. Drafting and filing of listing agreement and completing formalities with Stock Exchanges, Registrar of Companies and SEBI. (b) Preparation of publicity budget, advice regarding arrangements for selection of (i) admedia, (ii) centres for holding conferences of brokers, investors, etc., (iii) bankers to issue, (iv) collection centres, (v) brokers to issue, (vi) underwriters and the underwriting arrangement, distribution of publicity and issue material including application form, prospectus and brochure and deciding on the quantum of issue material (In doing so, the relevant provisions of the Code of Ethics must be kept in mind). (c) Advice regarding selection of various agencies connected with issue, namely Registrars to Issue, printers and advertising agencies. (d) Advice on the post issue activities, e.g., follow up steps which include listing of instruments and despatch of certificates and refunds, with the various agencies connected with the work. Explanation - For removal of doubts, it is hereby clarified that the activities of broking, underwriting and portfolio management are not permitted. (xx) Investment counselling in respect of securities [as defined in the Securities Contracts (Regulation) Act, 1956 and other financial instruments.] (In doing so, the relevant provisions of the Code of Ethics must be kept in mind). (xxi) Acting as registrar to an issue and for transfer of shares/other securities. (In doing so, the relevant provisions of the Code of Ethics must be kept in mind). (xxii) Quality Audit. (xxiii) Environment Audit. (xxiv) Energy Audit. (xxv) Acting as Recovery Consultant in the Banking Sector.

23.10

Advanced Auditing and Professional Ethics

(xxvi) Insurance Financial Advisory Services under the Insurance Regulatory & Development Authority Act, 1999, including Insurance Brokerage.* Pursuant to Section 2(2) (iv) of the Chartered Accountants Act, 1949, read with Regulation 191 of Chartered Accountants Regulations, 1988 a member shall be deemed to be in practice if he, in his professional capacity and neither in his personal capacity nor in his capacity as an employee, acts as a liquidator, trustee, executor, administrator, arbitrator, receiver, adviser or representative for costing, financial or taxation matters or takes up an appointment made by the Central Government or a State Government or a court of law or any other legal authority or acts as a Secretary unless his employment is on a salary-cum-full-time basis. It is necessary to note that a person is deemed to be in practice not only when he is actually engaged in the practice of accountancy but also when he offers to render accounting services whether or not he in fact does so. In other words, the act of setting up of an establishment offering to perform accounting services would tantamount to being in practice even though no client has been served. A member of the Institute is deemed to be in practice during the period he renders ‘service with armed forces’. Significance of the certificate of Practice 23.7 A member who is not in practice is precluded from accepting engagement to render services of any of the types normally prescribed for a Chartered Accountant, even though for doing so, he does not require special qualifications. The Council of the institute is of view that (i)

Once the person concerned becomes a member of The Institute, he is bound by the provisions of the Chartered Accountants Act and its Regulations. If and when he appears before the Income-tax Tribunal as an Income-tax representative after having become a member of the Institute, he could so appear only in his capacity as a Chartered Accountant and a member of the Institute. Having, as it were, brought himself within the jurisdiction of the Chartered Accountants Act and its Regulations, he could not set them at naught by contending that even though he continues to be a member of the Institute and has been punished by suspension from practice as a member, he would be entitled, in substance, to practice in some other capacity.

(ii)

A member of the Institute can have no other capacity in which he can take up such practice, separable from his capacity to practice as a member of the Institute.” For example a member of the institute who was in practice till the 10th November, 1954, was by an order of the high Court dated 11th November, 1954 suspended from practice for a period of six months though not removed from membership. [Ref . A.C. Kaher in Re :- Page 64 of Vol. IV (1) of Disciplinary Cases]. Pursuant to the order of the High Court, He was asked to

*

Pursuant to power under Section 2(2) of the Chartered Accountants Act, 1949, the Council at its 245th Meeting held form 31 August 2004 to 2nd September 2004 has decided to include “ Insurance Financial Advisory Services under the Insurance Regulatory and Development Authority Act ,1999 including Insurance Brokerage within the definition of ‘Management Consultancy & Other Services.’

Professional Ethics

23.11

surrender the Certificate of Practice issued to him for the period of suspension, which he did. He however, wrote to the Institute enquiring whether he could practice as an income tax practitioner under Section 61 of the Indian Income Tax Act 1922 being qualified otherwise than as a chartered Accountant to do so. In reply he was informed that if a member acted as a representative in taxation matters, he would be deemed to be in practice as a Chartered Accountant, and his attention in this connection was drawn to section 2(2) of the Chartered Accountants Act and Regulation 78 of the Chartered Accountants Regulation 1949. He wrote back to the Institute saying that he was not “going in for practice as Chartered Accountant but doing income-tax cases as per the provision of section 61 (iv) (a), (b) and (c) of the Indian Income tax Act, 1922”. He also stated that in his opinion Section 2(2) of the Chartered Accountants Act did not supersede Section 61 of the Indian Income tax Act and that he was entitled to practice as an Income tax practitioner even before becoming a member of the Institute and he had only resumed this work since he could not practice as a Chartered Accountant. He was again informed by the Institute that he continued to be member of the Institute but he was only suspended from practice under the order of the High Court for a period of six months, and that he should comply with the provision of the Act and the Regulations in so far as they were applicable to member of the Institute. Therefore A Chartered Accountant whose name has been removed from the membership for professional and/or other misconduct, during such period of removal, will not appear before the various tax authorities or other bodies before whom he could have appeared in his capacity as a member of this Institute 23.7.1 A Member in practice is prohibited from using a Designation other than Chartered Accountant (i)

The member of the Institute are now permitted to use the word 'CA' as prefix before their name irrespective of the fact that are in practice or not

(ii)

Under Section 7 of the Chartered Accountants Act, 1949 a member in practice cannot use any designation other than that of a Chartered Accountant, nor can he use any other description, whether in addition thereto or in substitution therefore, but a member who is not in practice and does not use the designation of a Chartered Accountant may use any other description. Nevertheless a member in practice may use any other letters or description indicating membership of Accountancy Bodies which have been approved by the Council or of bodies other than Accountancy Institutes so long as such use does not imply adoption of a designation and/or does not amount to advertisement or publicity For example, though a member cannot designate himself as a Cost Accountant, he can use the letters A.I.C.W.A. after his name, when he is a member of that Institute

(iii) The members may apply for and obtain registration as category IV Merchant Banker under the SEBI’s rules and regulations and act as Advisor or Consultant to an issue. In client Companies’ offer documents and advertisements regarding capital issue, name and address of the Chartered Accountant or firm of Chartered Accountants acting as Advisor or Consultant to the Issue could be indicated under the caption “Advisor/Consultant to the Issue”. However, the name and address of such Chartered Accountant/firm of Chartered

23.12

Advanced Auditing and Professional Ethics

Accountants should not appear prominently. Chartered accountants or firms of Chartered Accountants acting as Advisor or Consultant to an Issue should ensure that the description ‘Merchant Banker” is not associated with their names in the offer documents and/or advertisements regarding capital issue of their client Companies. The mention of the name of Chartered Accountant/firm under the caption ‘Merchant Banker’ could be misleading, as there ware four categories of Merchant Bankers and the members of the profession were permitted to register only as category IV ‘Merchant Bankers’, i.e. to act only as Advisor or Consultant to an Issue. Further, such members and firms should not use the designation of either ‘Merchant Banker’ or Advisor/Consultant to Issue’ in their own letterheads, visiting cards, professional documents, etc. As per Regulation 3(2A) of SEBI (Merchant Bankers) Regulations, 1992, with effect from 9th December, 1997 registration as category IV Merchant Banker has been dispensed with. Disabilities for Purpose of Membership 23.8 Section 8 of the Act enumerates the circumstances under which a person is debarred from having his name entered in or borne on the Register of Members, as follows: (i)

If he has not attained the age of twenty one years at the time of his application for the entry of his name in the Register; or

(ii)

If he is of unsound mind and stands so adjudged by a competent court; or

(iii) If he is an undischarged insolvent; or (iv)

If he, being a discharged insolvent, has not obtained from the court a certificate stating that his insolvency was caused by misfortune without any misconduct on his part; or

(v) If he has been convicted by a competent Court whether within or without India, of an offence involving moral turpitude and punishable with transportation or imprisonment or of an offence, not of a technical nature, committed by him in his professional capacity unless in respect of the offence committed he has either been granted a pardon or, on an application made by him in this behalf, the Central Government has, by an order in writing, removed the disability; or (vi) If he has been removed from membership of the Institute on being found on inquiry to have been guilty of professional or other misconduct; Provided that a person who has been removed from membership for a specified period, shall not be entitled to have his name entered in the Register until the expiry of such period. Failure on the part of a person to disclose the fact that he suffers from any one of the disabilities aforementioned would constitute professional misconduct. The name of the person, who is found to have been subject at any time to any of the disabilities aforementioned, can be removed from the Register of Members by the Council (Section 20). Disciplinary Procedure 23.9 Amended provisions of the Chartered Accountant, Act, 1949 regarding (i)

Disciplinary Directorate,

(ii)

Board of Discipline,

Professional Ethics

23.13

(iii) Disciplinary Committee, (iv) Appellate Authority and procedure in enquiries for disciplinary matters relating to misconduct of the members of the Institute as per amendment Act No. 9 of 2006 assented by the president of India on 22nd march 2006 and published in Gazette of India on 23rd March 2006 are as hereunder; Flow Chart of Discipline Procedure Mechanism Complaint against member of ICAI of allege misconduct alongwith prescribed fee.

Disciplinary Directorate

The Director (Discipline) shall arrive at a prima facie opinion on the occurrence of alleged misconduct and decide whether he is guilty of professional or other misconduct falling in

Second schedule or Both Schedule

First Schedule

Place the matter before

Place the matter before

Board of Discipline

Disciplinary Committee

If found guilty,it can reprimand the member remove name of the member upto permanent or for any duration (iii) impose fine upto Rs. 100.00 (i) (ii)

if found guilty, it can (i) reprimand the member (ii) reprimand the name of 3 months member (iii) impose fine upto Rs. 5,00,000

Any member aggrieved by order of Board of Disciplinary Committee can prefer an appeal within 90 days before.

Appellate Authority It can (i) Confirm, modify or set aside the order, (ii) Impose, Set aside, Reduce or enhance penalty. (iii) remit the case to the Board of Discipline or Disciplinary Committee for reconsideration (iv) Pass such order as the Authority thinks fit.

23.14

Advanced Auditing and Professional Ethics

23.9.1 Section 21 Disciplinary Directorate – (1) The Council shall, by notification, establish a Disciplinary Directorate headed by an officer of the Institute designated as Director (Discipline) and such other employees for making investigations in respect of any information or complaint received by it. (2) On receipt of any information or complaint along with the prescribed fee, the Director (Discipline) shall arrive at a prima facie opinion on the occurrence of the alleged misconduct. (3) Where the Director (Discipline) is of the opinion that a member is guilty of any professional or other misconduct mentioned in the First Schedule, he shall place the matter before the Board of Discipline and where the Director (Discipline) is of the opinion that a member is guilty of any professional or other misconduct mentioned in the Second Schedule or in both the Schedules, he shall place the matter before the Disciplinary Committee. (4) In order to make investigations under the provisions of this Act, the Disciplinary Directorate shall follow such procedure as may be specified. (5) Where a complainant withdraws the complaint, the Director (Discipline) shall place such withdrawal before the Board of Discipline or, as the case may be, the Disciplinary Committee, and the said Board or Committee may, if it is of the view that the circumstances so warrant, permit the withdrawal at any stage.. 23.9.2 Section 21A. Board of Discipline (1) The Council shall constitute a Board of Discipline consisting of (a) a person with experience in law and having knowledge of disciplinary matters and the profession, to be its presiding officer; (b) two members one of whom shall be a member of the Council elected by the Council and the other member shall be the nominated by the Central Government from amongst the persons of eminence having experience in the field of law, economics, business, finance or accountancy; (c) the Director (Discipline) shall function as the Secretary of the Board. (2) The Board of Discipline shall follow summary disposal procedure in dealing with all cases before it. (3) Where the Board of Discipline is of the opinion that a member is guilty of a professional or other misconduct mentioned in the First Schedule, it shall afford to the member an opportunity of being heard before making any order against him and may thereafter take any one or more of the following actions, namely: (a) reprimand the member; (b) remove the name of the member from the Register up to a period of three months; (c) impose such fine as it may think fit, which may extend to rupees one lakh. (4) The Director (Discipline) shall submit before the Board of Discipline all information and complaints where he is of the opinion that there is no prima facie case and the Board of

Professional Ethics

23.15

Discipline may, if it agrees with the opinion of the Director (Discipline), close the matter or in case of disagreement, may advise the Director (Discipline) to further investigate the matter. 23.9.3 Section 21B. Disciplinary Committee (1) The Council shall constitute a Disciplinary Committee consisting of the President or the Vice-President of the Council as the Presiding Officer and two members to be elected from amongst the members of the Council and two members to be nominated by the Central Government from amongst the persons of eminence having experience in the filed of law, economics, business, finance or accountancy: Provided that the Council may constitute more Disciplinary Committees as and when it considers necessary. (2) The Disciplinary Committee, while considering the cases placed before it shall follow such procedure as may be specified. (3) Where the Disciplinary Committee is of the opinion that a member is guilty of a professional or other misconduct mentioned in the Second Schedule or both the First Schedule and the Second Schedule, it shall afford to the member an opportunity of being heard before making any order against him and may thereafter take any one or more of the following actions, namely: (a) reprimand the member; (b) remove the name of the member from the Register permanently or for such period, as it thinks fit; (c) impose such fine as it may think fit, which may extend to rupees five lakh. (4) The allowances payable to the members nominated by the Central Government shall be such as may be specified. 23.9.4 Section 21C. Authority, Disciplinary Committee, Board of Discipline and Director (Discipline) to have powers of civil court - For the purposes of an inquiry under the provisions of this Act, the Authority, the Disciplinary Committee, Board of Discipline and the Director (Discipline) shall Slave the same powers as are vested in a civil court under the Code of Civil Procedure, 1908 (5 of 1908), in respect of the following matters, namely: (a) summoning and enforcing the attendance of any person and examining him on oath; (b) the discovery and production of any document; and (c) receiving evidence on affidavit. Explanation : for the purposes of sections 21, 21A, 21B, 21C and 22, “member of the Institute” includes a person who was a member of the Institute on the date of the alleged misconduct although he has ceased to be a member of the Institute at the time of the inquiry 23.9.5 Section 21 D. Transitional provisions - All complaints pending before the Council or any inquiry initiated by the Disciplinary Committee or any reference or appeal made to a High Court prior to the commencement of the Chartered Accountants (Amendment) Act, 2006, shall

23.16

Advanced Auditing and Professional Ethics

continue to be governed by the provisions of this Act, as if this Act had not been amended by the Chartered Accountants (Amendment) Act, 2006.’ 23.9.6 Section 22A.Constitution of Appellate Authority (1) The Central Government shall, by notification, constitute an Appellate Authority consisting of (a) a person who is or has been a judge of a High Court, to be its Chairperson; (b) two members to be appointed from amongst the persons who have been members of the Council for at least one full term and who is not a sitting member of the Council; (c) two members to be nominated by the Central Government from amongst persons having knowledge and practical experience in the field of law, economics, business, finance or accountancy. (2) The Chairperson and other members shall be part-time members. 23.9.7 Section 22B.Term of office of Chairperson and members of Authority (1) A person appointed the Chairperson shall hold office for a term of three years from the date on which he enters upon his office or until he attains the age of sixty-five years, whichever is earlier. (2) A person appointed as a member shall hold office for a term of three years from the date on which he enters upon his office or until he attains the age of sixty-two years, whichever is earlier. 23.9.8 Section 22C. Allowances and conditions of service of Chairperson and members of Authority- The allowances payable to, and other terms and conditions of service of, the Chairperson and members are the manner of meeting expenditure of the Authority by the Council and such other authorities shall be such as may be specified. 23.9.9 Section 22D. Procedure to be regulated by Authority (1) The office of the Authority shall be at Delhi. (2) The Authority shall regulate its own procedure. (3) All orders and decisions of the Authority shall be authenticated by an officer duly authorised by the Chairperson in this behalf. 23.9.10 Section 22E. Officers and other staff of Authority (1) The Council shall make available to the Authority such officers and other staff members as may be necessary for the efficient performance of the functions of the Authority. (2) The salaries and allowances and conditions of service of the officers and other staff members of the Authority shall be such as may be prescribed. 23.9.11 Section 22F.Resignation and removal of Chairperson and members (1) The Chairperson or a member may, by notice in writing under his hand addressed to the Central Government, resign his office:

Professional Ethics

23.17

Provided that the Chairperson or a member shall, unless he is permitted by the Central Government to relinquish his office sooner, continue to hold office until the expiry of three months from the date of receipt of such notice or until a person duly appointed as his successor enters upon his office or until the expiry of term of office, whichever is earlier. (2) The Chairperson or a member shall not be removed from his office except by an order of the Central Government on the ground of proved misbehaviour or incapacity after an inquiry made by such person as the Central Government may appoint for this purpose in which the Chairperson or a member concerned has been informed of the charges against him and given a reasonable opportunity of being heard in respect of such charges. 23.9.12 Section 22G.Appeal to Authority(1) Any member of the Institute aggrieved by any order of The Board of Discipline or the Disciplinary Committee imposing on him any of the penalties referred to in sub-section (3) of section 21A and sub-section (3) of section 21B, may within ninety days of the date on which the order is communicated to him, prefer an appeal to the Authority: Provided that the Director (Discipline) may also appeal against the decision of the Board of Discipline or the Disciplinary Committee to the Authority, if so authorised by the Council, within ninety days: Provided further that the Authority may entertain any such appeal after the expiry of the said period of ninety days, if it is satisfied that there was sufficient cause for not filing the appeal in time. (2) The Authority may, after calling for the records of any case, revise any order made by the Board of Discipline or the Disciplinary Committee under sub-section (3) of section 21A and sub-section (3) of section 21B and may (a) confirm, modify or set aside the order; (b) impose any penalty or set aside, reduce, or enhance the penalty imposed by the order; (c) remit the case to the Board of Discipline or Disciplinary Committee for such further enquiry as the Authority considers proper in the circumstances of the case; or (d) pass such other order as the Authority thinks fit: Provided that the Authority shall give an opportunity of being heard to the parties concerned before passing any order.” Professional Misconduct 23.10 For the purposes of this Act, the expression “professional or other misconduct” shall be deemed to include any act or omission provided in any of the Schedules, but nothing in this section shall be construed to limit or abridge in any way the power conferred or duty cast on the Director (Discipline) under sub-section (1) of section 21 to inquire into the conduct of any member of the Institute under any other circumstances.’.

23.18

Advanced Auditing and Professional Ethics

23.10.1 Other Misconduct - A member is liable to disciplinary action under Section 21 of the Chartered Accountants Act, if he is found guilty of any professional or “Other Misconduct”. Other misconduct has been defined in part IV of the First Schedule an part III of the Second Schedule[ Newly inserted parts by Chartered Accountants (Amendment) Act,. 2006]. As per part IV of the First Schedule to the Chartered Accountants Act, A member of the Institute, whether in practice or not, shall be deemed to be guilty of other misconduct, if he(1) is held guilty by any civil or criminal court for an offence which is punishable with imprisonment for a term not exceeding six months; (2) in the opinion of the Council, brings disrepute to the profession or the Institute as a result of his action whether or not related to his professional work. As per Part III of the Second Schedule to the Chartered Accountants Act, A member of the Institute, whether in practice or not, shall be deemed to be guilty of other misconduct, if he is held guilty by any civil or criminal court for an offence which is punishable with imprisonment for a term exceeding six months This provision empowers the Council to inquiry into any misconduct of a member even it does not arise out of his professional work. This is considered necessary because a chartered accountant is expected to maintain the highest standards of integrity even in his personal affairs and any deviation from these standards, even in his non-professional work, would expose him to disciplinary action. For example, a member who is found to have forged the will of a relative, would be liable to disciplinary action even though the forgery may not have been done in the course of his .professional duty. Other misconduct would also relate to conviction by a competent court for an offence involving moral turpitude punishable with cause transportation or imprisonment to an offence not of a technical nature committed by the member in his professional capacity [See section 8(v) of the Act]. Some illustrative examples, where a member may be found guilty of “Other Misconduct”, under the aforesaid provisions rendering, himself unfit to be member are: (i)

Where a chartered accountant retains the books of account and documents of the client and fails to return these to the client on request without a reasonable cause.

(ii)

Where a chartered accountant makes a material misrepresentation.

(iii) Where a chartered accountant uses the services of his articled or audit clerk for purposes other than professional practice. (iv) Conviction by a competent court of law for any offence under Section 8 (v) of the Chartered Accountants Act 1949. (v) Misappropriation by office-bearer of a Regional Council of the Institute, of a large amount and utilisation thereof for his personal use. (vi) Non-replying within a reasonable time and without a good cause to the letter of the public authorities.

Professional Ethics

23.19

(vii) Where certain assessment records of income tax department belonging to the client of Chartered Accountant were found in the almirah of the bed-room of the chartered accountant. (viii) Where a chartered accountant had adopted coercive methods on a bank for having a loan sanctioned to him. Penalty for Falsely claiming to be a Member Etc. 23.11 Section 24 of the Act provides - any person who (i)

not being a member of the Institute; (a) represents that he is a member of the Institute; or (b) uses the designation Chartered Accountant;

(ii)

being a member of the Institute, but not having a certificate of practice, represents that he is in practice or practices as a Chartered Accountant, shall be punishable on first conviction with fine which may extend to one thousand rupees, and on any subsequent conviction with imprisonment which may extend to six months or with fine which may extend to five thousand rupees, or with both. In a case under the above provision, the Court of Additional Chief Judicial Magistrate had by its judgement dated 18th July, 1989 found the accused guilty under Section 24 (i) (a) & (b) of the Chartered Accountants Act and Section 465 of the Indian Penal Code. The Court imposed a fine on the accused and in the event of his failure to pay the fine, sentenced to rigorous imprisonment for three months. (Case of Prem Batra decided on 18.7.1989 and published in September, 1989 issue of the Institute’s journal at Page 246),

Maintenance of Branch offices 23.12 In terms of Section 27 of the Act if a Chartered Accountant in practice or a Firm of Chartered Accountants has more than one office in India, each one of such offices should be in the separate charge of a member of the Institute. Failure on the part of a member or a firm to have a member in charge of its branch and a separate member in case of each of the branches, where there are more than one, would constitute professional misconduct. However, exemption has been given to members practicing in hill areas subject to certain conditions. The conditions are: . 1.

Such members/firm be allowed to open temporary offices in a city in the plains for a limited period not exceeding three months in a year.

2.

The regular office need not be closed during this period and all correspondence can continue to be made at the regular office.

3.

The name board of the firm in the temporary office should not be displayed at times other than the period such office is permitted to function as above.

4.

The temporary office should not be mentioned in the letterheads, visiting cards or any other documents as a place of business of the member/firm.

23.20 5.

Advanced Auditing and Professional Ethics

Before commencement of every winter it shall be obligatory on the member/firm to inform the Institute that he/it is opening the temporary office from a particular date and after the office is closed at the expiry of the period of permission, an intimation to that effect should also be sent to the office of the Institute by registered post.

It is necessary to mention that the Chartered Accountant in charge of the branch of another firm should be associated with him or with the firm either as a partner or as a paid assistant. If he is a paid assistant, he must be in whole time employment with him. The above rule applies having additional office is situated at a place beyond 50 Kms. from the municipal limits in which the office is situated. However, a member can be incharge of two offices if they are located in one and the same Accommodation. In this context the Council’s decisions are as follows: (1) Definition of Office: “A place where a name-board is fixed or where such place is mentioned in the letter-head or any other documents as a place of business.” (2) With regard to the use of the name-board, there will be no bar to the putting up of a nameboard in the place of residence of a member with the designation of Chartered Accountant, provided it is a name-plate or a name-board of an individual member and not of the firm. (3) The requirement of Section 27 in regard as to a member being in-charge of an office of a Chartered Accountant or a firm of such Chartered Accountants shall be satisfied only if the member is actively associated with such office. Such association shall be deemed to exist if the member resides in the place where the office is situated for a period of not less than 182 days in a year or if he attends the said office for a period of not less than 182 days in a year or in such other circumstances as, in the opinion of the Executive Committee, establishes such active association. The expression ‘member’ in the context of above, shall mean, where more than one member is designated as in-charge of an office, then, any one of them and when there is only one member and he leaves the firm during his successor(s) in office. (4) In view of the Council’s decision, however, the exemption may be granted under proviso to Section 27 ,(1) of the Chartered Accountants Act, 1949 to a member or a firm of Chartered Accountants in practice to have a second office without such second office being under the separate charge of a member of the Institute, provided (a) the second office is located in the same premises, in which the first office is located or (b) the second office is located in the same city, in which the first office is located or (c) the second office is located within a distance of 50 km. from the municipal limits of a city, in which the first office is located. A member having two offices of the type referred to above, shall have to declare, which of the two offices is his main office, which would constitute his professional address. (5) The expression ‘member’ in the above context shall mean, where more than one member is designated as in-charge of an office, then any such member and in other cases more than one member where a change in the designated member in-charge of an officio taxes plan during the year.

Professional Ethics

23.21

Schedules to the Act 23.13 Acts or omissions which comprise professional misconduct within the meaning of Section 22 of the Chartered Accountants Act are defined in two Schedules viz. The First Schedule and the Second Schedule. The First Schedule is divided into four parts, Part I of the First Schedule deals with the misconduct of a member in practice which would have the effect generally of compromising his position as an independent person. Part II deals with misconduct of members in services. Part-III deals with the misconduct of members generally and part IV deals with other misconduct in relation to members of the institute generally. The Second Schedule is divided into three parts. Part I deals with misconduct in relation to a member in practice, Part II deals with misconduct of members generally and part III deals with other misconduct in relation to members of the Institute generally. The implication of the different clauses in the schedules are discussed below: 23.13.1 The First Schedule - Where the Director (Discipline) is of the opinion that member is guilty of any professional or other misconduct mentioned in the First Schedule, he shall place the matter before the Board of Discipline. PART I - Professional misconduct in relation to Chartered Accountants in practice A Chartered Accountant in practice is deemed to be guilty of professional misconduct if he: Clause (1) allows any person to practice in his name as a chartered accountant unless such person is also a chartered accountant in practice and is in partnership with or employed by him; The above clause is intended to safeguard the public against unqualified accountant practicing under the cover of qualified accountant. It ensures that the work of the accountant will be carried out by a Chartered Accountant who may be his partner, or his employee and would work under his control and supervision. Clause (2) pays or allows or agrees to pay or allow, directly or indirectly, any share, commission or brokerage in the fees or profits of his professional business, to any person other than a member of the Institute or a partner or a retired partner or the legal representative of a deceased partner, or a member of any other professional body or with such other persons having such qualification as may be prescribed, for the purpose of rendering such professional services to time in or outside India; Explanation - In this item, “partner” includes a person residing outside India with whom a chartered accountant in practice has entered into partnership which is not in contravention of item (4) of this Part. Previously this clause was allowing sharing or disbursing fees or profits of professional business among the partners who were virtually members of the Institute. Otherwise payment was permissible to the legal representative of deceased partner's case only on a share in goodwill of firm. The Status of deceased case is unaltered but the amendment in Chartered Accountants Act, 1949 carried out by Act No. 9 of 2006 has changed scenario and permitted sharing of fees or profits among members of any other professional body or with such other persons having

23.22

Advanced Auditing and Professional Ethics

such qualifications as may be prescribed, for the purpose of rendering such, professional services from time to time in or outside India. This amendment has enabled members of the Institute to form multi-disciplinary firms and offer multi- professional services in a Competitive and commercial manner. The council or the qualifications for permitting such partnership. the concept of limited liability partnership like U.K. is under consideration of parliament and appropriate amendment in the companies Act, 1956 is proposed to incorporate provision of LLP. Goodwill - When there are two or more partners and one of them dies, them dies, the widow of the deceased "partner can continue to receive a share of the firm. A legal representative, say, widow of a deceased partner, would be entitled to share the profits only where the partnership agreement contains a provision that on the death of the partner his widow or legal representative would be entitled to such payment by way of sharing of fees or otherwise for some specified period. There could not be any sharing of fees between the widow or the legal representative of the proprietor of a single member firm and the purchaser of the goodwill of the firm on the death of the Sole proprietor of the firm. Payment of goodwill to the widow is permissible in such cases only for the goodwill of the firm and to enable such payments to be made in instalments provided the agreement of the sale of goodwill contains such a provision. These payments even if they are spread over the specified period should not be linked up with participation in the earnings of the firm. The widow of a partner, when the partnership agreement does not contain a-provision entitling her to share in profits, would not be entitled to such profits. The Council has taken the view, in a case-referred to it, that it is not permissible for the widow of a deceased member, whose professional work consisted mainly of income tax representation, to receive a monthly lump-sum payment for a period of five years or a specified percentage of income. The Council of the institute considered the issue whether the goodwill of a proprietary firm of chartered accountant can be sold transferred to another eligible member .of the Institute, after the death of the proprietor concerned and came to the view that the same is permissible. Accordingly, the Council passed the following resolution with a view to mitigating the hardship generally faced by the families after the death of such proprietors: "resolved that the sale/transfer of goodwill in the case of a proprietary firm of chartered accountant to another eligible member of the Institute shall be permitted. (a) in respect of cases where the death of the proprietor concerned occurred on or after 30.8.1998. Provided such a sale is completed effected in all respects and the Institute's permission to practice in deceased's proprietary firm name is sought within a year of the death of such proprietor concerned. In respect of these cases, the name of the proprietary firm concerned would be kept in abeyance (i.e. not removed on receipt of information about the death of the proprietor as is being done at present) only upto a period of one year from the death of proprietor concerned as aforesaid.

Professional Ethics

23.23

(b) in respect of cases where the death of the proprietor concerned occurred on or after 30.8.1998 and there existed a dispute as to the legal heir of the deceased proprietor Provided the information as to the existence of the dispute is received by the Institute within a year of the death of the proprietor concerned. In respect of these cases, the name of proprietary firm concerned shall be kept in abeyance till one year from the date of settlement of dispute. (c) In respect of cases where the death of the proprietor concerned had occurred on or before 29th August, 1998 (irrespective of the time lag between the date of death of the proprietor concerned and the date of sale/transfer of goodwill completed/to be completed). Provided such a sale/transfer is completed/effected and the Institute's permission to practice in the deceased's proprietary firm name is sought for by 28!h August, 1999 and also further provided that the firm name concerned is still available with the Institute." In case of a partnership firm when all the partners die at the same time, the above Council decision would also be applicable. In recent years it has become necessary for members to work in association with engineering, legal or other professionals on specified projects. In such cases, care should be taken by the member not to extend his service beyond the normal sphere of professional practice and any reports or recommendations should clearly delimit the responsibilities assumed and services rendered. In a decision of the Council, where a Chartered Accountant entered into an agreement whereby he had clearly agreed to pay the share in profits of his professional business to the complainant and another person who were not the members of the Institute, it was held that he was guilty of professional misconduct under the clause. (Vadilal V.Shah vs. J.B. Sanghavi- page 239 of Vol. V of the Disciplinary Cases decided on 15th & 16th February, 1974). A Chartered Accountant gave 50% of the audit fees received by him to the complainant, who was not a Chartered Accountant, under the nomenclature of office allowance and such an arrangement continued for a number of years, it was held by the Council that in substance the Chartered Accountant had shared his profits and, therefore, was guilty of professional misconduct under the clause. It is not the nomenclature to a transaction that is material but it is the substance of the transaction, which has to be looked into. (D. S. Sadri vs B.M. Pithewala - Page 300 of Vol. V of the Disciplinary Cases-decided on 14th & 17th September, 1974) Clause (3) accepts or agrees to accept any part of the profits of the professional work of a person who is not a member of the Institute: Provided that nothing herein contained shall be construed as prohibiting a member ‘from entering into profit sharing or other similar arrangements, including receiving any share commission or brokerage in the fees, with a member of such professional body or other person having qualifications, as is referred to in item (2) of this Like Sharing of fees & profits, receipts

23.24

Advanced Auditing and Professional Ethics

from others are also restricted in the same manner as in clause (2), but by new amendment above mentioned proviso is inserted in clause (3) thereby permitting the members of the Institute to enter into profit sharing or similar arrangements, including receiving any share, commission or brokerage in the fees, with a member of any other professional body or with such other persons having such qualifications as may be prescribed by the council or the Government. With the enactment of amendments, in clause (2) & (3) , the professionals, viz, C.A., ICWA, CS etc. can form multidisciplinary firms (Subject to such specific notification to be issued by the Institute) and face global competition in much more stronger and effective manner. With growing preference among multinational and other Companies for “one -stop shop” or multidisciplinary firms, the pressure seems to be increasing on our profession to strengthen our collective competencies by establishing synergistic relationships. Clause (4) enters into partnership, in or outside India, with any person other then Chartered Accountant in practice or such other person who is a member of any other professional body having such qualifications as may be prescribed, including a resident who but for his residence abroad would be entitled to be registered as a member under close (V) of sub-section (1) of section 4 or whose qualifications are recognized by the Central Government or the Council for the purpose of permitting such partnerships; A Chartered Accountants in practice can enter into partnership with: (i)

A Chartered Accountant in practice, or

(ii)

A Member of any other professional body having prescribed Qualifications,

The Council of the Institute and the central Government has power to prescribe such professional bodies to whom members, partnership can be entered into. The resident members of the institute residing abroad but entitled to be registered as a member of Institute under section 4(1)(v) or whose qualification are recognized by C.G or the Council to enter into partnership can form partnership firms with any practicing chartered Accountant. This amendment has enabled the members of the Institute to form multi-disciplinary firms and offer multi-professional services in a competitive and commercial manner. The council or the Central Government will specify the qualifications for permitting such partnership. The amendment in the Companies Act, 1956 is also proposed and under consideration of Parliament to incorporate the provisions to form Limited Liability Partnership in this regard. Clause (5) Secures either through the services of a person who is not an employee of such Chartered Accountant or who is not his partner or by means which are not open to a Chartered Accountant, any professional business ; Provided that nothing herein contained shall be construed as prohibiting any agreement permitted in terms of item (2), (3) and (4) of this part. “A man must stand erect, and not to be kept erect by others”, is a dictum by Marcus Aurelius which though applicable for a man in every walk of life is more so in the case of a professional life. He must seek work not through any agency, but by the respect , that he is able to command for his professional talent and skill and by the confidence he is able to inspire by his reputation. As per amended clause (5) of the First Schedule to the Chartered Accountants (Amendment) Act [ As amended by Chartered Accountants (Amendment) Act, 2006] securing any professional

Professional Ethics

23.25

business through certain categories of non- members, to be prescribed, from time to time in the Regulation, is permitted. Clause (6) Solicits clients or professional work either directly or indirectly by circular, advertisement, personal communication or interview or by any other means ; Provided that nothing herein contained shall be construed as preventing or prohibiting (i)

Any Chartered Accountant from applying or requesting for or inviting or securing professional work from another chartered accountant in practice ; or

(ii) A member from responding to tenders or enquiries issued by various users of professional services or organizations from time to time and securing professional work as a consequence. It is an elaboration of the principle propounded in the preceding clause enjoining that for securing professional work the help of others should not be sought. This clause further enjoins on a member not to solicit professional work by means of advertisement, circular, personal communication or interview or by any other means. The members should not adopt any indirect methods to adventure their professional practice with a view to gain publicity and thereby solicit clients or professional work. Such a restraint must be practiced so that members may maintain their independence of judgment and may be able to command the respect of their prospective clients. In the early years of their professional career, members may find this restraint inconvenient and irksome. A question may arise in their minds as to how they would be able to find professional work if they are not permitted to advertise or solicit work. A little reflection would show that professional work can not be secured either by advertisement or by circulars or by solicitation. It can only be obtained by a member gradually building confidence in his ability and integrity. The service tendered by an accountant is of a personal and intimate nature and its value can be apprised only by personal contact and experience. A public advertisement is likely to lead to an impression that the professional person is over anxious to win confidence, which however will have the opposite effect. The satisfaction of clients would be the best advertisement, which would lead to other clients. Unabashed advertisement would affect the public esteem in which the profession is held and would act to the disadvantage of its members. An advertisement is not a key to success in the profession. It is the quality service, which attracts and retains the clients. Consequent to amendment made by Chartered Accountant (Amendment) Act , 2006 in clause 6 of part 1 of the First Schedule, Ban on Solicitation is relaxed in the following situation of client or professional work If work or professional work occurs within the fraternity: or If professional work is secured from responding to tenders, or enquiries issued by various users of professional services or organization. Some forms of soliciting work which the Council has prohibited are discussed below: (a) Advertisement and note in the press – Members should not advertise for soliciting work or advertise in a manner which could be interpreted as soliciting or offering to undertake professional work. They are also not permitted to use the less open method of circulating

23.26

Advanced Auditing and Professional Ethics

letters to a small field of possible clients. Personal canvassing or canvassing for clients of previous employer through the help of the employees are also not permitted. The exceptions to the above rule are: (i)

a member may advertise changes in partnerships of dissolution of a firm, or of any change in address of practice and telephone numbers. Such announcements should be limited to a bare statement of facts and consideration given to the appropriateness of the area of distribution of the newspaper or magazine and number of insertions.

(ii)

a member is also permitted to issue a classified advertisement in the journal/ newsletter of the Institute intended to give information for sharing professional work on assignment basis or for seeking partnership or salaried employment of an accountancy nature, provided it only contains the accountant’s name, address or telephone number, fax number, e-mail address.

(b) Application for empanelment for allotment of audit and other professional work – The Government departments, government companies/Corporations, courts, co-operative societies and banks and other similar institutions prepare panels of chartered accountants for allotment of audit and other professional work. Where the existence of such a panel is within the knowledge of a member, he is free to write to the concerned organization with a request to place his name on the panel. However, it would not be proper for the Chartered Accountant to make roving enquiries by applying to any such organization for having his name included in any such panel. It is permissible to quote fees on enquiries being received from the such bodies, which maintain such panel. It is however, not proper for the members to send printed or cyclostyled copies of the scales of fees in reply to such enquiries. An advertisement for any part-time work undertaken by practicing Chartered Accountants would not be permissible because it would essentially be an offer of professional services and therefore would offend the rule. (c) Publication of Name or Firm Name by Chartered Accountants in the Telephone or other Directories published by Telephone Authorities or Private Bodies – The Council has held that it would not be proper for a chartered accountant to have entries made in a Telephone Directory either by making a special request or by means of an additional payment. The Council has also considered the question of permitting entries in respect of chartered accountants and their firms under specified groups in telephone/trade directories brought out by government and non-government agencies. It has decided to permit such entries subject to the following restrictions: 1.

The entry should appear in the section / category of “Chartered Accountants”.

2.

The member/firm should belong to the town/city in respect of which the directory is being published.

3.

The entry should be in normal type of letters. Entry in bolder type or abnormal type of letters or in a box is not permissible.

4.

The order of the entries should be alphabetical and logical.

Professional Ethics

23.27

5.

The entry should not appear in a manner giving the impression of publicity/advertisement. Entry should not be given in a manner which gives prominence to it as compared to other entries.

6.

The payment, if any, for the entry should not be unreasonable.

7.

The entries should not be restricted and should be open to all the chartered accountants/firms of chartered accountants in the particular city/town in respect whereof the directory is published.

8.

Subject to the above conditions, the members can also include their names in trade directories which are published and/or otherwise available such as electronic media e.g. internet, telephone services like ‘Ask me Services’.

(d) Issuing Hand Bills - A member is prohibited from distributing hand bills ostensibly for the guidance, of persons other than his regular clients in matters such as changes in tax laws. (e) Publication of Books or Articles - A member is not permitted to indicate in a book or an article, published by him, the association with any firm of Chartered Accountants. (f)

Issue of greeting cards or invitations - The Council does not approve of the issue of greeting cards or personal invitations by members indicating their professional designation, status and qualification etc. However, the Council is of the view that the designation “Chartered Accountant” as well as the name of the firm may be used in greeting cards, invitations for marriages and religious ceremonies and any invitation for opening or inauguration of office of the members, change in office premises and change in telephone members, provided that .such greeting cards or invitations etc. are sent only to clients, relatives and close friends of the members concerned.

(g) Soliciting professional work by making roving inquiries - It is not permissible for a member to address letters or circulars to persons who are likely to require services of a Chartered Accountant since it would tantamount to advertisement. (h) Scope of Representation which an auditor is entitled to make under Section 225(3) of the Companies Act, 1956 - The right to make representation does not mean that an auditor has any prescriptive right or a lien to an audit. The wording of his representation should be such that apart from the opportunity not being abused to secure needless publicity, it does not tantamount directly or indirectly to canvassing or soliciting for his continuance as an auditor. The letter should merely set out in a dignified manner how he has been acting independently and conscientiously through the term of office and may, in addition, indicate if he so chooses his willingness to continue as auditor if re appointed by the shareholders. (i)

Acceptance of original professional work by a member emanating from the client Introduced to him by another member - The Council has decided that a member should not accept the original professional work emanating from a client introduced to him by another member. If any professional work of such client comes to him directly, it should be his duty to ask the client that he should come through the other member dealing generally with his original work.

23.28 (j)

Advanced Auditing and Professional Ethics

Giving public Interviews - While giving any interview or otherwise furnishing details about themselves or their firms in public interviews or to the press or at any forum, the members should ensure that it should not result in publicity. Due care should be taken to ensure that such interviews or details about the members or their firms are not given in a manner highlighting their professional attainments.

(k) Members and / or firms who publish advertisements under Box numbers Members/Firms are prohibited from inserting advertisements for soliciting clients or professional work under box numbers in the newspapers. This practice is in violation of this clause. Website - The Council at its meeting held in January, 2001 approved the detailed guidelines for posting the particulars on Website by Chartered Accountants in practice and firm(s) of Chartered Accountants in practice. The guidelines are as under: 1.

The Chartered Accountants and/or Chartered Accountants’ Firms would be free to create their own Website subject to the overall guidelines laid down by the Council hereunder. The actual format of the Website is not being prescribed nor any standard format of the Website is being given to provide independence to the Members. There is no restriction on the colours which may be used in the Website.

2.

Individual Members would also be permitted to have their Webpages in their trade name or individual name.

3.

The Chartered Accountants and/or Chartered Accountants’ Firms would ensure that their Websites are run on a “pull” model and not a “push” model of the technology to ensure that any person who wishes to locate the Chartered Accountants or Chartered Accountants’ firms would only have access to the information and the information should be provided only on the basis of specific “pull” request.

4.

The Chartered Accountants and/or Chartered Accountants’ Firms should ensure that none of the information contained in the Website be circulated on their own or through E-mail or by any other mode or technique except on a specific “pull” request.

5.

The Chartered Accountants would also not issue any circular or any other advertisement or any other material of any kind whatsoever by virtue of which they solicit people to visit their Website. The Chartered Accountants would, however, be permitted to mention their Website address on their professional stationery.

6.

The following information may be allowed to be displayed on the Firms’/Members’ Websites: (i)

Member/Trade/Firm name.

(ii)

Year of establishment.

(iii) Member/Firm’s Address (both Head Office and Branches) Tel. No(s) Fax No(s)

Professional Ethics

23.29

E-mail ID(s) (iv) Nature of services rendered (to be displayable only on specific “pull” request) (v) Partners Partners Name

Year of Other Tel. No. Direct, Area of Experience Qualification Qualification(s) Res., Mobile, (to be displayable E-mail, Address only on specific "pull" request) (vi) Details of Employees Professional Other Name Designation Area of Experience (to be displayable only on specific "pull" request) (vii) Job vacancies for the Chartered Accountant/firm of Chartered Accountants (including article ship). (viii) No. of articled clerks, (to be displayable only on specific “pull” request), (ix) Nature of assignments handled (to be displayable only on specific “pull” request) Names of clients and fee charged cannot be given. 7.

Since Chartered Accountants in practice/firms of Chartered Accountants are not permitted to use logo with effect from 1st July, 1998, they cannot use logo on Website also.

8.

No photographs of any sort are permitted.

9.

The members may include articles, professional information, professional updation and other matters of larger importance or of professional interest.

10. The bulletin boards can be provided. 11. The chat rooms can be provided which permit chatting amongst members of the ICAI and between Firms and its clients. The confidentiality protocol would have to be observed. 12. The members/firms can provide on line advice to their clients who specifically request for the advice whether free of charge or on payment. 13. The listing on suitable search engine should be permitted. However, the field of search should be restricted only to the field of “Chartered Accountants” or “CA” or “Indian CA”, “Indian CPA”, “Indian Chartered Accountant” or any permutation or combination related thereto. The Websites would be subjected to the guidelines contained herein and normally would not be vetted by the Institute of Chartered Accountants of India (ICAI). ICAI at its sole discretion may vet any of the Websites created by its members or individual Chartered Accountant or firms of Chartered Accountants and would have powers to direct deletion of certain portions and/or issue specific directions. In addition, necessary action can be taken in accordance with the Chartered Accountants Act, 1949 and the Regulations framed there under, in case there is any violation of the above guidelines.

23.30

Advanced Auditing and Professional Ethics

14. The details in the Website should be so designed that it does not amount to soliciting client or professional work or advertisement of professional attainments or services. In case any content or technical feature of Website is against the professional Code of Conduct and Ethics as well as the restrictions contained in the schedules to the Chartered Accountants Act, 1949 or against the guidelines or directions issued by the ICAI from time to time, appropriate action will be initiated by the ICAI in terms of its disciplinary mechanism either suo motu or on complaint as provided under the Chartered Accountants Act. 1949. 15. The Website should ensure adequate secrecy of the matters of the clients handled through Website. 16. A number of Chartered Accountants Societies or other bodies are creating data-bases of Chartered Accountants or Chartered Accountants’ Firms and are offering listing to Chartered Accountants. Such listing would be permitted with or without payment. In case a Chartered Accountant or Chartered Accountants’ Firm is a member of a professional body or association or Chamber of Commerce and they offer listing to the members or firm, the same would be permitted. 17. The Institute of Chartered Accountants of India will regularly inform the aforesaid guidelines to the members and the Chartered Accountants’ Firms to ensure the strict compliance of the guidelines. The guidelines may be revised from time to time. 18. No Advertisement in the nature of banner or any other nature will be permitted on the Website. 19. The Website should be befitting the profession of Chartered Accountants and should not contain any information or material which is unbecoming of a chartered accountant. 20. The Website may provide a link to the Website of ICAI, its Regional Councils and Branches and also to the Websites of Government/Government Departments/Regulatory Authorities. Except that neither link to nor information about any other Website is permitted. 21. The address of the Website can be different from the name of the firm. But it should not amount to soliciting clients or professional work or advertisement of professional attainments or services. The Website address should be as near as possible to the individual name/trade name, firm name of the Chartered Accountant in practice or firm of Chartered Accountants in practice. The Committee on Ethical Standards and Unjustified Removal of Auditors (CESURA) of ICAI will decide in case there is any difficulty. 22. The address of the Website should be intimated to the ICAI within 30 days. 23. The Website should mention the date upto which it is updated and the information should not be at material variance from the information as per the ICAI’s records. A number of non-Chartered Accountants’ firms, corporate including banks, finance companies and newspapers have set up their own Websites providing advisory services on taxation and other areas where Chartered Accountants are rendering professional service. Some of such Websites may request Chartered Accountants or Chartered Accountants’ firms to provide consultation and advice through their Websites. This would’ be permitted subject to the condition that on the Website, contact address of the Chartered Accountant concerned is not provided nor

Professional Ethics

23.31

such Website will contain any material which advertises professional achievements or status of such Chartered Accountant except making a statement that they are Chartered Accountants. The name of Chartered Accountants’ firm with suffix “Chartered Accountants” would not be permitted. Some of the decisions of the Councils/High Courts on this clause are given below: Solicitation - Where a chartered accountant sent a printed card and circular letters soliciting work. Held, he was guilty under the clause. (M.J. Gadre vs. W.G. Ambekar - Page 43 of Vol. I of the Disciplinary Cases and pages 87-89 of August, 1952 issue of the Institute’s Journal-judgement delivered on 4th April, 1952). In a case, where a chartered accountant wrote’ to the Ministry of Commerce and Industry to enroll the name of his firm in the list of auditors maintained by Department-Held, he was guilty of the charge. (K.C.J. Satyavadi in Re: Page 98 of Vol. II of the Disciplinary Cases and page 221 of December, 1955 issue of the Institute’s journal - Judgement delivered on 7th November, 1955). . Where a chartered accountant firm issued a letter of authority in favour of two other chartered accountants to accept and carry out audits of Co-operative Societies on its behalf and they (the two chartered accountants) issued circulars of which the firm was not aware - Held, that the firm was not guilty of professional misconduct. (V.B. Kirtane in Re: Page 423 of Vol. Ill of the Disciplinary Cases and page 465 of January, 1958 issue of the Institute’s journal - Judgement delivered on 11th November, 1957) But the person, in whose favour the letter of authority was given in the above case, was held guilty. (MR Walke In Re: Page 441 of Vol. Ill of the Disciplinary Cases and pages 469 - 470 of January, 1958 issue of the Institute’s journal • Judgement delivered on 11th November, 1957) ‘Where a chartered accountant sent an application to the Chairman of a Co-operative Society offering himself for appointment as an auditor. Held that the infringement was a serious breach of professional-ethics. (G.K. Joglekar in Re: and D.G. Jawalker in Re Pages 429 and 433 of Vol. Ill of the Disciplinary Cases and pages 466 - 469 of January, 1958 issue of the Institute’s Journal - Judgement delivered on 11th November, 1957) A letter of request was sent for being appointed as auditor. Held he was guilty. (B.K. Swain in Re: Page 134 of Vol. IV-of the Disciplinary Cases and pages 356-358 of March, 1960 issue of Institute’s, Journal - Judgement delivered on 12th February, 1960). A chartered accountant sent a printed circular to a person unknown to him offering his services in profit planning and profit improvement programmes. The circular conveyed the idea that it was meant for strangers only. Held, the chartered accountant was guilty of professional misconduct under the clause as he used the circulars to solicit clients and professional work.

23.32

Advanced Auditing and Professional Ethics

(B.S.N. Bhushan in Re: Page 989 of Vol. IV of the Disciplinary Cases - decided on 11th & 12th January, 1965). A chartered accountant wrote several letters to the Assistant Registrar of Co-operative Societies, Government of West Bengal stating that though his firm was on the panel of auditors, no audit work was allotted to the firm and requested them to look into the matter. Held the chartered accountant was guilty of professional misconduct under the clause. (D.C. Pal in Re: Page 1001 of Vol. IV of the Disciplinary Cases - decided on 12th, 13th and 14th September, 1966). A chartered accountant wrote several letters to Assistant Registrars/Registrars of Co-operative Societies, Government of West Bengal requesting for allotment of audit work and to enroll his name-on panel of auditors. Held he was guilty of professional misconduct under the clause. The activities of the chartered accountant went much beyond the instructions of the Council to the effect that roving enquiries should not be made with the Government Department for empanelling the name unless it had been ascertained in advance that specific panel was being maintained. It was also held that an auditor of co-operative societies under a license granted by co-operative department was not its employee and, therefore, he could not solicit work. (Chief Auditor of Co-operative Societies, West Bengal vs. B.B. Mukherjee - Page 1007 of Vol. IV of the Disciplinary Cases - decided on 16th September 1967) A chartered accountant, inspite of the previous reprimand, sent letters to registrar Co-operative societies, Calcutta, stating that no allotment of audit was made to him and requested to take action immediately and oblige. Held he was guilty of professional misconduct under the clause. (D.N. Das Gupta, Chief auditor of Co-operative Societies, West Bengal vs. B.B. Mukherjee – Page 1028 of Vol. IV of the Disciplinary Cases – decided on 15th and 16th September, 1969). A Chartered Accountant approached the principal of a secondary school through a third person known to the principal for his appointment as auditor of that school. Further, the chartered accountant misrepresented to the pervious Auditor that he had been offered appointment as auditor of the school and enquired whether he had any objection to his accepting the same though it was a fact that the appointment of chartered accountant was not made, the chartered accountant was guilty of professional misconduct under the clause. It was further held that writing letter by the Chartered Accountant to the previous auditor offering his services to audit the accounts of school was not wrong as it was an offer to professional colleague and not to a prospective client. (M. L. Agarwal in Re. Page 1033 of Vol. IV(1) of the Disciplinary Cases – decided on 16th and 17th February, 1973) An assistant of the chartered accountant under his authorization wrote letter to stranger association requesting for appointment as auditor- Held the Chartered accountant was guilty of professional misconduct under the clause. (S.N. Mukherjee & Co. vs. P. K. Ghose- page 273 of vol. V of the Disciplinary Cases – Decided on 20th & 21st February, 1975)

Professional Ethics

23.33

A member was found guilty of professional misconduct under Clauses 6 and 7 Part I of the First Schedule for having issued circular letter regarding change of address of his firm to persons who were not in professional relationship with him and for having written to the shareholders thanking them for appointing him as auditor. He was reprimanded by the council under Section 21(4). On an appeal made by the Council having regard to the ethical requirement about publicity by the members of the Institute as laid down in the “ Code of Conduct” ( K.K. Mehta vs. M..K. Kaul- Page 80 of Vol. V of the Disciplinary Cases and pages 189-191 of February 1976 issue of the Institute Journal- Judgement delivered on 23rd October 1975). An advertisement was published in a newspaper containing the member’s photograph wherein he was congratulated on the occasion of the opening ceremony of his office. He was found guilty by the Council and later, by High Court of violating the Clause( soliciting work by advertisement). The following observations of the High Court may be relevant. (a) The advertisement which had been put in by the member is a noticeable one and the profession of Chartered Accountancy should maintain high standards of integrity, professional ethics and efficiency. (b) If soliciting of work is allowed the independence and forthrightness of a Chartered Accountant in the discharge of duties can not be maintained and therefore some discipline must be maintained by the profession. (G.P. Agrawal in Re: Page 14 of Vol. VI (2) of Disciplinary Cases - Decided on 30.4.1982) A member had published an advertisement, in a newspaper inviting professional work for accounts ‘writing, Income tax matters etc. It was held that the insertion of an advertisement of such a nature amounted to soliciting professional work by advertisement and the member was found guilty in terms of this Clause. (Vallabh C. Shah in Re: Page 25 of Vol. VI (2) of Disciplinary Cases - Decided from 20th to 23rd April, 1983) A member had issued a circular letter highlighting his attainments and offering his professional services. He was found guilty in terms of this Clause. (R.K. Chawla in Re: page 61 of Vol. VI(2) of Disciplinary Cases - Decided on 29th, 30th and 31st December, 1987) A member who got an advertisement published in a newspaper offering his “services in matters of Accounts, Income Tax, Labour laws, Law matters and Management Services was found guilty in terms of this clause as also under Clause (7). (Anil K. Garg in Re. Page 70 of Vol. Vl(2) of Disciplinary cases - Decided on 29th, 30th, 31st December, 1987) A member had an advertisement published in a newspaper regarding inauguration of his professional office. It was held that having regard to: (i)

the nature of the advertisement

(ii)

the function organised on that occasion

23.34

Advanced Auditing and Professional Ethics

(iii) the persons invited (iv) the medium used (v) the names of various concerns which had conveyed their good wished (vi) the advertisement having been released by the Respondent himself (vii) the member had solicited professional work by advertisement and he was founded guilty in terms of his clause. (Shashindra S. Ostwal in Re: Page 81 of Vol. VI (2) of Disciplinary Cases - Decided on 11th 12th and 13th February, 1988) A chartered accountant, inspite of the previous reprimand, sent letters to Registrar Co-operative Societies, Calcutta, stating that no allotment of audit was made to him and requested to take action immediately and oblige. Held he was guilty of professional misconduct under the clause. (D.N. Das Gupta, Chief Auditor of Co-operative Societies, West Bengal vs. BB. Mukherjee Page 1028 of Vol. IV of the Disciplinary Cases - decided on 15th and 16th September, 1969). A member issued a printed circular latter to a Company highlighting the details of his professional attainments and services which he could render in various fields offering his professional services on a contractual basis. He was found guilty in terms of this clause. (Parimal Majumder in Re: Page 333 of Vol. VI (2) of Disciplinary Cases - Decided on 11th 12th 13th and 14th September, 1989). A member wrote a letter to a Company in standard format highlighting his expertise in sales tax matters and had requested for a draft of Rs. 200/- if his knowledge of the Sales tax matters has been found worthwhile. The member was found guilty in terms of this Clause. (K.A. Gupta in Re: Page 371 of Vol. Vl(2) of Disciplinary Cases.- Decided on 18th, 19th and December, 1989). Where a Chartered Accountant had visited personally the clients for securing the appointment as auditors of the Institutions. Held that he was guilty under clause (6) of Part I of First Schedule. [J.S. Bhati Vs. M.L Aggarwal. Vol. Vll(2) of Disciplinary Cases to be published-Judgement dated 30th October. 1991]. Where a Chartered Accountant had addressed an undated but signed letter to-a Bank requesting for empanelment of his firm as auditor alongwith the particulars of his firm showing the past experience and other details of the firm; and a Member of Parliament had also sent a letter to the Bank recommending the name of the said Chartered Accountant’s firm for immediate empanelling for Internal Audit/Inspection Audit/Management Audit, Expenditure Audit. Held that the member was guilty under clause (6) of Part I of the First Schedule. [Naresh C.Aggarwal in Re: Vll(2) of Disciplinary Cases to be published-Council’s. decision dated 16th to 18th July. 1992] Where a Chartered Accountant had published an advertisement in newspapers box numbers mentioning that he was a Senior Chartered Accountant having administrative ability and was

Professional Ethics

23.35

available on retainership for setting up Accounts Department/Internal Auditing/Finance Management. Held that he was guilty under the clause. [DM Kothari in Re: Vol. Vll(2) of Disciplinary cases to be published - Council’s decision dated 5th to 7th August, 1993]. Where a Chartered Accountant had issued undated and unsigned cyclostyled inland letter containing the name & address of his firm and also bearing his firm’s rubber stamp with address on its reverse in the space earmarked for sender’s name and address seeking audit assignment from a Cooperative Society. Held that the member was guilty under the clause. [V. M. Chhallani in Re: Vol. Vll(2) of Disciplinary Cases to be published - Council’s decision dated 5th to 7th August, 1993] Where a Chartered Accountant had sent a letter on the letterhead of his firm to a non-member introducing himself as a chartered accountant giving details of services rendered by him and the schedule of his fees for rending various kinds of services. Held that he was guilty under the clause,. [Vijay Kumar Goel in Re: Vol. Vll(2) of Disciplinary Cases to be published - Council’s decision dated 5th to 7th December, 1994] Where a Chartered Accountant had written a letter to a Co-operative Society wherein he had mentioned that he had been authorised by the Registrar of Societies to conduct the statutory audit of the Societies and requested it to contact him. Held that it tantamount to solicitation of the audit and he had violated the provisions of the clause. [M. V. Lonkar in Re: Vol. Vll(2) of Disciplinary Cases to be published - Council’s decision dated 23rd & 24th February, 1996] Where a chartered accountant had solicited clients and Professional work by personal communication as also by enclosing a circular with his communication, utilised the influence of a Minister as well as created political pressure to secure Professional work, etc. Held he was guilty under the clause. [K. Bhattacharjee vs. B.K. Chakraborty Vol. VII(2) of Disciplinary Cases to be published, Judgement dated 10th June, 1996]. Members of the Institute in practice who are otherwise eligible may practice as advocates subject to the permission of the Bar Council but in such case, they should not use designation ‘chartered accountant’ in respect of the matters involving the practice as an advocate. In respect of other matters they should use the designation ‘chartered- accountant’ but they should not use the designation ‘chartered accountant and advocate simultaneously. Clause (7) “Advertises his professional attainments or services, or uses any designation or expressions other than the Chartered Accountant on professional documents, visiting cards, letter heads or sign boards unless it be a degree of a University established by law in India or recognized by the Central Government or a title indicating membership of the Institute of Chartered Accountants or of any other institution that has been recognized by the Central Government or may be recognized by the Council

23.36

Advanced Auditing and Professional Ethics

Provided that a member in practice may advertise through a write up, setting out the service provided by him or his firm and particulars of his firm subject to such guidelines as may be issued by the Council. This clause prohibits advertising of professional attainments or services of a member It also restrains a member from using any designation or expression other than that of a Chartered Accountant in documents through which the professional attainments of the member would come to the notice of the public. It is improper for a Chartered Accountant to state on his professional documents that he is an Income-tax Consultant or a Cost Consultant or a Management Consultant, The date of setting up the practice by a member or the date of establishment of the firm on the letterheads and other professional documents, etc. should not be mentioned. However in the Website, the year of establishment can be given on the specific “pull” request. A member must not use the designation such as ‘Member of Parliament’, Municipal Councillor any other functionary in addition to that of Chartered Accountant. Members of the Institute in practice who are otherwise eligible may practice as advocates subject to the permission of the Bar Council but in such case, they should not use designation ‘chartered accountant in respect of the matters involving the practice as an advocate. In respect of other matters they should use the designation ‘chartered accountant’ but they should not use the designation ‘chartered accountant’ and ‘advocate’ simultaneously. It is not proper for Chartered Accountant to use the designation “Chartered Accountant” except on professional documents, visiting cards, letter heads or sign boards and under the circumstances clarified under para (g) of Clause 6. The name, description and address of member (or firm) may appear in any directory or list of members of a particular body in which the names are listed alphabetically. For a specialised directory or a publication such as a “Who’s Who” (including those compiled on purely local basis), a member should use his discretion in supplying information, bearing in mind the nature and purpose of the publications, In addition to his name, description and address and those of his firm, a member give where appropriate, directorship held and reasonable personal details and may state his outside interests. He should not, however, give the names of any of his clients or details of the service offered by his firm. Publication of Name or Firm Name by Chartered Accountants in the Telephone or other Directories published by Telephone Authorities or Private Bodies. Detailed directions of the Council in this regard are published under Clause (6). There should be no objection to the publication of photographs and brief particulars of members in magazines provided no payment is made for such publication and there is no advertisement of professional attainments. A special exemption has been made as regards publication of the name and address of a member or that of his firm, with the description Chartered Accountant(s), in an advertisement appearing in the press in the following circumstances, provided that the advertisement is not displayed more prominently than is usual for such advertisements or the member or that of his

Professional Ethics

23.37

firm with the designation Chartered Accountant(s) appears in type not bolder than the substance of the advertisement. (a) Advertisements for recruiting staff in the members’ own office. (b) Advertisements inserted on behalf of clients requiring staff or wishing to acquire or dispose of business or property. (c) Advertisement for the sale of a business or property by a member acting in a professional capacity as trustee, liquidator or receiver. When advertising for staff, it is desirable that members should avoid the expression such as “a well-known firm”, since this would savour of advertisement. Similar considerations apply to advertisements for articled clerks. The advertisements should not contain any promotional element nor should there be any suggestion that the services offered by the Chartered Accountant or his firm are superior to those offered by other accountants. Notice in the press relating to the success in an examination of an individual candidate, should not contain any element of undesirable publicity either in relating to the articled/audit clerk or an employee or the member or the firm with whom he has served. It is usual for local papers to publish details of the examination success of local candidates. Some biographical information is often included. The rule aforementioned is not intended to discourage the printing of news of local interest but is intended to indicate the need for restraint. The candidate’s name and address, school and local background, examinations passed with details of any prize or place gained, the name of the principal, firm and town in which the principal practices may be published. The reports and certificates issued by a Chartered Accountant brings him to the notice of the public in a greater or lesser degree. It is therefore incumbent upon him to ensure that the extent and manner of publications of certificates are limited to what is necessary to enable the report or certificate to serve its proper purpose. Member may appear on television and films and agree to broadcast in the Radio or give lectures at forums and may give their names and describe themselves as Chartered Accountants. Special qualifications or specialized knowledge directly relevant to the subject matter of the programme may also be given But no reference should be made, in the case of practicing member to the name and address or services of his firm. What he may say or write must not be promotional of his or his firm but must be an objective professional view of the topic under consideration. Publicity is permitted for appointments to positions of local or national importance or for the views of members on matters of similar importance. Mention of the membership of the Institute is desirable in such cases. What should be aimed at is to achieve suitable publicity for the Institute and its member generally. Members giving talks or lectures or attending a conference may describe themselves as Chartered Accountants only when they are acting in their capacity as Chartered Accountant. Here again reference to the professional firm of the member should not he given profession.

23.38

Advanced Auditing and Professional Ethics

A professional accountant in public practice holding training courses, seminars etc. for his staff may also invite the staff of other professional accountants and clients to attend the same. However, undue prominence should not be given to the name of the profession accountant in any booklet or document issued in connection ‘herewith. Members writing articles or letters to the press on subjects connected with the profession may give their names and use the description ‘Chartered Accountant’. With regard to the size of signboard for his office that member can put up, it is matter in which the members should exercise their own discretion and good taste. Use of glow signs or lights on large-sized boards as is used by traders or shop-keepers would not be proper. A member can have a name board at the place of his residence with the designation of a Chartered Accountant provided it is a name plate or name board of an individual member and not of the firm. The Council has issued following Guidance Note for Members Holding Certificate of Practice on acceptance of directorships in companies: The Council’s attention has been drawn to the fact that more and more companies are appointing Chartered Accountants as directors on their Boards. The prospectus or public announcements issued by these companies often publish descriptions about the Chartered Accountant’s expertise, specialization and knowledge in any particular field or add appellation or adjectives to their names. Attention of the members in this context is invited to the provisions of clauses (6) and (7) of Part I of the First Schedule to the Chartered Accountants Act. In order that the inclusion of the name of a member of the Institute in the prospectus or public announcements or other public communications issued by the companies in which the member is a director does not contravene the above noted provisions, it is necessary that the members should take necessary steps to ensure that such prospectus or public announcements or public communications do not advertise his professional’ attainments and also that such prospectus or public announcements or public communications do not directly or indirectly amount to solicitation of clients for professional work by the member. While it may be difficult to lay down a rigid rule in this respect, the members must use their good judgement, depending upon the facts and circumstances of each case to ensure that the above noted provisions are complied with both in letter and spirit. It is advisable for a member that as soon as he is appointed as a director on the Board of a Company, he should specifically invite the attention of the management of the company to the aforesaid provisions and should request that before any such prospectus or public announcements or public communication mentioning the name of the member concerned, is issued, the material pertaining to the member concerned should, as far as practicable be got approved by him The use of the expression ‘Chartered Accountant’ is permissible. However, the member must ensure that descriptions about his expertise, specialization and knowledge in any particular field of other appellation or adjectives are not published with his name. Particulars about directorships held by the member in other companies can, however, be given, but the name of the Firm of Chartered Accountants in which the member is a partner, should not be given.

Professional Ethics

23.39

The Council has issued the following guidelines for use of expressions such as ‘Associates of ‘Correspondents of... etc. on letter heads, visiting cards etc. of firms of Chartered Accountants: The use of expressions / words ‘in Association with .... ‘Associates of ‘Correspondents of.... etc., on the stationery letter heads, visiting cards and professional documents etc. of firms of Chartered Accountants is not permissible in view of the provisions of clause (7) of Part I of the First Schedule to the Chartered Accountants Act, 1949 irrespective of whether the connection bearing name sought to be used was the name of an Indian firm or a foreign firm. The Council has not barred entering into such association and the restriction given under the above clause is to bar an advertisement appearing / derived from such associations. For use of logos by Members on letter heads, visiting cards etc. the Council has decided that the logos unconnected with the first letter of the name of the firm or its partners or proprietors will not be permitted for use by members in practice / firms of chartered accountants on their letter heads, visiting cards etc. as the same amounts to advertisement or smacking of publicity. Accordingly, an announcement was published in October, 1995 issue of “The Chartered Accountant” at page 66. Subsequent to above, the Institute came across cases of registration of firm name in circumvention of the provisions contained in the Regulation 190 of the Chartered Accountants Regulations, 1988. The members/firms by themselves or through engineered name had been seeking to obtain firm name approval based on the name of the partner/s selected in the manner that logo of the firm would be identical to the firm name which would have not otherwise been permissible as firm name under Regulation 190. In order to ensure compliance with the Regulations, the Council at its meeting held in December, 1997, therefore, decided that the use of logo/monogram of any kind/form/style/design/colour, etc. whatsoever on any display material or media e.g. paper stationery, documents, visiting cards, magnetic devices, internet, sign board, by the members in practice and/or the firm of Chartered Accountants, be prohibited. Use/printing of member/firm name in any other manner tantamounting to logo/monogram was also prohibited. An announcement was published in February, 1998 issue of the Journal at pages 54 & 55 informing that the use of logo/monogram as above was prohibited with immediate effect in the case of newly enrolled members in practice/new firms of Chartered Accountants. The members already in practice/existing firms of Chartered Accountants using logo/monogram were advised to take immediate steps for discontinuing use of the logo/monogram so as to stop using the logo/monogram in any case before 1st July, 1998. The Council at its meeting held in December 1999 has reiterated its decision to ban logo. The decisions of the Council/High Court on this clause are given below: Advertisement: Where a Chartered Accountant used the designation ‘Incorporated Accountant London’ and ‘Registered Accountant’, India, in the Balance Sheet and also failed to report to the shareholders in the prescribed form under the Banking Companies Act - Held the chartered accountant was guilty of the two charges. The word ‘member’ in Section 21 of the Act should be constructed as including a past member for the purpose of inquiry, as what was required membership at the time of the ^commission of the alleged misconduct.

23.40

Advanced Auditing and Professional Ethics

(Mirza M. Hussain in Re: Page 24 of Vol. II of the Disciplinary Cases and pages 26-29 of July. 1955 issue of the Institute’s Journal-Judgement delivered on 10th May, 1955). A chartered accountant used the designation ‘Industrial and Management Consultant’ in addition to the designation ‘Chartered Accountant’ on printed circular sent to a stranger. Held, he was guilty of professional misconduct under the clause. (B.S.N. Bhushan in Re: Page 989 of Vol. IV of the Disciplinary Cases-decided on 11th and 12th January, 1965). A chartered accountant wrote several letters to Government Department, inter alia, pointing out seniority of his firm, sending his life sketch and stating that he had a glorious record of service to the country as well as to the organisation of accountancy profession with a view to get the audit work. These letters were clearly in the nature of advertising professional attainments. Held, he was guilty of professional misconduct under the clause. (Sirdar P.S. Sodhbans in Re: Page 1022 of Vol. IV of the Disciplinary Cases - decided on 13th and 14th March, 1969). Where a Chartered Accountant in his firm’s letter head had used the designation ‘Manager (Liaison & Sales)’. Held that he Was guilty under clause (7) of Part I of the First Schedule. [Bijoy Kumar in Re: Vol. VII (2) of the Disciplinary Cases to be published - Council’s decision dated 16th September 1991]. Where a Chartered Accountant had issued two insertions in a Journal published by a Chamber of Commerce expressing his willingness to offer the concession in respect of all services offered by him. Held that he was guilty under clauses 6 & 7. [N.O. Abraham Isaac Raj in Re: Vol. VII (2) of ‘Disciplinary cases - to be published Council’s decision dated 9th to 11th April, 1992]. Where a Chartered Accountant had addressed a letter to the Managing Director of a company offering his services as a practicing chartered accountant and giving impression that the letter had been addressed to more than one organization for the above purpose, it was held that the member had contravened the provisions of clauses (6) & (7). [Yogash Gupta in Re: Vol. VII (2) of Disciplinary Cases to be published - Council’s decision dated 23rd & 24th February, 1996] Where a chartered accountant had used the designation and expression other than the chartered accountant, mentioned his experience as General Manager of a Cooperative Bank, expressed himself as President and Chief Executive of an Institute in his professional documents and had depicted religion end politics in his letterheads and letters for professional attainments. Held he was guilty under clause (7). [K. Bhartarcharjee vs. B.K. Chakraborty - Vol. VII of Disciplinary Cases to be published Judgement dated 10th June, 1996]. Clause (8) accepts a position as auditor previously held by another chartered accountant or a certified auditor who has been Issued certificate under the Restricted Certificate Rules, 1932 without first communicating with him in writing;

Professional Ethics

23.41

It must be pointed out that professional courtesy alone is not the major reason for requiring a member to communicate with the existing accountant who is a member of the Institute or a certified auditor. The underlying objective is that the member may have an opportunity to know the reasons for the change in order to be able to safeguard his own interest the legitimate interest of the public and the independence of the existing accountant. It is not intended, in any way, to prevent or obstruct the change. When making the inquiry from the retiring auditor, the one proposed to be appointed or already appointed should primarily find out whether there is any professional or other reasons why he should not accept the appointment. It is important to remember that every client has an inherent right to choose his accountant also that he may, subject to compliance, with the- statutory requirements in the case of limited companies, make a change whenever he looses, whether or not the reasons which had impelled him to do so are good and valid. The change normally occurs where there has been a change of venue of business and a local accountant is preferred or where the partner who has been dealing with the client’s affairs retires or dies or where temperaments clash or the client has some good reasons to feel dissatisfied. In such cases, the retiring auditor should always accept the situation with good grace. The existence of a dispute as regards the fees not having been paid often may be the root cause of an auditor being changed, but this would not constitute valid professional reasons on account of which an audit should not be accepted by the member to whom it is offered. It is no doubt true that the incoming auditor should in appropriate circumstances use his influence in favour of his predecessor to have the disputes as regards the fees settled. Also a number of members would not accept appointment in such circumstances unless and until they are satisfied that the predecessor has been fairly treated, but there is no rule to that effect and the decision in this regard must rest with the good sense of the member himself The professional reasons for not accepting an audit could be: (i)

Non-compliance of the provisions of Sections 224 and 225 of the Companies Act as mentioned in clause (9);

(ii)

Non-payment of undisputed audit fees by auditees other than in case of sick units for carrying out the statutory audit under the Companies Act, 1956 or various other statutes; and

(iii) Under-cutting of fees; (iv) Issuance of a qualified report. In the first two cases, an auditor who accepts the audit would be guilty of professional misconduct. The Council has taken the view that the provision for audit fee made in accounts signed by both - the auditee and auditor shall be considered as ‘undisputed’ audit fees. In this connection, attention of members is invited to the notification No.1-CA(7)46/99 published in the Gazette of India dated 13th November, 1999 and also published at page 83 of January, 2000 issue of the Journal. It is appearing with the other notifications issued under Clause (ii) of Part II of the Second Schedule. In the last case, however, he may accept the audit if he is satisfied that the attitude of the retiring auditor was not proper and justified. If, on the other hand, he feels that

23.42

Advanced Auditing and Professional Ethics

the retiring auditor has qualified the report for good and valid reasons, it would be helping practice not to accept the audit. There is however no rule, written or unwritten, which would prevent an auditor from accepting the appointment offered to him in these circumstances. However, before accepting the auditor he should ascertain full facts of the case. For nothing will bring the profession to disrepute so much as the knowledge amongst the public that if an auditor is found to be “inconvenient” by the client, he could readily be replaced by another who would not displease the client and this point cannot be too over-emphasized. What should be the correct procedure to adopt when a prospective client tells you that he wants to change his auditor and wants you to take up his work? There being two persons involved, the company and the old auditor, the former should be asked whether the retiring auditor has been informed of the intention to change. If the answer is in the affirmative, then a communication should be addressed to the retiring auditor. If, however, it is learn that the old auditor has not been informed, and the client is not willing to make the first move, it would be necessary to ask him the reason for the proposed change. If new is no valid reason for a change, it would be healthy practice not to accept the audit. If he decides to accept the audit he should address a communication to the retiring auditor. As stated earlier the object of the incoming auditor, in communicating with the retiring auditor is to ascertain from him whether, there is any circumstances which warrants him not to accept the appointment. For example, whether the previous auditor has been changed on account of having qualified his report or he had expressed a wish not to continue on account of something inherently wrong with the administration of the business. The retiring auditor may even give out information regarding the condition of the accounts of the client or the reason that impelled him to qualify his report. In all these cases it would be essential for the incoming auditor to carefully consider the facts before deciding whether or not he should accept the audit, and should he do so, he must also take into account the information while discharging his duties and responsibilities. Sometimes, the retiring auditor fails without justifiable cause except a feeling of hurt because of the change, to respond to the communication of the incoming auditor. So that it may not create a deadlock, the auditor appointed can act, after waiting for a reasonable time for a reply. The Council has taken the view that a mere posting of a letter “under certificate of posting” is not sufficient to establish communication with the retiring auditor unless there is some evidence to show that the letter has in fact reached the person communicated with. A Chartered Accountant who relies solely upon a letter posted “under certificate of posting” therefore does so at his own risk. The view taken by the Council has been confirmed in a decision by the Rajasthan High Court in J.S. Bhati v.s. The Council of the Institute of Chartered Accountants of India and another. The following observations of the Court are relevant in this context: “Mere obtaining a certificate of posting in my opinion does not fulfil the requirements of Clause(8) of Schedule I as the presumption under Section 114 of the Evidence Act that the letter in due course reached the addressee cannot replace that positive degree of proof of the delivery of the letter to the addressee which the letters of the law in that case required. The

Professional Ethics

23.43

expression ‘in ‘ communication with’ when read in the light of the instructions contained in the booklet ‘Code of Conduct’ (now Code of Ethics) can not be interpreted in any other manner but to mean that there should be positive evidence of the fact that the communication addressed to the outgoing auditor by the incoming auditor reached his hands. Certificate of posting of a letter cannot, in the circumstances, be taken as positive of its delivery to the addressee”. Members should therefore communicate with a retiring auditor in such a manner as to retain in their hands positive evidence of the delivery of the communication to the addressee. In the opinion of the Council, communication by a letter sent “Registered Acknowledgment due” or by hand against a written acknowledgment would in the normal course provide such evidence. The Council is of the opinion that it would be a healthy practice if the practice of communication with the member who had done the work previously is followed in every case where a Chartered Accountant is required to give a certificate or in respect of a verification of the books of account for special purpose as well as in cases where he is appointed as a Liquidator, Trustee or Receiver and his predecessor was a Chartered Accountant. As a matter of professional courtesy and professional obligation it is necessary for the new auditor appointed to act jointly with the earlier auditor and to communicate with such earlier auditor. It is desirable that a member, on receiving communication from the auditor who has been appointed in his place, should send a reply to him as soon as possible setting out in detail the reasons which according to him had given rise to the change and other attended circumstances but without disclosing any information as regards the affairs of the client which he is not competent to do. The Council has taken the view that it is not obligatory for the auditor appointed to conduct a Special Audit under Section 233A of Companies Act, 1956 to communicate with the previous auditor who had conducted the regular audit for the period covered by the Special Audit. The Council has also laid down the detailed guidelines on the subject as under: 1.

The requirement for communicating with the previous auditor being a chartered accountant in practice would apply to all types of audit viz., statutory audit, tax audit, internal audit, concurrent audit or any other kind of audit.

2.

Various doubts have been raised by the members about the terms “audit”, “previous auditor”, “Certificate” and “report”, normally while interpreting the aforesaid Clause (8). These terms need to be clarified.

3.

As per para 2 of the Institute’s publication viz., Statement on Standard Auditing Practices (AAS) 1 on “Basic Principles Governing an Audit”, an “audit” is the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.

4.

The term “previous auditor” means the immediately preceding auditor who held same or similar assignment comprising same/similar scope of work. For example, a chartered

23.44

Advanced Auditing and Professional Ethics

accountant in practice appointed for an assignment of physical verification of inventory of raw materials, spares, stores and finished goods, before acceptance of appointment, must communicate with the previous auditor being a chartered accountant in practice who was holding the appointment of physical verification of inventory of raw materials, stores, finished goods and fixed assets. The mandatory communication with the previous auditor being a Chartered Accountant is required ever in a case where the previous auditor happens to be an auditor for a year other than the immediately preceding year. 5.

As explained in para 2.2 of the Institute’s publication viz., ‘Guidance Note on Audit Report and Certificates for Special Purposes’, a “certificate” is a written confirmation of the accuracy of the facts stated therein and does not involve any estimate or opinion. A “report”, on the other hand, a formal statement usually made after an enquiry, examination or review of specified matters under report and includes the reporting auditor’s opinion thereon. Thus, when a reporting auditor issue a certificate, he is responsible for the factual accuracy of what is stated therein. On the other hand, when a reporting auditor gives a report, he is responsible for ensuring that the report is based on factual data, that his opinion is in due accordance with facts, and that it is arrived at by the application of due care and skill.

6.

A communication is mandatorily required for all types of audit/report if the previous auditor is a chartered accountant. For certification, it would be healthy practice to communicate. In case of assignments done by other professionals not being chartered accountants, it would also be a healthy practice to communicate.

7.

Although the mandatory requirement of communication with previous auditor being chartered accountant applies, in uniform manner, to audits of both government and nongovernment entities, yet in the case of audit of government is made well in time to enable the obligation must be complied with before accepting the audit. However, in case the time schedule given for the assignment is such that there is no time to wait for the reply from the outgoing auditor, the incoming auditor may give a conditional acceptance of the appointment and commence the work which needs to be attended to immediately after he has sent the communication to the previous auditor in accordance with this clause. In his acceptance letter, he should make clear to the client that his acceptance of appointment is subject to professional objections, if any, from the previous auditors and that he will decide about his final acceptance after taking into account the information received from the previous auditor. The decisions of the Council/High Court on this matter are briefly given in the following paragraphs:

A Chartered Accountant commenced the work of audit on the very day he sent letter to the ‘previous auditor - Held, he was guilty of professional misconduct under the clause. The appointment could be accepted only when the outgoing auditor does not respond within a reasonable time. (S.N. Johri vs. N.K. Jain-Page 1042 of Vol. IV of the Disciplinary Cases-Decided on 13th & 14th September, 1973).

Professional Ethics

23.45

A Chartered Accountant sent a registered letter to the previous auditor after the commencement of the audit by him. Held he was guilty of professional misconduct under the clause. (Radhey Shyam vs. K.S. Dubey - Page 234 of Vol. V of the Disciplinary Cases-decided on 15th & 16th February, 1974). A Chartered Accountant commenced the audit within five days of the date of his appointment without sending any communication to the previous auditor. The previous auditor also denied the receipt of any communication-Held he was guilty of professional misconduct under the clause. (S. B. Chidrawaar vs. O.K. Rao - Page 251 of Vol. V of the Disciplinary Cases-decided on 19th & 20th July, 1974). A chartered accountant had sent a communication to the previous auditor under certificate of posting without obtaining any acknowledgment thereof. The Council held the member guilty in terms of this Clause. On an appeal made by the member, the High Court observed that the expression “in communication with” when read in the light of the instructions contained in the booklet “Code of Conduct” could not be interpreted in any other manner but to mean that there should be positive evidence of the fact that the communication addressed to the outgoing auditor had reached his hands. Certificate of Posting of a letter could not in the circumstances be taken as positive evidence of its delivery to the addressee. (M.L. Agarwal vs. J.S. Bhati - Page 65 of Vol. V of the Disciplinary Cases and pages 305 - 307 of November, 1975 issue of the Institute’s Journal - Judgment delivered on 29th August, 1975) A Chartered Accountant sent under postal certificate, letters to the previous auditor before appointment and also before commencement of audit by him but there was no proof that they were received by the previous auditor. Held he was guilty of professional misconduct under the clause. The communication was not proper within the meaning of the words. ‘Communication with occurring in the clause. (Mehra Khanna & Co. vs. Man Mohan Mehra-page 292 of Vol. V of the Disciplinary Cases decided on 22nd & 23rd. December, 1976). A Chartered Accountant sent a letter by ordinary post to the previous auditor after the acceptance of the audit assignment. Moreover, no evidence was produced to show that the said letter was either sent to or was received by the previous auditor. Held he was guilty of professional misconduct under the clause as the same amounts to non-communication, with the previous auditor. (K.K. Sud vs. K.N. Chandla - Page 306 of Vol. V of the Disciplinary Cases-decided on 26th & 28th October, 1978). A member sent under Certificate of posting a letter to the previous auditor before accepting his appointment as the auditor of a society but there was no proof that the said letter was received by the previous auditor. He was found guilty in terms of this Clause because a mere posting of a letter “under certificate of posting” is not sufficient to establish communication with the

23.46

Advanced Auditing and Professional Ethics

retiring auditor unless there is some other evidence to show that the letter has in fact reached the person communicated with. (A.K. Todani vs. A.P. Bhadani - Page 177 of Vol. VI(2) of the Disciplinary Cases - Decided on 15th, 16th and 17th December, 1988) The provision of Clause 7 requiring a communication with the previous auditor is absolute and applicable even in respect of a appointment by the Government agencies and even in case where the member is aware that the previous auditor had been made aware of the appointment. (Rajeev Kumar vs. R.K. Agrawal - Page 143 of Vol. Vl(2) of the Disciplinary Cases - Decided on 15th, 16th and 17th December, 1988). The requirements of Clause 8 of Part I of the First Schedule can be considered to have been complied with only: (i)

if there is evidence that a communication to the previous auditor had been by R.P.A.D.

(ii)

if there was positive evidence about delivery of the communication to the previous auditor.

In the absence of both, the member should be found to have contravened this Clause. (R.M. Singhai vs. R.V. Agarwal - Page 155 of Vol. Vl(2) of the Disciplinary Cases - Decided on 15th, 16th and 17th December, 1988) A member sent “under Certificate of posting” letter to the previous auditor before accepting the audit of a charitable society. He could not produce any conclusive evidence that the said letter was received by the previous auditor. Mere posting of a letter “under Certificate of posting” is not sufficient to prove communication with the retiring auditor unless there is other evidence that the letter has in fact reached the person communicated with. He was found guilty in terms of this Clause. J. Patnaik vs. Y. Pani - Page 219 of Vol. VI(2) of the Disciplinary Cases - Decided on 15th’ 16th and 17th December, 1988). A member sent under “Certificate of posting” letter to the previous auditor before accepting the tax audit of a partnership firm. But there was no proof that the said letter was received by the outgoing auditor. He was found guilty in terms of this Clause because a mere posting of a letter “under certificate of posting” is not sufficient to establish communication with the retiring auditor unless there is some other evidence to show that the letter has in fact reached the person communicated with. (S.K. Jain vs. O.K. Karmakar - Page 348 of Vol. Vl(2) of the Disciplinary Cases - Decided on 11th, 12th, 13th and 14th September, 1989). Where a Chartered Accountant had conducted tax audit of a firm without first communicating in writing with the Complainant, who was the previous tax auditor of the said firm. Held that he was guilty under the clause.

Professional Ethics

23.47

(V.A. Parikh vs. R.I. Galledar - Vol. Vll(2) of the Disciplinary Cases to be published - Council’s decision dated 6th to 8th June, 1991). Where a Chartered Accountant had accepted a position as auditor of a co-operative bank previously held by the complainant without first communicating with him in writing before accepting the audit. Held that he was guilty under the clause. (D. H. Firke vs. L.B. Jadhav - Vol. Vll(2) of the Disciplinary Cases to be published - Council’s decision dated 6th to 8th June, 1991.) Where a chartered Accountant had not replied to two letters which were sent to him and had conducted the audits without communicating with the Complainant in writing. Held that the member was guilty under clause (8). (U. K. Gupta vs. A.K. Jain - Vol. Vll(2) of the Disciplinary Cases to be published - Council’s decision dated 16th September, 1991). Where a Chartered Accountant had not communicated with the Complainant before accepting the appointment as auditor of a school. Held that he was guilty under clause (8). (J. S. Bhaii vs. M.L. Aggarwal - Vol. Vll(2) of the Disciplinary cases to be published Judgement dated 30th October, 1991). Where a Chartered Accountant had accepted the position as an auditor of a company previously held by the Complainant without first communicating with him in writing. Held that he was guilty under clause (8) of Part I of the First Schedule. (S.K. Kansal vs. S.L. Gupta - Vol. Vll(2) of the Disciplinary cases to be published - Council’s decision dated 16th to 18th July, 1992) Where a Chartered Accountant had accepted the audit of a firm under Section 44AB of the Income-tax Act without first communicating with the Complainant. Held that he was guilty under clause (8). (M/s M.R. Daga & Co. vs. R.K. Vora - Vol. Vll(2) of the Disciplinary cases to be published Council’s decision dated 25th to 27th September, 1992). Where a Chartered Accountant had accepted the position as an auditor of a company previously held by the Complainant without first communicating with the Complainant in writing. Held that he was guilty under clause (8) of Part I of the First Schedule. (H.P. Kumbhani & Co. vs. -M.P. Shah - Vol. Vll(2) of the Disciplinary cases to be published Council’s decision dated 5th to 7th August, 1993). Where a Chartered Accountant had accepted the position as a statutory auditor of a company without first communicating in writing with the Complainants Firm which was the previous auditor. Held that he was guilty under clause (8.) (H.P. Kumbhani & Co. vs. P.V. Dalai - Vol. Vll(2) of Disciplinary cases to be published Council’s decision dated 24th to 26th November, 1993).

23.48

Advanced Auditing and Professional Ethics

Clause (9) Accepts an appointment as auditor of a company without first ascertaining from it whether the requirements of Section 225 of the Companies Act, 1956, In respect of such appointment have been duly complied with”. The Companies Act, 1956 provides for the requirements which an auditor appointed in respect of a company should satisfy himself about, before he accepts the appointment, relevant provisions are contained in Sections 224 and 225 of the said act and the Council has notified that the provisions to be complied with under clause (9) are those contained in Sections 224 and 225 of the Act. Section 224 contains several provisions in the matter of appointment of auditors in different circumstances and situations whereas Section 225 lays down the procedure which must be followed whenever a company desires to change its auditors. In order that the validity of the appointment of an auditor is not challenged or objected to by shareholders or the retiring auditors at a later date, it has been made obligatory on the incoming auditor to ascertain from the company that the appropriate procedure in the matter of appointment has been faithfully followed. The following guidelines have been issued by the Council for this purpose: 1.

“Clause (9) of part I of the First Schedule to Chartered Accountants Act, 1949, provides that a member in practice shall be deemed to be guilty of professional misconduct if he ‘accepts’ an appointment as auditor of a company without first ascertaining from it whether the requirements of Sections 224 and 225 of the Companies Act, 1956, in respect of such appointment have been duly complied with. Under this clause it is obligatory on the incoming auditor to ascertain from the company that the appropriate procedure in the matter of his appointment has been duly complied with so that no shareholder or retiring auditor may, at a later date, challenge the validity of such appointment.

2.

A question arises as to what is the duty of the incoming auditor under this clause and what steps he should take in order to ascertain whether the company has complied with the provisions of Sections 224 and 225 of the Companies Act. These guidelines are issued by the Council in order to assist the members in practice to ensure that the provisions of Clause (9) are duly complied with.

3.

It may be clarified that though Clause (9) refers to compliance with Sections 224 and 225 of the Companies Act, it is also necessary to ascertain that the provisions of Section 224A are duly complied with by the company. This Section deals with special provisions relating to appointment of auditors by certain companies and they have necessarily to be considered by the incoming auditor before he accepts his assignment.

4.

The steps to be taken by an auditor of a company who is appointed in .the following circumstances are indicated below: (i)

When the auditor appointed is the first auditor of the company.

(ii)

When the auditor is appointed in place of an existing auditor who has resigned or has been removed or has ceased to hold office for any other reason.

Professional Ethics (iii)

23.49

When the auditor or auditors appointed by the company were holding this office jointly with others and one or more of such joint auditors are not reappointed.

(iv) When one or more of the auditors appointed by the company was/were not holding this office earlier. 5.

The procedure to be followed by a company for appointment of an auditor is laid down in Section 224 of the Companies Act, 1956. The relevant provisions of the sections are summarized in the ensuing sub-paras.

5.1 The first auditor can be appointed by the Board of Directors within one month of the date of registration of the Company. The auditor so appointed will hold office up to the conclusion of the first Annual General Meeting. 5.2 If the Board of directors do not make such appointment, the company can make the appointment of first auditor at Annual General Meeting. 5.3 The first auditor appointed by the Board of Directors can be removed at any General Meeting and any other auditor can be appointed at such meeting if any member gives due notice of such resolution and such notice, is sent to all the members of the company at least fourteen days before the date of the meeting. The notice of such a resolution will have to be dealt with as provided in Sections 225(2) and 225(3). In this collection, the procedure discussed in paras 7.4 to 7.7 below will have to be followed before any resolution for removal of the first auditor is passed at the General Meeting. For the removal of the first auditor of a company approval of the Central Government as mentioned in para 5.14 below is not necessary. 5.4 Subsequent appointment of the auditor is to be made at each Annual General Meeting of the company. 5.5 Before making appointment or reappointment of an auditor, the company has to obtain a written certificate from the auditor proposed to be appointed that such appointment or reappointment will be in accordance with the limits in respect of maximum number of audits which he can accept under the provisions of Section 224 (I-B). 5.6 The auditor so appointed will hold big office from the conclusion of the meeting at which he is appointed to the conclusion of the next Annual General Meeting. 5.7 The company has to give intimation of the appointment to the auditor within seven days of his appointment. 5.8 If the retiring auditor has given a notice in writing of his unwillingness to be reappointed, the company can appoint any other auditor. 5.9 The members of the company can pass a resolution at the Annual General Meeting to the effect that the retiring auditor shall not be reappointed. They can also pass a resolution at that meeting to appoint someone-else in place of the retiring auditor. Where a notice has been given of an intended resolution to appoint some other auditor’s in the place of a retiring auditor but such a resolution cannot be proceeded with in view of the fact that the person or persons proposed to be appointed has incurred an incapacity or disqualification

23.50

Advanced Auditing and Professional Ethics

or has died, the retiring auditor shall not be reappointed. For this purpose the procedure laid down in Section 225 is to be complied with. 5.10 Except in the circumstances mentioned in 5.8 and 5.9 above, a retiring auditor shall be reappointed if he is otherwise qualified for such reappointment. 5.11 If the company fails to appoint an auditor at the Annual General Meeting, such appointment will be made by the Central Government. The company has to give intimation to the Central Government within seven days about the fact that no such appointment has been made. 5.12 The Board of Directors, except for the situation covered by 5.13 below, can fill any casual vacancy in the office of the auditor. Until this appointment is made the remaining auditor, in case there are joint auditors, can function as auditor of the company. 5.13 If the casual vacancy is caused by the resignation of an auditor, such vacancy can only be filled by the company in any General Meeting. The auditor appointed to fill any casual vacancy shall hold office until the conclusion of the next Annual General Meeting. 5.14 The company can remove the auditor before the expiry of his term of office by a resolution passed at any General Meeting and after obtaining previous approval of the Central Government. 6.

Section 224A of the Companies Act, lays down the procedure for appointment of auditor by a company in which 25% or more of the subscribed capital is held, whether singly or in combination, by the following institutions: (i)

A Public financial institution

(ii)

Any financial or other institution established under a State Act in which the State Government holds 51 % or more of the subscribed share capital.

(iii) Government company, Central Government or any State Government. (iv) A nationalized Bank or an Insurance company carrying on general insurance business. The procedure to be followed by such a company, in brief, is as under 6.1 The appointment or reappointment of auditor at each Annual General Meeting shall be made by a special resolution. 6.2 If the company fails to make such appointment or reappointment of auditor, the Central Government will have to make the appointment of auditor as provided in Section 224(3). 6.3 The provisions relating to appointment of first auditor, filling of casual vacancy, removal of auditor etc. which are contained in Section 224 will apply to the company specified in Section 224A. 7.

Section 225 of the Companies Act lays down the procedure for appointment of auditor other than the retiring auditor and for removal of existing auditor. The procedure for giving special notice as contained in Section 225(1) does not apply to the removal of the first auditor appointed by the Board of Directors, because separate provision as stated in para

Professional Ethics

23.51

5.3 above is made for this purpose. The procedure to be followed by the company, is as under. 7.1 If a member of the company wants that the retiring auditor should not be reappointed or that an auditor other than the retiring auditor should be appointed, he has to give a special notice to the company and specify the resolution which he proposes to move at the Annual General Meeting for this purpose. 7.2 Such special notice is required to be given if a member of the company wants to remove the auditor before the expiry of his term of office. 7.3 The special notice should be given at least 14 days before the date of the General Meeting when the question of appointment or reappointment of the auditor is to be considered. 7.4 On receipt of the special notice of such resolution, the company has to send a copy of the same to the retiring auditor forthwith. 7.5 The company is also required to send the special notice to the members of the company at least seven days before the meeting as per the provisions of Section 190(2) read with Sections 172(2) and 53(1) to 53(4) of the Companies Act. According to these provisions the notice should be sent by post or if that is not practicable then it should be given either by advertisement in a newspaper having an appropriate circulation or in any other mode allowed by the Articles of Association of the Company. 7.6 After receipt of the above notice, the retiring auditor can submit his representation to the members of the company. Such representation, on receipt by the company, is required to be sent to its members as required under Section 225 (3) of the Companies Act. 7.7 The representation received from the retiring auditor will have to be considered at the General Meeting of the company before the resolution proposed by the concerned member is passed. The resolution proposed by the concerned member can be passed only in accordance with the provisions of Section 189 of the Companies Act. Under Clause (9) of part I of the First Schedule to the Chartered Accountants Act, 1949, the incoming auditor has to ascertain whether the company has complied with the provisions of the above sections. The word “ascertain” means “to find out for certain”. This would mean that the incoming auditor should find out for certain as to whether the company has complied with the provisions of Sections 224, 224A and 225 of the Companies Act. In this respect, it would not be sufficient for the incoming auditor to accept a certificate from the management of the company that the provisions of the above sections have been complied with. It is necessary for the incoming auditor to verify the relevant records of the company and ascertain as to whether the company has, in fact, complied with the provisions of the above Sections. If the company is not willing to allow the incoming auditor to verify the relevant records in order to enable him to ascertain as to whether the provisions of the above sections have been complied with, the incoming auditor should not accept the audit assignment. It is suggested that the incoming auditor should verify the following records of the company.

23.52

Advanced Auditing and Professional Ethics

9.1 If the appointment of the auditor is being made for the first time after incorporation of the Company, the auditor should verify as to whether the Board of Directors have passed the resolution for his appointment within one month of the date of registration of the Company. 9.2 If the Board of Directors have not appointed the first auditor but the appointment is being made by a general meeting of the company, the auditor should verify as to whether a proper notice convening the general meeting has been issued by the Company and whether the resolution has been validly passed at the general meeting of the company. 9.3 If the appointment is being made to fill a casual vacancy, the incoming auditor should verify as to whether the Board of Directors have powers to fill the casual vacancy and whether the Board of Directors have passed the resolution filling the casual vacancy. 9.4 If the vacancy has arisen due to resignation of the auditor, the incoming auditor should see as to whether a proper resolution filling the vacancy has been passed at the General Meeting of the Company. 9.5 If the vacancy has arisen as a result of removal of the auditor before the expiry of his term of office, the incoming auditor should see that proper resolution has been passed at the General Meeting of the company and that the previous approval of the Central Government has been obtained by the company. 9.6 If the provisions of Section 224A apply to the company, the incoming auditor should verify as to whether a special resolution as required under the said Section has been duly passed. 9.7 Where the auditor other than the retiring auditor is proposed to be appointed, the incoming auditor should ascertain whether the provisions of Section 225 have been complied with. These provisions equally apply where an auditor who was jointly holding office with another auditor or auditors and any one or more of such joint auditors has not been reappointed. 9.8 For the purpose of ascertaining whether the company has complied with the provisions of Section 225 of the Companies Act the incoming auditor should verify the records of the Company in respect of the following matters: (i)

Whether a member of the Company has given special notice of the resolution as required under Section, 225(1) at least 14 days before the date of the general meeting. A true copy of this notice should be obtained by the incoming auditor.

(ii)

Whether this special notice has been sent to all the members of the Company as required under Section 190(2) at least 7 days before the date of the General Meeting.

(iii) Whether this special notice has been sent to the retiring auditor forthwith as required under Section 225(2) (iv) Whether the representation received from the retiring auditor has been sent to the members of the Company, as required under Section 225(3). (v) Whether the representation received from the retiring auditor has been considered at the general meeting and the resolution proposed by the special notice has been properly passed at the general meeting.

Professional Ethics

23.53

9.9 (A) As regards the mode of sending the notice of the resolution to the members of the company as provided in Sections 224 and 225, it should noted that there is no provision that the notice should necessarily be sent by registered post. The notice can be sent by the company in accordance with the provisions contained in Section 53. The relevant provisions of this section can be briefly summarised as under: (i)

The notice” can be sent by ordinary post by preparing and posting the letter after putting proper address of the person concerned.

(ii) If the member or the person concerned has given specific direction to the Company that the notice should be sent to him under certificate of posting or by registered post, with or without acknowledgment due, and has deposited with the Company the sum sufficient to defray the expenses for this purpose, the notice should be sent in such specified manner. (iii) When there are joint holders of shares in a company, the notice is to be sent to the’ joint holder whose name appears first in the register of members. (B) If it is not practicable to send the notice of the resolution to the members by post, such notice can be given either by advertisement in a newspaper having an appropriate circulation or in any other mode allowed by the Articles of Association of the Company. (C) In order to ascertain whether notice of the resolution has been sent to the members, the incoming auditor should ascertain whether there is sufficient evidence with the Company to indicate that the notice has been sent by any of the modes stated in (A) or (B) above. The despatch register, postage register, postal certificate (if notice is sent under postal certificate) or such other satisfactory evidence available with the company should be verified. (D) As regards the mode of sending the notice of the resolution to the retiring auditor as provided in Sections 224 and 225, attention is invited to the Department of Company Affairs circular dated 17.10.1981 issued to all Chambers of Commerce, which is reproduced below. “I am directed to say that it has been reported by the Institute of Chartered Accountant:; of India that difficulties are being experienced by retiring Auditors in the operation of the provisions of Section 225 of the Companies Act, 1956 whenever any appointment of a new auditor takes place. Such difficulties arise because of the fact that the copy of the special notice required to be served under Section 225(2) of the Act on the retiring auditors are not effectively served and proof of such service is not available. To obviate such difficulties, therefore, it is advisable than the copy of the special notice under Section 225(2) of the Act should be sent to the retiring auditors by Registered Post with A/D.” (E) Accordingly, it is necessary for the incoming auditor to satisfy himself that the notice provided for in Sections 224 & 225 has been effectively served on the outgoing auditor (e.g. by seeing that the notice has been duly served

23.54

Advanced Auditing and Professional Ethics through hand delivery or by Regd. Post A.D.). Production of a certificate of posting by the company would not be adequate for the purpose of the incoming auditor satisfying himself about compliance with Sections 224/225. Acknowledgement received from the outgoing auditor would be one of the forms in which satisfaction can be obtained.

9.10 A copy of the relevant minutes of the general meeting where the above resolution is passed duly verified by the Chairman of the meeting should also be obtained by the incoming auditor for his records. 10.1 Sometimes the annual general meeting is adjourned without conducting any business or after conducting business in respect of some of the items on the agenda. The items in respect of which the business is conducted may or may not include the item relating to appointment of auditors. Under Section 224(1) the retiring auditor holds office till the conclusion of the annual general meeting, Therefore, when the annual general meeting is adjourned in the circumstances stated above, the retiring auditor will continue to hold the office of auditor till the adjourned meeting is hold and the business listed in the agenda of the meeting is concluded. In case a new auditor is appointed at the original meeting (which is adjourned) such auditor can assume office only after the conclusion of such adjourned meeting. 10.2 If any annual general meeting is adjourned without appointing an auditor, no special notice for removal or replacement of the retiring auditor received after the adjournment can be taken note of and acted upon by the company, since in terms of Section 190(1) of the Companies Act, special notice should be given to the company at least fourteen clear days before the meeting in which the subject matter of the notice is to be considered. The meeting contemplated in Section 190(1) undoubtedly is the original meeting. 11. If the incoming auditor is satisfied that the company has complied with the provisions of Sections 224, 224A and 225 of the Companies Act, he should first communicate with the outgoing auditor in writing as provided in clause (8) of Part I of the First Schedule to the Chartered Accountants Act, 1949 before accepting the audit assignment. In order to examine various ethical issues and safeguard the independence of the Auditors, the Council has set up a Committee on Ethical Standards and Unjustified Removal of Auditors (CESURA). This Committee examines various issues concerning professional ethics governing the members of the Institute which are either raised by the members or are taken up based on their importance The recommendations of the Committee are forwarded to the Council for its consideration. This Committee is also charged with the responsibility of looking into the cases of removal and resignation of auditors and making an appropriate report to the Council. The following guidelines have been issued for this Committee for looking into the cases of Removal of Auditors 1.

Where an auditor resigns .his appointment as an auditor of a Company or does not offer himself for reappointment as auditor of such company, he shall send a communication, in writing, to the Board of Directors of the Company giving reasons therefore if he considers that there are professional reasons. Therefore, if he considers that there are professional reasons connected with his resignation or not

Professional Ethics

23.55

offering himself for reappointment which, in his opinion should be brought to the notice of the Board, and shall send a copy of such communication to the Institute. It shall be obligatory on the incoming auditor, before accepting appointment, to obtain a ‘copy of such communication, from the Beard and consider the same before accepting the appointment. 2.

Where an auditor, though willing for reappointment has not been reappointed, he shall file with the Institute a copy of the statement which he may have sent to the management of the company for circulation among the shareholders. It shall be obligatory on the incoming auditor before accepting the appointment, to obtain a copy of such a communication from the company and consider it, before accepting the appointment.

3.

The Committee, on a review of the communications referred to in paras (1) and (2) may call for such further information as it may require from the incoming auditor, the outgoing auditor and the company and make a report to the Council in cases where it considers necessary.

4.

The above procedure is also followed in the case of removal of auditors by the government and other statutory authorities.

A case of cancellation of bank audit was brought to the notice of Committee on Ethical Standards & Unjustified Removal of Auditors (CESURA) and the Council, in which a firm of Chartered Accountant was appointed as statutory branch auditor of two branches for the year ended 31st March by their Head office vide letter dated 16th March, of the year. As stipulated in the appointment letter, the firm sent its acceptance on 31st March to Head office, Under Postal Certificate. The firm started the audit of first branch and completed the same on 10th April. On contacting the second branch on 11th April, the representatives of the firm were not permitted to commence the audit by the branch manager and a written intimation was given to them to the effect that their appointment was cancelled by Bank’s Divisional office due to nonreceipt of acceptance letter. The CESURA after considering the facts and circumstances of the case, the comments of the bank and the firm’s observations thereon, decided that the appointment should not have been cancelled by the bank. The concerned bank was informed accordingly. Some decisions of the Council High Courts on this subject are given below: Failure to communicate with the previous auditor Where a chartered accountant failed to communicate in writing with the previous auditor of his appointment as auditor of a co-operative bank and such omission was not intentional. Held that the breach was only technical and that it was open to the High Court to award a lesser punishment than removal of a member. (S.V. Kharwandikar vs. O.K. Borkar - Page 113 of Vol. I of the Disciplinary Cases and page 236 of November, 1952 issue of the Institute’s Journal-Judgement delivered on 18th August, 1952). Failure to ascertain the requirements of Companies Act, re: appointment of auditors.

23.56

Advanced Auditing and Professional Ethics

Where a Board of Directors appointed a chartered accountant as auditor of a company, the company having failed to appoint one at its annual ordinary general meeting and he wrote to the previous auditor of his appointment and finished the audit on the same date-Held, the vacancy was not a casual vacancy and as the chartered accountant was under misapprehension as to the true legal position, he was warned. (U.C. Majumdar vs. J.N. Saikia - Page 292 of Vol. I of the disciplinary Cases and page 93 of August, 1954 issue of the Institute’s Journal-Judgement delivered on 20th May, 1954. Where a chartered accountant applied in response to an advertisement in a newspaper for appointment as auditor and was appointed by the Directors and failed to communicate with the previous auditor and ascertain from the company whether the requirements of the Companies Act as regards the appointment of the auditors were duly complied with. Held the respondent was guilty on both the counts under clauses (8) and (9). (B.N. Mohan vs. K.C.J. Satyawadi - Page 11 of Vol. 11 of the Disciplinary Cases and page 494 of May, 1955 issue of the Institute’s Journal-Judgement delivered on 10th March, 1955). A chartered accountant accepted the appointment as statutory auditor of the company on the basis of resolution of Board of Directors. There was no compliance with the requirement of Section 224 of the Companies Act, 1956 which in the present case required the appointment by the Central Government as the Company did not make appointment in the general meeting. Held, that the Chartered Accountant was guilty of professional misconduct under the Act. (M.K. Biswas in Re: Page 979 of VOL.IV of the Disciplinary Cases • decided on 11th September 1962). Acting as Auditor inspite of disqualification under law as to the indebtedness to the Company. A chartered accountant who was indebted to the company towards a loan for a sum exceeding Rs. 1000/- taken for the purchase of a car, in the ordinary course of financing business of the company against the hire purchase agreement and thus was disqualified under Section 226(3) of the Companies Act, 1956 to be appointed as auditor of the Company, acted as the auditor of the company. Held on borrowing loan, he would be deemed to have vacated his office as auditor but inspite of that he acted as the auditor of the company. The chartered accountant was guilty of professional misconduct under the clause. The word ‘indebted’ occurring in Section 226(3) means the obligation to pay. (Ram Parshad Handa & Hari Krishan Khosla vs. B.K. Choudhury - Page 1013 of Vol. IV of the Disciplinary Cases - decided on 14th September, 1968). A chartered accountant accepted the appointment as auditor of the company without ascertaining from the Company about the compliance with the requirements of Sections 224 and 225 of the Companies Act, 1956. He had not taken care to see whether a vacancy existed against which he was appointed, whether the notice of the extraordinary general meeting at which he was appointed was given to the previous auditor. Held he was guilty of professional misconduct under the clause. (M. Abdul Rahim vs. LR.Kamath - Page 264 of Vol. V of the Disciplinary Cases - decided on 13th and 14th September, 1974).

Professional Ethics

23.57

A chartered accountant accepted the appointment as auditor of the Company without first ascertaining whether the requirement of the Companies Act, 1956 in respect of such appointment have been complied with. The Central Government agreed to the removal of previous auditor and the appointment of the chartered accountant as auditor in his place subject to the approval of the shareholders in the general meeting. However, the chartered accountant accepted the audit on the basis of the resolution of the Board of Directors and before the General Meeting ratified of the resolution of the Board of Directors. Held he was guilty of professional misconduct under the clause. (D.L.Sukhadia in Re: Page 279 of Vol. V of the Disciplinary cases decided on 22nd & 23rd December, 1976). A chartered accountant accepted the appointment as auditor without first ascertaining from this company whether the provisions of Section 225 of the companies Act, 1956 in respect of such an appointment have been duly complied with. Special notice received from one of the shareholders though sent to outgoing auditor was not sent to the members which is one of the important requirements of Section 225 - Held chartered accountant was guilty of professional misconduct under the clause. (M.R. Gulati vs. S.C. Chirania - Page, 317 of Vol. of the Disciplinary 1978). A member had accepted appointment as, auditor of a Company without ascertaining from the company whether the requirements of Sections 224 and 225 of the Companies Act had been complied with. However, he realized this defect only after acceptance. It was held that the member had not taken care to see if he had been properly appointed as he had: ‘ (i)

accepted the appointment the very next day.

(ii)

satisfied himself on the basis of ‘No objection certificate’ from the previous auditor but without going through the Directors report, Minutes Book or any other documents.

It was observed that if he had taken care to go through this exercise before accepting the appointment, he could have satisfied himself whether or not the provision of Sections 224 and 225 had been complied with. The member was found guilty in terms of this Clause. (Y.S. Mazumdar & Co. vs. H.S. Sardeshpande - Page 116 of Vol. VI (2) of the Disciplinary Cases -Decided on 11th, 12th, 13th February. 1988). A member had been appointed the first auditor of a company within 30 days of the incorporation as required by Section 224(5) of the Companies Act. Later another member was appointed as the joint auditor nearly after 8 months of the incorporation of the company, by a resolution of the Board of Directors. It was found that the appointment of the second member was not valid in terms of Section 224(5) of the Companies Act. It was also found that the second member did not ascertain whether there was compliance with the Provisions of Sections 224(5) and 225 of the Companies Act, The second member was therefore found guilty in terms of his Clause. It was also found that respondent had not communicated with the complainant as required by Clause (8) and in so far as he had not done so, he was guilty.

23.58

Advanced Auditing and Professional Ethics

(C.L Tomson vs. A. Chandrasekhara Menon Page 357 of Vol. VI (2) of the Disciplinary Cases -Decided on 18th, 19th and 20th December, 1989) A member who was appointed as auditor of a Company failed to first ascertaining from the Company whether the requirements of Sections 224 and 225 of the Companies Act, 1956, have been duly complied with. He also, did not communicate with previous auditor before accepting the audit. Therefore, the member was found guilty in terms of Clauses (8) and (9). (B.B. Shah vs. N.K. Nagarkar - Page 380 of Vol. VI (2) of the Disciplinary Cases - Decided on 18th, 19th and 20th December, 1989) A chartered accountant was found guilty of professional misconduct for having failed to comply with the requirements of Clause (8) of Part I of the First Schedule namely, sending a communication which he was required to send to the previous auditor before accepting the audit. He had only sent a letter under certificate of posting without obtaining any acknowledgement thereof. The Council held the member guilty under Section 21(4). On an appeal made by the member, the High Court observed that the expression “in communication with” when read in the light of the instructions contained in the booklet “Code of Conduct” could not be interpreted in any other manner but to mean that there should be positive evidence of the fact that the communication addressed to the outgoing auditor by the incoming . Auditor reached his hands. Certificate of Posting of a letter could not in the circumstances be taken as positive evidence of its delivery to the addressee. (ML Agarwal vs. J.S. Bhati-Page 65 of Vol. V of the Disciplinary Cases and pages 305-307 of November, 1975 issue of the Institute’s Journal-Judgement delivered on 29th August, 1975). [P. P. Sangani in Re: VoL Vll(2) of disciplinary cases to be published - Judgement dated 10th August, 1991 Clause (10) “Charges or offers to charge, accepts or offers to accept In respect of any professional employment fees which are based on a percentage of profits or which are contingent upon the findings, or results of such employment, except as permitted under any regulations made under this Act.” What distinguishes a profession from a business is that professional services is not rendered with the sole purpose of a profit motive. Personal gain is one but not the main or the only objective. Professional opinion, therefore frowns upon methods where payment is made to depend on the basic of results. It is obvious that a person who is to receive payment in direct proportion to the benefit received by his client, may be tempted to exaggerate the advantage of his service or may adopt means that are not ethical. It will have the effect of undermining his integrity and impairing his independence. Therefore, member are prohibited from charging or accepting any remuneration based on a percentage of the profits or on the happening of a particular contingency such as, the successful outcome of an appeal in revenue proceedings. Professional services should not be offered or rendered under an arrangement whereby no fee will be charged unless a specified finding or result is obtained or where the fee is otherwise contingent upon the findings or results of such services. However, fees should not be regarded as being, contingent if fixed by a court or other public authority.

Professional Ethics

23.59

The Council of the Institute has however framed Regulation 192 which exempts members from the operation of this clause in certain professional services. The said Regulation 192 is reproduced 192. Restriction on fees - No Chartered Accountant in practice shall charge or offer to charge, accept or offer to accept, in respect of any professional work, fees which are based on a percentage of profits, or which are contingent upon the findings or results of such work, provided that: (a)

“In the case of a receiver or a liquidator, the fees may be based on a percentage of the realization or disbursement of the assets;

(b) In the case of an auditor of a co-operative society, the fees may be based on a percentage of the paid up capital or the working capital or the gross or net income or profits; and (c)

In the case of a valuer for the purposes of direct taxes and duties, the fees may be based on a percentage of the value of property valued.”

The decision of the High Court on this clause is given below: “Where a chartered accountant had charged fees at certain percentage of the expected relief Held, he was guilty of the charges. (R.B. Basu vs. P.K. Mukherji - Page 137 of Vol.111 of the Disciplinary Cases and pages 184194 of October, 1956 issue of the Institute’s Journal - Judgement delivered on 17th July, 1956).’ Clause (11) Engages in any business or occupation other than the profession of chartered accountant unless permitted by the Council so to engage ; Provided that nothing contained herein shall disentitle a chartered accountant from being a director of a company (Not being managing director or a whole time director) unless he or any of his partners is Interested in such company as an auditor.” This is a provision introduced to restrain a member in practice from engaging himself in any business or occupation other than that of chartered accountant except when permitted by the Council to be so engaged. The objective is to restrain members from carrying on any other business in conjunction with the profession of accountancy and combining such work with any business, which is not in keeping with the dignity of the profession. Another reason for the introduction of such prohibition is that a chartered accountant, if permitted to enter into all kinds of business, would be able to advertise for his other business and thereby secure an unfair advantage in his professional practice. The Council, on a very careful consideration of the matter, has formulated Regulation, 190A and 191 whiph are reproduced below, specifying the activities with which a member in practice : can associate himself with or without the permission of the Council. 190A. Chartered Accountant In practice not to engage in any other business or occupation

23.60

Advanced Auditing and Professional Ethics

“A chartered accountant in practice not to engage in any other business or occupation other than the profession of accountancy except with the permission granted in accordance with a resolution of the Council”. 191. Part-time employment a Chartered Accountant in practice may accept. “Notwithstanding anything contained in Regulation 190A but subject to the control of the Council, a chartered accountant in practice may act as a liquidator, trustee, executor, administrator, arbitrator, receiver, adviser or representative for costing, financial or taxation matter, or may take up an appointment that may be made by the Central Government or a State Government or a court of law or any other legal authority or may act as a Secretary in his professional capacity, provided his employment is not on a salary-cum-full-time basis”. Appendix 10-C.A. Regulations, 1988 The General and specific Resolutions passed by the Council under the power vested in it under Regulation 190A as included in Appendix 10 of C.A. Regulations, 1988 are also reproduced below for information. General Resolution (A) Permission granted generally - “Members of the Institute in practice be generally permitted to engage in the following categories of occupations, for which no specific permission from the Council would be necessary in individual cases: 1.

Employment under Chartered Accountants in practice or firms of such chartered accountants.

2.

Private tutorship

3.

Authorship of books and articles.

4.

Holding of Life Insurance Agency License for the limited purpose of getting renewal commission.

5.

Attending classes and appearing for any examination.

6.

Holding of public elective offices such as M.P., M.L.A. and M.L.C.

7.

Honorary office leadership of charitable-educational or other non-commercial organisations.

8.

Acting as Notary Public, Justice of the Peace, Special Executive Magistrate and the like.

9.

Part-time tutorship under the coaching organisation of the Institute,

10. Valuation of papers, acting us paper-setter, head-examiner or a moderator, for any examination. 11. Editorship of professional journals. 12. Acting as Surveyor and Loss Assessor under the Insurance Act, 1938 provided they are otherwise eligible. Specific Resolution - “Members of the Institute in practice may engage in the following categories of business or occupations, after obtaining the specific and prior approval of the Council in each case:

Professional Ethics

23.61

1.

Full-time or part-time employment in business concerns provided that the member and/or his relatives do not hold “substantial interest” in such concerns”.

2.

Full-time or part-time employment in non-business cc concern.

3.

Office of managing director or a whole-time director o a body corporate within the meaning of the Companies Act, 1956.

4.

Interest in family business concerns (including such interest devolving on the members as a result of in inheritance/succession / partition of the family business) or concerns in which interests has been acquired as a result of relationships and in the management of which no active part is taken.

5.

Interest in agricultural and allied activities carried on with the help, if required, of hired labour.

6.

Interest in an educational institution.

7.

Part-time or full-time lectureship for courses other than those relating to the Institute’s examinations conducted under the auspices of the Institute or the Regional councils or their branches.

8.

Part-time or full-time tutorship under any educational institution other than the coaching organization of the Institute.

9.

Editorship of journals other than professional journals.

10. Any other business or occupation for which the Executive Committee considers that permission may be granted. However, it is open to the Council to refuse permission in individual cases though covered under any of the above categories. For the purpose of the above resolution: (i)

the expression “relative”, in relation to a member, means the husband, wife, brother or sister or any lineal ascendant or descendant of that member;

(ii) a member shall be deemed to have a “substantial interest’ in a concern: (a) In a case where the concern is a company, if its shares (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profit) carrying not less than twenty percent of voting power at any time, during the relevant years are owned beneficially by such member or by any one or more of the following persons or partly by such member and partly by one or more of the following persons: (i)

one or more relatives of the member:

(ii)

one or more partners and/or their relative,

(iii) any concern in which any of the persons referred to above has a substantial interest; (b) In the case of any other concern, if such member is entitled or the other persons referred to above or such member and one or more of the other persons referred to

23.62

Advanced Auditing and Professional Ethics above or persons of such number and / or are more sections of such persons are entitled in the aggregate, at any time during the relevant years not less than twenty per cent of the profits of such concern.

Explanation (a) The relevant years in the context of Clause (4) of part I of the First Schedule to the Chartered Accountant Act, 1949 read with Appendix 17 mean the year/period which the report/certificate relates and the year/period during which the said report/certificate is signed. (b) The relevant years in the context of Clause (11) of part I of the First Schedule to the Chartered Accountants Act, 1949 read with Appendix 10 mean the year/period in which not less than 20% of voting power/20% share of profits were owned beneficially. Attention of the members is also invited to para 3 of the above Resolution relating to the holding of office of a managing director or a whole-time director in a company. In such cases, a member can accept the office of a managing director or a whole- time director only after obtaining, the specific and prior approval of the Council. Attention of the members is also invited to the provisions of Section 2 (26) of the Companies Act, 1956 under which even where a person is not designated as a managing director or a whole-time director, he can be deemed to be a managing director or a whole-time director if he is entrusted with the whole or substantially the whole of the management of the affairs of the company. It may be pointed out that a member cannot accept and hold the office of a managing director or a whole-time director in a company if the member and/or his partners and relatives hold substantial interest in such a company, The Council has considered the question of permitting members in practice to become a Director, Managing Director, full time/Executive Director etc. and related issues and the following decisions have been taken: As regards the question of permitting member in practice to be a Director, Promoter/PromoterDirector, Subscriber to the Memorandum and Articles of Association of any company including a board managed company, it was decided that (a)

Director of a Company

(i)

The expression “Director Simplicitor” means an ordinary / simple Director.

(ii)

A member in practice is permitted generally to be a Director Simplicitor in any company including a board-managed company and as such he is not required to obtain any specific permission of the council in this behalf irrespective of whether he and / or his relatives hold substantial interest in that company.

(b) Promoter / Promoter Director - There is no bar for a member to be a promoter / signatory to the Memorandum and Articles of Association of any company. There ‘s also no bar for such a promoter / signatory to be a Director Simplicitor of that company irrespective of whether the object of the company include areas which fall within the scope of the profession of chartered accounts. Therefore members are not required to obtain specific permission of the Council in

Professional Ethics

23.63

such cases. It must be clarified that under Section 25 of the Chartered Accountants Act, no company can practise as a chartered accountant. Item Nos. 4 & 5 of the Specific Resolution would be equally applicable to member carrying out the activities referred to therein in his capacity as Karta / representative of HUF provided he is not actively engaged in carrying on such activities. The decisions of the Council / High Court on this clause are given below: A chartered accountant engaged himself in carrying on a business known as Shivaji Engineering Works. Held he was guilty of Professional misconduct under the clause. (D.S. Sadri vs. B.M. Pithawalla - Page 300 of VOL. V of the Disciplinary Cases - decided on 14th, 15th, 16th & 17th September, 1977). A chartered accountant in practice entered into partnership with persons who were not the members of the Institute, for the purpose of carrying on business. The share of the chartered accountant in the profit and losses was 25%. He was to take part in the business and was entitled to represent the firm before Govt. authorities etc. He was operating the Bank account of the firm was receiving moneys from the customers and was also looking after the affairs of the partnership -Held he was guilty of professional misconduct under the clause, as he was engaged in the business, without the permission of the Council. (K.S. Dugar in Re: Page 1 of Vol. VI (2) of the Disciplinary Cases - decided on 2nd 3rd and 4th April, 1980). A member in practice was authorised by a resolution of the Board of Directors of a company held on 4.9.81 to look after the day to do affairs of the company and other more than 51% the said company. Later on 8.5.82, he applied to the Council for permission to hold the office of the Executive Chairman of the said company. It was held on the basis of facts and circumstances of the case that during the period 4.9.81 to 8.5.82 the member had engaged himself in ‘other occupation’ without the permission of the Council and was found guilty in terms of this Clause. (M.K. Abrol and S.S. Bawa vs. V.P. Vijh - Page 256 of Vol. VI (2) of the Disciplinary Cases Decided on 11th, 12th and 13th February, 1988) A member having a certificate of practice and having 2 Articled Clerks with him was simultaneously working as a financial controller of a company without the permission of the Council. He was held to be guilty in terms of this clause, in so far as he was engaging in business other than the profession of Chartered accountant’s without the permission of the Council. Therefore, he was found guilty in terms of clauses (4) and (11). (S.K. Kaul vs. S.C. Mangal - Page 132 of Vol. VI (2) of the Disciplinary Cases - Decided on 9th and 10th August, 1988) A member a Karta of his Hindu Undivided Family entered into partnership business for a short period with non-Chartered Accountants for engaging in business other than the profession without prior permission of the Council was found guilty in terms of clauses (4) and (11).

23.64

Advanced Auditing and Professional Ethics

(R.D. Bhatt vs. K.B. Parikh - Page 191 of Vol. VI (2) of the Disciplinary Cases - Decided on 15th, 16th and 17th December, 1988) The Bombay high Court in WP No. 4906 of 1985 decided on 09.02.1989 has held that the prohibition to enter into any partnership with any person other than a Chartered accountant under Clause(4) of Part I of the First Schedule is absolute but not so under Clause (11). According to the Court, Clause (11) enables the Chartered Accountant to engage in any business or any occupation other than the profession of Chartered Accountancy provided the Council grants permission to engage in such business or occupation. According to the Court, it is obvious that the Council desired to retain the power to permit a Chartered Accountant to engage in any business or occupation, which may be incidental or would be useful for carrying on the profession of chartered accountancy. Regulation 166 reiterates what Clause (11) provides. In pursuance of Regulation 166, the Council of the Institute has resolved that permission would be granted to the Chartered Accountancy engaged in any business or occupation other then the profession of chartered accountant in the cases set out in the resolution (Appendix 10). Clauses (4) and (11) contemplate two district and separate contingencies and Clause (4) cannot be so read as to make Clause (11) and the power retained by the Council to grant permission redundant. Nalin S. Sualy vs. Institute of Chartered Accountants of India-Bombay High Court WP No. of 1985 dated 19.02.1989. While dealing with the reasonableness of Clause (11), The Allahabad High Court in CWP No. 1823 of 1988 has decided on 10.07.1990 that it is always open to place reasonable restriction or to regulate any activity. Such restrictions are not new; they are to be found in many fields there it is provided that a person practicing any particular profession shall not be engaged in any other business. According to the Court, it may be necessary to have such regulatory provision so that proper and undivided attention of the person practicing a profession is available to those to whom they are supposed to render their services. Such professional services should be available to the needy with full and proper care and attention. The profession also requires to maintain certain standard of efficiency which it may not be possible to acquire if a person has his interest somewhere else. (Iqbal Hamid vs. Institute of Chartered Accountants of India - Allahabad High Court - W P No 1823 of 1988 dated 10.07. 1990) Where a Chartered Accountant had not disclosed to the Institute at an any time about his engagement as a proprietor of a non- Chartered Accountant’s firm while holding certificate of practice and had not furnished particulars of his engagement as a Director of a company despite various letters of the Institute which remained unreplied. Held that he was guilty under clause (11) of Part I and clauses (1) and (3) of Part III of the First Schedule. [P.S. Rao in Re: Vol. VII (2) of the Disciplinary Cases to be published - Council’s decision dated 9th to 11th April, 1992]. Where a chartered accountant was Karta of the HUF was engaged in the business of a firm without permission of the Council. Held that he was guilty) of professional misconduct under Clause(11)

Professional Ethics

23.65

[V. Krishnamoorthy vs. T. T. Krishnaswami, Vol. VII (2) of the Disciplanry Cases to be published Council s decision dated 27th to 29th September, 1992]. Where a Chartered Accountant had hold a salaried employment as Assistant Manager (Finance & Accounts in addition to the practice of chartered accountancy without obtaining permission of the Institute as required is guilty held under Clause (11) of Part I of First Schedule. [Anil Kumar in Re: Vol. Vll (2) of Disciplinary Cases to be published - Council's decision dated 16th to 18 January, 1994] Where a Chartered Accountant while practicing as a chartered accountant had engaged himself in other occupation as an LIC agent in another name. Held that he was held guilty Clause (11) of schedule. [C.I.T. (Admn.) vs. H.M. Giriya - Vol. VII (2) of the Disciplinary Cases to be published Council's decision dated 13th to 15th June, 1996] Where a charted Accountant had offered to help the Complainant in disposing of odd lot share holding, sold them at much lower rate than he had sent of the Complainant notes etc. and the said chartered accountant was personally involved in the share transfer and broker's business besides his profession activities. Held that he was guilty under Clause (11) of Part I. Clause (12) “Allows a person not being a member of the institute in practice or a member not being his partner to sign on his behalf or on behalf of his firm, any balance sheet, profit and loss account, report or financial statements”. The above clause prohibits a member from allowing another member who is not his partner to sign any balance sheet, profit and loss account or financial statements on his behalf or on behalf of his firm. This clause is to be read in conjunction with Section 26 of the Chartered Accountants Act, 1949 which stipulates that ‘No person other than a member of the Institute shall sign any document on behalf of a Chartered Accountant in practice or a firm of Chartered Accountants in his or its professional capacity. The term ‘financial statement’ for the purposes of this clause would cover an examination of the accounts or of financial statements given under a statutory enactment or otherwise. A report, however, may cover a wider range of documents but in the context in which it is used in this clause, it would mean only a report arising out of a professional assignment undertaken by him or his firm and submitted by him or his firm to the client(s) or where so required, to an outsider on behalf of himself or on behalf of the firm. The subject matter of report should be the expression of a professional opinion whether, financial or non-financial. The financial statements and the reports referred to in this clause obviously means the financial statements and reports as ultimately finalized and submitted to the outside authorities. The Council has clarified that the power to sign routine documents on which a professional opinion or authentication is not required to be expressed may be delegated in the following instances and such delegation will not attract provisions of this clause:

23.66

Advanced Auditing and Professional Ethics

(i)

Issue of audit queries during the course of audit.

(ii)

Asking for information or issue of questionnaire.

(iii) Letter forwarding draft observations/financial statements. (iv) Initiating and stamping of vouchers and of schedules prepared for the purpose of audit. (v) Acknowledging and carrying on routine correspondence with clients. (vi) Issue of memorandum of cash verification and other physical verification or recording the results thereof in the books of the clients, (vii) Issuing acknowledgements for records produced. Raising of bills and issuing acknowledgements for money receipts. (ix) Attending to routing matters in tax practice, subject to provisions of Section 288 of Income Tax Act. (x) Any other matter incidental to the office administration and routine work involved in practice of accountancy. It is also clarified that where the authority to sign documents given above is delegated by a chartered accountant or by a firm of chartered accountants the fact that the documents have not been signed by a chartered accountant is not a defence to him or to the firm in an enquiry relating to professional misconduct. However, the Council has decided that where a Chartered Accountant while signing a report or, a financial statement or any other document is statutory to disclose his name, the member should | disclose his name while appending his signature on the report or document. Where there is no such statutory requirement, the member may sign in the name of the firm. PART II - Professional misconduct in relation to members of the Institute in service A member of the Institute (other than a member in practice) shall be deemed to be guilty of professional misconduct, if he being an employee of any company, firm or person Clause (1) pays or allows or agrees to pay directly or indirectly to any person any share in the emoluments of the employment undertaken by him; A member of the Institute in service is deemed to be guilty of professional misconduct, if he is an employee of any company, firm or person and during that course whatever emoluments he receives, if he either pays or allows to pay or agree to pay any part or share thereof whether directly or indirectly. However, this clause dose not restricts such sharing or commitments among relatives, dependents, friends etc., if there is no relationship in procuring or retaining the job and payment is not a consideration for job procurement or retainership. The clear verdict of this clause is that job must be procured and retained with own professional capabilities and not by any financial deal impairing professional dignity. Clause (2) accepts or agrees to accept any part of fees, profits or gains from a lawyer, a chartered accountant or broker engaged by such company, firm or person or agent or customer of such company, firm or person by way of commission or gratification.

Professional Ethics

23.67

This clause restricts to accept or agrees to accept any part of fears, profits or gains from a lawyer, a chartered accountant or broker engaged by such company, firm or person or agent or customer of such company, firm or person by way of commission or gratification. The objective is that when a member is in employment, he must maintain high level of ethics and should not accept any other amount from anyone for which he is not entitled from employer under contractual agreement of service. PART III - Professional misconduct in relation to members of the Institute generally A member of the Institute, whether in practice or not, shall be deemed to be guilty of professional misconduct, if he Clause (1) not being a fellow of the Institute, acts as a fellow of the Institute; Every member of the Institute whether in practice or not, shall be deemed to be guilty of professional misconduct, if he is associate member (ACA) of the Institute, acts (including such disclosure of exhibition by way of letter, visiting card etc.) as fellow member (FCA) of the institute. The distinction between this clause and section 24 of the Chartered Accountants Act, 1949 should be very clear as the section prohibits any person who, (i)

not being a member of Institute; (a) represents that he is a member of the Institute; or (b) uses the designation of Chartered Accountant;

(ii)

being a member of Institute but does not have certificate of practice while represents himself as Chartered Accountant in practice, he shall be punished; (a) by fine upto Rs.1000/- for first conviction ,and (b) by fine upto Rs. 5000/- and /or imprisonment upto 6 months on subsequent conviction.

Clause (2) does not supply the information called for, or does not comply with the requirements asked for, by the Institute, Council or any of its Committees, Director (Discipline), Board of Discipline, Disciplinary Committee, Quality Review Board or the Appellate Authority; Where a chartered accountant, who was suspended for six months from practice by an order of the High Court, failed to return the certificate of practice, when directed to do so by the Institute, the Council treated it as information and proceeded against him under clause (3) Held, that no misconduct has been established against the chartered accountant. In a case where misconduct is . Alleged against a person, it must be established beyond all doubt. (A.C. Kaher in Re: Page 54 of Vol. IV of the Disciplinary Cases and pages 352 - 354 of March, 1960 issue of the Institutes Journal - Judgement delivered on 7th October, 1959). Inspite of repeated reminders a chartered accountant failed to reply to the letters of the Institute asking him to confirm the date of leaving the services by the paid assistant. - Held the chartered , accountant was guilty of professional misconduct under the Clause.

23.68

Advanced Auditing and Professional Ethics

(A. Umanath Rao in Re: Page 998 of Vol. IV of the Disciplinary Cases - decided on 11th and 12th January, 1965). Where a Chartered Accountant in his application for empanelment as auditor of branches of public sector banks submitted to the Institute included the name of another member as one of partners of his firm though in fact the said member was not a partner of the said firm on the date of the said application. Held that the Chartered Accountant had contravened clause (1) of Part III of the First Schedule in having submitted the application containing the particulars to the Council knowing them to be false. (Laxmi Narayan Gupta in Re: Vol. VII (2) of the Disciplinary Cases to be published - Council’s decision dated 6th to 8th June, 1991). Where a Chartered Accountant had submitted an application of his firm for empanelment as auditor of branches of Public Sector banks and Statutory Central Audit and Branch Audit of Regional Rural Banks mentioning under the head “Details of disciplinary proceedings pending against any partner / proprietor” as “NIL”, whereas a prima facie case against the member existed. Held that he had violated the provisions of clause (1) of Part III of the First Schedule by stating that no disciplinary proceedings were pending against him in the said application as he had deliberately furnished false information when he was fully aware that disciplinary proceedings were pending against him. (A.K. Mehra in Re: Vol. VII (2) of the Disciplinary Cases to be published Council’s decision dated 6th to 8th June, 1991). Clause (11) of Part I and clauses (1) and (3) of part III where a Chartered Accountant had not disclosed to the Institute at any time about his engagement as a proprietor of a non-chartered Accountant’s firm while holding certificate of practice and had not furnished particulars of his engagement a Director of a company despite various letters of the institute which remained unreplied. Held that he was guilty under clause (11) of part I and clauses (1) and (3) of Part III of the First Schedule. (P.S. Rao in Re: Vol. VII (2) of the Disciplinary Cases to be published - Council’s decision dated 9th to 11th April, 1992). Where a Chartered Accountant had continued to train an articled clerk though his name was removed from the membership of the Institute and he had failed to send any reply to the Institute asking him to send his explanation as to how he was training as his articled clerk when he was not a member of the Institute. Held that he was guilty under clause (3) of Part III of the First Schedule. (S.M. Vohra in Re: Vol. Vll(2) of the Disciplinary cases to be published - Council’s decision dated 16th to 18th July, 1992). Where a Chartered Accountant had while returning his Entry on Record for publication in the List of Members confirmed his status as in full time practice and did not disclose his engagement as salaried employee at the time of furnishing particulars in the prescribed Form 27 for registration of his firm. Held that he was guilty under clause (1) of Part III of the First Schedule. |

Professional Ethics

23.69

(R.K. Jain in Re: Vol. VII(2) of the Disciplinary Cases to be published - Council’s decision dated 10th to 12th June, 1993. Clause (3) while inviting professional work from another chartered accountant or while responding to tenders or enquiries or while advertising through a write up, or anything as provided for in items (6) and (7) of Part I of this Schedule, gives information knowing it to be false. Any member of the Institute, in the course of procurement of professional work from another Chartered Accountant or from any other source provides or renders any information which he knows to be false through any documents, or acts (like tenders, enquiries, response to advertisement, CV type write ups etc.), he would be deemed to guilty of professional misconduct under clause (3), Part-III of Schedule-I. PART IV- Other misconduct in relation to members of the Institute generally A member of the Institute, whether in practice or not, shall be deemed to be guilty of other misconduct, if he (1) is held guilty by any civil or criminal court for an offence which is punishable with imprisonment for a term not exceeding six months; (2) in the opinion of the Council, brings disrepute to the profession or the Institute as a result of his action whether or not related to his professional work. These clause (1) & (2) are self explanatory and any of the member of the Institute is found guilty by any civil or criminal court and prosecuted for an imprisonment in an offence involving moral turpitude or his acts bring disrepute to the profession or the Institute, irrespective of the fact whether such acts are related to profession or not, such member will be deemed to be guilty of other misconduct in Part IV of Schedule I. The important point to note is that if imprisonment tenure exceeds six months, this case will be covered in the clause of Part III of Schedule II. 23.13.2 The Second schedule - Where the Director (Discipline) is of the opinion that a member is guilty of any professional or other misconduct mentioned in the second schedule or in both the Schedule, he shall place the matter before the Disciplinary Committee. Part I - Professional misconduct in relation to chartered Accountant in practice A Chartered Accountant in practice shall be deemed to be guilty of professional misconduct, if he Clause (1) “Discloses Information acquired in the course of his professional engagement to any person other than his client so engaging him without the consent of his client or otherwise than as required by any law for the time being in force”. An accountant in public practice has access to a great deal of information of his client, which is of a highly confidential character. It is important for the work of an accountant and for maintaining the dignity and status of the profession that he should treat such information as having been provided to him, only to facilitate the performance of his professional duties for which his services have been engaged. To divulge such information would be a breach of

23.70

Advanced Auditing and Professional Ethics

professional confidence, which may give rise to the most serious consequences, even to an action by the client for the loss suffered by him through such a breach. But for this confidence that the public has developed in the integrity of accountants, if would not be possible for a person in a similar trade or industry to appoint the same accountant. The accountant’s duty not to disclose continues even after the completion of his assignment. If disclosure is required as a part of performance of professional duty by a practicing member in relation to a client, the fact that such performance is required by the client would itself amount to the client consenting to such disclosure. Thus, a member in practice submitting information to, say, exchange control authorities, while performing his professional duties cannot be considered to have made disclosure without the aforesaid consent. But, in all cases, the request or the initiative that the members do prefer the service, which would entail such disclosure, must come from the client in relation to whose affairs the disclosure would be entailed. If disclosure is required in other cases, it would be necessary to ensure that the consent of the client is given by a person who is competent to accord such consent. Thus, in the case of a sole proprietary concern, the consent may be given by the proprietor or his constituted attorney who is legally empowered to give such consent. In the case of partnership firm, since in turn, every partner has the authority to bind the firm by his acts, the consent may be given by any partner. In the case of a company, by virtue of section 291 of the Companies Act, the Board of Directors is empowered to do all that the company in a general meeting may do unless a resolution by the company in general meeting is required by the Act or by the Memorandum or Articles of the company. Hence, the consent may be given by the Managing Director if the powers of the Board of Directors are delegated to him comprehensively enough to include the power to give such consent, but if the powers of the Board of Directors are not so delegated, the consent should be obtained by means of resolution of the Board of Directors of the Company. An auditor is not required to provide the client or other auditors of the same enterprise or its related enterprise such as a parent or a subsidiary, access to his audit working papers. The main auditors of an enterprise do not have right of access to the audit working papers of the branch auditors. In the case of a company, the statutory auditor has to consider the report of the branch auditor and has a right to seek clarifications and/or to visit the branch if he deems it necessary to do so for the performance of the duties as auditor. An auditor can rely on the work of another auditor, without having any right of access to the audit working papers of the other auditor. For this purpose, the term ‘auditor’ includes ‘internal auditor’. However, the auditor may, at his discretion, in cases considered appropriate by him, make portions of or extracts from his working papers available to the client. The above clarification has been published in April, 2000 issue of the Journal, The Chartered Accountant’ at page 89. It is not possible to set out all the circumstances under which disclosure of information may be required by law. If under any legal compulsion and if it is not legally permissible to claim privilege under the Evidence Act, 1972 (Section 126), the disclosure made by a member of such information may not be considered as misconduct. However, such matters involve niceties of law and expert legal advice may be sought prior to, such disclosure.

Professional Ethics

23.71

The only circumstance in which this duty of confidence may give rise to a difficulty is where the accountant has reason to believe that the client has been guilty of some unlawful act or default. This matter is of special significance in the case where the client is guilty of tax evasion. Role of chartered accountants in relation to unlawful acts by their clients 1.

The question of the member’s liability when he is not directly involved in tax frauds committed by his client but he discovers such fraud in the course of his professional work, the action recommended to be taken by him is indicated below. These recommendations are generally in line with similar recommendations made by the Institute of chartered accountants in England and Wales for the guidance of its members.

2. The recommendations below are based on the following premises: (a) No duty is cast on a member, whether by Section 44 of Criminal Procedure Code, or by any other enactment, to inform the Income tax Authorities about taxation frauds by his client of which he comes to know during the course of his professional work. (b) Under Section 126 of the Evidence Act, a barrister, attorney, pleader or Vakil is barred from disclosing except with the express consent of his client, any communication made to him in the course of and for the purpose of his employment or to state the contents or conditions of any document with which he has become acquainted in such course. The proceedings before the Income tax authorities are judicial proceedings and the assessee is authorized to be represented by a chartered accountant The privilege given and the restrictions imposed by Section 126 apply as between the client and the member as the member is the client’s attorney. Nothing in Section 126 shall protect from disclosure any fact observed by a barrister, pleader, attorney or Vakil in the course of his employment of such showing that any crime or fraud has been committed since the commencement of his employment. (c) Subject to the above, it is not the duty of a member to shield a client from the consequences of( his tax frauds; on the contrary it is guiding principle of professional conduct to discourage tax evasion. 3. The paragraphs that follow apply to intentional suppressions or misstatement by the client in his tax returns. If there is a genuine mistake or inadvertent omission, it is presumed that the client would not have any objection to make a complete disclosure to the tax authorities. 4.

If the fraud discovered by the member relates to the accounts or tax matters of the client for past year(s) for which the client was not represented by the member, the client should be advised to make a disclosure. The member may, however, continue to act for the client in respect of current matters, but is under no obligation so to continue. It is assumed that the past fraud does not affect in any way the current tax matters, and the member should be extra careful to ensure that past behaviours is not reflected in current matters.

5.

If the fraud relates to accounts etc., examined by the member and reported upon, on the basis of which the tax assessment in the past has been made, or is currently to be made, the client should be advised to make a complete disclosure. If the client should refuse, he

23.72

Advanced Auditing and Professional Ethics

should be informed that the member would be entitled to dissociate himself from the case, and that, further, he would inform the authorities that the accounts prepared by him and/or reported upon by him are unreliable, on account of certain information since obtained. He should then make such a report to the authorities. But the information subsequently obtained should not as such be communicated to the authorities, unless the client consents in writing. 6. Normally, if disclosure is consented to by the client it should be made immediately. But if the suppression is trivial, the disclosure may be made when the current return is submitted. But if there is any possibility that the collection of tax would be prejudiced, on account of the client disposing of his property or removing his person from the jurisdiction of the Incometax authorities the postponement of disclosure would be improper. 7.

If the suppression etc. relates to accounts or returns currently being prepared, the member should advise the client to make full disclosure in the accounts and/or return, and should the client refuse, he should make full reservation in his report, and should not associate himself with the return.

8.

If the employment of the member is dispensed with before the accounts are completed or are reported on, or the return is submitted, no further duty regarding disclosure etc. rests on the member.

9.

The suppression may relate to accounts, which are not prepared and/or reported upon by the member, e.g. personal income, from investments other than business investments etc. The client may refuse full disclosure in the tax return but still wish that the member should continue to prepare and/ or report on his business accounts, though this is quite unlikely in practice. If so requested, the member may continue to do so, but is under no obligation so to do.

10. It should be impressed on the client that: (a) While disclosure may entail only monetary penalties, nondisclosure and subsequent discovery thereof may entail imprisonment and fine, in addition to penalties. (b) Any intimation by the member to the Income tax authorities that the member dissociates himself from the case is certain to start investigation by them in the whole matter. 11. The Income-tax authorities may summon the member for the purpose of examining him on oath, under Section 131(1) of the Income tax Act. The immunity from disclosure afforded by Section 126 of the Evidence Act, and the extent of such immunity are questions, which involve niceties of law, and expert legal advice should be sought in the matter. The refusal of the member to disclose may be taken down, and he may be required to certify it on oath. 12. Production of books of account and other documents may be called for under Section 131 (1). Here also the protection offered by Section 126 of the Evidence Act, is a matter for expert legal advice. The decision of the Court on this clause is given below-

Professional Ethics

23.73

Disclosure of information - Where a chartered accountant disclosed to the Income tax Officer information acquired in the course of his professional engagement without the consent of his clients. Held, he was guilty under clause (1). (Jamnadas Harakchand and others vs. P. C. Parekh- Page 492 of Vol. IV of the Disciplinary Cases and Pages 26-44 July, 1967 issue of the institute’s Journal - Judgement delivered on 12/16th January, 1967.) Where a Chartered accountant had disclosed information acquired by him in the course of his professional engagement to persons other than his clients without the consent of his client and without requirement in any law. It was held that he was guilty of professional misconduct under clause (1) of Part I of Second Schedule to the Chartered Accountants Act. (Bank of India vs. Ved Prakesh - Page 458 of Vol. VI (1) of the Disciplinary Cases- Judgement dated 13th July, 1989) Clause (2) “If he certifies or submits in his name or in the name of his firm,a report of an examination of financial statements unless the examination of such statements and the related records has been made by him or by a partner or an employee In his firm or by another chartered accountant in practice”. The above clause restrains a member from subscribing to the report on a financial statement so long as it has not been examined by him or by a partner or an employee of his firm or by another chartered accountant in practice. It has been introduced to ensure that the work entrusted to him has been carried out by the member either directly or under his supervision before he renders his report. An exception however has been made in respect of an examination carried out by another chartered accountant in practice. This enables two or more members to accept a joint assignment or enables a member also to carry out the examination of financial statements by or with the assistance of all either chartered accountant in practice, It must be pointed out that when they do so they are undertaking joint responsibility and in respect of any default or failure, they would be jointly and severally liable. Where the joint auditors are appointed, the work is normally divided among themselves in terms of identifiable units or areas, or with reference to the items of liabilities, or income or expenditure or to the period of time etc. Such division should be adequately documented and communicated to the auditee. In the course of his work, where a joint auditor comes across matters requiring discussion with or application of judgement by the joint auditors, he must communicate to the other joint auditors before submission of the report. In respect of audit work divided among the joint auditors, each joint auditor is responsible only for the work allocated to him, whether or not he has prepared a separate report on the work performed by him. On the other hand, all the joint auditors are jointly and severally responsible: (a) In respect of the audit work which is not divided among the joint auditors and is carried out by all of them;

23.74

Advanced Auditing and Professional Ethics

(b) In respect of decisions taken by all the joint auditors concerning the nature, timing or extent of the audit procedures to be performed by any of the joint auditors. It may, however, be clarified that all the joint auditors are responsible only in respect of the appropriateness of the decisions concerning the nature, timing or extent of the audit procedures agreed upon among them; proper execution on the joint auditor concerned. (c) In respect of matters which are brought to the notice of the joint auditors by any one of them and on which there is an agreement among the joint auditors; (d) For examining that the financial statements of the entity comply with the disclosure requirements of the relevant statute; and (e) For ensuring that the audit report complies with the requirements of the relevant statute. Each joint auditor should decide for himself the appropriateness of using test checks or sampling, the nature, timing and extent of audit procedures to be applied in relation to the work allotted to him. Obtaining and evaluating the information and explanations from the management is the joint responsibility of the joint auditors unless they agree upon a specific pattern of distribution of this responsibility. In case of distribution of the responsibility, the liability of the joint auditors is limited to the area allotted to that auditor. For detailed consideration of the subject, the members must refer to statement on standard Auditing Practices (SAP) 12 in this connection. Clause (3) “Permits his name or the name of his firm to be used in connection with an estimate of earnings contingent upon future transactions in manner which may lead to the belief that he vouches for the accuracy of the forecast”. This clause provides that a Chartered Accountant in practice shall be deemed to be guilty of professional misconduct if he permits his name or the name of his firm to be used in connection with the estimate of earnings contingent upon future transactions in a manner which may lead to the belief that he vouches for the accuracy of the forecast. The Council has issued a guidance note entitled “Guidance Note on Accountants Report on Profit Forecasts and/or Financial Forecasts” wherein they have considered the implications of the above clause. After consideration of the various factors Council has taken the view that the above clause does not preclude a Chartered Accountant from associating his name with forecasts. He can participate in the preparation of profit or financial forecasts and can review them, provided he indicates clearly in his report the sources of information, the basis of forecasts and also the major assumptions made in arriving at the forecasts and so long as he does not vouch for the accuracy of the forecasts. It is also clear that the words “vouch for the accuracy of the forecast” do not refer to the arithmetical accuracy. The Council recognizes that all forecasts are estimates based on certain assumptions duly evaluated on a consideration of various relevant factors and, as such, are not capable of being ascertained with accuracy. This is a special feature incidental to all :forecasting processes and is distinct from audits and other statements reported upon by Chartered Accountants.

Professional Ethics

23.75

Clause (4) Expresses his opinion on financial statements of any business or enterprise in which he, his firm, or a partner in his firm has a substantial interest; Now, the words "unless he discloses the interest also in his report" has been deleted from this clause there by making mandatory not to express opinion on financial statement of any business or enterprise in which he, his firm or a partner in his firm has a substantial interest. 1.

Where the member, his firm or his partner or his relative has substantial interest in the business or enterprise. The independence of mind is a fundamental concept of audit and/or expression of opinion on the financial statements in any form and, therefore, must always be maintained. Nothing can substitute for the essential and fundamental requirements of independence. Therefore, the Council’s views are clarified in the following circumstances.

2.

(i)

An enterprise/concern of which a member is either an owner or a partner. The holding of interest in the business or enterprise by a member himself whether as soleproprietor or partner in a firm, in the opinion of the Council, would affect his independence of mind in the performance of professional duties in conducting the audit and/or expressing an opinion on financial statements of such enterprise. Therefore, a member should not audit financial statements of such business or enterprise.

(ii)

Where the partner or relative of a member has substantial interest: The holding of substantial interest by the partner or relative of the member in the business or enterprise of which the audit is to be carried out and opinion is to be expressed on the financial statement, may also affect the independence of mind of the member, in the opinion of Council, in the performance of professional duties. Therefore, the member may, for the same reasons as not to compromise his independence, not from undertaking the audit of financial statements of such business or enterprise.

Where the member or his partner or relative is a director or in the employment of an officer or an employee of the company.

Section 226 of the Companies Act specifically prohibits a member from auditing the accounts of a company in which he is a director. Although the provisions of the aforesaid section are not specifically applicable in the context of audits performed under other statues, e.g. tax audit, yet the underlying principle of independence of mind is equally applicable in those situations also. Therefore, the Council’s views are clarified in the following situations. Where a member is a director, in cases where the member is a director of a company the financial statements of which are to be audited and/or opinion is to be expressed, he should not undertake such job and/or express opinion on the financial statements of that company. The Council has clarified that the members are not permitted to write books of account of their auditee clients. A statutory auditor of a company cannot also be its internal auditor, as it will not be possible for him to give independent and objective report issued under sub-section 4A of Section 227 of the Companies Act read with the Companies (Auditor’s Report) Order, 2003.

23.76

Advanced Auditing and Professional Ethics

A member should satisfy himself before accepting an appointment as an auditor of an entity that his appointment is in accordance with the statute governing the entity: In case the entity is constituted under a trust dated / instrument, the member should satisfy whether his appointment is valid according to the instrument constituting the entity and rules made hereunder. In case the appointment is to be authorized by the regulatory authorities such as in the case of cooperative societies, trusts etc. then the member must satisfy whether such regulatory authorities have authorized the managing committee of the society / trust for appointment of the auditors. In a case where any entity is being managed by a Managing Committee or Board of Trustees or Board of Governors by whatever name called he should ensure that his appointment is duly made by a resolution passed of such Managing Committee or Board of Trustees of Board of Governors. Even in case of partnership or sole proprietary, the member must ensure that a letter of appointment/ engagement is given by a financial statement before he accepts the assignment. Clause (5) fails to disclose a material fact known to him which is not disclosed in a financial statement, but disclosure of which is necessary in making such financial statement not misleading where he is concerned with that financial statement in a professional capacity; It may be observed that this clause refers to failure to disclose a material fact, which is known to him, in a financial statement reported on by the auditor. It is obvious, that before a member could be held guilty of misconduct, materiality has to be established, The word materiality has been defined in SAP-13 as follows. “Information is material, if its misstatements (i.e. omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information.” It should be borne in mind that there may be cases where an item may not be material from the point of view of the balance sheet, but may have material significance in relation to the profit and loss account for that year and vice-versa. It is therefore essential that care should be taken to ensure that the aspect of materiality should be judged in relation to both the balance sheet and the profit and loss account. The word “financial statements” used in this clause would cover both reports and certificate usually given after an examination of the accounts or of financial statements under any statutory enactment, or/for purposes of income tax assessments. This would not however, apply to cases where such statements are prepared by members in employment purely for the information of their respective employers in the normal course of their duties and not meant to be submitted to any outside authority. The decisions of the Courts on this clause are briefly given belowWhere a Chartered Accountant failed to report to the shareholders of a company about the non -creation of a sinking fund in accordance with the Debenture Trust Deed and did not make clear that the amounts shown as towards sinking fund where borrowed from the managing agents of the company-Held, that the chartered accountant was duty bound to see that the nature and subject matter of the charge over a security and the nature and mode of valuation of the sinking fund investment were disclosed in the Balance Sheet in accordance with Form F and he was found guilty of misconduct.

Professional Ethics

23.77

(Davar & Sons Ltd. vs M.S. Krishnaswamy-page 120 of Vol. I of the Disciplinary Cases and pages 33-40 or June, 1952 issue of the Institute’s bulletin-Judgement delivered on 3rd. October 1952). Where a Chartered Accountant failed to examine how debts become bad and were written offHeld he was guilty under Clause (5). (A. Doraiswami/ Naidu-vs. P.M. Raghavendra Rao - Page 468, of Vol. IV of the Disciplinary Cases and Pages 463-465 of February, 1966 issue of the Institutes journal-judgement delivered on 27th October, 1965). Where a Chartered Accountant had not disclosed the fact that a large amount of loan have been given out of the funds of an Employees Provident Fund to the Employer Company in contravention of the Rules of the Provident Fund and had failed to report on the default in clearing the cheques received in re-payment of the loan. Held by the High Court that he was not guilty of any non-disclosure to the individual subscribers of the Provident Fund because he owed no duty to disclose to them and he was well within his rights to have disclosed the irregularities to the trustees themselves and to the company which had appointed him. Held by the Supreme Court on appeal that it was no defiance for the chartered accountant to say that he had disclosed the irregularities to the company as it was his duty to have made a disclosure thereof to the beneficiaries of the Provident Fund in the statement of accounts signed by him as the legal position of the auditor in the present case was similar to that of the auditor appointed under the Companies Act. He was therefore guilty of professional misconduct under Clause (5). Kishori Lal Dutta vs-P.K. Mukherjee -Page 646 of Vol. IV of the Disciplinary Cases and page 573 of April 1968 issue of the Institute’s Journal-Judgement delivered on 26th February, 1968). Clause(6) “Fails to report a material misstatement known to him to appear in a financial statement with which he is concerned in a professional capacity”. This clause refers to failure on the part of a member to point out in his report a material misstatement appearing in a financial statement and he has knowledge of the same. Here also, it is obvious, that before a member could be held guilty of misconduct, materiality has to be established and the observations made under the preceding Clause (5), in this connection, will equally apply to this clause. The decisions of the Courts on this clause are briefly given belowWhere a Chartered Accountant prepared a balance sheet of a firm and subsequently prepared statement regarding the state of affairs of the firm without taking into account the balance sheet already prepared by him showing a lesser amount by way of opening stock and a lesser amount to the credit of the proprietor and subsequently when he was called upon by his client to prepare a fresh balance sheet and profit and loss account for the same year so that it should tally with the statement of affairs prepared by him he did so without reference to the actual account books but on instruction of the client, and as such it was a false and incorrect balance sheet. Held, he was guilty under Clauses (5) & (6).

23.78

Advanced Auditing and Professional Ethics

(Attorney General of Kenya-vs-V.B. Joshi-page 688 of Vol. IV of the Disciplinary Cases and page 681 June, 1968 issue of the Institute’s Journal- Judgement delivered on 19th February, 1968) A Chartered Accountant was charged under Clauses (5) and (6) for failure to report that there was a reduction of capital with corresponding reduction in the loans and advances on the assets side, which contravened Section 59 of the Travencore Companies Act, There was also a failure on his part to report on the non disclosure of the forfeiture and cancellation of share. Held the Respondent’s conduct was not proper. (Registrar of Joint Stock Companies- vs- S.S. lyer-page 94 of Vol. IV of the Disciplinary Cases and pages 405-408 of April, 1960 issue of the Institute’s Journal-Judgement delivered on 25th January 1960). A Chartered Accountant failed to disclose a misstatement or under statement by the company in the balance sheet of its liabilities, which amounted to a suppression of the correct state of affairs. He also failed to report a material misstatement by the company in not given the previous year’ figures in the corresponding column of the balance sheet. Held was guilty of professional misconduct under Clauses (6) and (7). Clause (7) does not exercise due diligence, or is grossly negligent in the conduct of his professional duties; Though very simply worded, it is a vital clause which unusually gets attracted whenever it is necessary to judge whether the accountant has honestly and reasonably discharged his duties. The expression negligence covers a wide field and extends from the frontiers of fraud to collateral minor negligence. The meaning and significance of this clause is well contained in the following passage quoted from the Judgement of the Karnataka High Court in a disciplinary case which came before it in 1977. It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably competent, careful, and cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watchdog but not a bloodhound. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonable cautious and careful. Professional misconduct is a term of fairly wide import but generally speaking, it implies fairly serious cases of misconduct of gross negligence. Negligence per se would not amount to gross negligence in the case of minor errors and lapses, which do not constitute professional misconduct and which, therefore, don’t require a reference to the Disciplinary Committee, the Council would nevertheless bring the matter to the attention of its members so that greater care may be taken in the future in avoiding errors and lapses of a similar type”. The decisions of the Courts on this clause are briefly mentioned below:

Professional Ethics

23.79

Where a Chartered Accountant failed to indicate the mode of valuation of investments in shares as required by the Companies Act and also to draw attention to the inclusion of uniforms in the fe depreciation account. - Held that he was guilty under Clause (7). (M.C. Poddar vs-P.S. Sodhbans - page 259 of Vol. I of the Disciplinary Cases and page 554 of March 1954 issue of the Institute’s Journal-Judgement delivered on 1st April, 1954). Where a Chartered Accountant, in a bank audit reported to the shareholders that he had not verified the cash on hand and that he has also signed the balance sheet in anticipation of the receipt of confirmation letters from the banks in respect of the cash said to be lying with them and failed to report on the weakness of the bank’s financial position. Held that he was guilty of the first and third charges falling under Clause (7). Verification of cash was an essential duty of an auditor, which he failed to discharge and in signing the report in anticipation of receiving the confirmation letters from bank banks, he had failed to perform his duties with the requisite skill and diligence. (S.N. Das Gupta in Re: page 57 of Vol. II of the Disciplinary Cases and pages 80-92 of September 1955 issue of the Institute’s Journal-Judgement Delivered on 1st August, 1955). Where a Chartered Accountant certified the circulation of a newspaper based on the statistic record but stated in his certificate that he had given it after examination of the books of account without verifying that the books of account and the statistical records agreed and also without taking into account the return of copies unsold. Held that he was guilty of gross negligence. (V.K. Madhava Rao in Re: page 21 of Vol. Ill of the Disciplinary Cases and pages 88-92 of August 1956 issue of the Institute’s Journal-Judgement delivered on 17th April, 1956). Where a certificate issued by a Chartered Accountant under Regulations 7(c) & 7(d) (i) of Part I d the First Schedule to the Insurance Act, 1938 was not correct, as the company had granted loans on policies which had already lapsed for non-payment of premium and also the claims in respect of two policies which has matured were not included in estimated liability in respect of outstanding claims shown in the Balance Sheet-Held he was guilty under Clauses (7) & (8). (Controller of Insurance vs H. C. Das - page 240 of Vol. Ill of the Disciplinary Cases and pages 422-429 of March, 1957 issue of the Institute’s Journal -Judgement delivered on 4th January 1957). Where a Chartered Accountant, appointed as auditor of the Madras branch of a limited company in Bombay was charged with failure to report to the Bombay office that some entries in the bank pas book has not been passed through the cash book of the branch. Held he was guilty of gross negligence. The High Court observed that a small fee paid to the respondent should not come in the way of his doing duty without fear or favour, although it involved unpleasant consequence namely, he might not be appointed again. (The Fairdeal Corporation Ltd. Bombay vs K. Gopalakrishna Rao - page 361 of Vol. Ill of the Disciplinary Cases and pages 196-203 of October, 1957 issue of the Institute’s JournalJudgement delivered on 23rd August, 1957).

23.80

Advanced Auditing and Professional Ethics

A certificate issued by a Chartered Accountant to a proprietor of a firm in respect of the turnover of betel nuts to enable the firm, which was not dealing in betel nuts, to obtain import license without checking the books and documents himself, but relying on his articled clerk for its correctness. Held he was guilty of gross negligence. (Sunder Lal Fatehpuria in Re: page 591 of Vol. Ill of the Disciplinary Cases and page 224 of January, 1959 issue of the Institute’s Journal-Judgement delivered on 14th November, 1958). Where a Chartered Accountant failed in his duty to check the bank balances with the pass books of the banks and failed to obtain certificates of balances from the bankers in respect of those balances. The Council found him guilty of misconduct under Clauses (7) & (8) of Part I of the’ Second Schedule. Held there being no proof of dishonesty or volume malafide on the part of the Chartered Accountant and in view of the circumstances of the case, the High Court took no more serious view of the matter than to express disapprobation of the conduct of the Chartered Accountant in the form of admonition. (Company Law Administration-vs-D.B. Kulkarni-page 185 of Vol. of the disciplinary Cases and pages 410-412 of April, 1960 issue of the Institutes Journal -Judgement- delivered on 1st April, 1960). In the course of some investigation of the affairs of a bank on liquidation, it was found that the authorities of the bank failed to disclose the total indebtedness of the directors in the balance sheet and to report on the numerous alterations and fictitious entries in the books of accounts of the bank. Held that no auditor could escape from personal liability by taking shelter under the misconduct of his own employees. There was nothing to indicate the status, qualifications or capacity of the assistants. Under the circumstances, the conduct of the Chartered Accountant in abdicating his functions to his subordinates amounted to gross negligence. (Superintendent of Police Madras vs M. Rajamany page 232 of Vol. IV of the Disciplinary Cases and pages 27-29 of July, 1961 issue of the Institute’s Journal - Judgement delivered on 5th May, .1961). Where a Chartered Accountant failed to report on the overpayment of remuneration to the managing agents of a company, which contravened Sections 18(2) and Section 87CC, of the Indian Companies Act, 1913 and was, therefore, not in accordance with law. Held he was guilty under Clauses (5), (7) and (9). (B K. Ray in Re: page 300 of Vol. IV of the Disciplinary Cases and pages 521-523 of January, 1963 issue of the Institute’s Journal- Judgement delivered on 30th November, 1962). ’Where a Chartered Accountant had placed implicit reliance on his paid assistant who took absolutely no step whatsoever to check the cash balances facilitating and resulting, in serious defalcations. Held he was guilty under Clauses (5), (7) (8) and (9). D. C. Sopariwala in Re: page 783 of Vol. IV of the Disciplinary Cases and pages 502-504 of March, 1969 issue of the Institute’s Journal -Judgement delivered on 27th November, 1968). Where a Chartered Accountant had falsely certified the circulation figures of a newspaper by stating that he had checked inter alia the newsprint sheets and machine room returns when they had not at all been maintained by the publisher. Held he was guilty under Clauses (5) and

Professional Ethics

23.81

(9). (Audit Bureau of Circulations Ltd. vs- K.L.Agrawl- page 616 of Vol. IV of the Disciplinary Cases and page 438 of February, 1968 issue of the Institute’s, Journal- Judgement delivered on 24th July, 1967). Where a certificate issued by a Chartered Accountant to the Joint Chief Controller of Imports & Exports, Calcutta stating that a firm had exported a certain quantity of onions during a certain period contained false and inaccurate particulars in respect of three items of invoice value the particulars themselves related to exports not by this firm but by two other firms. Held he was guilty of the charge of gross negligence. (The Chief Controller of Exports vs-G.P. Acharya- page 311 of Vol. IV of the Disciplinary Cases and pages 189-194 of September, 1963 issue of the Institute’s Journal- Judgement delivered on 30th November, 1962). Where a Chartered Accountant signed the accounts of an institution subject to separate notes. Held he was guilty of gross negligence. In the view of the High Court, the essential part was the separate notes. Any one going through his report would at least assume that those notes when prepared and were ready at the time when the report was signed by him. It could not be supposed that those notes were not in existence at that time and were written at some later date on some facts, which were still to be verified or ascertained. His act, though not suffering from bad or vicious intention, was still an act of gross negligence. (Hitkarini Mahavidyalaya, Jabalpur vs P.C, Madan-page 34 of Vol. IV of the Disciplinary Cases and pages 29-31 of July, 1963 issue of the Institute’s Journal-Judgement delivered on 11th April, 1963) On the basis of the investigation report on the affairs of a company by an inspector appointed by the Government, the auditor of that company was charged with failure of duty in not carrying out, complete audit, verify the assets and liabilities in-the balance sheet and report on the objectionable vouchers. Held he was guilty under Clause (7). (Registrar of Companies, Kerala State vs TS. Vaidyanath lyer - page 349 of Vol. IV of the Disciplinary Cases and pages 187-189 of September, 1963 issue of the Institute’s Journal Judgement delivered on 22nd May, 1963). Where a chartered accountant gave clean reports on the balance sheets whereas the reports on the special audit conducted subsequently revealed certain irregularities which amounted to failure to examine the pass book and to verify the cash balance. Held he was guilty under Clause (7). (Director of Accounts, Gujarat State, Ahmedabad vs K.D. Patel-page 636 of Vol. IV of (The Disciplinary Cases and page 572 (of April, 1968 Issue of the Institute’s Journal-Judgement delivered on 6th February, 1968). Where a Chartered Accountant had not completed his work relating to the audit of the accounts a company and had not submitted his audit report in due time to enable the company to comply with the statutory requirement in this regard. Held, he was guilty of professional misconduct under Clause (7).

23.82

Advanced Auditing and Professional Ethics

(Qaroon trading & Finance Pvt. Ltd.- vs Luxmi Narain Saxena and Jitendera Mohan Chadha Page 828 of Vol. IV of the Disciplinary Cases and Pages 47-49 of July, 1969 issue of the Institute’s Journal - Judgement delivered on 12th February, 1969). Where a Chartered Accountant failed to exercise sufficient care and diligence in his professional responsibilities in not checking the cash memos and not verifying the alterations in the trial balance with the original books in respect of one company and in not checking the journal entries and the final figures of the balance sheet with the general ledger in respect of another company. Held, he was guilty under Clause (7). (Messrs. 0. M. Agency Private Ltd. & Messers. Oriental Mercantile Distributors Private Ltd. Surendra Sastry- page 891 of Vol. IV of the Disciplinary Cases and pages 452-455 of November, 1971 issue of the Institute’s Journal-Judgement delivered on 21st April, 1971). In his audit report of a school, the auditor failed to point out wrong and misleading entries and a sum of Rs. 7.000/- on account of reserve fund did not find a place at all in the original statement sent to the school. The correction slip alleged to be sent by the Chartered Accountant was never received by the school. The Chartered Accountant had not proved that the correction slip was sent to the school. Held the Chartered Accountant was guilty of gross negligence in the conduct of professional duties and his conduct was quite unbecoming of a professional person entrusted with responsibility of dealing with the accounts. (B.L. Shoulder vs-M.K. Deb -page 121 of Vol. V of the Disciplinary Cases and page 196-198 of March 7th, 1977 issue of the institute’s Newsletter-Judgement delivered on 3rd November, 1976). A Chartered Accountant, without examination of stock register of the firm and without examining other relevant matters connected with the certificate, issued wrong consumption certificate in respect of raw material and components on the basis of which, license of higher value, for which the unit was not entitled, was issued by the Deputy controller of Imports and Exports. Held the Chartered Accountant was guilty of gross negligence under the Clause (7). (IS. Vaidyanath lyer in Re: page 153 of Vol. V of the Disciplinary Cases and pages 211-212 of April, 1977 issue of the Institute’s Newsletter - Judgement delivered on 27th January, 1977). A Chartered Accountant adopted arbitrary valuation of closing stock and no verification at all was done by him. Further he accepted the capitalization of a large sum of expenditure which was in the nature of revenue. He had merely adopted an adhoc basis in deciding upon capitalization of expenditure and failed to apply his mind and bring to bear on the subject the due diligence and care expected of a member of the profession. Held, the Chartered Accountant was guilty of gross negligence in the performance of his duties. (B. Shantharam Rao in Re: page 168 of Vol. V of the Disciplinary Cases and page 241-243 of May 1971 issue of the Institute’s Newsletter - Judgement delivered on 13th, 18th February, 1977). A Chartered Accountant was charged under Clauses (5), (6), (7) and (8) of Part I of Second Schedule in regard to a loss of Rs. 1.84 lakhs in a bank of sale of some investments out of which only a sum of Rs. 21,500 was written off by the bank. The value of investment in the

Professional Ethics

23.83

balance sheet was inflated and it did not exhibit the correct position and the profit and loss accounts did not show a true balance of profit and loss. Held, the respondent was guilty of conduct so as to render him ’unfit to be a member of the institute. (B.S. Waierker in Re: page 448 of Vol. Ill of the Disciplinary Cases and page 470-472 of January 1958 issue of the Institute’s Newsletter—Judgement delivered on 9th December, 1957). A Chartered Accountant was found guilty of professional misconduct under Clauses (5), (6), (7) and (9) of Part 1 of the Second Schedule on the following grounds: (1) That he failed to point out the contravention of Note (C) to Schedule VI of the Companies Act, that is, the requirement in the case of a subsidiary company that the number of shares held, by the holding company as well as by the ultimate holding company and its subsidiaries must be separately stated. (2) that he failed to point out the contravention of Part I Schedule VI, that is share capital issued in pursuance of a contract without payment being received in cash and shares allotted as fully paid up by way of bonus shares should have been shown separately; (3) that he failed to point out in his report, that the company, of which he was the auditor, was a public limited company or deemed to be a public limited company by virtue of Section 43A of the Companies Act: (4) That he failed to comment in his report on the debit balance in the current account with managing agents, in accordance with Section 369 of the Companies Act; (5) That he failed to report the money value of the contract for the supply of service with the associates of managing agents as required under Schedule VI Part 1. (Registrar of Companies, West Bengal vs V. V. Bapat-Page 8 of Vol. V of the disciplinary Cases and page 281 of December, 1974 issue of the Institute’s Journal-Judgement delivered on 22nd January, 1974) Where a Chartered Accountant issued two different certificates of circulation of a daily for one and the same period showing different figures in respect of the number of copies printed and circulated. Held, he was guilty under Clauses (7) and (8). (Registrar of Newspapers for India vs P.K. Mukherji-page 937 of Vol. IV of the Disciplinary Cases and pages 615-617 of January, 1972 issue of the Institute’s Journal -Judgement delivered on 20, August, 1971). A Chartered Accountant had failed to detect a fraud committed by the accountant of a canteen which could have been detected if he had checked the castings of the cash books and also checked the ‘contra’ entries of the bank and cash columns of the cash books. Held, he was guilty -of professional misconduct under Clauses (7), (8) and (9). (Air Commodore Dilbagh Singh vs C.G .Apte- page 107 of Vol. V of the Disciplinary cases and page 224 of September, 1976 issue of the Institute’s Journal-Judgement delivered on 5th July, 1976).

23.84

Advanced Auditing and Professional Ethics

Where a Chartered Accountant failed to make a reference in the “Income Certificates” prescribed by the ABC to the report which he had separately submitted to the newspaper concerned which did represent the correct state of affairs in all respects but which was not sent by the newspaper to the Bureau, Held, he was guilty under Clauses (7) and (9). (Audit Bureau of Circulations Ltd., vs A.D. Shinde -page 725 of Vol. IV of the Disciplinary, Cases and page 627 of May, 1968 issue of the Institute’s Journal-Judgement delivered on 26th February, 1968). The chartered accountant failed to obtain sufficient information to warrant the expression of an opinion. Held, that he was guilty under this clause. (Institute’s Journal August, 1982 (i) S.B. Patak in Re: (2) CS. Hariharan in Re: decided on 16th March, 1982 page 151-152 Vol. VI of the Disciplinary Cases). The Chartered Accountant relied upon the internal control without satisfying himself about the propriety and surrendered to the pressure of management and certified the accounts without examining and getting necessary clarification. Held that he was guilty of misconduct. (B.L. Purohit vs J.N. Chandak, decided on 10-12-1980, Vol. VI of the Disciplinary Cases to be published. The Institute’s Journal March, 1981 page 703-11). Clause (8) : “Fails to obtain sufficient information which is necessary for expression of an opinion or its exceptions are sufficiently material to negate the expression of an opinion”. It is expected of a Chartered Accountant to express his opinion on the truth and fairness of statements of accounts after examining their authenticity with reference to information and explanations given to him. A Chartered Accountant must determine the extent of information, which , should be obtained by him before he expresses an opinion on the financial statements submitted to him for report. The accountant should not express an opinion before obtaining the required data and information. The latter part of the clause enjoins that where due to inadequacy of information or data the report has to be circumscribed to an extent that it would cease to be of any expression of a categorical opinion, the auditor should clearly express his disclaimer in no uncertain terms. For example, if the auditor has not seen any evidence of the existence and/or valuation of the investment which constitute the only asset of a company, he should not say that: “Subject to the verification of the existence and value of the investments the balance sheet shows a true and fair view etc.”. On the other hand he should say that“As we have been unable to verify the existence and value of the investments of the company, we are unable to state whether the balance sheet shows a true and fair view etc. The Statement on Qualifications in Auditor’s Report issued by the Institute requires that all the qualifications should be contained in the auditors’ report. The notes to accounts normally represent explanatory statements given by the directors of the company and should not

Professional Ethics

23.85

contain the opinion of the auditors. The practice has grown recently of having a large number of notes to accounts, some of which are subject matter of qualifications in the auditors report and some of which are merely clarificatory. It is necessary that the auditors should reproduce the notes of a qualificatory nature in their report to enable the reader to know the importance of these qualifications. The Statement clarifies the use of the word “reproduce” in the above context does not imply a verbatim reproduction. Where notes of a qualificatory nature appear in the accounts. The auditor should state all qualifications independently in his report in an adequate manner so that a reader can assess the significance of these qualifications. For this purpose, where a note is already given in detail by the management it is not necessary to reproduce verbatim such a note in the audit report and a brief self-explanatory statement may be sufficient. The Statement further requires that the auditors should quantify, wherever possible the effect of the qualifications on the financial statements in a clear and unambiguous manner if the same is material. It has been observed that in complying with this requirement, some auditors quantify the effect of individual qualifications on financial statements without stating the total effect of all the qualifications on the profit and or loss/ or state of affairs. The Council is of the view that quantification of the total effect of the qualifications on profit or loss/or state of affairs is useful to the readers of the audit reports. The Council has, therefore, decided to bring it to the attention of the members that they are expected to quantify not only the effect of the qualifications on individual items of financial statements but also their overall effect on profit or loss and/or state of affairs. Accordingly, the Council has decided to make certain amendments in the relevant paragraphs of the Statement (i.e. paragraph 3.10). The Council has also decided to add some examples in the Statement to provide guidance to the members on the manner of quantifying the total effect of the qualifications. Certain changes have also been made in paragraph 3.7 of the Statement. The relevant extracts of the paragraphs of the statement which have been amended and examples which have been added pursuant to the above decision of the Council have been reproduced at page 90 of April, 2000 issue of ‘The Chartered Accountant’. In circumstances where it is not possible to quantify the effect of the qualifications accurately, the auditor may do so on the basis of estimates made by the management after carrying out such audit tests as are possible and clearly indicate the fact that the figures -are based on management estimates. Where non compliance with the provisions of the statute/guideline issued by regulatory authorities governing the enterprise has a bearing upon the accounts and transactions of the enterprise, the auditor in the normal course of his enquiry would become aware of the breaches of the statute and may have an obligation to report the same in his audit report. While qualifying a report, it is important to appreciate: (i)

As to which various items (the statements of fact and opinion) require a qualification;

23.86 (ii)

Advanced Auditing and Professional Ethics

Whether the auditors are in active disagreement with some thing which has been done by the company or are merely unable to form an opinion in regard to items for which there is lack of adequate information;

(iii) Whether the matters in question are so material as to affect the presentation of a true and fair view of the whole of the affairs of the company or are of such a nature as to affect only a particular item disclosed in the accounts; and (iv) Whether the matters constituting qualification involve a material contravention of any requirements of the Companies Act, 1956 which have a bearing on the accounts. Members may refer to the Institute’s Publication “Statement on Qualification on Auditor’s” Report in this regard. The decisions of the Courts on this subject are briefly presented below: A Chartered Accountant without examination of stock register and other relevant matters issued a wrong consumption certificate on the basis of which licence of higher value, for which the unit was not entitled, was issued by Controller of Imports & Exports. The examination done by the Chartered Accountant was so restricted that he could not have obtained the information necessary to warrant the expression of an opinion regarding consumption of raw material and components. Held the chartered accountant was guilty of professional misconduct under Clause (8). (T.S. Vaidyanatha lyer in Re: page 153 of Vol. V of the Disciplinary Cases and pages 211-212 of April, 1977 issue of the Institute’s Newsletter-Judgement delivered on 27th February, 1977). Clean certification of circulation was issued by a Chartered Accountant without any qualification and thereby expressing the opinion that he had conducted the audit in the manner prescribed by the ABC regulations undertaken by him. The interpolation of entries in the books and the absence of documents to support the receipts of monies from the agent should have raised the suspicion and he should have asked for further information in that regard. The Chartered Accountant was required to verify the stocks and whether the agent had accounted for all the sale proceedings. He was wrong in accepting the entries in the books without asking for further information. The Chartered Accountant was required not merely to verify the arithmetical accuracy of the accounts but he ought to have enquired into its substantial accuracy with all the skill, care and caution. If the Chartered Accountant had conscientiously audited the accounts and in accordance with the instruction of the ABC regulations, he could have probed into the matter to the bottom to find out whether the purported sale with agents was genuine or it was only a make believe arrangement. Held the chartered accountant was guilty of misconduct under Clause (8). (Audit Bureau of Circulations Ltd. vs S. Narayananpage 181 of Vol. V of the Disciplinary Cases and page 2-5 of July, 1977 issue of the Institute’s Newsletter Judgement delivered on 14th April, 1977). Where a Chartered Accountant relying on the work of the internal auditor of a company qualified his report that the books of account and the supporting vouchers had been examined by the internal auditor of the company, the Council taking the view that the qualification amounted to an exception sufficiently material to negate the expression of an opinion, found him guilty, of misconduct under the latter part of Clause (8). As a general rule, a statutory

Professional Ethics

23.87

auditor would be guilty under this clause, if he performed his work so recklessly as to give his report-without looking into the books of account of a company, on the basis of the work of the internal auditor whose opinion turned out to be false. (J.C. Chandhok in Re: page 367 of Vol. IV of the Disciplinary Cases and pages 681 - 683 of June, 1964, issue of the Institute’s Journal - Judgement delivered on 31st January, 1964). Where a Chartered Accountant issued a certificate of circulation of a periodical without going into the most elementary details of how the circulation of a periodical was being maintained i.e, by not looking into the financial records, bank statements or bank pass books, by not examining evidence of actual payment of printers bills and by not caring to ascertain how many copies were sold and paid for. Held he was guilty under Clause (8). (Registrar of Newspapers for India vs K. Rajinder Singh-page 920 of Vol. IV of the Disciplinary Cases and page 77-82 of July, 19th issue of the Institute’s Journal-Judgement delivered on 7th May, 1971). Clause (9) “Falls to invite attention to any material departure from the generally accepted procedure of audit applicable to the circumstances”. This clause implies that the audit should be performed in accordance with “generally accepted procedure of audit applicable to the circumstances” and if for any reason the auditor has not been able to perform the audit in accordance with such procedure, his report should draw attention to the material departures from such procedures. What constitutes “generally accepted audit procedure” would depend upon the facts and circumstances of each case, but guidance is available in general terms from the various pronouncements of the Institute is issued by way of statements and Guidance Notes and AASs to members. Members are also advised to refer to the ISA’s issued by the International Auditing Practices Committee of IFAC. An auditor of a company is appointed by the shareholders to perform certain statutory functions and duties and it is expected of him that he will in fact, perform these functions and duties. The failure to perform a statutory duty in the manner required is not excused merely by giving a qualification or reservation in auditor’s report. For example, if an auditor fails to verify the cash balance in circumstances where such verification was necessary, feasible and material, it is not sufficient for him merely to state in his report that he did not verify the cash balance in circumstances when giving any reservations or qualifications in the auditor’s report as required under this clause, a member would be well advised to indicate clearly the reasons why he was unable to perform the audit in accordance with generally accepted procedures and standards. It is not possible to exhaustively deal with instances or accepted procedure of audit applicable to special cases. Two instances of an audit requiring a special procedure are given below: Very often members are required to certify the figures of circulation cf newspapers, magazines etc. by their clients on behalf of the Audit Bureau of Circulations Ltd. Members are normally supplied by the ABC with the Rules and Regulations under which the certification of circulation is to be carried out. Members are also asked to give their acceptance in writing that they will

23.88

Advanced Auditing and Professional Ethics

observe the rules of procedure envisaged to report upon any lapse of such special requirements, even of a insignificant nature. Similarly, in the case of verification on behalf of banks, the rules or procedure for conducting such audit are different from the normal rules applicable to audits under the Companies Act. Members are required to be very familiar with the special procedure required in these matters and act accordingly. The decisions of the Court on this subject are briefly summarised below: Where a Chartered Accountant did not conduct sample checking of the bank accounts in relation to the accounts of the company and did not carry out vouching with respect to the transactions reflected in the accounts of the company and depended upon his assistant who was a Chartered Accountant and experienced clerk who were entrusted with the auditing work. Held he was guilty under Clauses (7), (8) and (9). (M.R. Ramanathan vs A. Utnatlath Rao - page 705 of Vol. IV of the Disciplinary Cases and page 165 of September, 1968, issue of the Institute’s Journal-Judgement delivered on 24th June, 1968). Where a Chartered Accountant failed to verify the actual disbursement of the amount by examining the various items of purchases and insisting for the bills to be produced in respect of the various items before issuing his certificate as mere payment would not constitute utilization of the amount for the purpose for which it was meant. Held he was guilty under Clauses (7), (8) and (9). (Punjab State Govt. vs K.N. Chandla - page 946 of Vol. IV of the Disciplinary Cases and pages 140-142 of August, 1972, issue of the Institute’s JournalJudgement delivered on 15th June, 1972). A Chartered Accountant had checked the cash book totals but not the bank column totals, had verified all the transactions in the bank columns but not the centra-entries, had taken the casting only of personal ledger and that too not of all accounts, had resorted to test check when there was no system of internal check, had not seen the pay-in-slips, had not checked the bank reconciliation statements for all the months. Held he was guilty of professional misconduct under Clauses (7), (8) and (9). “(Air Commodore Dilbagh Singh vs E.S. Venkataraman- page 100 of Vol. V of the Disciplinary Cases and page 224 of September, 1976, issue of the Instituted Journal-Judgement delivered on 5th July, 1976). ‘ Where the form of the certificate prescribed by the Audit Bureau of circulation Ltd., did not permit any alteration or explanation being given in the certificate itself, the Chartered Accountant had recorded, in a separate report the true state of affairs which he had found. Except making a report which explained the correct position he had no authority to indicate in the certificate itself the true position. But the separate report which he had sent along with the “Income Certificate” to the Newspaper concerned had not been forwarded by the newspaper to the Bureau. It was only later on that the ABC introduced a change in the procedure of audit by permitting a report being sent alongwith, with the “Incoming Certificate” in the various columns were subject to his separate report. Held he was guilty under Clauses (7) and (9).

Professional Ethics

23.89

(Audit Bureau of Circulations Ltd. v.s. M.L. Nanda-page 736 of Vol. IV of the Disciplinary, Cases and page 628 of May, 1968, issue of the Institute’s Journal-Judgement delivered on 26th February, 1968). Clause (10) fails to keep moneys of his client other than fees or remuneration or money meant to be expended in a separate banking account or to use such moneys for purposes for which they are intended within a reasonable time. In the course of his engagement as a professional accountant, a member may be entrusted with moneys belonging to his client. If he should receive such funds, it would be his duty to deposit them in a separate banking account, and to utilize such funds only in accordance with the instructions of the client or for the purposes intended by the client. In this connection the Council has considered some practical difficulties of the members and the following suggestions have been made to remove these difficulties: (i)

An advance received by a Chartered Accountant against services to be rendered does not fall under Clause (10) of Part I of the Second Schedule.

(ii)

Moneys received for expenses to be incurred, for example, payment of prescribed statutory fees, purchase of stamp paper etc., which are intended to be spent within a reasonably short time need not be put in a separate bank account. For this purpose, the expression; “reasonably time”, would depend upon the circumstances of each case.

(iii) Moneys received for expenses to be incurred which are not intended to be spent within” reasonably short time as aforesaid, should be put in a separate bank account immediately. (iv) Moneys received by a Chartered Accountant, in his capacity as trustee, executor liquidator, etc. Must be put in a separate bank account immediately. The decisions of the Court in this matters are briefly mentioned below: A Chartered Accountant was found guilty of professional misconduct under Clauses (7) & (10) of Part I of the Second Schedule to the Act for having filed to account satisfactorily for the various amounts entrusted to him by “the client and for failure to keep them in a separate bank account. A refund voucher issued in the name of the client by the Income Tax Department was credited by him to his account in the bank. (N.S. Chenoy v.s. K.V. Subba Rao - page 958 of Vol. IV of the Disciplinary Cases and pages 207-214 ol October, 1973, issue of the Institute’s Journal - Judgement delivered on 6th April, 1973). A Chartered Accountant was found guilty of not keeping the client’s money in a separate account and not using it for the purpose for which it was given. (Mr. R.S. Murgai Re: v.s. (I) S.K. Gadh & (2) V.K. Bajaj Decided on 10th August, 1981 Vol. IV of : the Disciplinary Cases to be published.) PART II - Professional misconduct in relation to members of the Institute generally A member of the Institute, whether in practice or not, shall be deemed to be guilty of professional misconduct, if he

23.90

Advanced Auditing and Professional Ethics

Clause (1) Contravenes any of the provisions of this Act or the regulations made there under or any guidelines issued by the Council; This clause is very important. It requires every member of the Institute to act within the framework of the Chartered Accountants Act and the Regulations made thereunder. Any violation either of the Act or the Regulations by a member would amount to misconduct. The Regulations under which cases of contravention have generally come to the notice of the Council are the following: Regulation 43

Engagement of Articled Clerks

Regulation 47

Premium from Articled Clerks

Regulation 48

Stipend to Articled Clerks

Regulation 46

Registration of Articled Clerks

Regulation 65

Articled Clerks not to engage in any other occupation

Regulation 56

Termination or assignment of Articles

Regulation 67

Complaint against the employer (from Articled Clerk)

Regulation 68 to 80

Audit Clerks

Regulation 125

Disciplinary action against member in connection with conduct of election

Regulation 190

Register of offices and firms

Regulation 190-A

Chartered Accountants not to engage in any other business or occupation

Regulation 191

Part time employment's a chartered Accountant may accept

Regulation 192

Restriction on fees

Appendix 10 to the Chartered Accountants Regulation, 1981 The decisions of the Court under this clause are mentioned below: .. A Chartered Accountant certified in Form K-2 that an audit clerk was in service with him while he was also, employed elsewhere with another employer between 11 A.M. and 5 P.M. and attended, the office of the Chartered Accountant thereafter until 8 P.M. The Chartered Accountant suspended the audit clerk when the Institute brought this fact to the notice of the Chartered Accountant. Held he was guilty of misconduct for making a misstatement to the institute in regard to the discharge of his professional duties. (J.K. Ghosh in Re: page 193 of Vol. I of the Disciplinary Cases and page 88 of August, 1954, issue of the Institute’s Journal-Judgement delivered on 3rd December, 1953). Where a Chartered Accountant agreed to take a person as an articled clerk in a vacancy shortly to arise and received the premium for the purpose and made him believe, when he executed the deed of articles that he was taking him in that vacancy, while, in fact, that vacancy had been filled up by the Chartered Accountant earlier by taking another audit clerk.

Professional Ethics

23.91

The audit clerk came to know from the Institute that the deed of articles was not registered as that was forwarded with a request for entertaining an extra articled clerk. Held that the Chartered Accountant was guilty of serious misconduct for having contravened Regulation 58. (A.K. Basu v.s. P.K. Mukherjee - Page 9 of Vol. Ill of the Disciplinary Cases and pages 40-30 of July, 1956, issue of the Institute’s Journal-Judgement delivered on 16th April, 1956). Where a Chartered Accountant, who was entitled to take three articled clerks, had already taken three such clerks, represented to a person that he had still a vacancy and induced him to enter into articles. A formal deed was executed and the premium was paid. He subsequently cancelled the articles of the third articled clerk for irregular attendance without reference to the Institute. Held that he had contravened the provisions of Regulation 58 and was guilty of grave misconduct. (J.K. Ghosh in Re: page 106 of Vol. II of the Disciplinary Cases and pages 278-280 of January, 1956 issue of the Institute’s Journal-Judgment delivered on 6th December, 1955). Where a Chartered Accountant (i) issued false certificates to two articled clerks stating that he had refunded the entire premium, while a part of it was claimed as a set off against food and halting allowances given to them while they were working in out-stations, (ii) violated Regulation 62 by not refunding the premium within the time specified in the Regulation, and (iii) the refund of premium in instalments in one case was not as specified in the certificate. Held he was guilty of dishonest behaviour both as regards his clients and articled clerks. (M.N. Bhargava in Re: page 512 of Vol. Ill of the Disciplinary Cases and pages 671-673 of June, 1958, issue of the Institute’s-Judgement delivered on 1st May, 1958). Where a Chartered Accountant after signing the Articles of Agreement, failed to forward the articles for registration as required by Regulation 64 and the statement of particulars in the prescribed form as required by Regulation 64 inspite of repeated enquiries from the articled clerk and even failed to take notice of communications addressed to him in that behalf and having two other articled clerks along with the present one who articles were not sent for registration took up a fourth articled clerk without being entitled to do so. Held he was guilty for breach of Regulation 46. (Mohan Sehwani v.s. Sunderlal Fatehpuria - page 704 of Vol. IV of the Disciplinary Cases and page 629 of May, 1968, issue of the Institute’s Journal judgement delivered on 23rd February, 1968). A Chartered Accountant was found guilty of professional misconduct in terms of Clause (i) of Part 11 Schedule to the Act for contravention of Section 6 of the Act for having issued a certificate in respect of a consumption statement of a concern as a Chartered Accountant in practice on a date when he had not even applied for a certificate of practice to the Institute. (N.K. Ray Chowdhery in Re: page 1 of Vol. V of the Disciplinary Cases and pages 545-546 of April, 1974, issue of the Institute’s Journal-Judgement delivered on 30th November, 1973). A Chartered Accountant issued a confidential and private circular to clients where, in addition to, describing himself as “Chartered Accountant” he also described himself as “Investment Consultant Public Accountant”. By this circular he introduced himself to the public and private

23.92

Advanced Auditing and Professional Ethics

limited companies, which were accepting, fixed deposits and loans through him. Held he was guilty of professional misconduct under Clause (i) of Part II of the Second Schedule. (B. M. Lala in Re: page 95 of Vol. V of the Disciplinary Cases and page 224 of September, 1976, issue of the Institute’s Journal-Judgement delivered on 5th July, 1976). A Chartered Accountant took loan from a firm in which the articled clerk and his father were both Interested, against the provisions of the Chartered Accountants Regulations, 1988 which prohibit ‘taking of loan or deposit etc. from the articled clerk. Held the Chartered Accountant was guilty of professional misconduct under the clause. (M.K. Tripathi in Re: published in the May, 1980, issue of the Institute’s Journal at page 1014 tent delivered on 26th October, 1979). A Chartered Accountant did not pay stipend to his articled clerk, in accordance with Regulation 48 of the Chartered Accountants Regulations 1988, while to another articled clerk, he was paying every month. The stipend was paid only after the articled clerk left him after working for a months and complaint was lodged with the Institute. The plea of the Chartered Accountant that he had an agreement with the articled clerk to pay stipend on annual basis was found to be misconceived as the same should be against the provisions of Regulation 48. (Radhey Mohan in Re: Published in the March, 1980 issue of the Institute’s Journal at pages 849-852 Judgement delivered on 9th November, 1979). A Chartered Accountant failed to pay the stipend to his articled clerk in accordance with Regulation 48, which requires that the payment should be made every month. The payment was made long after the matter was brought to the notice of the Institute. The Chartered Accountant pleaded that Regulation 48 did not prescribe the periodicity of payment but only the rate at which stipend had to be paid and further the payment was not made in view of a letter written by an advocate who introduced the articled clerk to the effect that the payment should not be made directly to the articled clerk but to his father whenever he desired. To other articled clerks, the payments were made in lump sum. Held the Chartered Accountant had contravened Regulation 48 by not making payments of stipend on a month to month basis. (B.B. Rohatgi in Re: Published in July, 1980, issue of the Institute’s Journal at pages 50-55 and Judgement delivered on 17th April, 1980). Three articled clerks of a Chartered Accountant informed Institute that the Chartered Accountant had failed to make the payments of stipend to them every month in accordance with Regulation 48. Held the Chartered Accountant was guilty of professional misconduct under the clause as he contravened Regulation 48 by not making the payment every month. The court rejected two contentions put forward by the Chartered Accountant, viz, (i) that the declaration filed by the articled clerks could not be regarded as ‘information’ in order to justify the commencement of disciplinary proceedings (2) that under Regulation 48 the payments had to be made at a monthly rate and not that the payments had to be made every month. The third contention that the payments could not be made every month or regularly because of financial stringency was also rejected particularly in view of the fact that the Chartered Accountant during the relevant period had purchased a plot of land and constructed a house

Professional Ethics

23.93

at the cost of more than 1 lakh of rupees and he had in his employment throughout the relevant period a Chartered Accountant at a salary of Rs.500 Per Month. (R.C. Gupta in Re: published at pages 241 - 242 of the September, 1980, issue of the Institute’s Journal - judgement delivered on 21st July, 1980). The Chartered Accountant received Rs. 2000/- by way of security from the complainant’s father as a consideration for taking him as an articled clerk. Held that he was guilty under the provision. (Virender Kumar v.s. K.B. Madan decided on 26th August, 1980, Disciplinary Cases Vol. VI to to be published). A Chartered Accountant was guilty of professional misconduct, as the stipend had been paid only after a complaint was lodged with the Institute. Clause (2) being an employee of any company, firm or person, discloses confidential Information acquired in the course of his employment except as and when required by any law for the time being in force or except as permitted by the employer; This clause is same as Clause I of part I of Schedule II subject to mutatis mutandis adjustment for employee in place of client. Clause (3) Includes in any information, statement, return or form to be submitted to the Institute, Council or any of its Committees, Director (Discipline), Board of Discipline. Disciplinary Committee, Quality Review Board or the Appellate Authority any particulars knowing them to be false; If a Chartered Accountant includes in any information, statement, return or form to be submitted to the Institute Council etc. any particular knowing him to be false, he will be held guilty of misconduct. Clause (4) Defalcates or embezzles money received in his professional capacity. Defalcation and embezzlement of moneys received in professional capacity amounts to fraud (Covered in AAS-4) and such member will be deemed to be guilty of professional misconduct under this clause. Part III - Other misconduct in relation to members of the Institute generally A member of the Institute, whether in practice or not, shall be deemed to be guilty of other mis- conduct, if he is held guilty by any civil or criminal court for an offence which is punishable with imprisonment for a term exceeding six months. Imprisonment awarded for a term exceeding six months in any civil/criminal matter treated as a major offence under ‘other misconduct’ is included in this Schedule. Refer Clause 1 of part IV of Schedule I.

23.94

Advanced Auditing and Professional Ethics

Recommended Self-Regulatory Measures 23.14 As the members are aware, the Council has decided upon certain self -regulatory measures in order to ensure a healthy growth of the profession and an equitable flow of professional work among the members. These measures are reviewed from time to time and are published in the Journal of the Institute for observance by the members. The selfregulatory measures are recommendatory. However, considering the spirit underlying these measures, the Council expects that each and every member will effectively implement them. The Council earnestly believes that- implementation of these measures would go a long way in ensuring equitable flow of work among the members and would also further enhance the prestige of the profession in the society.. The more important of these recommendations are as under: 23.14.1 Branch Audits - The branch audits of a company should not be conducted by its statutory auditors consisting of ten or more members, but should be conducted by the local firms of auditors consisting of less than ten members. This should not be understood to mean any restriction on the right of the statutory auditors to have access over branch accounts conferred under the Companies Act, 1956. This restriction may not apply in the following cases. (i)

where the accounting records of the branches are maintained at the head office of the respective companies, and

(ii)

where significant operations of an undertaking or a company are carried out at its branch office.

23.14.2 Joint Audit - In the case of large companies the practice of associating a practicing firm with less than five members as Joint auditors should be encouraged. Where a client desires to appoint such a firm as joint auditor, the senior firm should not object to the same. 23.14.3 Ratio Between Qualified and Unqualified Staff - In the Council’s view, a practicing firm of Chartered Accountants engaged in audit work should have at least one member for every five non-qualified members of the staff, excluding articled and audit clerks, typists, peons and other persons not engaged directly in such professional work. 23.14.4 Disclosure of Interest by Auditors in other Firms - The Council has decided that as a good and healthy practice, auditors should make a disclosure of the payments received by them for other services through the medium of a different firm or firms in which the said auditor may be either a partner or proprietor. 23.14.5 Ceiling on the Fees - To ensure that the professional independence of a member in full - time or part-time practice does not appear to be as far as possible, take care to see that the professional fees for audit and other services received by the firm in which he is a partner, by him and his partners individually and by firm or firms in which he or his partner are partners from one or more clients or companies under the same management does not exceed 40% of the gross annual fees of the firm, firms and partners referred to above. ‘Companies under the same management’ here would refer to the definition of this expression as provided in Section 370(1 -B) of the Companies Act, 1956.

Professional Ethics

23.95

Provided that no such ceiling on the gross annual professional fees of a member would be applicable in the case of audit of government companies, public undertakings nationalised banks. Important Notifications 23.15 Important Notifications issued by the Institute under Clause (ii) of Part II of Schedule II to the Chartered Accountants Act, 1949 have been reproduced below A member of the Institute shall be held to be guilty of professional misconduct if: Particulars 1

(i)

Notification

W.E.F

He accepts appointment as Cost Auditor of a company u/ s 223 B of the Companies Act, 1956 while he is (a) An auditor of the company u/s 224 (b) An officer or employee of the company (c) A partner or employee of (a) or (b)

CA(37)/70 23.05.1970

(d) A Indebted or has provided a guarantee to the company for an amount exceeding Rs. 1,000 OR (ii)

After his appointment as Cost Auditor, he becomes subject to any of the disabilities mentioned in 1(a) to 1(d) above and continues to function as a Cost Auditor thereafter

2.

He accepts appointment as auditor of a

CA(39)/70

24.10.1970

Company u/s 224 of the Companies Act, 1956 while being an employee of the Cost Auditor of the company 3.

He or the firm of chartered accountants in

CA (153)/86

30.08.1986

CA(7)/3/88

04.02.1989

CA(7)29/95

1.04.1995

which he is a partner fails to maintain proper books of accounts Including Cash Book and Ledger. 4.

He accepts more than 30 tax audit assignment in financial year (Whether in respect of Corporate or non-Corporate assesses)

5.

He becomes a members of the Institute Chartered Financial Analysts of India on

23.96

Advanced Auditing and Professional Ethics

or after 1.1.1990 or being a member, does not surrender his membership before the said date. 6.

He, on behalf of firm of Chartered Accountants

1-CA(7)93/2006 18.09.2006

in which he is partner, accepts or carries out any audit work involving receipt of audit fees of an amount less than as mentioned below: (With at least one partner holding C.P. for 5 years or more) Practicing firm having 5 or more partners but less than 10 partners (i) In cities with population of Rs. 6000/- p.a. 3 million and above (as per the last census) (ii) In cities/towns having population of less than 3 million (as per the last census)

Rs. 3500/-

Practicing firm having 10 or more partners Rs. 12000/- p.a.

Rs. 8000/- p.a.

Provided that such restrictions shall not apply in respect of the following: (i)

Audit of Accounts of Charitable Institution, Clubs, Provident Funds, etc., where the appointment is honorary, i.e. without any fees.

(ii)

Statutory audit of branches of banks including regional rural banks;

(iii) Audit of newly formed concerns relating to two accounting years from the date of commencement of their operation; (iv) Certification or audit under Income-tax Act or other attestation work carried out by the Statutory Auditor; and (v) Sales Tax Audit and VAT Audit. 7.

He accept appointment as auditor of an

CA(7)/46/99

13.11.1999

CA(7)/53/01

19.05.2001

entity(not being a sick unit ) in case the undisputed statutory audit fees of another Chartered Accountant has not been paid. 8.

He holds more then thirty statutory audit/ assignment of companies. Of these the numbers

Professional Ethics

23.97

of audits of public companies , each of which has a paid up share capital of Rs. 25 lakhs or more, shall not exceed. The record of audit assignments is required to be maintained in the following format : Guidelines Issued By the Institute 23.16 The Institute has issued certain guidelines on the applicability of the Code of Ethics. The important guidelines have been summarized below 23.16.1 Advertisements & Notes in the Press - A member may advertise changes in partnerships or dissolution of a firm or change in address of practice and telephone numbers being limited to bare statement of facts and appropriateness of area of distribution of newspaper/ magazine etc. A member may issue classified advertisement in the Journal/Newsletter of the Institute for sharing or seeking professional work. 23.16.2 Application for Empanelment for Allotment of Audit and Other Professional Work Members may write to authorities such as government departments, banks, etc., for entering their name in the panel of auditors maintained by them. 23.16.3 Publication of Name/ Firm Name by Chartered Accountants in Telephone or Other Directories - Special entries in telephone directory made on request or additional payment shall not be permitted Members shall be permitted to have their or their firm’s names entered in Telephone/ Trade Directories brought out by government and non-government agencies in compliance with the following guidelines: 1.

These entries should appear in the section/category of “Chartered Accountants”.

2.

The member/firm should belong to the town/city in respect of which the directory is being published.

3.

The entry should be in normal type of letters. Entry in bolder type or abnormal type of letters or in a box is not permissible.

4.

The order of the entries should be alphabetical and logical.

5.

The entry should not appear in a manner giving the impression of publicity/ advertisement. Entry should not be given in a manner, which gives prominence to it as compared to other entries.

6.

The payment, if any, for the entry should not be unreasonable.

7.

The entries should not be restricted and should be open to all the Chartered Accountants/ firms of Chartered Accountants in the particular city/town in respect whereof the directory is published.

23.98

Advanced Auditing and Professional Ethics

23.16.4 Responding to Tenders, Advertisements and Circulars - Members are not permitted to respond to advertisement tenders, writing applications or quotations for rendering of professional service restricted to Chartered Accountants. 23.16.5 Advertisements♦

A member cannot distribute handbills carrying information, such as changes in tax laws, ostensibly for guidance of persons other than his regular clients. ♦ A member is not permitted to indicate in a book or article published by him, his association with any firm of Chartered Accountants. ♦ Members may use the designation “Chartered Accountant” as well as the name of the firm in greeting cards, invitation for marriages, religious ceremonies or for opening of offices, changes in address/telephones numbers, provided such cards/invitations are sent only to clients, relatives and friends of the members concerned. ♦ Members are prohibited from inserting advertisements for soliciting clients or professional work under box numbers in the newspapers. 23.16.6 Website ♦ ♦ ♦

♦ ♦

♦

♦ ♦ ♦ ♦ ♦ ♦

Members are allowed to set up websites subject to the following guidelines: Members shall be free to set up website in their personal or trade name or in their firm’s name. The website should be run on a “pull” model and not a “push” model of technology, i.e. only a person who wishes to locate the Chartered Accountant(s) would have access to the information and the information is provided only on the basis of specific “pull” request. The website address can be mentioned on the professional stationery. Information may be posted about the firm such as Name, Address, Contact Nos. and E-mail ID(s), Year of establishment, Names and Qualifications of Partners and Employees and Job vacancies. The following information is to be given only on a specific ‘pull’ request: Nature of services rendered, Areas of experience of the Partners and Employees, No. of Articled Clerks and Nature of assignments handled. Names of clients and fee charged cannot be given. No photographs of any sort are permitted. Articles, professional information, updates and matters of professional interest can be posted. Bulletin boards and Chat Rooms can be provided. The members/firms can provide on line advice to their clients who specifically request for the advice, whether free of charge or on payment. No advertisement in the nature of banner or any other nature will be permitted on the website.

Professional Ethics

23.99

♦

The website may provide a link to the website of ICAI, its Regional Councils and Branches and also to the websites of Govt./Govt. Departments/Regulatory authorities; except that neither link to nor information about any other website is permitted. ♦ Accountant in Practice or firm of Chartered Accountants in Practice. ♦ The website should mention the date upto which it is updated. The address of the website should be intimated to the ICAI within 30 days. 23.16.7 Advertisement of Professional Attainments ♦

A Member is not permitted to state on his professional documents that he is an Income Tax Consultant, Cost Accountant, Management Consultant, or Cost Consultant. ♦ The date of setting up of practice or date of establishment should not be mentioned on letterheads and other professional documents. ♦ Members of the Institute in Practice, who are otherwise eligible, may practise as Advocates subject to the permission of the Bar Council but they should not be allowed to use both the designations, viz. Chartered Accountant and Advocate simultaneously. 23.16.8 Logos - Members in practice and/or firm of Chartered Accountants are prohibited from using logo / monogram of any kind on any display material or media. Photo: Member are not Permitted to use own photograph on visiting cards. 23.16.9 Member being Director, Managing Director, etc. - Clause (11) of Part I of the First Schedule to the Chartered Accountants Act, 1949 reads as under- “A Chartered Accountant in practice shall be deemed to be guilty of professional misconduct, if he engages in any business or occupation other than the profession of chartered accountants unless permitted by the Council so to engage. Provided that nothing contained herein shall disentitle a Chartered Accountant from being a director of a company unless he or any of his partners is interested in such company as an auditor. The council of the Institute has recently considered the question of permitting members in practice to become Director, Managing Director, Full-time/Executive Director, etc., and related issues. As regards the question of permitting a member in practice to be a Director, Promoter/ Promoter-Director, subscriber to ‘the Memorandum and Articles of Association of any company including a board managed company, it was decided that: (a)

Director of a Company (i)

The expression “Director Simplicitor” shall be used in future for an ordinary/simple Director;

(ii)

A member in practice is permitted generally to be Director Simplicitor in any company including a board-managed company and as such he is not required to obtain any specific permission of the Council in this behalf irrespective of whether he and/or his relatives hold substantial interest in that company.

23.100 Advanced Auditing and Professional Ethics (b) Promoter/Promoter-Director - There is no bar for a member to be a promoter/signatory to the Memorandum and Articles of Association of any company. There is also no bar for such a promoter/ signatory to be a Director Simplicitor of that company irrespective of whether the objects of the company include areas, which fall within the scope of the profession of Chartered Accountants. Therefore, members are not required to obtain specific permission of the Council in such cases. As regards the question relating to permitting a member to be a Managing Director, Whole time/ Executive Director, etc., as also rendering of services to a company as a professional accountant in addition to his being a Director/Managing Director, etc., necessary guidelines (presented below) had already been provided in this behalf. As per Resolution passed by the Council under the then Regulation 166 of the Chartered Accountants Regulations 1964 (presently Regulation 190A of the Chartered Accountants Regulations 1988), and published as Appendix No. (10) to the Chartered Accountants Regulations, 1988, members of the Institute in practice may, inter alia, engage in the following category of business or occupation alter obtaining the specific and prior approval of the Council : “Office of a Managing Director or a Whole-time Director of a body corporate within the meaning of the Companies Act, 1956 provided that the member and/or his relatives do not hold substantial interest in such a concern”. The expression “relative”, in relation to a member means the husband, wife, brother or sister or any lineal ascendant or descendant of that member. A member shall be deemed to have a “substantial interest” in a concern(i)

In a case where the concern is a company, if its shares (not being shares entitled to a fixed rate of dividend whether with or without a further right to participate in profits) carrying not less than 20 per cent of voting power at any time, during the relevant years are owned beneficially by such member, or by any one or more of the following persons, or partly by such member and partly by one or more of the following persons: (a) One or more relatives of the members; (b) Any concern in which any of the persons referred to above has a substantial interest; (ii) In the case of any other concern, if such member is entitled, or the other persons referred to above, or such member and one or more of the other persons referred to above, are entitled in the aggregate, at any time during the relevant years, to not less than 20 percent of the profits of such concern.

Explanation (a) The relevant years in the context of Clause (4) of Part I of the First Schedule to the Chartered Accountants Act, 1949 read with Appendix (17) mean the year/period, to which the report/certificate relates, and the year/period during which the said report/ certificate is signed. (b) The relevant years in the context of Clause (11) of Part I of the First Schedule to the Chartered Accountants Act, 1949 read with Appendix (10) mean the year/period in which

Professional Ethics 23.101 not less than 20 per cent of voting power / 20 per cent share of profits were owned beneficially. Self Regulatory Measures 23.17 Recommended Scale of Fees for Work Done by Chartered Accountants Effective 1st April, 2000 (Figures in Rs.) Nature of Work

Principal

Qualified Assistant

Expert evidence in court of law in India Statutory/Tax/Internal audit and Secretarial work Taxation Work

5,000 to 10,000 per day 600 to 1,200 per day

N.A.

Semiqualified/Other Assistant N.A.

300 to 600 per day

100 to 200 per day

1,000 to 2,000 per hour 1,500 to 3,000 per hour

500 to 1,000 per hour

200 to 400 per hour

750 to 1,500 per hour

250 to 500 per hour

Investigation, Management services or special assignments

Note: Office time spent in travelling is chargeable. In case of outstation work, travelling and out-of-pocket expenses are also chargeable. 23.17.1 Mandatory CPE to (i) members of the Institute who are not in practice and (ii) members in practice abroad (255th Council) - The Continuing Professional Education (CPE) for the members not in practice be continued to be recommendatory in nature only. The specific recommendation being that members not in practice should strive to obtain a minimum of 10 hours of CPE Credit in a calendar year. The Council also decided to make CPE recommendatory for the members of the Institute residing abroad w.e.f. 1st January 2006, in partial modification of the policy decision taken on making CPE mandatory for members in practice generally. 23.17.2 Allowing the members of lCAI to certify the financial statements of multinational companies having presence in India, in their capacity as members of lCAl or otherwise. (257th Council) - The members of ICAI who are also members ‘of the AICPA and are eligible to sign the financial statements as CPAs (i.e. as members of the AICPA), may do so. So far as ethical standards are concerned, the ICAI ethical standards will apply. The Council also decided that any issue arising out of jurisdictional problems will be taken up as and when they arise. The Council further decided that when the ICAI members sign the financial document(s) as CPAs, they be required to indicate, in an appropriate manner, that their firm is an Indian

23.102 Advanced Auditing and Professional Ethics accounting firm registered with the Institute of Chartered Accountants of India under the Chartered Accountants Act, 1949. In other words, such a member should ensure to appropriately reflect the fact in the relevant document(s) that his firm falls within the purview of the ICAI.

PART I STATEMENTS ON STANDARD AUDITING PRACTICES

FRAMEWORK OF STATEMENTS ON STANDARD AUDITING PRACTICES AND GUIDANCE NOTES ON RELATED SERVICES Introduction 1. The Auditing Practices Committee (APC) of the Institute of Chartered Accountants of India develops Statements on Standard Auditing Practices (SAPs) and Guidance Notes on related services. SAPs and Guidance Notes1 are issued under the authority of the Council of the Institute. The purpose of this document is to describe the framework within which SAPs and Guidance Notes on related services are issued in relation to the services which may be performed by auditors. 2. For ease of reference, except where indicated, the term “auditor” is used throughout the SAPs and Guidance Notes (except where a different term is considered appropriate) when describing both auditing and related services which may be performed. Such reference is not intended to imply that a person performing related services need be the auditor of the entity’s financial statements. Financial Reporting Framework 3. Financial statements are ordinarily prepared and presented annually and are directed toward the common information needs of a wide range of users. Many of those users rely on the financial statements, as their major source of information because they do not have the power to obtain additional information to meet their specific information needs. Thus, financial statements need to be prepared in accordance with one, or a combination of: (a) relevant statutory requirements, e.g., the Companies Act, 1956, for companies; (b) accounting standards issued by the Institute of Chartered Accountants of India; and (c) other recognised accounting principles and practices, e.g., those recommended in the Guidance Notes issued by the Institute of Chartered Accountants of India. Framework For Auditing And Related Services 4. This Framework distinguishes audits from related services. Related services comprise reviews, agreed-upon procedures and compilations. As illustrated in the diagram below, audits 1

For the authoritative status of SAPs and Guidance Notes, attention is invited to the ''Clarification Regarding Authority Attached to the Documents Issued by the institute'' (first published in the December, 1985 issue of the Journal).

I.2

Advanced Auditing & Professional Ethics

and reviews are designed to enable the auditor to provide high and moderate levels of assurance respectively, such terms being used to indicate their comparative ranking. Engagements to undertake agreed-upon procedures and compilations are not intended to enable the auditor to express assurance. Auditing

_____Related Services_____ Review

Agreedupon Procedures

Compilation

Comparative level High, but not of assurance absolute provided by the assurance auditor

Moderate assurance

No assurance

No assurance

Positive assurance on assertion(s)

Negative assurance on assertion(s)

Factual findings of procedures

Identification of information compiled

Nature of service

Report provided

Audit

5. The Framework does not apply to other services provided by auditors such as taxation, consultancy, and financial and accounting advice. Levels Of Assurance 6. Assurance in the context of this Framework refers to the auditor’s satisfaction as to the reliability of an assertion being made by one party for use by another party. To provide such assurance, the auditor assesses the evidence collected as a result of procedures conducted and expresses a conclusion. The degree of satisfaction achieved and, therefore, the level of assurance which may be provided is determined by the procedures performed and their results. 7. In an audit engagement, the auditor provides a high, but not absolute, level of assurance that the information subject to audit is free of material misstatement. This is expressed positively in the audit report. 8. In a review engagement, the auditor provides a moderate level of assurance that the information subject to review is free of material misstatement. This is expressed in the form of negative assurance. 9. For agreed-upon procedures, as the auditor simply provides a report of the factual findings, no assurance is expressed. Instead, users of the report assess for themselves the procedures and findings reported by the auditor and draw their own conclusions from the auditor’s work.

Part I : Auditing and Assurance Standards

I.3

10. In a compilation engagement, although the users of the compiled information derive some benefit from the involvement of a member2 of the Institute, no assurance is expressed in the report. Audit 11. The objective of an audit of financial statements is to enable the auditor to express an opinion whether the financial statements are prepared, in all material respects, in accordance with an identified financial reporting framework. The phrase used to express the auditor’s opinion is “give a true and fair view”. A similar objective applies to the audit of financial or other information prepared in accordance with appropriate criteria. 12. In forming the audit opinion, the auditor obtains sufficient appropriate audit evidence to be able to draw conclusions on which to base that opinion. 13. The auditor’s opinion enhances the credibility of financial statements by providing a high, but not absolute, level of assurance. Absolute assurance in auditing is not attainable as a result of such factors as the need for judgement, the use of test checks, the inherent limitations of any accounting and internal control systems and the fact that most of the evidence available to the auditor is persuasive, rather than conclusive, in nature. Related Services Reviews 14. The objective of a review3 of financial statements is to enable an auditor4 to state whether, on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to the auditor’s attention that causes the auditor to believe that the financial statements are not prepared, in all material respects, in accordance with an identified financial reporting framework. A similar objective applies to the review of financial or other information prepared in accordance with appropriate criteria. 15. A review comprises inquiry and analytical procedures which are designed to review the reliability of an assertion that is the responsibility of one party for use by another party. While a review involves the application of audit skills and techniques and the gathering of evidence, it does not ordinarily, involve an assessment of accounting and internal control systems, tests of records and of responses to inquiries by obtaining corroborating evidence through inspection, observation, confirmation and computation, which are procedures ordinarily performed during an audit. 16. Although the auditor attempts to become aware of all significant matters, the procedures of a review make the achievement of this objective less likely than in an audit engagement, thus the level of assurance provided in a review report is correspondingly less than that given in an audit report. 2

To distinguish compilation engagements from audits and other related services, the term ''member'' (rather than ''auditor'' has been used to refer to a professional accountant in practice. 3 The Institute of Chartered Accountants of India has issued a Guidance Note on Engagements to Review Financial Statements. 4 As explained in paragraph 2, the term auditor is used when describing both auditing and related services. Such reference is not intended to imply that a person performing related services need be the auditor of the entity's financial statements.

I.4

Advanced Auditing & Professional Ethics

Agreed-Upon Procedures 17. In an engagement to perform agreed-upon procedures5, an auditor is engaged to carry out those procedures of an audit nature to which the auditor and the entity and any appropriate third parties have agreed and to report on factual findings. The recipients of the report must form their own conclusions from the report by the auditor. The report is restricted to those parties that have agreed to the procedures to be performed since others, unaware of the reasons for the procedures, may misinterpret the results. Compilations 18. In a compilation engagement6, a member7 of the Institute is engaged to use accounting expertise as opposed to auditing expertise to collect, classify and summarise financial information. This ordinarily entails reducing detailed data to a manageable and understandable form without a requirement to test the assertions underlying that information. The procedures employed are not designed and do not enable the member to express any assurance on the financial information. However, users of the compiled financial information derive some benefit as a result of the member’s involvement because the service has been performed with due professional skill and care. Auditor’s Association With Financial Information 19. An auditor is associated with financial information when the auditor attaches a report to that information or consents to the use of the auditor’s name in a professional connection. If the auditor is not associated in this manner, third parties can assume no responsibility of the auditor. If the auditor learns that an entity is inappropriately using the auditor’s name in association with financial information, the auditor would require management to cease doing so and consider what further steps, if any, need to be taken, such as informing any regulatory authority and/or known third party users of the information of the inappropriate use of the auditor’s name in connection with the information. The auditor may, if necessary, take other action, for example, seeking legal advice.

5 The Institute of Chartered Accountants of India has issued a Guidance Note on Engagements to Perform Agreed-upon Procedures regarding Financial Information. 6 The Institute of Chartered Accountants of India has issued a Guidance Note on Members Duties regarding Engagements involving Compilation of Financial Statements. 7 To distinguish compilation engagements from audits and other related services, the term ''member'' (rather than ''auditor'') has been used to refer to a professional accountant in practice.

Part I : Auditing and Assurance Standards

I.5

PREFACE TO THE STATEMENTS ON STANDARD AUDITING PRACTICES8 The Auditing Practices Committee of the Institute of Chartered Accountants of India was established in 1982 with, inter alia, the objectives of preparing the Statements on Standard Auditing Practices (SAPs), Guidance Notes on matters related to auditing, etc. At its 226th meeting held on July 2, 2002 at New Delhi, the Council of the Institute of Chartered Accountants of India approved the recommendations of the Auditing Practices Committee to strengthen the role being played by it in the growth and development of the profession of chartered accountancy in India. The Council also approved renaming of the Committee as, “Auditing and Assurance Standards Board” (AASB) with immediate effect to better reflect the activities being undertaken by the Committee. Certain other changes were also adopted which were designed to strengthen the process for establishing auditing and assurance standards and bringing about greater transparency in the working of the Auditing Practices Committee now known as the Auditing and Assurance Standards Board (AASB). The Council also approved the renaming of the Statements on Standard Auditing Practices (SAPs) as, “Auditing and Assurance Standards” (AASs). 1.

Formation Of The Auditing Practices Committee

The Institute of Chartered Accountants of India constituted the Auditing Practices Committee (APC) on 17th September, 1982. 2.

Scope And Functions Of Auditing Practices Committee

2.1 The Institute has, from time to time, issued Statements and Guidance Notes on auditing practices. The main function of the APC is to review the existing auditing practices in India and to develop Statements on Standard Auditing Practices (SAPs) so that these may be issued by the Council of the Institute. 2.2 The Institute is a member of the International Federation of Accountants (IFAC). The broad objective of IFAC is the development and enhancement of a co-ordinated world-wide accountancy profession with harmonised standards. The IFAC has constituted the International Auditing Practices Committee (IAPC) to formulate international auditing guidelines. While formulating the SAPs in India, the APC will give due consideration to the International Auditing Guidelines issued by the IAPC and try to integrate them, to the extent possible, in the light of the conditions and practices prevailing in India. 2.3 While formulating the SAPs, the APC will take into consideration the applicable laws, customs, usages and business environment in India. 2.4 The SAPs will be issued under the authority of the Council of the Institute. The APC will issue Guidance Notes on the issues arising from the SAPs wherever necessary. The APC will also review the SAPs at periodical intervals. 3.

Scope Of The Statements On Standard Auditing Practices

3.1 The SAPs will apply whenever an independent audit is carried out; that is, in the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size, or legal form (unless specified otherwise) when such an examination is conducted with a 8

Issued in June, 1983

I.6

Advanced Auditing & Professional Ethics

view to expressing an opinion thereon. The SAPs may also have application as appropriate, to other related functions of auditors. 3.2 Any limitation of the applicability of a specific SAP will be made clear in the introductory paragraph of that Statement. 4.

Procedure For Issuing The Statements On Standard Auditing Practices

Broadly, the following procedure will be adopted for the formulation of SAPs. 4.1 The APC will determine the broad areas in which the SAPs need to be formulated and the priority in regard to the selection thereof. 4.2 In the preparation of SAPs, the APC will be assisted by Study Groups constituted to consider specific subjects. In the formation of Study Groups, provision will be made for participation of a cross-section of members of the Institute. 4.3 On the basis of the work of the Study Groups, an exposure draft of the proposed SAP will be prepared by the Committee and issued for comments by members of the Institute. 4.4 After taking into consideration the comments received, the draft of the proposed SAP will be finalised by the APC and submitted to the Council of the Institute. 4.5 The Council of the Institute will consider the final draft of the proposed SAP, and if necessary, modify the same in consultation with the APC. The SAP will then be issued under the authority of the Council. 5.

Compliance With The Statements On Standard Auditing Practices

While discharging their attest function, it will be the duty of the members of the Institute to ensure that the SAPs are followed in the audit of financial information covered by their audit reports. If for any reason a member has not been able to perform an audit in accordance with the SAPs, his report should draw attention to the material departures therefrom. 6.

Existing Statements

Existing statements on auditing practices issued by the Institute will remain in force until withdrawn. It is recognised, that basically the SAPs represent the formalisation, of existing good practices. However, in the event of a possible or perceived conflict between an existing statement and a SAP, the practices laid down in the SAP will prevail. 7.

Effective Date

Auditors will be expected to follow SAPs in the audits commencing on or after the date specified in the Statement. BASIC PRINCIPLES GOVERNING AN AUDIT (AAS 1) Introduction 1. This Standard describes the basic principles which govern the auditor’s professional responsibilities and which should be complied with whenever an audit is carried out. 2. An audit is the independent examination of financial information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is

Part I : Auditing and Assurance Standards

I.7

conducted with a view to expressing an opinion thereon9. In this Standard, the term “financial information” encompasses financial statements. 3. Other Auditing and Assurance Standards to be issued by the Institute will elaborate on the principles set out herein to give guidance on auditing procedures and reporting practices. 4. Compliance with the basic principles requires the application of auditing procedures and reporting practices appropriate to the particular circumstances. Integrity, Objectivity And Independence 5. The auditor should be straightforward, honest and sincere in his approach to his professional work. He must be fair and must not allow prejudice or bias to override his objectivity. He should maintain an impartial attitude and both be and appear to be free of any interest which might be regarded, whatever its actual effect, as being incompatible with integrity and objectivity. Confidentiality 6. The auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional duty to disclose. Skills And Competence 7. The audit should be performed and the report prepared with due professional care by persons who have adequate training, experience and competence in auditing. 8. The auditor requires specialised skills and competence which are acquired through a combination of general education, technical knowledge obtained through study and formal courses concluded by a qualifying examination recognised for this purpose and practical experience under proper supervision. In addition, the auditor requires a continuing awareness of developments including pronouncements of ICAI on accounting and auditing matters, and relevant regulations and statutory requirements. Work Performed By Others 9. When the auditor delegates work to assistants or uses work performed by other auditors and experts, he will continue to be responsible for forming and expressing his opinion on the financial information. However, he will be entitled to rely on work performed by others, provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. In the case of any independent statutory appointment to perform the work on which the auditor has to rely in forming his opinion, such as in the case of the work of branch auditors appointed under the Companies Act, 1956, the auditor’s report should expressly state the fact of such reliance.

9

See para. 3.1 of the ''Preface to the Statements on Standard Auditing Practices'' issued by the Council of the Institute of Chartered Accountants of India.

I.8

Advanced Auditing & Professional Ethics

10. The auditor should carefully direct, supervise and review work delegated to assistants. The auditor should obtain reasonable assurance that work performed by other auditors or experts is adequate for his purpose. Documentation 11. The auditor should document matters which are important in providing evidence that the audit was carried out in accordance with the basic principles. Planning 12. The auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner. Plans should be based on a knowledge of the client’s business. 13. Plans should be made to cover, among other things: (a) acquiring knowledge of the client’s accounting system, policies and internal control procedures; (b) establishing the expected degree of reliance to be placed on internal control; (c) determining and programming the nature, timing, and extent of the audit procedures to be performed; and (d) coordinating the work to be performed. 14. Plans should be further developed and revised as necessary during the course of the audit. Audit Evidence 15. The auditor should obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable him to draw reasonable conclusions therefrom on which to base his opinion on the financial information. 16. Compliance procedures are tests designed to obtain reasonable assurance that those internal controls on which audit reliance is to be placed are in effect. 17. Substantive procedures are designed to obtain evidence as to the completeness, accuracy and validity of the data produced by the accounting system. They are of two types: (i)

tests of details of transactions and balances;

(ii)

analysis of significant ratios and trends including the resulting enquiry of unusual fluctuations and items.

Accounting System And Internal Control 18. Management is responsible for maintaining an adequate accounting system incorporating various internal controls to the extent appropriate to the size and nature of the business. The auditor should reasonably assure himself that the accounting system is adequate and that all the accounting information which should be recorded has in fact been recorded. Internal controls normally contribute to such assurance.

Part I : Auditing and Assurance Standards

I.9

19. The auditor should gain an understanding of the accounting system and related internal controls and should study and evaluate the operation of those internal controls upon which he wishes to rely in determining the nature, timing and extent of other audit procedures. 20. Where the auditor concludes that he can rely on certain internal controls, his substantive procedures would normally be less extensive than would otherwise be required and may also differ as to their nature and timing. Audit Conclusions And Reporting 21. The auditor should review and assess the conclusions drawn from the audit evidence obtained and from his knowledge of business of the entity as the basis for the expression of his opinion on the financial information. This review and assessment involves forming an overall conclusion as to whether: (a) the financial information has been prepared using acceptable accounting policies, which have been consistently applied; (b) the financial information complies with relevant regulations and statutory requirements; (c) there is adequate disclosure of all material matters relevant to the proper presentation of the financial information, subject to statutory requirements, where applicable. 22. The audit report should contain a clear written expression of opinion on the financial information and if the form or content of the report is laid down in or prescribed under any agreement or statute or regulation, the audit report should comply with such requirements. An unqualified opinion indicates the auditor’s satisfaction in all material respects with the matters dealt with in paragraph 21 or as may be laid down or prescribed under the relevant agreement or statute or regulation, as the case may be. 23. When a qualified opinion, adverse opinion or a disclaimer of opinion is to be given or reservation of opinion on any matter is to be made, the audit report should state the reasons therefor. Effective Date 24. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1985. OBJECTIVE AND SCOPE OF THE AUDIT OF FINANCIAL STATEMENTS (AAS 2) Introduction 1. This Standard describes the overall objective and scope of the audit of general purpose financial statements of an enterprise by an independent auditor. According to para 3.3 of the ‘Preface to the Statements of Accounting Standards’ issued by the Institute of Chartered Accountants of India, “the term ‘General Purpose Financial Statements’ includes balance sheet, statement of profit and loss and other statements and explanatory notes which form part thereof, issued for the use of shareholders/members, creditors, employees and public at large.” References to financial statements in this Standard should be construed to refer to general

I.10

Advanced Auditing & Professional Ethics

purpose financial statements. Objective Of An Audit 2. The objective of an audit of financial statements, prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable an auditor to express an opinion on such financial statements. 3. The auditor’s opinion helps determination of the true and fair view of the financial position and operating results of an enterprise. The user, however, should not assume that the auditor’s opinion is an assurance as to the future viability of the enterprise or the efficiency or effectiveness with which management has conducted the affairs of the enterprise. Responsibility For The Financial Statements 4. While the auditor is responsible for forming and expressing his opinion on the financial statements, the responsibility for their preparation is that of the management of the enterprise. Management’s responsibilities include the maintenance of adequate accounting records and internal controls, the selection and application of accounting policies and the safeguarding of the assets of the enterprise. The audit of the financial statements does not relieve management of its responsibilities. Scope Of An Audit 5. The scope of an audit of financial statements will be determined by the auditor having regard to the terms of the engagement, the requirements of relevant legislation and the pronouncements of the Institute. The terms of engagement cannot, however, restrict the scope of an audit in relation to matters which are prescribed by legislation or by the pronouncements of the Institute. 6. The audit should be organised to cover adequately all aspects of the enterprise as far as they are relevant to the financial statements being audited. To form an opinion on the financial statements, the auditor should be reasonably satisfied as to whether the information contained in the underlying accounting records and other source data is reliable and sufficient as the basis for the preparation of the financial statements. In forming his opinion, the auditor should also decide whether the relevant information is properly disclosed in the financial statements subject to statutory requirements, where applicable. 7. The auditor assesses the reliability and sufficiency of the information contained in the underlying accounting records and other source data by: (a) making a study and evaluation of accounting systems and internal controls on which he wishes to rely and testing those internal controls to determine the nature, extent and timing of other auditing procedures; and (b) carrying out such other tests, enquiries and other verification procedures of accounting transactions and account balances as he considers appropriate in the particular circumstances. 8. The auditor determines whether the relevant information is properly disclosed in the financial statements by: (a) comparing the financial statements with the underlying accounting records and other

Part I : Auditing and Assurance Standards

I.11

source data to see whether they properly summarise the transactions and events recorded therein; and (b) considering the judgements that management has made in preparing the financial statements; accordingly, the auditor assesses the selection and consistent application of accounting policies, the manner in which the information has been classified, and the adequacy of disclosure. 9. The auditor’s work involves exercise of judgement, for example, in deciding the extent of audit procedures and in assessing the reasonableness of the judgements and estimates made by management in preparing the financial statements. Furthermore, much of the evidence available to the auditor can enable him to draw only reasonable conclusions therefrom. Because of these factors, absolute certainty in auditing is rarely attainable. 10. In forming his opinion on the financial statements, the auditor follows procedures designed to satisfy himself that the financial statements reflect a true and fair view of the financial position and operating results of the enterprise. The auditor recognises that because of the test nature and other inherent limitations of an audit, together with the inherent limitations of any system of internal control, there is an unavoidable risk that some material misstatement may remain undiscovered. While in many situations the discovery of a material misstatement by management may often arise during the conduct of the audit, such discovery is not the main objective of audit nor is the auditor’s programme of work specifically designed for such discovery. The audit cannot, therefore, be relied upon to ensure the discovery of all frauds or errors but where the auditor has any indication that some fraud or error may have occurred which could result in material misstatement, the auditor should extend his procedures to confirm or dispel his suspicions. 11. The auditor is primarily concerned with items which either individually or as a group are material in relation to the affairs of an enterprise. However, it is difficult to lay down any definite standard by which materiality can be judged. Material items are those which might influence the decisions of the user of the financial statements 10. It is a matter in which a decision is arrived at on the basis of the auditor’s professional experience and judgement. 12. The auditor is not expected to perform duties which fall outside the scope of his competence. For example, the professional skill required of an auditor does not include that of a technical expert for determining physical condition of certain assets. 13. Constraints on the scope of the audit of financial statements that impair the auditor’s ability to express an unqualified opinion on such financial statements should be set out in his report, and a qualified opinion or disclaimer of opinion should be expressed, as appropriate. Effective Date 14. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1985.

10

Accounting Standard (AS) 1, on ''Disclosure of Accounting Policies'' issued by the Council of the Institute of Chartered Accountants of India.

I.12

Advanced Auditing & Professional Ethics DOCUMENTATION (AAS 3)

Introduction 1. Auditing and Assurance Standard (AAS) 1, “Basic Principles Governing an Audit” (Paragraph 11), states, “The auditor should document matters which are important in providing evidence that the audit was carried out in accordance with the basic principles.” The purpose of this Standard is to amplify the basic principle outlined above. 2. Documentation, for purposes of this Standard, refers to the working papers prepared or obtained by the auditor and retained by him, in connection with the performance of his audit. 3.

Working papers:

♦

aid in the planning and performance of the audit;

♦

aid in the supervision and review of the audit work; and

♦

provide evidence of the audit work performed to support the auditor’s opinion.

Form And Content 4. Working papers should record the audit plan, the nature, timing and extent of auditing procedures performed, and the conclusions drawn from the evidence obtained. 5.

The form and content of working papers are affected by matters such as:

♦

The nature of the engagement.

♦

The form of the auditor’s report.

♦

The nature and complexity of the client’s business.

♦

The nature and condition of the client’s records and degree of reliance on internal controls.

♦

The needs in particular circumstances for direction, supervision and review of work performed by assistants.

6. Working papers should be designed and properly organised to meet the circumstances of each audit and the auditor’s needs in respect thereof. The standardisation of working papers (for example, checklists, specimen letters, standard organisation of working papers) improves the efficiency with which they are prepared and reviewed. It also facilitates the delegation of work while providing a means to control its quality. 7. Working papers should be sufficiently complete and detailed for an auditor to obtain an overall understanding of the audit. The extent of documentation is a matter of professional judgement since it is neither necessary nor practical that every observation, consideration or conclusion is documented by the auditor in his working papers. 8. All significant matters which require the exercise of judgement, together with the auditor’s conclusion thereon, should be included in the working papers. 9. To improve audit efficiency, the auditor normally obtains and utilises schedules, analyses and other working papers prepared by the client. In such circumstances, the auditor should

Part I : Auditing and Assurance Standards

I.13

satisfy himself that these working papers have been properly prepared. Examples of such working papers are detailed analyses of important revenue accounts, receivables, etc. 10. In the case of recurring audits, some working paper files may be classified as permanent audit files, which are updated currently with information of continuing importance to succeeding audits, as distinct from current audit files, which contain information relating primarily to the audit of a single period. 11. A permanent audit file normally includes: ♦

Information concerning the legal and organisational structure of the entity. In the case of a company, this includes the Memorandum and Articles of Association. In the case of a statutory corporation, this includes the Act and Regulations under which the corporation functions.

♦

Extracts or copies of important legal documents, agreements and minutes relevant to the audit.

♦

A record of the study and evaluation of the internal controls related to the accounting system. This might be in the form of narrative descriptions, questionnaires or flow charts, or some combination thereof.

♦

Copies of audited financial statements for previous years.

♦

Analysis of significant ratios and trends.

♦

Copies of management letters issued by the auditor, if any.

♦

Record of communication with the retiring auditor, if any, before acceptance of the appointment as auditor.

♦

Notes regarding significant accounting policies.

♦

Significant audit observations of earlier years.

12. The current file normally includes: ♦

Correspondence relating to acceptance of annual reappointment.

♦

Extracts of important matters in the minutes of Board Meetings and General Meetings, as are relevant to the audit.

♦

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 performed, and the results of such procedures.

♦

Evidence that the work performed by assistants was supervised and reviewed.

♦

Copies of communications with other auditors, experts and other third parties.

♦

Copies of letters or notes concerning audit matters communicated to or discussed with the client, including the terms of the engagement and material weaknesses in relevant internal controls.

I.14

Advanced Auditing & Professional Ethics

♦

Letters of representation or confirmation received from the client.

♦

Conclusions reached by the auditor concerning significant aspects of the audit, including the manner in which exceptions and unusual matters, if any, disclosed by the auditor’s procedures were resolved or treated.

♦

Copies of the financial information being reported on and the related audit reports.

Ownership And Custody Of Working Papers 13. Working papers are the property of the auditor. The auditor may, at his discretion, make portions of or extracts from his working papers available to his client. 14. The auditor should adopt reasonable procedures for custody and confidentiality of his working papers and should retain them for a period of time sufficient to meet the needs of his practice and satisfy any pertinent legal or professional requirements of record retention. Effective Date 15. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after July 1, 1985. THE AUDITOR’S RESPONSIBILITY TO CONSIDER FRAUD AND ERROR IN AN AUDIT OF FINANCIAL STATEMENTS (AAS 4) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's responsibility to consider fraud and error in an audit of financial statements. While this AAS focuses on the auditor's responsibilities with respect to fraud and error, the primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. In this Standard, the term 'financial information' encompasses 'financial statements'. In some circumstances, specific legislations and regulations may require the auditor to undertake procedures additional to those set out in this AAS. 2. When planning and performing audit procedures and evaluating and reporting the results thereof, the auditor should consider the risk of material misstatements in the financial statements resulting from fraud or error. Fraud and Error and Their Characteristics 3. Misstatements in the financial statements can arise from fraud or error. The term "error" refers to an unintentional misstatement in the financial statements, including the omission of an amount or a disclosure, such as: ♦

A mistake in gathering or processing data from which financial statements are prepared.

♦

An incorrect accounting estimate arising from oversight or misinterpretation of facts.

Part I : Auditing and Assurance Standards ♦

I.15

A mistake in the application of accounting principles relating to measurement, recognition, classification, presentation, or disclosure.

4. The term "fraud" refers to an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception to obtain an unjust or illegal advantage. Although fraud is a broad legal concept, the auditor is concerned with fraudulent acts that cause a material misstatement in the financial statements. Misstatement of the financial statements may not be the objective of some frauds. Auditors do not make legal determinations of whether fraud has actually occurred. Fraud involving one or more members of management or those charged with governance is referred to as "management fraud"; fraud involving only employees of the entity is referred to as "employee fraud". In either case, there may be collusion with third parties outside the entity. 5. Two types of intentional misstatements are relevant to the auditor's consideration of fraud-misstatements resulting from fraudulent financial reporting and misstatements resulting from misappropriation of assets. 6. Fraudulent financial reporting involves intentional misstatements or omissions of amounts or disclosures in financial statements to deceive financial statement users. Fraudulent financial reporting may involve: ♦

Deception such as manipulation, falsification, or alteration of accounting records or supporting documents from which the financial statements are prepared.

♦

Misrepresentation in, or intentional omission from, the financial statements of events, transactions or other significant information.

♦

Intentional misapplication of accounting principles relating to measurement, recognition, classification, presentation, or disclosure.

7. Misappropriation of assets involves the theft of an entity's assets. Misappropriation of assets can be accomplished in a variety of ways (including embezzling receipts, stealing physical or intangible assets, or causing an entity to pay for goods and services not received); it is often accompanied by false or misleading records or documents in order to conceal the fact that the assets are missing. 8. Fraud involves motivation to commit fraud and a perceived opportunity to do so. Individuals might be motivated to misappropriate assets, for example, because the individuals are living beyond their means. Fraudulent financial reporting may be committed because management is under pressure, from sources outside or inside the entity, to achieve an expected (and perhaps unrealistic) earnings target particularly when the consequences to management of failing to meet financial goals can be significant. A perceived opportunity for fraudulent financial reporting or misappropriation of assets may exist when an individual believes internal control could be circumvented, for example, because the individual is in a position of trust or has knowledge of specific weaknesses in the internal control system.

I.16

Advanced Auditing & Professional Ethics

9. The distinguishing factor between fraud and error is whether the underlying action that results in the misstatement in the financial statements is intentional or unintentional. Unlike error, fraud is intentional and usually involves deliberate concealment of the facts. While the auditor may be able to identify potential opportunities for fraud to be perpetrated, it is difficult, if not impossible, for the auditor to determine intent, particularly in matters involving management judgment, such as accounting estimates and the appropriate application of accounting principles. Responsibility Of Those Charged With Governance And Of Management 10. The primary responsibility for the prevention and detection of fraud and error rests with both those charged with the governance and the management of an entity. The respective responsibilities of those charged with governance and management may vary from entity to entity. Management, with the oversight of those charged with governance, needs to set the proper tone, create and maintain a culture of honesty and high ethics, and establish appropriate controls to prevent and detect fraud and error within the entity. 11. It is the responsibility of those charged with governance of an entity to ensure, through oversight of management, the integrity of an entity's accounting and financial reporting systems and that appropriate controls are in place, including those for monitoring risk, financial control and compliance with the laws and regulations. 12. It is the responsibility of the management of an entity to establish a control environment and maintain policies and procedures to assist in achieving the objective of ensuring, as far as possible, the orderly and efficient conduct of the entity's business. This responsibility includes implementing and ensuring the continued operation of accounting and internal control systems, which are designed to prevent and detect fraud and error. Such systems reduce but do not eliminate the risk of misstatements, whether caused by fraud or error. Accordingly, management assumes responsibility for any remaining risk. Responsibilities Of The Auditor 13. As described in AAS 2, "Objective and Scope of the Audit of Financial Statements", the objective of an audit of financial statements, prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable an auditor to express an opinion on such financial statements. An audit conducted in accordance with the auditing standards generally accepted in India11 is designed to provide reasonable assurance that the financial statements taken as a whole are free from material misstatement, whether caused by fraud or error. The fact that an audit is carried out may act as a deterrent, but the auditor is not and cannot be held responsible for the prevention of fraud and error. Inherent Limitations of an Audit 14. An auditor cannot obtain absolute assurance that material misstatements in the financial statements will be detected. Owing to the inherent limitations of an audit, there is an 11

Paragraph 15 of AAS 28. ''The Auditor's Report on Financial Statements'' describes auditing standards generally accepted in India.

Part I : Auditing and Assurance Standards

I.17

unavoidable risk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with the auditing standards generally accepted in India. An audit does not guarantee that all material misstatements will be detected because of such factors as the use of judgment, the use of testing, the inherent limitations of internal control and the fact that much of the evidence available to the auditor is persuasive rather than conclusive in nature. For these reasons, the auditor is able to obtain only a reasonable assurance that material misstatements in the financial statements will be detected. 15. The risk of not detecting a material misstatement resulting from fraud is higher than the risk of not detecting a material misstatement resulting from error because fraud, generally, involves sophisticated and carefully organized schemes designed to conceal it, such as forgery, deliberate failure to record transactions, or intentional misrepresentations being made to the auditor. Such attempts at concealment may be even more difficult to detect when accompanied by collusion. Collusion may cause the auditor to believe that evidence is persuasive when it is, in fact, false. The auditor's ability to detect a fraud depends on factors such as the skillfulness of the perpetrator, the frequency and extent of manipulation, the degree of collusion involved, the relative size of individual amounts manipulated, and the seniority of those involved. Audit procedures that are effective for detecting an error may be ineffective for detecting fraud. 16. Furthermore, the risk of the auditor not detecting a material misstatement resulting from management fraud is greater than for employee fraud, because those charged with governance and management are often in a position that assumes their integrity and enables them to override the formally established control procedures. Certain levels of management may be in a position to override control procedures designed to prevent similar frauds by other employees, for example, by directing subordinates to record transactions incorrectly or to conceal them. Given its position of authority within an entity, management has the ability to either direct employees to do something or solicit their help to assist management in carrying out a fraud, with or without the employees' knowledge. 17. The auditor's opinion on the financial statements is based on the concept of obtaining reasonable assurance; hence, in an audit, the auditor does not guarantee that material misstatements, whether from fraud or error, will be detected. Therefore, the subsequent discovery of a material misstatement of the financial statements resulting from fraud or error does not, in and of itself, indicate: (a) failure to obtain reasonable assurance, (b) inadequate planning, performance or judgment, (c) absence of professional competence and due care, or, (d) failure to comply with auditing standards generally accepted in India. This is particularly the case for certain kinds of intentional misstatements, since auditing procedures may be ineffective for detecting an intentional misstatement that is concealed through collusion between or among one or more individuals among management, those charged with governance, employees, or third parties, or involves falsified documentation.

I.18

Advanced Auditing & Professional Ethics

Whether the auditor has performed an audit in accordance with auditing standards generally accepted in India is determined by the adequacy of the audit procedures performed in the circumstances and the suitability of the auditor's report based on the result of these procedures. Professional Skepticism 18. The auditor plans and performs an audit with an attitude of professional skepticism. Such an attitude is necessary for the auditor to identify and properly evaluate, for example: ♦

Matters that increase the risk of a material misstatement in the financial statements resulting from fraud or error (for instance, management's characteristics and influence over the control environment, industry conditions, and operating characteristics and financial stability).

♦

Circumstances that make the auditor suspect that the financial statements are materially misstated.

♦

Evidence obtained (including the auditor's knowledge from previous audits) that brings into question the reliability of management representations.

19. However, unless the audit reveals evidence to the contrary, the auditor is entitled to accept records and documents as genuine. Accordingly, an audit performed in accordance with auditing standards generally accepted in India rarely contemplate authentication of documentation, nor are auditors trained as, or expected to be, experts in such authentication. Planning Discussions 20. In planning the audit, the auditor should discuss with other members of the audit team, the susceptibility of the entity to material misstatements in the financial statements resulting from fraud or error. 21. Such discussions would involve considering, for example, in the context of the particular entity, where errors may be more likely to occur or how fraud might be perpetrated. Based on these discussions, members of the audit team may gain a better understanding of the potential for material misstatements in the financial statements resulting from fraud or error in the specific areas of the audit assigned to them, and how the results of the audit procedures that they perform may affect other aspects of the audit. Decisions may also be made as to which members of the audit team will conduct certain inquiries or audit procedures, and how the results of those inquiries and procedures will be shared. Inquiries of Management 22. When planning the audit, the auditor should make inquiries of management: (a) to obtain an understanding of: (i)

management's assessment of the risk that the financial statements may be materially misstated as a result of fraud; and

(ii)

the accounting and internal control systems management has put in place to address such risk;

Part I : Auditing and Assurance Standards

I.19

(b) to obtain knowledge of management's understanding regarding the accounting and internal control systems in place to prevent and detect error; (c) to determine whether management is aware of any known fraud that has affected the entity or suspected fraud that the entity is investigating; and (d) to determine whether management has discovered any material errors. 23. The auditor supplements his own knowledge of the entity's business by making inquiries of management regarding management's own assessment of the risk of fraud and the systems in place to prevent and detect it. In addition, the auditor makes inquiries of management regarding the accounting and internal control systems in place to prevent and detect error. Since management is responsible for the entity's accounting and internal control systems and for the preparation of the financial statements, it is appropriate for the auditor to inquire of management how it is discharging these responsibilities. Matters that might be discussed as part of these inquiries include: (a) whether there are particular subsidiary locations, business segments, types of transactions, account balances or financial statement categories where the possibility of error may be high, or where fraud risk factors may exist, and how they are being addressed by management; (b) the work of the entity's internal audit function and whether internal audit has identified fraud or any serious weaknesses in the system of internal control; and (c) how management communicates to employees its view on responsible business practices and ethical behaviour, such as through ethics policies or codes of conduct. 24. The nature, extent and frequency of management's assessment of such systems and risk vary from entity to entity. In some entities, management may make detailed assessments on an annual basis or as part of continuous monitoring. In other entities, management's assessment may be less formal and less frequent. The nature, extent and frequency of management's assessment are relevant to the auditor's understanding of the entity's control environment. For example, the fact that management has not made an assessment of the risk of fraud may be indicative of the lack of importance that management places on internal control. 25. It is also important that the auditor obtains an understanding of the design of the accounting and internal control systems within the entity. In designing such systems, management makes informed judgments on the nature and extent of the control procedures it chooses to implement and the nature and extent of the risks it chooses to assume. As a result of making these inquiries of management, the auditor may learn, for example, that management has consciously chosen to accept the risk associated with a lack of segregation of duties. Information from these inquiries may also be useful in identifying fraud risk factors that may affect the auditor's assessment of the risk that the financial statements may contain material misstatements caused by fraud. 26. It is also important for the auditor to inquire about management's knowledge of frauds that have affected the entity, suspected frauds that are being investigated, and material errors

I.20

Advanced Auditing & Professional Ethics

that have been discovered. Such inquiries might indicate possible weaknesses in control procedures if, for example, a number of errors have been found in certain areas. Alternatively, such inquiries might indicate that control procedures are operating effectively because anomalies are being identified and investigated promptly. 27. Although the auditor's inquiries of management may provide useful information concerning the risk of material misstatements in the financial statements resulting from employee fraud, such inquiries are unlikely to provide useful information regarding the risk of material misstatements in the financial statements resulting from management fraud. Accordingly, the auditor's follow-up of fraud risk factors, as discussed in paragraph 39, is of particular relevance in relation to management fraud. Discussions with Those Charged with Governance 28. Those charged with governance of an entity have oversight responsibility for systems for monitoring risk, financial control and compliance with the law. In case of clients whose corporate governance practices are well developed and those charged with governance play an active role in oversight of how management has discharged its responsibilities, auditors are encouraged to seek the views of those charged with governance on the adequacy of accounting and internal control systems in place to prevent and detect fraud and error, the risk of fraud and error, and the competence and integrity of management. Such inquiries may, for example, provide insights regarding the susceptibility of the entity to management fraud. The auditor may have an opportunity to seek the views of those charged with governance during, for example, a meeting with the audit committee to discuss the general approach and overall scope of the audit and eliciting views of independent directors. This discussion may also provide those charged with governance with the opportunity to bring matters of concern to the auditor's attention. 29. Since the responsibilities of those charged with governance and management may vary by entity, it is important that the auditor understands the nature of these responsibilities within an entity to ensure that the inquiries and communications described above are directed to the appropriate individuals12. 30. In addition, following the inquiries of management described in paragraphs 22-27, the auditor considers whether there are any matters of governance interest to be discussed with those charged with governance of the entity13. Such matters may include for example: ♦

Concerns about the nature, extent and frequency of management's assessments of the accounting and control systems in place to prevent and detect fraud and error, and of the risk that the financial statements may be misstated.

♦

A failure by management to address appropriately material weaknesses in internal control identified during the prior period's audit.

12

AAS 27. ''Communications of Audit Matters with Those Charged with Governance'', paragraph 8, discusses with whom the auditor communicates when the entily's governance structure is not well defined. 13 For a discussion of these matters, see AAS 27, ''Communication of Audit Matters with Those Charged with Governance paragraphs 11.14

Part I : Auditing and Assurance Standards

I.21

♦

The auditor's evaluation of the entity's control environment, including questions regarding management’s competence and integrity.

♦

The effect of any matters, such as those above, on the general approach and overall scope of the audit, including additional procedures that the auditor may need to perform.

Audit Risk 31. AAS 6 (Revised), "Risk Assessments and Internal Control," paragraph 3, states that "audit risk" is the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Such misstatements can result from either fraud or error. AAS 6 (Revised) identifies the three components of audit risk i.e., inherent risk, control risk and detection risk, and also provides guidance on how to assess these risks. Inherent Risk and Control Risk 32. When assessing inherent risk and control risk in accordance with AAS 6 (Revised), “Risk Assessments and Internal Control”, the auditor should consider how the financial statements might be materially misstated as a result of fraud or error. In considering the risk of material misstatement resulting from fraud, the auditor should consider whether fraud risk factors are present that indicate the possibility of either fraudulent financial reporting or misappropriation of assets. 33. AAS 6 (Revised), “Risk Assessments and Internal Control”, describes the auditor's assessment of inherent risk and control risk, and how those assessments affect the nature, timing and extent of the audit procedures. In making those assessments, the auditor considers how the financial statements might be materially misstated as a result of fraud or error. 34. The fact that fraud is usually concealed can make it very difficult to detect. Nevertheless, using the auditor's knowledge of the business, the auditor may identify events or conditions that provide an opportunity, a motive or a means to commit fraud, or indicate that fraud may already have occurred. Such events or conditions are referred to as "fraud risk factors". For example, a document may be missing, a general ledger may be out of balance, or an analytical procedure may not make sense. However, these conditions may be the result of circumstances other than fraud. Therefore, fraud risk factors do not necessarily indicate the existence of fraud, however, they often have been present in circumstances where frauds have occurred. The presence of fraud risk factors may affect the auditor's assessment of inherent risk or control risk. Examples of fraud risk factors are set out in Appendix 1 to this AAS. 35. Fraud risk factors cannot easily be ranked in order of importance or combined into effective predictive models. The significance of fraud risk factors varies widely. Some of these factors will be present in entities where the specific conditions do not present a risk of material misstatement. Accordingly, the auditor exercises professional judgment when considering fraud risk factors individually or in combination and whether there are specific controls that mitigate the risk.

I.22

Advanced Auditing & Professional Ethics

36. Although the fraud risk factors described in Appendix 1 cover a broad range of situations typically faced by auditors, they are only examples. Moreover, not all of these examples are relevant in all circumstances, and some may be of greater or lesser significance in entities of different size, with different ownership characteristics, in different industries, or because of other differing characteristics or circumstances. Accordingly, the auditor uses professional judgment when assessing the significance and relevance of fraud risk factors and determining the appropriate audit response. 37. The size, complexity, and ownership characteristics of the entity have a significant influence on the consideration of relevant fraud risk factors. For example, in the case of a large entity, the auditor ordinarily considers factors that generally constrain improper conduct by management, such as the effectiveness of those charged with governance, and the internal audit function. The auditor also considers what steps have been taken to enforce a formal code of conduct, and the effectiveness of the budgeting system. In the case of a small entity, some or all of these considerations may be inapplicable or less important. For example, a smaller entity might not have a written code of conduct but, instead, may have developed a culture that emphasizes the importance of integrity and ethical behaviour through oral communication and by management example. Domination of management by a single individual in a small entity does not generally, in and of itself, indicate a failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Furthermore, fraud risk factors considered at a business segment operating level may provide different insights than the consideration thereof at an entity-wide level. 38. The presence of fraud risk factors may indicate that the auditor will be unable to assess control risk at less than high for certain financial statement assertions. On the other hand, the auditor may be able to identify internal controls designed to mitigate those fraud risk factors that the auditor can test to support a control risk assessment below high. Detection Risk 39. Based on the auditor's assessment of inherent and control risks (including the results of any tests of controls), the auditor should design substantive procedures to reduce to an acceptably low level the risk that misstatements resulting from fraud and error that are material to the financial statements taken as a whole will not be detected. In designing the substantive procedures, the auditor should address the fraud risk factors that the auditor has identified as being present. 40. AAS 6 (Revised) “Risk Assessments and Internal Control”, explains that the auditor's control risk assessment, together with the inherent risk assessment, influences the nature, timing and extent of substantive procedures to be performed to reduce detection risk to an acceptably low level. In designing substantive procedures, the auditor addresses fraud risk factors that the auditor has identified as being present. The auditor's response to those factors is influenced by their nature and significance. In some cases, even though fraud risk factors have been identified as being present, the auditor's judgment may be that the audit procedures, including both tests of control, and substantive procedures, already planned, are sufficient to respond to the fraud risk factors.

Part I : Auditing and Assurance Standards

I.23

41. In other circumstances, the auditor may conclude that there is a need to modify the nature, timing and extent of substantive procedures to address fraud risk factors present. In these circumstances, the auditor considers whether the assessment of the risk of material misstatement calls for an overall response, a response that is specific to a particular account balance, class of transactions or assertion, or both types of response. The auditor considers whether changing the nature of audit procedures, rather than the extent of them, may be more effective in responding to identified fraud risk factors. Examples of response procedures are set out in Appendix 2 to this AAS, including examples of responses to the auditor's assessment of the risk of material misstatement resulting from both fraudulent financial reporting and misappropriation of assets. Procedures When Circumstances Indicate A Possible Misstatement 42. When the auditor encounters circumstances that may indicate that there is a material misstatement in the financial statements resulting from fraud or error, the auditor should perform procedures to determine whether the financial statements are materially misstated. 43. During the course of the audit, the auditor may encounter circumstances that indicate that the financial statements may contain a material misstatement resulting from fraud or error. Examples of such circumstances that, individually or in combination, may make the auditor suspect that such a misstatement exists are set out in Appendix 3 to this AAS. 44. When the auditor encounters such circumstances, the nature, timing and extent of the procedures to be performed depends on the auditor's judgment as to the type of fraud or error indicated, the likelihood of its occurrence, and the likelihood that a particular type of fraud or error could have a material effect on the financial statements. Ordinarily, the auditor is able to perform sufficient procedures to confirm or dispel a suspicion that the financial statements are materially misstated resulting from fraud or error. If not, the auditor considers the effect on the auditor's report, as discussed in paragraph 48. 45. The auditor cannot assume that an instance of fraud or error is an isolated occurrence and therefore, before the conclusion of the audit, the auditor considers whether the assessment of the components of audit risk made during the planning of the audit may need to be revised and whether the nature, timing and extent of the auditor's other procedures may need to be reconsidered. {See AAS 6 (Revised), "Risk Assessments and Internal Control," paragraphs 40 and 47} For example, the auditor would consider: ♦

The nature, timing and extent of substantive procedures.

♦

The assessment of the effectiveness of internal controls if control risk was assessed below high.

♦

The assignment of audit team members that may be appropriate in the circumstances.

Considering Whether An Identified Misstatement May Be Indicative Of Fraud 46. When the auditor identifies a misstatement, the auditor should consider whether such a misstatement may be indicative of fraud and if there is such an indication, the auditor should consider the implications of the misstatement in relation to other aspects of the audit, particularly the reliability of management representations.

I.24

Advanced Auditing & Professional Ethics

47. If the auditor has determined that a misstatement is, or may be, the result of fraud, the auditor evaluates the implications, especially those dealing with the organizational position of the person or persons involved. For example, fraud involving misappropriations of cash from a small petty cash fund is ordinarily of little significance to the auditor in assessing the risk of material misstatement due to fraud. This is because both the manner of operating the fund and its size tend to establish a limit on the amount of potential loss, and the custodianship of such funds is ordinarily entrusted to an employee with a low level of authority. Conversely, when the matter involves management with a higher level of authority, even though the amount itself is not material to the financial statement, it may be indicative of a more pervasive problem. In such circumstances, the auditor reconsiders the reliability of evidence previously obtained since there may be doubts about the completeness and truthfulness of representations made and about the genuineness of accounting records and documentation. The auditor also considers the possibility of collusion involving employees, management or third parties when reconsidering the reliability of evidence. If management, particularly at the highest level, is involved in fraud, the auditor may not be able to obtain the evidence necessary to complete the audit and report on the financial statements. Evaluation And Disposition Of Misstatements, And The Effect On The Auditor's Report 48. When the auditor confirms that, or is unable to conclude whether, the financial statements are materially misstated as a result of fraud or error, the auditor should consider the implications for the audit. AAS 13, "Audit Materiality," paragraphs 12-16, and AAS 28, “The Auditor’s Report on Financial Statements”, paragraphs 37-47, provide guidance on the evaluation and disposition of misstatements and the effect on the auditor's report. Where a significant fraud has occurred or the fraud is committed by those charged with governance, the auditor should consider the necessity for a disclosure of the fraud in the financial statements. If adequate disclosure is not made the auditor should consider the necessity for a suitable disclosure in his report. Documentation 49. The auditor should document fraud risk factors identified as being present during the auditor's assessment process (see paragraph 32) and document the auditor's response to any such factors (see paragraph 39). If during the performance of the audit, fraud risk factors are identified that cause the auditor to believe that additional audit procedures are necessary, the auditor should document the presence of such risk factors and the auditor's response to them. 50. The auditor must document matters which are important in providing evidence to support the audit opinion, and the working papers must include the auditor's reasoning on all significant matters which require the auditor's judgment, together with the auditor's conclusion thereon. Because of the importance of fraud risk factors in the assessment of the inherent or control risk of material misstatement, the auditor documents fraud risk factors identified and the response considered appropriate by the auditor. (Reference may also be had to AAS 3, “Documentation”).

Part I : Auditing and Assurance Standards

I.25

Management Representations 51. The auditor should obtain written representations from management that: (a) it acknowledges its responsibility for the implementation and operation of accounting and internal control systems that are designed to prevent and detect fraud and error; (b) it believes the effects of those uncorrected financial statement misstatements aggregated by the auditor during the audit are immaterial, both individually and in the aggregate, to the financial statements taken as a whole. A summary of such items should be included in or attached to the written representation; (c) it has disclosed to the auditor all significant facts relating to any frauds or suspected frauds known to management that may have affected the entity; and (d) it has disclosed to the auditor the results of its assessment of the risk that the financial statements may be materially misstated as a result of fraud. 52. AAS 11, “Representations by Management” provides guidance on obtaining appropriate representations from management in the audit. In addition to acknowledging its responsibility for the financial statements, it is important that management acknowledges its responsibility for the accounting and internal control systems designed to prevent and detect fraud and error. 53. Because management is responsible for adjusting the financial statements to correct material misstatements, it is important that the auditor obtains written representation from management that any uncorrected misstatements resulting from either fraud or error are, in management's opinion, immaterial, both individually and in the aggregate. Such representations are not a substitute for obtaining sufficient appropriate audit evidence. In some circumstances, management may not believe that certain of the uncorrected financial statement misstatements aggregated by the auditor during the audit are misstatements. For that reason, management may want to add to their written representation words such as, "We do not agree that items …… and ….… constitute misstatements because [description of reasons]." 54. The auditor may designate an amount below which misstatements need not be accumulated because the auditor expects that the accumulation of such amounts clearly would not have a material effect on the financial statements. In so doing, the auditor considers the fact that the determination of materiality involves qualitative as well as quantitative considerations and that misstatements of a relatively small amount could nevertheless have a material effect on the financial statements. The summary of uncorrected misstatements included in or attached to the written representation need not include such misstatements. 55. Because of the nature of fraud and the difficulties encountered by auditors in detecting material misstatements in the financial statements resulting from fraud, it is important that the auditor obtains a written representation from management confirming that it has disclosed to the auditor all facts relating to any frauds or suspected frauds that it is aware of that may have affected the entity, and that management has disclosed to the auditor the results of

I.26

Advanced Auditing & Professional Ethics

management's assessment of the risk that the financial statements may be materially misstated as a result of fraud. Communication 56. When the auditor identifies a misstatement resulting from fraud, or a suspected fraud, or error, the auditor should consider the auditor's responsibility to communicate that information to management, those charged with governance and, in some circumstances, when so required by the laws and regulations, to regulatory and enforcement authorities also. 57. Communication of a misstatement resulting from fraud, or a suspected fraud, or error to the appropriate level of management on a timely basis is important because it enables management to take necessary action. The determination of which level of management is the appropriate one is a matter of professional judgment and is affected by such factors as the nature, magnitude and frequency of the misstatement or suspected fraud. Ordinarily, the appropriate level of management is at least one level above the persons who appear to be involved with the misstatement or suspected fraud. 58. The determination of which matters are to be communicated by the auditor to those charged with governance is a matter of professional judgment and is also affected by any understanding between the parties as to which matters are to be communicated. Ordinarily, such matters include: ♦

Questions regarding management competence and integrity.

♦

Fraud involving management.

♦

Other frauds which result in a material misstatement of the financial statements.

♦

Material misstatements resulting from error.

♦

Misstatements that indicate material weaknesses in internal control, including the design or operation of the entity's financial reporting process.

♦

Misstatements that may cause future financial statements to be materially misstated.

Communication of Misstatements Resulting From Error to Management and to Those Charged With Governance 59. If the auditor has identified a material misstatement resulting from error, the auditor should communicate the misstatement to the appropriate level of management on a timely basis, and consider the need to report it to those charged with governance. 60. The auditor should inform those charged with governance of those uncorrected misstatements aggregated by the auditor during the audit that were determined by management to be immaterial, both individually and in the aggregate, to the financial statements taken as a whole. 61. As noted in paragraph 54, the uncorrected misstatements communicated to those charged with governance need not include the misstatements below a designated amount.

Part I : Auditing and Assurance Standards

I.27

Communication of Misstatements Resulting From Fraud to Management and to Those Charged with Governance 62. If the auditor has: (a) identified a fraud, whether or not it results in a material misstatement in the financial statements; or (b) obtained evidence that indicates that fraud may exist (even if the potential effect on the financial statements would not be material); The auditor should communicate these matters to the appropriate level of management on a timely basis, and consider the need to report such matters to those charged with governance. 63. When the auditor has obtained evidence that fraud exists or may exist, it is important that the matter is brought to the attention of an appropriate level of management. This is so even if the matter might be considered inconsequential (for example, a minor defalcation by an employee at a low level in the entity's organization). The determination of which level of management is the appropriate one is also affected in these circumstances by the likelihood of collusion or the involvement of a member of management. 64. If the auditor has determined that the misstatement is, or may be, the result of fraud, and either has determined that the effect could be material to the financial statements or has been unable to evaluate whether the effect is material, the auditor: (a) discusses the matter and the approach to further investigation with an appropriate level of management that is at least one level above those involved, and with management at the highest level; and (b) if appropriate, suggests that management consult legal counsel. Communication of Material Weaknesses in Internal Control 65. The auditor should communicate to management any material weaknesses in internal control related to the prevention or detection of fraud and error, which have come to the auditor's attention as a result of the performance of the audit. The auditor should also be satisfied that those charged with governance have been informed of any material weaknesses in internal control related to the prevention and detection of fraud that either have been brought to the auditor's attention by management or have been identified by the auditor during the audit. 66. When the auditor has identified any material weaknesses in internal control related to the prevention or detection of fraud or error, the auditor communicates these material weaknesses in internal control to management. Because of the serious implications of material weaknesses in internal control related to the prevention and detection of fraud, it is also important that such deficiencies be brought to the attention of those charged with governance. 67. If the integrity or honesty of management or those charged with governance are doubted, the auditor ordinarily considers seeking legal advice to assist in the determination of the appropriate course of action.

I.28

Advanced Auditing & Professional Ethics

Communication to Regulatory and Enforcement Authorities 68. The auditor's professional duty to maintain the confidentiality of client information ordinarily precludes reporting fraud and error to a party outside the client entity. However, the auditor's legal responsibilities may vary and in certain circumstances, statute, the law or courts of law may override the duty of confidentiality. For example, under the regulatory framework for Non-Banking Financial Companies, an obligation is cast upon the auditor to report to the Reserve Bank of India any adverse or unfavourable remarks in his report. In such circumstances, the auditor may consider seeking legal advice. Auditor Unable To Complete The Engagement 69. If the auditor concludes that it is not possible to continue performing the audit as a result of a misstatement resulting from fraud or suspected fraud, the auditor should: (a) consider the professional and legal responsibilities applicable in the circumstances, including whether there is a requirement for the auditor to report to the person or persons who made the audit appointment or, in some cases, to regulatory authorities; (b) consider the possibility of withdrawing from the engagement; and (c) if the auditor withdraws: (i)

discuss with the appropriate level of management and those charged with governance, the auditor's withdrawal from the engagement and the reasons for the withdrawal; and

(ii)

consider whether there is a professional or legal requirement to report to the person or persons who made the audit appointment or, in some cases, to regulatory authorities, the auditor's withdrawal from the engagement and the reasons for the withdrawal.

70. The auditor may encounter exceptional circumstances that bring into question the auditor's ability to continue performing the audit, for example, in circumstances where: (a) the entity does not take the remedial action regarding fraud that the auditor considers necessary in the circumstances, even when the fraud is not material to the financial statements; (b) the auditor's consideration of the risk of material misstatement resulting from fraud and the results of audit tests indicate a significant risk of material and pervasive fraud; or (c) the auditor has significant concern about the competence or integrity of management or those charged with governance. 71. Because of the variety of the circumstances that may arise, it is not possible to describe definitively when withdrawal from an engagement is appropriate. Factors that affect the auditor's conclusion include the implications of the involvement of a member of management or of those charged with governance (which may affect the reliability of management representations) and the effects on the auditor of continuing association with the entity.

Part I : Auditing and Assurance Standards

I.29

72. The auditor has professional and legal responsibilities in such circumstances and these responsibilities may vary in different circumstances. For example, the auditor may be entitled to, or required to, make a statement or report to the person or persons who made the audit appointment or, in some cases, to regulatory authorities. Given the exceptional nature of the circumstances and the need to consider the legal requirements, the auditor considers seeking legal advice when deciding whether to withdraw from an engagement and in determining an appropriate course of action. Communication with an Incoming Auditor 73. Clause 8 of Part I of the First Schedule to the Chartered Accountants Act, 1949 lays down that a Chartered Accountant in practice would be guilty of professional misconduct if he accepts a position as an auditor, previously held by another chartered accountant without first communicating to him in writing. On receipt of an inquiry from a incoming auditor, the existing auditor should advise whether there are any professional reasons why the incoming auditor should not accept the appointment. If the client denies the existing auditor permission to discuss its affairs with the incoming auditor or limits what the existing auditor may say, that fact should be disclosed to the incoming auditor. 74. The auditor may be contacted by an incoming auditor inquiring whether there are any professional reasons why the incoming auditor should not accept the appointment. The responsibilities of existing and incoming auditor are set out in the Code of Ethics, issued by the Institute of Chartered Accountants of India. 75. The extent to which an existing auditor can discuss the affairs of a client with an incoming auditor will depend on whether the existing auditor has obtained the client's permission to do so, and on the professional and legal responsibilities relating to such disclosure. Subject to any constraints arising from these responsibilities, the existing auditor advises the incoming auditor whether there are any professional reasons not to accept the appointment, providing details of the information and discussing freely with the incoming auditor all matters relevant to the appointment. If fraud or suspected fraud was a factor in the existing auditor's withdrawal from the engagement, it is important that the existing auditor take care to state only the facts (not his or her conclusions) relating to these matters. Effective Date 76. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods commencing on or after 1st April 2003. Compatibility With International Standard On Auditing (ISA) 240 The auditing standards established in this Auditing and Assurance Standard are generally consistent in all material respects with those set out in International Standard on Auditing (ISA) 240 on The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements.

I.30

Advanced Auditing & Professional Ethics Appendix 1 Examples of Risk Factors Relating to Misstatements Resulting from Fraud

The fraud risk factors identified in this Appendix are examples of such factors typically faced by auditors in a broad range of situations. However, the fraud risk factors listed below are only examples; not all of these factors are likely to be present in all audits, nor is the list necessarily complete. Furthermore, the auditor exercises professional judgment when considering fraud risk factors individually or in combination and whether there are specific controls that mitigate the risk. Fraud risk factors are discussed in paragraphs 34-38. Fraud Risk Factors Relating to Misstatements Resulting from Fraudulent Financial Reporting Fraud risk factors that relate to misstatements resulting from fraudulent financial reporting may be grouped in the following three categories: 1.

Management's Characteristics and Influence over the Control Environment.

2.

Industry Conditions.

3.

Operating Characteristics and Financial Stability.

For each of these three categories, examples of fraud risk factors relating to misstatements arising from fraudulent financial reporting are set out below: 1.

Fraud Risk Factors Relating to Management's Characteristics and Influence over the Control Environment

A.

These fraud risk factors pertain to management's abilities, pressures, style, and attitude relating to internal control and the financial reporting process. ♦

There is motivation for management to engage in fraudulent financial reporting. Specific indicators might include the following: 9

A significant portion of management's compensation is represented by bonuses, stock options or other incentives, the value of which is contingent upon the entity achieving unduly aggressive targets for operating results, financial position or cash flow.

9

There is excessive interest by management in maintaining or increasing the entity's stock price or earnings trend through the use of unusually aggressive accounting practices.

9

Management commits to analysts, creditors and other third parties to achieving what appear to be unduly aggressive or clearly unrealistic forecasts.

9

Management has an interest in pursuing inappropriate means to minimize reported earnings for tax-motivated reasons.

Part I : Auditing and Assurance Standards B.

I.31

There is a failure by management to display and communicate an appropriate attitude regarding internal control and the financial reporting process. Specific indicators might include the following: ♦

Management does not effectively communicate and support the entity's values or ethics, or management communicates inappropriate values or ethics.

♦

Management is dominated by a single person or a small group without compensating controls such as effective oversight by those charged with governance.

♦

Management does not monitor significant controls adequately.

♦

Management fails to correct known material weaknesses in internal control on a timely basis.

♦

Management sets unduly aggressive financial targets and expectations for operating personnel.

♦

Management displays a significant disregard for regulatory authorities.

♦

Management continues to employ ineffective accounting, information technology or internal auditing staff.

♦

Non-financial management participates excessively in, or is preoccupied with, the selection of accounting principles or the determination of significant estimates.

♦

There is a high turnover of management, counsel or board members.

♦

There is a strained relationship between management and the current or predecessor auditor. Specific indicators might include the following: 9

Frequent disputes with the current or a predecessor auditor on accounting, auditing or reporting matters.

9

Unreasonable demands on the auditor, including unreasonable time constraints regarding the completion of the audit or the issuance of the auditor's report.

9

Formal or informal restrictions on the auditor that inappropriately limit the auditor's access to people or information, or limit the auditor's ability to communicate effectively with those charged with governance.

9

Domineering management behaviour in dealing with the auditor, especially involving attempts to influence the scope of the auditor's work.

♦

There is a history of securities law violations, or claims against the entity or its management alleging fraud or violations of securities laws.

♦

The corporate governance structure is weak or ineffective, which may be evidenced by, for example: 9

A lack of members who are independent of management.

I.32

Advanced Auditing & Professional Ethics 9

2.

Little attention being paid to financial reporting matters and to the accounting and internal control systems by those charged with governance.

Fraud Risk Factors Relating to Industry Conditions

These fraud risk factors involve the economic and regulatory environment in which the entity operates. ♦

New accounting, statutory or regulatory requirements that could impair the financial stability or profitability of the entity.

♦

A high degree of competition or market saturation, accompanied by declining margins.

♦

A declining industry with increasing business failures and significant declines in customer demand.

♦

Rapid changes in the industry, such as high vulnerability to rapidly changing technology or rapid product obsolescence.

3.

Fraud Risk Factors Relating to Operating Characteristics and Financial Stability These fraud risk factors pertain to the nature and complexity of the entity and its transactions, the entity's financial condition, and its profitability.

♦

Inability to generate cash flows from operations while reporting earnings and earnings growth.

♦

Significant pressure to obtain additional capital necessary to stay competitive, considering the financial position of the entity (including a need for funds to finance major research and development or capital expenditures).

♦

Assets, liabilities, revenues or expenses based on significant estimates that involve unusually subjective judgments or uncertainties, or that are subject to potential significant change in the near term in a manner that may have a financially disruptive effect on the entity (for example, the ultimate collectibility of receivables, the timing of revenue recognition, the realisability of financial instruments based on highly-subjective valuation of collateral or difficult-to-assess repayment sources, or a significant deferral of costs).

♦

Significant related party transactions which are not in the ordinary course of business.

♦

Significant related party transactions which are not audited or are audited by another firm.

♦

Significant, unusual or highly complex transactions (especially those close to year-end) that pose difficult questions concerning substance over form.

♦

Significant bank accounts or subsidiary or branch operations in tax-haven jurisdictions for which there appears to be no clear business justification.

♦

An overly complex organizational structure involving numerous or unusual legal entities, managerial lines of authority or contractual arrangements without apparent business purpose.

♦

Difficulty in determining the organization or person (or persons) controlling the entity.

Part I : Auditing and Assurance Standards

I.33

♦

Unusually rapid growth or profitability, especially compared with that of other companies in the same industry.

♦

Especially high vulnerability to changes in interest rates.

♦

Unusually high dependence on debt, a marginal ability to meet debt repayment requirements, or debt covenants that are difficult to maintain.

♦

Unrealistically aggressive sales or profitability incentive programs.

♦

A threat of imminent bankruptcy, foreclosure or hostile takeover.

♦

Adverse consequences on significant pending transactions (such as a business combination or contract award) if poor financial results are reported.

♦

A poor or deteriorating financial position when management has personally guaranteed significant debts of the entity.

Fraud Risk Factors Relating to Misstatements Resulting from Misappropriation of Assets Fraud risk factors that relate to misstatements resulting from misappropriation of assets may be grouped in the following two categories: 1.

Susceptibility of Assets to Misappropriation.

2.

Controls.

For each of these two categories, examples of fraud risk factors relating to misstatements resulting from misappropriation of assets are set out below. The extent of the auditor's consideration of the fraud risk factors in category 2 is influenced by the degree to which fraud risk factors in category 1 are present. 1.

Fraud Risk Factors Relating to Susceptibility of Assets to Misappropriation

These fraud risk factors pertain to the nature of an entity's assets and the degree to which they are subject to theft. ♦

Large amounts of cash on hand or processed.

♦

Inventory characteristics, such as small size combined with high value and high demand.

♦

Easily convertible assets, such as bearer bonds, diamonds or computer chips.

♦

Fixed asset characteristics, such as small size combined with marketability and lack of ownership identification.

2.

Fraud Risk Factors Relating to Controls

These fraud risk factors involve the lack of controls designed to prevent or detect misappropriation of assets. ♦

Lack of appropriate management oversight (for example, inadequate supervision or inadequate monitoring of remote locations).

I.34

Advanced Auditing & Professional Ethics

♦

Lack of procedures to screen job applicants for positions where employees have access to assets susceptible to misappropriation.

♦

Inadequate record keeping for assets susceptible to misappropriation.

♦

Lack of an appropriate segregation of duties or independent checks.

♦

Lack of an appropriate system of authorization and approval of transactions (for example, in purchasing).

♦

Poor physical safeguards over cash, investments, inventory or fixed assets.

♦

Lack of timely and appropriate documentation for transactions (for example, credits for merchandise returns).

♦

Lack of mandatory vacations for employees performing key control functions. Appendix 2 Examples of Modifications of Procedures in Response to the Assessment of Fraud Risk Factors in Accordance with Paragraphs 39-41

The following are examples of possible responses to the auditor's assessment of the risk of material misstatement resulting from both fraudulent financial reporting and misappropriation of assets. The auditor exercises judgment to select the most appropriate procedures in the circumstances. The procedures identified may neither be the most appropriate nor necessary in each circumstance. The auditor's response to fraud risk factors is discussed in paragraphs 40-41. Overall Considerations Judgments about the risk of material misstatements resulting from fraud may affect the audit in the following ways: i.

Professional skepticism: The application of professional skepticism may include: (i) increased sensitivity in the selection of the nature and extent of documentation to be examined in support of material transactions, and (ii) increased recognition of the need to corroborate management explanations or representations concerning material matters.

ii.

Assignment of members of the audit team: The knowledge, skill and ability of members of the audit team assigned significant audit responsibilities need to be commensurate with the auditor's assessment of the level of risk for the engagement. In addition, the extent of supervision needs to recognize the risk of material misstatement resulting from fraud and the qualifications of members of the audit team performing the work.

iii.

Accounting principles and policies: The auditor may decide to consider further management's selection and application of significant accounting policies, particularly those related to revenue recognition, asset valuation or capitalizing versus expensing.

iv.

Controls: The auditor's ability to assess control risk below high may be reduced. However, this does not eliminate the need for the auditor to obtain an understanding of

Part I : Auditing and Assurance Standards

I.35

the components of the entity's internal control sufficient to plan the audit. In fact, such an understanding may be of particular importance in further understanding and considering any controls (or lack thereof) the entity has in place to address the fraud risk factors identified. However, this consideration also needs to include an added sensitivity to management's ability to override such controls. The nature, timing and extent of procedures may need to be modified in the following ways: ♦

The nature of audit procedures performed may need to be changed to obtain evidence that is more reliable or to obtain additional corroborative information. For example, more audit evidence may be needed from independent sources outside the entity.

♦

The timing of substantive procedures may need to be altered to be closer to, or at, yearend. For example, if there are unusual incentives for management to engage in fraudulent financial reporting, the auditor might conclude that substantive procedures should be performed near or at year-end because it would not be possible to control the incremental audit risk associated with that fraud risk factor.

♦

The extent of the procedures applied will need to reflect the assessment of the risk of material misstatement resulting from fraud. For example, increased sample sizes or more extensive analytical procedures may be appropriate. The auditor considers whether changing the nature of the audit procedures, rather than the extent of them, may be more effective in responding to identified fraud risk factors.

Considerations at the Account Balance, Class of Transactions and Assertion Level Specific responses to the auditor's assessment of the risk of material misstatement resulting from fraud will vary depending upon the types or combinations of fraud risk factors or conditions identified, and the account balances, classes of transactions and assertions they may affect. If these factors or conditions indicate a particular risk applicable to specific account balances or types of transactions, audit procedures addressing these specific areas will need to be considered that will, in the auditor's judgment, limit audit risk to an appropriate level in light of the fraud risk factors or conditions identified. The following are specific examples of responses: ♦

Visit locations or perform certain tests on a surprise or unannounced basis. For example, observe inventory at locations where auditor attendance has not been previously announced or count cash at a particular date on a surprise basis.

♦

Request that inventories be counted at a date closer to the year-end.

♦

Alter the audit approach in the current year. For example, contact major customers and suppliers orally in addition to sending written confirmation, send confirmation requests to a specific party within an organization, or seek more and different information.

♦

Perform a detailed review of the entity's quarter-end or year-end adjusting entries and investigate any entries that appear unusual as to nature or amount.

I.36

Advanced Auditing & Professional Ethics

♦

For significant and unusual transactions, particularly those occurring at or near year-end, investigate the possibility of related parties and the sources of financial resources supporting the transactions.

♦

Perform substantive analytical procedures at a detailed level. For example, compare sales and cost of sales by location and line of business to expectations developed by the auditor.

♦

Conduct interviews of personnel involved in areas for which there is a concern about the risk of material misstatement resulting from fraud, to obtain their insights about the risk and whether, or how, controls address the risk.

♦

When other auditors are auditing the financial statements of one or more subsidiaries, divisions or branches, consider discussing with them the extent of work necessary to be performed to ensure that the risk of material misstatement resulting from fraud resulting from transactions and activities among these components is adequately addressed.

♦

If the work of an expert becomes particularly significant with respect a financial statement item for which the risk of misstatement due to fraud is high, perform additional procedures relating to some or all of the expert's assumptions, methods or findings to determine that the findings are not unreasonable, or engage another expert for that purpose.

♦

Perform audit procedures to analyze selected opening balance sheet accounts of previously audited financial statements to assess how certain issues involving accounting estimates and judgments, for example, an allowance for sales returns, were resolved with the benefit of hindsight.

♦

Perform procedures on account or other reconciliation(s) prepared by the entity, including consideration of reconciliation(s) performed at interim periods.

♦

Perform computer-assisted techniques, such as data mining to test for anomalies in a population.

♦

Test the integrity of computer-produced records and transactions.

♦

Seeking additional audit evidence from sources outside of the entity being audited.

Specific Responses-Misstatements Resulting from Fraudulent Financial Reporting Examples of responses to the auditor's assessment of the risk of material misstatements resulting from fraudulent financial reporting are as follows: ♦

Revenue recognition: If there is a risk of material misstatement resulting from fraud that may involve or result in improper revenue recognition, it may be appropriate to confirm with customers certain relevant contract terms and the absence of side agreements, inasmuch as the appropriate accounting is often influenced by such terms or agreements.

♦

Inventory quantities: If there is a risk of material misstatement resulting from fraud relating to inventory quantities, reviewing the entity's inventory records may help to

Part I : Auditing and Assurance Standards

I.37

identify locations, areas or items for specific attention during or after the physical inventory count. Such a review may lead, for example, to a decision to observe inventory counts at certain locations on an unannounced basis, or to ask management to ensure that counts at all locations subject to count are performed on the same date. ♦

Non-standard journal entries: If there is a risk of material misstatements resulting from fraudulent financial reporting, performing tests of non-standard journal entries to confirm that they are adequately supported and reflect underlying events and transactions may help in identifying fictitious entries of aggressive recognition practices. While there is not generally accepted definition of non-standard journal entries, in general, they are financial statement changes or entries made in the books and records (including computer records) of an entity that usually are initiated by management-level personnel and are not routine or associated with the normal processing of transactions.

Specific Responses - Misstatements Resulting from Misappropriations of Assets Differing circumstances would necessarily dictate different responses. Ordinarily, the audit response to a risk of material misstatement resulting from fraud relating to misappropriation of assets will be directed toward certain account balances and classes of transactions. Although some of the audit responses noted in the two categories above may apply in such circumstances, the scope of the work is to be linked to the specific information about the misappropriation risk that has been identified. For example, where a particular asset is highly susceptible to misappropriation that is potentially material to the financial statements, it may be useful for the auditor to obtain an understanding of the control procedures related to the prevention and detection of such misappropriation and to test the operating effectiveness of such controls. Appendix 3 Examples of Circumstances that Indicate the Possibility of Fraud or Error The auditor may encounter circumstances that, individually or in combination, indicate the possibility that the financial statements may contain a material misstatement resulting from fraud or error. The circumstances listed below are only examples; neither all of these circumstances are likely to be present in all audits nor is the list necessarily complete. Circumstances that indicate a possible misstatement are discussed in paragraphs 43-44. ♦

Unrealistic time deadlines for audit completion imposed by management.

♦

Reluctance by management to engage in frank communication with appropriate third parties, such as regulators and bankers.

♦

Limitation in audit scope imposed by management.

♦

Identification of important matters not previously disclosed by management.

♦

Significant difficult-to-audit figures in the accounts.

I.38

Advanced Auditing & Professional Ethics

♦

Aggressive application of accounting principles.

♦

Conflicting or unsatisfactory evidence provided by management or employees.

♦

Unusual documentary evidence such as handwritten alterations to documentation, or handwritten documentation which is ordinarily electronically printed.

♦

Information provided unwillingly or after unreasonable delay.

♦

Seriously incomplete or inadequate accounting records.

♦

Unsupported transactions.

♦

Unusual transactions, by virtue of their nature, volume or complexity, particularly if such transactions occurred close to the year-end.

♦

Transactions not recorded in accordance with management's general or specific authorization.

♦

Significant unreconciled differences between control accounts and subsidiary records or between physical count and the related account balance which were not appropriately investigated and corrected on a timely basis.

♦

Inadequate control over computer processing (for example, too many processing errors; delays in processing results and reports).

♦

Significant differences from expectations disclosed by analytical procedures.

♦

Fewer confirmation responses than expected or significant differences revealed by confirmation responses.

♦

Evidence of an unduly lavish lifestyle by officers or employees.

♦

Unreconciled suspense accounts.

♦

Long outstanding account receivable balances. AUDIT EVIDENCE (AAS 5)

Introduction 1. Auditing and Assurance Standard (AAS) 1, “Basic Principles Governing an Audit”, states (paragraphs 15-17): “The auditor should obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable him to draw reasonable conclusions therefrom on which to base his opinion on the financial information. Compliance procedures are tests designed to obtain reasonable assurance that those internal controls on which audit reliance is to be placed are in effect. Substantive procedures are designed to obtain evidence as to the completeness, accuracy and validity of the data produced by the accounting system. They are of two types:

Part I : Auditing and Assurance Standards

I.39

(i)

tests of details of transactions and balances;

(ii)

analysis of significant ratios and trends, including the resulting enquiry of unusual fluctuations and items.”

The purpose of this Standard is to amplify the basic principle outlined above. In this Standard, the term “financial information” encompasses financial statements. Sufficient Appropriate Audit Evidence 2. Sufficiency and appropriateness are interrelated and apply to evidence obtained from both compliance and substantive procedures. Sufficiency refers to the quantum of audit evidence obtained; appropriateness relates to its relevance and reliability. Normally, the auditor finds it necessary to rely on evidence that is persuasive rather than conclusive. He may often seek evidence from different sources or of different nature to support the same assertion (see paragraphs 5 and 6). 3. The auditor should evaluate whether he has obtained sufficient appropriate audit evidence before he draws his conclusions therefrom. The audit evidence should, in total, enable the auditor to form an opinion on the financial information. In forming such an opinion, the auditor may obtain audit evidence on a selective basis by way of judgmental or statistical sampling procedures. For example, the auditor may select only certain accounts receivable for confirmation purposes, or make a selection of personnel records for the purpose of testing that changes in payroll rates have been properly authorised. 4. The auditor’s judgement as to what is sufficient appropriate audit evidence is influenced by such factors as: (a) The degree of risk of misstatement which may be affected by factors such as: (i)

the nature of the item;

(ii)

the adequacy of internal control;

(iii) the nature or size of the business carried on by the entity; (iv) situations which may exert an unusual influence on management; (v) the financial position of the entity. (b) The materiality of the item. (c) The experience gained during previous audits. (d) The results of auditing procedures, including fraud or error which may have been found. (e) The type of information available. (f)

The trend indicated by accounting ratios and analysis.

5. Obtaining audit evidence from compliance procedures is intended to reasonably assure the auditor in respect of the following assertions: Existence

– that the internal control exists.

Effectiveness

– that the internal control is operating effectively.

I.40

Advanced Auditing & Professional Ethics Continuity

– that the internal control has so operated throughout the period of intended reliance.

6. Obtaining audit evidence from substantive procedures is intended to reasonably assure the auditor in respect of the following assertions: Existence

– that an asset or a liability exists at a given date.

Rights Obligations

and– that an asset is a right of the entity and a liability is an obligation of the entity at a given date.

Occurrence

– that a transaction or event took place which pertains to the entity during the relevant period.

Completeness

– that there are no unrecorded assets, liabilities or transactions.

Valuation

– that an asset or liability is recorded at an appropriate carrying value.

Measurement

– that a transaction is recorded in the proper amount and revenue or expense is allocated to the proper period.

Presentation Disclosure

and– an item is disclosed, classified, and described in accordance with recognised accounting policies and practices and relevant statutory requirements, if any.

The extent and nature of substantive procedures to be performed will vary with respect to each of the above assertions. Obtaining evidence relevant to one of the above assertions will not compensate for failure to do so with respect to another matter concerning the same item, e.g., existence of inventory and its valuation. 7. The reliability of audit evidence depends on its source - internal or external, and on its nature - visual, documentary or oral. While the reliability of audit evidence is dependent on the circumstances under which it is obtained, the following generalisations may be useful in assessing the reliability of audit evidence: ♦

External evidence (e.g. confirmation received from a third party) is usually more reliable than internal evidence.

♦

Internal evidence is more reliable when related internal control is satisfactory.

♦

Evidence in the form of documents and written representations is usually more reliable than oral representations.

♦

Evidence obtained by the auditor himself is more reliable than that obtained through the entity.

8. The auditor may gain increased assurance when audit evidence obtained from different sources or of different nature is consistent. In these circumstances, he may obtain a cumulative degree of assurance higher than that which he attaches to the individual items of evidence by themselves. Conversely, when audit evidence obtained from one source is inconsistent with that obtained from another, further procedures may have to be performed to

Part I : Auditing and Assurance Standards

I.41

resolve the inconsistency. 9. The auditor should be thorough in his efforts to obtain evidence and be objective in its evaluation. 10. When the auditor is in reasonable doubt as to any assertion of material significance, he would attempt to obtain sufficient appropriate evidence to remove such doubt. If he is unable to obtain sufficient appropriate evidence he should not express an unqualified opinion. Obtaining Audit Evidence 11. The auditor obtains evidence in performing compliance and substantive procedures by one or more of the following methods: ♦

Inspection

♦

Observation

♦

Inquiry and confirmation

♦

Computation

♦

Analytical review

The timing of such procedures will be dependent, in part, upon the periods of time during which the audit evidence sought is available. Inspection 12. Inspection consists of examining records, documents, or tangible assets. Inspection of records and documents provides evidence of varying degrees of reliability, depending on their nature and source and the effectiveness of internal controls over their processing. Four major categories of documentary evidence, which provide different degrees of reliability to the auditor, are: ♦

documentary evidence originating from and held by third parties;

♦

documentary evidence originating from third parties and held by the entity;

♦

documentary evidence originating from the entity and held by third parties; and

♦

documentary evidence originating from and held by the entity. Inspection of tangible assets is one of the methods to obtain reliable evidence with respect to their existence but not necessarily as to their ownership or value.

Observation 13. Observation consists of witnessing a process or procedure being performed by others. For example, the auditor may observe the counting of inventories by client personnel or the performance of internal control procedures that leave no audit trail. Inquiry and Confirmation 14. Inquiry consists of seeking appropriate information from knowledgeable persons inside or outside the entity. Inquiries may range from formal written inquiries addressed to third parties

I.42

Advanced Auditing & Professional Ethics

to informal oral inquiries addressed to persons inside the entity. Responses to inquiries may provide the auditor with information which he did not previously possess or may provide him with corroborative evidence. 15. Confirmation consists of the response to an inquiry to corroborate information contained in the accounting records. For example, the auditor requests confirmation of receivables by direct communication with debtors. Computation 16. Computation consists of checking the arithmetical accuracy of source documents and accounting records or performing independent calculations. Analytical Review 17. Analytical review consists of studying significant ratios and trends and investigating unusual fluctuations and items. Effective Date 18. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after January 1, 1989. RISK ASSESSMENTS AND INTERNAL CONTROL (AAS 6) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the procedures to be followed to obtain an understanding of the accounting and internal control systems and on audit risk and its components: inherent risk, control risk and detection risk. The principles laid down in the other AASs, issued by the Institute of Chartered Accountants of India, would be applicable, to the extent practicable, to this AAS also. In this Standard, the term 'financial information' encompasses 'financial statements'. In some circumstances, specific legislations and regulations may require the auditor to undertake procedures additional to those set out in this AAS. 2. The auditor should obtain an understanding of the accounting and internal control systems sufficient to plan the audit and develop an effective audit approach. The auditor should use professional judgement to assess audit risk and to design audit procedures to ensure that it is reduced to an acceptably low level. 3. "Audit risk" means the risk that the auditor gives an inappropriate audit opinion when the financial statements are materially misstated. Audit risk has three components: inherent risk, control risk and detection risk. 4. "Inherent risk" is the susceptibility of an account balance or class of transactions to misstatement that could be material, either individually or when aggregated with misstatements in other balances or classes, assuming that there were no related internal controls. 5. "Control risk" is the risk that a misstatement, that could occur in an account balance or class of transactions and that could be material, either individually or when aggregated with misstatements in other balances or classes, will not be prevented or detected and corrected on a

Part I : Auditing and Assurance Standards

I.43

timely basis by the accounting and internal control systems. 6. "Detection risk" is the risk that an auditor's substantive procedures will not detect a misstatement that exists in an account balance or class of transactions that could be material, either individually or when aggregated with misstatements in other balances or classes. 7. "Accounting System" means the series of tasks and records of an entity by which transactions are processed as a means of maintaining financial records. Such systems identify, assemble, analyse, calculate, classify, record, summarise and report transactions and other events. 8. "Internal Control System" means all the policies and procedures (internal controls) adopted by the management of an entity to assist in achieving management's objective of ensuring, as far as practicable, the orderly and efficient conduct of its business, including adherence to management policies, the safeguarding of assets, the prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. The internal audit function constitutes a separate component of internal control with the objective of determining whether other internal controls are well designed and properly operated. 9. The system of internal control must be under continuing supervision by management to determine that it is functioning as prescribed and is modified, as appropriate, for changes in conditions. The internal control system extends beyond those matters which relate directly to the functions of the accounting system and comprises: (a) "the control environment" which means the overall attitude, awareness and actions of directors and management regarding the internal control system and its importance in the entity. The control environment has an effect on the effectiveness of the specific control procedures and provides the background against which other controls are operated. A strong control environment, for example, one with tight budgetary controls and an effective internal audit function, can significantly complement specific control procedures. However, a strong control environment does not, by itself, ensure the effectiveness of the internal control system. Factors reflected in the control environment include: ♦

The entity's organisational structure and methods of assigning authority and responsibility (including segregation of duties and supervisory functions).

♦

The function of the board of directors and its committees in the case of a company or the corresponding governing body in case of any other entity.

♦ ♦

Management's philosophy and operating style. Management's control system including the internal audit function, personnel policies and procedures.

(b) "control procedures" which means those policies and procedures in addition to the control environment which management has established to achieve the entity's specific objectives. Specific control procedures include: ♦

Reporting and reviewing reconciliations.

I.44

Advanced Auditing & Professional Ethics ♦ ♦

Checking the arithmetical accuracy of the records. Controlling applications and environment of computer information systems, for example, by establishing controls over: •

changes to computer programs

•

access to data files.

♦

Maintaining and reviewing control accounts and related subsidiary ledgers.

♦

Approving and controlling of documents.

♦

Comparing internal data with external sources of information.

♦

Comparing the results of physical verification of cash, fixed assets, investments and inventory with corresponding accounting records.

♦

Restricting direct access to assets, records and information.

♦

Comparing and analysing the financial results with corresponding budgeted figures.

10. In the audit of financial statements, the auditor is concerned only with those policies and procedures within the accounting and internal control systems that are relevant to the assertions made in the financial statements. The understanding of relevant aspects of the accounting and internal control systems, together with the inherent and control risk assessments and other considerations, will enable the auditor to: (a) assess the adequacy of the accounting system as a basis for preparing the financial statements; (b) identify the types of potential material misstatements that could occur in the financial statements; (c) consider factors that affect the risk of material misstatements; and (d) develop an appropriate audit plan and determine the nature, timing and extent of his audit procedures. 11. When developing the audit approach, the auditor considers the preliminary assessment of control risk (in conjunction with the assessment of inherent risk) to determine the appropriate detection risk that may be accepted by the auditor for the assertions made in the financial statements and to determine the nature, timing and extent of substantive procedures for such assertions. Inherent Risk 12. In developing the overall audit plan, the auditor should assess inherent risk at the level of financial statements. In developing the audit programme, the auditor should relate such assessment to material account balances and classes of transactions at the level of assertions made in the financial statements, or assume that inherent risk is high for the assertion, taking into account factors relevant both to the financial statements as a whole and to the specific assertions. When the auditor makes an assessment that the inherent risk is not high, he should document the reasons for such assessment.

Part I : Auditing and Assurance Standards

I.45

13. To assess inherent risk, the auditor would use professional judgement to evaluate numerous factors, having regard to his experience of the entity from previous audit engagements of the entity, any controls established by management to compensate for a high level of inherent risk, and his knowledge of any significant changes which might have taken place since his last assessment. Examples of such factors are: At the Level of Financial Statements ♦

The integrity of the management.

♦

Management's experience and knowledge and changes in management during the period, for example, the inexperience of management may affect the preparation of the financial statements of the entity.

♦

Unusual pressures on management, for example, circumstances that might predispose management to misstate the financial statements, such as the industry experiencing a large number of business failures or an entity that lacks sufficient capital to continue operations.

♦

The nature of the entity's business, for example, the potential for technological obsolescence of its products and services, the complexity of its capital structure, the significance of related parties and the number of locations and geographical spread of its production facilities.

♦

Factors affecting the industry in which the entity operates, for example, economic and competitive conditions as indicated by financial trends and ratios, and changes in technology, consumer demand and accounting practices common to the industry.

At the Level of Account Balance and Class of Transactions ♦

Quality of the accounting system.

♦

Financial statements are likely to be susceptible to misstatement, for example, accounts which required adjustment in the prior period or which involve a high degree of estimation.

♦

The complexity of underlying transactions and other events which might require using the work of an expert.

♦

The degree of judgement involved in determining account balances.

♦

Susceptibility of assets to loss or misappropriation, for example, assets which are highly desirable and movable such as cash.

♦

The completion of unusual and complex transactions, particularly, at or near period end.

♦

Transactions not subjected to ordinary processing.

Accounting And Internal Control Systems 14. Internal controls relating to the accounting system are concerned with achieving the following objectives: ♦

Transactions are executed in accordance with management's general or specific authorisation.

I.46

Advanced Auditing & Professional Ethics

♦

All transactions and other events are promptly recorded in the correct amount, in the appropriate accounts and in the proper accounting period so as to permit preparation of financial statements in accordance with the applicable accounting standards, other recognised accounting policies and practices and relevant statutory requirements, if any, and to maintain accountability for assets. .

♦

Assets and records are safeguarded from unauthorised access, use or disposition.

♦

Recorded assets are compared with the existing assets at reasonable intervals and appropriate action is taken with regard to any differences.

Inherent Limitations of Internal Controls 15. Accounting and internal control systems can provide only reasonable, but not absolute, assurance that the objectives stated above are achieved. This is because the internal control systems are subject to some inherent limitations, such as: ♦

Management's consideration that the cost of an internal control does not exceed the expected benefits to be derived.

♦

The fact that most internal controls do not tend to be directed at transactions of unusual nature.

♦

The potential for human error, such as, due to carelessness, distraction, mistakes of judgement and the misunderstanding of instructions.

♦

The possibility of circumvention of internal controls through the collusion with employees or with parties outside the entity.

♦

The possibility that a person responsible for exercising an internal control could abuse that responsibility, for example, a member of management overriding an internal control.

♦

The possibility that procedures may become inadequate due to changes in conditions and compliance with procedures may deteriorate.

♦

Manipulations by management with respect to transactions or estimates and judgements required in the preparation of financial statements.

Understanding the Accounting and Internal Control Systems 16. When obtaining an understanding of the accounting and internal control systems to plan the audit, the auditor obtains a knowledge of the design of the accounting and internal control systems, and their operation. For example, an auditor may perform a "walk-through" test, that is, tracing a few transactions through the accounting system. When the transactions selected are typical of those transactions that pass through the system, this procedure may be treated as part of the tests of control. The nature and extent of walk-through tests performed by the auditor are such that they alone would not provide sufficient appropriate audit evidence to support a control risk assessment which is less than high. 17. The nature, timing and extent of the procedures performed by the auditor to obtain an understanding of the accounting and internal control systems will vary with, among other things: ♦

The size and complexity of the entity and of its information system.

Part I : Auditing and Assurance Standards ♦

Materiality considerations.

♦

The type of internal controls involved.

♦

The nature of the entity's documentation of specific internal controls.

♦

The auditor's assessment of inherent risk.

I.47

18. Ordinarily, the auditor's understanding of the accounting and internal control systems significant to the audit is obtained through previous experience with the entity and is supplemented by: (a) inquiries of appropriate management, supervisory and other personnel at various organisational levels within the entity, together with reference to documentation, such as procedures manuals, job descriptions, systems descriptions and flow charts; (b) inspection of documents and records produced by the accounting and internal control systems; and (c) observation of the entity's activities and operations, including observation of the organisation of computer operations, personnel performing control procedures and the nature of transaction processing. Accounting System 19. The auditor should obtain an understanding of the accounting system sufficient to identify and understand: (a) major classes of transactions in the entity's operations; (b) how such transactions are initiated; (c) significant accounting records, supporting documents and specific accounts in the financial statements; and (d) the accounting and financial reporting process, from the initiation of significant transactions and other events to their inclusion in the financial statements. Control Environment 20. The auditor should obtain an understanding of the control environment sufficient to assess management's attitudes, awareness and actions regarding internal controls and their importance in the entity. Such an understanding would also help the auditor to make a preliminary assessment of the adequacy of the accounting and internal control systems as a basis for the preparation of the financial statements, and of the likely nature, timing and extent of audit procedures. 21. The auditor should obtain an understanding of the control procedures sufficient to develop the audit plan. In obtaining this understanding, the auditor would consider knowledge about the presence or absence of control procedures obtained from the understanding of the control environment and accounting system in determining whether any additional understanding of control procedures is necessary. Because control procedures are integrated with the control environment and the accounting system, as the auditor obtains an understanding of the control environment and the accounting system, some knowledge about control procedures is also likely

I.48

Advanced Auditing & Professional Ethics

to be obtained, for example, in obtaining an understanding of the accounting system pertaining to cash, the auditor ordinarily becomes aware of whether bank accounts are reconciled regularly. Ordinarily, development of the overall audit plan does not require an understanding of control procedures for every financial statement assertion in each account balance and transaction class. Control Risk 22. After obtaining an understanding of the accounting system and internal control system, the auditor should make a preliminary assessment of control risk, at the assertion level, for each material account balance or class of transactions. Preliminary Assessment of Control Risk 23. The preliminary assessment of control risk is the process of evaluating the likely effectiveness of an entity's accounting and internal control systems in preventing or detecting and correcting material misstatements. The preliminary assessment of control risk is based on the assumption that the controls operate generally as described and that they operate effectively throughout the period of intended reliance. There will always be some control risk because of the inherent limitations of any accounting and internal control system. 24. The auditor ordinarily assesses control risk at a high level for some or all assertions when: (a) the entity's accounting and internal control systems are not effective; or (b) evaluating the effectiveness of the entity's accounting and internal control systems would not be efficient. In the above circumstances, the auditor would obtain sufficient appropriate audit evidence from substantive procedures and from any audit work carried out in the preparation of financial statements. 25. The preliminary assessment of control risk for a financial statement assertion should be high unless the auditor: (a) is able to identify internal controls relevant to the assertion which are likely to prevent or detect and correct a material misstatement; and (b) plans to perform tests of control to support the assessment. Documentation of Understanding and Assessment of Control Risk 26. The auditor should document in the audit working papers: (a) the understanding obtained of the entity's accounting and internal control systems; and (b) the assessment of control risk. When control risk is assessed at less than high, the auditor would also document the basis for the conclusions. 27. Different techniques may be used to document information relating to accounting and internal control systems. Selection of a particular technique is a matter for the auditor's judgement. Common techniques, used alone or in combination, are narrative descriptions,

Part I : Auditing and Assurance Standards

I.49

questionnaires, check lists and flow charts. The form and extent of this documentation is influenced by the size and complexity of the entity and the nature of the entity's accounting and internal control systems. Generally, the more complex the entity's accounting and internal control systems and the more extensive the auditor's procedures, the more extensive the auditor's documentation will need to be. Tests of Control 28. Tests of control are performed to obtain audit evidence about the effectiveness of the: (a) design of the accounting and internal control systems, that is, whether they are suitably designed to prevent or detect and correct material misstatements; and (b) operation of the internal controls throughout the period. Tests of control include tests of elements of the control environment where strengths in the control environment are used by auditors to reduce control risk. 29. Some of the procedures performed to obtain the understanding of the accounting and internal control systems may not have been specifically planned as tests of control but may provide audit evidence about the effectiveness of the design and operation of internal controls relevant to certain assertions and, consequently, serve as tests of control. For example, in obtaining the understanding of the accounting and internal control systems pertaining to cash, the auditor may have obtained audit evidence about the effectiveness of the bank reconciliation process through inquiry and observation. 30. When the auditor concludes that procedures performed to obtain the understanding of the accounting and internal control systems also provide audit evidence about the suitability of design and operating effectiveness of policies and procedures relevant to a particular financial statement assertion, the auditor may use that audit evidence, provided it is sufficient to support a control risk assessment at less than a high level. 31. Tests of control may include: ♦

Inspection of documents supporting transactions and other events to gain audit evidence that internal controls have operated properly, for example, verifying that a transaction has been authorised.

♦

Inquiries about, and observation of, internal controls which leave no audit trail, for example, determining who actually performs each function and not merely who is supposed to perform it.

♦

Re-performance of internal controls, for example, reconciliation of bank accounts, to ensure they were correctly performed by the entity.

♦

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

32. The auditor should obtain audit evidence through tests of control to support any assessment of control risk which is less than high. The lower the assessment of control risk, the more evidence the auditor should obtain that accounting and internal control systems are suitably designed and operating effectively.

I.50

Advanced Auditing & Professional Ethics

33. When obtaining audit evidence about the effective operation of internal controls, the auditor considers how they were applied, the consistency with which they were applied during the period and by whom they were applied. The concept of effective operation recognises that some deviations may have occurred. Deviations from prescribed controls may be caused by such factors as changes in key personnel, significant seasonal fluctuations in volume of transactions and human error. When deviations are detected the auditor makes specific inquiries regarding these matters, particularly, the timing of staff changes in key internal control functions. The auditor then ensures that the tests of control appropriately cover such a period of change or fluctuation. 34. In a computer information systems environment, the objectives of tests of control do not change from those in a manual environment; however, some audit procedures may change. The auditor may find it necessary, or may prefer, to use computer-assisted audit techniques. The use of such techniques, for example, file interrogation tools or audit test data, may be appropriate when the accounting and internal control systems provide no visible evidence documenting the performance of internal controls which are programmed into a computerised accounting system. 35. Based on the results of the tests of control, the auditor should evaluate whether the internal controls are designed and operating as contemplated in the preliminary assessment of control risk. The evaluation of deviations may result in the auditor concluding that the assessed level of control risk needs to be revised. In such cases, the auditor would modify the nature, timing and extent of planned substantive procedures. Quality and Timeliness of Audit Evidence 36. Certain types of audit evidence obtained by the auditor are more reliable than others. Ordinarily, the auditor's observation provides more reliable audit evidence than merely making inquiries, for example, the auditor might obtain audit evidence about the proper segregation of duties by observing the individual who applies a control procedure or by making inquiries of appropriate personnel. However, audit evidence obtained by some tests of control, such as observation, pertains only to the point in time at which the procedure was applied. The auditor may decide, therefore, to supplement these procedures with other tests of control capable of providing audit evidence about other periods of time. 37. In determining the appropriate audit evidence to support a conclusion about control risk, the auditor may consider the audit evidence obtained in prior audits. In a continuing engagement, the auditor will be aware of the accounting and internal control systems through work carried out previously but will need to update the knowledge gained and consider the need to obtain further audit evidence of any changes in control. Before relying on procedures performed in prior audits, the auditor should obtain audit evidence which supports this reliance. The auditor would obtain audit evidence as to the nature, timing and extent of any changes in the entity's accounting and internal control systems since such procedures were performed and assess their impact on the auditor's intended reliance. The longer the time elapsed since the performance of such procedures the less assurance that may result. 38. The auditor should consider whether the internal controls were in use throughout the period. If substantially different controls were used at different times during the period, the

Part I : Auditing and Assurance Standards

I.51

auditor would consider each separately. A breakdown in internal controls for a specific portion of the period requires separate consideration of the nature, timing and extent of the audit procedures to be applied to the transactions and other events of that period. 39. The auditor may decide to perform some tests of control during an interim visit in advance of the period end. However, the auditor cannot rely on the results of such tests without considering the need to obtain further audit evidence relating to the remainder of the period. Factors to be considered include: ♦

The results of the interim tests.

♦

The length of the remaining period.

♦

Whether any changes have occurred in the accounting and internal control systems during the remaining period.

♦

The nature and amount of the transactions and other events and the balances involved.

♦

The control environment, especially supervisory controls.

♦

The nature, timing and extent of substantive procedures which the auditor plans to carry out.

Final Assessment of Control Risk 40. Before the conclusion of the audit, based on the results of substantive procedures and other audit evidence obtained by the auditor, the auditor should consider whether the assessment of control risk is confirmed. In case of deviations from the prescribed accounting and internal control systems, the auditor would make specific inquiries to consider their implications. Where, on the basis of such inquiries, the auditor concludes that the deviations are such that the preliminary assessment of control risk is not supported, he would amend the same unless the audit evidence obtained from other tests of control supports that assessment. Where the auditor concludes that the assessed level of control risk needs to be revised, he would modify the nature, timing and extent of his planned substantive procedures. Relationship Between The Assessments Of Inherent And Control Risks 41. Management often reacts to inherent risk situations by designing accounting and internal control systems to prevent or detect and correct misstatements and therefore, in many cases, inherent risk and control risk are highly interrelated. In such situations, if the auditor attempts to assess inherent and control risks separately, there is a possibility of inappropriate risk assessment. As a result, audit risk may be more appropriately determined in such situations by making a combined assessment. Detection Risk 42. The level of detection risk relates directly to the auditor's substantive procedures. The auditor's control risk assessment, together with the inherent risk assessment, influences the nature, timing and extent of substantive procedures to be performed to reduce detection risk, and therefore audit risk, to an acceptably low level. Some detection risk would always be present even if an auditor were to examine 100 percent of the account balances or class of transactions because, for example, most audit evidence is persuasive rather than conclusive.

I.52

Advanced Auditing & Professional Ethics

43. The auditor should consider the assessed levels of inherent and control risks in determining the nature, timing and extent of substantive procedures required to reduce audit risk to an acceptably low level. In this regard the auditor would consider: (a) the nature of substantive procedures, for example, using tests directed toward independent parties outside the entity rather than tests directed toward parties or documentation within the entity, or using tests of details for a particular audit objective in addition to analytical procedures; (b) the timing of substantive procedures, for example, performing them at period end rather than at an earlier date; and (c) the extent of substantive procedures, for example, using a larger sample size. 44. There is an inverse relationship between detection risk and the combined level of inherent and control risks. For example, when inherent and control risks are high, acceptable detection risk needs to be low to reduce audit risk to an acceptably low level. On the other hand, when inherent and control risks are low, an auditor can accept a higher detection risk and still reduce audit risk to an acceptably low level. Refer to the Appendix to this SAP for an illustration of the interrelationship of the components of audit risk. 45. While tests of control and substantive procedures are distinguishable as to their purpose, the results of either type of procedure may contribute to the purpose of the other. Misstatements discovered in conducting substantive procedures may cause the auditor to modify the previous assessment of control risk. Refer to the Appendix to this SAP for an illustration of the interrelationship of the components of audit risk. 46. The assessed levels of inherent and control risks cannot be sufficiently low to eliminate the need for the auditor to perform any substantive procedures. Regardless of the assessed levels of inherent and control risks, the auditor should perform some substantive procedures for material account balances and classes of transactions. 47. The auditor's assessment of the components of audit risk may change during the course of an audit, for example, information may come to the auditor's attention when performing substantive procedures that differs significantly from the information on which the auditor originally assessed inherent and control risks. In such cases, the auditor would modify the planned substantive procedures based on a revision of the assessed levels of inherent and control risks. 48. The higher the assessment of inherent and control risks, the more audit evidence the auditor should obtain from the performance of substantive procedures. When both inherent and control risks are assessed as high, the auditor needs to consider whether substantive procedures can provide sufficient appropriate audit evidence to reduce detection risk, and therefore audit risk, to an acceptably low level. When the auditor determines that detection risk regarding a financial statement assertion for a material account balance or class of transactions cannot be reduced to an acceptable level, the auditor should express a qualified opinion or a disclaimer of opinion as may be appropriate.

Part I : Auditing and Assurance Standards

I.53

Audit Risk In The Small Business 49. The auditor needs to obtain the same level of assurance in order to express an unqualified opinion on the financial statements of both small and large entities. However, many internal controls which would be relevant to large entities are not practical in the small business. For example, in small businesses, accounting procedures may be performed by a few persons who may have both operating and custodial responsibilities, and therefore segregation of duties may be missing or severely limited. Inadequate segregation of duties may, in some cases, be offset by a strong management control system in which owner/manager supervisory controls exist because of direct personal knowledge of the entity and involvement in transactions. In circumstances where segregation of duties is limited and audit evidence of supervisory controls is lacking, the audit evidence necessary to support the auditor's opinion on the financial statements may have to be obtained entirely through the performance of substantive procedures. Communication Of Weaknesses 50. As a result of obtaining an understanding of the accounting and internal control systems and tests of control, the auditor may become aware of weaknesses in the systems. The auditor should make management aware, as soon as practical and at an appropriate level of responsibility, of material weaknesses in the design or operation of the accounting and internal control systems, which have come to the auditor's attention. The communication to management of material weaknesses would ordinarily be in writing. However, if the auditor judges that oral communication is appropriate, such communication would be documented in the audit working papers. It is important to indicate in the communication that only weaknesses which have come to the auditor's attention as a result of the audit have been reported and that the examination has not been designed to determine the adequacy of internal control for management purposes. Effective Date 51. This Auditing and Assurance Standard becomes operative for all audits related to accounting periods beginning on or after 1st April, 2002. Appendix Illustration of the Interrelationship of the Components of Audit Risk The following table shows how the acceptable level of detection risk may vary based on assessments of inherent and control risks. Auditor's assessment of control risk High Auditor's High assessment of Medium inherent risk Low

Medium

Low

Lowest

Lower

Medium

Lower

Medium

Higher

Medium

Higher

Highest

I.54

Advanced Auditing & Professional Ethics

The shaded areas in this table relate to detection risk. There is an inverse relationship between detection risk and the combined level of inherent and control risks. For example, when inherent and control risks are high, acceptable levels of detection risk need to be low to reduce audit risk to an acceptably low level. On the other hand, when inherent and control risks are low, an auditor can accept a higher detection risk and still reduce audit risk to an acceptably low level. RELYING UPON THE WORK OF AN INTERNAL AUDITOR ( AAS 7) Introduction 1. Auditing and Assurance Standard (AAS)14, “Study and Evaluation of the Accounting System and Related Internal Controls in Connection with an Audit”, states (paragraph 8): "Internal Control System" means all the policies and procedures (internal controls) adopted by the management of an entity to assist in achieving management's objective of ensuring, as far as practicable, the orderly and efficient conduct of its business, including adherence to management policies, the safeguarding of assets, the prevention and detection of fraud and error, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. The internal audit function constitutes a separate component of internal control with the objective of determining whether other internal controls are well designed and properly operated.” 2. The purpose of this Standard is to provide guidance as to the procedures which should be applied by the external auditor in assessing the work of the internal auditor for the purpose of placing reliance upon that work. 3. With the introduction of the Manufacturing and Other Companies (Auditor’s Report) Order, 1988, internal audit function has acquired special significance as the statutory auditor is required to state, in relation to a company having a paid-up capital exceeding Rs. 25 lakhs or having an average annual turnover exceeding Rs. 2 crore for a period of three consecutive financial years immediately preceding the financial year concerned to which the Order applies, whether the internal audit system is commensurate with the size and nature of its business. 4.

In this Standard, “financial information” encompasses financial statements.

5. While the external auditor has sole responsibility for his report and for the determination of the nature, timing and extent of the auditing procedures, much of the work of the internal audit function may be useful to him in his examination of the financial information.

14

Paragraph 6 of AAS 6 (Revised), ''Risk Assessments and internal Controls'' in the paragraph corresponding to paragraph 8 of the erstwhile (the original AAS 6 which was issued in May, 1988) AAS 6, ''Study and Evaluation of the Accounting System and Related Internal Controls in connection with an Audit. A reference may be made to paragraph 6 of AAS 6 (revised), ''Risk Assessments and Internal Control.'' Reference may me made to the Institute's Statement on Manufacturing and Other Companies (Auditor's Report) Order, 1988 [Issued under Section 227(4A) of the Companies Act, 1956] for a study of various factors to be considered by the auditor in evaluating the adequacy of the internal audit system for the purposes of reporting under the Order.

Part I : Auditing and Assurance Standards

I.55

Scope And Objectives Of The Internal Audit Function 6. The scope and objectives of internal audit vary widely and are dependent upon the size and structure of the entity and the requirements of its management. Normally, however, internal audit operates in one or more of the following areas: (a) Review of accounting system and related internal controls: The establishment of an adequate accounting system and the related controls is the responsibility of management which demands proper attention on a continuous basis. The internal audit function is often assigned specific responsibility by management for reviewing the accounting system and related internal controls, monitoring their operation and recommending improvements thereto. (b) Examination for management of financial and operating information: This may include review of the means used to identify, measure, classify and report such information and specific inquiry into individual items including detailed testing of transactions, balances and procedures. (c) Examination of the economy, efficiency and effectiveness of operations including non-financial controls of an organisation: Generally, the external auditor is interested in the results of such audit work only when it has an important bearing on the reliability of the financial records. (d) Physical examination and verification: This would generally include examination and verification of physical existence and condition of the tangible assets of the entity. Relationship Between Internal And External Auditors 7. The role of the internal audit function within an entity is determined by management and its prime objective differs from that of the external auditor who is appointed to report independently on financial information. Nevertheless, some of the means of achieving their respective objectives are often similar and, thus, much of the work of the internal auditor may be useful to the external auditor in determining the nature, timing and extent of his procedures. 8. The external auditor should, as part of his audit, evaluate the internal audit function to the extent he considers that it will be relevant in determining the nature, timing and extent of his compliance and substantive procedures. Depending upon such evaluation, the external auditor may be able to adopt less extensive procedures than would otherwise be required. 9. By its very nature, the internal audit function cannot be expected to have the same degree of independence as is essential when the external auditor expresses his opinion on the financial information. The report of the external auditor is his sole responsibility, and that responsibility is not by any means reduced because of the reliance he places on the internal auditor’s work. General Evaluation Of Internal Audit Function 10. The external auditor’s general evaluation of the internal audit function will assist him in determining the extent to which he can place reliance upon the work of the internal auditor. The external auditor should document his evaluation and conclusions in this respect. The

I.56

Advanced Auditing & Professional Ethics

important aspects to be considered in this context are: (a) Organisational Status: Whether internal audit is undertaken by an outside agency or by an internal audit department within the entity itself, the internal auditor reports to the management. In an ideal situation, he reports to the highest level of management and is free of any other operating responsibility. Any constraints or restrictions placed upon his work by management should be carefully evaluated. In particular, the internal auditor should be free to communicate fully with the external auditor. (b) Scope of Function: The external auditor should ascertain the nature and depth of coverage of the assignment which the internal auditor discharges for management. He should also ascertain to what extent the management considers, and where appropriate, acts upon internal audit recommendations. (c) Technical Competence: The external auditor should ascertain that internal audit work is performed by persons having adequate technical training and proficiency. This may be accomplished by reviewing the experience and professional qualifications of the persons undertaking the internal audit work. (d) Due Professional Care: The external auditor should ascertain whether internal audit work appears to be properly planned, supervised, reviewed and documented. An example of the exercise of due professional care by the internal auditor is the existence of adequate audit manuals, audit programmes, and working papers. Coordination 11. Having decided in principle that he intends to rely upon the work of the internal auditor, it is desirable that the external auditor ascertains the internal auditor’s tentative plan for the year and discusses it with him at as early a stage as possible to determine areas where he considers that he could rely upon the internal auditor’s work. Where internal audit work is to be a factor in determining the nature, timing and extent of the external auditor’s procedures, it is desirable to plan in advance the timing of such work, the extent of audit coverage, test levels and proposed methods of sample selection, documentation of the work performed, and review and reporting procedures. 12. Coordination with the internal auditor is usually more effective when meetings are held at appropriate intervals during the year. It is desirable that the external auditor is advised of, and has access to, relevant internal audit reports and in addition is kept informed, along with management, of any significant matter that comes to the internal auditor’s attention and which he believes may affect the work of the external auditor. Similarly, the external auditor should ordinarily inform the internal auditor of any significant matters which may affect his work. Evaluating Specific Internal Audit Work 13. Where, following the general evaluation described in paragraph 10, the external auditor intends to rely upon specific internal audit work as a basis for modifying the nature, timing and extent of his procedures, he should review the internal auditor’s work, taking into account the following factors: (a) The scope of work and related audit programmes are adequate for the external auditor’s

Part I : Auditing and Assurance Standards

I.57

purpose. (b) The work was properly planned and the work of assistants was properly supervised, reviewed, and documented. (c) Sufficient appropriate evidence was obtained to afford a reasonable basis for the conclusions reached. (d) Conclusions reached are appropriate in the circumstances and any reports prepared are consistent with the results of the work performed. (e) Any exceptions or unusual matters disclosed by the internal auditor’s procedures have been properly resolved. The external auditor should document his conclusions in respect of the specific work which he has reviewed. 14. The external auditor should also test the work of the internal auditor on which he intends to rely. The nature, timing and extent of the external auditor’s tests will depend upon his judgement as to the materiality of the area concerned to the financial statements taken as a whole and the results of his evaluation of the internal audit function and of the specific internal audit work. His tests may include examination of items already examined by the internal auditor, examination of other similar items, and observation of the internal auditor’s procedures. Effective Date 15. This Auditing and Assurance Standard, becomes operative for all audits relating to accounting periods beginning on or after April 1, 1989. AUDIT PLANNING (AAS 8) Introduction 1. Auditing and Assurance Standard (AAS) 1, “Basic Principles Governing an Audit”, states (paragraphs 12-14): “The auditor should plan his work to enable him to conduct an effective audit in an efficient and timely manner. Plans should be based on a knowledge of the client’s business. Plans should be made to cover, among other things: (a) acquiring knowledge of the client’s accounting systems, policies and internal control procedures; (b) establishing the expected degree of reliance to be placed on internal control; (c) determining and programming the nature, timing, and extent of the audit procedures to be performed; and (d) coordinating the work to be performed. Plans should be further developed and revised as necessary during the course of the

I.58

Advanced Auditing & Professional Ethics audit.”

The purpose of this Standard is to amplify the basic principle outlined above. 2. This Standard applies to the planning process of the audit of both financial statements and other financial information. The Statement is framed in the context of recurring audits. In a first audit, the auditor may need to extend his planning process beyond the matters discussed herein. 3.

Planning should be continuous throughout the engagement and involves:

♦

developing an overall plan for the expected scope and conduct of the audit; and

♦

developing an audit programme showing the nature, timing and extent of audit procedures.

Changes in conditions or unexpected results of audit procedures may cause revisions of the overall plan and of the audit programme. The reasons for significant changes may be documented. 4.

Adequate audit planning helps to:

♦

ensure that appropriate attention is devoted to important areas of the audit;

♦

ensure that potential problems are promptly identified;

♦

ensure that the work is completed expeditiously;

♦

utilise the assistants properly; and

♦

co-ordinate the work done by other auditors and experts.

5. In planning his audit, the auditor will consider factors such as complexity of the audit, the environment in which the entity operates, his previous experience with the client and knowledge of the client’s business. 6. The auditor may wish to discuss elements of his overall plan and certain audit procedures with the client to improve the efficiency of the audit and to coordinate audit procedures with work of the client’s personnel. The overall audit plan and the audit programme, however, remain the auditor’s responsibility. Knowledge Of The Client’s Business 7. The auditor needs to obtain a level of knowledge of the client’s business that will enable him to identify the events, transactions and practices that, in his judgement, may have a significant effect on the financial information. Among other things, the auditor can obtain such knowledge from: ♦

The client’s annual reports to shareholders.

♦

Minutes of meetings of shareholders, board of directors and important committees.

♦

Internal financial management reports for current and previous periods, including budgets, if any.

♦

The previous year’s audit working papers, and other relevant files.

Part I : Auditing and Assurance Standards

I.59

♦

Firm personnel responsible for non-audit services to the client who may be able to provide information on matters that may affect the audit.

♦

Discussions with client.

♦

The client’s policy and procedures manual.

♦

Relevant publications of the Institute of Chartered Accountants of India and other professional bodies, industry publications, trade journals, magazines, newspapers or text books.

♦

Consideration of the state of the economy and its effect on the client’s business.

♦

Visits to the client’s premises and plant facilities.

8. With respect to the previous year’s audit working papers and other relevant files, the auditor should pay particular attention to matters that required special consideration and decide whether they might affect the work to be done in the current year. 9.

Discussions with the client might include such subjects as:

♦

Changes in management, organisational structure, and activities of the client.

♦

Current Government legislation, rules, regulations and directives affecting the client.

♦

Current business developments affecting the client.

♦

Current or impending financial difficulties or accounting problems.

♦

Existence of parties in whom directors or persons who are substantial owners of the entity are interested and with whom transactions are likely.

♦

New or closed premises and plant facilities.

♦

Recent or impending changes in technology, type of products or services and production or distribution methods.

♦

Significant matters arising from previous year’s financial statements, audit report and management letters, if any.

♦

Changes in the accounting practices and procedures and in the system of internal control.

♦

Scope and timing of the examination.

♦

Assistance of client personnel in data preparation.

♦

Relevance of any work to be carried out by the client’s internal auditors.

10. In addition to the importance of knowledge of the client’s business in establishing the overall audit plan, such knowledge helps the auditor to identify areas of special audit consideration, to evaluate the reasonableness both of accounting estimates and management representations, and to make judgements regarding the appropriateness of accounting policies and disclosures.

I.60

Advanced Auditing & Professional Ethics

Development of An Overall Plan 11. The auditor should consider the following matters in developing his overall plan for the expected scope and conduct of the audit: ♦

The terms of his engagement and any statutory responsibilities.

♦

The nature and timing of reports or other communication.

♦

The applicable legal or statutory requirements.

♦

The accounting policies adopted by the client and changes in those policies.

♦

The effect of new accounting or auditing pronouncements on the audit.

♦

The identification of significant audit areas.

♦

The setting of materiality levels for audit purposes.

♦

Conditions requiring special attention, such as the possibility of material error or fraud or the involvement of parties in whom directors or persons who are substantial owners of the entity are interested and with whom transactions are likely.

♦

The degree of reliance he expects to be able to place on accounting system and internal control.

♦

Possible rotation of emphasis on specific audit areas.

♦

The nature and extent of audit evidence to be obtained.

♦

The work of internal auditors and the extent of their involvement, if any, in the audit.

♦

The involvement of other auditors in the audit of subsidiaries or branches of the client.

♦

The involvement of experts.

♦

The allocation of work to be undertaken between joint auditors and the procedures for its control and review.

♦

Establishing and coordinating staffing requirements.

12. The auditor should document his overall plan. The form and extent of the documentation will vary depending on the size and complexity of the audit. A time budget, in which hours are budgeted for the various audit areas or procedures, can be an effective planning tool. Developing The Audit Programme 13. The auditor should prepare a written audit programme setting forth the procedures that are needed to implement the audit plan. The programme may also contain the audit objectives for each area and should have sufficient details to serve as a set of instructions to the assistants involved in the audit and as a means to control the proper execution of the work. 14. In preparing the audit programme, the auditor, having an understanding of the accounting system and related internal controls, may wish to rely on certain internal controls in determining the nature, timing and extent of required auditing procedures. The auditor may conclude that relying on certain internal controls is an effective and efficient way to conduct

Part I : Auditing and Assurance Standards

I.61

his audit. However, the auditor may decide not to rely on internal controls when there are other more efficient ways of obtaining sufficient appropriate audit evidence. The auditor should also consider the timing of the procedures, the coordination of any assistance expected from the client, the availability of assistants, and the involvement of other auditors or experts. 15. The auditor normally has flexibility in deciding when to perform audit procedures. However, in some cases, the auditor may have no discretion as to timing, for example, when observing the taking of inventories by client personnel or verifying the securities and cash balances at the year-end. 16. The audit planning ideally commences at the conclusion of the previous year’s audit, and along with the related programme, it should be reconsidered for modification as the audit progresses. Such consideration is based on the auditor’s review of the internal control, his preliminary evaluation thereof, and the results of his compliance and substantive procedures. Effective Date 17. This Auditing and Assurance Standard becomes operative in respect of all audits relating to accounting periods beginning on or after April 1, 1989. USING THE WORK OF AN EXPERT (AAS 9) Introduction 1. Auditing and Assurance Standard (AAS) 1, Basic Principles Governing an Audit, states (paragraphs 9-10): “When the auditor delegates work to assistants, or uses work performed by other auditors and experts, he will continue to be responsible for forming and expressing his opinion on the financial information. However, he will be entitled to rely on work performed by others, provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. In the case of any independent statutory appointment to perform the work on which the auditor has to rely in forming his opinion, such as in the case of the work of branch auditors appointed under the Companies Act, 1956, the auditor’s report should expressly state the fact of such reliance. “The auditor should carefully direct, supervise and review work delegated to assistants. The auditor should obtain reasonable assurance that work performed by other auditors or experts is adequate for his purpose.” This Standard discusses the auditor’s responsibility in relation to, and the procedures the auditor should consider in, using the work of an expert as audit evidence. In this Standard, the term ‘financial information’ encompasses financial statements. 2. The auditor’s education and experience enable him to be knowledgeable about business matters in general, but he is not expected to have the expertise of a person trained for, or qualified to engage in, the practice of another profession or occupation, such as an actuary or engineer.

I.62

Advanced Auditing & Professional Ethics

3. An expert (or a specialist), for the purpose of this Statement, is a person, firm or other association of persons possessing special skill, knowledge and experience in a particular field other than accounting and auditing. An ‘expert’ may be: ♦

engaged by the client,

♦

engaged by the auditor,

♦

employed by the client, or

♦

employed by the auditor.

4. When the auditor uses the work of an expert employed by him, he is using that work in the employee’s capacity as an expert rather than delegating the work to an assistant on the audit. Accordingly, in such circumstances, he should apply relevant procedures described in this Statement in satisfying himself as to his employee’s work and findings. Determining The Need To Use The Work Of An Expert 5. During the audit, the auditor may seek to obtain, in conjunction with the client or independently, audit evidence in the form of reports, opinions, valuations and statements of an expert. Examples are: ♦

Valuations of certain types of assets, for example, land and buildings, plant and machinery, works of art, and precious stones.

♦

Determination of quantities or physical condition of assets, for example, minerals stored in stockpiles, mineral and petroleum reserves, and the remaining useful life of plant and machinery.

♦

Determination of amounts using specialised techniques or methods, for example, an actuarial valuation.

♦

The measurement of work completed and to be completed on contracts in progress for the purpose of revenue recognition.

♦

Legal opinions concerning interpretations of agreements, statutes, regulations, notifications, circulars, etc.

6. When determining whether to use the work of an expert or not, the auditor should consider: ♦

the materiality of the item being examined in relation to the financial information as a whole,

♦

the nature and complexity of the item including the risk of error therein, and

♦

the other audit evidence available with respect to the item.

Skills and Competence of the Expert 7. When the auditor plans to use the expert’s work as audit evidence, he should satisfy himself as to the expert’s skills and competence by considering the expert’s:

Part I : Auditing and Assurance Standards

I.63

♦

professional qualifications, licence or membership in an appropriate professional body, and

♦

experience and reputation in the field in which the evidence is sought.

However, when the auditor uses the work of an expert employed by him, he will not need to inquire into his skills and competence. Objectivity Of The Expert 8. The auditor should also consider the objectivity of the expert. The risk that an expert’s objectivity will be impaired increases when the expert is: ♦

employed by the client, or

♦

related in some other manner to the client.

Accordingly, in these circumstances, the auditor should (after taking into account the factors in paragraphs 6 and 7) consider performing more extensive procedures than would otherwise have been planned, or he might consider engaging another expert. Evaluating the Work of an Expert 9. When the auditor intends to use the work of an expert, he should examine evidence to gain knowledge regarding the terms of the expert’s engagement and such other matters as : ♦

the objectives and scope of the expert’s work,

♦

a general outline as to the specific items in the expert’s report,

♦

confidentiality of the expert’s work, including the possibility of its communication to third parties,

♦

the expert’s relationship with the client, if any,

♦

confidentiality of the client’s information used by the expert.

10. The auditor should seek reasonable assurance that the expert’s work constitutes appropriate audit evidence in support of the financial information, by considering:♦

the source data used,

♦

the assumptions and methods used and, if appropriate, their consistency with the prior period, and

♦

the results of the expert’s work in the light of the auditor’s overall knowledge of the business and of the results of his audit procedures.

The auditor should also satisfy himself that the substance of the expert’s findings is properly reflected in the financial information. 11. The auditor should consider whether the expert has used source data which are appropriate in the circumstances. The procedures to be applied by the auditor should include: ♦

making inquiries of the expert to determine how he has satisfied himself that the source data are sufficient, relevant and reliable, and

I.64 ♦

Advanced Auditing & Professional Ethics conducting audit procedures on the data provided by the client to the expert to obtain reasonable assurance that the data are appropriate.

12. The appropriateness and reasonableness of assumptions and methods used and their application are the responsibility of the expert. The auditor does not have the same expertise and, therefore, cannot always challenge the expert’s assumptions and methods. However, the auditor should obtain an understanding of those assumptions and methods to determine that they are reasonable based on the auditor’s knowledge of the client’s business and on the results of his audit procedures. 13. Normally, completion of the above procedures will provide the auditor with reasonable assurance that he has obtained appropriate audit evidence in support of the financial information. In exceptional cases where the work of an expert does not support the related representations in the financial information, the auditor should attempt to resolve the inconsistency by discussions with the client and the expert. Applying additional procedures, including possibly engaging another expert, may also assist the auditor in resolving the inconsistency. 14. If, after performing these procedures, the auditor concludes that: ♦

the work of the expert is inconsistent with the information in the financial statements, or that

♦

the work of the expert does not constitute sufficient appropriate audit evidence (e.g., where the work of the expert involves highly technical matters or where, on grounds of confidentiality, the expert refuses to make available to the auditor the source data used by him),

he should express a qualified opinion, a disclaimer of opinion or an adverse opinion, as may be appropriate. Reference To An Expert In The Auditor’s Report 15. When expressing an unqualified opinion, the auditor should not refer to the work of an expert in his report. If, as a result of the work of an expert, the auditor decides to express other than an unqualified opinion, it may in some circumstances benefit the reader of his report if the auditor, in explaining the nature of his reservation, refers to or describes the work of the expert. Where, in doing so, the auditor considers it appropriate to disclose the identity of the expert, he should obtain prior consent of the expert for such disclosure if such consent has not already been obtained. Effective Date 16. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1991.

Part I : Auditing and Assurance Standards

I.65

USING THE WORK OF ANOTHER AUDITOR (AAS 10) Introduction 1. The Auditing and Assurance Standard (AAS) 1, Basic Principles Governing an Audit, states (paragraph 9): “When the auditor delegates work to assistants or uses work performed by other auditors and experts, he will continue to be responsible for forming and expressing his opinion on the financial information. However, he will be entitled to rely on work performed by others, provided he exercises adequate skill and care and is not aware of any reason to believe that he should not have so relied. In the case of any independent statutory appointment to perform the work on which the auditor has to rely in forming his opinion, such as in the case of the work of branch auditors appointed under the Companies Act, 1956 the auditor’s report should expressly state the fact of such reliance.” 2. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards to be applied in situations where an auditor (referred to herein as the ‘principal auditor’), reporting on the financial information of an entity, uses the work of another auditor (referred to herein as the ‘other auditor’) with respect to the financial information of one or more components included in the financial information of the entity. This Statement also discusses the principal auditor’s responsibility in relation to his use of the work of the other auditor. In this Statement, the term 'financial information' encompasses 'financial statements'. 3. This Standard does not deal with those instances where two or more auditors are appointed as joint auditors15 nor does it deal with the auditor’s relationship with a predecessor auditor. 4. When the principal auditor concludes that the financial information of a component is immaterial, the procedures outlined in this Statement do not apply. When several components, immaterial in themselves, are together material in relation to the financial information of the entity as a whole, the procedures outlined in this Statement should be considered. 5. When the principal auditor uses the work of another auditor, the principal auditor should determine how the work of the other auditor will affect the audit. 6. "Principal auditor" means the auditor with responsibility for reporting on the financial information of an entity when that financial information includes the financial information of one or more components audited by another auditor. 7. "Other auditor" means an auditor, other than the principal auditor, with responsibility for reporting on the financial information of a component which is included in the financial information audited by the principal auditor.

15

Auditing and Assurance Standard (AAS) 12, ''Responsibility of Joint Auditors'', deals with the audit procedures to be employed where two or more auditors are appointed as joint auditors.

I.66

Advanced Auditing & Professional Ethics

8. "Component" means a division, branch, subsidiary, joint venture, associated enterprises or other entity whose financial information is included in the financial information audited by the principal auditor. Acceptance As Principal Auditor 9. The auditor should consider whether the auditor's own participation is sufficient to be able to act as the principal auditor. For this purpose the auditor would consider: (a) the materiality of the portion of the financial information which the principal auditor audits; (b) the principal auditor's degree of knowledge regarding the business of the components; (c) the risk of material misstatements in the financial information of the components audited by the other auditor; and (d) the performance of additional procedures as set out in this AAS regarding the components audited by other auditor resulting in the principal auditor having significant participation in such audit. The Principal Auditor’s Procedures 10. In certain situations, the statute governing the entity may confer a right on the principal auditor to visit a component and examine the books of account and other records of the said component, if he thinks it necessary to do so. Where another auditor has been appointed for the component, the principal auditor would normally be entitled to rely upon the work of such auditor unless there are special circumstances to make it essential for him to visit the component and/or to examine the books of account and other records of the said component. 11. When planning to use the work of another auditor, the principal auditor should consider the professional competence of the other auditor in the context of specific assignment if the other auditor is not a member of the Institute of Chartered Accountants of India. 12. The principal auditor should perform procedures to obtain sufficient appropriate audit evidence, that the work of the other auditor is adequate for the principal auditor's purposes, in the context of the specific assignment. When using the work of another auditor, the principal auditor should ordinarily perform the following procedures: (a) advise the other auditor of the use that is to be made of the other auditor's work and report and make sufficient arrangements for co-ordination of their efforts at the planning stage of the audit. The principal auditor would inform the other auditor of matters such as areas requiring special consideration, procedures for the identification of intercomponent transactions that may require disclosure and the time-table for completion of audit; and (b) advise the other auditor of the significant accounting, auditing and reporting requirements and obtain representation as to compliance with them. 13. The principal auditor might discuss with the other auditor the audit procedures applied or review a written summary of the other auditor’s procedures and findings which may be in the form of a completed questionnaire or check-list. The principal auditor may also wish to visit the other auditor. The nature, timing and extent of procedures will depend on the circumstances of

Part I : Auditing and Assurance Standards

I.67

the engagement and the principal auditor's knowledge of the professional competence of the other auditor. This knowledge may have been enhanced from the review of the previous audit work of the other auditor. 14. The principal auditor may conclude that it is not necessary to apply procedures such as those described in paragraph 13 because sufficient appropriate audit evidence previously obtained that acceptable quality control policies and procedures are complied with in the conduct of other auditor's practice. 15. The principal auditor should consider the significant findings of the other auditor. 16. The principal auditor may consider it appropriate to discuss with the other auditor and the management of the component, the audit findings or other matters affecting the financial information of the components. He may also decide that supplemental tests of the records or the financial statements of the component are necessary. Such tests may, depending upon the circumstances, be performed by the principal auditor or the other auditor. 17. In certain circumstances, the other auditor may happen to be a person other than a professionally qualified auditor. This may happen, for instance, where a component is situated in a foreign country and the applicable laws permit a person other than a professionally qualified auditor to audit the financial statements of such component. In such circumstances, the procedures outlined in paragraphs 10 to 16 assume added importance. 18. The principal auditor should document in his working papers the components whose financial information was audited by other auditors; their significance to the financial information of the entity as a whole; the names of the other auditors; and any conclusions reached that individual components are not material. The principal auditor should also document the procedures performed and the conclusions reached. For example, the auditor would document the results of discussions with the other auditor and review of the written summary of the other auditor's procedures. However, the principal auditor need not document the reasons for limiting the procedures in the circumstances described at 14 above, provided those reasons are summarised elsewhere in the documentation maintained by the principal auditor. Where the other auditor’s report is other than unmodified16, the principal auditor should also document how he has dealt with the qualifications or adverse remarks contained in the other auditor’s report in framing his own report.

16

Auditing and Assurance Standard (AAS), 28, ''Auditor's Report on Financial Statements'', deals with the concept of ''modified audit report''. An auditor's report is considered to be modified when it includes. Matters that do not affect the auditor's opinion (a) emphasis of matter Matters that do affect the auditor's opinion (a) qualified opinion, (b) disclaimer of opinion , of (c) adverse opinion.

I.68

Advanced Auditing & Professional Ethics

Co-Ordination Between Auditors 19. There should be sufficient liaison between the principal auditor and the other auditor. For this purpose, the principal auditor may find it necessary to issue written communication(s) to the other auditor. 20. The other auditor, knowing the context in which his work is to be used by the principal auditor, should co-ordinate with the principal auditor. For example, by bringing to the principal auditor’s immediate attention any significant findings requiring to be dealt with at entity level, adhering to the time-table for audit of the component, etc. He should ensure compliance with the relevant statutory requirements. Similarly, the principal auditor should advise the other auditor of any matters that come to his attention that he thinks may have an important bearing on the other auditor’s work. 21. When considered necessary by him, the principal auditor may require the other auditor to answer a detailed questionnaire regarding matters on which the principal auditor requires information for discharging his duties. The other auditor should respond to such questionnaire on a timely basis. Reporting Considerations 22. When the principal auditor concludes, based on his procedures, that the work of the other auditor cannot be used and the principal auditor has not been able to perform sufficient additional procedures regarding the financial information of the component audited by the other auditor, the principal auditor should express a qualified opinion or disclaimer of opinion because there is a limitation on the scope of audit. 23. In all circumstances, if the other auditor issues, or intends to issue, a modified auditor's report, the principal auditor should consider whether the subject of the modification is of such nature and significance, in relation to the financial information of the entity on which the principal auditor is reporting, that it requires a modification of the principal auditor's report. Division Of Responsibility 24. The principal auditor would not be responsible in respect of the work entrusted to the other auditors, except in circumstances which should have aroused his suspicion about the reliability of the work performed by the other auditors. 25. When the principal auditor has to base his opinion on the financial information of the entity as a whole relying upon the statements and reports of the other auditors, his report should state clearly the division of responsibility for the financial information of the entity by indicating the extent to which the financial information of components audited by the other auditors have been included in the financial information of the entity, e.g., the number of divisions/branches/subsidiaries or other components audited by other auditors. Effective Date 26. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 2002.

Part I : Auditing and Assurance Standards

I.69

Compatibility With International Standard On Auditing (ISA) 600 The auditing standards established in this Auditing and Assurance Standard (AAS) are generally consistent, in all material respects, with those set out in ISA 600 "Using the Work of Another Auditor". REPRESENTATIONS BY MANAGEMENT (AAS 11) Introduction 1. The purpose of this Standard is to establish standards on the use of management representations as audit evidence, the procedures to be applied in evaluating and documenting management representations, and the action to be taken if management refuses to provide appropriate representations. 2. The auditor should obtain representations from management, where considered appropriate. Acknowledgement By Management Of Its Responsibility For The Financial Information 3. The auditor should obtain evidence that management acknowledges its responsibility for the appropriate preparation and presentation of financial information and that management has approved the financial information. Representations By Management As Audit Evidence 4. The auditor should exercise his professional judgement in determining the matters on which he wishes to obtain representations from management. Similarly, the matters on which the auditor wishes to obtain such representations in writing should also be determined by the auditor using his professional judgement. However, representations should be obtained from management invariably in writing on matters material to financial information, either individually or collectively, when other sufficient appropriate audit evidence cannot reasonably be expected to exist. Matters which might be included in a representation letter from management in an audit of financial statements are contained in the example of a management representation letter in the Appendix. 5. During the course of an audit, management makes many representations to the auditor, either unsolicited or in response to specific enquiries. When such representations relate to matters which are material to the financial information, the auditor should: (a) seek corroborative audit evidence from sources inside or outside the entity; (b) evaluate whether the representations made by management appear reasonable and consistent with other audit evidence obtained, including other representations; and (c) consider whether the individuals making the representations can be expected to be wellinformed on the matter. 6. Representations by management cannot be a substitute for other audit evidence that the auditor could reasonably expect to be available. For example, a representation by management as to the quantity, existence and cost of inventories is no substitute for adopting

I.70

Advanced Auditing & Professional Ethics

normal audit procedures regarding verification and valuation of inventories. If the auditor is unable to obtain sufficient appropriate audit evidence that he believes would be available regarding a matter which has or may have a material effect on the financial information, this will constitute a limitation on the scope of his examination even if he has obtained a representation from management on the matter. 7. In certain instances such as where knowledge of the facts is confined to management or where the matter is principally one of intention, a representation by management may be the only audit evidence which can reasonably be expected to be available; for example, intention of management to hold a specific investment for long-term appreciation. 8. If a representation by management is contradicted by other evidence, the auditor should examine the circumstances and, when necessary, reconsider the reliability of other representations made by management. Documentation Of Representations By Management 9. The auditor should document in his working papers evidence of management’s representations. 10. A written representation is better audit evidence than an oral representation and can take the form of: (a) a representation letter from management; (b) a letter from the auditor outlining the auditor’s understanding of management’s representations, duly acknowledged and confirmed by management; (c) a duly authenticated copy of relevant minutes of meetings of the board of directors or similar body. Basic Elements Of A Management Representation Letter 11. A management representation letter should be addressed to the auditor, containing the relevant information and be appropriately dated and signed. 12. A management representation letter would normally be dated the same date as the auditor’s report on the financial information or a date prior thereto. However, in certain circumstances, in respect to specific transactions or events, separate representation letters may also be obtained during the course of audit. 13. A management representation letter should ordinarily be signed by the members of management who have primary responsibility for the entity and its financial aspects, e.g., managing director, finance director. 14. If management refuses to provide representations on any matter that the auditor considers necessary, this will constitute a limitation on the scope of his examination. In such circumstances, the auditor should evaluate any reliance he has placed on other representations made by management during the course of his examination and consider if the refusal may have any additional effect on his report. 15. In case management is not willing to give in writing the representations made by it during

Part I : Auditing and Assurance Standards

I.71

the course of audit, the auditor should himself prepare a letter in writing setting out his understanding of management’s representations that have been made to him during the course of audit and send it to management with a request to acknowledge and confirm that his understanding of the representations is correct. If the management refuses to acknowledge or confirm the letter sent by the auditor, this will constitute a limitation on the scope of his examination. In such circumstances, the auditor should evaluate any reliance on those representations and consider if the refusal may have any additional effect on his report. Effective Date 16. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1995. Appendix Example of a Management Representation Letter in an Audit of Financial Statements (Ref. Paragraph 4) The following letter is for use as a general guide in conjunction with the considerations set forth in this Statement. Representations by management will vary from one entity to another, and from one year to the next. Therefore, this letter is not intended to be a standard letter and should be adapted in the light of individual requirements and circumstances. [Letterhead of Entity] [Date] [Name and Address of the Auditor] Dear Sir, This representation letter is provided in connection with your audit of the financial statements of ................ for the year ended ...... for the purpose of expressing an opinion as to whether the financial statements give a true and fair view of the financial position of ................ as of ...... and of the results of operations for the year then ended. We acknowledge our responsibility for preparation of financial statements in accordance with the requirements of the Companies Act, 195617 and recognised accounting policies and practices, including the Accounting Standards issued by the Institute of Chartered Accountants of India. We confirm, to the best of our knowledge and belief, the following representations: Accounting Policies 1. The accounting policies which are material or critical in determining the results of operations for the year or financial position are set out in the financial statements and are consistent with those adopted in the financial statements for the previous year. The financial statements are prepared on accrual basis. Assets 2. 17

The company has a satisfactory title to all assets and there are no liens or encumbrances or other relevant statue.

I.72

Advanced Auditing & Professional Ethics

on the company’s assets, except for those that are disclosed in Note X to the financial statements. Fixed Assets 3.

The net book values at which fixed assets are stated in the Balance Sheet are arrived at:

(a) after taking into account all capital expenditure on additions thereto, but no expenditure properly chargeable to revenue; (b) after eliminating the cost and accumulated depreciation relating to items sold, discarded, demolished or destroyed; (c) after providing adequate depreciation on fixed assets during the period. Capital Commitments 4. At the balance sheet date, there were no outstanding commitments for capital expenditure excepting those disclosed in Note X to the financial statements. Investments 5. The current investments as appearing in the Balance Sheet consist of only such investments as are by their nature readily realisable and intended to be held for not more than one year from the respective dates on which they were made. All other investments have been shown in the Balance Sheet as ‘long-term investments’. 6. Current investments have been valued at the lower of cost and fair value. Long-term investments have been valued at cost, except that any permanent diminution in their value has been provided for in ascertaining their carrying amount. 7. In respect of offers of right issues received during the year, the rights have been either been subscribed to, or renunciated, or allowed to lapse. In no case have they been renunciated in favour of third parties without consideration which has been properly accounted for in the books of account. 8. All the investments produced to you for physical verification belong to the entity and they do not include any investments held on behalf of any other person. 9. The entity has clear title to all its investments including such investments which are in the process of being registered in the name of the entity or which are not held in the name of the entity and there are no charges against the investments of the entity except those appearing in the records of the entity. Inventories 10. Inventories at the year-end consisted of the following: Raw Materials (including components)

Rs .........

Work-in-Process

Rs .........

Finished Goods (including by-products)

Rs .........

Maintenance supplies and Stores and Spare Parts

Rs .........

Part I : Auditing and Assurance Standards Loose Tools

Rs .........

Others (specify each major head separately)

Rs .........

Total

I.73

Rs .........

11. All quantities were determined by actual physical count or weight or measurement that was taken under our supervision and in accordance with written instructions, on ............ (date/dates of physical verification), except as follows 18: ........ ........ 12. All goods included in the inventory are the property of the entity, none of the goods are held as consignee for others or as bailee, and, except as set out below, none of the goods are subject to any charge. ........ ........ 13. All inventories owned by the entity, wherever located, have been recorded, including goods sent on consignment. 14. Inventories do not include goods sold to customers for which delivery is yet to be made. 15. Inventories have been valued on the following basis/bases: Raw Materials (including components) Work-in-Process Finished Goods (including by-products) Maintenance supplies and Stores and Spare Parts Loose Tools Others (specify each major head separately) (In describing the basis/bases of valuation, the method of ascertaining the cost (e.g. FIFO, Average Cost or LIFO) should also be stated. Similarly, the extent to which overheads have been included in the cost should also be stated.)

18

Where physical verification of inventories is carried out at a data other than the closing date, this paragraph may be modified as below. Inventories recorded in the books as at...........(date of balance sheet) aggregating to Rs. .........are based upon the physical inventories taken as at............(date of physical verification) by actual count, weight or measurement. The material discrepancies noticed on physical verification of stocks as compared to book records have been properly dealt with in the books of account and subsequent transactions recorded in the accounts fairly reflect the changes in the inventories up to..........(balance sheet date).

I.74

Advanced Auditing & Professional Ethics

16. The following provisions have been made in respect of excess, slow-moving, damaged, or obsolete inventories and these, in our view, are adequate. .......

.......

.......

.......

17. No item of inventories has a net realisable value in the ordinary course of business which is less than the amount at which it is included in inventories. 18. The basis/bases of valuation is/are the same as that/those used in the previous year, except as set out below: Class of inventory

Effect of change in Basis of Valuation

Basis of Valuation This Year

Last Year

.....

....

....

....

.....

....

....

....

Debtors, Loans and Advances 19. The following items appearing in the books as at .......(date of the Balance Sheet) are considered good and fully recoverable with the exception of those specifically shown as “doubtful” in the Balance Sheet. Sundry Debtors

Rs.

Loans and Advances

Rs.

Other Current Assets 20. In the opinion of the Board of Directors, other current assets have a value on realisation in the ordinary course of the company’s business which is atleast equal to the amount at which they are stated in the Balance Sheet, except as stated in Note X to the financial statements. Liabilities 21. We have recorded all known liabilities in the financial statements. 22. We have disclosed in notes to the financial statements all guarantees that we have given to third parties and all other contingent liabilities. 23. Contingent liabilities disclosed in the notes to the financial statements do not include any contingencies which are likely to result in a loss and which, therefore, require adjustment of assets or liabilities. Provisions for Claims and Losses 24. Provision has been made in the accounts for all known losses and claims of material amounts. 25. There have been no events subsequent to the balance sheet date which require adjustment of, or disclosure in, the financial statements or notes thereto.

Part I : Auditing and Assurance Standards

I.75

Profit And Loss Account 26. Except as disclosed in the financial statements, the results for the year were not materially affected by: (a) transactions of a nature not usually undertaken by the company; (b) circumstances of an exceptional or non-recurring nature; (c) charges or credits relating to prior years; (d) changes in accounting policies. General 27. The following have been properly recorded and, when appropriate, adequately disclosed in the financial statements: (a) Losses arising from sale and purchase commitments. (b) Agreements and options to buy back assets previously sold. (c) Assets pledged as collateral. 28. There have been no irregularities involving management or employees who have a significant role in the system of internal control that could have a material effect on the financial statements. 29. The financial statements are free of material misstatements, including omissions. 30. The company has complied with all aspects of contractual agreements that could have a material effect on the financial statements in the event of non-compliance. There has been no non-compliance with requirements of regulatory authorities that could have a material effect on the financial statements in the event of non-compliance. 31. We have no plans or intentions that may materially affect the carrying value or classification of assets and liabilities reflected in the financial statements. RESPONSIBILITY OF JOINT AUDITORS (AAS 12) Introduction 1. The practice of appointing more than one auditor to conduct the audit of large entities is in vogue these days. Such auditors, known as joint auditors, conduct the audit jointly and report on the financial statements of the entity. This Standard deals with the professional responsibilities which the auditors undertake in accepting such appointments as joint auditors. The Standard does not deal with the relationship between a principal auditor who is appointed to report on the financial statements of an entity and another auditor who is appointed to report on the financial statements of one or more divisions or branches included in the financial statements of the entity, e.g., the relationship between a company auditor appointed under section 224 of the Companies

I.76

Advanced Auditing & Professional Ethics

Act, 1956 and a branch auditor appointed under section 228 of the said Act19. Division Of Work 2. Where joint auditors are appointed, they should, by mutual discussion, divide the audit work among themselves. The division of work would usually be in terms of audit of identifiable units or specified areas. In some cases, due to the nature of the business of the entity under audit, such a division of work may not be possible. In such situations, the division of work may be with reference to items of assets or liabilities or income or expenditure or with reference to periods of time. Certain areas of work, owing to their importance or owing to the nature of the work involved, would often not be divided and would be covered by all the joint auditors. 3. The division of work among joint auditors as well as the areas of work to be covered by all of them should be adequately documented and preferably communicated to the entity. Coordination 4. Where, in the course of his work, a joint auditor comes across matters which are relevant to the areas of responsibility of other joint auditors and which deserve their attention, or which require disclosure or require discussion with, or application of judgement by, other joint auditors, he should communicate the same to all the other joint auditors in writing. This should be done by the submission of a report or note prior to the finalisation of the audit. Relationship Among Joint Auditors 5. In respect of audit work divided among the joint auditors, each joint auditor is responsible only for the work allocated to him, whether or not he has prepared a separate report on the work performed by him. On the other hand, all the joint auditors are jointly and severally responsible – (a) in respect of the audit work which is not divided among the joint auditors and is carried out by all of them; (b) in respect of decisions taken by all the joint auditors concerning the nature, timing or extent of the audit procedures to be performed by any of the joint auditors. It may, however, be clarified that all the joint auditors are responsible only in respect of the appropriateness of the decisions concerning the nature, timing or extent of the audit procedures agreed upon among them; proper execution of these audit procedures is the separate and specific responsibility of the joint auditor concerned; (c) in respect of matters which are brought to the notice of the joint auditors by any one of them and on which there is an agreement among the joint auditors; 19

These aspects have been dealt with in Auditing and Assurance Standard (AAS) 10 (revised 2002). Using the Work of Another Auditor. It may also be mentioned that presently, there is no legal requirement under the Companies Act, 1956 to prepare consolidated accounts or group accounts. Section 212 of the Companies Act, 1956 requires that the accounts of a holding company shall have attached thereto the Balance Sheet, Profit and Loss Account, Directors' Report and Auditors' Report of each subsidiary company. Certain additional information is also required. In view of the fact that a subsidiary is a separate legal entity, the Council of the Institute is of the opinion that no responsibility is cast upon the auditors of a holding company in respect of the work performed by the auditors of the subsidiary. However, Auditing and Assurance Standard (AAS) 10 (revised 2002), 'Using the Work of Another Auditor' lays down the responsibility of the auditors of the holding company when they are required to issue an audit opinion on consolidated financial statements.

Part I : Auditing and Assurance Standards

I.77

(d) for examining that the financial statements of the entity comply with the disclosure requirements of the relevant statute; and (e) for ensuring that the audit report complies with the requirements of the relevant statute. 6. If any matters of the nature referred to in paragraph 4 above are brought to the attention of the entity or other joint auditors by an auditor after the audit report has been submitted, the other joint auditors would not be responsible for those matters. 7. Subject to paragraph 5(b) above, it is the responsibility of each joint auditor to determine the nature, timing and extent of audit procedures to be applied in relation to the area of work allocated to him. The issues such as appropriateness of using test checks or sampling should be decided by each joint auditor in relation to his own area of work. This responsibility is not shared by the other joint auditors. Thus, it is the separate and specific responsibility of each joint auditor to study and evaluate the prevailing system of internal control relating to the work allocated to him. Similarly, the nature, timing and extent of the enquiries to be made in the course of audit as well as the other audit procedures to be applied are solely the responsibility of each joint auditor. 8. In the case of audit of a large entity with several branches, including those required to be audited by branch auditors, the branch audit reports/returns may be required to be scrutinised by different joint auditors in accordance with the allocation of work. In such cases, it is the specific and separate responsibility of each joint auditor to review the audit reports/returns of the divisions/branches allocated to him and to ensure that they are properly incorporated into the accounts of the entity. In respect of the branches which do not fall within any divisions or zones which are separately assigned to the various joint auditors, they may agree among themselves as regards the division of work relating to the review of such branch returns. It is also the separate and specific responsibility of each joint auditor to exercise his judgement with regard to the necessity of visiting such divisions/branches in respect of which the work is allocated to him. 9. A significant part of the audit work involves obtaining and evaluating information and explanations from the management. This responsibility is shared by all the joint auditors unless they agree upon a specific pattern of distribution of this responsibility. In cases where specific divisions, zones or units are allocated to different joint auditors, it is the separate and specific responsibility of each joint auditor to obtain appropriate information and explanations from the management in respect of such divisions/zones/units and to evaluate the information and explanations so obtained by him. 10. Each joint auditor is entitled to assume that the other joint auditors have carried out their part of the audit work in accordance with the generally accepted audit procedures20. It is not necessary for a joint auditor to review the work performed by other joint auditors or perform any tests in order to ascertain whether the work has actually been performed in such a manner. Each joint auditor is entitled to rely upon the other joint auditors for bringing to his notice any departure from generally accepted accounting principles or any material error 20

Reference may be made in this regard to the Auditing and Assurance Standards and other mandatory Statements relating to auditing matters issued by the Council of the Institute from time to time.

I.78

Advanced Auditing & Professional Ethics

noticed in the course of the audit. 11. Where separate financial statements of a division/branch are audited by one of the joint auditors, the other joint auditors are entitled to proceed on the basis that such financial statements comply with all the legal and professional requirements regarding the disclosures to be made and present a true and fair view of the state of affairs and of the working results of the division/branch concerned, subject to such observations as may be communicated by the joint auditor concerned. Reporting Responsibilities 12. Normally, the joint auditors are able to arrive at an agreed report. However, where the joint auditors are in disagreement with regard to any matters to be covered by the report, each one of them should express his own opinion through a separate report. A joint auditor is not bound by the views of the majority of the joint auditors regarding matters to be covered in the report and should express his opinion in a separate report in case of a disagreement. Effective Date 13. This Auditing and Assurance Standard becomes operative in respect of all audits relating to accounting periods beginning on or after April 1, 1996. AUDIT MATERIALITY (AAS 13) Introduction 1. The purpose of this Standard is to establish standards on the concept of materiality and its relationship with audit risk. 2. The auditor should consider materiality and its relationship with audit risk when conducting an audit. Materiality 3. Information is material if its misstatement (i.e., omission or erroneous statement) could influence the economic decisions of users taken on the basis of the financial information. Materiality depends on the size and nature of the item, judged in the particular circumstances of its misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which the information must have if it is to be useful. 4 The objective of an audit of financial information prepared within a framework of recognised accounting policies and practices and relevant statutory requirements, if any, is to enable the auditor to express an opinion on such financial information. The assessment of what is material is a matter of professional judgement. 5. The concept of materiality recognises that some matters, either individually or in the aggregate, are relatively important for true and fair presentation of financial information in conformity with recognised accounting policies and practices. The auditor considers materiality at both the overall financial information level and in relation to individual account balances and classes of transactions. Materiality may also be influenced by other

Part I : Auditing and Assurance Standards

I.79

considerations, such as the legal and regulatory requirements, non-compliance with which may have a significant bearing on the financial information, and considerations relating to individual account balances and relationships. This process may result in different levels of materiality depending on the matter being audited. 6. Although the auditor ordinarily establishes an acceptable materiality level to detect quantitatively material misstatements, both the amount (quantity) and nature (quality) of misstatements need to be considered. An example of a qualitative misstatement would be the inadequate or improper description of an accounting policy when it is likely that a user of the financial statements would be misled by the description. 7. The auditor needs to consider the possibility of misstatements of relatively small amounts that, cumulatively, could have a material effect on the financial information. For example, an error in a month-end (or other periodic) procedure could be an indication of a potential material misstatement if that error is repeated each month or each period, as the case may be. 8.

Materiality should be considered by the auditor when –

(a) determining the nature, timing and extent of audit procedures; (b) evaluating the effect of misstatements. The Relationship Between Materiality And Audit Risk 9. When planning the audit, the auditor considers what would make the financial information materially misstated. The auditor’s preliminary assessment of materiality, related to specific account balances and classes of transactions, helps the auditor decide such questions as what items to examine and whether to use sampling and analytical procedures. This enables the auditor to select audit procedures that, in combination, can be expected to support the audit opinion at an acceptably low degree of audit risk. 10. There is an inverse relationship between materiality and the degree of audit risk, that is, the higher the materiality level, the lower the audit risk and vice versa. For example, the risk that a particular account balance or class of transactions could be misstated by an extremely large amount might be very low, but the risk that it could be misstated by an extremely small amount might be very high. The auditor takes the inverse relationship between materiality and audit risk into account when determining the nature, timing and extent of audit procedures. For example, if, after planning for specific audit procedures, the auditor determines that the acceptable materiality level is lower, audit risk is increased. The auditor would compensate for this by either: (a) reducing the assessed degree of control risk, where this is possible, and supporting the reduced degree by carrying out extended or additional tests of control; or (b) reducing detection risk by modifying the nature, timing and extent of planned substantive procedures. Materiality And Audit Risk In Evaluating Audit Evidence 11. The auditor’s assessment of materiality and audit risk may be different at the time of initially planning the engagement from that at the time of evaluating the results of his audit

I.80

Advanced Auditing & Professional Ethics

procedures. This could be because of a change in circumstances or a change in the auditor’s knowledge as a result of the audit. For example, if the audit is planned prior to period end, the auditor will anticipate the results of operations and the financial position. If actual results of operations and financial position are substantially different, the assessment of materiality and audit risk may also change. Additionally, the auditor may, in planning the audit work, intentionally set the acceptable cut off level for verifying individual transactions at a lower level than is intended to be used to evaluate the results of the audit. This may be done to cover a larger number of items and thereby reduce the likelihood of undiscovered misstatements and to provide the auditor with the margin of safety when evaluating the effect of misstatements discovered during the audit. 12. In forming his opinion on the financial information, the auditor should consider whether the effect of aggregate uncorrected misstatements on the financial information is material. Qualitative considerations also influence an auditor in reaching a conclusion as to whether the misstatements are material. 13. The aggregate of uncorrected misstatements comprises: (a) specific misstatements identified by the auditor, including the net effect of uncorrected misstatements identified during the audit of previous periods; and (b) the auditor’s best estimate of other misstatements which cannot be specifically identified (that is, projected errors). 14. When the auditor tests an account balance or class of transactions by an analytical procedure, he ordinarily would not specifically identify misstatements but would only obtain an indication of whether misstatements might exist in the balance or class and possibly its approximate magnitude. If the analytical procedure indicates that misstatements might exist, but not its approximate amount, the auditor ordinarily would have to employ other procedures to enable him to estimate the aggregate misstatement in the balance or class. 15. When an auditor uses audit sampling to test an account balance or class of transactions, he projects the amount of known misstatements identified by him in his sample to the items in the balance or class from which his sample was selected. That projected misstatement, along with the results of other substantive tests, contributes to the auditor’s assessment of aggregate misstatement in the balance or class. 16. If the aggregate of the uncorrected misstatements that the auditor has identified approaches the materiality level, or if auditor determines that the aggregate of uncorrected misstatements causes the financial information to be materially misstated, he should consider requesting the management to adjust the financial information or extending his audit procedures. In any event, the management may want to adjust the financial information for known misstatements. The adjustment of financial information may involve, for example, application of appropriate accounting principles, other adjustments in amounts, or the addition of appropriate disclosure of inadequately disclosed matters. If the management refuses to adjust the financial information and the results of extended audit procedures do not enable the auditor to conclude that the aggregate of uncorrected misstatements is not material, the auditor should express a qualified or adverse opinion, as appropriate.

Part I : Auditing and Assurance Standards

I.81

Effective Date 17. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1996. ANALYTICAL PROCEDURES (AAS 14) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the application of analytical procedures during an audit. 2. The auditor should apply analytical procedures at the planning and overall review stages of the audit. Analytical procedures may also be applied at other stages. 3. “Analytical procedures” means the analysis of significant ratios and trends, including the resulting investigation of fluctuations and relationships that are inconsistent with other relevant information or which deviate from predicted amounts. Nature And Purpose Of Analytical Procedures 4. Analytical procedures include the consideration of comparisons of the entity's financial information with, for example: ♦

Comparable information for prior periods.

♦

Anticipated results of the entity, such as budgets or forecasts.

♦

Predictive estimates prepared by the auditor, such as an estimation of depreciation charge for the year.

♦

Similar industry information, such as a comparison of the entity's ratio of sales to trade debtors with industry averages, or with other entities of comparable size in the same industry.

5.

Analytical procedures also include consideration of relationships:

♦

Among elements of financial information that would be expected to conform to a predictable pattern based on the entity's experience, such as gross margin percentages.

♦

Between financial information and relevant non-financial information, such as payroll costs to number of employees.

6. Various methods may be used in performing the above procedures. These range from simple comparisons to complex analyses using advanced statistical techniques. Analytical procedures may be applied to consolidated financial statements, financial statements of components (such as subsidiaries, divisions or segments) and individual elements of financial information. The auditor's choice of procedures, methods and level of application is a matter of professional judgement. 7.

Analytical procedures are used for the following purposes:

(a) to assist the auditor in planning the nature, timing and extent of other audit procedures;

I.82

Advanced Auditing & Professional Ethics

(b) as substantive procedures when their use can be more effective or efficient than tests of details in reducing detection risk for specific financial statement assertions; and (c) as an overall review of the financial statements in the final review stage of the audit. Analytical Procedures In Planning The Audit 8. The auditor should apply analytical procedures at the planning stage to assist in understanding the business and in identifying areas of potential risk. Application of analytical procedures may indicate aspects of the business of which the auditor was unaware and will assist in determining the nature, timing and extent of other audit procedures. 9. Analytical procedures in planning the audit use both financial and non-financial information, for example, the relationship between sales and square footage of selling space or volume of goods sold. Analytical Procedures As Substantive Procedures 10. The auditor's reliance on substantive procedures to reduce detection risk relating to specific financial statement assertions may be derived from tests of details, from analytical procedures, or from a combination of both. The decision about which procedures to use to achieve a particular audit objective is based on the auditor's judgement about the expected effectiveness and efficiency of the available procedures in reducing detection risk for specific financial statement assertions. 11. The auditor will ordinarily inquire of management as to the availability and reliability of information needed to apply analytical procedures and the results of any such procedures performed by the entity. It may be efficient to use analytical data prepared by the entity, provided the auditor is satisfied that such data is properly prepared. 12. When intending to perform analytical procedures as substantive procedures, the auditor will need to consider a number of factors such as the: ♦

Objectives of the analytical procedures and the extent to which their results can be relied upon (paragraphs 14-16).

♦

Nature of the entity and the degree to which information can be disaggregated, for example, analytical procedures may be more effective when applied to financial information on individual sections of an operation or to financial statements of components of a diversified entity, than when applied to the financial statements of the entity as a whole.

♦

Availability of information, both financial, such as budgets or forecasts, and non-financial, such as the number of units produced or sold.

♦

Reliability of the information available, for example, whether budgets are prepared with sufficient care.

♦

Relevance of the information available, for example, whether budgets have been established as results to be expected rather than as goals to be achieved.

♦

Source of the information available, for example, sources independent of the entity are

Part I : Auditing and Assurance Standards

I.83

ordinarily more reliable than internal sources. ♦

Comparability of the information available, for example, broad industry data may need to be supplemented to be comparable to that of an entity that produces and sells specialised products.

♦

Knowledge gained during previous audits, together with the auditor's understanding of the effectiveness of the accounting and internal control systems and the types of problems that in prior periods have given rise to accounting adjustments.

Analytical Procedures In The Overall Review At The End Of The Audit 13. The auditor should apply analytical procedures at or near the end of the audit when forming an overall conclusion as to whether the financial statements as a whole are consistent with the auditor's knowledge of the business. The conclusions drawn from the results of such procedures are intended to corroborate conclusions formed during the audit of individual components or elements of the financial statements and assist in arriving at the overall conclusion as to the reasonableness of the financial statements. However, in some cases, as a result of application of analytical procedures, the auditor may identify areas where further procedures need to be applied before the auditor can form an overall conclusion about the financial statements. Extent Of Reliance On Analytical Procedures 14. The application of analytical procedures is based on the expectation that relationships among data exist and continue in the absence of known conditions to the contrary. The presence of these relationships provides audit evidence as to the completeness, accuracy and validity of the data produced by the accounting system. However, reliance on the results of analytical procedures will depend on the auditor's assessment of the risk that the analytical procedures may identify relationships as expected when, in fact, a material misstatement exists. 15. The extent of reliance that the auditor places on the results of analytical procedures depends on the following factors: (a) materiality of the items involved, for example, when inventory balances are material, the auditor does not rely only on analytical procedures in forming conclusions. However, the auditor may rely solely on analytical procedures for certain income and expense items when they are not individually material; (b) other audit procedures directed toward the same audit objectives, for example, other procedures performed by the auditor in reviewing the collectibility of accounts receivable, such as the review of subsequent cash receipts, might confirm or dispel questions raised from the application of analytical procedures to an ageing schedule of customers' accounts; (c) accuracy with which the expected results of analytical procedures can be predicted. For example, the auditor will ordinarily expect greater consistency in comparing gross profit margins from one period to another than in comparing discretionary expenses, such as research or advertising; and

I.84

Advanced Auditing & Professional Ethics

(d) assessments of inherent and control risks, for example, if internal control over sales order processing is weak and, therefore, control risk is high, more reliance on tests of details of transactions and balances than on analytical procedures in drawing conclusions on receivables may be required. 16. The auditor will need to consider testing the controls, if any, over the preparation of information used in applying analytical procedures. When such controls are effective, the auditor will have greater confidence in the reliability of the information and, therefore, in the results of analytical procedures. The controls over non-financial information can often be tested in conjunction with tests of accounting-related controls. For example, an entity in establishing controls over the processing of sales invoices may include controls over the recording of unit sales. In these circumstances, the auditor could test the controls over the recording of unit sales in conjunction with tests of the controls over the processing of sales invoices. Investigating Unusual Items 17. When analytical procedures identify significant fluctuations or relationships that are inconsistent with other relevant information or that deviate from predicted amounts, the auditor should investigate and obtain adequate explanations and appropriate corroborative evidence. 18. The investigation of unusual fluctuations and relationships ordinarily begins with inquiries of management, followed by: (a) corroboration of management's responses, for example, by comparing them with the auditor's knowledge of the business and other evidence obtained during the course of the audit; and (b) consideration of the need to apply other audit procedures based on the results of such inquiries, if management is unable to provide an explanation or if the explanation is not considered adequate. Effective Date 19. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1997. AUDIT SAMPLING (AAS 15) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the design and selection of an audit sample and the evaluation of the sample results. This AAS applies equally to both statistical and non-statistical sampling methods. Either method, when properly applied, can provide sufficient appropriate audit evidence. 2. When using either statistical or non-statistical sampling methods, the auditor should design and select an audit sample, perform audit procedures thereon, and evaluate sample results so as to provide sufficient appropriate audit evidence.

Part I : Auditing and Assurance Standards

I.85

3. "Audit sampling" means the application of audit procedures to less than 100% of the items within an account balance or class of transactions to enable the auditor to obtain and evaluate audit evidence about some characteristic of the items selected in order to form or assist in forming a conclusion concerning the population. 4. It is important to recognise that certain testing procedures do not come within the definition of sampling. Tests performed on 100% of the items within a population do not involve sampling. Likewise, applying audit procedures to all items within a population which have a particular characteristic (for example, all items over a certain amount) does not qualify as audit sampling with respect to the portion of the population examined, nor with regard to the population as a whole, since the items were not selected from the total population on a basis that was expected to be representative. Such items might imply some characteristic of the remaining portion of the population but would not necessarily be the basis for a valid conclusion about the remaining portion of the population. Design Of The Sample 5. When designing an audit sample, the auditor should consider the specific audit objectives, the population from which the auditor wishes to sample, and the sample size. Audit Objectives 6. The auditor would first consider the specific audit objectives to be achieved and the audit procedures which are likely to best achieve those objectives. In addition, when audit sampling is appropriate, consideration of the nature of the audit evidence sought and possible error conditions or other characteristics relating to that audit evidence will assist the auditor in defining what constitutes an error and what population to use for sampling. For example, when performing tests of control over an entity's purchasing procedures, the auditor will be concerned with matters such as whether an invoice was clerically checked and properly approved. On the other hand, when performing substantive procedures on invoices processed during the period, the auditor will be concerned with matters such as the proper reflection of the monetary amounts of such invoices in the financial statements. Population 7. The population is the entire set of data from which the auditor wishes to sample in order to reach a conclusion. The auditor will need to determine that the population from which the sample is drawn is appropriate for the specific audit objective. For example, if the auditor's objective were to test for overstatement of accounts receivable, the population could be defined as the accounts receivable listing. On the other hand, when testing for understatement of accounts payable, the population would not be the accounts payable listing, but rather subsequent disbursements, unpaid invoices, suppliers' statements, unmatched receiving reports, or other populations that would provide audit evidence of understatement of accounts payable. 8. The individual items that make up the population are known as sampling units. The population can be divided into sampling units in a variety of ways. For example, if the auditor's objective were to test the validity of accounts receivables, the sampling unit could be defined as customer balances or individual customer invoices. The auditor defines the sampling unit in

I.86

Advanced Auditing & Professional Ethics

order to obtain an efficient and effective sample to achieve the particular audit objectives. Stratification 9. To assist in the efficient and effective design of the sample, stratification may be appropriate. Stratification is the process of dividing a population into sub-populations, each of which is a group of sampling units, which have similar characteristics (often monetary value). The strata need to be explicitly defined so that each sampling unit can belong to only one stratum. This process reduces the variability of the items within each stratum. Stratification therefore, enables the auditor to direct audit efforts towards the items which, for example, contain the greatest potential monetary error. For example, the auditor may direct attention to larger value items for accounts receivable to detect overstated material misstatements. In addition, stratification may result in a smaller sample size. Sample Size 10. When determining the sample size, the auditor should consider sampling risk, the tolerable error, and the expected error. Examples of some factors affecting sample size are contained in Appendix 1 and Appendix 2. Sampling Risk 11. Sampling risk21 arises from the possibility that the auditor's conclusion, based on a sample, may be different from the conclusion that would be reached if the entire population were subjected to the same audit procedure. 12. The auditor is faced with sampling risk in both tests of control and substantive procedures as follows: (a) Tests of Control: (i)

Risk of Under Reliance: The risk that, although the sample result does not support the auditor's assessment of control risk, the actual compliance rate would support such an assessment.

(ii)

Risk of Over Reliance: The risk that, although the sample result supports the auditor's assessment of control risk, the actual compliance rate would not support such an assessment.

(b) Substantive Procedures:

21

(i)

Risk of Incorrect Rejection: The risk that, although the sample result supports the conclusion that a recorded account balance or class of transactions is materially misstated, in fact it is not materially misstated.

(ii)

Risk of Incorrect Acceptance: The risk that, although the sample result supports the conclusion that a recorded account balance or class of transactions is not materially

Sampling risk can be contrasted with non-sampling risk which arises when the auditor uses any audit procedures. Non-sampling risk arises because, for example, most audit evidence is persuasive rather than conclusive, the auditor might use inappropriate procedures or might misinterpret evidence and, thus, fail to recognise an error. The auditor attempts to reduce non-sampling risk to a negligible degree by appropriate planning, direction, supervision and review.

Part I : Auditing and Assurance Standards

I.87

misstated, in fact it is materially misstated. 13. The risk of under reliance and the risk of incorrect rejection affect audit efficiency as they would ordinarily lead to additional work being performed by the auditor, or the entity, which would establish that the initial conclusions were incorrect. The risk of over reliance and the risk of incorrect acceptance affect audit effectiveness and are more likely to lead to an erroneous opinion on the financial statements than either the risk of under reliance or the risk of incorrect rejection. 14. Sample size is affected by the level of sampling risk the auditor is willing to accept from the results of the sample. The lower the risk the auditor is willing to accept, the greater the sample size will need to be. Tolerable Error 15. Tolerable error is the maximum error in the population that the auditor would be willing to accept and still conclude that the result from the sample has achieved the audit objective. Tolerable error is considered during the planning stage and, for substantive procedures, is related to the auditor's judgement about materiality. The smaller the tolerable error, the greater the sample size will need to be. 16. In tests of control, the tolerable error is the maximum rate of deviation from a prescribed control procedure that the auditor would be willing to accept, based on the preliminary assessment of control risk. In substantive procedures, the tolerable error is the maximum monetary error in an account balance or class of transactions that the auditor would be willing to accept so that when the results of all audit procedures are considered, the auditor is able to conclude, with reasonable assurance, that the financial statements are not materially misstated. Expected Error 17. If the auditor expects error to be present in the population, a larger sample than when no error is expected ordinarily needs to be examined to conclude that the actual error in the population is not greater than the planned tolerable error. Smaller sample sizes are justified when the population is expected to be error free. In determining the expected error in a population, the auditor would consider such matters as error levels identified in previous audits, changes in the entity's procedures, and evidence available from other procedures. Selection Of The Sample 18. The auditor should select sample items in such a way that the sample can be expected to be representative of the population. This requires that all items in the population have an opportunity of being selected. 19. While there are a number of selection methods, three methods commonly used are: ♦

Random selection, which ensures that all items in the population have an equal chance of selection, for example, by use of random number tables.

♦

Systematic selection, which involves selecting items using a constant interval between selections, the first interval having a random start. The interval might be based on a

I.88

Advanced Auditing & Professional Ethics certain number of items (for example, every 20th voucher number) or on monetary totals (for example, every Rs 1,000 increase in the cumulative value of the population). When using systematic selection, the auditor would need to determine that the population is not structured in such a manner that the sampling interval corresponds with a particular pattern in the population. For example, if in a population of branch sales, a particular branch's sales occur only as every 100th item and the sampling interval selected is 50, the result would be that the auditor would have selected all, or none, of the sales of that particular branch.

♦

Haphazard selection, which may be an acceptable alternative to random selection, provided the auditor attempts to draw a representative sample from the entire population with no intention to either include or exclude specific units. When the auditor uses this method, care needs to be taken to guard against making a selection that is biased, for example, towards items which are easily located, as they may not be representative.

Evaluation Of Sample Results 20. Having carried out, on each sample item, those audit procedures that are appropriate to the particular audit objective, the auditor should: (a) analyse any errors detected in the sample; (b) project the errors found in the sample to the population; and (c) reassess the sampling risk. Analysis of Errors in the Sample 21. In analysing the errors detected in the sample, the auditor will first need to determine that an item in question is in fact an error. In designing the sample, the auditor will have defined those conditions that constitute an error by reference to the audit objectives. For example, in a substantive procedure relating to the recording of accounts receivable, a mis-posting between customer accounts does not affect the total accounts receivable. Therefore, it may be inappropriate to consider this an error in evaluating the sample results of this particular procedure, even though it may have an effect on other areas of the audit such as the assessment of doubtful accounts. 22. When the expected audit evidence regarding a specific sample item cannot be obtained, the auditor may be able to obtain sufficient appropriate audit evidence through performing alternative procedures. For example, if a positive account receivable confirmation has been requested and no reply was received, the auditor may be able to obtain sufficient appropriate audit evidence that the receivable is valid by reviewing subsequent payments from the customer. If the auditor does not, or is unable to, perform satisfactory alternative procedures, or if the procedures performed do not enable the auditor to obtain sufficient appropriate audit evidence, the item would be treated as an error. 23. The auditor would also consider the qualitative aspects of the errors. These include the nature and cause of the error and the possible effect of the error on other phases of the audit. 24. In analysing the errors discovered, the auditor may observe that many have a common feature, for example, type of transaction, location, product line, or period of time. In such circumstances, the auditor may decide to identify all items in the population which possess the

Part I : Auditing and Assurance Standards

I.89

common feature, thereby producing a sub-population, and extend audit procedures in this area. The auditor would then perform a separate analysis based on the items examined for each sub-population. Projection of Errors 25. The auditor projects the error results of the sample to the population from which the sample was selected. There are several acceptable methods of projecting error results. However, in all the cases, the method of projection will need to be consistent with the method used to select the sampling unit. When projecting error results, the auditor needs to keep in mind the qualitative aspects of the errors found. When the population has been divided into sub-population, the projection of errors is done separately for each sub-population and the results are combined. Reassessing Sampling Risk 26. The auditor needs to consider whether errors in the population might exceed the tolerable error. To accomplish this, the auditor compares the projected population error to the tolerable error taking into account the results of other audit procedures relevant to the specific control or financial statement assertion. The projected population error used for this comparison in the case of substantive procedures is net of adjustments made by the entity. When the projected error exceeds tolerable error, the auditor reassesses the sampling risk and if that risk is unacceptable, would consider extending the audit procedure or performing alternative audit procedures. Effective Date 27. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1998. Appendix 1 Examples of Factors Influencing Sample Size for Tests of Control Factor Assessment of control risk Tolerable error Allowable risk of over reliance Expected error

Conditions leading to Smaller Sample Size Larger Sample Size Higher preliminary assessment of Lower preliminary assessment of control risk control risk Higher acceptable rate of Lower acceptable rate of deviation deviation Higher risk of over reliance Lower risk of over reliance Lower expected rate of deviation Higher expected rate of deviation in population in population* Virtually no effect on sample size unless population is small

Number of items in population *High expected deviation rates ordinarily warrant little, if any, reduction of control risk and, therefore, tests of controls might be omitted.

I.90

Advanced Auditing & Professional Ethics

Appendix 2 Examples of Factors Influencing Sample Size for Substantive Procedures Conditions Leading to Factor Assessment of control risk

Smaller Sample Size Lower control risk

Larger Sample Size Higher Control risk

Reduction in detection risk Greater use of because of other substantive substantive tests tests related to the same financial statement assertions

other

Reduced use of substantive tests

other

Tolerable error

Large measure of tolerable error

Smaller measure of tolerable error

Expected error

Smaller errors frequency

Larger errors frequency

Population value

Smaller monetary significance to the financial statements

Number of items in population

Virtually no effect on sample size unless population is small

Acceptable level of detection risk

Higher acceptable level of detection risk

Lower acceptable level of detection risk

Stratification

Stratification of the population, if appropriate

No stratification population

or

lower

or

higher

Larger monetary significance to the financial statements

of

the

GOING CONCERN (AAS 16) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's responsibilities in the audit of financial statements regarding the appropriateness of the going concern assumption as a basis for the preparation of the financial statements. 2. When planning and performing audit procedures and in evaluating the results thereof, the auditor should consider the appropriateness of the going concern assumption underlying the preparation of the financial statements. 3. The auditor's report helps establish the credibility of the financial statements. However, the auditor's report is not a guarantee as to the future viability of the entity. 4. An entity's continuance as a going concern for the foreseeable future, generally a period not to exceed one year after the balance sheet date, is assumed in the preparation of financial statements in the absence of information to the contrary. Accordingly, assets and liabilities

Part I : Auditing and Assurance Standards

I.91

are recorded on the basis that the entity will be able to realise its assets and discharge its liabilities in the normal course of business. If this assumption is unjustified, the entity may not be able to realize its assets at the recorded amounts and there may be changes in the amounts and maturity dates of liabilities. As a consequence, the amounts and classification of assets and liabilities in the financial statements may need to be adjusted. Appropriateness Of The Going Concern Assumption 5. The auditor should consider the risk that the going concern assumption may no longer be appropriate. 6. Indications of risk that continuance as a going concern may be questionable could come from the financial statements or from other sources. Examples of such indications that would be considered by the auditor are listed below. This listing is not all-inclusive nor does the existence of one or more always signify that the going concern assumption needs to be questioned. Financial Indications ♦

Negative net worth or negative working capital.

♦

Fixed-term borrowings approaching maturity without realistic prospects of renewal or repayment, or excessive reliance on short-term borrowings to finance long-term assets.

♦

Adverse key financial ratios.

♦

Substantial operating losses.

♦

Substantial negative cash flows from operations.

♦

Arrears or discontinuance of dividends.

♦

Inability to pay creditors on due dates.

♦

Difficulty in complying with the terms of loan agreements.

♦

Change from credit to cash-on-delivery transactions with suppliers.

♦

Inability to obtain financing for essential new product development or other essential investments.

♦

Entering into a scheme of arrangement with creditors for reduction of liability.

Operating Indications ♦

Loss of key management without replacement.

♦

Loss of a major market, franchise, licence, or principal supplier.

♦

Labour difficulties or shortages of important supplies.

Other Indications ♦

Non-compliance with capital or other statutory requirements.

♦

Pending legal proceedings against the entity that may, if successful, result in judgments that could not be met.

I.92

Advanced Auditing & Professional Ethics

♦

Changes in legislation or government policy.

♦

Sickness of the entity under any statutory definition.

7. The significance of such indications can often be mitigated by other factors. For example, the effect of an entity being unable to make its normal debt repayments may be counterbalanced by management's plans to maintain adequate cash flows by alternative means, such as by disposal of assets, rescheduling of loan repayments, obtaining additional capital or having funding arrangements backed by government. Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable alternative source of supply. Audit Evidence 8. When a question arises regarding the appropriateness of the going concern assumption, the auditor should gather sufficient appropriate audit evidence to attempt to resolve, to the auditor's satisfaction, the question regarding the entity's ability to continue in operation for the foreseeable future. 9. During the course of the audit, the auditor carries out audit procedures designed to obtain audit evidence as the basis for the expression of an opinion on the financial statements. When a question arises regarding the going concern assumption, certain of these procedures may take on additional significance or it may be necessary to perform additional procedures or to update information obtained earlier. Procedures that are relevant in this connection may include: ♦

Analyse and discuss cash flow, profit and other relevant forecasts with management.

♦

Review events after the balance sheet date for items affecting the entity's ability to continue as a going concern.

♦

Analyse and discuss the entity's latest available interim financial statements.

♦

Review the terms of debentures and loan agreements and determine whether any have been breached.

♦

Read minutes of the meetings of shareholders, the board of directors and important committees for reference to financing difficulties.

♦

Review the status of matters under litigation and claims.

♦

Confirm the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assess the financial ability of such parties to provide additional funds.

♦

Consider the entity's position concerning unfilled customer orders.

10. When analysing cash flow, profit and other relevant forecasts, the auditor would consider the reliability of the entity's system for generating such information. The auditor would also consider whether the assumptions underlying the forecast appear appropriate in the circumstances. In addition, the auditor would compare the prospective data for recent prior periods with historical results, and would compare the prospective data for the current period with results achieved to date.

Part I : Auditing and Assurance Standards

I.93

11. The auditor would also consider and discuss with management its plans for future action, such as plans to liquidate assets, borrow money or restructure debt, reduce or delay expenditure, or increase capital. The relevance of such plans to an auditor generally decreases as the time period for planned actions and anticipated events increases. Particular emphasis is ordinarily placed on plans that might have a significant effect on the entity's solvency within the foreseeable future. The auditor would obtain sufficient appropriate audit evidence that these plans are feasible, are likely to be implemented and that the outcome of these plans will improve the situation. The auditor would ordinarily seek written representations from management regarding these plans. Audit Conclusions And Reporting 12. After the procedures considered necessary have been carried out, all the information required has been obtained, and the effect of any plans of management and other mitigating factors have been considered, the auditor would decide whether the question raised regarding the going concern assumption has been satisfactorily resolved. Going Concern Assumption Considered Appropriate 13. If, in the auditor's judgement, sufficient appropriate audit evidence has been obtained to support the going concern assumption, the auditor would not qualify his report on this account. 14. If, in the auditor's judgement, the going concern assumption is appropriate because of mitigating factors, in particular management's plans for future action, the auditor should consider whether such plans or other factors need to be disclosed in the financial statements. Where the auditor concludes that such plans or other factors need to be disclosed, but have not been adequately disclosed, the auditor should express a qualified or adverse opinion, as appropriate. Going Concern Question not Resolved 15. If, in the auditor's judgement, the going concern question is not satisfactorily resolved, the auditor would consider whether the financial statements: (a) adequately describe the principal conditions that raise substantial doubt about the entity's ability to continue in operation for the foreseeable future; (b) state that there is significant uncertainty that the entity will be able to continue as a going concern and, therefore, may be unable to realise its assets and discharge its liabilities in the normal course of business; and (c) state that the financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, or to amounts and classification of liabilities that may be necessary if the entity is unable to continue as a going concern. Provided the disclosure is considered adequate, the auditor would not express a qualified or adverse opinion. 16. If adequate disclosure is made in the financial statements, the auditor should ordinarily express an unqualified opinion. However, he should, in his report, add a paragraph that

I.94

Advanced Auditing & Professional Ethics

highlights the going concern problem by drawing attention to the note in the financial statements that discloses the matters set out in paragraph 15. The following is an example of such a paragraph: "We draw attention to Note X in the financial statements. The Company incurred a net loss of Rs. XXX during the year ended March 31, 19X1 and, as of that date, the Company's current liabilities exceeded its current assets by Rs. XXX and its total liabilities exceeded its total assets by Rs. XXX. These factors, along with other matters as set forth in Note X, raise substantial doubt that the Company will be able to continue as a going concern." The auditor is not precluded from expressing a disclaimer of opinion for a going concern uncertainty. 17. If adequate disclosure is not made in the financial statements, the auditor should express a qualified or adverse opinion, as appropriate. The following is an example of the explanation and opinion paragraphs when a qualified opinion is to be expressed: "The Company has been unable to renegotiate its borrowings from its bankers. Without such financial support there is substantial doubt that it will be able to continue as a going concern. Consequently, adjustments may be required to the recorded asset amounts and classification of liabilities. The financial statements (and notes thereto) do not disclose this fact. In our opinion, subject to the omission of the information dealt with in the preceding paragraph, the financial statements give a true and fair view of the financial position of the Company at March 31, 19X1 and the results of its operations for the year then ended." Going Concern Assumption Considered Inappropriate 18. If, on the basis of the additional procedures carried out and the information obtained, including the effect of mitigating circumstances, the auditor's judgment is that the entity will not be able to continue in operation for the foreseeable future, the auditor would conclude that the going concern assumption used in the preparation of the financial statements is inappropriate. If the result of the inappropriate assumption used in the preparation of the financial statements is so material and pervasive as to make the financial statements misleading, the auditor should express an adverse opinion. Effective Date 19. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1999. QUALITY CONTROL FOR AUDIT WORK (AAS 17) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the quality control:

Part I : Auditing and Assurance Standards

I.95

(a) policies and procedures of an audit firm regarding audit work generally; and (b) procedures regarding the work delegated to assistants on an individual audit. 2. Quality control policies and procedures should be implemented at both the level of the audit firm and on individual audits. 3.

In this AAS, the following terms have the meaning attributed below:

(a) "the auditor" means the person with final responsibility for the audit; (b) "audit firm" means either the partners of a firm providing audit services or a sole practitioner providing audit services, as appropriate; (c) "personnel" means all partners and professional staff engaged in the audit practice of the firm; and (d) "assistants" means personnel involved in an individual audit other than the auditor. Audit Firm 4. The audit firm should implement quality control policies and procedures designed to ensure that all audits are conducted in accordance with Auditing and Assurance Standards (AASs). 5. Compliance with Auditing and Assurance Standards (AASs) is essential whenever an audit is carried out and requires the application of auditing procedures and reporting practices appropriate to the particular circumstances. An audit firm needs to implement appropriate quality control policies and procedures to ensure that all audits are carried out in accordance with Auditing and Assurance Standards (AASs). 6. The objectives of the quality control policies to be adopted by an audit firm will ordinarily incorporate the following: (a) Professional Requirements: Personnel in the firm are to adhere to the principles of Independence, Integrity, Objectivity, Confidentiality and Professional Behavior. (b) Skills and Competence22: The firm is to be staffed by personnel who have attained and maintain the Technical Standards and Professional Competence required to enable them to fulfil their responsibilities with Due Care. (c) Assignment: Audit work is to be assigned to personnel who have the degree of technical training and proficiency required in the circumstances. (d) Delegation: There is to be sufficient direction, supervision and review of work at all levels to provide reasonable assurance that the work performed meets appropriate standards of quality. (e) Consultation: Whenever necessary, consultation within or outside the firm is to occur with those who have appropriate expertise.

22

Refer to AAS : 'Basic Principles Governing an Audit'.

I.96 (f)

Advanced Auditing & Professional Ethics Acceptance and Retention of Clients: An evaluation of prospective clients and a review, on an ongoing basis, of existing clients is to be conducted. In making a decision to accept or retain a client, the firm's independence and ability to serve the client properly are to be considered.

(g) Monitoring: The continued adequacy and operational effectiveness of quality control policies and procedures is to be monitored. 7. The firm's general quality control policies and procedures should be communicated to its personnel in a manner that provides reasonable assurance that the policies and procedures are understood and implemented. Individual Audits 9. The auditor, and assistants with supervisory responsibilities, will consider the professional competence of assistants performing work delegated to them when deciding the extent of direction, supervision and review appropriate for each assistant. 10. Any delegation of work to assistants would be in a manner that provides reasonable assurance that such work will be performed with due care by persons having the degree of professional competence required in the circumstances. Direction 11. Assistants to whom work is delegated need appropriate direction. Direction involves informing assistants of their responsibilities and the objectives of the procedures they are to perform. It also involves informing them of matters, such as the nature of the entity's business and possible accounting or auditing problems that may affect the nature, timing and extent of audit procedures with which they are involved. 12. The audit programme is an important tool for the communication of audit directions. Time budgets and the overall audit plan are also helpful in communicating audit directions. Supervision 13. Supervision is closely related to both direction and review and may involve elements of both. 14. Personnel carrying out supervisory responsibilities perform the following functions during the audit: (a) monitor the progress of the audit to consider whether: (i)

assistants have the necessary skills and competence to carry out their assigned tasks;

(ii)

assistants understand the audit directions; and

(iii) the work is being carried out in accordance with the overall audit plan and the audit programme; (b) become informed of and address significant accounting and auditing questions raised during the audit, by assessing their significance and modifying the overall audit plan and the audit programme as appropriate; and

Part I : Auditing and Assurance Standards

I.97

(c) resolve any differences of professional judgement between personnel and consider the level of consultation that is appropriate. Review 15. The work performed by each assistant needs to be reviewed by personnel of at least equal competence to consider whether: (a) the work has been performed in accordance with the audit programme; (b) the work performed and the results obtained have been adequately documented; (c) all significant audit matters have been resolved or are reflected in audit conclusions; (d) the objectives of the audit procedures have been achieved; and (e) the conclusions expressed are consistent with the results of the work performed and support the audit opinion. 16. The following need to be reviewed on a timely basis: (a) overall audit plan and the audit programme; (b) assessments of inherent and control risks, including the results of tests of control and the modifications, if any, made to the overall audit plan and the audit programme as a result of tests of control; (c) documentation of the audit evidence obtained from substantive procedures and the conclusions drawn therefrom, including the results of consultations; and (d) financial statements, proposed adjustments in financial statements arising out of the auditor's examination, and the auditor's proposed observations/report. 17. The process of reviewing an audit may include, particularly in the case of large complex audits, requesting personnel not otherwise involved in the audit to perform certain additional procedures before issuing the auditor's report. Effective Date 18. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 1999. AUDIT OF ACCOUNTING ESTIMATES (AAS 18) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the audit of accounting estimates contained in financial statements. This AAS is not intended to be applicable to the examination of prospective financial information23. 2. 23

The auditor should obtain sufficient appropriate audit evidence regarding accounting

In this regard, it may be noted that the Institute of Chartered Accountants of India has issued a Guidance Note on Accountant's Report on Profit Forecasts and/or Financial Forecasts.

I.98

Advanced Auditing & Professional Ethics

estimates. 3. "Accounting estimate" means an approximation of the amount of an item in the absence of a precise means of measurement. Examples are: ♦

Allowances to reduce inventory and accounts receivable to their estimated realisable value.

♦

Provisions to allocate the cost of fixed assets over their estimated useful lives.

♦

Accrued revenue.

♦

Provision for taxation.

♦

Provision for a loss from a lawsuit.

♦

Insurer's liability for outstanding claims.

♦

Losses on construction contracts in progress.

♦

Amortisation of certain items like goodwill and deferred revenue expenditure.

♦

Provision to meet warranty claims.

♦

Provision for retirement benefits in the financial statements of employers.

4. Management is responsible for making accounting estimates included in financial statements. These estimates are often made in conditions of uncertainty regarding the outcome of events that have occurred or are likely to occur and involve the use of judgement. As a result, the risk of material misstatement is greater when accounting estimates are involved. Nature Of Accounting Estimates 5. The determination of an accounting estimate may be simple or complex, depending upon the nature of the item. For example, accruing a charge for rent may be a simple calculation, whereas estimating a provision for slow-moving or surplus inventory may involve considerable analysis of current data and a forecast of future sales. In complex estimates, a high degree of special knowledge and judgment may be required. 6. Accounting estimates may be determined as part of the routine accounting system operating on a continuing basis, or may be non-routine, operating only at the end of the period. In many cases, accounting estimates are made by using a formula based on experience, such as the use of standard rates for depreciating each category of fixed assets or a standard percentage of sales revenue for computing a warranty provision. In such cases, the formula needs to be reviewed regularly by management, for example, by reassessing the remaining useful lives of assets or by comparing actual results with the estimate and adjusting the formula when necessary. 7. The uncertainty associated with an item, or the lack of objective data may make it incapable of reasonable estimation, in which case, the auditor needs to consider the same while expressing his opinion on the financial statements.

Part I : Auditing and Assurance Standards

I.99

Audit Procedures 8. The auditor should obtain sufficient appropriate audit evidence as to whether an accounting estimate is reasonable in the circumstances and, when required, is appropriately disclosed in the financial statements. The evidence available to support an accounting estimate will often be more difficult to obtain and less conclusive than evidence available to support other items in the financial statements. 9. An understanding of the procedures and methods, including the accounting and internal control systems, used by management in making the accounting estimates is often important for the auditor to plan the nature, timing and extent of the audit procedures. 10. The auditor should adopt one or a combination of the following approaches in the audit of an accounting estimate: (a) review and test the process used by management to develop the estimate; (b) use an independent estimate for comparison with that prepared by management; or (c) review subsequent events which confirm the estimate made. Reviewing and Testing the Process Used by Management 11. The steps ordinarily involved in reviewing and testing of the process used by management are: (a) evaluation of the data and consideration of assumptions on which the estimate is based; (b) testing of the calculations involved in the estimate; (c) comparison, when possible, of estimates made for prior periods with actual results of those periods; and (d) consideration of management's approval procedures. Evaluation of Data and Consideration of Assumptions 12. The auditor would evaluate whether the data on which the estimate is based is accurate, complete and relevant. When accounting data is used, it will need to be consistent with the data processed through the accounting system. For example, in substantiating a warranty provision, the auditor would obtain audit evidence that the data relating to products still within the warranty period, at period end, agree with the sales information within the accounting system. 13. External evidence is, usually, more reliable for the purpose of an audit than internal evidence. Accordingly, obtaining external evidence may be warranted in certain circumstances. For example, where there may be uncertainties with regard to the anticipated future sales of products requiring provision for obsolescence of inventories, the auditor, in addition to examining internal data such as past levels of sales, orders on hand etc., may seek external evidence to corroborate the requirement for inventory obsolescence provision. Similarly, in respect of claims against the entity arising out of litigation, internal evidence may be required to be corroborated by making a reference to entity's lawyers, if so required. Internal evidence relating to provision for gratuity, pension or other terminal benefits for the

I.100

Advanced Auditing & Professional Ethics

staff, where funded by external agencies, may sought to be corroborated by external evidence. 14. The auditor would evaluate whether the data collected is appropriately analysed to form a reasonable basis for determining the accounting estimate. For example, the analysis of the age of accounts receivable to estimate the provision for doubtful debts and advances. 15. The assumptions used in the accounting estimate will be specific to the entity and would be based on internally generated data, while in other cases, the assumptions may be based on industry or government statistics. The auditor would evaluate whether the entity has an appropriate base for the principal assumptions used in the accounting estimate. 16. In evaluating the assumptions on which the estimate is based, the auditor would consider, among other things, whether they are: ♦

Reasonable in light of actual results in prior periods.

♦

Consistent with those used for other accounting estimates.

♦

Consistent with management's plans which appear appropriate.

The auditor would need to pay particular attention to assumptions which are sensitive to variation, subjective or susceptible to material misstatement. 17. In the case of complex estimating processes involving specialised techniques, it may be necessary for the auditor to use the work of an expert, for example, engineers for estimating quantities in stock piles of mineral ores. Requirements as to how to use the work of an expert are prescribed in SAP 9, "Using the Work of an Expert." 18. The auditor would review the continuing appropriateness of formulae used by management in the preparation of accounting estimates. For this purpose, the auditor's knowledge of the financial results of the entity in prior periods, practices used by other entities in the industry and the future plans of management as disclosed to the auditor would be useful. Testing of Calculations 19. The auditor would test the calculation procedures used by management. The nature, timing and extent of the auditor's testing will depend on such factors as the complexity involved in calculating the accounting estimate, the auditor's evaluation of the procedures and methods used by the entity in producing the estimate and the materiality of the estimate in the context of the financial statements. Comparison of Previous Estimates with Actual Results 20. When possible, the auditor would compare accounting estimates made for prior periods with actual results of those periods to assist in: (a) obtaining evidence about the general reliability of the entity's estimating procedures; (b) considering whether adjustments to estimating formulae may be required; and (c) evaluating whether differences between actual results and previous estimates have been quantified and that, where necessary, appropriate adjustments or disclosures have been

Part I : Auditing and Assurance Standards

I.101

made. Consideration of Management's Approval Procedures 21. Material accounting estimates are ordinarily reviewed and approved by management. The auditor would consider whether such review and approval is performed by the appropriate level of management and that it is evidenced in the documentation supporting the determination of the accounting estimate. Use of an Independent Estimate 22. The auditor may make or obtain an independent estimate and compare it with the accounting estimate, prepared by management. When using an independent estimate, the auditor would ordinarily evaluate the data, consider the assumptions and test the calculation procedures used in its development. It may also be appropriate to compare accounting estimates so made for prior periods with actual results of those periods. Review of Subsequent Events 23. Transactions and events which occur after period end, but prior to completion of the audit, may provide audit evidence regarding an accounting estimate made by management. The auditor's review of such transactions and events may reduce, or even remove, the need for the auditor to review and test the process used by management to develop the accounting estimate or to use an independent estimate in assessing the reasonableness of the accounting estimate. Evaluation Of Results Of Audit Procedures 24. The auditor should make a final assessment of the reasonableness of the estimate based on the auditor's knowledge of the business and whether the estimate is consistent with other audit evidence obtained during the audit. 25. The auditor would consider whether there are any significant subsequent transactions or events which affect the data and the assumptions used in determining the accounting estimate. 26. Because of the uncertainties inherent in accounting estimates, evaluating differences can be more difficult than in other areas of the audit. When there is a difference between the auditor's estimate of the amount best supported by the available audit evidence and the estimated amount included in the financial statements, the auditor would determine whether such a difference requires adjustment. If the difference is reasonable, for example, because the amount in the financial statements falls within a range of acceptable results, it may not require adjustment. However, if the auditor believes the difference is unreasonable, management would be requested to revise the estimate. If management refuses to revise the estimate, the difference would be considered a misstatement and would be considered with all other misstatements in assessing whether the effect on the financial statements is material. However, the auditor would also consider whether individual differences which have been accepted as reasonable are biased in one direction, so that, on a cumulative basis, they may have a material effect on the financial statements. In such circumstances, the auditor would evaluate the accounting estimates taken as a whole.

I.102

Advanced Auditing & Professional Ethics

Effective Date 27. This Auditing and Assurance Standard becomes operative for all audits commencing on or after 1st April, 2000. SUBSEQUENT EVENTS (AAS 19) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's responsibility regarding subsequent events. In this AAS, the term "subsequent events" is used to refer to significant events occurring between the balance sheet date and the date of the auditor's report. In the context of audit of a component, such as a branch or division, of an entity “subsequent events” would refer to significant events upto the date of the report of the auditor of that component of the entity. 2. The auditor should consider the effect of subsequent events on the financial statements and on the auditor's report. 3. Accounting Standard (AS) 4, “Contingencies and Events Occurring After the Balance Sheet Date”, issued by the Institute of Chartered Accountants of India, deals with the treatment in financial statements of events, both favourable and unfavourable, occurring between the balance sheet date and the date on which the financial statements are approved by the Board of Directors in the case of a company, and, by the corresponding approving authority in the case of any other entity. AS 4 identifies two types of events: (a) those which provide further evidence of conditions that existed at the balance sheet date; and (b) those which are indicative of conditions that arose subsequent to the balance sheet date. Audit Procedures 4. The auditor should perform procedures designed to obtain sufficient appropriate audit evidence that all events up to the date of the auditor's report that may require adjustment of, or disclosure in, the financial statements have been identified. These procedures are in addition to routine procedures which may be applied to specified transactions occurring after the balance sheet date to obtain audit evidence as to account balances as at the balance sheet date, for example, the testing of inventory cut-off and payments to creditors. The auditor is not, however, expected to conduct a continuing review of all matters to which previously applied procedures have provided satisfactory conclusions. 5. The procedures to identify events that may require adjustment of, or disclosure in, the financial statements would be performed as near as practicable to the date of the auditor's report and ordinarily include the following: ♦

Reviewing procedures that the management has established to ensure that subsequent events are identified.

♦

Reading minutes of the meetings of shareholders, the board of directors and audit and

Part I : Auditing and Assurance Standards

I.103

executive committees held after the balance sheet date and inquiring about matters discussed at meetings for which minutes are not yet recorded. ♦

Reading the entity's latest available interim financial statements and, as considered necessary and appropriate, budgets, cash flow forecasts and other related management reports.

♦

Inquiring, or extending previous oral or written inquiries, of the entity's lawyers concerning litigation and claims.

♦

Inquiring of management as to whether any subsequent events have occurred after the balance sheet date which might affect the financial statements. Examples of inquiries of management on specific matters are: ¾

The current status of items that were accounted for on the basis of preliminary or inconclusive data.

¾

Whether there have been any developments regarding risk areas and contingencies.

¾

Whether any unusual accounting adjustments have been made or are contemplated.

¾

Whether any events have occurred or are likely to occur which will bring into question the appropriateness of accounting policies used in the financial statements as would be the case, for example, if such events call into question the validity of the going concern assumption.

6. When a component, such as a division or a branch, of an entity, has already been audited by another auditor, the principal auditor would make similar enquiries as set out in para 5 in respect of events, occurring between the date of signing of the report of the auditor of the component of the entity and signing of his report. 7. When the auditor becomes aware of events which materially affect the financial statements, the auditor should consider whether such events are properly accounted for in the financial statements. When the management does not account for such events that the auditor believes should be accounted for, the auditor should express a qualified opinion or an adverse opinion, as appropriate. Effective Date 8. This Auditing and Assurance Standard becomes operative for all audits commencing on or after 1st April, 2000. KNOWLEDGE OF THE BUSINESS (AAS 20) Introduction 1. The purpose of this Standard is to establish standards on what is knowledge of the business, why it is important to the auditor and to members of the audit staff working on an engagement, why it is relevant to all phases of an audit, and how the auditor obtains and uses

I.104

Advanced Auditing & Professional Ethics

that knowledge. 2. In performing an audit of financial statements, the auditor should have or obtain knowledge of the business sufficient to enable the auditor to identify and understand the events, transactions and practices that, in the auditor's judgment, may have a significant effect on the financial statements or on the examination or audit report. Such knowledge is used by the auditor in assessing inherent and control risks and in determining the nature, timing and extent of audit procedures. 3. The auditor's level of knowledge for an engagement would include a general knowledge of the economy and the industry within which the entity operates, and a more particular knowledge of how the entity operates. The level of knowledge required by the auditor would, however, ordinarily be less than that possessed by management. A list of matters to be considered in a specific engagement is set out in the Appendix. Obtaining The Knowledge 4. Prior to accepting an engagement, the auditor would obtain a preliminary knowledge of the industry and of the nature of ownership, management and operations of the entity to be audited, and would consider whether a level of knowledge of the business adequate to perform the audit can be obtained. 5. Following acceptance of the engagement, further and more detailed information would be obtained. To the extent practicable, the auditor would obtain the required knowledge at the start of the engagement. As the audit progresses, that information would be assessed and updated and more information would be obtained. 6. Obtaining the required knowledge of the business is a continuous and cumulative process of gathering and assessing the information and relating the resulting knowledge to audit evidence and information at all stages of the audit. For example, although information is gathered at the planning stage, it is ordinarily refined and added to in later stages of the audit as the auditor and the members of his audit staff learn more about the business. 7. For continuing engagements, the auditor would update and re-evaluate information gathered previously, including information in the prior year's working papers. The auditor would also perform procedures designed to identify significant changes that have taken place since the last audit. 8. The auditor can obtain knowledge of the industry and the entity from a number of sources. For example: ♦

Previous experience with the entity and its industry.

♦

Discussion with people with the entity (for example, directors and senior operating personnel).

♦

Discussion with internal audit personnel and review of internal audit reports.

♦

Discussion with other auditors and with legal and other advisors who have provided services to the entity or within the industry.

♦

Discussion with knowledgeable people outside the entity (for example, industry

Part I : Auditing and Assurance Standards

I.105

economists, industry regulators, customers and suppliers). ♦

Publications related to the industry (for example, government statistics, surveys, texts, trade journals, reports prepared by banks and institutions and financial newspapers).

♦

Legislation and regulations that significantly affect the entity.

♦

Visits to the entity premises and plant facilities.

♦

Documents produced by the entity (for example, minutes of meetings, material sent to shareholders or furnished to regulatory authorities, promotional literature, prior years' annual and financial reports, budgets, internal management reports, interim financial reports, management policy manual, manuals of accounting and internal control systems, chart of accounts, job descriptions, marketing and sales plans).

Using The Knowledge 9. Knowledge of the business is a frame of reference within which the auditor exercises professional judgment. Understanding the business and using this information appropriately assists the auditor in: ♦

Assessing risks and identifying problems.

♦

Planning and performing the audit effectively and efficiently.

♦

Evaluating audit evidence.

♦

Providing better service to the client.

10. The auditor makes judgments about many matters throughout the course of the audit where knowledge of the business is important. For example: ♦

Assessing inherent risk and control risk.

♦

Considering business risks and management's response thereto.

♦

Developing the overall audit plan and the audit programme.

♦

Determining a materiality level and assessing whether the materiality level chosen remains appropriate.

♦

Assessing audit evidence to establish its appropriateness and the validity of the related financial statement assertions.

♦

Evaluating accounting estimates and management representations.

♦

Identifying areas where special audit consideration and skills may be necessary.

♦

Identifying related parties and related party transactions.

♦

Recognising conflicting information (for example, contradictory representations).

♦

Recognising unusual circumstances (for example, fraud and non-compliance with laws and regulations, unexpected relationships of statistical operating data with reported financial results).

♦

Making informed inquiries and assessing the reasonableness of answers.

I.106 ♦

Advanced Auditing & Professional Ethics Considering the appropriateness of accounting policies and financial statement disclosures.

11. The auditor should ensure that the audit staff assigned to an audit engagement obtain sufficient knowledge of the business to enable them to carry out the audit work delegated to them. The auditor would also ensure that the audit staff understand the need to be alert for additional information and the need to share that information with the auditor and other audit staff. 12. To make effective use of knowledge about the business, the auditor should consider how it affects the financial statements taken as a whole and whether the assertions in the financial statements are consistent with the auditor's knowledge of the business. Effective Date 13. This Auditing and Assurance Standard becomes operative for all audits commencing on or after 1st April, 2000. Appendix Knowledge of the Business - Matters to Consider This list covers a broad range of matters applicable to many engagements; however, not all matters will be relevant to every engagement and the listing is only illustrative. A.

General Economic Factors

General level of economic activity (for example, recession, growth) ♦

Interest rates and availability of finance

♦

Inflation, currency revaluation

♦

Government policies : ¾

monetary

¾

fiscal

¾

taxation-corporate and other

¾

financial incentives (for example, government grants and subsidies)

¾

tariffs, trade restrictions

♦

Foreign currency rates and controls

B.

The Industry - Important Conditions Affecting the Client's Business

♦

The market and competition

♦

Cyclical or seasonal activity

♦

Changes in product technology

♦

Business risk (for example, high technology, high fashion, ease of entry for competition)

♦

Declining or expanding operations

Part I : Auditing and Assurance Standards ♦

Adverse conditions (for example, declining demand, excess capacity, serious price competition)

♦

Key ratios and operating statistics

♦

Specific accounting practices and problems

♦

Environmental requirements and problems

♦

Legislation and Regulatory framework

♦

Energy supply and cost

♦

I.107

Specific or unique practices (for example, relating to labour contracts, financing methods, accounting methods)

C.

The Entity

1.

Management and ownership - important characteristics

♦

Structure of entity (corporate and non-corporate) - private, public, government (including any recent or planned changes)

♦

Beneficial owners and related parties (local, foreign, business reputation and experience)

♦

Capital structure (including any recent or planned changes)

♦

Organizational structure

♦

Management objectives, philosophy, strategic plans

♦

Business restructuring - Acquisitions, mergers or disposals of business activities (planned or recently executed)

♦

Sources and methods of financing (current, historical)

♦

Board of directors - Corporate form

♦

¾

composition

¾

business reputation and experience of individuals

¾

independence from and control over operating management

¾

frequency of meetings

¾

existence of audit committee and scope of its activities

¾

existence of policy on corporate conduct

Members of the Managing Committee (by whatever name called) - non-corporate entities ¾

composition and election of members

¾

business reputation and experience of individuals

¾

independence from and control over operating management

¾

frequency of meetings

¾

existence of policy on conduct of business by the enterprise

I.108 ♦

Advanced Auditing & Professional Ethics Operating Management

¾

experience and reputation

¾

turnover

¾

key financial personnel and their status in the organization

¾

staffing of accounting department

¾

incentive or bonus plans as part of remuneration (for example, based on profit)

¾

use of forecasts and budgets

¾ ¾

pressures on management (for example, over-extended dominance by one individual, unreasonable deadlines for announcing results) management information systems

♦

Internal audit function (existence, quality)

♦

Attitude to internal control environment

2.

The entity's business - products, markets, suppliers, expenses, operations.

♦

Nature of business(es) (for example, manufacturer, wholesaler, financial services, import/export)

♦

Location of production facilities, warehouses, offices

♦

Employment (for example, by location, supply, wage levels, union contracts, pension commitments, government regulation)

♦

Products or services and markets (for example, major customers and contracts, terms of payment, profit margins, market share, competitors, exports, pricing policies, reputation of products, warranties, order book, trends, marketing strategy and objectives, manufacturing processes)

♦

Important suppliers of goods and services (for example, long-term contracts, stability of supply, terms of payment, imports, methods of delivery such as "just-in-time")

♦

Inventories (for example, locations, quantities)

♦

Franchises, licenses, patents

♦

Important expense categories

♦

Research and development

♦

Foreign currency assets, liabilities and transactions - by currency hedging

♦

Legislation and regulation that significantly affect the entity

♦

Information systems - current, plans to change

3.

Financial performance - factors concerning the entity's financial condition and profitability

♦

Key ratios and operating statistics

Part I : Auditing and Assurance Standards ♦

Trends

♦

Debt structure, including covenants and restrictions

I.109

4. Reporting environment - external influences which affect management in the preparation of the financial statements 5.

Legislation

♦

Regulatory environment and requirements

♦

Taxation, both direct and indirect

♦

Measurement and disclosure issues peculiar to the business

♦

Audit reporting requirements

♦

Users of the financial statements CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL STATEMENTS (AAS 21)

Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor’s responsibility regarding consideration of laws and regulations in an audit of financial statements. 2. When planning and performing audit procedures and in evaluating and reporting the results thereof, the auditor should recognize that non-compliance by the entity with laws and regulations may materially affect the financial statements. However, an audit cannot be expected to detect non-compliance with all laws and regulations. Detection of non-compliance, regardless of materiality, requires consideration of the implications for the integrity of management or employees and the possible effect on other aspects of the audit. 3. The term “non-compliance” as used in this AAS refers to acts of omission or commission by the entity being audited, either intentional or unintentional, which are contrary to the prevailing laws or regulations. Such acts include transactions entered into by, or in the name of, the entity or on its behalf by its management or employees. For the purpose of this AAS, non-compliance does not include personal misconduct (unrelated to the business activities of the entity) by the entity’s management or employees. 4. Whether an act constitutes non-compliance is a legal determination that is ordinarily beyond the auditor’s professional competence. The auditor’s training, experience and understanding of the entity and its industry may provide a basis for recognition that some acts coming to the auditor’s attention may constitute non-compliance with laws and regulations. The determination as to whether a particular act constitutes or is likely to constitute non-compliance is generally based on the advice of an informed expert qualified to practice law but ultimately can only be determined by a court of law. 5.

Laws and regulations vary considerably in their relation to the financial statements. Some

I.110

Advanced Auditing & Professional Ethics

laws or regulations determine the form or content of an entity’s financial statements or the amounts to be recorded or disclosures to be made in financial statements. Other laws or regulations are to be complied with by management or prescribe the provisions under which the entity is allowed to conduct its business. Some entities operate in heavily regulated industries (such as banks, sugar and pharmaceuticals industries). Others are only subject to the many laws and regulations that generally relate to the operating aspects of the business (such as those related to occupational safety and health). Non-compliance with laws and regulations could result in financial consequences for the entity such as fines, litigation, etc. Generally, the further removed non-compliance is from the events and transactions ordinarily reflected in financial statements, the less likely the auditor is to become aware of it or to recognize its possible non-compliance. 6. This AAS applies to audits of financial statements and does not apply to other engagements in which the auditor is specifically engaged to test and report separately on compliance with specific laws or regulations. 7. The auditor’s responsibility to consider fraud and errors in an audit of financial statements is provided in AAS 4, “Fraud and Error”24. Responsibility Of Management For The Compliance With Laws And Regulations 8. It is management’s responsibility to ensure that the entity’s operations are conducted in accordance with laws and regulations. The responsibility for the prevention and detection of non-compliance rests with management. 9. The following policies and procedures, among others, may assist management in discharging its responsibilities for the prevention and detection of non-compliance with laws and regulations: ♦

Monitoring legal requirements and ensuring that operating procedures are designed to meet these requirements.

♦

Instituting and operating appropriate systems of internal control.

♦

Developing, publicising and following a Code of Conduct25.

♦

Ensuring employees are properly trained and understand the Code of Conduct.

♦

Monitoring compliance with the Code of Conduct and acting appropriately to discipline employees who fail to comply with it.

♦

Establishing a legal department and/or engaging legal advisors to assist in monitoring legal requirements.

♦

Maintaining a register of significant laws with which the entity has to comply within its particular industry and a record of complaints in respect of non-compliance.

24

The Original AAS 4, 'Fraud and Error' which was issued in June, 1987 has been revised in January, 2003. The revised AAS is titled ''The Auditor's Responsibility to consider Fraud and Error and Error in an Audit of Financial Statements''. 25 Code of Conduct in this context means a document containing standard instructions to be following by employee for ensuring compliance with laws and regulations.

Part I : Auditing and Assurance Standards ♦

I.111

In larger entities, these policies and procedures may be supplemented by assigning appropriate responsibilities to: ¾

An internal audit function

¾

An audit committee

The Auditor’s Consideration Of Compliance With Laws And Regulations 10. The auditor is not, and cannot be held responsible for preventing non-compliance. The fact that an audit is carried out may, however, act as a deterrent. 11. An audit is subject to the unavoidable risk that some material misstatements of the financial statements will not be detected, even though the audit is properly planned and performed in accordance with AASs and other generally accepted audit procedures. This risk is higher with regard to material misstatements resulting from non-compliance with laws and regulations due to factors such as: ♦

Existence of laws and regulations, relating to the operating aspects of the entity, that do not have a material effect on the financial statements and are not captured by the accounting and internal control systems.

♦

The inherent limitations of the accounting and internal control systems and the testing procedures.

♦

Persuasive rather than conclusive nature of audit evidence, in general.

♦

Deliberate designs, such as collusion, forgery, deliberate failure to record transactions, senior management override of controls or intentional misrepresentations being made to the auditor, to conceal non-compliance.

12. The auditor should plan and perform the audit recognizing that the audit may reveal conditions or events that would lead to questioning whether an entity is complying with laws and regulations. 13. In accordance with specific statutory requirements, the auditor may be specifically required to report as part of the audit of the financial statements whether the entity complies with certain provisions of laws or regulations. In these circumstances, the auditor would plan to test for compliance with these provisions of the laws and regulations. 14. In order to plan the audit, the auditor should obtain a general understanding of the legal and regulatory framework applicable to the entity and how the entity is complying with that framework. 15. In obtaining this general understanding, the auditor would particularly recognize that noncompliance of some laws and regulations may have a fundamental effect on the operations of the entity and may even cause the entity to cease operations, or call into question the entity’s continuance as a going concern. For example, a Non-Banking Financial Company might have to cease to carry on the business of a non-banking financial institution if it fails to obtain a certificate of registration issued under Chapter III B of the Reserve Bank of India Act, 1934 and if its Net Owned Funds are less than the amount specified by the RBI in this regard.

I.112

Advanced Auditing & Professional Ethics

16. To obtain the general understanding of laws and regulations, the auditor would ordinarily: ♦

Use the existing knowledge of the entity’s industry and business.

♦

Inquire of management as to the laws or regulations that may be expected to have a fundamental effect on the operations of the entity.

♦

Inquire of management concerning the entity’s policies and procedures regarding compliance with laws and regulations.

♦

Discuss with management the policies or procedures adopted for identifying, evaluating and accounting for litigation claims and assessments.

17. After obtaining the general understanding, the auditor should perform procedures to identify instances of non-compliance with those laws and regulations where non-compliance should be considered when preparing financial statements, specifically: ♦

Inquiring of management as to whether the entity is in compliance with such laws and regulations.

♦

Inspecting correspondence with the relevant licensing or regulatory authorities.

18. Further, the auditor should obtain sufficient appropriate audit evidence about compliance with those laws and regulations generally recognised by the auditor to have an effect on the determination of material amounts and disclosures in financial statements. The auditor should have a sufficient understanding of these laws and regulations in order to consider them when auditing the assertions related to the determination of the amounts to be recorded and the disclosures to be made. 19. Such laws and regulations would be well established and known to the entity and within the industry; they would be considered on a recurring basis each time financial statements are issued. These laws and regulations may relate, for example, to the form and content of financial statements, including industry specific requirements or the accrual or recognition of expenses for retirement benefits, etc. 20. Other than as described in paragraphs 17, 18 and 19, the auditor need not test or perform other procedures on the entity’s compliance with laws and regulations since this would be outside the scope of an audit of financial statements. 21. The auditor should be conscious that procedures applied for the purpose of forming an opinion on the financial statements may bring instances of possible non-compliance with laws and regulations to the auditor’s attention. For example, such procedures include reading minutes; inquiring of the entity’s management and legal counsel concerning litigation, claims and assessments; and performing substantive tests of details of transactions or balances. 22. The auditor should obtain written representations that management has disclosed to the auditor all known actual or possible non-compliance with laws and regulations whose effects should be considered when preparing financial statements. 23. In the absence of evidence to the contrary, the auditor is entitled to assume the entity is in compliance with these laws and regulations.

Part I : Auditing and Assurance Standards

I.113

Procedures When Non-Compliance Is Discovered 24. The Appendix to this AAS sets out examples of the type of information that might come to the auditor’s attention that may indicate non-compliance. 25. When the auditor becomes aware of information concerning a possible instance of noncompliance, the auditor should obtain an understanding of the nature of the act and the circumstances in which it has occurred, and sufficient other information to evaluate the possible effect on the financial statements. 26. When evaluating the possible effect on the financial statements, the auditor considers: ♦

The potential financial consequences, such as fines, penalties, damages, litigation, threat of expropriation of assets and enforced discontinuation of operations, including violation of the going concern assumption.

♦

Whether the potential financial consequences require disclosure.

♦

Whether the potential financial consequences are so serious as to call into question the true and fair view given by the financial statements.

27. When the auditor believes there may be non-compliance, the auditor should document the findings and discuss them with management. Documentation of findings would include copies of records and documents and making minutes of conversations, if appropriate. 28. If management does not provide satisfactory information that it is in fact in compliance, the auditor would consult with the entity’s lawyer about the application of the laws and regulations to the circumstances and the possible effects on the financial statements. When it is not considered appropriate to consult with the entity’s lawyer or when the auditor is not satisfied with the opinion, the auditor would consider consulting some other lawyer as to whether a violation of a law or regulation is involved, the possible legal consequences and what further action, if any, the auditor would take. 29. When adequate information about the suspected non-compliance cannot be obtained, the auditor should consider the effect of the lack of audit evidence on the auditor’s report. 30. The auditor should consider the implications of non-compliance in relation to other aspects of the audit, particularly the reliability of management representations. In this regard, the auditor reconsiders the risk assessment and the validity of management representations, in case of non-compliance not detected by internal controls or not included in management representations. The implications of particular instances of non-compliance discovered by the auditor will depend on the relationship of the perpetration and concealment, if any, of the act to specific control procedures and the level of management or employees involved. Communication/Reporting Of Non-Compliance To Management 31. The auditor should, as soon as practicable, either communicate with the audit committee, the board of directors and senior management, or obtain evidence that they are appropriately informed, regarding non-compliance that comes to the auditor’s attention. However, the auditor need not do so for matters that are clearly inconsequential or trivial and may reach

I.114

Advanced Auditing & Professional Ethics

agreement in advance on the nature of such matters to be communicated. 32. If in the auditor’s judgement, the non-compliance is believed to be intentional and/or material, the auditor should communicate the finding without delay. 33. If the auditor suspects that members of senior management, including members of the board of directors, are involved in non-compliance, the auditor should communicate the matter to the next higher level of authority at the entity, such as an audit committee or board of directors. Where no higher authority exists, or if the auditor believes that the communication may not be acted upon or is unsure as to the person to whom to report, the auditor may consider seeking legal advice. To the Users of the Auditor’s Report on the Financial Statements 34. If the auditor concludes that the non-compliance has a material effect on the financial statements, and has not been properly reflected in the financial statements, the auditor should express a qualified or an adverse opinion. 35. If the auditor is precluded by the entity from obtaining sufficient appropriate audit evidence to evaluate whether non-compliance that may be material to the financial statements has, or is likely to have, occurred, the auditor should express a qualified opinion or a disclaimer of opinion on the financial statements on the basis of a limitation on the scope of the audit. 36. If the auditor is unable to determine whether non-compliance has occurred because of limitations imposed by the circumstances rather than by the entity, the auditor should consider the effect on the auditor’s report. To Regulatory and Enforcement Authorities 37. The auditor’s duty of confidentiality would ordinarily preclude reporting non-compliance to a third party. However, in certain circumstances, that duty of confidentiality is overridden by statute, law or by courts of law (for example, the auditor is required to report certain matters of non-compliance to the Reserve Bank of India as per the requirements of Non Banking Financial Companies Auditor’s Report (Reserve Bank) Directions, 1988, issued by the Reserve Bank of India). Withdrawal From The Engagement 38. The auditor may conclude that withdrawal from the engagement is necessary when the entity does not take the remedial action that the auditor considers necessary in the circumstances, even when the non-compliance is not material to the financial statements. Factors that would affect the auditor’s conclusion include the implications of the involvement of the highest authority within the entity which may affect the reliability of management representations, and the effects on the auditor of continuing association with the entity. In appropriate circumstances, the auditor may consider seeking legal advice. 39. An outgoing auditor, on receiving communication from the incoming auditor, should send a reply to him as soon as possible, setting out in detail the reasons, which according to him had given rise to the attendant circumstances but without disclosing any information as regards the affairs of the client which he is not competent to do. However, with the permission

Part I : Auditing and Assurance Standards

I.115

of the client he may disclose information regarding affairs of the client to the incoming auditor. Effective Date 40. This Auditing and Assurance Standard becomes operative for all audits commencing on or after 1st July, 2001. Appendix Indications That Non-compliance May Have Occurred Examples of the type of information that may come to the auditor’s attention that may indicate that non-compliance with laws or regulations has occurred are listed below: ♦

Investigation by government departments or payment of fines, additional taxes or penalties.

♦

Payments for unspecified services or loans to consultants, related parties, employees or government employees.

♦

Sales commission or agent’s fees that appear excessive in relation to those ordinarily paid by the entity or in its industry or to the services actually received.

♦

Purchases at prices significantly above or below market price.

♦

Unusual payments in cash and other unusual transactions.

♦

Unusual transactions with companies registered in tax havens.

♦

Payments for goods or services made other than to the country from which the goods or services originated.

♦

Payments without proper exchange control documentation.

♦

Existence of an accounting system which fails, whether by design or by accident, to provide an adequate audit trail or sufficient evidence.

♦

Unauthorised transactions or improperly recorded transactions.

♦

Media comment. INITIAL ENGAGEMENTS - OPENING BALANCES (AAS 22)

Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards regarding audit of opening balances in case of initial engagements, i.e., when the financial statements are audited for the first time or when the financial statements for the preceding period were audited by another auditor. This Statement would also be considered by the auditor so that he may become aware of contingencies and commitments existing at the beginning of the current period.

I.116

Advanced Auditing & Professional Ethics

2. “Opening balances” means those account balances which exist at the beginning of the period. Opening balances are the closing balances of the preceding period brought forward to the current period and reflect the effect of: (a) transactions and other events of the preceding periods; and (b) accounting policies applied in the preceding period. 3. For initial audit engagements, the auditor should obtain sufficient appropriate audit evidence that: (a) the closing balances of the preceding period have been correctly brought forward to the current period; (b) the opening balances do not contain misstatements that materially affect the financial statements for the current period; and (c) appropriate accounting policies are consistently applied. 4. In an initial audit engagement, the auditor will not have previously obtained audit evidence supporting the opening balances. Audit Procedures 5. For the purpose of this Statement, the sufficiency and appropriateness of the audit evidence, the auditor will need to obtain regarding opening balances, would depend on the following matters: ♦

The accounting policies followed by the entity.

♦

Whether the auditor’s report contained an unqualified opinion, a qualified opinion, adverse opinion or disclaimer of opinion where the financial statements for the preceding period were audited.

♦

The nature of the opening balances, including the risk of their misstatement in the financial statements for the current period.

♦

The materiality of the opening balances relative to the financial statements for the current period.

6. The auditor will need to consider whether the accounting policies followed in the preceding period, as per which the opening balances have been arrived at, were appropriate and that those policies are consistently applied in the financial statements for the current period and where such accounting policies are inappropriate, the same have been changed in the current period and adequately disclosed. 7. When the financial statements for the preceding period were audited by another auditor, the current auditor may be able to obtain sufficient appropriate audit evidence regarding opening balances by perusing the copies of the audited financial statements. Ordinarily, the current auditor can place reliance on the closing balances contained in the financial statements for the preceding period, except when during the performance of audit procedures for the current period the possibility of misstatements in opening balances is indicated.

Part I : Auditing and Assurance Standards

I.117

8. When the financial statements of the preceding period were not audited or the auditor is not satisfied by using the procedures described in paragraph 7, the auditor will need to perform other procedures such as those discussed in paragraphs 9 and 10. 9. For current assets and liabilities, some audit evidence can ordinarily be obtained as part of the audit procedures performed during the current period. For example, the collection/payment of opening accounts receivable/ accounts payable during the current period will provide some audit evidence as to their existence, rights and obligations, completeness and valuation at the beginning of the period. 10. For other assets and liabilities, such as fixed assets, investments and long-term debt, the auditor will ordinarily examine the records underlying the opening balances. In certain cases, the auditor may be able to obtain confirmation of opening balances from third parties, for example, for long-term debt and investments. Audit Conclusions And Reporting 11. If, after performing procedures including those set out above, the auditor is unable to obtain sufficient appropriate audit evidence concerning opening balances, the auditor should, as appropriate, express: (a) a qualified opinion, or (b) a disclaimer of opinion. The auditor may also express an opinion which is qualified or disclaimed regarding the profit or loss and unqualified regarding state of affairs, as appropriate. 12. If the opening balances contain misstatements which materially affect the financial statements for the current period and the effect of the same is not properly accounted for and adequately disclosed, the auditor should express a qualified opinion or an adverse opinion, as appropriate. Effective Date 13. This Auditing and Assurance Standard becomes operative for all audits commencing on or after 1st July, 2001. RELATED PARTIES (AAS 23) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor’s responsibilities and audit procedures regarding related parties and transactions with such parties. 2 The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence regarding the identification and disclosure by management of related parties and the related party transactions that are material to the financial statements. However, an audit cannot be expected to detect all related party transactions. 3.

In certain circumstances there are limitations that may affect the persuasiveness of

I.118

Advanced Auditing & Professional Ethics

evidence available to the auditor to draw conclusions on particular financial statement assertions. Because of the degree of uncertainty associated with the financial statement assertions regarding the completeness of information of related parties, the procedures identified in this AAS will provide sufficient appropriate audit evidence regarding those assertions in the absence of any circumstance identified by the auditor that: (a) increases the risk of misstatement beyond that which would ordinarily be expected; or (b) indicates that a material misstatement regarding related parties has occurred. Where there is any indication that such circumstances exist, the auditor should perform modified, extended or additional procedures as are appropriate in the circumstances. 4. Definitions regarding related parties are given in Accounting Standard (AS) 18, "Related Party Disclosures" and are adopted for the purposes of this AAS26. 5. Management is responsible for the identification and disclosure of related parties and transactions with such parties. This responsibility requires management to implement adequate accounting and internal control systems to ensure that transactions with related parties are appropriately identified in the accounting records and disclosed in the financial statements. 6. The auditor needs to have a level of knowledge of the entity’s business and industry that will enable identification of the events, transactions and practices that may have a material effect on the financial statements. While the existence of related parties and transactions between such parties are considered ordinary features of business, the auditor needs to be aware of them because: (a) the financial reporting framework may require disclosure in the financial statements of certain related party relationships and transactions, such as those required by AS 18; (b) the existence of related parties or related party transactions may affect the financial statements. For example, the entity’s tax liability and expense may be affected by the tax laws which require special consideration when related parties exist; (c) the source of audit evidence affects the auditor’s assessment of its reliability. A greater degree of reliance may be placed on audit evidence that is obtained from unrelated third parties; and (d) a related party transaction may be motivated by other than ordinary business considerations, for example, profit sharing or even fraud.

26

Definitions of ''Related Party'' and ''Related Party Transactions'' from Accounting Standard (AS) 18 Related Party Disclosures'' are Related Party-- parties are considered to be related if at any time during the reporting period one party has...............control the other party or exercise significant influence over the other party in making financial and/or operating ............. Related Party Transactions-- a transfer of resources or obligations between related parties regardless............ not a price is charged.

Part I : Auditing and Assurance Standards

I.119

Existence And Disclosure Of Related Parties 7. The auditor should review information provided by the management of the entity, identifying the names of all known related parties and should perform the following procedures in respect of the completeness of this information: (a) review his working papers for the prior years for names of known related parties; (b) review the entity’s procedures for identification of related parties; (c) inquire as to the affiliation of directors and key management personnel27, officers with other entities; (d) review shareholder records to determine the names of principal shareholders or, if appropriate, obtain a list of principal shareholders from the share register; (e) review memorandum and articles of association, minutes of the meetings of shareholders and the board of directors and its committees and other relevant statutory records such as the register of directors’ interests; (f)

inquire of other auditors28 of the entity as to their knowledge of additional related parties and review the report of the predecessor auditors;

(g) review the entity’s income tax returns and other information supplied to regulatory agencies; and (h) review the joint venture and other relevant agreements entered into by the entity. If, in the auditor’s judgement, the risk of significant related parties remaining undetected is low, these procedures may be reduced or modified as appropriate. 8. Where the financial reporting framework requires disclosure of related party relationships, the auditor should satisfy himself that the disclosure is adequate. Transactions With Related Parties 9. The auditor should review information provided by directors and key management personnel of the entity identifying related party transactions and should be alert for other material related party transactions. 10. When obtaining an understanding of the accounting and internal control systems and making a preliminary assessment of control risk, the auditor should consider the adequacy of control procedures over the authorisation and recording of related party transactions. 11. During the course of the audit, the auditor needs to be alert for transactions which appear unusual in the circumstances and may indicate the existence of previously unidentified related parties. Examples include: 27

Definition ''Key Management Personal'' from AS 18 is: Key Management Personnel - those persons who have the authority and responsibility for planning, directing and controlling the activities of the reporting enterprise. 28 The term ''Other Auditors'' includes internal auditor, special auditors appointed under any statute, cost auditors, and concurrent auditors.

I.120

Advanced Auditing & Professional Ethics

♦

Transactions which have abnormal terms of trade, such as, unusual prices, interest rates, guarantees, and repayment terms.

♦

Transactions which lack an apparent logical business reason for their occurrence.

♦

Transactions in which substance differs from form.

♦

Transactions processed in an unusual manner.

♦

High volume or significant transactions with certain customers or suppliers as compared with others.

♦

Rendition of services without receipt or provision of management services at no charge.

12. During the course of the audit, the auditor carries out procedures which may identify the existence of transactions with related parties. Examples include: ♦

Performing detailed tests of transactions and balances.

♦

Reviewing minutes of meetings of shareholders and directors.

♦

Reviewing accounting records for large or unusual transactions or balances, paying particular attention to transactions recognised at or near the end of the reporting period.

♦

Reviewing the entity's income tax returns and other information supplied to regulatory agencies.

♦

Reviewing confirmations of loans receivable and payable and confirmations from banks. Such a review may indicate guarantor relationship and other related party transactions.

♦

Reviewing investment transactions, for example, purchase or sale of an equity interest in a joint venture or other entity.

Examining Identified Related Party Transactions 13. In examining the identified related party transactions, the auditor should obtain sufficient appropriate audit evidence as to whether these transactions have been properly recorded and disclosed. 14. Given the nature of related party relationships, evidence of a related party transactions may be limited, for example, regarding the existence of inventory held by a related party on consignment or an instruction from a parent company to a subsidiary to record a royalty expense. Because of the limited availability of appropriate evidence about such transactions, the auditor would consider performing procedures such as: ♦

Confirming the terms and amount of the transaction with the related party.

♦

Obtaining confirmation from persons associated with the transaction, such as, banks, lawyers, guarantors and agents.

Management Representations 15. The auditor should obtain a written representation from management concerning: (a) the completeness of information provided regarding the identification of related parties; and

Part I : Auditing and Assurance Standards

I.121

(b) the adequacy of related party disclosures in the financial statements. 16. An example of a written representation to be obtained from management is given as an Appendix to this Statement. Audit Conclusions And Reporting 17. If the auditor is unable to obtain sufficient appropriate audit evidence concerning related parties and transactions with such parties or concludes that their disclosure in the financial statements is not adequate, the auditor should express a qualified opinion or a disclaimer of opinion in the audit report, as may be appropriate. Effective Date 18. This Auditing and Assurance Standard becomes operative for all audits related to accounting periods beginning on or after 1st April, 2001. Appendix Example of a Management Representation Letter Regarding Related Parties (Refer Paragraph 16) The following letter is for use as a general guide in conjunction with the considerations set forth in this Statement. Representations by management will vary from one entity to another, and from one year to the next. Therefore, this letter is not intended to be a standard letter and should be adapted in the light of individual requirements and circumstances. [Letterhead of Entity] [Date] [Name and Address of the Auditor] Dear Sir, This representation letter is provided in connection with your audit of the financial statements of ____________ for the year ended _______. We acknowledge our responsibility for preparation of financial statements in accordance with the requirements of the Companies Act, 1956 and recognised accounting policies and practices, including the Accounting Standards issued by the Institute of Chartered Accountants of India. We confirm the following representation in respect of related parties: 1. We have identified all the related parties and transactions with all such parties. The information provided to you is complete in all respects. 2. The disclosures made in the financial statements are adequate having regard to the framework under which the financial statements have been drawn. 3. The financial statements are free from material misstatements, including omissions with regard to related parties and transactions with related parties. {Signature of the Authorised Person(s) of the Entity}

I.122

Advanced Auditing & Professional Ethics AUDIT CONSIDERATIONS RELATING TO ENTITIES USING SERVICE ORGANISATIONS (AAS 24)

Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards for an auditor whose client uses a service organisation. This AAS also describes the reports of the auditors of the service organisation which may be obtained by the auditor of the client. 2. The auditor should consider how a service organisation affects the client's accounting and internal control systems so as to plan the audit and develop an effective audit approach. 3. Service organisations undertake a wide range of activities, for example, information processing, maintenance of accounting records, facilities management, maintenance of safe custody of assets such as investments, and initiation or execution of transactions on behalf of the other enterprise. Not all the activities undertaken by the service organisations are likely, by themselves, to have a significant effect on a user enterprise’s financial statements. A client may use a service organisation such as one that executes transactions and maintains related accountability or records transactions and processes related data (e.g., a computer systems service organisation). If a client uses a service organisation, certain policies, procedures and records maintained by the service organisation might be relevant to the audit of the financial statements of the client. Consequently, the auditor would consider the nature and extent of activities undertaken by service organisations so as to determine whether those activities are relevant to the audit and, if so, to assess their effect on audit risk. Considerations for the Auditor of the Client 4. A service organisation may establish and execute policies and procedures that affect a client organisation's accounting and internal control systems. These policies and procedures are physically and operationally separate from the client’s organisation. When the services provided by the service organisation are limited to recording and processing transactions of the client and the client retains authorisation and maintenance of accountability, the client might be able to implement effective policies and procedures within its organisation. When the service organisation executes the client's transactions and maintains accountability, the client may deem it necessary to rely on policies and procedures at the service organisation. 5. While planning the audit, the auditor of the client should determine the significance of the activities of the service organisation to the client and their relevance to the audit. In doing so, the auditor of the client would need to consider the following, as appropriate: ♦

Nature of the services provided by the service organisation.

♦

Terms of contract and relationship between the client and the service organisation.

♦

The material financial statement assertions that are affected by the use of the service organisation.

♦

Inherent risk associated with those assertions.

♦

Extent to which the client's accounting and internal control systems interact with the systems at the service organisation.

Part I : Auditing and Assurance Standards

I.123

♦

Client's internal controls that are applied to the transactions processed by the service organisation.

♦

Service organisation's capability and financial strength, including the possible effect of the failure of the service organisation on the client.

♦

Information about the service organisation such as that reflected in user and technical manuals, if any.

♦

Information available on general controls and computer systems controls relevant to the client's applications.

6. The auditor of the client would also consider the availability of third-party reports from service organisation’s auditors, internal auditors, or regulatory agencies as a means of providing information about the accounting and internal control systems of the service organisation and about its operation and effectiveness. Consideration of the above may lead the auditor to decide that the control risk assessment will not be affected by controls at the service organisation; if so, further consideration of this AAS is unnecessary. 7. If the auditor of the client concludes that the activities of the service organisation are significant to the entity and relevant to the audit, the auditor should obtain sufficient information to understand the accounting and internal control systems of the service organisation and to assess control risk at either the maximum, or a lower level if tests of control are performed. 8. If the information is insufficient, the auditor of the client would consider the need to request the service organisation to have its auditor perform such procedures as to supply the necessary information in the forms of reports mentioned at paragraph 12. If such reports are not made available within a reasonable time, the auditor of the client would consider the need to visit the service organisation to obtain the relevant information. An auditor of the client wishing to visit a service organisation may advise the client to request the service organisation to give the auditor of the client access to the necessary information. 9. The auditor of the client may be able to obtain an understanding of the accounting and internal control systems affected by the service organisation by reading the third-party report of the service organisation’s auditor. In addition, when assessing control risk for assertions affected by the systems, controls of the service organisation, the auditor of the client may also use the service organisation auditor's report. When the auditor of the client uses the report of a service organisation’s auditor, the auditor of the client should consider the professional competence of the other auditor in the context of specific assignment if the other auditor is not a member of the Institute of Chartered Accountants of India. 10. The auditor of the client may conclude that it would be appropriate to obtain audit evidence from tests of control to support an assessment of control risk at a lower level.

I.124

Advanced Auditing & Professional Ethics

Service Organisation Auditor's Reports 11. When using a service organisation auditor's report, the auditor of the client should consider the nature of and content of that report. 12. The report of the service organisation’s auditor will ordinarily be one of two types as follows: Type A - Report on Suitability of Design (a) a description of the service organisation's accounting and internal control systems, ordinarily prepared by the management of the service organisation; and (b) an opinion by the service organisation’s auditor that: (i)

the above description is accurate;

(ii)

the systems' controls have been placed in operation; and

(iii) the accounting and internal control systems are suitably designed to achieve their stated objectives. Type B - Report on Suitability of Design and Operating Effectiveness (a) a description of the service organisation's accounting and internal control systems, ordinarily prepared by the management of the service organisation; and (b) an opinion by the service organisation’s auditor that: (i)

the above description is accurate;

(ii)

the systems’ controls have been placed in operation;

(iii) the accounting and internal control systems are suitably designed to achieve their stated objectives; and (iv) the accounting and internal control systems are operating effectively based on the results from the tests of control. In addition to the opinion on operating effectiveness, the service organisation’s auditor would identify the tests of control performed and related results. The report of the service organisation’s auditor will ordinarily contain restrictions as to its use (generally to management of the service organisation and its customers, and the specified client’s auditor). 13. The auditor should consider the scope of work performed by the service organisation’s auditor and should assess the usefulness and appropriateness of reports issued by the service organisation’s auditor. 14. While Type A reports may be useful to an auditor of the client in gaining the required understanding of the accounting and internal control systems, an auditor would not use such reports as a basis for reducing the assessment of control risk. 15. In contrast, Type B reports may provide such a basis since tests of control have been performed. When a Type B report is to be used as evidence to support a lower control risk assessment, the auditor of the client would consider whether the controls tested by the service

Part I : Auditing and Assurance Standards

I.125

organisation’s auditor are relevant to the client's transactions (significant assertions in the client's financial statements) and whether the service organisation auditor's tests of control and the results are adequate. With respect to the latter, two key considerations are the length of the period covered by the service organisation auditor's tests and the time since the performance of those tests. 16. For those specific tests of control and results that are relevant, the auditor of the client should consider whether the nature, timing and extent of such tests provide sufficient appropriate audit evidence about the effectiveness of the accounting and internal control systems to support the client auditor's assessed level of control risk. 17. The auditor of a service organisation may be engaged to perform substantive procedures that are of use to auditor of the client. Such engagements may involve the performance of procedures agreed upon by the client and its auditor and by the service organisation and its auditor. 18. When the auditor of the client uses a report from the auditor of a service organisation, no reference should be made in the client auditor's report to the service organisation’s auditor’s report. Effective Date 19. This Auditing and Assurance Standard becomes operative for all audits related to accounting periods beginning on or after April 1, 2003. Compatibility With International Standard On Auditing (ISA) 402 The auditing standards established in this Auditing and Assurance Standard are generally consistent in all material respects with those set out in ISA 402 "Audit Considerations Relating to Entities Using Service Organisations". COMPARATIVES (AAS 25) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor’s responsibilities regarding comparatives. It does not deal with situations when summarized financial statements or data are presented with the audited financial statements. 2. The auditor should determine whether the comparatives comply, in all material respects, with the financial reporting framework relevant to the financial statements being audited. 3. The existence of differences in financial reporting frameworks results in comparative financial information being presented differently in each framework. Comparatives in financial statements, for example, may present amounts (such as financial position, results of operations, cash flows) and appropriate disclosures of an entity for more than one period, depending on the framework. The frameworks and methods of presentation that are referred to in this AAS are as follows:

I.126

Advanced Auditing & Professional Ethics

(a) Corresponding Figures where amounts and other disclosures for the preceding period are included as part of the current period financial statements, and are intended to be read in relation to the amounts and other disclosures relating to the current period (referred to as “current period figures” for the purpose of this AAS). These corresponding figures are not presented as complete financial statements capable of standing alone, but are an integral part of the current period financial statements intended to be read only in relationship to the current period figures; and (b) Comparative Financial Statements where amounts and other disclosures for the preceding period are included for comparison with the financial statements of the current period, but do not form part of the current period financial statements. 4. Comparatives are presented in compliance with the relevant financial reporting framework. The essential audit reporting differences are that: (a) for corresponding figures, the auditor’s report only refers to the financial statements of the current period; whereas (b) for comparative financial statements, the auditor’s report refers to each period that financial statements are presented. 5. This AAS establishes standard on the auditor’s responsibilities for comparatives and for reporting on them under the 'corresponding figures' framework. This AAS does not establish standards on the auditor's responsibilities when the 'comparative financial statements' framework is used for presentation of comparative financial information. It is recognised that such framework for presentation of comparative financial information is not widely prevalent in India. Appendix I to this AAS discusses these different reporting frameworks. Auditor’s Responsibilities 6. The auditor should obtain sufficient appropriate audit evidence that the corresponding figures meet the requirements of the relevant financial reporting framework. The extent of audit procedures performed on the corresponding figures is significantly less than that for the audit of the current period figures and is ordinarily limited to ensuring that the corresponding figures have been correctly reported and are appropriately classified. This involves the auditor assessing whether: (a) accounting policies used for the corresponding figures are consistent with those of the current period or whether appropriate adjustments and/or disclosures have been made; and (b) corresponding figures agree with the amounts and other disclosures presented in the prior period or whether appropriate adjustments and/or disclosures have been made. 7. When the financial statements of the prior period have been audited by another auditor, the incoming auditor should assess whether the corresponding figures meet the conditions specified in paragraph 6 above. The auditor should also comply with the requirements of Auditing and Assurance Standard (AAS) 22, "Initial Engagements-Opening Balances". 8. When the financial statements of the prior period have not been audited, the incoming auditor nonetheless should assess whether the corresponding figures meet the conditions

Part I : Auditing and Assurance Standards

I.127

specified in paragraph 6 above. The auditor should also comply with the requirements of Auditing and Assurance Standard (AAS) 22, "Initial Engagements-Opening Balances". 9. If the auditor becomes aware of a possible material misstatement in the corresponding figures when performing the current period audit, the auditor should perform such additional procedures as are appropriate in the circumstances. Reporting 10. When the comparatives are presented as corresponding figures, the auditor's report should not specifically identify comparatives because the auditor’s opinion is on the current period financial statements as a whole, including the corresponding figures. However, the auditor’s report would make specific reference to the corresponding figures in the circumstances described in paragraphs 11, 12, 14(b), 15 and 16. 11. When the auditor’s report on the prior period, as previously issued, included a qualified opinion, disclaimer of opinion, or adverse opinion and the matter which gave rise to the modification in the audit report29 is: (a) unresolved, and results in a modification of the auditor’s report regarding the current period figures, the auditor’s report should also be modified regarding the corresponding figures; or (b) unresolved, but does not result in a modification of the auditor’s report regarding the current period figures, the auditor’s report should be modified regarding the corresponding figures. Illustrative audit reports for situations discussed above are given in Appendix II to this AAS. 12. When the auditor’s report on the prior period, as previously issued, included a qualified opinion, disclaimer of opinion, or adverse opinion and the matter which gave rise to the modification is resolved and properly dealt with in the financial statements, the current report does not ordinarily refer to the previous modification. However, if the matter is material to the current period, the auditor may include an emphasis of matter paragraph dealing with the situation. 13. In performing the audit of the current period financial statements, the auditor, in certain unusual circumstances, may become aware of a material misstatement that affects the prior period financial statements on which an unmodified report has been previously issued. 14. In such circumstances, the auditor should examine that: 29

Auditing and Assurance Standard (AAS) 28, ''Auditor's Report on Financial Statements'', deals with the concept of modified audit report''. An auditor's report is considered to be modified when it includes. Matters that do not affect the auditor's opinion (a) emphasis of matter Matters that do affect the auditor's opinion (a) qualified opinion, (b) disclaimer of opinion, or (c) adverse opinion.

I.128

Advanced Auditing & Professional Ethics

(a) appropriate disclosures have been made; or (b) if appropriate disclosures have not been made, the auditor should issue a modified report on the current period financials modified with respect to the corresponding figures included therein. 15. If, in the circumstances described in paragraph 13, appropriate disclosures have been made in the current period financial statements, the auditor may include an emphasis of matter paragraph describing the circumstances and referencing to the appropriate disclosures. Appropriate disclosures could be in the form of proforma comparative information being presented in the notes to the financial statements. Proforma comparative information would help the reader of the financial statements to clearly perceive the effect of misstatement on the corresponding figures. Incoming Auditor-Additional Requirements Prior Period Financial Statements Not Audited 16. When the prior period financial statements are not audited, the incoming auditor should state in the auditor’s report that the corresponding figures are unaudited. Such a statement does not, however, relieve the auditor of the requirement to perform appropriate procedures regarding opening balances of the current period. Disclosure in the financial statements that the corresponding figures are unaudited is encouraged. Effective Date 17. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after April 1, 2003. Compatibility With International Standard On Auditing (ISA) 710 Comparative Financial Statements Framework This Auditing and Assurance Standard does not establish standards on the auditor's responsibilities when the 'comparative financial statements' framework is used for presentation of comparative financial information. This is a material departure from the standards set out in ISA 710 "Comparatives". It is recognised that such framework for presentation of comparative financial information is not widely prevalent in India. Incoming Auditor—Additional Requirements ISA 710 requires that in situations where the incoming auditor identifies that the corresponding figures are materially misstated, the auditor should request management to revise the corresponding figures or if management refuses to do so, the auditor appropriately modifies the audit report. This requirement of ISA does not find a place in AAS 25 in view of the current legal position prevailing in the Country under which the auditor is not expected to request the management to revise the corresponding figures. ISA 710 recognises that in some reporting frameworks the incoming auditor is permitted to refer to the predecessor auditor’s report on the corresponding figures in the incoming auditor’s

Part I : Auditing and Assurance Standards

I.129

report for the current period. According to the ISA, when the auditor decides to refer to another auditor, the incoming auditor’s report should indicate: (a) that the financial statements of the prior period were audited by another auditor; (b) the type of report issued by the predecessor auditor and, if the report was modified, the reasons therefor; and (c) the date of that report. In India, the incoming auditor is not permitted to refer to the predecessor auditor's report on the corresponding figures in his audit report. Therefore, this requirement of ISA has not been made part of AAS 25. The other auditing standards established in this AAS are generally consistent in all material respects with those set out in ISA 710 “Comparatives”. Appendix I Discussion of Financial Reporting Frameworks for Comparatives 1.

Comparatives covering one or more preceding periods provide the users of financial statements with information necessary to identify trends and changes affecting an entity over a period of time.

2.

Under financial reporting frameworks (both implicit and explicit), comparability and consistency are desirable qualities for financial information. Defined in broadest terms, comparability is the quality of having certain characteristics in common and comparison is normally a quantitative assessment of the common characteristics. Consistency is a quality of the relationship between two accounting numbers. Consistency (for example, consistency in the use of accounting principles from one period to another, the consistency of the length of the reporting period, etc.) is a prerequisite for true comparability.

3.

There are two broad financial reporting frameworks for comparatives: the corresponding figures and the comparative financial statements.

4.

Under the corresponding figures framework, the corresponding figures for the prior period(s) are an integral part of the current period financial statements and have to be read in conjunction with the amounts and other disclosures relating to the current period. The level of detail presented in the corresponding amounts and disclosures is dictated primarily by its relevance to the current period figures.

5.

Under the comparative financial statements framework, the comparative financial statements for the prior period(s) are considered separate financial statements. Accordingly, the level of information included in those comparative financial statements (including all statement amounts, disclosures, footnotes and other explanatory statements to the extent that they continue to be of significance) approximates that of the financial statements of the current period.

I.130

Advanced Auditing & Professional Ethics Appendix II Illustrative Auditor's Report

Illustration 1.

Illustrative Audit Report for the circumstances described in paragraph 11(a). (Prepared under the reporting framework of Section 227 of the Companies Act, 1956)

Auditor's Report to the Members of ………………(name of the Company) 1.

We have audited the attached Balance Sheet of……………….(name of the Company), as at 31st March, 20X1 and also the Profit and Loss Account for the year ended on that date annexed thereto30. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

2.

We conducted our audit in accordance with auditing standards generally accepted in India. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

3.

As required by the Manufacturing and Other Companies (Auditor's Report) Order, 1988 issued by the Central Government of India in terms of sub-section (4A) of section 227 of the Companies Act, 1956, we enclose in the Annexure31 a statement on the matters specified in paragraphs 4 and 5 of the said Order.

4.

Further to our comments in the Annexure referred to above, we report that: (i)

We have obtained all the information and explanations, which to the best of our knowledge and belief were necessary for the purposes of our audit;

(ii)

In our opinion, proper books of account as required by law have been kept by the company so far as appears from our examination of those books (and proper returns adequate for the purposes of our audit have been received from the branches not visited by us. The Branch Auditor’s Report(s) have been forwarded to us and have been appropriately dealt with);

(iii) The Balance Sheet and Profit and Loss Account dealt with by this report are in agreement with the books of account (and with the audited returns from the branches);

30

Refer footnote 1 of AAS 28, ''The Auditor's Report on Financial Statements''. Alternatively, instead of giving the comments on Manufacturing and Other Companies (Auditor's Report), Order, 1988 in an Annexure, the comments may be contained in the body of the main report. Members' attention in this regard is invited to the Statement on Manufacturing and Other Companies (Auditor's Report) Order, 1988 [Issued under Section 227(4A) the Companies Act, 1956], issued by the Institute of Chartered Accountants of India. 31

Part I : Auditing and Assurance Standards

I.131

(iv) On the basis of written representations received from the directors, as on 31st March, 20X1, and taken on record by the Board of Directors, we report that none of the directors is disqualified as on 31st March 20X1 from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Companies Act, 1956; (v) As discussed in Note YY of Schedule ZZ to the financial statements, no depreciation has been provided in the financial statements which practice, in our opinion, is not in accordance with Accounting Standard 6 on Depreciation issued by the Institute of Chartered Accountants of India. This is the result of a decision taken by management at the start of the preceding financial year and caused us to qualify our audit opinion on the financial statements relating to that year. Based on the straight-line method of depreciation and annual rates of 5% for the building and 20% for the equipment, the loss for the period ended 31st March 20X1 should be increased by Rs.XXXX and the loss for the previous period ended 31st March 20X0 should be increased by Rs.XXXX. The fixed assets as at 31st March 20X1 should be reduced by accumulated depreciation of Rs.XXXX and the fixed assets for the previous period ended 31st March 20X0 should be reduced by accumulated depreciation of Rs.XXXX. The accumulated loss should be increased by Rs.XXXX for the period ended 31st March 20X1 and by Rs.XXXX for the previous period ended 31st March 20X0. (vi) Except for non-provision of depreciation referred to in the preceding paragraph, in our opinion, the Balance Sheet and Profit and Loss Account comply with the accounting standards referred to in sub-section (3C) of section 211 of the Companies Act, 1956. 5. In our opinion, and to the best of our information and according to the explanations given to us, except for the effect on the financial statements of non-provision of depreciation referred to in paragraph 4(vi) foregoing, the said financial statements, read together with the other notes thereon give the information required by the Companies Act, 1956 in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India: (a) in the case of the Balance Sheet, of the state of affairs of the Company, as at 31st March 20X1, and (b) in the case of the Profit and Loss Account, of the loss for the year ended on that date. For ABC and Co. Chartered Accountants Signature (Name of the Member Signing the Audit Report) (Designation32) 32

Partner or Proprietor, as the case may be.

I.132

Advanced Auditing & Professional Ethics Address: Date:

Illustration 2 :

Illustrative report for the circumstances described in paragraph 11(b). (prepared under the reporting framework of Section 227 of the Companies Act, 1956)

Auditor's Report to the Members of ………………(name of the Company) 1.

We have audited the attached Balance Sheet of……………….(name of the Company), as at 31st March, 20X1 and also the Profit and Loss Account for the year ended on that date annexed thereto. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.

2.

We conducted our audit in accordance with auditing standards generally accepted in India. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

3.

As required by the Manufacturing and Other Companies (Auditor's Report) Order, 1988 issued by the Central Government of India in terms of sub-section (4A) of section 227 of the Companies Act, 1956, we enclose in the Annexure33 a statement on the matters specified in paragraphs 4 and 5 of the said Order.

4.

Further to our comments in the Annexure referred to above, we report that: (i)

We have obtained all the information and explanations, which to the best of our knowledge and belief were necessary for the purposes of our audit;

(ii)

In our opinion, proper books of account as required by law have been kept by the company so far as appears from our examination of those books (and proper returns adequate for the purposes of our audit have been received from the branches not visited by us. The Branch Auditor’s Report(s) have been forwarded to us and have been appropriately dealt with);

(iii) The Balance Sheet and Profit and Loss Account dealt with by this report are in agreement with the books of account (and with the audited returns from the branches);

33

Alternatively, instead of giving the comments on Manufacturing and Other Companies (Auditor's Report) Order, 1988 in an Annexure, the comments may be contained in the body of the main report. Members' attention in this regard is invited do the Statement on Manufacturing and Other Companies (Auditor's Report) Order, 1988 [Issued under Section 227(4A) of the Companies Act, 1956], issued by the Institute of Chartered Accountants of India.

Part I : Auditing and Assurance Standards

I.133

(iv) It was not possible for us to obtain external confirmations about accounts receivable balances amounting to Rs. XXXXXX as at 31st March 20X0. Owing to the nature of company's records, we were unable to satisfy ourselves about the valuation and existence of accounts receivable and provisioning thereon. Since provisioning on accounts receivable enter into the determination of the results of operations and the balances are included in determination of state of affairs, we were unable to determine the effect of valuation and provisioning on the financial statements for the period ended 31st March 20X0. Our audit report on the financial statements for the period ended 31st March 20X0 was modified accordingly. (v) In our opinion, the Balance Sheet and Profit and Loss Account dealt with by this report comply with the accounting standards referred to in sub-section (3C) of section 211 of the Companies Act, 1956; (vi) On the basis of written representations received from the directors, as on 31st March 20X1, and taken on record by the Board of Directors, we report that none of the directors is disqualified as on 31st March 20X1 from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Companies Act, 1956; 5.

In our opinion, and to the best of our information and according to the explanations given to us, except for the effect on the corresponding figures for period ended 31st March 20X0 of the adjustments, if any, to the results of operations for the ended 31st March 20X0 and to the state of affairs as on that date, which we might have determined to be necessary had we been able to obtain external confirmations about accounts receivable balances amounting to Rs. XXXXXX as at 31st March 20X0, the said financial statements, read together with the other notes thereon give the information required by the Companies Act, 1956 in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India: (a) in the case of the Balance Sheet, of the state of affairs of the Company, as at 31 March, 20X1, and (b) in the case of the Profit and Loss Account, of the loss for the year ended on that date. For ABC and Co. Chartered Accountants Signature (Name of the Member Signing the Audit Report) (Designation34) Address: Date:

34

Partner or Proprietor, as the case may be.

I.134

Advanced Auditing & Professional Ethics TERMS OF AUDIT ENGAGEMENT (AAS 26)

Introduction 1.

The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on: (a) agreeing the terms of the engagement with the client; and (b) the auditor's response to a request by a client to change the terms of an engagement to one that provides a lower level of assurance35.

2. The auditor and the client should agree on the terms of the engagement. The agreed terms would need to be recorded in an audit engagement letter or other suitable form of contract. 3. This AAS is intended to assist the auditor in the preparation of engagement letters relating to audits of financial statements. The Standard is also applicable to related services. When other services such as tax, accounting, or management consultancy and other services36 are to be provided, separate letters may be appropriate. 4. Though the objective and scope of an audit and the auditor's obligations are, normally, laid down in the applicable statute or regulations and the pronouncements of the Institute of Chartered Accountants of India, the audit engagement letters would be informative for the clients. Audit Engagement Letters 5. In the interest of both client and auditor, the auditor should send an engagement letter, preferably before the commencement of the engagement, to help avoid any misunderstandings with respect to the engagement. The engagement letter documents and confirms the auditor's acceptance of the appointment, the objective and scope of the audit and the extent of the auditor's responsibilities to the client. Principal Contents 6. The form and content of audit engagement letter may vary for each client, but it would generally include reference to:

•

The objective of the audit of financial statements.

•

Management’s responsibility for the financial statements.

•

Management's responsibility for selection and consistent application of appropriate accounting policies, including implementation of the applicable accounting standards alongwith proper explanation relating to material departures from those accounting standards.

35

Refer to Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services for the meaning of the term ''assurance'' and the type of engagements that provide a lower level of assurance than an audit. 36 Code of Ethics issued by the Institute of Chartered Accountants of India defines the term ''management consultancy and other services''.

Part I : Auditing and Assurance Standards

I.135

•

Management’s responsibility for preparation of the financial statements on a going concern basis.

•

Management’s responsibility for making judgements and estimates that are reasonable and prudent so as to give a true and fair view of the state of affairs of the entity at the end of the financial year and of the profit or loss of the entity for that period.

•

Management's responsibility for the maintenance of adequate accounting records and internal controls for safeguarding the assets of the company and for preventing and detecting fraud or other irregularities.

•

The scope of the audit, including reference to the applicable legislation, regulations, and the pronouncements of the Institute of Chartered Accountants of India.

•

The fact that having regard to the test nature of an audit, persuasive rather than conclusive nature of audit evidence together with inherent limitations of any accounting and internal control system, there is an unavoidable risk that even some material misstatements, resulting from fraud, and to a lesser extent error, if either exists, may remain undetected.

•

Unrestricted access to whatever records, documentation and other information requested in connection with the audit.

•

The fact that the audit process may be subjected to a peer review under the Chartered Accountants Act, 1949.

7.

The auditor may also include the following matters in the engagement letter:

•

Arrangements regarding the planning of the audit.

•

Expectation of receiving from management representations made in connection with the audit.

•

Request for the client to confirm the terms of the engagement by acknowledging receipt of the engagement letter.

•

Description of any other letters or reports the auditor expects to issue to the client.

•

Basis on which fees are computed and any billing arrangements.

8.

When relevant, the following points could also be included in the engagement letter:

•

Arrangements concerning the involvement of other auditors and experts in some aspects of the audit.

•

Arrangements concerning the involvement of internal auditors and other staff of the client.

•

Arrangements to be made with the predecessor auditor, if any, in the case of an initial audit, i.e., when the financial statements for the preceding period were audited by another auditor.

•

Any restriction of the auditor's liability when such possibility exists.

written

confirmation

concerning

I.136

•

Advanced Auditing & Professional Ethics A reference to any further agreements between the auditor and the client.

An example of an engagement letter for audit under a statute is set out in the Appendix37. Audit of Components 9. When the auditor of a parent entity is also the auditor of its subsidiary, branch or division (component), the factors that influence the decision whether to send a separate engagement letter to the component include:

•

Who appoints the auditor of the component.

•

Whether a separate audit report is to be issued on the component.

•

Legal requirements.

•

The extent of any work performed by other auditors.

•

Degree of ownership by parent.

•

Degree of independence of the management of the component.

Recurring Audits 10. On recurring audits, the auditor should consider whether circumstances require the terms of the engagement to be revised and whether there is a need to remind the client of the existing terms of the engagement. 11. The auditor may decide not to send a new engagement letter each period. However, the following factors may make it appropriate to send a new letter:

•

Any indication that the client misunderstands the objective and scope of the audit.

•

Any revised or special terms of the engagement.

•

A recent change of senior management, board of directors or ownership.

•

A significant change in nature or size of the client's business.

•

Legal requirements or pronouncements of the Institute of Chartered Accountants of India, or changes in the existing ones.

Acceptance of a Change in Engagement 12. An auditor who, before the completion of the engagement, is requested to change the engagement to one which provides a lower level of assurance, should consider the appropriateness of doing so. 13. A request from the client for the auditor to change the engagement may result from a change in circumstances affecting the need for the service, a misunderstanding as to the nature of an audit or related service originally requested or a restriction on the scope of the 37

The formats of the engagement letters to be issued in case of compilation, review or agreed upon procedures are given in the Guidance Note on Member's Duties regarding Engagements involving Compilation of Financial Statements. Guidance Note on Engagements to Review Financial Statements and Guidance Note on Engagements to Perform Agreed upon Procedures, respectively.

Part I : Auditing and Assurance Standards

I.137

engagement, whether imposed by management or caused by circumstances. The auditor would consider carefully the reason given for the request, particularly the implications of a restriction on the scope of the engagement. 14. A change in circumstances that affects the entity's requirements or a misunderstanding concerning the nature of service originally requested would ordinarily be considered a reasonable basis for requesting a change in the engagement. In contrast, a change would not be considered reasonable if it appears that the change relates to information that is incorrect, incomplete or otherwise unsatisfactory. 15. Before agreeing to change an audit engagement to a related service, an auditor who was engaged to perform an audit in accordance with AASs would consider, in addition to the above matters, any legal or contractual implications of the change. 16. If the auditor concludes that there is reasonable justification to change the engagement and if the audit work performed complies with the AASs applicable to the changed engagement, the report issued would be that appropriate for the revised terms of engagement. In order to avoid confusion, the report would not include reference to: (a) the original engagement; or (b) any procedures that may have been performed in the original engagement, except where the engagement is changed to an engagement to undertake agreed-upon procedures and thus reference to the procedures performed is a normal part of the report. 17. Where the terms of the engagement are changed, the auditor and the client should agree on the new terms. 18. The auditor should not agree to a change of engagement where there is no reasonable justification for doing so. An example might be an audit engagement where the auditor is unable to obtain sufficient appropriate audit evidence regarding receivables and the client asks for the engagement to be changed to a review engagement to avoid a qualified, adverse or a disclaimer of opinion. 19. If the auditor is unable to agree to a change of the engagement and is not permitted to continue the original engagement, the auditor should withdraw and consider whether there is any obligation, either contractual or otherwise, to report the circumstances necessitating the withdrawal to other parties, such as the board of directors or shareholders. Effective Date 20. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after 1st April, 2003. Compatibility With International Standard On Auditing (ISA) 210 The auditing standards established in this AAS are generally consistent in all material respects with those set out in ISA 210 “Terms of Audit Engagements".

I.138

Advanced Auditing & Professional Ethics Appendix Example Of An Engagement Letter For An Audit Under A Statute38 {The following letter is for use as a guide in conjunction with the considerations outlined in this AAS and will need to be varied according to individual requirements and circumstances relevant to the engagement. This Appendix does not form part of the Standard.}

To the Board of Directors (or the appropriate representative of senior management). You have requested that we audit the balance sheet of (Name of the Company) as at 31st March, 2XXX and the related profit and loss account and the (cash flow statement)39 for the year ended on that date. We are pleased to confirm our acceptance and our understanding of this engagement by means of this letter. Our audit will be conducted with the objective of our expressing an opinion on the financial statements. We will conduct our audit in accordance with the auditing standards generally accepted in India and with the requirements of the Companies Act, 1956. Those Standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatements. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. However, having regard to the test nature of an audit, persuasive rather than conclusive nature of audit evidence together with inherent limitations of any accounting and internal control system, there is an unavoidable risk that even some material misstatements of financial statements, resulting from fraud, and to a lesser extent error, if either exists, may remain undetected. In addition to our report on the financial statements, we expect to provide you with a separate letter concerning any material weaknesses in accounting and internal control systems which might come to our notice. The responsibility for the preparation of financial statements on a going concern basis is that of the management. The management is also responsible for selection and consistent application of appropriate accounting policies, including implementation of applicable accounting standards along with proper explanation relating to any material departures from those accounting standards. The management is also responsible for making judgements and estimates that are reasonable and prudent so as to give a true and fair view of the state of affairs of the entity at the end of the financial year and of the profit or loss of the entity for that period. The responsibility of the management also includes the maintenance of adequate accounting records and internal controls for safeguarding of the assets of the company and for the preventing and detecting fraud or other irregularities. As part of our audit process, we will 38 39

In this Illustration, the Companies Act, 1956. Only in cases where relevant.

Part I : Auditing and Assurance Standards

I.139

request from management written confirmation concerning representations made to us in connection with the audit. We also wish to invite your attention to the fact that our audit process is subject to 'peer review' under the Chartered Accountants Act, 1949. The reviewer may examine our working papers during the course of the peer review. We look forward to full cooperation with your staff and we trust that they will make available to us whatever records; documentation and other information are requested in connection with our audit. Our fees will be billed as the work progresses. This letter will be effective for future years unless it is terminated, amended or superseded. Please sign and return the attached copy of this letter to indicate that it is in accordance with your understanding of the arrangements for our audit of the financial statements. XYZ & Co. Chartered Accountants ………………………… (Signature) (Name of the Member) (Designation40) Acknowledged on behalf of ABC Company by …………………….. (Signature) Name and Designation Date COMMUNICATIONS OF AUDIT MATTERS WITH THOSE CHARGED WITH GOVERNANCE (AAS 27) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on communications of audit matters arising from the audit of financial statements between the auditor and those charged with governance of an entity. These communications relate to audit matters of governance interest as defined in this AAS. This AAS does not provide guidance on communications by the auditor to parties outside the entity, for example, external regulatory or supervisory agencies.

40

Partner or proprietor, as the case may be

I.140

Advanced Auditing & Professional Ethics

2. The auditor should communicate audit matters of governance interest arising from the audit of financial statement with those charged with governance of an entity. 3. For the purpose of this AAS, the term “governance” is used to describe the role of persons entrusted with the supervision, control and direction of an entity. Those charged with governance are, ordinarily, accountable for ensuring that the entity achieves its objectives, financial reporting, and reporting to interested parties. Those charged with governance include management only when it performs such functions. 4. For the purpose of this AAS, “audit matters of governance interest” are those matters that arise from the audit of financial statements and are, in the opinion of the auditor, both important and relevant to those charged with governance in overseeing the financial reporting and disclosure process. Audit matters of governance interest include only those matters that have come to the attention of the auditor as a result of the performance of the audit. The auditor is not required, in an audit in accordance with auditing standards generally accepted in India41, to design procedures for the specific purpose of identifying matters of governance interest. Relevant Persons 5. The auditor should determine the relevant persons who are charged with governance and with whom audit matters of governance interest are to be communicated. 6. The structure of governance may vary from entity to entity, depending upon size and legal constitution. For example, in case of companies, the Board of Directors and the committees constituted under the Board like the audit committee, ethics committee; in case of trusts, societies etc., the board of trustees or the management committee, etc. 7. The auditor uses judgement to determine those persons with whom audit matters of governance interest are communicated, taking into account, the governance structure of the entity, the circumstances of the engagement and relevant legislation, if any. The auditor also considers the legal responsibilities of those persons. The auditor also considers the importance and sensitivity of the audit matters of governance interest to be communicated. For example, in case of a company where the board of directors has established an audit committee under it, the auditor may decide to communicate with the audit committee, or with the whole board, depending on the importance of the audit matters of governance interest. 8. When the entity’s governance structure is not well defined, or those charged with governance are not clearly identified by the circumstances of the engagement, or by legislation, the auditor comes to an agreement with the entity about with whom the audit matters of governance interest are to be communicated. Examples include some owner-managed entities, not for profit organisations, government agencies, etc. 9. To avoid misunderstandings, an audit engagement letter42 may explain that the auditor will communicate only those matters of governance interest that come to attention as a result of the 41

Paragraph 15 of AAS 28. ''The Auditor's Report on Financial Statement'' describes auditing standards generally accepted in India. 42 Refer Auditing and Assurance Standard (AAS) 26, ''Terms of Audit Engagement'', issued by the Council of the Institute of Chartered Accountants of India.

Part I : Auditing and Assurance Standards

I.141

performance of an audit and that the auditor is not required to design procedures for the specific purpose of identifying matters of governance interest. The engagement letter may also: ♦

Describe the form in which any communication on audit matters of governance interest will be made;

♦

Identify the relevant persons with whom such communications will be made;

♦

Identify any specific audit matters of governance interest which it has been agreed are to be communicated.

10. The effectiveness of communications is enhanced by developing a constructive working relationship between the auditor and those charged with governance. This relationship is developed while maintaining an attitude of professional independence and objectivity. Audit Matters of Governance Interest to be Communicated 11. The auditor should consider audit matters of governance interest that arise from the audit of financial statements and communicate them with those charged with governance. Such matters may include: ♦

The general approach and overall scope of the audit, including any expected limitations thereon, or any additional requirements;

♦

The selection of or changes in, significant accounting policies and practices that have, or could have, a material effect on the entity’s financial statements;

♦

The potential effect on the financial statements of any significant risks and exposures, such as pending litigation, that are required to be disclosed in the financial statements;

♦

Adjustments to financial statements arising out of audit that have, or could have, a significant effect on the entity’s financial statements;

♦

Material uncertainties related to events and conditions that may cast significant doubt on the entity’s ability to continue as a going concern;

♦

Disagreements with management about matters that, individually or in aggregate, could be significant to the entity’s financial statements or the auditor’s report. These communications include consideration of whether the matter has, or has not, been resolved and the significance of the matter;

♦

Expected modifications to the auditor’s report;

♦

Other matters warranting attention by those charged with governance, such as material weaknesses in internal control, questions regarding management integrity, and fraud involving management;

♦

Any other matters agreed upon in the terms of the audit engagement.

12. As part of the auditor’s communications, those charged with governance are informed that: ♦

The auditor’s communications of matters include only those audit matters of governance interest that have come to the attention of the auditor as a result of the performance of the audit;

I.142 ♦

Advanced Auditing & Professional Ethics An audit of financial statements is not designed to identify all matters that may be relevant to those charged with governance. Accordingly, the audit does not ordinarily identify all such matters.

13. The auditor should communicate audit matters of governance interest on a timely basis. This enables those charged with governance to take appropriate action. 14. In order to achieve timely communications, the auditor discusses with those charged with governance the basis and timing of such communications. In certain cases, because of the nature of the matter, the auditor may communicate that matter sooner than previously agreed. Forms of Communication 15. The auditor’s communication with those charged with governance may be made orally or in writing. The auditor’s decision whether to communicate orally or in writing is affected by factors such as: ♦

The size, operating structure, legal structure, and communications processes of the entity being audited;

♦

The nature, sensitivity and significance of the audit matters of governance interest to be communicated;

♦

The arrangements made with respect to periodic meetings or reporting of audit matters of governance interest;

♦

The amount of on-going contact and dialogue the auditor has with those charged with governance.

16. When audit matters of governance interest are communicated orally, the auditor should document in the working papers the matters communicated and any responses to those matters. This document may take the form of minutes of the auditor’s discussion with those charged with governance. In certain circumstances, depending on the nature, sensitivity, and significance of the matter, it may be advisable for the auditor to confirm in writing with those charged with governance any oral communication on audit matters of governance interest. 17. Ordinarily, the auditor initially discusses audit matters of governance interest with management, except those matters relating to questions related to management’s competence or integrity. In case of matters relating to questions related to management’s competence or integrity, the auditor discusses the audit matters with those charged with governance. These initial discussions with management are important in order to clarify facts and issues, and to give management an opportunity to provide further information. If management agrees to communicate a matter of governance interest with those charged with governance, the auditor may not need to repeat the communications, provided that the auditor is satisfied that such communications have effectively and appropriately been made.

Part I : Auditing and Assurance Standards

I.143

Other Matters 18. If the auditor considers that having regard to the facts and circumstances of the case a modification43 of the auditor’s report on financial statements is required, as described in AAS 28, “The Auditor’s Report on Financial Statements”, communications between the auditor and those charged with governance cannot be regarded as a substitute. 19. The auditor considers whether audit matters of governance interest previously communicated may have an effect on the current year’s financial statements. The auditor considers whether the point continues to be a matter of governance interest and whether to communicate the matter again with those charged with governance. Confidentiality 20. The requirements of professional pronouncements, legislation or regulation may impose obligations of confidentiality that restrict the auditor’s communications of audit matters of governance interest. The auditor refers to such requirements before communicating with those charged with governance. In some circumstances, the potential conflicts with the auditor’s ethical and legal obligations of confidentiality and reporting may be complex. In these cases, the auditor may wish to consult a legal counsel. Laws and Regulations 21. The requirements of professional pronouncements, legislation or regulation may impose obligation on the auditor to make communications on governance related matters. For example,the requirements of regulators, such as report under Section 619 (3) of the Companies Act, 1956, in case of Public Sector Undertakings and Long Form Audit Report in the case of Public Sector Banks, may impose obligation on the auditor to make communications on governance related matters. These additional communication requirements are not covered by this AAS; however, they may affect the content, form and timing of communications with those charged with governance. Effective Date 22. This Auditing and Assurance Standard is effective for all audits relating to accounting periods beginning on or after 1st April, 2003. Compatibility With International Standard On Auditing (ISA) 260 The auditing standards established in this AAS are generally consistent in all material respects with those set out in ISA 260 “Communications of Audit Matters with Those Charged with Governance”. THE AUDITOR’S REPORT ON FINANCIAL STATEMENTS (AAS 28) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the form and content of the auditor’s report issued as a result of an audit performed by an

43

Paragraph 31 of AAS 28, ''The Auditor's Report on financial Statements'' deals with the concept of ''modified audit report''.

I.144

Advanced Auditing & Professional Ethics

auditor of the financial statements of an entity. Much of the standards laid down by this AAS can be adapted to auditor’s reports on financial information other than financial statements. 2. The auditor should review and assess the conclusions drawn from the audit evidence obtained as the basis for the expression of an opinion on the financial statements. 3. This review and assessment involves considering whether the financial statements have been prepared in accordance with an acceptable financial reporting framework applicable to the entity under audit. It is also necessary to consider whether the financial statements comply with the relevant statutory requirements. 4. The auditor’s report should contain a clear written expression of opinion on the financial statements taken as a whole. Basic Elements of the Auditor’s Report 5. The auditor’s report includes the following basic elements, ordinarily, in the following layout: (a) Title; (b) Addressee; (c) Opening or introductory paragraph (i)

identification of the financial statements audited;

(ii)

a statement of the responsibility of the entity’s management and the responsibility of the auditor;

(d) Scope paragraph (describing the nature of an audit) (i)

a reference to the auditing standards generally accepted in India;

(ii)

a description of the work performed by the auditor;

(e) Opinion paragraph containing

(f)

(i)

a reference to the financial reporting framework used to prepare the financial statements; and

(ii)

an expression of opinion on the financial statements;

Date of the report;

(g) Place of signature; and (h) Auditor’s signature. A measure of uniformity in the form and content of the auditor’s report is desirable because it helps to promote the reader’s understanding of the auditor’s report and to identify unusual circumstances when they occur. 6. A statute governing the entity or a regulator may require the auditor to include certain matters in the audit report or prescribe the form in which the auditor should issue his report. In such a case, the auditor should incorporate in his audit report, the matters specified by the

Part I : Auditing and Assurance Standards

I.145

statute or regulator and/or report in the form prescribed by them in addition to the requirements of this AAS. Title 7. The auditor’s report should have an appropriate title. It may be appropriate to use the term “Auditor’s Report” in the title to distinguish the auditor’s report from reports that might be issued by others, such as by the officers of the entity, the board of directors, or from the reports of others. Addressee 8. The auditor’s report should be appropriately addressed as required by the circumstances of the engagement and applicable laws and regulations. Ordinarily, the auditor’s report is addressed to the authority appointing the auditor. Opening or Introductory Paragraph 9. The auditor’s report should identify the financial statements44 of the entity that have been audited, including the date of and period covered by the financial statements. 10. The report should include a statement that the financial statements are the responsibility of the entity’s management and a statement that the responsibility of the auditor is to express an opinion on the financial statements based on the audit. 11. Financial statements are the representations of management. The preparation of such statements requires management to make significant accounting estimates and judgments, as well as to determine the appropriate accounting principles and methods used in preparation of the financial statements. This determination will be made in the context of the financial reporting framework that management chooses, or is required to use. In contrast, the auditor’s responsibility is to audit these financial statements in order to express an opinion thereon. 12. An illustration of these matters in an opening (introductory) paragraph is: “We have audited the attached Balance Sheet of ………. (Name of the entity) as at 31st March 2XXX and also the Profit and Loss Account for the year ended on that date annexed thereto. These financial statements are the responsibility of the entity’s 44

The Council of the Institute has made Accounting Standard (AS) 3, Cash Flow Statements, mandatory for certain entities in respect of accounting periods commencing on or after 1.4.2001. Further, the Council has also decided that AS 3 should also be treated as a ''specified'' accounting standard for the purpose of section 211 of the Companies Act, 1956 thereby making the Cash Flow Statements a part of the Balance Sheet and Profit and Loss Account. However irrespective of the fact that the case flow statement is considered to be a part of the Balance Sheet and Profit and Loss Account, the opening or the introductory paragraph of the auditor's report on financial statements of such companies and other entities for which As 3 has been made mandatory, would also identify the Cash Flow Statement as a part of the financial statements audited apart from the Balance Sheet and Profit and Loss Account. Similar reporting considerations would also apply to the entities which, though not required to comply with AS 3 in view of its not being mandatory for them, voluntarily prepare the case flow statements. Further, in the above mentioned cases, the auditor's report on financial statements would also contain an expression of opinion on the true and fair view of the cash flows for the period under audit (refer to Appendix for an illustrative auditor's report on the financial statements in the case of a company for which AS 3 has been made mandatory).

I.146

Advanced Auditing & Professional Ethics

management. Our responsibility is to express an opinion on these financial statements based on our audit.” Scope Paragraph 13. The auditor’s report should describe the scope of the audit by stating that the audit was conducted in accordance with auditing standards generally accepted in India. The reader needs this as an assurance that the audit has been carried out in accordance with established standards. 14. “Scope” refers to the auditor’s ability to perform audit procedures deemed necessary in the circumstances. Auditing and Assurance Standard (AAS) 2, “Objective and Scope of the Audit of Financial Statements”, with regard to the determination of the “scope” states (paragraph 5): “The scope of an audit of financial statements will be determined by the auditor having regard to the terms of the engagement, the requirements of relevant legislation and the pronouncements of the Institute. The terms of engagement cannot, however, restrict the scope of an audit in relation to matters which are prescribed by legislation or by the pronouncements of the Institute.” 15. The Auditing and Assurance Standards issued by the Institute of Chartered Accountants of India establish the auditing standards generally accepted in India. 16. The report should include a statement that the audit was planned and performed to obtain reasonable assurance whether the financial statements are free of material misstatement. 17. The auditor’s report should describe the audit as including: (a) examining, on a test basis, evidence to support the amounts and disclosures in financial statements; (b) assessing the accounting principles used in the preparation of the financial statements; (c) assessing the significant estimates made by management in the preparation of the financial statements; and (d) evaluating the overall financial statement presentation. 18. The report should include a statement by the auditor that the audit provides a reasonable basis for his opinion. 19. An illustration of these matters in a scope paragraph is: “We conducted our audit in accordance with the auditing standards generally accepted in India. Those Standards require that we plan and perform the audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial

Part I : Auditing and Assurance Standards

I.147

statement presentation. We believe that our audit provides a reasonable basis for our opinion.” Opinion Paragraph 20. The opinion paragraph of the auditor’s report should clearly indicate the financial reporting framework used to prepare the financial statements and state the auditor’s opinion as to whether the financial statements give a true and fair view in accordance with that financial reporting framework and, where appropriate, whether the financial statements comply with the statutory requirements. 21. The term used to express the auditor’s opinion, “give a true and fair view”, indicates, amongst other things, that the auditor considers only those matters that are material to the financial statements. 22. Paragraph 3 of Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services, issued by the Institute of Chartered Accountants of India, discusses the financial reporting framework. The paragraph reads as under: “Financial Reporting Framework Financial statements are ordinarily prepared and presented annually and are directed towards the common information needs of a wide range of users. Many of those users rely on financial statements as their major source of information because they do not have the power to obtain additional information to meet their specific information needs. Thus, financial statements need to be prepared in accordance with one, or a combination of: (a) relevant statutory requirements, e.g., the Companies Act, 1956, for companies; (b) accounting standards issued by the Institute of Chartered Accountants of India; and (c) other recognised accounting principles and practices, e.g., those recommended in the Guidance Notes issued by the Institute of Chartered Accountants of India.” 23. An illustration of these matters in an opinion paragraph is: “In our opinion and to the best of our information and according to the explanations given to us, the financial statements give a true and fair view in conformity with the accounting principles generally accepted in India: (a) in the case of the Balance Sheet, of the state of affairs of the ………… (name of the entity) as at 31st March 2XXX; and (b) in the case of the Profit and Loss Account, of the profit/loss for the year ended on that date.” 24. In addition to an opinion on the true and fair view, the auditor’s report may need to include an opinion as to whether the financial statements comply with other requirements specified by relevant statutes or law. For example, in the case of companies incorporated under the Companies Act, 1956, section 227(2) of the said Act requires that the auditor’s report should state in his audit report, whether in the auditor’s opinion and to the best of his

I.148

Advanced Auditing & Professional Ethics

information and according to the explanations given to the auditor, the financial statements give the information required by the Companies Act, 1956 in the manner so required45. Date of Report 25. The date of an auditor’s report on the financial statements is the date on which the auditor signs the report expressing an opinion on the financial statements. The date of report informs the reader that the auditor has considered the effect on the financial statements and on the report of the events and transactions of which the auditor became aware and that occurred up to that date. 26. Since the auditor’s responsibility is to report on the financial statements as prepared and presented by management, the auditor should not date the report earlier than the date on which the financial statements are signed or approved by management. Place of Signature 27. The report should name specific location, which is ordinarily the city where the audit report is signed. Auditor’s Signature 28. The report should be signed by the auditor in his personal name. Where the firm is appointed as the auditor, the report should be signed in the personal name of the auditor and in the name of the audit firm. The partner/proprietor signing the audit report should also mention the membership number assigned by the Institute of Chartered Accountants of India. The Auditor’s Report 29. An unqualified opinion should be expressed when the auditor concludes that the financial statements give a true and fair view in accordance with the financial reporting framework used for the preparation and presentation of the financial statements. An unqualified opinion indicates, implicitly, that any changes in the accounting principles or in the method of their application, and the effects thereof, have been properly determined and disclosed in the financial statements. An unqualified opinion also indicates that: (a) the financial statements have been prepared using the generally accepted accounting principles, which have been consistently applied; (b) the financial statements comply with relevant statutory requirements and regulations; and (c) there is adequate disclosure of all material matters relevant to the proper presentation of the financial information, subject to statutory requirements, where applicable. 30. The following is an illustration of a complete auditor’s report incorporating the basic elements set forth and illustrated above. This report illustrates the expression of an unqualified opinion.

45 Refer to Appendix for an illustration of the opinion paragraph in the case of a company incorporated under the Companies Act, 1956. Also refer footnote 1 for applicability of AS 3 to an entity and the auditor's duties and responsibilities in this regard.

Part I : Auditing and Assurance Standards

I.149

Auditor’s Report (Appropriate Addressee) We have audited the attached Balance Sheet of ..…... (Name of the entity) as at 31st March 2XXX and also the Profit and Loss Account for the year ended on that date annexed thereto46. These financial statements are the responsibility of the entity’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in India. Those Standards require that we plan and perform the audit to obtain reasonable assurance whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion and to the best of our information and according to the explanations given to us, the financial statements give a true and fair view in conformity with the accounting principles generally accepted in India47 (a) in the case of the Balance Sheet, of the state of affairs of ……….. (Name of the entity) as at 31st March 2XXX; and (b) in the case of the Profit and Loss Account, of the profit/loss for the year ended on that date. For ABC and Co., Chartered Accountants Auditor’s Signature (Name of Member signing the Audit Report) (Designation48) (Membership Number) Place of Signature Date An illustration of auditor’s report on the financial statements in the case of a company incorporated under the Companies Act, 1956 to which AS 3 is applicable is given in the Appendix.

46

Refer to footnote 1. ibid. 48 Partner or proprietor, as the case may be. 47

I.150

Advanced Auditing & Professional Ethics

Modified Reports49 31. An auditor’s report is considered to be modified when it includes: (a) Matters That Do Not Affect the Auditor’s Opinion ♦

emphasis of matter

(b) Matters That Do Affect the Auditor’s Opinion ♦

qualified opinion

♦

disclaimer of opinion

♦

adverse opinion

Uniformity in the form and content of each type of modified report will enhance the user’s understanding of such reports. Accordingly, this AAS includes suggested wordings to express an unqualified opinion as well as examples of modifying phrases for use when issuing modified reports. Matters That Do Not Affect the Auditor’s Opinion 32. In certain circumstances, an auditor’s report may be modified by adding an emphasis of matter paragraph to highlight a matter affecting the financial statements which is included in a note to the financial statements that more extensively discusses the matter. The addition of such an emphasis of matter paragraph does not affect the auditor’s opinion. The paragraph would preferably be included preceding the opinion paragraph and would ordinarily refer to the fact that the auditor’s opinion is not qualified in this respect. 33. The auditor should modify the auditor’s report by adding a paragraph to highlight a material matter regarding a going concern problem where the going concern question is not resolved and adequate disclosures have been made in the financial statements. 34. The auditor should consider modifying the auditor’s report by adding a paragraph if there is a significant uncertainty (other than going concern problem), the resolution of which is dependent upon future events and which may affect the financial statements. An uncertainty is a matter whose outcome depends on future actions or events not under the direct control of the entity but that may affect the financial statements. 35. An illustration of an emphasis of matter paragraph for a significant uncertainty in an auditor’s report is as follows: “Without qualifying our opinion, we draw attention to Note X of Schedule …… to the financial statements. The entity is the defendant in a lawsuit alleging infringement of certain patent rights and claiming royalties and punitive damages. The entity has filed a counter action, and preliminary hearings and discovery proceedings on both actions are in progress. The ultimate outcome of the matter cannot presently be determined, and no provision for any liability that may result has been made in the financial statements.

49

This AAS lays down the basic principles that, govern the auditor's report on financial statements. The reporting requirements contained in other AASs issued by the Council of the Institute would also be applicable.

Part I : Auditing and Assurance Standards

I.151

In our opinion ……….. (remaining words are the same as illustrated in the opinion paragraph — paragraph 30 above). “ (An illustration of an emphasis of matter paragraph relating to going concern is set out in AAS 16, “Going Concern.”) 36. The addition of a paragraph emphasising a going concern problem or significant uncertainty is ordinarily adequate to meet the auditor’s reporting responsibilities regarding such matters. However, in extreme cases, such as situations involving multiple uncertainties that are significant to the financial statements, the auditor may consider it appropriate to express a disclaimer of opinion instead of adding an emphasis of matter paragraph. Matters that Do Affect the Auditor’s Opinion 37. An auditor may not be able to express an unqualified opinion when either of the following circumstances exists and, in the auditor’s judgment, the effect of the matter is or may be material to the financial statements: (a) there is a limitation on the scope of the auditor’s work; or (b) there is a disagreement with management regarding the acceptability of the accounting policies selected, the method of their application or the adequacy of financial statement disclosures. The circumstances described in (a) could lead to a qualified opinion or a disclaimer of opinion. The circumstances described in (b) could lead to a qualified opinion or an adverse opinion. These circumstances are discussed in paragraphs 42 - 47. 38. A qualified opinion should be expressed when the auditor concludes that an unqualified opinion cannot be expressed but that the effect of any disagreement with management is not so material and pervasive as to require an adverse opinion, or limitation on scope is not so material and pervasive as to require a disclaimer of opinion. A qualified opinion should be expressed as being ‘subject to’ or ‘except for’ the effects of the matter to which the qualification relates. 39. A disclaimer of opinion should be expressed when the possible effect of a limitation on scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and is, accordingly, unable to express an opinion on the financial statements. 40. An adverse opinion should be expressed when the effect of a disagreement is so material and pervasive to the financial statements that the auditor concludes that a qualification of the report is not adequate to disclose the misleading or incomplete nature of the financial statements. 41. Whenever the auditor expresses an opinion that is other than unqualified, a clear description of all the substantive reasons should be included in the report and, unless impracticable, a quantification of the possible effect(s), individually and in aggregate, on the financial statements should be mentioned in the auditor’s report. In circumstances where it is not practicable to quantify the effect of modifications made in the audit report accurately, the auditor may do so on the basis of estimates made by the management after carrying out such

I.152

Advanced Auditing & Professional Ethics

audit tests as are possible and clearly indicate the fact that the figures are based on management estimates. Ordinarily, this information would be set out in a separate paragraph preceding the opinion or disclaimer of opinion and may include a reference to a more extensive discussion, if any, in a note to the financial statements. Circumstances That May Result In Other Than An Unqualified Opinion Limitation on Scope 42. A limitation on the scope of the auditor’s work may sometimes be imposed by the entity, for example, when the terms of the engagement specify that the auditor will not carry out an audit procedure that the auditor believes is necessary. However, when the limitation in the terms of a proposed engagement is such that the auditor believes the need to express a disclaimer of opinion exists; the auditor should ordinarily not accept such a limited engagement as an audit engagement, unless required by statute. Also, a statutory auditor should not accept such an audit engagement when the limitation infringes on the auditor’s statutory duties. 43. A scope limitation may be imposed by circumstances, for example, when the timing of the auditor’s appointment is such that the auditor is unable to observe the counting of physical inventories. It may also arise when, in the opinion of the auditor, the entity’s accounting records are inadequate or when the auditor is unable to carry out an audit procedure believed to be desirable. In these circumstances, the auditor would attempt to carry out reasonable alternative procedures to obtain sufficient appropriate audit evidence to support an unqualified opinion. 44. When there is a limitation on the scope of the auditor’s work that requires expression of a qualified opinion or a disclaimer of opinion, the auditor’s report should describe the limitation and indicate the possible adjustments to the financial statements that might have been determined to be necessary had the limitation not existed. 45. Illustrations of these matters are set out below : Limitation on Scope — Qualified Opinion “We have audited .……….. (remaining words are the same as illustrated in the introductory paragraph —paragraph 30 above). Except as discussed in the following paragraph, we conducted our audit in accordance with .………. (remaining words are the same as illustrated in the scope paragraph — paragraph 30 above). We did not observe the counting of the physical inventories as at 31st March 2XXX since that date was prior to the time we were appointed as auditors of ………….(Name of the entity). Owing to the nature of the entity’s records, we were unable to satisfy ourselves as to inventory quantities by other audit procedures. In our opinion and to the best of our information and according to the explanations given to us, subject to the effects of such adjustments, if any, as might have been determined to be necessary had we been able to satisfy ourselves as to physical inventory

Part I : Auditing and Assurance Standards

I.153

quantities, the financial statements give a …………. (remaining words are the same as illustrated in the opinion paragraph —paragraph 30 above).” Limitation on Scope — Disclaimer of Opinion “We were engaged to audit the attached Balance Sheet of ………..(Name of the entity) as at 31st March 2XXX and also the Profit and Loss Account for the year ended on that date annexed thereto. These financial statements are the responsibility of the entity’s management. (Omit the sentence stating the responsibility of the auditor). (The paragraph discussing the scope of the audit would either be omitted or amended according to the circumstances.) (Add a paragraph discussing the scope limitation as follows:) We were not able to observe all physical inventories and confirm accounts receivable due to limitations placed on the scope of our work by the entity. Because of the significance of the matters discussed in the preceding paragraph, we do not express an opinion on the financial statements. “ Disagreement with Management 46. The auditor may disagree with management about matters such as the acceptability of accounting policies selected, the method of their application, or the adequacy of disclosures in the financial statements. If such disagreements are material to the financial statements, the auditor should express a qualified or an adverse opinion. 47. Illustrations of these matters are set out below: Disagreement on Accounting Policies-Inappropriate Accounting Method—Qualified Opinion “We have audited ……... (remaining words are the same as illustrated in the introductory paragraph — paragraph 30 above). We conducted our audit in accordance with .………. (remaining words are the same as illustrated in the scope paragraph—paragraph 30 above). As stated in Note X of Schedule ……. to the financial statements, no depreciation has been provided for the period in the financial statements. This is contrary to Accounting Standard (AS) 6 on “Depreciation Accounting”, issued by the Institute of Chartered Accountants of India and the accounting policy being followed by the entity according to which depreciation is provided on straight line basis. Had this accounting policy been followed, the provision for depreciation for the period would have been Rs............. This short provisioning for depreciation has resulted into the profit for the year, fixed assets and reserves and surplus being overstated by Rs………. Or As stated in Note X of Schedule …….. to the financial statements, hire purchase sales have been treated as outright sales by the entity and contrary to accepted accounting practice, the entire profit thereon has been taken into account. The profit relating to

I.154

Advanced Auditing & Professional Ethics installment not due as at the date of the Balance Sheet and included in profit for the year amounted to Rs…….. This has resulted in the profit for the year, inventories and reserve and surplus being overstated by Rs …… In our opinion and to the best of our information and according to the explanations given to us, subject to the effect on the financial statements of the matter referred to in the preceding paragraph, the financial statements give a true and ... (remaining words are the same as illustrated in the opinion paragraph-paragraph 30 above).” Disagreement on Accounting Policies—Inadequate Disclosure-Qualified Opinion “We have audited .……. (remaining words are the same as illustrated in the introductory paragraph — paragraph 30 above). We conducted our audit in accordance with ……..... (remaining words are the same as illustrated in the scope paragraph—paragraph 30 above). On 15th January 2XXX, the ……….. (Name of the entity) issued debentures in the amount of Rs.XXX for the purpose of financing plant expansion. The debentures agreement restricts the payment of future cash dividends to earnings after 31st March 2XXX. In our opinion, disclosure of this information is required by ............ In our opinion and to the best of our information and according to the explanations given to us, subject to the omission of the information included in the preceding paragraph, the financial statements give a true and ………. (remaining words are the same as illustrated in the opinion paragraph, paragraph 30 above).” Disagreement on Accounting Policies - Inadequate Disclosure - Adverse Opinion “We have audited the attached Balance Sheet of ………. (Name of the entity), as at 31st March 2XXX, and also the Profit and Loss Account for the year ended on that date annexed thereto50. These financial statements are the responsibility of the entity’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with ..........51 (remaining words are the same as illustrated in the scope paragraph—paragraph 30 above). (Paragraph(s) discussing the disagreement). In our opinion and to the best of our information and according to the explanations given to us, because of the effects of the matters discussed in the preceding paragraph(s), the financial statements do not give a true and fair view in conformity with the accounting principles generally accepted in India: (a) in the case of the Balance Sheet, of the state of affairs of the company as at 31st March 2XXX; and

50 51

Refer to footnote 3. ibid.

Part I : Auditing and Assurance Standards

I.155

(b) in the case of the Profit and Loss Account, of the profit/loss for the year ended on that date. Effective Date 48. This Auditing and Assurance Standard becomes operative for all audits relating to accounting periods beginning on or after 1st April 2003. Earlier application of the AAS is encouraged. Compatibility With The International Standard On Auditing (ISA) 700 The auditing standards established in this Auditing and Assurance Standard are generally consistent in all material respects with those set out in the International Standard on Auditing (ISA) 700, The Auditor’s Report on Financial Statements, except the following: (a) Due to the practices prevailing in India, the AAS requires the auditor to mention the “Place of Signature” instead of the “Auditor’s Address” in the auditors report. The place of signature is the name of specific location, which is ordinarily the city where the audit report is signed [see paragraph 27]. According to ISA 700, the expression “Auditor’s Address” means the name of a specific location, which is ordinarily the city where the auditor maintains the office that has the responsibility for the audit. (b) The AAS requires the auditor to mention the membership number assigned by the Institute of Chartered Accountants of India [see paragraph 28]. ISA 700, however, does not contain any corresponding requirement. (c) The AAS requires that whenever the auditor expresses an opinion that is other than unqualified, a clear description of all the substantive reasons should be included in the report and, unless impracticable, a quantification of the possible effect(s), individually and in aggregate, on the financial statements should be mentioned in the auditor’s report [see paragraph 41]. ISA 700 does not require the auditor to quantify the possible effect(s) in aggregate on the financial statements. Appendix Illustrative Auditor’s Report on the Financial Statements in the Case of a Company Incorporated Under the Companies Act, 1956 to which AS 3 is applicable52 [see paragraph 30] Auditor’s Report The Members of ………………(name of the Company)53 We have audited the attached Balance Sheet of ………………. (name of the company), as at 31st March 2XXX, and also the Profit and Loss Account and the cash flow statement for the 52

In case AS 3 is not applicable to a company and such company also does not voluntarily prepare the cash flow statement, the reference to cash flow statement should be deleted from the entire report. 53 Reference may also be made to the Statement on Qualifications in Auditor's Report and the Guidance Note on Section 227(3)(e) and (f) of the Companies Act, 1956 issued by the Council of the institute of Chartered Accountants of India.

I.156

Advanced Auditing & Professional Ethics

year ended on that date annexed thereto. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the auditing standards generally accepted in India. Those Standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. As required by the Manufacturing and Other Companies (Auditor’s Report) Order, 1988 issued by the Central Government of India in terms of sub-section (4A) of section 227 of the Companies Act, 1956, we enclose in the Annexure54 a statement on the matters specified in paragraphs 4 and 5 of the said Order. Further to our comments in the Annexure referred to above, we report that: (i)

We have obtained all the information and explanations, which to the best of our knowledge and belief were necessary for the purposes of our audit;

(ii)

In our opinion, proper books of account as required by law have been kept by the company so far as appears from our examination of those books (and proper returns adequate for the purposes of our audit have been received from the branches not visited by us. The Branch Auditor’s Report(s) have been forwarded to us and have been appropriately dealt with)55;

(iii) The Balance Sheet, Profit and Loss Account and cash flow statement dealt with by this report are in agreement with the books of account (and with the audited returns from the branches)56; (iv) In our opinion, the Balance Sheet, Profit and Loss Account and cash flow statement dealt with by this report comply with the accounting standards referred to in sub-section (3C) of section 211 of the Companies Act, 1956; (v) On the basis of written representations received from the directors, as on 31st March 2XXX and taken on record by the Board of Directors, we report that none of the directors is disqualified as on 31st March 2XXX from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Companies Act, 1956; (vi) In our opinion and to the best of our information and according to the explanations given 54

Alternatively, instead of giving the comments on Manufacturing and Other Companies (Auditor's Report) Order, 1988 in an Annexure, the comments may be contained in the body of the main report. Members attention in this regard is invited to the Statement on Manufacturing and Other Companies (Auditor's Report) Order, 1988 [Issued under Section 227(4A) of the Companies Act, 1956], issued by the Institute of Chartered Accountants of India. It may also be noted that requirements of the Manufacturing and Other Companies (Auditor's Report) Order, 1988 have not been reproduced in this illustration. 55 Wherever applicable. 56 ibid.

Part I : Auditing and Assurance Standards

I.157

to us, the said accounts give the information required by the Companies Act, 1956, in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India57: (a) in the case of the Balance Sheet, of the state of affairs of the company as at 31st March 2XXX; (b) in the case of the Profit and Loss Account, of the profit / loss 58 for the year ended on that date; and (c) in the case of the cash flow statement, of the cash flows for the year ended on that date. For ABC and Co. Chartered Accountants Signature (Name of the Member Signing the Audit Report) (Designation59) Membership Number Place of Signature Date

AUDITING IN A COMPUTER INFORMATION SYSTEMS ENVIRONMENT (AAS 29) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on procedures to be followed when an audit is conducted in a computer information systems (CIS) environment. For the purposes of this AAS, a CIS environment exists when one or more computer(s) of any type or size is (are) involved in the processing of financial information, including quantitative data, of significance to the audit, whether those computers are operated by the entity or by a third party. 2. The overall objective and scope of an audit does not change in a CIS environment. However, the use of a computer changes the processing, storage, retrieval and communication of financial information and may affect the accounting and internal control systems employed by the entity. Accordingly, a CIS environment may affect: ♦

57

the procedures followed by the auditor in obtaining a sufficient understanding of the accounting and internal control system.

ibid. Whichever is applicable. 59 Partner or Proprietor, as the case may be. 58

I.158

Advanced Auditing & Professional Ethics

♦

the auditor’s evaluation of inherent risk and control risk through which the auditor assesses the audit risk.

♦

the auditor’s design and performance of tests of control and substantive procedures appropriate to meet the audit objective.

3. The auditor should consider the effect of a CIS environment on the audit. The auditor should evaluate, inter alia, the following factors to determine the effect of CIS environment on the audit: (a) the extent to which the CIS environment is used to record, compile and analyse accounting information; (b) the system of internal control in existence in the entity with regard to: (i)

flow of authorised, correct and complete data to the processing center;

(ii)

processing, analysis and reporting tasks undertaken in the installation; and

(c) the impact of computer-based accounting system on the audit trail that could otherwise be expected to exist in an entirely manual system. Skills and Competence 4. The auditor should have sufficient knowledge of the computer information systems to plan, direct, supervise, control and review the work performed. The sufficiency of knowledge would depend on the nature and extent of the CIS environment. The auditor should consider whether any specialised CIS skills are needed in the conduct of the audit. Specialised skills may be needed, inter alia, to – ♦

obtain sufficient understanding of the effect of the CIS environment on accounting and internal control systems;

♦

determine the effect of the CIS environment on the assessment of overall audit risk and of risk at the account balance and class of transactions level; and

♦

design and perform appropriate tests of control and substantive procedures.

If specialised skills are needed, the auditor would seek the assistance of an expert possessing such skills, who may either be the auditor’s staff or an outside professional. If the use of such a professional is planned, the auditor should, in accordance with AAS 9, “Using the Work of an Expert”, obtain sufficient appropriate audit evidence that the work performed by the expert is adequate for the purposes of the audit. Planning 5. In accordance with the Auditing and Assurance Standard (AAS) 6, “Risk Assessments and Internal Control”, the auditor should obtain an understanding of the accounting and internal control systems sufficient to plan the audit and to determine the nature, timing and extent of the audit procedures. Such an understanding would help the auditor to develop an effective audit approach. 6. In planning the portions of the audit which may be affected by the CIS environment, the auditor should obtain an understanding of the significance and complexity of the CIS activities

Part I : Auditing and Assurance Standards

I.159

and the availability of the data for use in the audit. This understanding would include such matters as: (a) the computer information systems infrastructure [hardware, operating system(s), etc., and application software(s) used by the entity, including changes therein since last audit if any]. (b) the significance and complexity of computerised processing in each significant accounting application. Significance relates to materiality of the financial statement assertions affected by the computerised processing. An application may be considered to be complex when, for example: ♦

the volume of transactions is such that users would find it difficult to identify and correct errors in processing.

♦

the computer automatically generates material transactions or entries directly to another application.

♦

the computer performs complicated computations of financial information and/or automatically generates material transactions or entries that cannot be (or are not) validated independently.

♦

transactions are exchanged electronically with other organisations [as in electronic data interchange (EDI) systems] without manual review for propriety or reasonableness.

(c) determination of the organisational structure of the client’s CIS activities and the extent of concentration or distribution of computer processing throughout the entity, particularly, as they may affect segregation of duties. (d) determination of the availability of data. Source documents, computer files, and other evidential matter that may be required by the auditor may exist for only a short period or only in machine-readable form. Computer information systems may generate reports that might be useful in performing substantive tests (particularly analytical procedures). The potential for use of computer-assisted audit techniques may permit increased efficiency in the performance of audit procedures, or may enable the auditor to economically apply certain procedures to the entire population of accounts or transactions. 7. When the computer information systems are significant, the auditor should also obtain an understanding of the CIS environment and whether it may influence the assessment of inherent and control risks. The nature of the risks and the internal control characteristics in CIS environments include the following: ♦

Lack of transaction trails: Some computer information systems are designed so that a complete transaction trail that is useful for audit purposes might exist for only a short period of time or only in computer readable form. Where a complex application system performs a large number of processing steps, there may not be a complete trail. Accordingly, errors embedded in an application’s program logic may be difficult to detect on a timely basis by manual (user) procedures.

I.160

Advanced Auditing & Professional Ethics

♦

Uniform processing of transactions: Computer processing uniformly processes like transactions with the same processing instructions. Thus, the clerical errors ordinarily associated with manual processing are virtually eliminated. Conversely, programming errors (or other systemic errors in hardware or software) will ordinarily result in all transactions being processed incorrectly.

♦

Lack of segregation of functions: Many control procedures that would ordinarily be performed by separate individuals in manual systems may become concentrated in a CIS environment. Thus, an individual who has access to computer programs, processing or data may be in a position to perform incompatible functions.

♦

Potential for errors and irregularities: The potential for human error in the development, maintenance and execution of computer information systems may be greater than in manual systems, partially because of the level of detail inherent in these activities. Also, the potential for individuals to gain unauthorised access to data or to alter data without visible evidence may be greater in CIS than in manual systems.

In addition, decreased human involvement in handling transactions processed by computer information systems can reduce the potential for observing errors and irregularities. Errors or irregularities occurring during the design or modification of application programs or systems software can remain undetected for long periods of time. ♦

Initiation or execution of transactions: Computer information systems may include the capability to initiate or cause the execution of certain types of transactions, automatically. The authorisation of these transactions or procedures may not be documented in the same way as that in a manual system, and management’s authorisation of these transactions may be implicit in its acceptance of the design of the computer information systems and subsequent modification.

♦

Dependence of other controls over computer processing: Computer processing may produce reports and other output that are used in performing manual control procedures. The effectiveness of these manual control procedures can be dependent on the effectiveness of controls over the completeness and accuracy of computer processing. In turn, the effectiveness and consistent operation of transaction processing controls in computer applications is often dependent on the effectiveness of general computer information systems controls.

♦

Potential for increased management supervision: Computer information systems can offer management a variety of analytical tools that may be used to review and supervise the operations of the entity. The availability of these analytical tools, if used, may serve to enhance the entire internal control structure.

♦

Potential for the use of computer-assisted audit techniques: The case of processing and analysing large quantities of data using computers may require the auditor to apply general or specialised computer audit techniques and tools in the execution of audit tests.

Part I : Auditing and Assurance Standards

I.161

Both the risks and the controls introduced as a result of these characteristics of computer information systems have a potential impact on the auditor’s assessment of risk, and the nature, timing and extent of audit procedures. 8. While evaluating the reliability of the accounting and internal control systems, the auditor would consider whether these systems, inter alia: (a) ensure that authorised, correct and complete data is made available for processing; (b) provide for timely detection and correction of errors; (c) ensure that in case of interruption in the working of the CIS environment due to power, mechanical or processing failures, the system restarts without distorting the completion of the entries and records; (d) ensure the accuracy and completeness of output; (e) provide adequate data security against fire and other calamities, wrong processing, frauds etc.; (f)

prevent unauthorised amendments to the programs; and

(g) provide for safe custody of source code of application software and data files. Assessment of Risk 9. The auditor should make an assessment of inherent and control risks for material financial statement assertions, in accordance with AAS 6, “Risk Assessments and Internal Control”. 10. The inherent risks and control risks in a CIS environment may have both a pervasive effect and an account-specific effect on the likelihood of material misstatements, as follows: ♦

The risks may result from deficiencies in pervasive CIS activities such as program development and maintenance, system software support, operations, physical CIS security, and control over access to special-privilege utility programs. These deficiencies would tend to have a pervasive impact on all application systems that are processed on the computer.

♦

The risks may increase the potential for errors or fraudulent activities in specific applications, in specific databases or master files, or in specific processing activities. For example, errors are not uncommon in systems that perform complex logic or calculations, or that must deal with many different exception conditions. Systems that control cash disbursements or other liquid assets are susceptible to fraudulent actions by users or by CIS personnel.

11. As new CIS technologies emerge for data processing, they are frequently employed by clients to build increasingly complex computer systems that may include micro-to-mainframe links, distributed data bases, end-user processing, and business management systems that feed information directly into the accounting systems. Such systems increase the overall sophistication of computer information systems and the complexity of the specific applications that they affect. As a result, they may increase risk and require further consideration.

I.162

Advanced Auditing & Professional Ethics

Audit Procedures 12. In accordance with AAS 6, “Risk Assessments and Internal Control”, the auditor should consider the CIS environment in designing audit procedures to reduce audit risk to an acceptably low level. He should make enquiries and particularly satisfy himself whether: (a) adequate procedures exist to ensure that the data transmitted is correct and complete; and (b) cross-verification of records, reconciliation statements and control systems between primary and subsidiary ledgers do exist and are operative and that accuracy of computer compiled records are not assumed. 13. The auditor’s specific audit objectives do not change whether accounting data is processed manually or by computer. However, the methods of applying audit procedures to gather evidence may be influenced by the methods of computer processing. The auditor can use manual audit procedures, or computer-assisted audit techniques, or a combination of both to obtain sufficient evidential matter. However, in some accounting systems that use a computer for processing significant applications, it may be difficult or impossible for the auditor to obtain certain data for inspection, inquiry, or confirmation without computer assistance. Documentation 14. The auditor should document the audit plan, the nature, timing and extent of audit procedures performed and the conclusions drawn from the evidence obtained. In an audit in CIS environment, some of the audit evidence may be in the electronic form. The auditor should satisfy himself that such evidence is adequately and safely stored and is retrievable in its entirety as and when required. Effective Date 15. This Auditing and Assurance Standard (AAS) becomes operative for all audits related to accounting periods beginning on or after 1st April, 2003. Compatibility With International Standard On Auditing (ISA) 401 The auditing standards established in this Auditing and Assurance Standard are generally consistent in all material respects with those set out in International Standard on Auditing (ISA) 401 on Auditing in a Computer Information Systems Environment except for the additional requirement related to “Documentation” [see paragraph 14]. ISA 401 does not contain any requirement related to documentation. EXTERNAL CONFIRMATIONS (AAS 30) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor's use of external confirmations as a means of obtaining audit evidence. 2. The auditor should determine whether the use of external confirmations is necessary to obtain sufficient appropriate audit evidence to support certain financial statement assertions.

Part I : Auditing and Assurance Standards

I.163

In making this determination, the auditor should consider materiality, the assessed level of inherent and control risk, and how the evidence from other planned audit procedures will reduce audit risk to an acceptably low level for the applicable financial statement assertions. The auditor should employ external confirmation procedures in consultation with the management. 3. Auditing and Assurance Standard (AAS) 5, “Audit Evidence” states that the reliability of audit evidence is influenced by its source and nature. It indicates that, in general, audit evidence from external sources is more reliable than audit evidence generated internally, and that written (documentary) audit evidence is more reliable than audit evidence in oral form. Accordingly, audit evidence in the form of written responses to confirmation requests received directly by the auditor from third parties who are not related to the entity being audited, when considered individually or cumulatively with audit evidence from other procedures, may assist in reducing audit risk for the related financial statement assertions to an acceptably low level. 4. External confirmation is the process of obtaining and evaluating audit evidence through a direct communication from a third party in response to a request for information about a particular item affecting assertions made by management in the financial statements. In deciding to what extent to use external confirmations, the auditor considers the characteristics of the environment in which the entity being audited operates and the practice of potential respondents in dealing with requests for direct confirmation. 5.

The process of external confirmations, ordinarily, consists of the following:

♦

Selecting the items for which confirmations are needed.

♦

Designing the form of the confirmation request.

♦

Communicating the confirmation request to the appropriate third party.

♦

Obtaining response from the third party.

♦

Evaluating the information or absence thereof.

6. External confirmations are frequently used in relation to account balances and their components, but need not be restricted to these items. For example, the auditor may request external confirmation of the terms of agreements or transactions an entity has with third parties. The confirmation request is designed to ask if any modifications have been made to the agreement, and if so, the relevant details thereof. Other examples of situations where external confirmations may be used include the following: ♦

Bank balances and other information from bankers.

♦

Accounts receivable balances.

♦

Stocks held by third parties.

♦

Property title deeds held by third parties.

♦

Investments purchased but delivery not taken.

♦

Loans from lenders.

I.164

Advanced Auditing & Professional Ethics

♦

Accounts payable balances.

♦

Long outstanding share application money.

7. The reliability of the evidence obtained by external confirmations depends, among other factors, upon the application of appropriate procedures by the auditor in designing the external confirmation request, performing the external confirmation procedures, and evaluating the results of the external confirmation procedures. Factors affecting the reliability of confirmations include the control which the auditor exercises over confirmation requests and responses, the characteristics of the respondents, and any restrictions included in the response or imposed by management. Relationship of External Confirmation Procedures to the Auditor's Assessments of Inherent Risk and Control Risk 8. Auditing and Assurance Standard (AAS) 6 (Revised), "Risk Assessments and Internal Control" discusses audit risk and the relationship between its components: inherent risk, control risk, and detection risk. It outlines the process of assessing inherent and control risk to determine the nature, timing, and extent of substantive procedures to reduce detection risk, and therefore, audit risk, to an acceptable level. 9. AAS 6 (Revised) also indicates that the nature and extent of evidence to be obtained from the performance of substantive procedures varies depending on the assessment of inherent and control risks, and that the assessed levels of inherent and control risk cannot be sufficiently low to eliminate the need to perform any substantive procedures. These substantive procedures may include the use of external confirmations for specific financial statement assertions. 10. Paragraph 48 of AAS 6 (Revised) indicates that the higher the assessment of inherent and control risk, the more audit evidence the auditor needs to obtain from the performance of substantive procedures. Consequently, as the assessed level of inherent and control risk increases, the auditor designs substantive procedures to obtain more evidence, or more persuasive evidence, about a financial statement assertion. In these situations, the use of confirmation procedures may be effective in providing sufficient appropriate audit evidence. 11. The auditor should assess whether the evidence provided by the confirmations reduces audit risks for the related assertions to an acceptably low level. In making that assessment, the auditor should consider the materiality of the account balance and the auditor’s assessment of the inherent and control risk. If the auditor concludes that the evidence provided by the confirmations alone is not sufficient, he should perform additional procedures. 12. The lower the assessed level of inherent and control risk, the less assurance the auditor needs from substantive procedures to form a conclusion about a financial statement assertion. For example, an entity may have a loan that it is repaying according to an agreed repayment schedule, the terms of which the auditor has confirmed in previous years. If the other work carried out by the auditor (including such tests of controls as are necessary) indicates that the terms of the loan have not changed and has lead to the level of inherent and control risk over the balance of the loan outstanding being assessed as low, the auditor might limit substantive

Part I : Auditing and Assurance Standards

I.165

procedures to testing details of the payments made, rather than again confirming the balance directly with the lender. 13. Unusual or complex transactions may be associated with higher levels of inherent or control risk than simple transactions. If the entity has entered into an unusual or complex transaction and the level of inherent and control risk is assessed as high, the auditor considers confirming the terms of transaction with the other parties in addition to examining documentation held by the entity. Assertions Addressed by External Confirmations 14. AAS 5, “Audit Evidence”, categorises the assertions contained in the financial statements as existence, rights and obligations, occurrence, completeness, valuation, measurement, and presentation and disclosure. While external confirmations may provide audit evidence regarding these assertions, the ability of an external confirmation to provide evidence relevant to a particular financial statement assertion varies. 15. External confirmation of an account receivable provides strong evidence regarding the existence of the account as at a certain date. Confirmation also provides evidence regarding the operation of cut-off procedures. However, such confirmation does not ordinarily provide all the necessary audit evidence relating to the assertion regarding valuation, since it is not practicable to ask the debtor to confirm detailed information relating to its ability to pay the account. 16. Similarly, in the case of goods held on consignment, external confirmation is likely to provide strong evidence to support the assertions related to existence and the rights and obligations, but might not provide evidence that supports the assertions related to valuation. 17. The relevance of external confirmations to auditing a particular financial statement assertion is also affected by the objective of the auditor in selecting information for confirmation. For example, when auditing the assertion regarding the completeness of accounts payable, the auditor also needs to obtain evidence that there is no material unrecorded liability. Accordingly, sending confirmation requests to an entity's principal suppliers, asking them to provide copies of their statements of account directly to the auditor, even if the entity’s records show no amount currently owing to them, will usually be more effective in detecting unrecorded liabilities than selecting accounts for confirmation based on the larger amounts recorded in the accounts payable subsidiary ledger. 18. When obtaining evidence for assertions not adequately addressed by confirmations, the auditor considers other audit procedures to complement confirmation procedures or to be used instead of confirmation procedures. Timing of External Confirmations 19. The auditor may request external confirmations either as at the date of the financial statements or as at any other selected date which is reasonably close to the date of financial statements. The date may be, alternatively, settled by the auditor in consultation with the management. Where the auditor decides to request for confirmations as at date which is other than the date of the financial statements, the auditor would need to examine the movement in

I.166

Advanced Auditing & Professional Ethics

the concerned account(s) that occur between the date of the confirmations and the date of the financial statements. For example, when the auditor uses confirmation as at a date prior to the balance sheet to obtain evidence to support a financial statement assertion, the auditor would obtain sufficient appropriate audit evidence that transactions relevant to the assertions in the intervening period have not been materially misstated. For practical reasons, when the level of inherent and control risk is assessed at less than high, the auditor may decide to confirm balances at a date other than the period end, for example, when the audit is to be completed within a short time after the balance sheet date. As with all types of pre-year-end work, the auditor would consider the need to obtain further audit evidence relating to the remainder of the period also. Design of the External Confirmation Request 20. The auditor should design external confirmation requests to the specific audit objective. When designing the request, the auditor considers the assertions being addressed and the factors that are likely to affect the reliability of the confirmations. Factors such as the form of the external confirmation request, prior experience on the audit or similar engagements, the nature of the information being confirmed, and the intended respondent, affect the design of the requests because these factors have a direct effect on the reliability of the evidence obtained through external confirmation procedures. The other factors which have an effect on the design of an external confirmation request include effectiveness of the internal control system of the entity, apparent possibility of disputes, inaccuracies and irregularities in the accounts, the possibility that the request will receive a consideration and the materiality of the amount involved. Nature of Information Being Confirmed 21. In designing the request, the auditor considers the type of information respondents will be able to confirm readily since this may affect the response rate and the nature of the evidence obtained. For example, certain respondents' accounting systems may facilitate the external confirmation of single transactions rather than of entire account balances. In addition, respondents may not always be able to confirm certain types of information, such as the overall accounts receivable balance, but may be able to confirm individual invoice amounts within the total balance. 22. The auditor’s understanding of the client’s arrangements and transactions with the third parties is important in determining the information to be confirmed. The auditor should obtain an understanding of the substance of such transactions and arrangements to decide about the information to be included in the request for confirmation. The auditor also considers the possibility of oral modifications in the arrangements and transactions and, accordingly, requests the management to provide him the details thereof. 23. Confirmation requests ordinarily include authorization of the entity’s management to the respondent to disclose the information to the auditor. Respondents may be more willing to respond to a confirmation request containing management's authorization, and in some cases may be unable to respond unless the request contains such authorization.

Part I : Auditing and Assurance Standards

I.167

Prior Experience 24. The auditor should consider the information from audits of earlier years. This information would, normally, include the misstatements, inaccuracies or irregularities identified by the auditor or those pointed out by the third parties in the earlier years, the response rate etc. Form of Confirmation Request—Use of Positive and Negative Confirmations 25. The auditor may use positive or negative external confirmation requests or a combination of both. 26. A positive external confirmation request asks the respondent to reply to the auditor in all cases either by indicating the respondent's agreement with the given information, or by asking the respondent to fill in information. The use of a positive confirmation is preferable when individual account balances are large, or where the internal controls are weak, or where the auditor has reasons to believe that there may be a substantial number of accounts in dispute or inaccurate or irregular. A response to a positive confirmation request is ordinarily expected to provide reliable audit evidence. There is a risk, however, that a respondent may reply to the confirmation request without verifying that the information is correct. The auditor is not ordinarily able to detect whether this has occurred. The auditor may reduce this risk, however, by using positive confirmation requests that do not state the amount (or other information) on the confirmation request, but ask the respondent to fill in the amount or furnish other information. On the other hand, use of this type of "blank" confirmation request may result in lower response rates because additional effort is required of the respondents. 27. A negative external confirmation request asks the respondent to reply only in the event of disagreement with the information provided in the request. However, when no response has been received to a negative confirmation request, the auditor remains aware that there will be no explicit evidence that intended third parties have received the confirmation requests and verified that the information contained therein is correct or that the confirmation was sent by the respondent but not received by him. Accordingly, the use of negative confirmation requests ordinarily provides less reliable evidence than the use of positive confirmation requests, and the auditor considers performing other substantive procedures to supplement the use of negative confirmations. 28. Negative confirmation requests may be used to reduce audit risk to an acceptable level when: (a) the assessed level of inherent and control risk is low; (b) a large number of small balances is involved; (c) a substantial number of errors is not expected; and (d) the auditor has no reason to believe that respondents will disregard these requests. 29. A combination of positive and negative external confirmations may be used. For example, where the total accounts receivable balance comprises a small number of large balances and a large number of small balances, the auditor may decide that it is appropriate to confirm all or a sample of the large balances with positive confirmation requests and a sample of the small balances using negative confirmation requests.

I.168

Advanced Auditing & Professional Ethics

Characteristics of Respondents 30. The reliability of evidence provided by a confirmation is affected by the respondent's competence, independence, authority to respond, knowledge of the matter being confirmed, and objectivity. For this reason, the auditor attempts to ensure, where practicable, that the confirmation request is directed to an appropriate individual. For example, when confirming that a covenant related to an entity's long-term debt has been waived, the auditor directs the request to an official of the creditor who has knowledge about the waiver and has the authority to provide the information. 31. The auditor also assesses whether certain parties may not provide an objective or unbiased response to a confirmation request. Information about the respondent's competence, knowledge, motivation, ability or willingness to respond may come to the auditor’s attention. The auditor considers the effect of such information on designing the confirmation request and evaluating the results, including determining whether additional procedures are necessary. The auditor also considers whether there is sufficient basis for concluding that the confirmation request is being sent to a respondent from whom the auditor can expect a response that will provide sufficient appropriate evidence. For example, the auditor may encounter significant unusual year-end transactions that have a material effect on the financial statements, the transactions being with a third party that is economically dependent upon the entity. In such circumstances, the auditor considers whether the third party may be motivated to provide an inaccurate response. The External Confirmation Process 32. When performing confirmation procedures, the auditor should maintain control over the process of selecting those to whom a request will be sent, the preparation and sending of confirmation requests, and the responses to those requests. Maintaining control means maintaining direct communications between the intended recipients and the auditor to minimize the possibility that the results of the confirmation process will be biased because of the interception and alteration of confirmation requests or responses. The auditor may give a list of accounts selected for confirmation to the management for preparing requests for confirmations, which should be properly addressed and stamped, alternatively, the auditor may request the management to furnish duly authorised confirmation letters and fill in the names, addresses and other relevant details relating to the accounts selected by him. The auditor should, however, ensure that it is the auditor who sends out the confirmation requests, that the requests are properly addressed, and that it is requested that all replies and the undelivered confirmations are delivered directly to the auditor. The auditor considers whether replies have come from the purported senders. No Response to a Positive Confirmation Request 33. The auditor should perform alternative procedures where no response is received to a positive external confirmation request. The alternative audit procedures should be such as to provide the evidence about the financial statement assertions that the confirmation request was intended to provide.

Part I : Auditing and Assurance Standards

I.169

34. When using a confirmation request other than a negative confirmation request, the auditor, generally, follows up with a second and sometimes third request to those parties from whom replies have not been received or, alternatively, contact the recipient of the request to elicit a response. Where the auditor is unable to obtain a response, the auditor would need to use alternative audit procedures. The nature of alternative procedures varies according to the account and assertion in question. In the examination of accounts receivable, alternative procedures may include examination of subsequent cash receipts, examination of shipping documentation or other client documentation to provide evidence for the existence assertion, and sales cut-off tests to provide evidence for the assertion related to completeness. In the examination of accounts payable, alternative procedures may include examination of subsequent cash disbursements or correspondence from third parties to provide evidence of the existence assertion, and examination of other records, such as goods received notes, to provide evidence of the assertion regarding completeness. Reliability of Responses Received 35. The auditor should consider whether there is any indication that external confirmations received may not be reliable. The auditor should also consider the authenticity of the response and perform appropriate procedures to dispel any doubts. The auditor may choose to verify the source and contents of a response in a telephone call to the purported sender. In addition, the auditor would also request the purported sender to mail the original confirmation directly to the auditor. With ever-increasing use of technology, the auditor needs to consider validating the source of replies received in electronic format (for example, fax or electronic mail). Oral confirmations should be documented in the work papers. If the information in the oral confirmations or that received though a fax is significant, the auditor requests the parties involved to submit written confirmation of the specific information directly to the auditor since in such cases it is difficult to ascertain the source of the response. Causes and Frequency of Exceptions 36. When the auditor forms a conclusion that the confirmation process and alternative procedures have not provided sufficient appropriate audit evidence regarding an assertion, the auditor should undertake additional procedures to obtain sufficient appropriate audit evidence. In forming the conclusion, the auditor considers the: (a) reliability of the confirmations and alternative procedures; (b) nature of any exceptions, including the implications, both quantitative and qualitative of those exceptions; and (c) evidence provided by other procedures. Based on this evaluation, the auditor would determine whether additional audit procedures are needed to obtain sufficient appropriate audit evidence. 37. Any discrepancies revealed by the external confirmations received or by the additional procedures carried out by the auditor might have a bearing on the assertions and the accounts within the given assertion not selected for external confirmation. The auditor, in such a case, should request the management to verify and reconcile the discrepancies. The auditor should

I.170

Advanced Auditing & Professional Ethics

also consider what further tests can be carried out to satisfy himself as to the correctness of related assertion. 38. The auditor should also consider the causes and frequency of exceptions reported by respondents. An exception might indicate a misstatement in the entity's records, in which case, the auditor determines the reasons for the misstatement and assesses whether it has a material effect on the financial statements. If an exception indicates a misstatement, the auditor would reconsider the nature, timing and extent of audit procedures necessary to provide the evidence required. If the responses received indicate a pattern of misstatements, the auditor should reconsider his assessment of inherent and control risk and also consider the effect on his audit procedures. Evaluating the Results of the Confirmation Process 39. The auditor should evaluate whether the results of the external confirmation process together with the results from any other procedures performed, provide sufficient appropriate audit evidence regarding the financial statement assertion being audited. In conducting this evaluation, the auditor considers the guidance provided by AAS 15, "Audit Sampling”. Management Requests 40. When the auditor seeks to confirm certain balances or other information, and management requests the auditor not to do so, the auditor should consider whether there are valid grounds for such a request and obtain evidence to support the validity of management's requests. The auditor should also ask the management to submit its request in a written form, detailing therein the reasons for such request. The management, for example, might make such a request on the grounds that due to a dispute with the particular debtor, the request for confirmation might aggravate the sensitive negotiations between the entity and the debtor. The auditor, in such a case, would examine any available evidence to support management’s request, say, examining the correspondence between the management and the debtor. If the auditor agrees to management's request not to seek external confirmation regarding a particular matter, the auditor should document the reasons for acceding to the management’s request and should apply alternative procedures to obtain sufficient appropriate evidence regarding that matter. 41. If the auditor does not accept the validity of management's request and is prevented from carrying out the confirmations, there has been a limitation on the scope of the auditor's work and the auditor should consider the possible impact on the auditor's report. The auditor should, however, in this case also, document the request made by the management along with the reasons given by the management therefore as well as his own reasons for not acceding to the management’s request. 42. When considering the reasons provided by management, the auditor would apply professional skepticism and consider whether the request has any implications regarding management's integrity. The auditor would also consider whether management's request might indicate the possible existence of fraud or error. If the auditor believes that fraud or error exists, the auditor would consider the requirements of AAS 4, “The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements". The auditor would also need to

Part I : Auditing and Assurance Standards

I.171

consider whether the alternative procedures will provide sufficient appropriate evidence regarding that matter. Effective Date 43. This Auditing and Assurance Standard is effective for audits related to accounting periods beginning on or after 1st April, 2003. Compatibility With International Standard On Auditing (ISA) 505 The auditing standards established in this AAS are generally consistent in all material respects with the International Standard on Auditing (ISA) 505, “External Confirmations”, except the following: (a) The AAS requires the auditor to obtain an understanding of the substance of transactions and agreement with the third parties to decide about the information to be included in the request for confirmation (see paragraph 22). ISA 505 does not contain any requirements in this regard. (b) The AAS requires the auditor to consider the information from audits of earlier years (see paragraph 24). This requirement is not present in ISA 505. (c) The AAS requires the auditor to request the management to verify and reconcile the discrepancies revealed by the external confirmations received or by the additional procedures carried out by the auditor. The AAS further requires the auditor to consider what further tests can be carried out to satisfy him self as to the correctness of related assertions (see paragraph 37). This requirement is not present in ISA 505. ENGAGEMENTS TO COMPILE FINANCIAL INFORMATION (AAS 31) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on professional responsibilities of an accountant when an engagement to compile financial statements or other financial information is undertaken and the form and content of the report to be issued in connection with such a compilation so that the association of the name of the accountant with such financial statements or financial information is not misconstrued by a user of those statements or information as having been audited by him. 2. This AAS is directed towards the compilation of financial information. However, it should be applied to the extent practicable, to engagements to compile non-financial information, provided the accountant has adequate knowledge of the subject matter in question. Engagements to provide limited assistance to a client in the preparation of financial statements (for example, selection of an appropriate accounting policy), do not constitute an engagement to compile financial statements. This AAS should be read in conjunction with the “ Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services.”

I.172

Advanced Auditing & Professional Ethics

Objective of a Compilation Engagement 3. The objective of a compilation engagement is for an accountant to use accounting expertise, as opposed to auditing expertise, to collect, classify and summarise financial information. This ordinarily entails reducing detailed data to a manageable and understandable form without the requirement to test the assertions underlying that information. The procedures employed are not designed and do not enable the accountant to express any assurance on the financial information. However, users of the compiled financial information derive some benefit as a result of the accountant’s involvement because the service has been performed with professional competence and due care. 4. A compilation engagement would ordinarily include the preparation of financial statements (which may or may not be a complete set of financial statements) but may also include the collection, classification and summarisation of other financial information, for example, preparation of quarterly financial results, restatement of financial statements in accordance with a financial reporting framework other than in accordance with which the financial statements to be restated are already prepared and presented. General Principles of a Compilation Engagement 5. The accountant should comply with the “Code of Ethics” issued by the Institute of Chartered Accountants of India. The ethical principles governing the accountant’s professional responsibilities for this type of engagement are: (a) Integrity; (b) Objectivity; (c) Professional competence and due care; (d) Confidentiality; (e) Professional conduct; and (f)

Technical standards.

Independence is not a requirement for a compilation engagement. However, where the accountant is not independent, a statement to that effect should be made in the accountant’s report. 6. In all circumstances when an accountant’s name is associated with financial information compiled by him, the accountant should issue a report. Responsibility of Management 7. The management is responsible for taking reasonable steps to prevent and detect errors, fraud or other irregularities. This includes: a)

Ensuring that the financial information generated in the entity is correct, complete and reliable;

b)

Maintaining adequate accounting and other records and internal controls and selecting and applying appropriate accounting policies;

Part I : Auditing and Assurance Standards

I.173

c)

Establishing controls designed to safeguard the assets of the entity and also to deter fraudulent or other dishonest conduct and to detect any fraud that occurs;

d)

Establishing controls to provide reasonable assurance that the entity complies with laws and regulations applicable to its activities, or for detecting any non-compliance with laws or regulations that occurs.

8. A compilation engagement cannot be regarded as providing assurance on the adequacy of the client’s internal control systems or on the actual incidence of fraud or non-compliance with laws and regulations. A compilation engagement carried out by the accountant does not relieve the management of these responsibilities. 9. The management is also responsible for preparation and presentation of financial statements or other financial information in accordance with the applicable laws and regulations, if any. The accountant should, accordingly, obtain an acknowledgement from the management of its responsibility for the appropriate preparation and presentation of the financial statements or other information and of its approval of such information to be compiled. The accountant should also obtain an acknowledgement from management of its responsibility for the accuracy and completeness of the underlying accounting data and the complete disclosure of all material and relevant information to the accountant. Defining the Terms of the Engagement 10. An engagement letter will be of assistance in planning the compilation work. The scope of a compilation engagement would, normally, be defined by the instructions of the client, though in certain cases, for example, in case of compilation of financial statements of a company, the form and content of such financial statements might be laid down under a statute. The accountant should, therefore, ensure that there is a clear understanding between the client and the accountant regarding the terms of the engagement by means of an engagement letter or such other suitable form of contract. Thus, it is in the interest of both the accountant and the entity that the accountant sends an engagement letter documenting the key terms of the appointment. An engagement letter confirms the accountant’s acceptance of the engagement and helps avoid misunderstanding regarding matters such as the objective and scope of the engagement and the extent of the auditor’s responsibilities. 11. The engagement letter would include matters such as the following: (a) Nature of the engagement including the fact that neither an audit nor a review will be carried out and that accordingly no assurance will be expressed. (b) Fact that the engagement cannot be relied upon to disclose fraud or defalcations that may exist but that the accountant will bring to the attention of the management any such matter which might come to his attention during the course of his engagement. (c) Nature of the information to be supplied by the client. (d) Fact that management is responsible for: ♦

the accuracy and completeness of the information supplied to the accountant, including maintenance of adequate accounting records and internal controls and selection and application of appropriate accounting policies.

I.174

Advanced Auditing & Professional Ethics

♦

preparation and presentation of the financial statements of the entity, in accordance with the applicable laws and regulations, if any.

♦

safeguarding the assets of the entity and also establishing appropriate controls designed to prevent and detect fraud and other irregularities.

♦

ensuring that the activities of the entity are carried in accordance with applicable laws and regulations and that it institutes appropriate controls to prevent and detect any noncompliance.

♦

ensuring complete disclosure of all material and relevant information to the accountant.

(e) Intended use and distribution of the information, once compiled. (f)

Basis of accounting on which financial information is to be compiled and the fact that the basis, and any known departures therefrom, if any will be disclosed.

(g) The fact that the management is responsible to the users for the information to be compiled by the accountant. (h) Unrestricted access to whatever records, documents and other information is requested in connection with the compilation engagement. (i)

Basis on which fees would be computed and any billing arrangements.

(j)

Request for the client to confirm the terms of engagement by acknowledging the receipt of the engagement letter.

An example of an engagement letter for a compilation engagement appears in Appendix I. Planning 12. The accountant should plan the work so that an effective engagement will be performed. Documentation 13. The accountant should document matters, which are important in providing evidence that the engagement was carried out in accordance with this Auditing and Assurance Standard and the terms of the engagement. Procedures 14. The accountant should obtain a general knowledge of the business and operations of the entity and should be familiar with the accounting principles and practices of the industry in which the entity operates and with the form and content of the financial statements/ other financial information that is appropriate in the circumstances. 15. To compile financial information, the accountant requires a general understanding of the nature of the entity’s business transactions, the form of its accounting records and the accounting basis on which the financial information is to be presented. The accountant ordinarily obtains knowledge of these matters through experience with the entity or inquiry of the entity’s personnel. 16. Other than as noted in this Auditing and Assurance Standard, the accountant is not, ordinarily, required to:

Part I : Auditing and Assurance Standards

I.175

(a) make any inquiries of management to assess the reliability and completeness of the information provided; (b) assess internal controls; (c) verify any matters; or (d) verify any explanations. In a compilation engagement, an accountant would normally have to rely on the management for most of the information needed to compile the financial statements or other financial information, including accounting estimates as well as the fact that the information given to the accountant is complete and reliable. The accountant should request management representation letter covering significant information or explanations given orally on which he considers representations are required. 17. If the accountant becomes aware that the information supplied by management is incorrect, incomplete, or otherwise unsatisfactory, the accountant should consider performing the procedures listed in Paragraph 16 and request management to provide additional information. If management refuses to provide additional information, the accountant should withdraw from the engagement, informing the entity of the reasons for the withdrawal. 18. The accountant should read the compiled information and consider whether it appears to be appropriate in form and free from obvious material misstatements. In this sense, material misstatements include: (a) mistakes in the application of the identified financial reporting framework. (b) non-disclosure of the financial reporting framework and any known departures therefrom. (c) non-disclosure of any other significant matters of which the accountant has become aware. The identified financial reporting framework and any known departures therefrom should be disclosed within the financial information, though their effects need not be quantified. Special Considerations Clients Having an Identified Financial Reporting Framework 19. As far as practicable, in case of compilation of financial statements prepared within an identified financial reporting framework60, the accountant should ensure that the financial statements or other financial information compiled comply with the requirements of the identified financial reporting framework. In case of any material departures from the 60

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

I.176

Advanced Auditing & Professional Ethics

requirements of the identified financial reporting framework, the fact should be stated in the Notes to the Accounts or other compiled financial information as well as in the accountant’s report on the compilation. Clients Having No Identified Financial Reporting Framework 20. In case of clients for whom compliance with an identified financial reporting framework is not required or the Accounting Standards issued by the Institute of Chartered Accountants of India are not mandatory, the client may specify that the accounts should be compiled on, for example, based on the requirements of the Income Tax Act, 1961. However, since, accounts are normally assumed to be compliant with the generally accepted accounting practices, including the Accounting Standards issued by the Institute of Chartered Accountants of India, the different basis of compilation should be set out in the Notes to the Accounts or other compiled financial information as well as the report issued by the accountant on compilation. Non-Compliance with the Accounting Standards 21. In the case of a company, the financial statements compiled must comply with the relevant provisions of the Companies Act, 1956, including the Accounting Standards and, accordingly, give a true and fair view. However, without carrying out the procedures necessary for an audit, the accountant cannot form any opinion on whether the accounts give a true and fair view, even though he has compiled these financial statements. The compilation is based on the information supplied to the accountant by the client and does not include any verification thereof. However, if the accountant becomes aware of material non-compliance with any applicable Accounting Standard(s), the same should be brought to the attention of the management and, if the same is not rectified by the management, it should be included in the Notes to the Accounts and the compilation report of the accountant. Accounting Estimates Made by Clients 22. Often in compilation engagements, it is necessary for certain items in the accounts, for example, work in progress, to be based on estimates by the client. Such estimated items should be so described where material. If, based on the information provided to the accountant, it appears that certain estimates are unreasonable, the accountant should draw these to the attention of the management for reconsideration. 23. If the accountant becomes aware of material misstatements, the accountant should persuade the management to carry out necessary amendments in the financial statements or other compiled financial information. If such amendments are not made and the financial statements are still considered to be misleading, the accountant should withdraw from the engagement. 24. The financial statements or other financial information compiled should be approved by the client before the compilation report is signed by the accountant. The client should be asked to sign a statement on the face of the accounts retained by the accountant. The accountant should ensure that the users of the financial statements or other financial information so compiled are aware of the extent of his/her involvement with the accounts so that the users do not derive unwarranted assurance. Accordingly, the word ‘audit’ should not be used in describing the nature of services involving compilation of financial statements or

Part I : Auditing and Assurance Standards

I.177

other financial information, nor the fee for these services be described as “auditors’ fee”, or remuneration in the accounts, correspondence or any other document. The accountant should also take note that the financial statements or other financial information so compiled should not be prepared on the letter-heads or other stationery of the accountant, carrying his (or firm’s) name and address since it is liable to be misinterpreted. Reporting on a Compilation Engagement 25. It is essential that the accountant clearly brings out the nature of association with the financial statements and the nature of the work performed by him. The report on compilation engagements should, ordinarily, be in the following lay out: (a) Title: The title of the report should be “Accountant’s Report on Compilation of Unaudited Financial Statements” (and not “Auditor’s Report”); (b) Addressee: The report should ordinarily be addressed to the appointing authority; (c) Identification of the financial information also noting that it is based on the information provided by the management; (d) When relevant, a statement that the accountant is not independent of the entity; (e) A statement that the management is responsible for: ♦

completeness and accuracy of the underlying data and complete disclosure of all material and relevant information to the accountant;

♦

maintaining adequate accounting and other records and internal controls and selecting and applying appropriate accounting policies;

♦

preparation and presentation of financial statements or other financial information in accordance with the applicable laws and regulations, if any;

♦

establishing controls to safeguard the assets of the entity and preventing and detecting frauds or other irregularities;

♦

establishing controls for ensuring that the activities of the entity are carried out in accordance with the applicable laws and regulations and preventing and detecting any non-compliance;

(f)

A statement that the engagement was performed in accordance with this Auditing and Assurance Standard;

(g) A statement that neither an audit nor a review has been carried out and that accordingly no assurance is expressed on the financial information; (h) A paragraph, when considered necessary, drawing attention to the disclosure of material departures from the identified financial reporting framework; (i)

Date of the report;

(j)

Place of signature; and

(k) Accountant’s signature: The report on compilation of financial information should be signed by the auditor in his personal name. Where a firm is appointed for the

I.178

Advanced Auditing & Professional Ethics engagement, the report should be signed in the personal name of the accountant and in the name of the firm. The partner/proprietor signing the report on compilation of financial information should also mention the membership number assigned by the Institute of Chartered Accountants of India

Appendix II to this Standard contains examples of compilation reports. 26. The financial statements or other financial information compiled by the accountant should contain a reference such as “Unaudited,” “Compiled without Audit or Review” and also “Refer to Compilation Report” on each page of the financial information or on the front of the complete set of financial statements. Effective Date 27. This Auditing and Assurance Standard is applicable to all compilation engagements beginning on or after April 1, 2004. Compatibility With International Standard On Auditing (ISA) 930 The standards for compilation engagements established in this Auditing and Assurance Standard are generally consistent in all material respects with those set out in the International Standard on Auditing (ISA) 930, “Engagements to Compile Financial Information”, except for the additional section titled, “Special Considerations”, as given in paragraphs 19 to 22 of this Auditing and Assurance Standard. The said section has been added to provide guidance to members in respect of certain typical issues which might be faced by the members in carrying out compilation engagements. For example, duties and responsibilities of the accountant in case of clients having an identified financial reporting framework, such as the Companies Act, 1956 and any material departures therefrom; clients having no identified financial reporting framework, say, where the financial statements are based on the requirements of the Income Tax Act, 1961. The section also provides guidance in respect of situations where the accountant becomes aware of a material non-compliance with the applicable Accounting Standards; as also duties of the accountant relating to accounting estimates made by the client. Moreover, the Auditing and Assurance Standard, in paragraph 24, unlike the International Standard on Auditing (ISA) 930, also requires that the financial statements should be approved by the client before compilation report is signed by the accountant. The AAS also requires the accountant to ensure that the users of the compiled financial statements are aware of the extent of his/ her involvement with the accounts so that the users do not derive any unwarranted assurance. The AAS, unlike the ISA, also prohibits the accountant from preparing the financial statements on his letter head or other stationery bearing his (or firm’s) name or address. In addition, the AAS, unlike the ISA, does not require the accountant to send a form of expected report to the client alongwith the engagement letter. Also, the AAS requires the accountant to mention the place of signature in his report as compared to the ISA which requires the accountants to give his address.

Part I : Auditing and Assurance Standards

I.179

Appendix I Example of an Engagement Letter for a Compilation Engagement The following letter is for use as a guide in conjunction with the considerations outlined in paragraph 11 of this Auditing and Assurance Standard. This example is for the compilation of financial statements of a company and will need to be varied according to individual requirements and circumstances. (Date) To the Board of Directors (or other appropriate representatives of senior management): You have, vide your letter dated ________ requested that we compile the balance sheet of __________(name of the company) as at ______________(date) and the related profit and loss account and the (cash flow statement)61 for the year ended on that date. We are pleased to confirm our acceptance and understanding of the engagement by means of this letter. As no audit or review engagement procedures would be carried out, no opinion on the financial statements will be expressed. Further, our engagement cannot be relied upon to disclose whether frauds or defalcations, or illegal acts exist. However, we will inform you of any such matters which might come to our attention in the course of the engagement. As management, you are responsible for: (a) the accuracy and completeness of the information supplied to us, including maintenance of adequate accounting records and internal controls and selection and application of appropriate accounting policies. (b) preparation and presentation of the financial statements of the entity, in accordance with the applicable laws and regulations, if any. (c) safeguarding the assets of the entity and also establishing appropriate controls designed to prevent and detect fraud and other irregularities. (d) ensuring that the activities of the entity are carried in accordance with applicable laws and regulations and that it institutes appropriate controls to prevent and detect any noncompliance. You will confirm that events and transactions are recorded in accordance with the applicable Accounting Standard(s), issued by the Institute of Chartered Accountants of India and other recognised accounting principles and practices and inform us of any departures therefrom. As part of our normal procedures, we may request you to provide written confirmations of any information or explanations given to us orally during the course of our work. We understand that the intended use and distribution of the information we have compiled is _________________ (specify).

61

Only in cases where relevant.

I.180

Advanced Auditing & Professional Ethics

We look forward to full cooperation with your staff and we trust that they will make available to us whatever records, documentation and other information requested in connection with our engagement. Our fees will be billed as the work progresses. Please sign and return the attached copy of this letter to indicate that it is in accordance with your understanding of the arrangements for our compilation of your financial statements. XYZ & Co. Chartered Accountants …………………………… Signature (Name of the Member) Designation62 Address: Date: For ABC & Co. Acknowledged on behalf of ______________(name of the company) ---------------Signature Name and Designation Date Address

Appendix II Examples of a Report of an Engagement to Compile Financial Statements Illustration 1: Report on Compilation of Financial Statements Accountant’s report on Compilation of Unaudited Financial Statements To……. On the basis of the accounting records and other information and explanations provided to us by the management, we have compiled, the unaudited balance sheet of ………………..(name

62

Partner or proprietor, as the case may be.

Part I : Auditing and Assurance Standards

I.181

of the entity) as at March 31, XXXX and the related profit and loss account and the cash flow statement63 for the period then ended. The management of the _________ (name of the entity) is responsible for: (a) Completeness and accuracy of the underlying data and complete disclosure of all material and relevant information to the accountant. (b) Maintaining adequate accounting and other records and internal controls and selecting and applying appropriate accounting policies; (c) Preparation and presentation of financial statements in accordance with the applicable laws and regulations, if any. (d) Establishing controls to safeguard the assets of the entity and preventing and detecting frauds or other irregularities. (e) Establishing controls for ensuring that the activities of the entity are carried out in accordance with the applicable laws and regulations and preventing and detecting any non compliance. The compilation engagement was carried out by us in accordance with the Auditing and Assurance Standard (AAS) 31, “Engagements to Compile Financial Information”, issued by the Institute of Chartered Accountants of India. The balance sheet and the profit and loss account are in agreement with the books of account. We have not audited or reviewed these financial statements and accordingly express no opinion thereon. For ABC & Co. Chartered Accountants …………………………... Signature (Name of the accountant and membership number) Designation64 Date: Place: Illustration 2: Compiled Financial Statements Where Such Financial Statements do not Comply with the Generally Accepted Accounting Practices in India. Accountant’s report on Compilation of Unaudited Financial Statements To……… On the basis of the accounting records and other information and explanations provided to us by the management, we have compiled the unaudited balance sheet of __________ (name of

63 64

Where applicable Partner or Proprietor.

I.182

Advanced Auditing & Professional Ethics

the entity) as of March 31, XXXX and the related profit and loss account and the cash flow statement65 for the period then ended. The management of the _________ (name of the entity) is responsible for: (a) Completeness and accuracy of the underlying data and complete disclosure of all material and relevant information to the accountant. (b) Maintaining adequate accounting and other records and internal controls and selecting and applying appropriate accounting policies; (c) Preparation and presentation of financial statements in accordance with the applicable laws and regulations, if any. (d) Establishing controls to safeguard the assets of the entity and preventing and detecting frauds or other irregularities. (e) Establishing controls for ensuring that the activities of the entity are carried out in accordance with the applicable laws and regulations and preventing and detecting any non-compliance. The compilation engagement was carried out by us in accordance with the Auditing and Assurance Standard (AAS) 31, “Engagements to Compile Financial Information”, issued by the Institute of Chartered Accountants of India. Since the financial statements have been compiled for the Income Tax Department and have been drawn up on cash basis of accounting to reflect the necessary adjustments for computation of the income by the Department, these financial statements, accordingly, do not comply with the generally accepted accounting principles in India. The balance sheet and the profit and loss account are in agreement with the books of account. We have not audited or reviewed these financial statements and accordingly express no opinion thereon. Date: Place: For ABC & Co. Chartered Accountants …………………………... Signature (Name of the accountant and membership number) Designation66

65 66

Where applicable. Partner or proprietor.

Part I : Auditing and Assurance Standards

I.183

ENGAGEMENTS TO PERFORM AGREED-UPON PROCEDURES REGARDING FINANCIAL INFORMATION (AAS 32) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards and provide guidance on the auditor’s67 professional responsibilities when an engagement to perform agreed-upon procedures regarding financial information is undertaken and on the form and content of the report that the auditor issues in connection with such an engagement. 2. In an engagement to perform agreed-upon procedures, the auditor is engaged by the client to issue a report of factual findings, based on specified procedures performed on specified subject matter of specified elements, accounts or items of a financial statement. For example, an engagement to perform agreed-upon procedures may require the auditor to perform certain procedures concerning individual items of financial data, say, accounts payable, accounts receivable, purchases from related parties and sales and profits of a segment of an entity, or a financial statement, say, a balance sheet or even a complete set of financial statements. 3. This AAS is directed towards engagements regarding financial information. However, it may provide useful guidance for engagements to perform agreed-upon procedures regarding non-financial information, provided the auditor has adequate knowledge of the subject matter in question and reasonable criteria exist on which to base his findings. This AAS is to be read in conjunction with the Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services. The principles laid down in the other AASs, issued by the Institute of Chartered Accountants of India, may be used by the auditor, to the extent practicable, in applying this AAS. Objective of an Agreed-upon Procedures Engagement 4. The objective of an agreed-upon procedures engagement is for the auditor to carry out procedures of an audit nature to which the auditor and the entity and any appropriate third parties have agreed and to report on factual findings. 5. As the auditor simply provides a report of the factual findings of agreed-upon procedures, no assurance is expressed by him in his report. Instead, users of the report assess for themselves the procedures and the findings reported by the auditor and draw their own conclusions from the work done by the auditor. 6. The report is restricted to those parties that have agreed to the procedures to be performed since others, unaware of the reasons for the procedures, may misinterpret the results. However, it is possible in certain circumstances that the report of the engagement may not be restricted only to those parties that have agreed to the procedures to be performed, but made available to a wider range of entities or individuals, e.g., in case of government organisations. 67

The term ''auditor'' is used throughout this AAS when describing services involving performance of agreed-upon procedures. Such reference is not intended to imply that a person performing related services need necessarily by the auditor of the entity's financial statements.

I.184

Advanced Auditing & Professional Ethics

General Principles of an Agreed-upon Procedures Engagement 7. The auditor should comply with the Code of Ethics, issued by the Institute of Chartered Accountants of India. Ethical principles governing the auditor’s professional responsibilities for this type of engagement are: (a)

Integrity;

(b) Objectivity; (c)

Professional competence and due care;

(d) Confidentiality; (e) Professional conduct; and (f)

Technical standards

Independence is not a requirement for agreed-upon procedures engagement, however, the terms or objective of the engagement may require the auditor to comply with the independence requirements of the Code of Ethics issued by the Institute of Chartered Accountants of India. Where the auditor is not independent, a statement to that effect should be made in the report of factual findings. 8. The auditor should conduct an agreed-upon procedure engagement in accordance with this AAS and the terms of the engagement. Defining the Terms of the Engagement 9. The auditor should ensure with representatives of the entity and, ordinarily, other specified parties who will receive copies of the report of factual findings, that there is a clear understanding regarding the agreed procedures and the conditions of the engagement. Matters to be agreed include the following: (a) Nature of the engagement including the fact that the procedures performed will not constitute an audit or a review and that accordingly no assurance will be expressed. (b) Stated purpose for the engagement. (c) Identification of the financial information to which the agreed-upon procedures will be applied. (d) Nature, timing and extent of the specific procedures to be applied. (e) Limitations on distribution of the report of factual findings. When such limitation would be in conflict with the legal requirements, if any, the auditor would not accept the engagement. 10. In certain circumstances, for example, when the procedures have been agreed to between the regulator, industry representatives and representatives of the accounting profession, the auditor may not be able to discuss the procedures with all the parties who will receive the report. In such cases, the auditor may consider, for example, discussing the procedures to be applied with appropriate representatives of the parties involved, reviewing relevant correspondence from such parties.

Part I : Auditing and Assurance Standards

I.185

11. It is in the interests of both the client and the auditor that the auditor sends an engagement letter documenting the key terms of the appointment. An engagement letter confirms the auditor’s acceptance of the appointment and helps avoid misunderstanding regarding such matters as the objectives and scope of the engagement, the extent of the auditor’s responsibilities and the form of reports to be issued. 12. Matters that would be included in the engagement letter include: ♦

A listing of the procedures to be performed as agreed-upon between the parties.

♦

A statement that the distribution of the report of factual findings would be restricted to the specified parties who have agreed to the procedures to be performed.

An example of an engagement letter appears in Appendix I to this AAS. Planning 13. The auditor should plan the work so that an effective engagement will be performed. Documentation 14. The auditor should document matters, which are important in providing evidence to support the report of factual findings, and evidence that the engagement was carried out in accordance with this AAS and the terms of the engagement. Procedures and Evidence 15. The auditor should carry out the procedures agreed-upon and use the evidence obtained as the basis for the report of factual findings. 16. The procedures applied in an engagement to perform agreed-upon procedures may include: ♦

Inquiry and analysis.

♦

Recomputation, comparison and other clerical accuracy checks.

♦

Observation.

♦

Inspection.

♦

Obtaining confirmations.

Appendix II to this AAS is an example report which contains an illustrative list of procedures which may be used as one part of a typical agreed-upon procedures engagement. Reporting 17. The report on an agreed-upon procedures engagement needs to describe the purpose and the agreed-upon procedures of the engagement in sufficient detail to enable the reader to understand the nature and the extent of the work performed. The report should also clearly mention that no audit or review has been performed. 18. The report of factual findings should contain: (a) Title;

I.186 (b)

Advanced Auditing & Professional Ethics Addressee (ordinarily, the appointing authority );

(c) Identification of specific financial or non-financial information to which the agreed-upon procedures have been applied; (d) A statement that the procedures performed were those agreed-upon with the recipient; (e) A statement that the engagement was performed in accordance with the Auditing and Assurance Standard applicable to agreed-upon procedures engagements; (g) Identification of the purpose for which the agreed-upon procedures were performed; (h) A listing of the specific procedures performed; (i)

A description of the auditor’s factual findings including sufficient details of errors and exceptions found;

(j)

A statement that the procedures performed do not constitute either an audit or a review and, as such, no assurance is expressed;

(k) A statement that had the auditor performed additional procedures, an audit or a review, other matters might have come to light that would have been reported; (l)

A statement that the report is restricted to those parties that have agreed to the procedures to be performed;

(m) A statement (when applicable) that the report relates only to the elements, accounts, items or financial and non-financial information specified and that it does not extend to the entity’s financial statements taken as a whole; (n) Date of the report; (o) Place of signature; and (p) Auditor’s signature The report should be signed by the accountant in his personal name. Where the firm is appointed, the report should be signed in the personal name of the accountant and in the name of the firm. The partner/proprietor signing the report on agreed-upon procedures should also mention the membership number assigned by the Institute of Chartered Accountants of India Appendix II to this AAS contains an example of a report of factual findings issued in connection with an engagement to perform agreed-upon procedures regarding financial information. Effective Date 19. This Auditing and Assurance Standard is applicable to all agreed upon procedures engagements beginning on or after April 1, 2004. Compatibility with the International Standard on Auditing (ISA) 920 The standards established in this Auditing and Assurance Standards are generally consistent in all material respects with those set out in the International Standard on Auditing (ISA) 920, “Engagements to Perform Agreed-upon Procedures regarding Financial Information”.

Part I : Auditing and Assurance Standards

I.187

Appendix I Example of an Engagement Letter for an Agreed-upon Procedures Engagement The following letter is for use as a guide in conjunction with paragraph 12 of this Auditing and Assurance Standard and is not intended to be a standard letter. The engagement letter will need to be varied according to individual requirements and circumstances. Date To the Board of Directors (or other appropriate representatives of the client who engaged the auditor) This is in reference to your letter dated ________, appointing us to perform agreed-upon procedures in respect of _______________ (identify the items, e.g., sales, profit of a segment, accounts receivables, etc., of the entity). This letter is to confirm our understanding of the terms and objectives of our engagement and the nature and limitations of the services that we will provide. Our engagement will be conducted in accordance with the Auditing and Assurance Standard on Engagements to Perform Agreed-upon Procedures regarding Financial Information, issued by the Institute of Chartered Accountants of India and we will indicate so in our report. We have agreed to perform the following procedures and report to you the factual findings resulting from our work: (Describe the nature, timing and extent of the procedures to be performed, including specific reference, where applicable, to the identity of documents and records to be read, individuals to be contacted and parties from whom confirmations will be obtained.) The procedures that we will perform are solely to assist you in ______________________ (state purpose). Our report is not to be used for any other purpose and is solely for your information, and/ or for use by _________________ (in case the terms of reference so require). The procedures that we will perform will not constitute an audit or a review made in accordance with the generally accepted auditing standards in India and, consequently, no assurance will be expressed. We look forward to your full cooperation and trust that you will make available to us whatever records, documentation and other information requested in connection with our engagement. Our fees will be billed as work progresses.

I.188

Advanced Auditing & Professional Ethics

Please sign and return the attached copy of this letter to indicate that it is in accordance with your understanding of the terms of the engagement including the specific procedures, which we have agreed will be performed. For XYZ & Co Chartered Accountants ……………………… Signature (Name of the Member) Designation 68 Date: Address: Acknowledged on behalf of ABC Company by (signed ) ................... Name and Title Date Address Appendix II Example of a Report of Factual Findings in Connection with Accounts Receivable Confidential Report of Factual Findings In Connection With Agreed-upon Procedures Assignment Related To Accounts Receivable To (those who engaged the auditor) We have performed the procedures agreed with you and enumerated below with respect to the accounts receivable of ABC Company as at _______(date), set forth in the accompanying schedules (not shown in this example). Our engagement was undertaken in accordance with the Auditing and Assurance Standard on Engagements to Perform Agreed-upon Procedures regarding Financial Information, issued by the Institute of Chartered Accountants of India. The procedures were performed solely to assist you in evaluating the validity of the accounts receivable and are summarized as follows: 1. We obtained and checked the addition of the trial balance of accounts receivable as at __________ (date), prepared by ABC Company, and we compared the total to the balance in the related general ledger account. 68

Partner of Proprietor, as the case may be.

Part I : Auditing and Assurance Standards

I.189

2. We compared the attached list (not shown in this example) of major customers and the amounts outstanding at ____________ (date) to the related names and amounts in the trial balance. 3. We obtained customers’ statements or confirmations from customers to confirm balances outstanding at ________________ (date). 4. We compared such statements or confirmations to the amounts referred to in 2 above. For amounts which did not agree, we obtained reconciliations from ABC Company. For reconciliations obtained, we identified and listed outstanding invoices, debit notes and outstanding cheques, each of which was greater than Rs. XXX. We located and examined such invoices and debit notes subsequently raised and cheques subsequently received and we ascertained that they have been rightly listed as outstanding on the reconciliations. We report our findings below: (a) With respect to item 1, we found the addition to be correct and the total amount to be in agreement. (b) With respect to item 2, we found the amounts compared to be in agreement. (c) With respect to item 3, we found there were suppliers’ statements for all such customers. (d) With respect to item 4, we found the amounts agreed, or with respect to amounts which did not agree, we found the Company had prepared reconciliations and that the debit notes, invoices and outstanding cheques over Rs. XXX were appropriately listed as reconciling items with the following exceptions: (Detail the exceptions) Because the above procedures do not constitute either an audit or a review made in accordance with the generally accepted auditing standards in India, we do not express any assurance on the accounts receivable as at _______(date). Had we performed additional procedures or had we performed an audit or review of the financial statements in accordance with the generally accepted auditing standards in India, other matters might have come to our attention that would have been reported to you. Our report is solely for the purpose set forth in the first paragraph of this report and for your information and is not to be used for any other purpose or to be distributed to any other parties. This report relates only to the accounts and items specified above and does not extend to any financial statements of ABC Company, taken as a whole. Date: Place:

69

Partner of Proprietor, as the case may be.

For XYZ & Co Chartered Accountants ……………………… Signature (Name of the Member and Membership number) Designation69

I.190

Advanced Auditing & Professional Ethics ENGAGEMENTS TO REVIEW FINANCIAL STATEMENTS (AAS 33)

Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards and provide guidance on the auditor’s70 professional responsibilities when an engagement to review financial statements is undertaken and on the form and content of the report that the auditor issues in connection with such a review. 2. This AAS is directed towards the review of financial statements. However, it is to be applied to the extent practicable to engagements to review financial or other related information, for example, interim financial statements prepared by an entity pursuant to Accounting Standard (AS) 25, Interim Financial Reporting. This AAS is to be read in conjunction with the “Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services” issued by the Institute of Chartered Accountants of India. Objective of a Review Engagement 3. The objective of a review of financial statements is to enable an auditor to state whether, on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to the auditor’s attention that causes the auditor to believe that the financial statements are not prepared, in all material respects, in accordance with the financial reporting framework used for the preparation and presentation of the financial statements 71 (negative assurance). General Principles of a Review Engagement 4. The auditor should comply with the Code of Ethics issued by the Institute of Chartered Accountants of India. Ethical principles governing the auditor’s professional responsibilities are: (a) Independence; (b) Integrity; (c) Objectivity; 70

As explained in the Framework of Statements on Standard Auditing Practices and Guidance Notes on related Services, the SAPs (now AASs) and Guidance Notes use the term ''auditor'' when describing both auditing and related services which may be performed. Such reference is not intended to imply that a person performing related services need be the auditor of the entity's financial statements. 71 Paragraph 3 of Framework of Statements on Standard Auditing Practices and Guidance Notes on Related Services, issued by the Institute of Chartered Accountants of India, discusses the financial reporting framework. The paragraph reads as under: ''Financial Reporting Frame work Financial statements are ordinarily prepared and presented annually and are directed towards the common information needs of a wide range of users. Many of those users rely on financial statements as their major source of information because they do not have the power to obtain additional information to meet their specific information needs. Thus, financial statements need to be prepared accordance with one, or a combination of: (a) relevant statutory requirements, e.g., the Companies Act, 1956, for companies; (b) accounting standards issued by the Institute of Chartered Accountants of India; and (c) other recognised accounting principles and practices, e.g., those recommended in the Guidance Notes issued by the Institute of Chartered Accountants of India.''

Part I : Auditing and Assurance Standards

I.191

(d) Professional competence and due care; (e) Confidentiality; (f)

Professional conduct; and

(g) Technical standards. 5.

The auditor should conduct a review in accordance with this AAS.

6. The auditor should plan and perform the review with an attitude of professional skepticism recognising that circumstances may exist, which cause the financial statements to be materially misstated. 7. For the purpose of expressing negative assurance in the review report, the auditor should obtain sufficient appropriate evidence primarily through inquiry and analytical procedures to be able to draw conclusions. Scope of a Review 8. The term “scope of a review” refers to the review procedures deemed necessary in the circumstances to achieve the objective of the review. The procedures required to conduct a review of financial statements should be determined by the auditor having regard to the requirements of this AAS, relevant legislation, regulation and, where appropriate, the terms of the review engagement and reporting requirements. The scope of a review is substantially narrower as compared to an audit in accordance with the generally accepted auditing standards for the expression of an opinion on the financial statements. Accordingly, while a review involves the application of audit skills and techniques, it does not usually involve a study and evaluation of internal accounting controls, tests of accounting records and of responses to inquiries by obtaining corroborating evidential matter through inspection, observation or confirmation and certain other procedures ordinarily performed during an audit. Moderate Assurance 9. A review engagement provides a moderate level of assurance that the information subject to review is free of material misstatement; this is expressed in the form of negative assurance. Although the auditor attempts to become aware of all significant matters, the limited procedures of a review make the achievement of this objective less likely than in an audit engagement, thus the level of assurance provided is correspondingly less than that given in an audit. Terms of Engagement 10. The auditor and the client should agree on the terms of the engagement. The agreed terms would be recorded in an engagement letter or other suitable form such as a contract. 11. An engagement letter will be of assistance in planning the review work. It is in the interests of both the auditor and the client that the auditor sends an engagement letter documenting the key terms of the appointment. An engagement letter confirms the auditor’s acceptance of the appointment and helps avoid misunderstanding regarding such matters as the objectives and scope of the engagement and the extent of the auditor’s responsibilities.

I.192

Advanced Auditing & Professional Ethics

12. Matters that would be included in the engagement letter include: ♦

The objective of the service being performed.

♦

Management’s responsibility for the financial statements.

♦

The scope of the review, including reference to this AAS.

♦

Unrestricted access to whatever records, documentation and other information requested in connection with the review.

♦

The fact that the engagement cannot be relied upon to disclose errors, violation of laws or other irregularities, for example, fraud or defalcations that may exist.

♦

A statement that an audit is not being performed and that an audit opinion will not be expressed. To emphasise this point and to avoid confusion, the auditor may also consider pointing out that a review engagement will not satisfy any statutory or third party requirements for an audit.

An example of an engagement letter for a review of financial statements appears in Appendix 1 to this AAS. Planning 13. The auditor should plan the work so that an effective review engagement will be performed. 14. In planning a review of financial statements, the auditor should obtain or update the knowledge of the business including consideration of the entity’s organisation, accounting systems, operating characteristics and the nature of its assets, liabilities, revenues and expenses. 15. The auditor needs to possess an understanding of such matters and other matters relevant to the financial statements, for example, knowledge of the entity’s production and distribution methods, product lines, operating locations and related parties. The auditor requires this understanding to be able to make relevant inquiries and to design appropriate procedures, as well as to assess the responses and other information obtained. Work Performed by Others 16. When using work performed by another auditor or an expert, the auditor should be satisfied that such work is adequate for the purposes of the review. Documentation 17. The auditor should document matters which are important in providing evidence to support the review report, and evidence that the review was carried out in accordance with this AAS. Procedures and Evidence 18. The auditor should apply judgment in determining the specific nature, timing and extent of review procedures. The auditor will be guided by such matters as:

Part I : Auditing and Assurance Standards

I.193

♦

Any knowledge acquired by carrying out audits or reviews of the financial statements for prior periods.

♦

The auditor’s knowledge of the business including knowledge of the accounting principles and practices of the industry in which the entity operates.

♦

The entity’s accounting systems.

♦

The extent to which a particular item is affected by management judgment.

♦

The materiality of transactions and account balances.

19. The auditor should apply the same materiality considerations as would be applied if an audit opinion on the financial statements were being given. Although there is a greater risk that misstatements will not be detected in a review than in an audit, the judgment as to what is material is made by reference to the information on which the auditor is reporting and the needs of those relying on that information, not to the level of assurance provided. 20. Procedures for the review of financial statements will ordinarily include: ♦

Obtaining an understanding of the entity’s business and the industry in which it operates.

♦

Inquiries concerning the entity’s accounting principles, policies and practices.

♦

Inquiries concerning the entity’s procedures for recording, classifying and summarising transactions, accumulating information for disclosure in the financial statements and preparing financial statements.

♦

Inquiries concerning all material assertions in the financial statements.

♦

Analytical procedures designed to identify relationships and individual items that appear unusual. Such procedures would include: ¾

Comparison of the financial statements with statements for prior periods.

¾

Comparison of the financial statements with anticipated results and financial position.

¾

Study of the relationships of the elements of the financial statements that would be expected to conform to a predictable pattern based on the entity’s experience or industry norm.

In applying these procedures, the auditor would consider the types of matters that required accounting adjustments in prior periods. ♦

Inquiries concerning actions taken at meetings of shareholders, the board of directors, committees of the board of directors and other meetings that may affect the financial statements.

♦

Reading the financial statements to consider, on the basis of information coming to the auditor’s attention, whether the financial statements appear to conform to the basis of accounting indicated.

♦

Obtaining reports from other auditors, if any and if considered necessary, who have been engaged to audit or review the financial statements of components of the entity.

I.194 ♦

♦

Advanced Auditing & Professional Ethics Inquiries of persons having responsibility for financial and accounting matters concerning, for example: ¾

Whether all transactions have been recorded.

¾

Whether the financial statements have been prepared in accordance with the basis of accounting policies indicated.

¾

Changes in the entity’s business activities and accounting principles, policies and practices.

¾

Matters as to which questions have arisen in the course of applying the foregoing procedures.

Obtaining written representations from management when considered appropriate.

Appendix 2 to this AAS provides an illustrative list of procedures which are often used in an engagement to review financial statements. The list is not exhaustive, nor is it intended that all the procedures suggested apply to every review engagement. 21. The auditor should inquire about events subsequent to the balance sheet date that may require adjustment of, or disclosure in the financial statements. The auditor does not have any responsibility to perform procedures to identify events occurring after the date of the review report. 22. If the auditor has reason to believe that the information subject to review may be materially misstated, the auditor should carry out additional or more extensive procedures as are necessary to be able to express negative assurance or to confirm that a modified report is required. Conclusions and Reporting 23. The review report should contain a clear written expression of negative assurance. The auditor should review and assess the conclusions drawn from the evidence obtained as the basis for the expression of negative assurance. 24. Based on the work performed, the auditor should assess whether any information obtained during the review indicates that the financial statements do not give a true and fair view (or ‘are not presented fairly, in all material respects’) in accordance with the financial reporting framework used for the preparation and presentation of financial statements and relevant statutory requirements, if any. 25. The report on a review of financial statements describes the scope of the engagement to enable the reader to understand the nature of the work performed and make it clear that an audit was not performed and, therefore, that an audit opinion is not expressed. 26. The report on a review of financial statements should contain the following basic elements, ordinarily in the following layout:

Part I : Auditing and Assurance Standards

I.195

(a) Title72; (b) Addressee; (c) Opening or introductory paragraph including: (i)

Identification of the financial statements on which the review has been performed; and

(ii)

A statement of the responsibility of the entity’s management and the responsibility of the auditor;

(d) Scope paragraph, describing the nature of a review, including: (i)

A reference to this AAS applicable to review engagements, or to relevant laws or regulations;

(ii)

A statement that a review is limited primarily to inquiries and analytical procedures; and

(iii) A statement that an audit has not been performed, that the procedures undertaken provide less assurance than an audit and that an audit opinion is not expressed; (e) Statement of negative assurance; (f)

Date of the report;

(g) Place; and (h) Auditor’s signature and membership number assigned by the Institute of Chartered Accountants of India. Appendices 3 and 4 to this AAS contain illustrations of review reports. 27. The review report should: (a) State that nothing has come to the auditor’s attention based on the review that causes the auditor to believe the financial statements do not give a true and fair view (or ‘are not presented fairly, in all material respects’) in accordance with the framework used for the preparation and presentation of financial statements (negative assurance); or (b) If matters have come to the auditor’s attention, describe those matters that impair a true and fair view (or a fair presentation, in all material respects) in accordance with the framework used for the preparation and presentation of financial statements including, unless impracticable, a quantification of the possible effect(s) on the financial statements, and either: (i)

Express a qualification of the negative assurance provided; or

(ii)

When the effect of the matter is so material and pervasive to the financial statements that the auditor concludes that a qualification is not adequate to disclose

72 It may be appropriate to use the term ''independent '' in the title to distinguish the auditor's report from reports might be issued by others, such as officers of the entity, or from the reports of other auditors who are not required to abide by the ethical requirements laid down by the Institute of Chartered Accountants of India.

I.196

Advanced Auditing & Professional Ethics the misleading or incomplete nature of the financial statements, give an adverse statement that the financial statements do not give a true and fair view (or ‘are not presented fairly, in all material respects’) in accordance with the framework used for the preparation and presentation of financial statements; or

(c) If there has been a material scope limitation, describe the limitation and either: (i)

Express a qualification of the negative assurance provided regarding the possible adjustments to the financial statements that might have been determined to be necessary had the limitation not existed; or

(ii)

When the possible effect of the limitation is so significant and pervasive that the auditor concludes that no level of assurance can be provided, not provide any assurance.

28. The auditor should date the review report as of the date the review is completed, which is the date on which the auditor signs the review report. The date of report informs the reader that the auditor has considered the effect on the financial statements and on the report of the events and transactions of which the auditor became aware and that occurred up to that date. Therefore, the review should include performing procedures relating to events occurring up to the date of the report. 29. Since the auditor’s responsibility is to report on the financial statements as prepared and presented by the management, the auditor should not date the report earlier than the date on which the financial statements are signed or approved by the management. 30. The auditor should not agree to a change of engagement where there is no reasonable justification for doing so. If the auditor is unable to agree to a change of the engagement and is not permitted to continue the original engagement, the auditor should withdraw and consider whether there is any obligation, either contractual or otherwise, to report the circumstances necessitating the withdrawal to other parties, such as the board of directors or shareholders. Effective Date 31. This Auditing and Assurance Standard (AAS) becomes operative for all review engagements relating to accounting periods beginning on or after 1 April 2005. Compatibility With International Standard On Review Engagement (ISRE) 2400 The auditing standards established in this Auditing and Assurance Standard are generally consistent in all material respects with those set out in International Standard on Review Engagements (ISREs) 2400 on Engagements to Review Financial Statements except the following: (a) The AAS does not require the engagement letter to include form of report to be issued pursuant to the engagement since the format of report, in some cases, is prescribed by the laws or regulations pursuant to which the financial statements are required to be reviewed. (b) Due to the practices prevailing in India, the AAS requires the auditor to mention the “Place” instead of the “Auditor’s Address” [see paragraph 26] in the report on a review of

Part I : Auditing and Assurance Standards

I.197

financial statements. The place of signature is the name of specific location, which is ordinarily the city where the review report is signed. According to ISA 700 (which defines the term), the expression “Auditor’s Address” means the name of a specific location, which is ordinarily the city where the auditor maintains the office that has the responsibility for the audit. (c) The AAS requires the auditor to mention the membership number assigned by the Institute of Chartered Accountants of India [see paragraph 26]. ISRE 2400, however, does not contain any corresponding requirement. (d) Paragraph 29 of the AAS requires that the auditor should not agree to a change of engagement where there is no reasonable justification for doing so. If the auditor is unable to agree to a change of the engagement and is not permitted to continue the original engagement, the auditor should withdraw and consider whether there is any obligation, either contractual or otherwise, to report the circumstances necessitating the withdrawal to other parties, such as the board of directors or shareholders. There is no corresponding requirement in ISRE 2400. Appendix 1 Example of an Engagement Letter for a Review of Financial Statements The following letter is for use as a guide in conjunction with the consideration outlined in paragraph 10 of this AAS and will need to be varied according to individual requirements and circumstances. To the Board of Directors (or the appropriate representative of senior management): This is with reference to your letter dated_______, appointing us to review the financial statements for the period ended_______. This letter is to confirm our understanding of the terms and objectives of our engagement and the nature and limitations of the services we will provide. We will perform the following services: We will review the balance sheet of ABC Company as of March 31, 20XX, and the related statement of profit and loss and cash flows for the year then ended, in accordance with the Auditing and Assurance Standard (AAS) 33, Engagements to Review Financial Statements issued by the Institute of Chartered Accountants of India. We will not perform an audit of such financial statements and, accordingly, we will not express an audit opinion on them. Accordingly, we are expected to provide a negative assurance on the financial statements reviewed by us. Responsibility for the financial statements, including adequate disclosure, is that of the management of the company. This includes the maintenance of adequate accounting records and internal controls and the selection and application of accounting policies. As part of our review process, we will request written representations from management concerning assertions made in connection with the review.

I.198

Advanced Auditing & Professional Ethics

This letter will be effective for future years unless it is terminated, amended or superseded (applicable only in a continuing engagement). Our engagement cannot be relied upon to disclose whether fraud or errors, or violation of laws and regulations exist. However, we will inform you of any material matters that come to our attention. We also wish to invite your attention to the fact that our audit process is subject to ‘peer review’ under the Chartered Accountants Act, 1949. The reviewer may examine our working papers during the course of the peer review. Please sign and return the attached copy of this letter to indicate that it is in accordance with your understanding of the arrangements for our review of the financial statements. XYZ & Co. Chartered Accountants ………………………… (Signature) (Name of the Member) (Designation73) Acknowledged on behalf of ABC Company by …………………….. (Signature) Name and Designation Date Appendix 2 Illustrative Detailed Procedures that may be performed in an Engagement to Review Financial Statements 1. The inquiry and analytical review procedures carried out in a review of financial statements are determined by the auditor’s judgment. When the auditor performs the inquiry and analytical review procedures, the auditor should use his professional judgement and experience in evaluating the results of such procedures and their effect on the review report and other procedures to be performed in connection with the review engagement. The procedures listed below are for illustrative purposes only. It is not intended that all the procedures suggested apply to every review engagement. This Appendix is not intended to serve as a program or checklist in the conduct of a review. General 73

partner or proprietor, as the case may be.

Part I : Auditing and Assurance Standards

I.199

2.

Discuss terms and scope of the engagement with the client and the engagement team.

3.

Prepare an engagement letter setting forth the terms and scope of the engagement.

4. Obtain an understanding of the entity’s business activities and the system for recording financial information and preparing financial statements. 5.

Inquire whether all financial information is recorded:

(a) completely; (b) promptly; and (c) after the necessary authorisation. 6. Obtain the trial balance and verify whether it agrees with the general ledger and the financial statements. 7. Consider the results of previous audits and review engagements, including accounting adjustments made. 8. Inquire whether there have been any significant changes in the entity from the previous year (e.g., changes in ownership or changes in capital structure). 9.

Inquire about the accounting policies and consider whether:

(a) they comply with accounting standards; (b) they have been applied appropriately; and (c) they have been applied consistently and, if not, consider whether disclosure has been made of any changes in the accounting policies. 10. Read the minutes of meetings of shareholders, the board of directors and other appropriate committees in order to identify matters that could be important to the review. 11. Inquire if actions taken at shareholder, board of directors or comparable meetings that affect the financial statements have been appropriately reflected therein. 12. Inquire about the existence of transactions with related parties, how such transactions have been accounted for and whether related parties have been properly disclosed. 13. Inquire about contingencies and commitments. 14. Inquire about plans to dispose off major assets or business segments. 15. Obtain the financial statements and discuss them with management. 16. Consider the adequacy of disclosures in the financial statements and their suitability as to classification and presentation. 17. Compare the results shown in the current period financial statements with those shown in financial statements for comparable prior periods and, if available, with budgets and forecasts. 18. Obtain explanations from management for any unusual fluctuations or inconsistencies in the financial statements.

I.200

Advanced Auditing & Professional Ethics

19. Consider the effect of any unadjusted errors—individually and in aggregate. Bring the errors to the attention of management and determine how the unadjusted errors will influence the report on the review. 20. Consider obtaining a representation letter from management. Analytical Procedures and Inquiry 21. Obtain interim financial information and make the following comparisons for individual items appearing in the financial statements: ♦

Current period to budgets and forecasts

♦

Current period to immediately preceding period

♦

Current period to same period in preceding year

♦

Current year-to-date to preceding year-to-date

♦

Current period to last audited period, wherever appropriate

22. Inquire about significant changes since the last audited balance sheet in various items such as: ♦

Capital and reserves

♦

Loans

♦

Current liabilities and provisions

♦

Fixed assets

♦

Investments

♦

Inventories

♦

Current assets

♦

Loans and advances

♦

Deferred revenue expenditure, etc.

23. Obtain or calculate selected ratios on a comparative basis. These ratios could be: ♦

Current

♦

Quick

♦

Debtors turnover

♦

Inventory turnover

♦

Depreciation to fixed assets

♦

Debt to equity

♦

Gross profit

♦

Net profit

Part I : Auditing and Assurance Standards ♦

I.201

Input output

24. Inquire about the relationship between related items in the statement of profit and loss as well as the quantitative data relating to production, purchases, sales, etc. and assess the reasonableness thereof, in the context of similar relationships for prior periods and other information available to the auditor. 25. In respect of comparison made in 21 through 24 above, obtain reasons for significant variances and discuss with management. Cash and Bank 26. Obtain the bank reconciliation statement. Inquire about any old or unusual reconciling items with client personnel. 27. Inquire about transfers between cash accounts for the period before and after the review date. 28. Inquire whether there are any restrictions on cash accounts. Receivables 29. Inquire about the accounting policies for initial recording of trade receivables and determine whether any allowances or discounts are given on such transactions. 30. Obtain a schedule of receivables and verify whether the total agrees with the trial balance. 31. Obtain and consider explanations of significant variations in account balances from previous periods or from those anticipated. 32. Obtain an aged analysis of the trade receivables. Inquire about the reason for unusually large accounts, credit balances on accounts or any other unusual balances and inquire about the collectibility of receivables. 33. Discuss with management the classification of receivables, including net credit balances and amounts due from directors and other related parties in the financial statements. 34. Inquire about the method for identifying “slow payment” accounts and setting allowances for doubtful accounts and consider it for reasonableness. 35. Inquire whether receivables have been pledged, factored or discounted. 36. Inquire about procedures applied to ensure that a proper cut-off of sales transactions and sales returns has been achieved. 37. Inquire whether receivables attributable to goods sent on consignment account have not been included in sales and such goods have been included in inventories. 38. Inquire whether any large credits relating to revenue recorded have been issued after the balance sheet date and whether provision has been made for such amounts.

I.202

Advanced Auditing & Professional Ethics

Inventories 39. Obtain the inventory list and verify that the total agrees with the balance in the trial balance or other relevant records. 40. Inquire the procedures followed for recording inventory and determine the necessity of physical count of inventory. For example, a physical count may not be carried out, in case ♦

A perpetual inventory system is used and periodic comparisons are made with actual quantities on hand.

♦

An integrated cost system is used and it has produced reliable information in the past.

41. In case of physical count, inquire about the method for counting inventory and agree the inventory list with the physical count. 42. Discuss adjustments made resulting from the last physical inventory count. 43. Inquire about procedures applied to control cut-off and any inventory movements at the end of the period. 44. Inquire about the basis used in valuing each category of the inventory and, in particular, regarding the elimination of inter-branch profits. Inquire whether inventory is valued at the lower of cost and net realisable value. 45. Consider the consistency with which inventory valuation methods have been applied. 46. Compare amounts of major inventory categories with those of prior periods and with those anticipated for the current period. Inquire about major fluctuations and differences. 47. Inquire about the method used for identifying slow moving and obsolete inventory and whether such inventory has been accounted for at net realisable value. 48. Inquire whether any inventory has been consigned to the entity and, if so, whether adjustments have been made to exclude such goods from inventory. 49. Inquire whether any inventory is pledged, stored at other locations or on consignment to others and consider whether such transactions have been accounted for appropriately. Investments 50. Obtain a schedule of the investments at the balance sheet date and verify whether it agrees with the trial balance. 51. Inquire about the accounting policy applied to investments. 52. Inquire about the classification of long-term and current investments. 53. Consider whether there has been proper accounting for gains and losses and investment income. 54. Inquire from management about the carrying values of investments. Consider whether there is any permanent diminution in value thereof.

Part I : Auditing and Assurance Standards

I.203

Fixed Assets and Depreciation 55. Obtain a schedule of the fixed assets indicating the cost and accumulated depreciation and verify whether it agrees with the trial balance. 56. Inquire about the accounting policy applied regarding the provision for depreciation and distinguishing between capital and maintenance items. 57. Discuss with management the additions and deletions to fixed assets accounts and accounting for gains and losses on sales or retirements. Inquire whether all such transactions have been accounted for. 58. Inquire about the consistency with which the depreciation method and rates have been applied and compare depreciation provisions with prior years. 59. Obtain schedule of repairs and maintenance and inquire about significant amounts. 60. Consider whether the fixed assets have suffered a material, impairment in value and adequate provision has been made in respect thereof. 61. Inquire whether there are any liens on the fixed assets. 62. Consider whether lease agreements have been properly dealt with in the financial statements in conformity with accounting pronouncements. Prepaid Expenses 63. Obtain schedules identifying the nature of these accounts and discuss with management the recoverability thereof wherever appropriate. 64. Inquire about the basis for recording these accounts and the adjustment methods used. 65. Compare balances of related expense accounts with those of prior periods and discuss significant variations with management. Intangibles and Other Assets 66. Obtain schedules of intangible and other assets accounts, determine the nature of these accounts and discuss with management the recoverability of intangible and other assets, wherever appropriate. 67. Inquire about the basis of recognition of such assets and the methods of amortisation used for such accounts. 68. Inquire about the consistency with which the amortisation methods have been applied and compare amortisation provisions with prior years. Capital and Reserves 69. Obtain and consider a schedule of the transactions in the capital account and reserves accounts, including new issues, redemption, buy back, and dividends. 70. Inquire whether there are any restrictions on reserves and surpluses.

I.204

Advanced Auditing & Professional Ethics

Loans Payable 71. Obtain from management a schedule of loans payable and verify whether the total agrees with the trial balance. 72. Inquire whether there are any loans where management has not complied with the provisions of the loan agreement and, if so, inquire as to management’s actions and whether appropriate adjustments have been made in the financial statements. 73. Consider the reasonableness of interest expense in relation to loan balances. 74. Inquire whether loans payable are secured. 75. Inquire whether loans payable have been appropriately classified between long-term and short-term. Trade Payables 76. Obtain a schedule of trade payables and verify whether the total agrees with the trial balance. 77. Inquire about the accounting policies for initial recording of trade payables and whether the entity is entitled to any allowances or discounts given on such transactions. 78. Obtain and consider explanations of significant variations in account balances from previous periods or from those anticipated. 79. Inquire whether balances are reconciled with the creditors’ statements and compare with prior period balances. 80. Consider whether there could be material unrecorded liabilities. Accrued and Contingent Liabilities 81. Obtain a schedule of the accrued liabilities and verify whether the total agrees with the trial balance. Inquire about the method of determining accrued liabilities. 82. Compare major balances of related expense accounts with similar accounts for prior periods. 83. Determine whether the recognition of major expenses has taken place in the appropriate periods. 84. Inquire about approvals for such accruals, terms of payment, compliance with terms. 85. Inquire as to the nature of amounts included in contingent liabilities and commitments. Inquire whether any actual or contingent liabilities exist which have not been appropriately dealt with in the financial statements . If so, discuss with management whether provisions need to be made in the accounts or whether disclosure should be made in the notes to the financial statements. Litigation 86. Inquire from management whether the entity is the subject of any legal actionsthreatened, pending or in process. Consider the effect thereof on the financial statements.

Part I : Auditing and Assurance Standards

I.205

Income and Other Taxes 87. Inquire from management if there were any events, including disputes with taxation authorities (both direct and indirect taxes), which could have a significant effect on the taxes payable by the entity. If yes, determine whether any provision is required. 88. Consider the tax expense (both current and deferred) in relation to the entity’s income for the period. 89. Inquire from management as to the adequacy of the recorded deferred and current tax liabilities including provisions in respect of prior periods. Subsequent Events 90. Obtain from management the latest interim financial statements and compare them with the financial statements being reviewed or with those for comparable periods from the preceding year. 91. Inquire about events after the balance sheet date that would have a material effect on the financial statements under review and, in particular, inquire whether: (a) Any substantial commitments or uncertainties have arisen subsequent to the balance sheet date; (b) Any significant changes in the share capital, long-term debt or working capital have occurred up to the date of inquiry; and (c) Any unusual adjustments have been made during the period between the balance sheet date and the date of inquiry. 92. Obtain and read the minutes of meetings of shareholders, directors and appropriate committees subsequent to the balance sheet date. 93. Consider the need for adjustments or disclosure in the financial statements. Extraordinary Items 94. Inquire and determine whether there are any extraordinary and unusual items and if so, whether these have been appropriately disclosed. Operations 95. Compare results with those of prior periods and those expected for the current period. Discuss significant variations with management. 96. Discuss whether the recognition of major sales and expenses have taken place in the appropriate periods. 97. Consider and discuss with management the relationship between related items in the statement of profit and loss and assess the reasonableness thereof in the context of similar relationships for prior periods and other information available to the auditor.

I.206

Advanced Auditing & Professional Ethics

Other Procedures 98. Inquire about: ♦

Changes in key management personnel.

♦

Major interruptions of operations due to strike, casualty, such as fire, etc.

♦

Significant contracts and agreements entered into/committed during the period.

♦

Wage settlements, if any.

♦

Changes in legislation that are likely to have material affect on the entity. Appendix 3 Form of Unqualified Review Report

Review report to... We have reviewed the accompanying balance sheet of ABC Company at March 31, 20XX, and the related statement of profit and loss and cash flows for the year then ended. These financial statements have been approved by the board of directors of the company and are the responsibility of the company’s management. Our responsibility is to issue a report on these financial statements based on our review. We conducted our review in accordance with the Auditing and Assurance Standard (AAS) 33, Engagements to Review Financial Statements issued by the Institute of Chartered Accountants of India. This Standard requires that we plan and perform the review to obtain moderate assurance as to whether the financial statements are free of material misstatement. A review is limited primarily to inquiries of company personnel and analytical procedures applied to financial data and thus provides less assurance than an audit. We have not performed an audit and, accordingly, we do not express an audit opinion. Based on our review, nothing has come to our attention that causes us to believe that the accompanying financial statements do not give a true and fair view (or ‘are not presented fairly, in all material respects’) in accordance with Accounting Standards issued by the Institute of Chartered Accountants of India. For ABC and Co., Chartered Accountants Auditor’s Signature (Name of Member signing the Audit Report) (Designation74) (Membership Number) Place Date

74

partner or proprietor, as the case may be.

Part I : Auditing and Assurance Standards

I.207

Appendix 4 Examples of Review Reports other than Unqualified Qualification for a Departure from an Accounting Standard Review report to... We have reviewed the accompanying balance sheet of ABC Company at March 31, 20XX, and the related statement of profit and loss and cash flows for the year then ended. These financial statements have been approved by the board of directors of the company and are the responsibility of the company’s management. Our responsibility is to issue a report on these financial statements based on our review. We conducted our review in accordance with the Auditing and Assurance Standard (AAS) 33, Engagements to Review Financial Statements issued by the Institute of Chartered Accountants of India. This Standard requires that we plan and perform the review to obtain moderate assurance as to whether the financial statements are free of material misstatement. A review is limited primarily to inquiries of company personnel and analytical procedures applied to financial data and thus provides less assurance than an audit. We have not performed an audit and, accordingly, we do not express an audit opinion. Management has informed us that inventory has been stated at its cost, which is in excess of its net realisable value. Management’s computation, which we have reviewed, shows that inventory, if valued at the lower of cost and net realisable value as required by Accounting Standard (AS) 2, “Valuation of Inventories” issued by the Institute of Chartered Accountants of India, would have been decreased by Rs. X, and net profit and reserves would have been decreased by Rs. X. Based on our review, except for the effects of the overstatement of inventory described in the previous paragraph, nothing has come to our attention that causes us to believe that the accompanying financial statements do not give a true and fair view (or ‘are not presented fairly, in all material respects’) in accordance with the Accounting Standards issued by the Institute of Chartered Accountants of India. For ABC and Co., Chartered Accountants Auditor’s Signature (Name of Member signing the Audit Report) (Designation75) (Membership Number) Place Date

75

partner or proprietor, as the case may be.

I.208

Advanced Auditing & Professional Ethics

Adverse Report for a Departure from an Accounting Standard Review report to... We have reviewed the accompanying balance sheet of ABC Company at March 31, 20XX, and the related statement of profit and loss and cash flows for the year then ended. These financial statements have been approved by the board of directors of the company and are the responsibility of the company’s management. Our responsibility is to issue a report on these financial statements based on our review. We conducted our review in accordance with the Auditing and Assurance Standard (AAS) 33, Engagements to Review Financial Statements issued by the Institute of Chartered Accountants of India. This Standard requires that we plan and perform the review to obtain moderate assurance as to whether the financial statements are free of material misstatement. A review is limited primarily to inquiries of company personnel and analytical procedures applied to financial data and thus provide less assurance than an audit. We have not performed an audit and, accordingly, we do not express an audit opinion. As noted in note X, the Company has adopted the method of taking entire profits on construction contracts to the statement of profit and loss on entering into the contract. This has resulted in anticipating the profit in cases where the contracts have not even been commenced or where only a very minor part of the expenditure relating to the construction contracts has been incurred. This method of accounting is contrary to the requirements of Accounting Standard (AS) 7, “Accounting for Construction Contracts”, issued by the Institute of Chartered Accountants of India. Based on our review, because of the pervasive effect on the financial statements of the matter discussed in the preceding paragraph, the accompanying financial statements do not give a true and fair view (or ‘are not presented fairly, in all material respects’) in accordance with the Accounting Standards issued by the Institute of Chartered Accountants of India. For ABC and Co., Chartered Accountants Auditor’s Signature (Name of Member signing the Audit Report) (Designation76) (Membership Number) Place Date AUDIT EVIDENCE – ADDITIONAL CONSIDERATIONS FOR SPECIFIC ITEMS (AAS 34) Introduction 1. The purpose of this Auditing and Assurance Standard (AAS) is to establish standards on the auditor’s responsibilities, audit procedures and provide additional guidance to that 76

partner or proprietor, as the case may be.

Part I : Auditing and Assurance Standards

I.209

contained in AAS 5, “Audit Evidence”, with respect to certain specific financial statement amounts and other disclosures. Application of the standards and guidance provided in this AAS will assist the auditor in obtaining audit evidence with respect to the specific financial statement amounts and other disclosures. This AAS comprises the following parts: Part A:

Attendance at Physical Inventory Counting

Part B:

Inquiry Regarding Litigation and Claims

Part C:

Valuation and Disclosure of Long-term Investments

Part D:

Segment Information

Part A:

Attendance At Physical Inventory Counting

2. The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence during his attendance at physical inventory counting. Definitions 3. Definitions regarding “Inventory” are given in Accounting Standard (AS) 2, Valuation of Inventories, issued by the Institute of Chartered Accountants of India, and are adopted for the purposes of this AAS77. 4. Physical verification of inventories is the responsibility of the management of the entity. Management ordinarily establishes procedures under which inventory is physically counted at least once in a year (end of the year, generally, or as near the end of the year as possible) to serve as a basis for preparation of the financial statements or to ascertain the reliability of the perpetual inventory system. 5. When inventory is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its existence and condition by attendance at physical inventory counting unless impracticable, due to factors such as the nature and location of the inventory. The attendance at such physical inventory counting will enable the auditor to inspect the inventory, to observe compliance with the operation of management’s procedures for recording and controlling the results of the count and to provide evidence as to the reliability of management’s procedures. 6. If unable to attend the physical inventory count on the date planned due to unforeseen circumstances, the auditor should take or observe some physical counts on an alternative date and where necessary, perform alternative audit procedures to assess whether the changes in inventory between the date of physical count and the period end date are correctly recorded. 7. Where attendance at the physical inventory counting is impracticable, the auditor should consider whether alternative procedures provide sufficient appropriate audit evidence of 77

Paragraph 3 of the Accounting Standard (AS)2, Valuation of inventories, states as follows. The following terms are used in this Statement with the meanings specified. Inventories are assets; (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services.

I.210

Advanced Auditing & Professional Ethics

existence and condition of inventory to conclude that the auditor need not make reference to a scope limitation. For example, the auditor should examine a sample of documents evidencing the movement of inventory into and out of stores shortly before and after the cut – off date, and verify whether the inventory represented by those documents were included or excluded, as appropriate during the inventory count. 8. In planning attendance at the physical inventory count or the alternative procedures, the auditor would consider the following: ♦

The nature of the accounting and internal control systems used regarding inventory.

♦

Inherent, control and detection risks, and materiality related to inventory.

♦

Whether adequate procedures are established and proper instructions issued for physical inventory counting.

♦

The timing of the count.

♦

The locations at which inventory is held and its nature.

♦

Whether an expert’s assistance is needed.

When inventory is situated in several locations, the auditor would consider at which locations attendance is appropriate, taking into account the materiality of the inventory and the risk of material misstatement and the assessment of inherent and control risk at different locations. 9.

The auditor would review management’s instructions regarding:

(a) The application of control procedures, for example, collection of used stock-sheets, accounting for unused stock-sheets, tagging and count and re-count procedures; (b) Accurate identification of the stage of completion of work in progress, slow moving, obsolete, damaged or rejected items, inventory owned by a third party, for example, on consignment and inventory in transit; and (c) Appropriate arrangements made regarding the movement of inventory between areas and the shipping and receipt of inventory before and after the cut-off date. 10. The auditor would also consider cut-off procedures including details of the movement of inventory just prior to, during and after the count to ensure that such movements are appropriately included and/or excluded, as applicable from such inventory. For example, (a) goods purchased but not received are included in the inventories; and (b) goods sold but not despatched are excluded from the inventories. 11. When the quantities are to be determined by a physical inventory count and the auditor attends such a count, or when the entity operates a perpetual inventory system and the auditor attends a count one or more times during the year, the auditor would ordinarily observe count procedures and perform test counts. 12. If the entity uses procedures to estimate the physical quantity, such as estimating a coal pile, the auditor would need to be satisfied regarding the reasonableness of those procedures. 13. To obtain assurance that management’s procedures are adequately implemented, the auditor would observe physical verification procedures performed by the employees and

Part I : Auditing and Assurance Standards

I.211

perform test counts. When performing counts, the auditor would test both the completeness and the accuracy of the count records by tracing items selected from those records to the physical inventory sheets and items selected from the physical inventory to the count records. Where tagging method of physical count of inventory is used, the auditor would verify the tag reconciliation prior to the counting or before finalising the count. The auditor would consider the extent to which copies of such count records need to be retained for subsequent audit procedures, testing and comparison. 14. For practical reasons, the physical inventory count may be conducted at a date other than period end. This will ordinarily be adequate for audit purposes only when the control risk is assessed at less than high. The auditor would assess whether, through the performance of appropriate audit procedures, changes in inventory between the count date and period end are correctly recorded. 15. When the entity operates a perpetual inventory system, which is used to determine the period end balance, the auditor would assess whether, through the performance of additional procedures, the reasons for any significant differences between the physical count and the perpetual inventory records are understood and the records are properly adjusted. 16. The auditor performs audit procedures over the final inventory listing to assess whether it accurately reflects actual inventory counts. 17. When inventory is under the custody and control of a third party, the auditor would ordinarily obtain direct confirmation from the third party/arrange with the entity for sending requests for such confirmation as to the quantities and condition of inventory held on behalf of the entity. Further, depending on materiality of this inventory the auditor would also consider the following: ♦

The conduct of the third party in the past with the entity and independence of the third party.

♦

Observing, or arranging for another auditor to observe, the physical inventory count.

♦

Obtaining another auditor’s report on the adequacy of the third party’s accounting and internal control systems for ensuring that the inventory is correctly counted and adequately safeguarded.

♦

Inspecting documentation regarding inventory held by third parties, for example, warehouse receipts.

♦

Subsequent receipt of goods from third parties.

Management Representations 18. The auditor should obtain a written representation from management concerning: (a) the completeness of information provided regarding the inventory; and (b) assurance with regard to adherence to laid down procedures for physical inventory count.

I.212

Advanced Auditing & Professional Ethics

Audit Conclusions and Reporting 19. If the auditor is unable to obtain sufficient appropriate audit evidence concerning the existence of inventory or adequacy of procedures adopted by the management in respect of physical inventory count the auditor should make a reference to a scope limitation in his audit report. If the inventory is not disclosed appropriately in the financial statements, the auditor should issue a qualified opinion. Part B:

Inquiry Regarding Litigation And Claims

Definitions 20(a)"Litigation" means a lawsuit or legal action including all proceedings therein. (b) "Claims" means a right to payment or right to an equitable remedy for breach of performance. 21. Litigation and claims involving an entity may have a material effect on the financial statements and thus may be required to be disclosed and/or provided for in the financial statements. 22. The auditor should carry out audit procedures in order to become aware of any litigation and claims involving the entity which may have a material effect on the financial statements. Such procedures would include the following: ♦

Make appropriate inquiries of management including obtaining representations.

♦

Review board /committee minutes and correspondence with the entity’s lawyers.

♦

Examine legal and other relevant expense accounts.

♦ Use any information obtained regarding the entity’s business including information obtained from discussions with in-house legal department, if any. 23. When litigation or claims have been identified by the management or when the auditor believes they may exist, and are likely to be material, the auditor may seek direct communication with the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims. Such communication will assist in obtaining sufficient appropriate audit evidence as to whether potentially material litigation and claims are known and management’s estimates of the financial implications, including costs, are reliable. 24. The letter seeking direct communication with the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims should be prepared by management. The auditor should maintain control over the process of preparation and sending of the letter. The letter should request the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims to communicate directly with the auditor. The letter would ordinarily specify the following: ♦

A list of litigation and claims.

♦

Management’s assessment of the outcome of the litigation or claim and its estimate of the financial implications, including costs involved.

♦

A request that the entity’s lawyer confirm:

Part I : Auditing and Assurance Standards

I.213

¾

the reasonableness of management’s assessments;

¾

provide the auditor with further information if the list is considered to be incomplete or incorrect; and

¾

provide updated information as and when requested by the auditor upto the date of the audit report.

25. The auditor considers the status of legal matters up to the date of the audit report. In some instances, the auditor may need to obtain updated information from lawyers. 26. In certain circumstances, for example, where the matter is complex or there is disagreement between management and the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims, it may be necessary for the auditor to meet with the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims to discuss the likely outcome of litigation and claims. Such meetings would take place with management’s permission and, preferably, with a representative of management in attendance. 27. If management refuses to give the auditor permission to communicate with the entity’s lawyers, this would constitute a limitation on the scope of the auditor’s work that requires expression of a qualified opinion or a disclaimer of opinion as the case may be. Where a lawyer or a professional refuses to respond in an appropriate manner and the auditor is unable to obtain sufficient appropriate audit evidence by applying alternative procedures, the auditor would consider whether there is a scope limitation which may lead to a qualified opinion or a disclaimer of opinion. Management Representations 28. The auditor should obtain a written representation from management concerning the completeness and adequacy of information provided regarding the identification of litigation and claims, estimates of financial implications, including costs, etc. Part C:

Valuation And Disclosure Of Long-Term Investments

29. The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence for valuation and disclosure of long term investments. Definitions 30. Definition regarding “Long Term Investments” is given in Accounting Standard (AS) 13, Accounting for Investments, issued by the Institute of Chartered Accountants of India and is adopted for the purposes of this AAS78. 31. When long-term investments are material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding their valuation and disclosure. 78

Paragraph 3 of Accounting standard (AS) 13, Accounting for Investments, states as follows: ''3. The following terms are used in this Statement with the meanings assigned: A Current Investment is an investment that is by its nature readily reailizable and is intended to be held for not more than one year from the date on which such investment is made. A long term investment is an investment other than a current investment.''

I.214

Advanced Auditing & Professional Ethics

32. Audit procedures regarding long-term investments ordinarily include obtaining audit evidence with respect to their ownership and existence as to whether the entity has the ability to continue to hold the investments on a long term basis and discussing with management whether the entity will continue to hold the investments as long-term investments and obtaining written representations to that effect. 33. Other procedures would ordinarily include: (a) In the case of quoted securities, considering related financial statements and other information, such as market quotations, which provide an indication of value and comparing such values to the carrying amount of the securities up to the date of the auditor’s report. (b) In case of unquoted securities, ascertaining the method adopted by the entity for determining the value of such securities as at the year end. The auditor should examine whether the method adopted by the entity is one of the recognised methods of valuation of securities such as Profit Earning capacity Value method, break-up value method, capitalisation of yield method, yield to maturity method, etc. (c) In the case of investments other than in the form of securities, ensuring that the market value has been ascertained on the basis of authentic market reports, and /or based on expert’s opinion, if warranted. 34. If such values do not exceed the carrying amounts, the auditor would consider whether a write-down is required. If there is an uncertainty as to whether the carrying amount will be recovered, the auditor would consider whether appropriate adjustments and/or disclosures have been made. Management Representations 35. The auditor should obtain a written representation from management regarding : (a) the completeness of information provided regarding valuation and disclosure of long term investments; (b) the valuation of long term investments in the financial statements including adequacy of provision for diminution in such values, wherever required; and (c) the intention of the management to continue to hold long-term investments as long-term investments. Audit Conclusions and Reporting 36. If the auditor is unable to obtain sufficient appropriate audit evidence concerning the existence, valuation of long term investments or concludes that their disclosure in the financial statements is not adequate, the auditor should express a qualified opinion or a disclaimer of opinion in the audit report, as may be appropriate. Part D:

Segment Information

37. The auditor should perform audit procedures designed to obtain sufficient appropriate audit evidence for appropriate disclosure of segment information.

Part I : Auditing and Assurance Standards

I.215

Definitions 38. “Segment Information” means the information to be disclosed in respect of reportable segments as given in Accounting Standard (AS) 17, “Segment Reporting”, issued by the Institute of Chartered Accountants of India or as defined in the financial reporting framework applicable to the entity. 39. When segment information is material to the financial statements, the auditor should obtain sufficient appropriate audit evidence regarding its disclosure in accordance with the applicable identified financial reporting framework. 40. The auditor considers segment information in relation to the financial statements taken as a whole, and is not required to apply auditing procedures that would be necessary to express an opinion on the segment information standing alone. Audit procedures regarding segment information ordinarily consist of analytical procedures and other audit tests appropriate in the circumstances. 41. The auditor would discuss with management the methods used in determining segment information, and consider whether such methods are likely to result in disclosure in accordance with the applicable financial reporting framework and test the application of such methods. The auditor would consider sales, transfers and charges between segments, elimination of inter-segment amounts, comparisons with budgets and other expected results, for example, operating profits as a percentage of sales, and the allocation of assets and costs among segments including consistency with prior periods and the adequacy of the disclosures with respect to inconsistencies. Management Representations 42. The auditor should obtain a written representation from management concerning: (a) the completeness of information regarding segments and disclosure thereof; and (b) appropriateness of the selected segments based on risks and returns; and (c) the organizational structure of an enterprise and its internal financial reporting system and any deviations therefrom. Audit Conclusions and Reporting 43. If the auditor is unable to obtain sufficient appropriate audit evidence concerning segment information or concludes that their disclosure in the financial statements is not adequate, the auditor should express a qualified opinion or a disclaimer of opinion in the audit report, as may be appropriate. Effective Date 44. This Auditing and Assurance Standard becomes operative for all audits related to accounting periods beginning on or after 1 April 2005. Compatibility With The International Standard On Auditing (ISA) 501 The auditing standards established in this AAS are generally consistent in all material respects with those set out in ISA 501, “Audit Evidence – Additional Considerations for Specific Items" except the following:

I.216

Advanced Auditing & Professional Ethics

(a) Due to practical reasons, paragraph 23 of the AAS requires that when litigation or claims have been identified by the management or when the auditor believes they may exist, and are likely to be material, the auditor may seek direct communication with the entity’s lawyers. The auditor need not necessarily communicate with the entity’s lawyers and such other professionals to whom the entity engages for litigation and claims in case the auditor is able to obtain the sufficient appropriate audit evidence regarding the identification of litigation and claims involving the entity which may have a material effect on the financial statements. The ISA on the other hand requires that the auditor should communicate with the entity’s lawyers to obtain sufficient appropriate audit evidence as to whether potentially material litigation and claims are known and management’s estimates of the financial implications, including costs, are reliable. (b) Each part of the AAS contains the requirements related to obtaining the management representations [see paragraphs 18, 28, 35 and 42]. There is, however, no such requirement in the ISA.

Part I : Auditing and Assurance Standards

I.217

GENERAL CLARIFICATION (GC)-AASB/1/2002 ON AAS 9 Auditing and Assurance Standard (AAS) 9, Using the Work of an Expert {The following is the General Clarification (GC)-AASB/1/2002 issued by the Auditing and Assurance Standards Board of the Institute of Chartered Accountants of India on Auditing and Assurance Standard (AAS) 9, “Using the Work of an Expert.”} 1.

Paragraph 12 of AAS 9 provide as under:

“12. The appropriateness and reasonableness of assumptions and methods used and their application are the responsibility of the expert. The auditor does not have the same expertise and, therefore, cannot always challenge the expert’s assumptions and methods. However, the auditor should obtain an understanding of those assumptions and methods to determine that they are reasonable based on the auditor’s knowledge of the client’s business and on the results of his audit procedures. 2. The auditor while verifying the accrued liability for retirement benefits or for Group Gratuity Schemes has to use the work of an another expert, i.e., actuary or the insurer itself. In such a case, the issue to be considered is whether it is sufficient for the auditor to rely on the certificate given by insurer or actuary without establishing the reasonableness of the assumptions made by the actuary or the insurer based on the auditor’s knowledge of the client’s business. It is clarified that the auditor should, while using the certificate issued by the actuary or the insurer, obtain an understanding of the methods used by the actuary or the insurer in determining the liability and should also judge the appropriateness and reasonableness of assumptions, for example, with regard to the following: (i)

Rate of Return

(ii)

Number of Employees

(iii) Retirement Age (iv) Salaries (v) Promotion Policies (vi) Age of Employees GENERAL CLARIFICATION (GC)-AASB/3/2004 ON AAS 16 Auditing and Assurance Standard (AAS) 16, Going Concern {The following is the General Clarification (GC)/AASB/3/2004 issued by the Auditing and Assurance Standards Board of the Institute of Chartered Accountants of India on Auditing and Assurance Standard (AAS) 16, ‘Going Concern”.} 1. The Companies (Amendment) Act, 2000 has mandated that every private company existing on 13th December 2000 with a paid-up capital of less than one lakh rupees, shall, within a period of two years from such commencement enhance its paid up capital to one lakh rupees. Similarly, every public company existing on 13th December 2000 with a paid-up capital of less than five lakh rupees, shall, within a period of two years from such commencement enhance its paid up capital to five lakh rupees. Where a private company or a

I.218

Advanced Auditing & Professional Ethics

public company fails to enhance the paid-up capital to the statutory minimum, as mentioned above, such company shall be deemed a defunct company within the meaning of section 560 of the Companies Act, 1956 and its name shall be struck off from the register by the Registrar. 2. Paragraphs 5 and 6 of Auditing and Assurance Standard (AAS) 16, Going Concern provide as follows: “5. The auditor should consider the risk that the going concern assumption may no longer be appropriate. 6.

Indications of risk that continuance as a going concern may be questionable could come from the financial statements or from other sources.”

3. Further, AAS 16 also mentions that non-compliance with capital or other statutory requirements could be an example of an indication of risk that the going concern assumption may no longer be appropriate. 4. If a company fails to enhance its paid-up capital up to the statutory minimum, such company shall be deemed a defunct company within the meaning of section 560 of the Companies Act, 1956 and therefore, its name shall be struck off from the register by the Registrar of Companies. However, such an entity may decide not to carry on business or may decide to carry on the business in some other form of organisation, e.g., partnership, etc. This situation gives rise to the risk that the going concern assumption may no longer be appropriate. 5. The auditor, in such a situation, performs the audit procedures as required by the Auditing and Assurance Standard (AAS) 16, Going Concern. Unless, the entity under audit demonstrates otherwise, the auditor should consider the going concern assumption as inappropriate and report in accordance with paragraph 18 of AAS 16. GENERAL CLARIFICATION (GC)-AASB/2/2004 ON AAS 26 Auditing and Assurance Standard (AAS) 26, Terms of Audit Engagement {The following is the General Clarification (GC)/AASB/2/2004 issued by the Auditing and Assurance Standards Board of the Institute of Chartered Accountants of India on Auditing and Assurance Standard (AAS) 26, “Terms of Audit Engagement.”} 1. The Auditing and Assurance Standard (AAS) 26, Terms of Audit Engagement was issued with a view to establish standards on: (a) agreeing the terms of the engagement with the client; and (b) the auditor's response to a request by a client to change the terms of an engagement to one that provides a lower level of assurance. 2. A question that arises is whether it is necessary that the engagement letter issued by the auditor should be acknowledged by addressee and returned to the auditor to indicate that the client’s understanding of the terms of the engagement is in accordance with the engagement letter issued by the auditor and to establish that the auditor has complied with the requirements of the Standard in so far as they are related to sending the audit engagement letter.

Part I : Auditing and Assurance Standards 3.

I.219

Paragraphs 2 through 4 of AAS 26 provide as follows:

“2. The auditor and the client should agree on the terms of the engagement. The agreed terms would need to be recorded in an audit engagement letter or other suitable form of contract. 3. This AAS is intended to assist the auditor in the preparation of engagement letters relating to audits of financial statements. The Standard is also applicable to related services. When other services such as tax, accounting, or management consultancy and other services are to be provided, separate letters may be appropriate. 4. Though the objective and scope of an audit and the auditor's obligations are, normally, laid down in the applicable statute or regulations and the pronouncements of the Institute of Chartered Accountants of India, the audit engagement letters would be informative for the clients.” 4. From the above it is clear that the basic purpose of issuing an engagement letter is that the auditor and the client should agree on the terms of the engagement. The auditor and the client are normally considered to be agreeing on the terms of the engagement if the objective and scope of an audit and the auditor's obligations are laid down in the statute or regulations governing the engagement. Examples of such engagements include audit under section 227 of the Companies Act, 1956, audit of public sector banks, etc. In such cases, it is not necessary that the engagement letter sent by the auditor in accordance with paragraph 5 of AAS 26 is acknowledged by the addressee and returned to the auditor to establish that the client’s understanding of the terms of the engagement is in accordance with the engagement letter issued by the auditor. It shall be sufficient compliance with the requirements related to sending the audit engagement letter, if an engagement letter is appropriately delivered to the client and the auditor retains the evidence for such delivery. In such cases, the audit engagement letters would be informative for the clients. 5. If, however, the client seeks any further explanations or clarification in regard to any terms, conditions or other contents of the engagement letter issued, it might indicate that there exists a difference in understanding of the terms of audit engagement either on the part of the client or on the part of the auditor. The auditor, in such cases, should take necessary steps to resolve the issues, for example by appropriately replying to the issues raised by the client. It is also desirable that the auditor documents the evidence indicating that the issues are settled and the client and auditor agree on the terms of the engagement. 6. There may be certain engagements where the objective and scope of the engagement and the auditor's obligations are not laid down in the applicable statute or regulations. In such situations, the auditor should request the client that a copy of the engagement letter be acknowledged by the addressee and returned to the auditor to establish: (a) that the client’s understanding of the arrangements for the engagement is in accordance with the engagement letter issued by the auditor; and (b) that the auditor has complied with the requirements of the standard in so far as they are related to sending the audit engagement letter.

PART II GUIDANCE NOTES

1.

PROVISION FOR PROPOSED DIVIDEND1

1. This Statement summarises the Council’s view regarding the responsibility of the auditor relating to the provision for and disclosure of proposed dividend and replaces all earlier statements on this subject. 2. The Council is aware of the fact, that a large number of companies do not provide for the proposed dividend but either carry forward the balance on the profit and loss account or transfer an amount to the General Reserve and charge the dividend to the profit and loss account or to the reserve when payment is made. 3 The Council is of the view that a proposed dividend does not represent a liability nor does it amount to a provision, pending the approval of the shareholders in General Meeting. Since the meeting to approve the accounts would take place after the Balance Sheet date, there could not be any liability in respect of the proposed dividend on the date of the Balance Sheet. The Council is of the opinion that merely because the form requires proposed dividend to be shown under “Current Liabilities and Provisions”, it does not mean that in fact the proposal for the dividend becomes a liability or is necessarily a provision. The Council would draw attention to the forms of accounts laid down under the Insurance Act, 1938 and the Banking Regulation Act, 1949, in both of which it is not a requirement to show “proposed dividend” and it cannot be contended that merely because proposed dividend is not shown in the accounts, that the accounts of Insurance and Banking Companies do not disclose a ‘true and fair’ view. 4. Since, however, the form of Balance Sheet prescribed in Part 1 of Schedule VI requires “proposed dividends” to be shown under “Provisions”, and since paragraph 3(xiv) of Part II of the same Schedule requires the “proposed dividends” to be disclosed, the Council is of the opinion that, though on correct accounting principles, the proposed dividend does not become a liability for reasons mentioned above, the attention of the shareholders would have to be drawn to the fact that no appropriation has been made for the proposed dividend, the amount in respect of which should be specified. 5. The Council, therefore, recommends that the fact that provision for proposed dividend has not been made should be disclosed by means of a note in the accounts and that the auditor should refer to the note in his report and make his report subject thereto. 1

Published in CICA Newsletter, November, 1975, p.78.

II.2

Advanced Auditing & Professional Ethics 2.

INDEPENDENCE OF AUDITORS

The following is the text of the Guidance Note on Independence of Auditors issued by the Council of the Institute of Chartered Accountant of India. 1.

Introduction

1.1 This guidance note aims to clarify the meaning of independence while performing their duties as auditors. Professional integrity and independence is an essential characteristic of all the learned professions but is more so in the case of accounting profession. Independence implies that the judgement of a person is not subordinate to the wishes or directions of another person who might have engaged him, or to his own self-interest. This document shall provide guidance to members about the specific circumstances and relationship that may create threats to independence. The Guidance Note also provide safeguards that should be employed by the auditors to mitigate the risk arising from such circumstances and relationship leading to the threats to independence. 1.2 It is not possible to define “independence” precisely. Rules of professional conduct dealing with independence, like other rules, are framed primarily with a certain objective. The rules themselves cannot create or ensure the existence of independence. Although by now it has become somewhat trite to say so, independence is a condition of mind and personal character and should not be confused with the superficial and visible standards of independence which are sometimes imposed by law (and which are referred to below). These legal standards may be relaxed or strengthened but the quality of independence remains unaltered. 1.3 There are two interlinked perspective of independence of Auditors, one, independence of mind; and two, independence in appearance. The Code of Ethics for Professional accountants, issued by International Federation of Accountant (IFAC) defines the term ‘ Independence’ as follows: “ Independence is: (a) Independence of mind – the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional skepticism; and (b) Independence in appearance – the avoidance of facts and circumstances that are so significant a reasonable and informed third, having knowledge of all relevant information, including any safeguards applied, would reasonably conclude a firm’s, or a member of the assurance team’s, integrity, objectivity or professional skepticism had been compromised.” 1.4 Independence of the auditor has not only to exist in fact, but also appear to so exist to all reasonable persons. The relationship between the auditor and his client should be such that firstly, he is himself satisfied about his independence and secondly, no unbiased person would be forced to the conclusion that, on an objective assessment of the circumstances, there is likely to be an abridgement of the auditors' independence.

Part II : Guidance Notes

II.3

1.5 In all phases of a Chartered Accountant's work, he is expected to be independent, but in particular in his work as auditor, independence has a special meaning and significance. Not only the client but in the case of companies, also the shareholders, prospective investors, bankers and government agencies rely upon the accounts of an enterprise when they are audited by a Chartered Accountant. As statutory auditor of the accounts of a limited company, for example, the Chartered Accountant would cease to perform any useful function if the persons who rely upon the accounts of the company do not have any faith in the independence and integrity of the Chartered Accountant. In such cases he is expected to be objective in his approach, fearless, and capable of expressing an honest opinion based upon the performance of work such as his training and experience enables him to do so. 1.6 The objective of an audit of Financial statements, prepared within a framework of recognized accounting policies and practices and relevant statutory requirements, If any, is to enable an auditor to express an opinion on such financial statement. The auditor’s opinion helps determination of true and fair view of the financial position and operating results of an enterprise. The user, however, should not assume that the auditor’s opinion is an assurance as to the future viability of the enterprise or the efficiency or the effectiveness with which management has conducted the affairs of the enterprise. 1.7 The idea of independence is instilled in the minds of Chartered Accountants from the commencement of their training under articles or audit service. It has to be applied in their day-to-day work and their success is dependent entirely upon their integrity, competence and independence of approach. 1.8 Dependent as it is on the state of mind and character of a person, independence, is a very subjective matter. One person might be independent in a particular set of circumstances. While another might feel he is not independent in similar circumstances. It is, therefore, the duty of every Chartered Accountant to determine for himself whether or not he can act independently in the given circumstances of a case and quite apart from legal rules, in no case to place himself in a position which would compromise his independence. 1.9 The auditor should be straightforward, honest and sincere in his approach to his professional work. He must be fair and must not allow prejudice or bias to override his objectivity. He should maintain an impartial attitude and both be and appear to be free of any interest which might be regarded, whatever its actual effect, as being incompatible with integrity and objectivity. This is not self evident in the exercise of the reporting function but also applies to all other professional work. In determining whether a member in practice is or is not seen to be free of any interest which is incompatible with objectivity, the criterion should be whether a reasonable person, having knowledge of relevant facts and taking into account the conduct of the member and the member's behaviour under the circumstances, could conclude that the member has placed himself in a position where his objectivity would or could be impaired. 1.10 While performing audit functions, maintaining quality control is the objectives of the quality control and policies to be adopted by an Auditor shall ordinarily incorporate the following:

II.4

Advanced Auditing & Professional Ethics

(a) Professional Requirements: Personnel in the firm are to adhere to the principles of Independence, Integrity, Objectivity, Confidentiality and Professional Behaviours. (b) Skills and Competence: The firm is to be staffed by personnel who have attained and maintained the Technical Standards and Professional Competence required to enable them to fulfill their responsibilities with Due Care. (c) Assignment: Audit work is to be assigned to personnel who have the degree of technical training and proficiency required in the circumstances (d) Delegation: There is to be sufficient direction supervision and review of work at all levels to provide reasonable' assurance that the work performed meets appropriate standards of quality. (e) Consultation: Whenever necessary, consultation within or outside the firm is to occur with those who have appropriate expertise (f)

Acceptance and Retention of Clients: An evaluation of prospective clients and a review, on an ongoing basis, of existing clients is to be conducted. In making a decision to accept or retain a client the firm's independence and ability to serve the client properly are to be considered.

(g) Monitoring: The continued adequacy and operational effectiveness of quality control policies and procedures is to be monitored. 1.11 A member not in practice has a duty to be objective in carrying out his or her professional work whether or not the appearance of professional independence is attainable. Thus a member performing professional work must recognize the problems created by personal relationships or financial involvement, which by reason of their nature or degree might threaten his independence. 1.12 Standing alone, the word "Independence" may lead observers to suppose that a person exercising professional judgment ought to be free from all economic, financial and other relationships. This is impossible, as every member of society has relationships with others. Therefore, the significance of economic financial and other relationships should also be evaluated in the light of what a reasonable and informed third party having knowledge of all relevant information would reasonably conclude to be unacceptable. 1.13 Many different circumstances, or combination of circumstances, may be relevant and accordingly it is impossible to define every situation that creates threats to independence and specify the appropriate mitigating action that should be taken. In addition the nature of assurance engagements may differ and consequently different threats may exist requiring the application of different safeguards. A conceptual framework that requires chartered accountants to identify, evaluate and address threats to independence, rather than merely comply with a set of specific rules in the public interest. 2. Threats to Independence 2.1 The Code of Ethics for Professional Accountants, prepared by the International Federation of Accountants (IFAG) identifies five types of threats. These are:

Part II : Guidance Notes

II.5

1. Self-interest threats, which occur when an auditing firm, its partner or associate could benefit from a financial interest in an. audit client. Examples include (i) direct financial interest or materially significant indirect financial interest in a client, (ii) loan or guarantee to or from the concerned client, (iii) undue dependence on a client's fees and, hence, concerns about losing the engagement, (iv) close business relationship with an audit client,' (v) potential employment with the client. and (vi) contingent fees for the audit engagement. 2. Self-review threats, which occur when during a review of any judgement or conclusion reached in a previous audit or non-audit engagement; or when a member of the audit team was previously, a director or senior employee of the client. Instances, where such threats come into play are (i) when an auditor having recently been a director or senior officer of the company and (ii) when auditors perform services that, are themselves subject matters of audit. 3. Advocacy threats which occur when the auditor promotes, or is perceived to promote, a client's opinion to a point where people may believe that objectivity is getting compromised, e.g. when an auditor deals with shares or securities of the audited company, or becomes the client's advocate in litigation and third party disputes. 4. Familiarity threats are self-evident, and occur when auditors form relationships with the client where they end up being too sympathetic to the client's interests. This can occur in many ways: (i) close relative of the audit team working in a senior position in the client company, (ii) former partner of the audit firm being a director or senior employee of the client, (Hi) long association between specific 'auditors and their specific client counterparts, and (iv) acceptance of significant gifts or hospitality from the client company its directors or employees. 5. Intimidation threats, which occur when auditors are deterred from acting objectively with an adequate degree of professional skepticism. Basically, these could happen because of threat of replacement over disagreements with the application of accounting principles, or pressure to disproportionately reduce work in response to reduced audit fees. 3.

Safeguards To Independence

3.1 The Chartered Accountant has a responsibility to remain independent by taking into account the context in which they practice, the threats to independence and the safeguards available to eliminate the threats. 3.2 To address the issue, Members are advised to apply the following guiding principles: ♦ For the public to have confidence in the quality of audit it is essential that auditors should always be and appears to be' independent of the entities that they are auditing. ♦ In the case of audit, the key fundamental principles are integrity, objectivity and professional skepticism, which necessarily require the auditor to be independent. ♦ Before taking on any work, an auditor must conscientiously consider whether it involves threats to his independence."

II.6

Advanced Auditing & Professional Ethics ♦ When such threats exist, the auditor should either desist from the task or, at the very least, put in place safeguards that eliminate them. All such safeguards measure needs to be recorded in a form that can, serve as evidence of compliance with due process. ♦ If the auditor is unable to fully implement credible and adequate safeguards, then he must not accept the work.

3.3 Provisions contained under the Companies Act, 1956 3.3.1 In order to ensure independence, the law has made certain provisions which either prohibit the appointment of a person as auditor in. certain circumstances or place certain restrictions on his appointment as -auditor or put third parties on guard against the possibility of an abridgement of independence by requiring certain disclosures to be made. These provisions are briefly outlined below: 3.3.2 Section 226 of the Companies Act, 1956 prohibits the appointment of a Chartered Accountant as auditor of a Company if he is: (i)

an officer or employee of the Company;

(ii)

a partner of a person in the employment of an officer or of an employee of the Company; (iii) a person who is indebted to the company for an amount exceeding Rs. 1000;

(iv) a person who has given any guarantee or provided any .security in connection with the indebtedness of any third person to the company for an amount exceeding Rs. 1000; (v) a person holding any security of that company. 3.3.3 A person who is disqualified from becoming auditor of any body corporate under the above rules is also disqualified 'from appointment as auditor of such body's subsidiary, co subsidiary or holding company. . 3.3.4 Section 314. of the Companies Act, 1956 makes separate provision for the case where an auditor of a Company (whether public or private) is a relative of a director, or manager of a private company of which the director of the company is a director or member. In the case of such a person he may be appointed as auditor of a company only if such appointment if approved with the consent of the company in general meeting obtained by a special resolution. . 3.3.5 It will be observed from the above that the Act has specifically provided for cases where the independence of an auditor may be affected by his connection with the company and prohibited or restricted him from acting as auditor under those circumstances. . 3.3.6 A question often arises as to whether an indebtedness (as referred in para (Hi) above) arises in cases where in accordance with the terms of his engagement by a client (e.g. resolution passed at the general meeting) the auditor recovers his fees on a progressive basis as and when a part of the work is done without waiting for. the completion of the whole job. In these circumstances, where in accordance with such terms the auditor recovers his fees on a progressive basis he cannot be said to be indebted to the company at any stage.

Part II : Guidance Notes

II.7

3.3.7 A question of indebtedness may also be raised where an auditor of a company purchases goods or services from a company audited by him. In such a case, if the amount outstanding exceeds Rs. 10001- irrespective of the nature of the purchase or period of credit allowed to other customers the provisions concerning disqualification of auditor as contained in Section 226 (3)(d) of the Companies Act, 1956 will be attracted. 3.3.8 Another question which arises for consideration is whether a partner is disqualified from appointment as auditor when the firm of which he is a partner is indebted to the company in excess of the limit prescribed and whether, the firm is disqualified from appointment as auditor when a partner of, the firm indebted, in excess, of the prescribed limit. In both cases, the disqualification will apply, because when a firm is appointed as auditor, each partner is deemed to be so appointed and when a firm is Indebted, each partner is deemed to be indebted. 3.3.9 There may also be situations in which, though the appointment is in the individual name of a partner, the work, is, in fact, carried out by the firm and the fees are credited to the account of the firm. In such situations, the firm will be deemed to be acting as auditor and the disqualification will be attracted. 3.4 Provisions contained under the Chartered Accountants Act, 1949, Chartered Accountants Regulations, 1988 and under Code of Ethics to ensure Independence of Auditors. 3.4.1 Clause (10) of Part I of the First Schedule to the Chartered Accountants Act, 1949 prohibits acceptance of, what have been described as contingent fees, i.e., fees, which are enter based on percentage of profits or otherwise dependent on the finding or the results of employment. 3.4.2 What distinguishes a profession from a business is that professional service is not rendered with the sole purpose of a profit motive. Personal gain is one but not the main or the only objective. Professional opinion, therefore, frowns upon methods where payment is made to depend on the basis of results. It is obvious that a person who is to receive payment in direct proportion to the benefit received by his client, may be tempted to exaggerate the 'advantage of his service or may adopt means which are not ethical. It will have the effect of undermining his integrity and impairing his independence. Therefore, the members are prohibited from charging or accepting any remuneration based on a percentage of the profits or on the happening of a particular contingency such as, the successful outcome of an appeal in revenue proceedings. 3.4.3 Professional services should not be offered or rendered under an arrangement whereby no fee will be charged unless a specified finding or result is obtained or where the fee is otherwise contingent upon the findings or results of such services. However, fee should not be regarded as being contingent if fixed by a Court or other public authority. 3.4.4 The Council of the Institute has framed Regulation 192, which exempts members from the operation of this Clause in certain professional services. The said Regulation 192 is reproduced below:

II.8

Advanced Auditing & Professional Ethics

192. Restriction on fees No chartered accountant in practice shall charge or offer to charge, accept or offer to accept in respect of any professional work, fees which are based on a percentage of profits, or which are contingent upon the findings, or results of such work: Provided that: (a) in the case of a receiver or a liquidator, the fees may be based on a percentage of the realisation or disbursement of the assets; (b) in the case of an auditor of a co-operative society, the fees may be based on a percentage of the paid up capital or the working capital or the gross or net income or profits; and (c) in the case of a valuer for the purposes of direct taxes and duties, the fees may be based on a percentage of the value of the property valued. 3.4.5 Attention of the members is invited to the provisions of Clause (4) of Part I of the Second Schedule to the Chartered Accountants Act, 1949 which provides that a Chartered Accountant in practice shall be deemed to be guilty of professional misconduct if he expresses his opinion on financial statements of any business or any enterprise in which he, his firm or a partner in his firm has a substantial interest, unless he discloses his interest also in his report. 3.4.6 If the opinion of auditors are to command respect and the confidence of the public, it is essential that they must disclose every factor which is likely to affect their independence. Since financial interest in the business can be one of the important factors, which may disturb independence, the clause provides that the existence of such an interest direct or indirect should be disclosed. This is intended to assure the public as regards the faith and confidences that could be reposed on the independent opinion expressed by the auditors. 3.4.7 The words "financial statements" used in this clause would cover both reports and certificates usually given after an examination of the accounts or the financial statement or any attest function under any statutory enactment or for purposes of income-tax assessments. This would not however, apply to cases where such statements are prepared by members in employment purely for the information of their respective employers in the normal course of their duties and not meant to be submitted to any outside authority. 3.4.8 Public conscience is expected to be ahead of the law. Members, therefore, are expected to interpret the requirement as regards independence much more strictly than what the law requires and should not place themselves in positions which would either compromise or jeopardize their independence. . 3.4.9 A Member must take care to see that he does not get into situations where there could be a conflict of interest and duty. For example, where a Chartered Accountant is appointed the liquidator of a company, he should not himself audit the Statement of Account to be filed under Section 551 (1) of the Companies Act, 1956. The audit in such circumstances should be done by a Chartered Accountant other than the one who is the liquidator of the company. Attention of the members is drawn to the audit assignments where appointment is done by the Comptroller & Auditor General of India (C&AG), Reserve Bank of India (RBI) and such other

Part II : Guidance Notes

II.9

authorities. In addition to ensuring independence during the assignment, it is also essential to avoid any situation in near future which may be interpreted as a threat to independence, as for example, he or any other partner of his firm should not accept any other assignment such as internal audit, system audit and management consultancy services within one year from the completion of audit assignment. 3.4.10 A Chartered Accountant in employment should not certify the financial statements of the concern in which he is employed, or of a concern under the same management as the concern in which he is employed, even though he holds certificate of practice and that such certification can be done by any chartered accountant in practice. This restriction would not however apply where the certification is permitted by any law, e.g. Section 228 (iv) of the Companies Act, 1956 and the Companies (Branch Audit Exemption) Rules made thereunder. The Council has decided that a chartered accountant should not be himself or in his firm name:(i)

accept the auditorship of a college, if he is working as a part-time lecturer in the college.

(ii)

accept the auditorship of a trust where his partner is either an employee or a trustee of the trust.

3.4.11 Many new areas of professional work have been added, e.g., Special Audit under the Statutes, Tax Audit, Concurrent Audit of Banks, Concurrent Audit of Borrowers of Financial institutions, Audit of non-corporate borrowers of banks and financial institutions, audit of stock exchange, brokers etc. The Council wishes to emphasis that the requirement of Clause (4) of Part I of the Second Schedule to the Chartered Accountants Act, 1949 Act, is equally applicable white performing all types of attest functions by the members. 3.4.12 Some of the situations which may arise in the applicability of Clause (4) of Part I of the Second Schedule to the Chartered Accountants Act, 1949 are discussed below for the guidance of members;1.

Where the member, his firm or his partner or his relative has substantial interest in the business or enterprise. The independence of mind is a fundamental concept of audit and/or expression of opinion on the financial statements in any form and, therefore, must always be maintained. Nothing can substitute for the essential and fundamental requirements of independence. Therefore, the Council's views are clarified in the following circumstances. (i)

An enterprise/concern of which a member is either an owner or a partner The holding of interest in the business or enterprise by a member himself whether as sole-proprietor or partner in a firm, in the opinion of the Council, would affect his independence of mind in the performance of professional duties in conducting the audit and/or expressing an opinion on financial statements of such enterprise. Therefore, a member should not audit financial statements of such business or enterprise.

II.10

Advanced Auditing & Professional Ethics (ii) Where the partner or relative of a member has substantial interest The holding of substantial interest by the partner or relative of the member in the business or enterprise of which the audit is to be carried out and opinion is to be expressed on the financial statement, may also affect the independence of mind of the member, in the opinion of Council, in the performance of professional duties. Therefore, the member may, for the same reason as not to compromise his independence, desist from undertaking the audit of financial statements of such business or enterprise. However, where a member undertakes the audit of such business or enterprise, he should disclose such interest in his report while expressing his opinion on the financial statements of such business or enterprise.

2. Where the member or his partner or relative is a director or in the employment of an officer or an employee of the company Section 226 of the Companies Act, 1956 specifically prohibits a member from auditing the accounts of a company in which he is a director or in the employment of an officer or an employee of the company. Although the provisions of the aforesaid section are not specifically applicable in the context of audits performed under other statutes, e.g. tax audit, yet the underlying principle of independence of mind is equally applicable in those situations also. Therefore, the Council's views are clarified in the following situations. (i)

Where a member is a director In cases where the member is a director of a company the financial statements of which are to be audited and/or opinion is to be expressed, he should not undertake such job and/or express opinion on the financial statements of the company.

(ii) Where a partner or relative of the member is a director in the company who has a substantial interest. In such cases for the reason as not to compromise with the independence of mind, the member may desist from undertaking the audit of financial statements and/or expression of opinion thereon. However, if a member feels that his independence is not affected and undertakes the audit of such company, he should disclose such interest in his report while expressing his opinion on the financial statements of such company. The meaning of the words ''relative'' and ''substantial interest'' shall be the same as are contained in the Resolution passed by the Council in pursuance to Regulation 190A of Chartered Accountants Regulations, 1988 (Appendix 9 of 2002 edition). 3.4.13 An accountant is expected to be on less independence in the discharge of his duties as a tax consultant or as a financial adviser than as auditor. In fact, it is necessary that he should bear the same degree of integrity and independence of mind in all spheres of his work. Unless this is done, the accounts of companies audited by Chartered Accountants or statements made by them during the course of assessment proceedings would not be relied upon as correct by the authorities.

Part II : Guidance Notes 3.4.14 clients.

II.11

The Members are not permitted to write the books of accounts of their auditee

3.4.15 A statutory auditor of a company cannot also be its internal auditor, as it will not be possible for him to give independent and objective report issued under sub-Section 4A of Section 227 of the Companies Act, 1956 read with the Companies (Auditor's Report) Order, 2003. 3.4.16 The Council has issued a Notification No .1-CA(37)/70 dated 23rd May, 1970 whereby a member of the Institute in practice shall be deemed to be guilty of professional misconduct, if-I.

The accepts appointment as Cost auditor of Company under Section 233B of the Companies Act, 1956 while he (a) is an auditor of the company appointed under Section 224 of the Companies Act; or (b) is an officer or employee of the company; or (c) is a partner, or is in the employment of an officer or employee of the company; or (d) is a partner or is in the employment of the Company's auditor appointed under Section 224 of the Companies Act, 1956; or (e) is indebted to the company for an amount exceeding one thousand rupees, or has given any guarantee or provided any security in connection with the indebtedness of any third person to the company for an amount exceeding one thousand rupees; OR

II.

after his appointment as Cost Auditor, he becomes subject to any of the disabilities stated in items I (a) to (e) above and continues to function as a cost auditor thereafter.

3.4.17 The Council has issued a Notification No. 1-CA(39)/70 dated 16th October, 1970 where a member of the Institute in practice shall be deemed to be guilty of professional misconduct, if he accepts the appointment as auditor of a company under Section 224 of the Companies Act, 1956 while he is an employee of the cost auditor of the Company appointed under Section 233B of the Companies Act, 1956. 3.4.18 The Council has issued a Notification No. 1-CA(7)/60/2002 dated 8th March, 2002 wherein a member of the Institute in practice shall be deemed to be guilty of professional misconduct, if he accepts the appointment as statutory auditor of Public Sector Undertaking(s)/Government Company(ies)/Listed Company(ies) and other Public Company(ies) having turnover of Rs. 50 crores or more in a year and accepts any other work(s) or assignment(s) in regard to the same Undertaking(s)/ Company(ies) on a remuneration which in total exceeds the fee payable for carrying out the statutory audit of the same Undertaking/company. 3.4.19 The Council has issued a Notification No.1-CA(7)/63/2002 dated 2nd August, 2002 whereby a member of the Institute in practice shall be deemed to be guilty of professions misconduct, if he accepts appointment as auditor of a concern while he is indebted to the concern or has given any guarantee or provided any security in connection with the

II.12

Advanced Auditing & Professional Ethics

indebtedness of any third person to the concern, for limits fixed in the statue and in other cases for amount exceeding Rs. 10,000/3.4.20 To ensure that the professional independence of a member doing attest function does not appear to be jeopardized he should, as far as possible, take care to see that the professional fees for audit and other services received by the firm in which he is a partner, by him and his partner individually and by firm or firms in which he or his partner are partners from one or more clients or companies under the same management does not exceed 40% of the gross annual fees of the firm, firms and partners referred to above. 'Companies under the same management' here would refer to the definition of this expression as provided in section 370(1-B) of the Company Act, 1956. Provided that no such ceiling on the gross annual professional fees of a member would be applicable where such fees do not exceed two lakhs of rupees in respect of a member or firm including fees received by the member or firm for other services rendered through the medium of a different firm or firms in which such member or firm may be a partner or proprietor. Provided further that no such ceiling on the gross annual professional fees of a member would be applicable in the case of audit of government companies, public undertakings, nationalized banks, public financial institutions or where appointments of auditors are made by the Government. 3.4.21 'Members' attention is also drawn to Clauses (8) & (9) of Part I of the First Schedule to the Chartered Accountants Act, 1949: A Member shall be deemed to be guilty of professional misconduct, if he: XX

XXX

XXXX

(8) accepts a position as auditor previously held by another chartered accountant or a restricted state auditor without first communicating with him in writing; (9) accepts an appointment as auditor of a company without first ascertaining from it whether the requirements of Section 225 of the Companies Act, 1956 in respect of such appointment have been duly complied with.'' 3.4.22 Clause (8) of Part I of First Schedule to the Chartered Accountants Act, 1949 emphasized the requirement of mandatory communication with the previous auditor in all types of audit viz., statutory audit, tax audit, internal audit, concurrent audit or any kind of audit and it is equally applicable to audits of both government and non-government entities. 3.4.23 Clause (9) of Part I of First Schedule to the Chartered Accountants Act, 1949 provided that an auditor of the company before accepting the appointment, should ascertain from the auditor whether the requirements of Section 225 of the Companies Act, 1956 in respect of such appointment have been duly complied with. Section 224 of the Companies Act, 1956 contains several provisions in the matter of appointment of auditors in different circumstances and situations whereas Section 225 laid down the procedure which must be followed whenever a company desires to change its auditor. Also that the validity of the appointment of an auditor is not challenged or objected to by shareholders or the retiring auditors at a later date, it has been made obligatory to ascertain from the company that the

Part II : Guidance Notes

II.13

appropriate procedure in the matter of appointment has been faithfully followed. Independence of auditor is a concept to be addressed through its all the possible aspects and the message of Clause (8) & (9) is to ensure that an auditor should be conscious about this aspect from the very point of accepting the position of an auditor. 4.

Conclusion

4.1 The Council feels that there are adequate safeguards provided in the Companies Act, 1956 as well as in the Chartered Accountants Act, 1949. The Council is of the view that independence, being a state of the mind, is not necessarily affected by the fact of mere relationship any more than it should be existence if the relationship did not exist. In any case, lest there may be any feeling in the public mind that relationship of an auditor, with a Managing or a Whole-Time Director the independence of an auditor is likely to be jeopardized, he should use his good sense, and acting in the best traditions of the profession, refrain from accepting the appointment. 4.2 If the opinion of chartered accountant is to command respect and the confidence of the public, it is essential that they must ensure their independence to assure the public as regards the faith and confidence that could be reposed on them. The Chartered Accountant should ensure his independence in all assurance services including concurrent audit, tax audit and internal audit. The chartered accountant should make it certain that his independence is not jeopardized. Where he feels that his independence is jeopardized, he should refrain from accepting the assignment. 3.

GUIDANCE NOTE ON AUDITOR'S REPORT ON REVISED ACCOUNTS OF COMPANIES BEFORE CIRCULATION TO SHAREHOLDERS2

1. The attention of the Council has been drawn to the fact that in some cases, the Balance Sheet and the Profit and Loss Account of companies, approved by the Board of Directors and authenticated on its behalf in terms of Section 215 of the Companies Act and audited and reported upon by the statutory auditors are amended by the Companies for various reasons, before circulation to the shareholders. In such cases, the amended accounts are re-approved by the Boards of the Companies and statutory auditors are requested to make a report once again on the amended accounts. 2. The question which arises for consideration is the manner in which the statutory auditor should report upon such amended accounts. The statutory auditor owes a duty to the members of the company and this duty is completed when he addresses a report to the members. It is for the company to circulate the report to the members. The Companies Act does not normally contemplate the revision of the accounts and a further report by the statutory auditor on the amended accounts. At the same time, it is entirely within the competence of a Board of Directors to amend the accounts and resubmit them to the statutory auditors for report before the accounts are placed before the annual general meeting. The report issued by the statutory auditor on such amended accounts will be in substitution of the 2

''Published in ''The Chartered Accountant'' December, 1979, pp.554.

II.14

Advanced Auditing & Professional Ethics

report issued on the accounts before amendment and unless all copies of the original accounts and reports are returned to the auditor, such substitution is not possible. 3. Having considered the issue involved and to safeguard the position of the statutory auditor, the Council recommends that members of the Institute, when called upon to issue a report on the amended accounts for the same period consequent upon the revision of the Balance Sheet and/or the Profit and Loss Account should ensure that unless all copies of the original accounts and report are returned to the auditor, and adequate disclosure of the fact of the revision on the accounts already approved by the Board and reported upon by the statutory auditors appears as a specific Note on the amended accounts. In case the statutory auditor is satisfied that the disclosure so made by the company in the Note on the accounts is adequate, there may not be any further need for the auditor to refer to the revision of the Balance Sheet and/or the Profit and Loss Account in his report. However, if the Notes to accounts do not contain any note on the revision or if such a note is contained therein but not considered by the statutory auditor as adequately comprehensive, it will be the duty of the statutory auditor to refer to the fact of revision of the accounts in his report. 4. In the opinion of the Council, the general principles enunciated above are as well applicable to the audit of the accounts of Government Companies as defined in Section 617 of the Companies Act. In respect of such Companies, since it may not be possible for all copies of the original accounts and report to be returned to the auditors, it would be necessary to ensure that adequate disclosure is made as discussed above either by way of a Note in the accounts or by a reference in auditor's report. 4.

GUIDANCE NOTE ON AUDIT REPORTS AND CERTIFICATES FOR SPECIAL PURPOSES

1. Introduction 1.1 Government authorities may under various statutes or notifications, require reports or certificates from auditors in support of statements or other information prepared by an enterprise. Reports or certificates on specific matters may also be required from auditors by an enterprise, for its own special purposes. These reports or certificates cater, to specific requirements of the individual users unlike a ‘general purpose report’ e.g., an auditor’s report on financial statements which is intended for general use. An audit report or certificate for special purpose is one to which the format of general purpose audit report is not applicable. 1.2 This note is intended to provide guidance to members who may be called upon to give audit reports or certificates for special purposes (herein referred to as ‘reporting auditors'). Reports on profit and/or financial forecasts and on tax audit do not fall within the scope of this Guidance Note3.

3 These subjects have been dealt with in separate publications of the Institute, viz. Guidance Note on Accountants Report on Profit Forecast and/or. Financial Forecasts' and 'Guidance Note on Tax Audit under Section 44AB of the Income Tax Act, 1961'.

Part II : Guidance Notes

II.15

2. Scope Of Special Purpose Audit Reports And Certificates 2.1 Audit reports or certificates for special purposes may be issued in connection with: (a) financial statements which are prepared in addition to general purpose financial statements; (b) specified elements, accounts or items of a financial statement; (c) compliance with requirements of any agreement or statute or regulation; (d) financial information given in special purpose formats or schedules; or (e) compilation of statistics or ascertainment of basic figures e.g., for the purpose of fixing quotas or levies. 2.2 A reporting auditor should appreciate the difference between the terms ‘certificate’ and ‘report’. A certificate is a written confirmation of the accuracy of the facts stated therein and does not involve any estimate or opinion. A report, on the other hand, is a formal statement usually made after an enquiry, examination or review of specified matters under report and includes the reporting auditor’s opinion thereon. Thus, when a reporting auditor issues a certificate, he is responsible for the factual accuracy of what is stated therein. On the other hand, when a reporting auditor gives a report, he is responsible for ensuring that the report is based on factual data, that his opinion is in due accordance with facts, and that it is arrived at by the application of due care and skill. 3. Responsibility For Preparation Of Special Purpose Statements The primary responsibility for the contents of a special purpose statement rests with the enterprise and this would be evidenced by a suitable declaration or authentication by the management on the face of the statement. 4. Scope Of A Reporting Auditor’s Function 4.1 A reporting auditor should have a clear understanding of the scope and nature of the terms of his assignment. It is desirable for him to obtain the terms in writing to avoid any misunderstanding. 4.2 A reporting auditor is not an expert on purely technical matters and as such, when he is required to report on or certify such matters (e.g., composition or quality of a product) which are of paramount importance and constitute the very basis of the figures contained in the statement, he should state his limitations clearly in the report or certificate. At the same time, he should indicate the extent to which he has been able to exercise his own professional skill and judgement with regard to the matter being reported upon. For instance, he may state that, for the purpose of forming his opinion, he has relied upon a certificate from technical experts. He should, of course, satisfy himself about the technical qualifications of the expert, and subject the expert's certificate to a reasonable review. 5. Contents Of Reports And Certificates For Special Purposes 5.1 In many cases, a reporting auditor can choose the form and contents of his report or certificate. In other cases, the form and contents of the report or certificate are specified by

II.16

Advanced Auditing & Professional Ethics

statute or notification and cannot be changed. 5.2 Where a reporting auditor is free to draft his report or certificate, he should consider the following: (a) Specific elements, accounts or items covered by the report or certificate should be clearly identified and indicated. (b) The report or certificate should indicate the manner in which the audit was conducted, e.g., by the application of generally accepted auditing practices, or any other specific tests. (c) If the report or certificate is subject to any limitations in scope, such limitations should be clearly mentioned. (d) Assumptions on which the special purpose statement is based should be clearly indicated if they are fundamental to the appreciation of the statement. (e) Reference to the information and explanations obtained should be included in the report or certificate. In certain cases apart from a general reference to information and explanations obtained, a reporting auditor may also find it necessary to refer in his report or certificate to specific information or explanations on which he has relied. (f)

The title of the report or certificate should clearly indicate its nature, i.e., whether it is a report or a certificate. Similarly, the language should be unambiguous, i.e., it should clearly bring out whether the reporting auditor is expressing an opinion (as in the case of a report) or whether he is only confirming the accuracy of certain facts (as in the case of a certificate). For this, the choice of appropriate words and phrases is important.

(g) If the special purpose statement is based on general purpose financial statements, the report or certificate should contain a reference to such statements. However, the report or certificate should not contain a reference to any other statement unless the same is attached therewith. It should be clearly indicated whether or not the statutory audit of the general purpose financial statements has been completed and also, whether such audit has been conducted by the reporting auditor or by another auditor. In case the general purpose financial statements have been audited by another auditor, the reporting auditor should specify the extent to which he has relied on them. He may communicate with the statutory auditor for securing his cooperation and in appropriate circumstances, discuss relevant matters with him, if possible. (h) Where a report requires the interpretation of a statute, the reporting auditor should clearly indicate the fact that he is merely expressing his opinion in the matter. He should take sufficient care to ensure that in respect of matters which are capable of more than one interpretation, his report is not misconstrued as representing a settled legal position. (i)

An audit report or certificate should ordinarily be a self-contained document. It should not confine itself to a mere reference to another report or certificate issued by the reporting auditor but should include all relevant information contained in such report or certificate.

(j)

The reporting auditor should clearly indicate in his report or certificate, the extent of responsibility which he assumes. Where the statement on which he is required to give his

Part II : Guidance Notes

II.17

report or certificate, includes some information which has not been audited, he should clearly indicate in his report or certificate the particulars of such information. 5.3 In certain cases, the form and/or contents of the report or certificate, as prescribed by a statute or a notification, may not be appropriate or adequate. In such situations, the reporting auditor may consider modifying the report or certificate on the basis of the suggestions made in para 5.2 supra, to the extent applicable. In case this is not possible, he should clearly indicate the limitations in his report or certificate itself. 6. Extent Of Reliance On General Purpose Audit Report 6.1 Where a special purpose engagement is undertaken after the statutory audit has been completed, a reporting auditor should invariably review the statutory audit report to ascertain whether there are any matters which have a bearing on his report or certificate. 6.2 In cases, where a reporting auditor is required to report or certify certain specific matters arising from the financial statements taken as a whole, he should not normally issue his report or certificate until the statutory audit has been completed. For instance, a reporting auditor may be required to state whether, in the case of an Indian branch of a foreign company, the profit shown in the accounts represents the remittable surplus of the branch, or he may be asked to report on the computation of 'gross profit' for the purpose of bonus under the Payment of Bonus Act, 1965. In such cases, it would normally not be proper for him to give his report or certificate until the statutory audit has been completed, since he would not really be in a position to state whether the profit shown in the accounts itself has been properly computed. 6.3 Where an audit report or certificate is required before the statutory audit is completed, a reporting auditor should clearly state in his audit report or certificate that he is reporting on or certifying specific matters arising out of the financial statements of the enterprise, the statutory audit of which has not been completed. 6.4 Where the reporting auditor prepares his report or certificate on the basis of duly audited general purpose financial statements he may take the following precautions: (i)

He may clearly state in his report or certificate that the figures from the audited general purpose financial statements have been used and relied upon.

(ii)

He may include in his report or certificate a statement showing the reconciliation between the figures in the general purpose financial statements and the figures appearing in his report or certificate.

II.18

Advanced Auditing & Professional Ethics

7. Limited Review Report Section 7, “Limited Review Report” was withdrawn pursuant to issuance of the Guidance Note on Engagements to Review Financial Statements. However, the Guidance Note, “Limited Review Report” has also been withdrawn the issuance of AAS 33, “Engagements to Review Financial Statements”. 8. Reports And Certificates On Specified Accounts Or Items Of Financial Statements 8.1 The test of materiality which a reporting auditor uses in connection with special purpose reports may be different, depending upon the circumstances, from the test he would use in connection with a general purpose report. For example, where he is required to express an opinion on specified accounts or items of financial statements, he may judge the materiality of an item solely in relation to such individual accounts of items rather than to the aggregate thereof or to the financial statements as a whole. A reporting auditor’s examination of certain records for an audit report or certificate for special purpose may also be more intensive than the examination of the same records by the statutory auditor for the purpose of expressing an opinion on the general purpose financial statements as a whole. 8.2 Certain accounts or items of financial statements are inter-related, e.g., sales and debtors, purchases and creditors, fixed assets and depreciation, etc. Therefore, where reporting auditor is required to examine and report upon or certify a specified account or items of financial statements, he may also need to examine the related accounts or items to discover the inconsistencies, if any, between these inter-related accounts or items. 9. Other Engagements Section 9, “Other Engagements” has been withdrawn pursuant to the issuance of the Guidance Note on Members’ Duties regarding Engagements involving Compilation of Financial Statements. However, the Guidance Note, “Other Engagements” has also been withdrawn with the issuance of AAS 31, “Engagements to Compile Financial Information”.

10. Communication Of Report Or Certificate 10.1 The reporting auditor may address his report or certificate to the client or to the public authority or person requiring it, as the case may be. In appropriate circumstances, a certificate may be issued without reference to any particular person or authority by using the words, ‘To Whomsoever It May Concern’. 10.2 The report or certificate should normally be issued to the client who should be responsible for forwarding the same to the concerned authority, where so required. 11. Communication With The Previous Reporting Auditor It would be a healthy tradition if the practice of communicating with the member who had done the work previously is followed in every case where a member is required to give a report or

Part II : Guidance Notes

II.19

certificate for a special purpose. 12. Illustrations The appendices to this Note give certain illustrations of audit reports and certificates for special purposes. Appendix I contains certain statutory certificates while Appendix II comprises of specimen certificates of non-statutory nature. It may be noted that there are a large number of other certificates-statutory and non-statutory-which a Chartered Accountant may be called upon to issue under specific circumstances. Appendix-I Illustrations of Statutory Audit Reports and Certificates for Special Purposes (1) Auditor’s certificate in the application for consent to the issue of bonus shares made to the Controller of Capital Issues4: “We have verified the information furnished by the company for issue of bonus shares and find the same as correct. We also certify that we have received all the information required by us for the verification. We hereby certify that the proposal contained in the application for the issue of bonus shares meets all the requirements of the bonus issue guidelines, including the guidelines contained in paragraphs 8, 9, 11 and 13 in force issued by the Government in this regard according to the information furnished to us and to the best of our knowledge.” (2) Auditors’ certificate in the application form5 for issue of securities other than bonus shares under the Capital Issues Control Act, I947. "We have verified the information furnished in the above application of the company for issue of fresh capital and find the same as correct. We also certify that we have received all the information required by us for the verification. We hereby certify that the requirements of clause 5 of the Capital Issues (Exemption) Order, 1969, have been fully met by the company for the issue of acknowledgment/consent by the Controller of Capital Issues according to the information furnished to us and to the best of our knowledge." (3) Chartered Accountant's Certificate6 on Exports Ref No......... Date ....... Place ........ 4

Part E of Schedule B to the Capital Issues (Application for Consent) Rules, 1966, Notification No. G.S.R. 600 dated 29th March 1966, Government of India, Ministry of Finance. 5 Part G of Schedule A to the Capital Issues (Application for Consent) Rules, 1966, Notification No. G.S.R. 600 dated 29th March 1966, Government of India, Ministry of Finance. 6 Annexure XI of Appendix 10 to The Hand Book of Import-Export Procedures, 1983-84, Vol. II, Government of India. Ministry of Commerce, page 162

II.20

Advanced Auditing & Professional Ethics Chartered Accountant’s Certificate

“This is to certify that we have checked and verified the above particulars of exports from the books / documents of M/s..........................................and found the same to be correct.” (Signature of the Chartered Accountant) Official Stamp Full Address...........… Regn. No…......................... (4) Chartered Accountant’s certificate 7 on certain matters in the application for grant/renewal of ‘Export House’ certificate under Import- Export Policy 1983-84 Certificate of the Chartered Accountant “We..................................(name and address of the Chartered Accountant) hereby certify that we have checked and verified the above particulars of exports from the books / documents of M/s...........................................and found the same to be correct. We also certify that the exports mentioned in this statement, excluding those exports which were made as associates of the STC/MMTC are direct exports of M/s. …………………... and the export documents viz, export order/contract, bank certificate and invoice were in the name of M/s. ................................... We have verified that each export invoice is properly supported by a purchase voucher.” Signature of the Chartered Accountant Official Stamp Full Address ........ Registration No ......... Dated ........ (5) Chartered Accountant's Certificate8 on the statement showing consumption of imported raw materials, Components and Consumables under Import-Export Policy 1983-84. 1.

“I/We have verified that the applicant unit has duly furnished to the D.G.T.D, Department of Electronics, Textile Commissioner or other sponsoring authorities concerned, its production returns for the year 1982-83 and other prescribed returns/statements for the same year, as it was required to furnish under the provisions of Imports and Exports Control Rules, Industrial (Development and Regulation) Act, Textile Control Order, etc.

2.

I/We do hereby certify that consumption as certified in the statement has been verified from the books maintained by M/s. ................. and found the same as correct. I/We have also put my/our office seal and signature on the books from which the information has

7

Annexure XX of Appendix 10 to The Hand Book of Import-Export Procedures, 1983-84, Vol. II, Government of India. Ministry of Finance, page 171 8 Appendix 11 of the import and Export Policy, 1983-84, Vol. 1, Government of India. Ministry of Finance, page. 182.

Part II : Guidance Notes

II.21

been verified. 3.

I/We also certify that the applicant unit has been maintaining proper account of consumption in the prescribed form as indicated in the Hand Book of Import-Export Procedures, 1983-84.

4.

I am not a partner, a Director or an employee of the applicant firm or its associates.

5.

I have been duly appointed for the purpose by the Board of Directors of the Company or management as the case may be (In the case of Chartered Accountants/Cost Accountant)” Signature and Seal of Chartered Accountant Name of the Signatory

Full address........ Date .......... (Seal) (6) Chartered Accountant's certificate regarding certain matters in the Application for Grant of Export Performance Certificate9 under Import-Export Policy 1983-84. “I/We do hereby certify that the information given in this statement has been verified from the books maintained by M/s ..................................,and found the same as correct. I/We have also put my/our office seal and signature on the books from which the information has been verified. I/We am/are neither a partner, a Director nor an employee of the applicant or its associates.” Place Date Signature and seal of Chartered Accountant Name of the signatory Full address ....... Membership No ......... (Seal) Residential Address ......... Appendix-II Illustration of non-statutory audit reports and certificates for special purposes (1) Chartered Accountant’s certificate10 regarding employers’ bonus computation “We have reviewed the figure in the above computation, in comparison with the books and records of X Company Limited, produced to us, the audit of which has already been completed by us and/or another firm of chartered accountants and report that, subject to the notes given on the face of computation, in our opinion, and to the best of our knowledge and belief and 9

Appendix 13 of the import and Export Policy, 1983-84, Vol. 1, Government of India. Ministry of Finance, page. 185. The Payment of Bonus Act, 1965-An Accountant's Study, The Institute of Chartered Accountants of India, page 7.

10

II.22

Advanced Auditing & Professional Ethics

according to the information and explanations given to us, the above computation is in due accordance therewith and has been made on a basis reasonably consistent with the provisions of the Payment of Bonus Act, 1965.” (2) Auditor’s certificate11 pursuant to Companies (Acceptance of Deposits) Rules, 1975. "We have examined the books of account and records maintained by ......................................... Company Ltd. in respect of the particulars furnished in the Return of Deposits as on 31st March 19...... and certify that to the best of our knowledge and according to the information and explanations given to us and as shown by the records examined by us, the figures of deposits and interest rates under Parts A, B and C of the Return are correct. We further certify the correctness of the particulars of the paid up capital and free reserves, etc. given in the Manager's Certificate." (3) Chartered Accountant’s Report on the basis of a limited review of interim financial statements12. (4) Accountants' Report on Unaudited Statements13 5.

REVISION/ RECTIFICATION OF FINANCIAL STATEMENTS14

Under the Companies Act, the Board of Directors of a company is required to prepare a Balance Sheet and Profit and Loss Account in relation to every financial year and lay the same before the Company in Annual General Meeting. Ordinarily, the accounts once adopted at the Annual General Meeting cannot be reopened. The broader aspects of the auditor's duties and responsibilities when he is required by the management to report on the revised accounts, subsequent to their adoption at the Annual General Meeting of a Company, have been considered by the Council from time to time15. The views of the Department of Company affairs on this subject were sought in 1977 and the reply received from the Department was published in February, 1977 issue of the Newsletter issued by the Council (Pages 189 & 190). The matter has again been considered by the Council at its 106th meeting and it has been decided that the reopening or rectification of accounts after they have been adopted at the Annual General Meeting should not be permitted under any circumstances.

11

A Note on the Companies (Acceptance of Deposits) Rules, 1975, The Institute of Chartered Accountants of India, page 77. 12 Refer to AAS 33, ''Engagements to Review Financial Statements'. 13 Refer to AAS 31, ''Engagements to Review Financial Statements'. 14 Published in the Chartered Accountant, pp. 102-103, August, 1983. 15 ''See the Annexure to this Chapter which suggests the manner of qualification.

Part II : Guidance Notes

II.23

Annexure Auditors’ responsibility in case of revision/rectification of balance sheet and profit and loss account of a company already adopted by the company at its annual general meeting16. Attention of the members is invited to the announcement appearing at pages 102 and 103 of the August, 1983 issue of the Journal on the above subject. The Council of the Institute of Chartered Accountants of India reiterates its view that accounts of a company once adopted at its annual general meeting cannot be reopened and revised. However, it has been brought to the notice of the Council that members are sometimes called upon to report on accounts reopened and revised by the board of directors. In such situations, members may adopt the following format for their qualified report on such revised accounts. Auditors' Report I.

We have examined the attached Balance Sheet of M/s ________ as at _____ and the annexed Profit and Loss Account for the year ended on that date, which are the revised statements of the original Balance Sheet and Profit and Loss Account covered by the audit report of M/s _______ dated ______ and adopted by the shareholders at the ______ Annual General Meeting held on __________.

II.

As per the opinion of the Institute of Chartered Accountants of India and that of the Department of Company Affairs, a company cannot reopen and revise the accounts once adopted by the shareholders at an annual general meeting. Contrary to these opinions, the Board of Directors of the Company has reopened and revised the aforesaid Accounts.

III.

We have considered the earlier auditor’s report dated ----------on the original accounts and have examined the changes made therein which are as under: (Deal with changes and their effect - state the qualifications, if any, required to be made. Qualifications in the previous auditor's report, to the extent applicable, should also be given).

IV. As required by the Manufacturing and Other Companies (Auditor's Report) Order 197517, issued by the Company Law Board in terms of Section 227 (4A) of the Companies Act, 1956, we annex hereto a statement on the matters specified in paragraphs 4 and 5 of the said Order. V.

Further to our comments in the annexures referred to in paragraph IV above, and subject to the remarks in paragraphs II and III we report that: (a) we have obtained all the information and explanation which to the best of our knowledge and belief were necessary for the purpose of our audit; (b) in our opinion, proper books of account as required by law have been kept by the company so far as appear from our examination of the books;

16

''Published in the Chartered Accountant, pp. 655, February, 1985. The Department of Company Affairs has notified the Companies (Auditor's Report) Order, 2003 in June 2003 terms of the powers given to it under section 227(4A) of the Companies Act, 1956. 17

II.24

Advanced Auditing & Professional Ethics (c) the balance sheet and profit and loss account dealt with by the this report are in agreement with the books of account; (d) in our opinion and to the best of our information and according to the explanations given to us, the accounts give the information required by the Companies Act, 1956, in the manner so required and given a true and fair view; (i)

in the case of the Balance Sheet, of the state of affairs of the Company as at _________; and

(ii)

in the case of the Profit and Loss Account, of the profit for the year ended on that date.

Date ___________

Signature ____________ Chartered Accountants

Note: In case there is no change in the auditors, the above form would have to be suitably changed. 6.

CLARIFICATION ON THE AUDITORS’ RIGHTS WHERE CLIENTS AND OTHER AUDITORS SEEK ACCESS TO THEIR AUDIT WORKING PAPERS18

1. Statement on Standard Auditing Practice (SAP)19 1, Basic Principles Governing An Audit, states in para 6, “The auditor should respect the confidentiality of information acquired in the course of his work and should not disclose any such information to a third party without specific authority or unless there is a legal or professional duty to disclose.” Statement on Standard Auditing Practice (AAS) 3, Documentation (Paragraph 13), states, “Working papers are the property of the auditor. The auditor may, at his discretion, make portions of or extracts from his working papers available to his client.” SAP 3 further requires (paragraph 14), inter alia, that the “auditor should adopt reasonable procedures for custody and confidentially of his working papers.” 2. Part I of the Second Schedule to the Chartered Accountants Act, 1949 provides that “A Chartered Accountant in practice shall be deemed to be guilty of professional misconduct, if he – “Discloses information acquired in the course of his professional engagement to any person other than his client, without the consent of his client or otherwise than as required by any law for the time being in force.” 3. Requests are sometimes received by the members of the Institute, who have/had been performing the duties as the auditors of an enterprise, to provide access to their audit working papers. The requests may be made by the clients or other auditors of the enterprise or its related enterprise such as a parent enterprise. 18 19

Published in May, 2000 issue of ''The Chartered Accountant''. Now known as Auditing and Assurance Standards (AASs).

Part II : Guidance Notes

II.25

4. It is hereby clarified that except to the extent stated in para 5 below, an auditor is not required to provide the client or the other auditors of the same enterprise or its related enterprise such as a parent or a subsidiary, access to his audit working papers. The main auditors of an enterprise do not have right of access to the audit working papers of the branch auditors. In the case of a company, the statutory auditor has to consider the report of the branch auditor and has a right to seek clarifications and/or to visit the branch if he deems it necessary to do so for the performance of the duties as auditor. An auditor can rely on the work of another auditor, without having any right of access to the audit working papers of the other auditor20. For this purpose, the term ‘auditor’ includes ‘internal auditor’. 5. As stated in para 4, the client does not have a right to access the working papers of the auditor. However, the auditor may, at his discretion, in cases considered appropriate by him, make portions of or extracts from his working papers available to the client. 7.

GUIDANCE NOTE ON SECTION 227(3)(e) AND (f) OF THE COMPANIES ACT, 1956 [REVISED]

Introduction 1. Section 227 of the Companies Act, 1956 (hereinafter referred to as the ”Act”) deals with the powers and duties of the auditors of companies. Section 227(1A) of the Act requires the auditor to make certain specific enquiries during the course of audit. Section 227(2) of the Act requires the auditor, inter alia, to give his report to the members of company on the accounts examined by him, and on every balance sheet and profit and loss account and every document declared to be a part of or annexed to such balance sheet or profit and loss account which are laid before the company in a general meeting during the tenure of the auditor’s office. Sub-section (3) of section 227 of the Act also lays down certain matters necessarily required to be reported upon by the auditor in his report. The auditor is also required to include a statement on the matters specified in the Companies (Auditor’s Report) Order, 2003 (hereinafter referred to as “CARO, 2003”) issued under section 227(4A) of the Act. Subsection (3) of section 227 of Act provides as follows: "(3) The auditor's report shall also state (a) whether he has obtained all the information and explanations, which to the best of his knowledge and belief, were necessary for the purposes of his audit; (b) whether, in his opinion, proper books of account, as required by law, have been kept by the company so far as appears from his examination of those books, and proper returns adequate for the purposes of his audit have been received from branches not visited by him; (bb) whether the report on the accounts of any branch office audited under section 228 by a person other than the company's auditor has been forwarded to him as 20

Reference in this regard may be made to the Auditing and Assurance Standard (AAS) 10, ''Using the Work of Another Auditor'' and the Auditing and Assurance Standard (AAS) 7, ''Relying on the Work of Internal Auditor''.

II.26

Advanced Auditing & Professional Ethics required by clause (c) of sub-section (3) of that section and how he has dealt with the same in preparing the auditor's report; (c) whether the company's balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and returns; (d) whether, in his opinion, the profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of section 211; (e) in thick type or in italics the observations or comments of the auditors which have any adverse effect on the functioning of the company; (f)

whether any director is disqualified from being appointed as director under clause (g) of sub-section (1) of section 274;

(g) whether the cess payable under section 441A has been paid and if not, the details of the amount of cess not paid21. 2. In terms of reporting requirements under sub-sections (2) and (3) of section 227 of the Act, matters on which the auditor has to report upon, can be broadly divided into two categories as under: (i)

statements of fact; and

(ii)

opinions.

3.

The statements of fact are:

(i)

whether he has obtained all the information and explanations which to the best of his knowledge and belief were necessary for the purposes of his audit;

(ii)

whether the report on the accounts of any branch office audited under section 228 by a person other than the company's auditors has been forwarded to him as required by section 228(3)(c) and how he has dealt with the same in preparing the auditor's report;

(iii) whether the company's balance sheet and profit and loss account dealt with by the report are in agreement with the books of account and returns; (iv) whether any director is disqualified from being appointed as a director under clause (g) of sub-section (1) of section 274; and (v) whether the cess payable under section 441A has been paid and if not, the details of the amount of cess not paid. 4.

The opinions which the auditor is required to express are:

(i)

whether proper books of account as required by law have been kept by the company so far as it appears from the examination of the books and proper returns adequate for the purposes of the audit have been received from branches not visited by him;

(ii)

whether the profit and loss account and balance sheet comply with the accounting standards referred to in sub-section (3C) of section 211;

21

Inserted by the Companies (Second Amendment) Act, 2002.

Part II : Guidance Notes

II.27

(iii) whether the accounts give the information required by the Act in the manner so required; and (iv) whether the accounts give a true and fair view, in the case of the balance sheet of the state of the company's affairs, and in the case of the profit and loss account, of the profit or loss for the year. Scope of the Guidance Note 5. This Guidance Note is intended to assist the auditors in discharging their duties in respect of clauses (e) and (f) of sub-section (3) of section 227 of the Act. Clause (e) of the said sub-section creates a requirement for the auditor to consider whether any matter leading to the modification of the auditor’s report on financial statements is likely to have an adverse effect on the functioning of the company. It may be noted that the matters that lead to modification in the auditor’s report on financial statements are an emphasis of matter paragraph, qualification, situation giving rise to limitation on scope and disagreement with the management22. If the matter leading to the modification of the auditor’s report on financial statements is likely to have an adverse effect on the functioning of the company, the auditor is required to highlight such matter in thick type or in italics. Under clause (f) of sub-section (3) of section 227 of the Act, the auditor is required to state whether any director of the company is disqualified from being appointed a director of a company in terms of clause (g) of subsection (1) of section 274 of the Act. Reporting under Section 227(3)(e) of the Act 6.

The relevant extracts of section 227(3)(e) of the Act are reproduced below: “3. The auditor’s report shall also state – ……………………………………. (e) in thick type or in italics, the observations or comments of the auditors, which have any adverse effect on the functioning of the company”.

7. Clause (e) requires the auditor to highlight "in thick type or in italics, the observations or comments which have any adverse effect on the functioning of the company". An auditor’s report may contain matters leading to modifications in the auditor’s report on financial statements. Such matters may be related to issues which may have an adverse effect on the functioning of the company. The words “observations” or “comments” as appearing in clause (e) of section 227(3) are construed to have the same meaning as referring to “emphasis of matter paragraphs, qualifications, situations giving rise to limitation on scope, disagreements with the management leading to modification in the auditors report”. Therefore, only such "observations" or "comments" which have an adverse effect on the functioning of the company are required to be stated in thick type or in italics. For the sake of clarity, it may be noted that neither the auditor’s observations nor the comments made by him have any adverse effect on the functioning of a company. Instead, these observations or comments made by the auditor might contain matters which might have an adverse effect on the functioning of a company. 22

Reference may be made to paragraphs 31 through 47 of Auditing and Assurance Standard (AAS) 28, ''The Auditor's Report on Financial Statements.''

II.28

Advanced Auditing & Professional Ethics

8. The Act does not specify the meaning of the phrase 'adverse effect on the functioning of the company'. The expression may be interpreted to mean that any event affecting the functioning of the company, observed by the auditor, should be reported upon even though it does not affect the financial statements, e.g., revocation of a license to manufacture one out of the many products during the year to which the financial statements relate, etc. However, such an interpretation would not only be beyond the scope of the audit of financial statements of the company but would also not be in accordance with the objective and concept of audit stipulated under the Act. A more logical and harmonious interpretation is that the amendment does not intend to change the basic objective and the concept of audit of financial statements of a company, which is to examine the financial statements with a view to express an opinion thereon. 9. The scope of the audit and auditor’s role remains as contemplated under the Auditing and Assurance Standards (AASs) and other relevant pronouncements issued by the Institute of Chartered Accountants of India as well as laid down in the Act, i.e., to lend credibility to the financial statements by reporting whether they reflect a true and fair view. AAS 2, “Objective and Scope of the Audit of Financial Statements” specifies, “the auditor’s opinion helps determination of the true and fair view of the financial position and operating results of an enterprise. The user, however, should not assume that the auditor’s opinion is an assurance as to the future viability of the enterprise or the efficiency or effectiveness with which management has conducted the affairs of the enterprise”. It also states, “the auditor’s work involves exercise of judgement, for example, in deciding the extent of audit procedures and in assessing the reasonableness of the judgements and estimates made by management in preparing the financial statements. Furthermore, much of the evidence available to the auditor can enable him to draw only reasonable conclusions therefrom. Because of these factors, absolute certainty in auditing is rarely attainable”. Further, it also clarifies that “in forming his opinion on the financial statements, the auditor follows procedures designed to satisfy himself that the financial statements reflect a true and fair view of the financial position and operating results of the enterprise. The auditor recognises that because of the test nature and other inherent limitations of an audit, together with the inherent limitations of any system of internal control, there is an unavoidable risk that some material misstatement may remain undiscovered. While in many situations the discovery of a material misstatement by management may often arise during the conduct of the audit, such discovery is not the main objective of audit nor is the auditor’s programme of work specifically designed for such discovery”. 10. There is no change in the objective and scope of an audit of financial statements because of inclusion of clause (e) in sub-section (3) of section 227 of the Act. The auditor expresses his opinion on the true and fair view presented by the financial statements through his report which may be modified in certain circumstances. However, the auditor would now have to evaluate subject matters leading to modification of the audit report to make judgement as to which of them has an adverse effect on the functioning of the company within the overall context of audit of financial statements of the company. Only such matters, which in the opinion of the auditor, deal with matters that have an adverse effect on the functioning of the company should be given in thick type or in italics. Conversely, such qualifications or adverse

Part II : Guidance Notes

II.29

remarks of the auditor, which do not deal with matters that have adverse effect on the functioning of the company, need not be given in thick type or in italics. Examples of qualifications or adverse comments which have an adverse effect on the functioning of the company include a situation where the going concern assumption is considered inappropriate or there exists any item having a significant impact on the current financial results of the company and which might also have a material effect on the future results of the entity, e.g., non-determination of obsolete stocks / bad debts, significant impairment of the assets, etc. 11. As far as inquiries under section 227(1A) are concerned, the auditor is not required to report on these matters unless he has any special comments to make on any of the items referred to therein. The auditor may also consider highlighting such comments in thick type or in italics which have any adverse effect on the functioning of the company. Another issue which arises is whether any observation or comment made by the auditor in respect of his statements on matters specified in CARO, 2003 issued under section 227(4A) of the Act, which has any adverse effect on the functioning of the company, should also be reported in terms of this clause. In this regard, it is noted that section 227(4A) of the Act treats the comments on the matters specified in CARO, 2003 as a part of the auditor’s report. Accordingly, any observation or comment made by the auditor in his report under CARO, 2003 contain such matters, which, in his opinion, will have any adverse effect on the functioning of the company, should also be reported in thick type or italics as required by this clause. An example in this regard may be where an auditor in respect of paragraph 4(i)(c) of CARO, 2003 reports that there exists a substantial doubt that without the replacement of significant part of fixed assets sold during the year, the company would be able to continue as a going concern for the foreseeable future. Reporting under Section 227(3)(f) of the Act 12. Clause (f) of section 227(3) of the Companies Act, 1956, is reproduced below: “227(3) The auditor’s report shall also state – ……………………………………. ……………………………………. (f)

whether any director is disqualified from being appointed as a director under clause

(g) of sub-section (1) of section 274." 13. In order to report upon clause (f) of sub-section (3) of section 227 of the Act, it is essential that the auditor understands the requirements of clause (g) of sub-section (1) of section 274 of the Act. The relevant extracts of section 274(1)(g) referred to in clause (f) of section 227(3), are reproduced below: "274(1)

A person shall not be capable of being appointed director of a company, if— .................………………………………………………………….. ……………………………………………………………………….

(g) such person is already a director of a public company which − (A) has not filed the annual accounts and annual returns for any continuous three

II.30

Advanced Auditing & Professional Ethics financial years commencing on and after the first day of April, 1999; or (B) has failed to repay its deposit or interest thereon on due date or redeem its debentures on due date or pay dividend and such failure continues for one year or more;

Provided that such person shall not be eligible to be appointed as a director of any other public company for a period of five years from the date on which such public company in which he is a director failed to file annual accounts and annual returns under sub-clause (a) or has failed to repay its deposit or interest or redeem its debentures on due date or pay dividend referred to in clause (B)." 14. On a perusal of section 227(3)(f), it is apparent that the auditor of a company, public or private, has to report on whether any of the directors of the company is disqualified from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Act. This is because while clause (f) of section 227(3) is the operating clause, clause (g) of sub-section (1) of section 274 is the defining clause. Thus, in order to be able to make a statement pursuant to clause (f) of sub-section (3) of section 227 of the Act in his report, the auditor would need to satisfy himself as to whether any of the directors of the company is disqualified under section 274(1)(g) from being appointed as a director in a company. It may also be noted that where none of the directors of a private company have been directors in a public company, the disqualification mentioned under section 274(1)(g) would not get attracted since the disqualification under the said section is defined in respect of a person who is director of a public company. 15. Disqualification of a director for being appointed as a director of a company under section 274(1)(g) should be determined with reference to a particular date only. This is so because a director can become disqualified under the said section at any point of time during the year. Further, a director can attract the disqualification if any of the defaults mentioned under section 274(1)(g) is either done by the company being audited (if the company being audited is a public company) or any other public company in which a director of the company being audited is a director or has been a director in a public company which incurred the defaults and the period of five years has not elapsed. These factors make it impracticable for an auditor to determine whether any of the directors of the company attracted the disqualification under section 274(1)(g) at any point of time during the period covered by the auditor’s report. It is, therefore, practicable that whether any of the directors of the company has attracted disqualification should be considered as on a particular date, namely, at the balance sheet date. 16. The Department of Company Affairs23 (“the Department”) vide its Notification numbered GSR 830(E) dated October 21, 2003, has issued “The Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003 (hereinafter referred to as the “Rules”) to carry out the purpose of clause (g) of sub-section (1) of section 274 of the Act. The text of the Rules is reproduced in Appendix I to this Guidance Note. 17. The Rules are applicable to all public limited companies. 23

Now ''Ministry of Company Affairs''.

However, the question

Part II : Guidance Notes

II.31

regarding the applicability of the Rules to a company, which has been granted license under section 25 of the Act, and a private company, which is a subsidiary of a body corporate incorporated outside India, is required to be examined. 18. Section 25 of the Act only contains conditions subject to which the Central Government may dispense with the requirement to use the word "limited" or “private limited” in the name of a company. Thus, a public company, which is granted a license under section 25 of the Act, continues to be a public limited company under the Act and therefore the Rules would be applicable to such a public limited company. 19. As far as a private company, which is a subsidiary of a body corporate incorporated outside India is concerned, it may be noted that section 4(7) of the Act provides that: “(7) A private company, being a subsidiary of a body corporate incorporated outside India, which, if incorporated in India, would be a public company within the meaning of this Act, shall be deemed for the purposes of this Act to be a subsidiary of a public company if the entire share capital in that private company is not held by that body corporate whether alone or together with one or more other bodies corporate incorporated outside India.” 20. By virtue of section 3(iv)(c), a private company, if it is a subsidiary of a body corporate incorporated outside India, which if incorporated in India would have been a public company and some part of its share capital is held by a legal entity in India, would become a public company within the meaning of the Act. Therefore, the Rules would also be applicable to such a private company. Disqualification under Section 274(1)(g) 21. The situation for disqualification of a director, as envisaged in sub-clause (A) of clause (g) of section 274 (1) of the Act is that the concerned public company has not filed the annual accounts and annual returns for any continuous three financial years commencing on or after the first day of April 1999. Further, sub-rule (a) of Rule 3 lays down that in such a case, persons who are directors on the last due date for filing the annual accounts and the annual returns shall be disqualified from being appointed as a director of another public company. In this context, it is also necessary to understand as to what is the “last due date” as envisaged by the Rules. The last due date would mean the due date with reference to the annual accounts and annual returns of the last of the three consecutive financial years for which the annual accounts and annual returns have not been filed. The proviso to clause (g) of subsection (1) of section 274 provides that the period of five years would be reckoned from the date as specified in sub-clause (A), on which the public company failed to file its annual accounts and annual returns. From the above, it is clear that if the following conditions are satisfied in respect of a person, he would become disqualified under sub-clause (A) of clause (g) of sub-section (1) of section 274 of the Act: (a) The person is a director in a public company as on the last due date for filing the annual accounts and annual return for three continuous financial years. Thus, even if the person concerned has been appointed as a director in the public company only a few days before the last due date, the person would attract disqualification under section

II.32

Advanced Auditing & Professional Ethics 274(1)(g). Further, a person who ceased to be a director of the public company as on the last due date for filing the annual accounts and annual return for three continuous financial years would not be disqualified from being appointed as a director of a public company.

(b) The public company has not filed the annual accounts and annual return for three consecutive financial years. Thus, if the said failure is not for a period of three continuous financial years, the disqualification would not be attracted. (c) The public company has failed to file both, the annual accounts and annual return. Thus, if the company has filed either the annual accounts or annual return within the due dates, the disqualification would not be attracted. (d) The period of five years has not elapsed since the date of default made by the public company. Thus, if the period of five years has elapsed since the date of the default, the person concerned shall not remain disqualified under sub-clause (A) of section 274(1)(g). 22. The situation for disqualification of a director, as envisaged in sub-clause (B) of clause (g) of section 274 of the Act is that the concerned public company has failed to repay its deposit or interest thereon on due date or redeem its debentures on due date or pay dividend and such failure continues for a period of one year or more. Further, sub-rule (b) of Rule 3 provides that if a company has failed to repay any deposit, irrespective of the enactment, rules or regulations under which the deposits have been accepted by the companies, or interest thereon, or redeem its debentures, or pay any dividend declared on the respective due dates, and if such failure continues for one year, as described in sub-clause (B) of clause (g) of subsection (1) of section 274, then the directors of that company would stand disqualified immediately on expiry of one year from the respective due dates. The proviso to the Rule further provides that that all the directors who have been directors in the relevant year, from the due date to the expiry of one year after the due date, will also be disqualified. It may also be noted that that the disqualification on account of the reasons cited under sub-rule (b) of Rule 3 of the Rules is also applicable to the reappointment as a director. 23. The Explanation to Rule 3, however, clarifies that a company would not be considered as having defaulted in payment of the dividend referred to in sub-clause (B) of clause (g) of section 274(1) in the following situations: (i)

The dividend in question has not been claimed; or

(ii)

The dividend in question has been transferred to a separate bank account, i.e., the Unpaid Dividend Account of the company in accordance with the requirements of section 205A of the Act; or

(iii) The dividend in question has been paid into the Investor Education and Protection Fund as required under section 205C of the Act. 24. The Department has also issued certain Circulars/Notifications in respect of operation/applicability of clause (g) of section 274(1) of the Act. A gist of these Notifications/Circulars is as under: (i)

In respect of sub clause (B) of clause (g) of section 274(1) of the Act, the Department,

Part II : Guidance Notes

II.33

vide its general circular numbered 5 of 2003 (F No. 2/5/2001-CLV) dated 14-1-2003 has clarified that default in repayment of privately placed bonds/ debentures/ debt instruments by public financial institutions will not be considered as default to disqualify directors under section 274(1)(g) of the Act. (ii)

The Department has, vide its notification numbered GSR 829(E), also clarified that the provisions of clause (g) of sub section (1) of section 274 of the Act shall not be applicable to a Government company.

(iii) Further, the Department has also clarified, vide its general circular numbered 8/2002, dated 22-3-2002, that the nominee directors appointed by the public financial institutions and companies established under the Act of Parliament having non obstante provisions over the Companies Act, 1956 like IDBI, LIC, UTI, IIBI, etc., in their respective statutes shall not be liable to be disqualified under section 274(1)(g) of the Act. The Department has also clarified that the nominee directors appointed on the boards of assisted concerns or other public companies by (a) public financial institutions within the meaning of section 4A of the Act; (b) Central or State Government; and (c) banking companies are also exempt from the provisions of section 274(1)(g) of the Act. 25. The proviso to sub-section (1) of section 252 of the Act requires that that a public company having a paid-up capital of rupees five crores or more; or one thousand or more small shareholders may have a director elected by such small shareholders in the manner as may be prescribed. The Department had, vide its Notification No. GSR. 168(E), dated March 9, 2001, issued the “Companies (Appointment of the Small Shareholders’ Director) Rules, 2001. The said Rules define “small shareholders” as “a shareholder holding shares of nominal value of twenty thousand rupees or less in a public company to which section 252 of the Act applies. The said Rules deal with the manner of election of small shareholders’ director, disqualification of such directors and vacation of office by such directors. Rule 5 of the said Rules which deals with the disqualification of small shareholders’ directors lists out certain conditions wherein a person shall not be capable of being appointed as a small shareholders’ director of a company. The said Rule 5, however, does envisage the situations outlined in clause (g) of section 274(1) as a condition for disqualification. Thus, a logical interpretation of the situation would be that a person appointed as a small shareholders’ director pursuant to the above mentioned Rules would not be subject to any disqualification arising in terms of clause (g) of section 274(1) of the Act. 26. The Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003 (the “Rules”) have also introduced the concepts of “Disqualifying” and “Appointing” companies. As per Rule 2, a “disqualifying” company is “the company in which the default has occurred on account of which a director stands disqualified”. Further, Rule 2 also defines an “appointing” company as “the company in which an individual is seeking an appointment as a director, including reappointment as a director”. However, this distinction between the “appointing company” and “disqualifying company” apparently has no significance to the auditor since he is required to state in his report on the financial statements of the company whether any of the directors of the company as on the balance sheet is disqualified from being appointed as a director of a company under section 274(1)(g) of the Act.

II.34

Advanced Auditing & Professional Ethics

27. Under Rule 9, every director in a public company registered under the Companies Act, 1956, is required to file Form DD-A, as prescribed in the Rules, before he is appointed or reappointed in any company. Rule 5 also casts a duty on every company which has failed to file its annual accounts and returns and/or fails to repay any deposit, interest, dividend, or fails to redeem its debentures, as described in clauses (A) and (B) of clause (g) of sub-section (1) of section 274 of the Act, to immediately file a return in duplicate in Form DD-B (prescribed in the said Rules) with the Registrar of Companies. 28. Another point to note is that the provisions of clause (g) of section 274(1) of the Act do not find a place in the provisions of section 283 of the Act, which deals with vacation of office by the director(s). Therefore, a director should not be construed as having vacated his office merely because of his having incurred a disqualification under clause (g) of section 274(1) of the Act. Another question that arises in this regard is whether in case all the directors of a company are disqualified under section 274(1)(g), whether such directors can approve the financial statements of the company. As mentioned, in case a director of a company becomes disqualified from being appointed as a director in a company in terms of section 274(1)(g) of the Act, he continues to be a director of the company until the expiry of his term. Therefore, even in a case where all the directors become disqualified from being appointed as a director in a company they can approve the financial statements and continue to discharge the duties and responsibilities assigned by the Act. Duties of the Auditor under the Rules 29. Rule 4 of the Rules deals with the duties of the statutory auditors of both the disqualifying as well as the appointing companies. Sub-rule (a) of Rule 4 requires that the statutory auditors of both the appointing as well as the disqualifying company to: (i)

report under section 227(3)(f) of the Act to the members of the respective companies as to whether any director is disqualified from being appointed as a director under clause (g) of section 274(1) of the Companies Act, 1956; and

(ii)

furnish a certificate every year as to whether on the basis of his examination of the books and records of the company, any director of the company is disqualified as a director or not.

30. It is, therefore, clear that the statutory auditors of both the disqualifying as well as the appointing company would, in addition to their report in terms of section 227(3)(f) of the Act, would also have to, each financial year, furnish a certificate as required in Rule 4. 31. Sub Rule (b) of Rule 4 further casts a duty on the statutory auditors of the “disqualifying” company to report to the members of the company as required under section 227(3)(f) whether any director in the company has been disqualified during the year from being reappointed as director, or being appointed as a director in another company under clause (g) of section 274(1). Auditor’s Procedures for Compliance with Section 227(3)(f) and the Rules 32. In order to comply with the requirements of section 227(3)(f) of the Act and the Rules, the auditor should obtain a written representation as to:

Part II : Guidance Notes

II.35

(a) Names of directors of the company during the period covered by the auditor’s report (including the directors at the balance sheet date), showing separately, the names of nominee directors and directors appointed in accordance with the Companies (Appointment of the Small Shareholders’ Director) Rules, 2001 (b) Particulars of appointment/reappointment, resignation/retirement etc., of each of the above directors. (c) Whether in case of directors appointed on or after the date of the Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003 coming into effect, each such director has submitted Form DD-A, as required under the said Rules. (d) That the information contained in the register of directors maintained under section 303(1) is updated to show the position as on the balance sheet date. (e) Whether the company has committed any default as envisaged in sub-clauses (A) and/or (B) of clause (g) of section 274 (1) of the Act. (f)

In case the company has committed a default under sub-clauses (A) and/ or (B) of clause (g) of section 274(1) of the Act, whether the company has furnished the Form DD-B, as required by the Rules.

33. The auditor should also obtain a written representation from the directors of the company as to whether they have attracted the disqualification in terms of clause (g) of sub-section (1) of section 274 of the Act. The auditor should require the directors to submit a written representation in respect of each public company in which they are directors as to whether as on the balance sheet date the public companies of which he is a director have defaulted in terms of the section 274(1)(g). There is a practice amongst many companies that the directors obtain a legal compliance report, periodically, to ensure that the companies have complied with all the legal requirements. Such compliance reports generally also contain the information regarding filing of annual accounts and annual return and compliance with clause (g) of sub-section (1) of section 274 can be a part of the said legal compliance report. Such a compliance report can, therefore, be submitted by the director as an evidence in this regard. In addition to written representation obtained from the director in respect of public companies of which he is a director, the auditor should also obtain written representation from the director in respect of each of those public companies in which he was a director in the past as to whether or not the director is disqualified to be appointed as a director in terms of proviso to Section 274(1)(g). The auditor should insist that written representations provided by the management as well as the directors appointed prior to the issuance of Rules or the legal compliance report, as the case may be, should be taken on record by the Board of Directors of the company being audited. However, in no case, is the auditor of either the appointing company or the disqualifying company expected to make any roving enquiries from such other companies in which the concerned director is also a director, as to whether or not they have committed any default in terms of sub clauses (A) and/ or (B) of clause (g) of section 274(1) of the Act. 34. The auditor should verify the information provided by the management and the directors

II.36

Advanced Auditing & Professional Ethics

from the information contained in the register maintained under section 303(1) of the Act. The said register contains various particulars relating to all the directors of the company including particulars in respect of the office of director, managing director, etc. The auditor can also examine the Form 32 filed by the company during the financial year under section 303(2) of the Act so as to know the changes, for example, appointment, retirement, resignation etc., of directors during the year. Form DD-A filed by the directors would also assist the auditor in assessing whether any director appointed during the year, at the time of appointed, was disqualified under section 274(1)(g) of the Act. 35. In case company being audited happens to be a public company which has not filed the annual accounts and annual returns for any continuous three financial years commencing on and after 1st April, 1999; or has failed to repay its deposit or interest thereon on due date or redeem its debentures on due date or pay dividend and such failure continues for one year or more; then the auditor must report that all the directors are disqualified from being appointed as director in terms of clause (g) of sub-section (1) of section 274 of the Act. The auditor, in such a case, should also examine the return in Form DD-B to be filed under the Rules. Form DD-B contains the particulars of directors during the relevant period. 36. Since the Rules are applicable to public limited companies only, Forms DD-A and DD-B would not be available to the auditor a private company. In such cases, the auditor’s employs the same procedures to comply with the requirements of section 227(3)(f) which are applied by an auditor of a public company except that the auditor is not required to examine Forms DD-A and DD-B because of their non-availability in a private company. 37. The reporting under clause (f) of sub-section (3) of section 227 of the Act may be as follows, keeping in view the situation concerned: (a) Where all the directors of the company are able to produce the evidence as specified in paragraph 33 above that the public company/(ies) of which they are directors have not defaulted in terms of section 274(1)(g), the auditor may report as follows: “On the basis of the written representations received from the directors, and taken on record by the Board of Directors, we report that none of the directors is disqualified as on 31st March, 2XXX from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Companies Act, 1956”. (b) In a situation where a director is unable to produce the written representation as specified in paragraph 33 above, the auditor may report as follows: “Mr. X, who is also a director of ABC Ltd., has not produced written representation as to whether ABC Ltd., in which Mr. X is a director as on 31st March, 2XXX, had not defaulted in terms of section 274(1)(g) of the Companies Act, 1956. In the absence of this representation, we are unable to comment whether Mr. X is disqualified from being appointed as a director under clause (g) of sub-section (1) of section 274 of the Companies Act, 1956. As far as other directors are concerned, on the basis of the written representations received from such directors, and taken on record by the Board of Directors, we report that none of the remaining directors is disqualified as on 31st March, 2XXX from being appointed as a director in terms of clause (g) of sub-section (1) of

Part II : Guidance Notes

II.37

section 274 of the Companies Act, 1956.” (c) Where on the basis of the written representation received from a director, it is noted that the director was disqualified from being appointed as a director under this clause, the auditor may report as follows: “On the basis of the written representation received from Mr. Y, who is a director of ABC Ltd., as on 31st March 2XXX, and taken on record by the Board of Directors, we report that he is disqualified from being appointed as a director in terms of clause (g) of subsection (1) of section 274 of the Companies Act, 1956. As far as other directors are concerned, on the basis of the written representations received from such directors, and taken on record by the Board of Directors, we report that none of the remaining directors is disqualified as on 31st March 2XXX from being appointed as a director in terms of clause (g) of sub-section (1) of section 274 of the Companies Act, 1956.” Certificate under the Rules 38. As mentioned, sub-rule (a) of Rule 4 requires that it shall be the duty of the statutory auditor to furnish a certificate each year as to whether on the basis of his examination of the books and records of the company, any director of the company is disqualified for appointment as a director or not. The Rules, however, are silent as to whom the said certificate would be addressed. An interpretation could be that the auditor should furnish such a certificate to the shareholders of the company. However, this does not seem to be logical since the shareholders would get the same information from the auditor’s statement in respect of clause (f) of sub-section (3) of section 227 of the Act. Therefore, it would be appropriate that the certificate is addressed to the Board of Directors of the Company. It may also be noted that the Rules are also silent as to the format and contents of the certificate. An illustrative format of the said certificate is given in Appendix II, which may be used by the auditors. Appendix I PUBLISHED IN THE GAZETTE OF INDIA, PART II, SECTION 3(i), EXTRAORDINARY Ministry of Finance (Department of Company Affairs) NOTIFICATION New Delhi, the 21st October, 2003 G.S.R. 830 (E).- In exercise of the powers conferred by clause (b) of sub-section (1) of section 642 of the Companies Act, 1956 (1 of 1956), the Central Government hereby makes the following rules to carry out the purpose of clause (g) of sub-section (1) of section 274 of the said Act, namely :1.

Short Title, Commencement and Extent

(1) These rules may be called the Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003.

II.38

Advanced Auditing & Professional Ethics

(2) These rules shall come into force from the date of their notification in the Official Gazette. (3) These rules shall apply to all public limited companies registered under the Companies Act, 1956. 2.

Definitions

In these Rules, unless the context otherwise requires, (a) “disqualifying company” is the company in which the default has occurred on account of which a director stands disqualified; (b) “appointing company” is the company in which an individual is seeking appointment as a director, including re-appointment as director. 3.

Disqualifications under clause (g) of sub-section (1) of section 274 of the Companies Act, 1956 (a) Whenever a company fails to file the annual accounts and annual returns, as described in sub-clause (A) of clause (g) of sub-section (1) of section 274, persons who are directors on the last due date for filing the annual accounts and the annual returns for any continuous three financial years commencing on and after the first day of April, 1999, shall be disqualified. (b) If a company has failed to repay any deposit, irrespective of the enactment, rules or regulations under which the deposits have been accepted by the companies, or interest thereon, or redeem its debentures, or pay any dividend declared on the respective due dates, and if such failure continues for one year, as described in sub-clause (B) of clause (g) of sub-section (1) of section 274, then the directors of that company shall stand disqualified immediately on expiry of that one year from the respective due dates:

Provided that all the directors who have been directors in the relevant year, from the due date to the expiry of one year after the due date, will be disqualified: Provided further that disqualification on account of the reasons cited under this Rule shall also apply to the reappointment as a director. Explanation-For the purpose of this rule, it is clarified that non-payment of dividend referred to in sub-clause (B) of clause (g) of sub-section (1) of section 274 due to the reason of dividend not being claimed or kept in separate bank account as required under section 205A of Companies Act, 1956 or paid into Investors Education & Protection Fund as required under section 205C of that Act shall not be deemed to be a failure to make payment of dividend. 4.

Duty of Statutory Auditor to Report on Disqualification (a) It shall be the duty of statutory auditor of the appointing company as well as disqualifying company, as required under section 227(3)(f) to report to the members of the company whether any director is disqualified from being appointed as director under clause (g) of sub-section (1) of section 274 and to furnish a certificate each year as to whether on the basis of his examination of the books and records of the company, any director of the company is disqualified for appointment as a director or not.

Part II : Guidance Notes

II.39

(b) It shall be the duty of the statutory auditors of the “disqualifying company” as required in section 227(3)(f) to report to the members of the company whether any director in the company has been disqualified during the year from being re-appointed as director, or being appointed as director in another company under clause (g), of sub-section (1) of section 274. 5.

Duty of Company to Intimate Disqualification

Whenever a company fails to file the annual accounts and returns, or fails to repay any deposit, interest, dividend, or fails to redeem its debentures, as described in clauses (A) and (B) of clause (g) of sub-section (1) of section 274, the company shall immediately file a return in duplicate in Form ‘DD-B’, prescribed under these rules for this purpose, to the Registrar of Companies, furnishing therein the names and addresses of all the Directors of the company during the relevant financial years: Provided that names of such directors who have been exempted from application of Section 274(1)(g) by the Central Government, from time to time, shall be excluded. Provided further that no unusual abbreviations or short forms shall be used in filling up the Form ‘DD-B’, which shall give such details as may be necessary to distinguish and identify each director without any ambiguity. 6.

Failure to Intimate Disqualification Shall render Director as Officer in Default

When a company fails to file the Form ‘DD-B’ as above within 30 days of the failure that would attract disqualification under Section 274(1)(g), officers of the company listed in section 5 of the Companies Act, 1956 shall be officers in default. 7.

(a) Upon receipt of the Form ‘DD-B’ in duplicate under Rule 5, the Registrar of Companies shall immediately register the document and place one copy of it in the document file for public inspection. (b) The Registrar of Companies shall forward the other copy to the Central Government.

8.

Names of the Disqualified Directors on the Website etc. (a) The Central Government shall place on the web site of the Department of Company Affairs the names and addresses and such other details including names and details of the companies concerned, as may be necessary, in respect of all the disqualified directors. (b) The Central Government may also publicize the names of disqualified directors in such manner as it may consider appropriate. (c)

9.

The Central Government shall take such steps as may be required to update its website to ensure that name of the person, in whose respect disqualification period has expired after 5 years, is deleted from the web-site.

Duty of Every Director

Every director in a public company registered under the Companies Act, 1956 shall file Form ‘DDA’, prescribed under these Rules, before he is appointed or re-appointed.

II.40

Advanced Auditing & Professional Ethics

10. If any question arises as to whether these rules are or are not applicable to a particular company, such question shall be decided by the Central Government. 11. Punishment for Contravention of the Rules If a company or any other person contravenes any provision of these rules for which no punishment is provided in the Companies Act, 1956, the company and every officer of the company who is in default or such other person shall be punishable with fine which may extend to five thousand rupees and where the contravention is a continuing one, with a further fine which may extend to five hundred rupees for every day after the first, during which the contravention continues. 12. On the commencement of these rules, all rules, orders or directions in force in relation to any matter for which provision is made in these Rules shall stand repealed, except as respects things done or omitted to be done before such repeal. [F. No.1/8/2002-CL.V] Rajiv Mehrishi, Joint Secretary FORM ‘DD-A’ Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003 Intimation by Director [Pursuant to Section 274(1)(g)] Registration No. of Company ______________ Nominal Capital Rs._____________ Paid-up Capital Rs. _____________ Name of Company__________________________ Address of its Registered Office___________________ To The Board of Directors of __________________________ I _______________ son/daughter/wife of _______________ resident of ___________________ director/managing director/manager in the company hereby give notice that I am/was a director in the following companies during the last 3 years: Name of the Company 1……………. 2…………….

Date of Appointment

Date of Cessation

Part II : Guidance Notes

II.41

I further confirm that I have not incurred disqualification under section 274(1)(g) of the Companies Act, 1956 in any of the above companies, in the previous financial year, and that I, at present, stand free from any disqualification from being a director. or I further confirm that I have incurred disqualifications under section 274(1)(g) of the Companies Act, 1956 in the following company(s) in the previous financial year, and that I, at present stand disqualified from being a director. Date of Appointment

Name of the Company

Date of Cessation

1……………. 2……………. Signature (Full Name) Dated this _________ day of _________ FORM ‘DD-B’ Report by a Public Company [Pursuant to Section 274(1)(g) read with Rule 5 of Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003] Registration No. of Company:____________________________ Nominal Capital Rs.____________________________________ Paid-up Capital Rs. ____________________________________ Name of Company_____________________________________ Address of its Registered Office__________________________ To The Registrar of Companies, It is hereby reported under section 274(1)(g) of Companies Act, 1956, that M/s. ___________ have failed to (i) file the annual accounts and annual returns for the last three financial years, or (ii) repay deposits or interest thereon on due date being ___________ or redeem its debentures on due date being _________ or pay dividend declared by the company since __________ or both. The period of one year has expired on ___________. The name and address of directors at the relevant period are as under :(a) Director’s name in full, without abbreviations

II.42

Advanced Auditing & Professional Ethics

(b) Director’s name as per company’s records (abbreviations may be expanded and shown) (c)

Address of the Director (i)

Permanent

(ii)

Present

(d) Positions held by the director in the last 5 years, prior to disqualification: Signature Designation24 Dated this _________ day of _________ *State whether Director, Managing Director, Manager or Secretary Appendix II FORMAT OF THE CERTIFICATE TO BE ISSUED UNDER RULE 4 (a) OF THE COMPANIES (DISQUALIFICATION OF DIRECTORS UNDER SECTION 274(1)(g) OF THE COMPANIES ACT, 1956) RULES, 2003 Auditor’s Certificate Rule 4 (a) of the Companies (Disqualification of Directors Under section 274(1)(g) of the Companies Act, 1956) Rules, 2003 To, The Board of Directors of __________(name of the company) In terms of Rule 4(a) of the Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003, I/we ………………………………………………………. (name of the chartered accountant/ firm, as the case may be), based on our examination of the books and records of the company, carried out in accordance with the requirements of the Guidance Note on Section 227(3)(e) and (f) of the Companies Act, 1956, issued by the Institute of Chartered Accountants of India, do hereby certify that none of the directors of the company, i.e., ………………………………………………………(name of the company) as on _______ (date of the balance sheet) is disqualified for appointment as a director in the aforementioned company in terms of clause (g) of sub section (1) of section 274 of the Companies Act, 1956. Date: Address:

24 25

Partner or proprietor, as the case may be. Partner or proprietor, as the case may be.

For XYZ & Co., Chartered Accountants …………………………………… (Signature) (Name of the Member Signing the Certificate) (Designation25) …………………………………… (Membership Number)

Part II : Guidance Notes 8.

II.43

GUIDANCE NOTE ON REVISION OF THE AUDIT REPORT

Introduction 1. This Guidance Note aims to provide guidance to members regarding revision of the audit report after the same has been issued, in case the auditor considers necessary to do so. It lays down the procedures to be followed by the auditor who, subsequent to the date of his report, becomes aware that facts may have existed at that date which might have affected his report had he been aware of such facts at the time of issuance of the audit report. Accordingly, this Guidance Note does not apply to situations arising from developments occurring after the date of the audit report; neither does it apply to situations where, after issuance of the audit report, final determinations or resolutions are made of contingencies or other matters which had been disclosed in the financial statements or which had resulted in qualification/ disclaimer/ adverse opinion in the original audit report. 2. A revision of the audit report may be warranted in several instances involving reasons such as apparent mistakes, wrong information about facts, subsequent discovery of facts existing at the date of the audit report, etc. The nature and range of instances may vary from one enterprise to another depending upon facts and circumstances. As it encompasses variety of conditions which might be encountered, these procedures are set out only in general terms for guidance of members and for having uniform approach in such cases. Members are advised to exercise professional judgement depending upon the actual facts and circumstances of the case. 3. The revision of the audit report would mean issuing a revised audit report as per procedure hereafter provided. The auditor under no circumstances is permitted to withdraw in any manner whatsoever the audit report once issued. However, the auditor may take steps to prevent reliance on the audit report issued by him in the manner hereafter provided. 4. It must be appreciated that the revision of the audit report is a matter of great significance since confidence of the stakeholders rests on the opinion expressed by the auditor in the audit report. The Guidance Note recognises that though the instances of revision of the audit report may be rare in actual practice, members are expected to exercise care and caution in view of the significance of the matter. Such a step on the part of the auditor not only demonstrates the independence of auditor to act in a free and fair manner but would also enhance confidence of the public at large in the profession. 5. It is clarified that revision of audit report does not absolve the member from the professional misconduct, if any, committed by him. 6. The Framework for SAPs and Guidance Notes on Related Services issued by the Institute of Chartered Accountants of India distinguishes between audit and related services. As per the Framework, related services comprise of reviews, agreed-upon procedures and compilation. This Guidance Note is applicable whenever an audit or related services is carried out. Therefore, the reference to the "audit report" includes any report that may be issued pursuant to audit or related services rendered to the entity. It may be noted that reference to financial statements in the Guidance Note may be construed as reference to financial or other such statements which may be the subject matter of report.

II.44

Advanced Auditing & Professional Ethics

7. It may be clarified that the auditor has no obligations to perform auditing procedures or make any enquiry regarding the audited financial statements after the auditor has signed the report. The responsibility to inform the auditor, of such facts which existed on the date of the report, primarily rests with management. However, the auditor may come to know of such facts through other sources also. Revision of Financial Statements by Management 8. As stated above, the management is expected to inform the auditor of any facts which existed on the date of the audit report which may affect the financial statements. When auditor becomes aware of such facts which may affect the financial statements, the auditor may consider whether the financial statements need amendment and discuss the matter with the management and may advise the management to revise the financial statements. When management agrees with the auditor's suggestion and decides to revise the financial statements then while reporting on such revised financial statements, members are expected to follow the Guidance Note on Audit Report on Revised Accounts of Companies Before Circulation of Shareholders. Members may not that the said Guidance Note also deals with the manner of revising the audit report under circumstances mentioned therein. Further, members' attention is also invited to the Guidance Note on Revision/Rectification of Financial Statements dealing with auditor's responsibility in case of revision/rectification of balance sheet and profit and loss account of a company already adopted by the company at its annual general meeting. Revision of the Audit Report 9. When an auditor considers that: ♦

amendment in financial statements is not warranted, or

♦

when he advises amendment to financial statements as above

♦

but the management does not intend to revise the same, or

♦

when management agrees for revision in financial statements but is unable to do so despite its bonafide intentions but management extends its cooperation to the auditor and agrees to ensure that anyone in receipt of the previously issued financial statements together with the audit report thereon is informed of the situation and would be issued the revised audit report, the auditor may then consider issuing the revised report as under:

♦

Refer to the earlier report issued by the auditor on the financial statements; and

State the Reasons for Revising the Report 10. In case of corporate entities, the auditor may consider revising the report till the accounts are adopted at annual general meeting. But in case of entities which are not required to adopt accounts by any such body, the auditor may consider revision of the audit report within a reasonable time having regard to prevailing circumstances but not later than issuance of the audit report for the accounts of immediately next accounting period. 11. A situation may also arise where the auditor is a continuing one, the auditor may consider that it may not be necessary to revise the financial statements and issue a revised report in

Part II : Guidance Notes

II.45

view of the fact that appropriate disclosures are made in the financial statements to be released pertaining to the immediate following period when such situation is imminent. Preventing Reliance on the Audit Report 12. When management neither agrees for revision of financial statements as laid down in para 8 nor takes steps as narrated in para 9 above, the auditor would notify those persons ultimately responsible for the overall direction of the entity that action will be taken by the auditor to prevent future reliance on the audit report. The steps that can appropriately be taken will depend upon the degree of certainty of the auditor's knowledge that there are persons who are currently relying or who will rely on the financial statements and the audit report, and who would attach importance to the information and the auditor's ability as a practical matter to communicate with them. The action taken will depend on the auditor's legal rights and obligations and the recommendations. In appropriate circumstances the auditor may consider seeking legal advice. The auditor may take the following steps to the extent applicable: (a) Notify the client that the audit report must no longer be associated with the financial statements. (b) Notify Regulatory Agencies having jurisdiction over the client that the audit report should no longer be relied upon. The Registrar of Companies, the Securities and Exchange Board of India, Reserve Bank of India, Income-tax Department, Insurance Regulatory and Development Authority or any other Governmental Regulatory body are appropriate agencies for this purpose as to entities within their jurisdiction. (c) Making an appropriate statement at the annual general meeting, if requested by the Chairman. Withdrawal from Engagement 13. When management neither agrees to revise the financial statements nor agrees to ensure that anyone in receipt of the previously issued financial statements and audit report thereon will be informed of the situation and would be issued revised audit report, the auditor may also conclude that withdrawal from the further engagement with the entity is necessary. Factors that would affect the auditor's conclusion include the implications of the involvement of the highest authority within the entity which may affect the reliability of management representations, and the effects on the auditor of continuing association with the entity. In appropriate circumstances, the auditor may consider seeking legal advice. 14. In case of an auditor being a partnership firm, it is recommended that the partner who signed the original audit report, should also sign the revised report or the letter indicating preventing reliance on the audit report, as the case may be. In case of signing by any other partner, the reasons thereof should be stated.

II.46

Advanced Auditing & Professional Ethics 9.

GUIDANCE NOTE ON AUDIT OF

MISCELLANEOUS EXPENDITURE [REVISED]26 Introduction 1. The following is the text of the Guidance Note on Audit of Miscellaneous Expenditure. This Guidance Note provides guidance on audit procedures to be applied while auditing miscellaneous expenditure. This Guidance Note also provides guidance for audit of items that generally constitute miscellaneous expenditure when Accounting Standard (AS) 26, Intangible Assets comes into effect or is voluntarily applied by an enterprise in accounting for intangible assets. This Guidance Note, however, does not provide any guidance on audit of intangible assets that are recognised in accordance with AS 26. The guidance provided herein is restricted to only those items which were hitherto (before application of AS 26—whether mandatory or otherwise) being classified as items of miscellaneous expenditure, but because of application of AS 26, accounting treatment of such items would change. 2. ‘Miscellaneous expenditure’ shown in the balance sheet of companies (or shown under this or some other appropriate heading in the balance sheet of other enterprises) embraces within its fold a variety of items of expenditure which are not entirely charged to income in the year in which they are incurred, but are carried forward in the balance sheet to be written-off in subsequent periods. Unless some benefit from the expenditure can reasonably be expected to be received in future and unless the amount of such benefit is reasonably determinable, there is no justification for carrying forward the expenditure for being writtenoff in subsequent periods. Also, the amount of expenditure to be carried forward should not exceed the expected future revenue/other benefits related to the expenditure. 3. The Guidance Note deals with the audit considerations related to the following items that normally constitute 'miscellaneous expenditure': (a) preliminary expenses; (b) expenses including commission or brokerage on underwriting or subscription of shares or debentures including discount allowed on the issue of shares or debentures; (c) research and development expenditure, etc. 4. The Council of the Institute of Chartered Accountants of India has issued Accounting Standard (AS) 26, 'Intangible Assets'. The objective of this AS 26 is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in another Accounting Standard. AS 26 requires an enterprise to recognise an intangible asset if, and only if, certain criteria are met. The accounting standard also specifies how to measure the carrying amount of intangible assets and requires certain disclosures about intangible assets. Consequently, the accounting treatment of some of the items that generally constitute

26

''Issued in September, 2003. The Guidance Note on Audit of Miscellaneous Expenditure shown in the Balance Sheet shall stand withdrawn in respect of audit of financial statements of enterprises for which AS 26, ''Intangible Assets'' has become mandatory and in respect of entity that has chosen to apply AS 26 to account for intangible assets.

Part II : Guidance Notes

II.47

'miscellaneous expenditure' would change as and when an enterprise adopts Accounting Standard 26 'Intangible Assets' to account for intangible assets. 5. Accounting Standard (AS) 26, 'Intangible Assets’ comes into effect in respect of expenditure incurred on intangible items during accounting periods commencing on or after 14-2003 and is mandatory in nature from that date for the following: (i)

Enterprises whose equity or debt securities are listed on a recognised stock exchange in India, and enterprises that are in the process of issuing equity or debt securities that will be listed on a recognised stock exchange in India as evidenced by the board of directors’ resolution in this regard.

(ii)

All other commercial, industrial and business reporting enterprises, whose turnover for the accounting period exceeds Rs. 50 crores.

In respect of all other enterprises, the Accounting Standard comes into effect in respect of expenditure incurred on intangible items during accounting periods commencing on or after 14-2004 and is mandatory from that date. The Accounting Standard, however, encourages earlier application. 6. In respect of intangible items appearing in the balance sheet as on the aforesaid date, i.e., 1-4-2003 or 1-4-2004, as the case may be, the Standard has limited its application as stated in paragraph 99 of AS 26. From the date of this Standard becoming mandatory for the concerned enterprises, the following stand withdrawn: (i)

Accounting Standard (AS) 8, Accounting for Research and Development;

(ii)

Accounting Standard (AS) 6, Depreciation Accounting, with respect to the amortisation (depreciation) of intangible assets; and

(iii) Accounting Standard (AS) 10, Accounting for Fixed Assets - paragraphs 16.3 to 16.7, 37 and 38. 7. Since AS 26, applies to different entity from different dates, it may happen that certain enterprises, till the date the standard becomes mandatory for them may continue to defer the expenditure incurred on items that normally constitute “miscellaneous expenditure”. Once an entity applies AS 26 to account for intangible assets, the expenditure incurred on items that normally constitute miscellaneous expenditure shall be governed by the Standard, except in the case of already appearing miscellaneous expenditure in the balance sheet which is to be accounted for using paragraph 99 of AS 26. 8. The following features of miscellaneous expenditure have an impact on the related audit procedures. (a) The items of expenditure included under this heading do not represent any tangible asset. (b) The expenditure on these items is usually of a non-recurring nature. (c) There is a justification for deferring the expenditure on the basis that the benefits from the expenditure can reasonably be expected as flowing into the future the

II.48

Advanced Auditing & Professional Ethics amount of such benefits is reasonably determinable, and the amount of deferred expenditure does not exceed the expected future benefits related thereto. (d) Unless some fresh expenditure is incurred, the balance in these items reduces each year by the amount written-off in the year.

9. The auditor’s primary objective in audit of items that generally constitute miscellaneous expenditure is to satisfy himself that — (a) in case where some items are shown in the balance sheet under the head Miscellaneous Expenditure whether it is proper to defer the expenditure; (b) in case where some items are shown in balance sheet under the head ‘Miscellaneous Expenditure’, the period of amortisation of the expenditure is reasonable; (c) the expenditure shown to have been incurred during the year actually occurred during the year and there is proper authority for the expenditure and for its deferral; (d) the criteria which previously justified the deferral of the expenditure continue to be met and the expected future revenue/other benefits related to the expenditure continue to exceed the amount of unamortised expenditure. (e) Where the entity has applied AS 26, for accounting for items that normally constitute miscellaneous expenditure, whether the same has been done in accordance with the Standard and the already appearing items under the head miscellaneous expenditure have been dealt with in accordance with paragraph 99 of AS 26. Internal Control Evaluation 10. The auditor should study and evaluate the system of internal control relating to the various items of miscellaneous expenditure to determine the nature, timing and extent of his other audit procedures. He should particularly review the following aspects. (a) There should be a system of control over expenditure incurred on these items. An effective method of exercising such control is budgeting which, apart from ensuring proper authorisation of the expenditure incurred, also shows in general how effectively such expenditure is being controlled. This is accomplished through periodical comparisons of actual with budgeted figures. (b) Accountability should be established over each item of such expenditure. This can be achieved, inter alia, by up-to-date maintenance of proper records. (c) The system should ensure that reliable information (including reports of experts) is available for assessment of the results achieved against the objectives and estimates of the expenditure determined originally. Verification 11. The nature, timing and extent of substantive procedures to be performed are matters of professional judgment of the auditor which is based, inter alia, on the auditor’s evaluation of the effectiveness of the related internal controls.

Part II : Guidance Notes

II.49

12. While verifying an item of miscellaneous expenditure in the year in which the relevant expenditure is incurred, the auditor should satisfy himself regarding the amount of such expenditure and its deferral as also regarding the reasonableness of the period of amortisation of the expenditure. Till the amount is fully amortised, the auditor should examine every year that a proper amount is amortised during the year by way of a charge to income for the year (and not as its appropriation). The auditor should also examine every year that the criteria which previously justified the deferral of the expenditure continue to be met. If those criteria no longer apply, the auditor should examine whether the unamortised balance has been charged as expense immediately. Where the auditor finds that the criteria for deferral continue to be met but the amount of unamortised balance of the expenditure exceeds the expected future revenue/other benefits related thereto, the auditor should examine whether such excess has been charged as an expense immediately. 13. The applicability of AS 26 on items that generally constitute miscellaneous expenditure and special considerations in audit of various items of miscellaneous expenditure when AS 26 is applied are discussed in subsequent paragraphs of this Guidance Note. Preliminary Expenses 14. Preliminary expenses are the expenses relating to the formation of an enterprise. For example, in the case of a company, preliminary expenses would normally include the following. (a) Legal cost in drafting the memorandum and articles of association. (b) Fees for registration of the company. (c) Cost of printing of the memorandum and articles of association and statutory books of the company. (d) Any other expenses incurred to bring into existence the corporate structure of the company. 15. Paragraph 55 of AS 26 requires that expenditure on an intangible item should be recognised as an expense when it is incurred unless: (a) it forms part of the cost of an intangible asset that meets the recognition criteria laid down in paragraphs 19-54 of AS 26; or (b) the item is acquired in an amalgamation in the nature of purchase and cannot be recognised as an intangible asset. If this is the case, this expenditure (included in the cost of acquisition) should form part of the amount attributed to goodwill (capital reserve) at the date of acquisition. 16. Paragraph 56 of AS 26 provides some examples where the expenditure is recognised as an expense when it is incurred. The examples given include, expenditure on start-up of activities (start-up costs), unless this expenditure is included in the cost of an item of fixed asset under AS 10. Start-up costs may consist of preliminary expenses incurred in establishing a legal entity such as legal and secretarial costs, expenditure to open a new facility or business (pre-opening costs) or expenditures for commencing new operations or launching new products or processes (pre-operating costs).

II.50

Advanced Auditing & Professional Ethics

17. Preliminary expenses, therefore, incurred on or after the date on which the Standard becomes mandatory for an enterprise or the preliminary expenses incurred on or after the date on which the enterprise opts to apply the Standard in the preparation and presentation of financial statements would be written off in the year in which they are incurred. The expenditure on preliminary expenses shall not be carried forward in the balance sheet to be written off in subsequent accounting periods. 18. Preliminary expenses already shown in the balance sheet on the date the Standard is first applied would be required to be accounted for in accordance with the requirements laid down by paragraph 99 of AS 26. 19. The auditor should verify these expenses with reference to supporting documents such as invoices and contracts relating to these expenses. In the case of a company, the auditor should also examine that the reimbursement of such expenses to promoters is in accordance with the disclosures made in the prospectus. Compliance with legal provisions regarding reimbursement of the promoters’ expenses should be specifically examined. In addition to the audit procedures mentioned above, the auditor should also apply the following audit procedures with regard to preliminary expenditure: (a) The auditor should verify whether the preliminary expenses incurred on or after the date the Standard is applied by the enterprise are entirely charged to the profit and loss account in the year in which they are incurred. (b) In the case of preliminary expenses already appearing in the balance sheet on the date the Standard is applied, the auditor should satisfy himself that the estimate made by the management of the enterprise of the useful life of the preliminary expenses is appropriate. (c) The auditor should verify whether the carrying amount of the preliminary expenses already appearing in the balance sheet is eliminated with a corresponding adjustment to the opening balance of the revenue reserve in case the amortisation period determined under paragraph 63 of AS 26 has already expired. (d) The auditor should satisfy himself that the preliminary expenses already appearing in the balance sheet are being amortised in accordance with the requirements of AS 26 in case the amortisation period determined under paragraph 63 of AS 26 has not expired. Expenses Related to Subscription or Issue of Shares 20. Expenses related to subscription or issue of shares include commission or brokerage on underwriting or subscription of shares or debentures, discount allowed on issue of shares or debentures. AS 26 excludes from its scope certain activities or transactions which are so specialised that they give rise to accounting issues that may need to be dealt with in a different way. Such accounting issues, inter alia, are accounting for discount or premium relating to borrowings and ancillary costs incurred in connection with the arrangement of borrowings, share issue expenses and discount allowed on the issue of shares.

Part II : Guidance Notes

II.51

21. The auditor should examine whether the payment of brokerage, commission, etc., is authorised by articles of association or other rules/regulations and is in accordance with the provisions of the relevant statute. 22. The auditor should also examine whether the rates of commission paid or payable to brokers and underwriters are in accordance with the disclosures made in the prospectus. The auditor should verify the commission with reference to the agreements with brokers and underwriters. 23. The auditor should examine the certificate issued by the merchant bankers with regard to commission payable to underwriters, and ensure that the payment made to underwriters is in accordance with such certificate. 24. Other expenses on issue of shares or debentures, such as fees of the managers to the issue, fees of the registrars to the issue including mailing and handling charges, fees of the advisors to the issue, advertisement expenses, expenses on printing and supply of prospectus and application forms, expenses on printing of share/debenture certificates, etc., should be verified with reference to supporting documents such as invoices, agreements, etc. The auditor should also examine whether the limits on such expenses as laid down in the applicable statute have been complied with. Research and Development Expenditure 25. Entities generally incur expenditure on research and development activities. Paragraph 41 of AS 26, Intangible Assets provides that no intangible asset arising from research or from the research phase of an internal project should be recognised and should therefore, be charged as an expenses, as and when incurred. According to AS 26, expenditure incurred in the development or during the development phase of an enterprise is required to be recognised as an intangible asset if, and only if, the requirements of paragraph 44 of AS 26 are met. It may be noted that the expenditure incurred on research or incurred during the research phase of an enterprise are required to be recognised as an expense when such expenses are incurred. 26. The expenditure, therefore, incurred in the development or during the development phase of an enterprise on or after the date on which the Standard becomes mandatory for an enterprise or the preliminary expenses incurred on or after the date on which the enterprise opts to apply the Standard in the preparation and presentation of financial statements would be recognised as an asset if the requirements of paragraph 44 of AS 26 are met. Where the expenditure qualifies to be recognised as an intangible asset then the requirements, related to carrying amount of the intangible asset, its amortisation and disclosures, laid down by AS 26 shall apply to the development expenditure. 27. The development expenditure shown in the balance sheet on the date on which the Standard is first applied shall be accounted for in accordance with the requirements of paragraph 99 of AS 26 from that date. If any expenditure incurred on the research or during the research phase of an enterprise already appears in the balance sheet, the same shall also be required to be accounted for in accordance with paragraph 99 of AS 26 from the date the Standard is first applied by the enterprise.

II.52

Advanced Auditing & Professional Ethics

28. The auditor should perform the following audit procedures with regard to research and development expenditure: (a) The auditor should verify the research expenditure and development expenditure with reference to supporting documents such as purchase invoices, agreements with third parties etc. A variety of expenses may be incurred by an enterprise during the research phase or development phase of an enterprise. The auditor should apply the procedures mentioned in the Guidance Note on Audit of Expenses with regard to the items of expenditure covered therein. (b) The auditor should verify that the expenses incurred on research or incurred during the research phase of an internal project on or after the date the Standard is first applied by the enterprise are entirely charged to the profit and loss account in the year in which they are incurred; (c) In the case of research and development expenses already appearing in the balance sheet on the date the Standard is first applied, the auditor should satisfy himself that the estimate made by the management of the enterprise of the useful life of such expenses is appropriate; (d) The auditor should verify whether the carrying amount of the research and development expenses already appearing in the balance sheet is eliminated with a corresponding adjustment to the opening balance of the revenue reserve in case the amortisation period determined under paragraph 63 of AS 26 has already expired. (e) The auditor should satisfy himself that the research and development expenses already appearing in the balance sheet are being amortised in accordance with the requirements of AS 26 in case the amortisation period determined under paragraph 63 of AS 26 has not expired. (f)

The auditor should also examine that the intangible asset recognised is accounted for in accordance with the requirements of AS 26.

(g) Where an intangible asset has been recognised, the auditor should verify whether the asset so recognised is tested for impairment in accordance with Accounting Standard (AS) 28, Impairment of Assets. The auditor should examine whether the test of impairment is appropriate and where impairment has occurred, an impairment loss has be provided for in the financial statements. Other Items 29. Expenditure during construction period includes a variety of expenditure. Some of the expenditure during construction period may also constitute miscellaneous expenditure. Where an enterprise applies AS 26 to account for intangible assets, either voluntarily or is required to do so by operation of the accounting standard itself, the accounting treatment of some of the items of expenditure during construction period might be governed by the principles enunciated in AS 26. The auditor, in such cases, should verify the expense incurred during the construction period with reference to the supporting documents, such as, invoices,

Part II : Guidance Notes

II.53

contracts, etc., relating to those expenses. The auditor should also verify that the requirements of AS 26 have been complied with in accounting for such items. 30. In case where an enterprise does not apply AS 26 to account for intangible assets because it is not required to do so, the auditor apart from verifying the expense incurred during the construction period with reference to the supporting documents, such as, invoices, contracts, etc., relating to those expenses should also examine whether the deferral and the amortisation of expenditure incurred during the construction period are in accordance with recognised accounting policies and practices (see, for example, Guidance Note on Treatment of Expenditure During Construction Period, issued by the Institute of Chartered Accountants of India). Where the entity incurs heavy expenditure of a revenue nature during the year, the benefits of which are likely to extend beyond that year, the expenditure may sometimes be deferred and written-off over the number of years for which the benefits are expected to be derived by the entity. Some instances of such expenditure are removal of business from one location to another and massive advertisement in one year to introduce a product or develop a market. In such cases, the auditor should examine whether the deferred of the expenditure meets the relevant criteria and whether the amount of periodic write-off of the expenditure is appropriate. Disclosures 31. The auditor should examine whether the financial statements contain adequate disclosures as required by AS 26. The auditor should also examine that the financial statements disclose the accounting policy with regard to miscellaneous expenditure. On the first occasion when AS 26 is applied by an enterprise for accounting for items of miscellaneous expenditure, the financial statements should also disclose the change in accounting policy with regard to miscellaneous expenditure in accordance with the requirements of paragraph 32 of Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies. 10. GUIDANCE NOTE ON COMPUTER ASSISTED AUDIT TECHNIQUES (CAATS) Introduction 1. The overall objectives and scope of an audit do not change when an audit is conducted in a computer information systems (CIS) environment. The application of auditing procedures may, however, require the auditor to consider techniques known as Computer Assisted Audit Techniques (CAATs) that use the computer as an audit tool for enhancing the effectiveness and efficiency of audit procedures. CAATs are computer programs and data that the auditor uses as part of the audit procedures to process data of audit significance, contained in an entity’s information systems. 2. The purpose of this Guidance Note is to provide guidance in the use of CAATs. This Guidance Note describes computer assisted audit techniques including computer tools, collectively referred to as CAATs. This Guidance Note applies to all uses of CAATs when a computer of any type or size is involved whether that computer is operated by the entity or by a third party.

II.54

Advanced Auditing & Professional Ethics

Description of Computer Assisted Audit Techniques (CAATs) 3. Computer Assisted Audit Techniques (CAATs) are important tools for the auditor in performing audits. CAATs may be used in performing various auditing procedures, including the following: ♦

tests of details of transactions and balances, for example, the use of audit software for recalculating interest or the extraction of invoices over a certain value from computer records;

♦

analytical procedures, for example, identifying inconsistencies or significant fluctuations;

♦

tests of general controls, for example, testing the set-up or configuration of the operating system or access procedures to the program libraries or by using code comparison software to check that the version of the program in use is the version approved by management ;

♦

sampling programs to extract data for audit testing;

♦

tests of application controls, for example, testing the functioning of a programmed control; and

♦

reperforming calculations performed by the entity’s accounting systems.

4. CAATs allow the auditor to give access to data without dependence on the client, test the reliability of client software, and perform audit tests more efficiently. CAATs are computer programs and data that the auditor uses as part of the audit procedures to process data of audit significance contained in an entity’s information systems. CAATs may consist of package programs, purpose-written programs, utility programs or system management program. Regardless of the origin of the programs, the auditor substantiates their appropriateness and validity for audit purposes before using them. A brief description of the programs commonly used is given below. ♦

Package Programs are generalized computer programs designed to perform data processing functions, such as reading data, selecting and analyzing information, performing calculations, creating data files and reporting in a format specified by the auditor.

♦

Purpose-Written Programs perform audit tasks in specific circumstances. These programs may be developed by the auditor, the entity being audited or an outside programmer hired by the auditor. In some cases, the auditor may use an entity’s existing programs in their original or modified state because it may be more efficient than developing independent programs.

♦

Utility Programs are used by an entity to perform common data processing functions, such as sorting, creating and printing files. These programs are generally not designed for audit purposes, and therefore may not contain features such as automatic record counts or control totals.

♦

System Management Programs are enhanced productivity tools that are typically part of a sophisticated operating systems environment, for example, data retrieval software or

Part II : Guidance Notes

II.55

code comparison software. As with utility programs these tools are not specifically designed for auditing use and their use requires additional care. Details of some of the techniques used are mentioned in the Appendix. Considerations in the Use of CAATs 5. When planning an audit, the auditor may consider an appropriate combination of manual and computer assisted audit techniques. In determining whether to use CAATs, the factors to consider include: ♦

the IT knowledge, expertise and experience of the audit team;

♦

the availability of CAATs and suitable computer facilities and data;

♦

the impracticability of manual tests;

♦

effectiveness and efficiency; and

♦

time constraints.

Before using CAATs the auditor considers the controls incorporated in the design of the entity’s computer systems to which CAAT would be applied in order to determine whether, and if so, how, CAATs should be used. IT Knowledge, Expertise and Experience of the Audit Team 6. Auditing and Assurance Standard (AAS) 29, “Auditing in a Computer Information Systems Environment” deals with the level of skill and competence the audit team needs to conduct an audit in a CIS environment. It provides guidance when an auditor delegates work to assistants with CIS skills or when the auditor uses work performed by other auditors or experts with such skills. Specifically, the audit team should have sufficient knowledge to plan, execute and use the results of the particular CAAT adopted. The level of knowledge required depends on “availability of CAATs” and “suitable computer facilities”. Availability of CAATs and Suitable Computer Facilities 7. The auditor considers the availability of CAATs, suitable computer facilities and the necessary computer-based information systems and data. The auditor may plan to use other computer facilities when the use of CAATs on an entity’s computer is uneconomical or impractical, for example, because of an incompatibility between the auditor’s package program and entity’s computer. Additionally, the auditor may elect to use their own facilities, such as PCs or laptops. 8. The cooperation of the entity’s personnel may be required to provide processing facilities at a convenient time, to assist with activities such as loading and running of CAAT on the entity’s system, and to provide copies of data files in the format required by the auditor. Impracticability of Manual Tests 9. Some audit procedures may not be possible to perform manually because they rely on complex processing (for example, advanced statistical analysis) or involve amounts of data that would overwhelm any manual procedure. In addition, many computer information systems perform tasks for which no hard copy evidence is available and, therefore, it may be

II.56

Advanced Auditing & Professional Ethics

impracticable for the auditor to perform tests manually. The lack of hard copy evidence may occur at different stages in the business cycle. ♦

Source information may be initiated electronically, such as by voice activation, electronic data imaging, or point of sale electronic funds transfer. In addition, some transactions, such as discounts and interest calculations, may be generated directly by computer programs with no specific authorization of individual transactions.

♦

A system may not produce a visible audit trail providing assurance as to the completeness and accuracy of transactions processed. For example, a computer program might match delivery notes and suppliers’ invoices.

♦

In addition, programmed controlled procedures, such as checking customer credit limits, may provide hard copy evidence only on an exception basis.

♦

A system may not produce hard copy reports. In addition, a printed report may contain only summary totals while computer files retain the supporting details.

Effectiveness and Efficiency 10. The effectiveness and efficiency of auditing procedures may be improved by using CAATs to obtain and evaluate audit evidence. CAATs are often an efficient means of testing a large number of transactions or controls over large populations by: ♦

analyzing and selecting samples from a large volume of transactions;

♦

applying analytical procedures; and

♦

performing substantive procedures.

11. Matters relating to efficiency that an auditor might consider include: ♦

the time taken to plan, design, execute and evaluate CAAT;

♦

technical review and assistance hours;

♦

designing and printing of forms (for example, confirmations); and

♦

availability of computer resources

12. In evaluating the effectiveness and efficiency of CAAT, the auditor considers the continuing use of CAAT application. The initial planning, design and development of CAAT will usually benefit audits in subsequent periods. Time Constraints 13. Certain data, such as transaction details, are often kept for a short time and may not be available in machine-readable form by the time auditor wants them. Thus, the auditor will need to make arrangements for the retention of data required, or may need to alter the timing of the work that requires such data. 14. Where the time available to perform an audit is limited, the auditor may plan to use CAAT because its use will meet the auditor’s time requirement better than other possible procedures.

Part II : Guidance Notes

II.57

Using CAATs 15. The major steps to be undertaken by the auditor in the application of CAAT are to: (a) set the objective of CAAT application; (b) determine the content and accessibility of the entity’s files; (c) identify the specific files or databases to be examined; (d) understand the relationship between the data tables where a database is to be examined; (e) define the specific tests or procedures and related transactions and balances affected; (f)

define the output requirements;

(g) arrange with the user and IT departments, if appropriate, for copies of the relevant files or database tables to be made at the appropriate cut off date and time; (h) identify the personnel who may participate in the design and application of CAAT; (i)

refine the estimates of costs and benefits;

(j)

ensure that the use of CAAT is properly controlled;

(k) arrange the administrative activities, including the necessary skills and computer facilities; (l)

reconcile data to be used for CAAT with the accounting and other records;

(m) execute CAAT application; (n) evaluate the results; (o) document CAATs to be used including objectives, high level flowcharts and run instructions; and (p) assess the effect of changes to the programs/system on the use of CAAT. Testing CAAT 16. The auditor should obtain reasonable assurance of the integrity, reliability, usefulness, and security of CAAT through appropriate planning, design, testing, processing and review of documentation. This should be done before reliance is placed upon CAAT. The nature, timing and extent of testing is dependent on the commercial availability and stability of CAAT. Controlling CAAT Application 17. The specific procedures necessary to control the use of CAAT depend on the particular application. In establishing control, the auditor considers the need to: (a) approve specifications and conduct a review of the work to be performed by CAAT; (b) review the entity’s general controls that may contribute to the integrity of CAAT, for example, controls over program changes and access to computer files. When such controls cannot be relied on to ensure the integrity of CAAT, the auditor may consider processing CAAT application at another suitable computer facility; and

II.58

Advanced Auditing & Professional Ethics

(c) ensure appropriate integration of the output by the auditor into the audit process. 18. Procedures carried out by the auditor to control CAATs applications may include: (a) participating in the design and testing of CAAT; (b) checking, if applicable, the coding of the program to ensure that it conforms with the detailed program specifications; (c) asking the entity’s staff to review the operating system instructions to ensure that the software will run in the entity’s computer installation; (d) running the audit software on small test files before running it on the main data files; (e) checking whether the correct files were used, for example, by checking external evidence, such as control totals maintained by the user, and that those files were complete; (f)

obtaining evidence that the audit software functioned as planned, for example, by reviewing output and control information; and

(g) establishing appropriate security measures to safeguard the integrity and confidentiality of the data. When the auditor intends to perform audit procedures concurrently with online processing, the auditor reviews those procedures with appropriate client personnel and obtains approval before conducting the tests to help avoid the inadvertent corruption of client records. 19. To ensure appropriate control procedures, the presence of the auditor is not necessarily required at the computer facility during the running of CAAT. It may, however, provide practical advantages, such as being able to control distribution of the output and ensuring the timely correction of errors, for example, if the wrong input file were to be used. 20. Audit procedures to control test data applications may include: ♦

controlling the sequence of submissions of test data where it spans several processing cycles;

♦

performing test runs containing small amounts of test data before submitting the main audit test data;

♦

predicting the results of the test data and comparing it with the actual test data output, for the individual transactions and in total;

♦

confirming that the current version of the programs was used to process the test data; and

♦

testing whether the programs used to process the test data were the programs the entity used throughout the applicable audit period.

21. When using CAAT, the auditor may require the cooperation of entity staff with extensive knowledge of the computer installation. In such circumstances, the auditor considers whether the staff improperly influenced the results of CAAT. 22. Audit procedures to control the use of audit-enabling software may include:

Part II : Guidance Notes

II.59

♦

verifying the completeness, accuracy and availability of the relevant data, for example, historical data may be required to build a financial model;

♦

reviewing the reasonableness of assumptions used in the application of the tool set, particularly, when using modeling software;

♦

verifying availability of resources skilled in the use and control of the selected tools; and

♦

confirming the appropriateness of the tool set to the audit objective, for example, the use of industry specific systems may be necessary for the design of audit programs for unique business cycles.

Documentation 23. The various stages of application of CAATs should be sufficiently documented to provide adequate audit evidence. 24. The audit working papers should contain sufficient documentation to describe CAAT application, including the details set out in the sections below: (a) Planning ♦

CAAT objectives;

♦

CAAT to be used;

♦

Controls to be exercised; and

♦

Staffing, timing and cost.

(b) Execution ♦

CAAT preparation and testing procedures and controls;

♦

Details of the tests performed by CAAT;

♦

Details of inputs (e.g., data used, file layouts), processing (e.g., CAATs high-level flowcharts, logic) and outputs (e.g., log files, reports);

♦

Listing of relevant parameters or source code; and

♦

Relevant technical information about the entity’s accounting system, such as file layouts.

(c) Audit Evidence ♦

Output provided;

♦

Description of the audit work performed on the output;

♦

Audit findings; and

♦

Audit conclusions;

(d) Other ♦

Recommendations to the entity management; and

In addition, it may be useful to document suggestions for using CAAT in future years.

II.60

Advanced Auditing & Professional Ethics

Arrangements with the Entity 25. The auditor may make arrangements for the retention of the data files, such as detailed transaction files, covering the appropriate audit time frame. 26. In order to minimize the effect on the organisation’s production environment, access to the organisation’s information system facilities, programs/systems and data should be arranged well in advance of the needed time period 27. The auditor should also consider the effect of these changes on the integrity and usefulness of CAAT, as well as the integrity of the programs/system and data used by the auditor. Using CAATs in Small Entities 28. Although the general principles outlined in this Guidance Note apply in small entity IT environments, the following points need special consideration: (a) The level of general controls may be such that the auditor will place less reliance on the system of internal control. This will result in greater emphasis on tests of details of transactions and balances and analytical review procedures, which may increase the effectiveness of certain CAATs, particularly, audit software. (b) Where smaller volumes of data are processed, manual methods may be more cost effective. (c) A small entity may not be able to provide adequate technical assistance to the auditor, making the use of CAATs impracticable. (d) Certain audit package programs may not operate on small computers, thus restricting the auditor’s choice of CAATs. The entity’s data files may, however, be copied and processed on another suitable computer.

Part II : Guidance Notes

II.61

Appendix Examples Of Computer Assisted Audit Techniques Techniques

Description

Advantages

Audit Automation

♦ Expert Systems

♦ These techniques ♦ Not applicable in are more useful the case of when auditors are mainframe using laptops computers. which can be directly linked with the entity’s system.

♦ Tools to evaluate a client’s risk management procedures ♦ Electronic working papers, which provide for the direct extraction of data from clients computer records

Disadvantages

♦ Corporate and financial modeling programs for use as predictive audit test Audit Software

Core Image Comparison

♦ Software used by the auditor to read data on client’s files, to provide information for the audit and/or to re-perform procedures carried out by the client’s programs.

♦ Performs a wide ♦ Requires a variety of audit reasonable degree tasks of skill to use

Software used by the auditor to compare the executable version of a program with a secure master copy

♦ Provides a high ♦ Requires a high degree of comfort degree of skill to concerning the set up and to executable version interpret the results. of the program programs ♦ Where ♦ Particularly useful have been

♦ Long economies ♦ Reads records

term actual

♦ Capable of dealing with large volumes of transactions

♦ Initial set up costs can be high ♦ Adaptation needed machine machine

often from to

II.62

Advanced Auditing & Professional Ethics where executable versions distributed

only are

recompiled comparison invalidated program everything difference

the may be as the records as a

♦ Printouts are hard to interpret and the actual changes made are difficult to establish ♦ Availability restricted to certain machine types Database Analysers

Software used by the auditor to examine the rights associated with terminals and the ability of users to access information on a database

♦ Provides detailed ♦ Requires a high information degree of skill to concerning the set up and to operation of the interpret the results database ♦ Restricted ♦ Enhances the availability both as auditor’s regards machine understanding of types and database the database management management systems system ♦ Specific and limited audit applicability

Embedded Code

Software used by the auditor to examine transactions passing through the system by placing his own program in the suite of programs used for processing.

♦ Performs a wide variety of audit tasks

a ♦ There is processing overhead involved because of the each ♦ Examines extra programs transaction as it passes through the ♦ Definition of what system constitutes an unusual transaction ♦ Operates needs to be very continuously precise of ♦ Capable ♦ Precautions need to identifying unusual be taken over the transactions output from the passing through

Part II : Guidance Notes the system.

II.63

programs to ensure is security ♦ Precautions need to be taken to ensure that the program cannot be suppressed or tampered with some ♦ Requires degree of skill to use and to interpret the results

Long Analysers

Software used by the auditor to read and analyse records of machine activity

♦ Provides detailed information on machine usage. ♦ Long economies ♦ Effective testing controls

Mapping

Software used by the auditor to list unused program instructions

term

♦ Requires a high degree of skill to use and to interpret the results

♦ Limited availability as regards machine when types integrity ♦ High volume of records restricts extent of test

♦ Identifies program code which may be there for fraudulent reasons.

♦ Very objective

specific

♦ Requires a high degree of skill to use and to interpret the results ♦ Adaptation needed from machine to machine.

Modelling

A variety of software, ♦ Can be a very ♦ A high volume of usually associated powerful analytical data may need to with a tool be entered initially microcomputer, require enabling the auditor ♦ Can enable the ♦ Results auditor to examine careful to carry out provisions on a interpretation analytical reviews of number of different client’s results, to

II.64

Advanced Auditing & Professional Ethics alter conditions so as bases to identify amounts ♦ Very flexible in use for provisions or claims, or to project ♦ Can provide the results and compare auditor with useful actual results with information on those expected trends and patterns

On-line Testing

Techniques whereby ♦ Very widely the auditor arranges applicable or manipulates data either real or ♦ Easy to use fictitious, in order to ♦ Can be targetted see that a specific for specific program or screen functions carried edit test is doing its out by programs work

♦ Each use satisfies only one particular objective ♦ Care must be taken to ensure that “live” data does not actual impact results

Program Code Analysis

An examination by ♦ Gives a reasonable ♦ The auditor must the auditor of the understand the degree of comfort source code of a program language about the program particular program logic ♦ The auditor needs with a view to The auditor can ♦ to check that the following the logic of examine every source code the program so as to function of the represents the satisfy himself that it version in the program code will perform source library, and according to his that this version understanding equates to the executable version

Program Library Analysers

Software used by the auditor to examine dates of changes made to the executable library and the use of utilities to amend programs

♦ Provides the ♦ Requires a high auditor with useful degree of skill to use and to interpret information the results concerning the program library ♦ Availability restricted to certain ♦ Identifies abnormal machine types changes to the library ♦ Only relevant when testing integrity when ♦ Useful controls testing program security

Part II : Guidance Notes Snapshots

Software used by the ♦ Permits the auditor auditor to take a to examine “picture” of a file of processing at a data or a transaction specific point in passing through the time to carry out system at a tests, or to confirm particular point in the way a time particular aspect of the system operates

Source Comparison

Software used by the auditor to compare the source version of a program with a secure master copy

II.65

♦ Can be expensive to set up

♦ Compares source ♦ Other procedures code line by line are necessary to and identifies all ensure that the differences executable version reflects the source when ♦ Useful code examined testing integrity some controls or ♦ Requires particularly degree of skill to important program use and to interpret procedures the results ♦ Availability restricted to certain machine types

Test Data “Live”, “Dead”, Integrated Test Facility or Base Case System Evaluation

Fictitious data applied against the client’s programs either whilst they are running or in an entirely separate operation. The results of processing the fictitious data are compared with the expected results based on the auditor’s understanding of the programs involved

♦ Performs a wide variety of tasks

♦ “Dead” test data requires additional work for the auditor ♦ Gives considerable to satisfy himself comfort about the the right programs operation of were used programs ♦ Care must be taken ♦ Can be precisely to ensure that “live” targetted for data does not specific procedures impact actual within programs results ♦ Long term ♦ Technique can be economies expensive to set up and cumbersome to use for ♦ Adequate detection of major

II.66

Advanced Auditing & Professional Ethics error but less likely to detect deepseated fraud

Tracing

Software used by the auditor to identify which instructions were used in a program and in what order

♦ Helps to analyse ♦ There may be less costly ways to the way in which a program operates achieve the same objectives, although not in the same detail ♦ Requires a high degree of skill to use and to interpret the results ♦ Adaptation needed from machine to machine

11. GUIDANCE NOTE ON AUDIT OF CAPITAL AND RESERVES27 The following is the text of the Guidance Note on Audit of Capital and Reserves, issued by the Council of the Institute of Chartered Accountants of India. The Guidance Note should be read in conjunction with the Auditing and Assurance Standards issued by the Institute. Introduction 1. Capital and reserves constitute the owners' funds. Capital comprises both the amounts contributed by the owners and the profits capitalised over a period of time (by way of issue of bonus shares in case of corporate entities or by way of crediting the retained earnings to the capital account in case of non-corporate entities). 2. Capital may consist of various classes of shares with varying voting rights in case of corporate entities. 3. Reserves are the portion of earnings, receipts or other surplus of an enterprise (whether capital or revenue) appropriated by the management for a general or a specific purpose other than a provision for depreciation or diminution in the value of assets or for a known liability. Reserves comprise both capital and revenue reserves. Ordinarily, revenue reserves are retained earnings, whereas the capital reserves may constitute both retained capital profits and owners' contribution in the form of premium on issue of shares and surpluses resulting Attention of the readers is invited to the fact that prior to the issuance of this Guidance Note, the aspect of audit of Capital and Reserves was covered by paragraphs 8.1 to 8.18 of the Statement on Auditing Practices. The Statements was withdrawn pursuant to the issuance of the Guidance Note on Audit of Payment of Dividend in August, 2005.

27

Part II : Guidance Notes

II.67

from re-issue of forfeited shares. Revaluation reserve arising from revaluation of fixed assets is also a capital reserve. 4. The auditor, in many audit engagements, particularly those relating to corporate entities, may find very few changes in the capital account and/ or reserve accounts. However, the transactions in the capital and reserve accounts are normally material in amount in addition to being significant in nature and, therefore, each transaction in these accounts requires careful attention. 5. In any auditing situation, the auditor employs appropriate procedures to obtain reasonable assurance about various assertions (see Auditing and Assurance Standard 5, Audit Evidence). In carrying out the audit of capital and reserves, the auditor is particularly concerned with obtaining sufficient appropriate audit evidence to corroborate the management's assertions regarding the following: Existence:

that the recorded amounts of capital and reserves exist at the given date

Occurrence:

that the transactions recorded in the capital and reserve account(s) occurred during the period under audit

Obligation:

that the amounts appearing in the capital and reserves account(s) are in fact a liability of the entity

Completeness:

that there are no unrecorded transactions in respect of capital and reserves account(s)

Measurement:

that the transactions in the capital and reserves account(s) have been recorded at the proper amount

Valuation:

that the amounts recorded in the capital and reserve account(s) are recorded at appropriate carrying value

Presentation and disclosure:

that the items of capital and reserves have been disclosed, classified, and described in the financial statements in accordance with recognised financial reporting framework applicable to the client.

6. The principal objectives of the auditor in the examination of capital and reserves, therefore, are: (a) to ascertain that amounts shown in capital and reserve account(s) as at the balance sheet date are correct; (b) to determine that all transactions during the year, affecting owners' funds were properly authorised and recorded; (c) to examine whether the applicable laws and regulations and terms of issue/ agreement, if any, have been complied with; and (d) to verify whether these amounts have been properly classified and disclosed in the financial statements.

II.68

Advanced Auditing & Professional Ethics

Internal Control Evaluation 7. Paragraph 2 of the Auditing and Assurance Standard (AAS) 6, Risk Assessments and Internal Control, requires the auditor to obtain an understanding of the accounting and internal controls relating to capital and reserves sufficient to plan the audit and develop an effective audit approach. Paragraph 1 of the AAS 5 requires the auditor to "obtain sufficient appropriate audit evidence through the performance of compliance and substantive procedures to enable him to draw reasonable conclusions therefrom on which to base his opinion on the financial information". Paragraph 1 further states: "Compliance procedures are tests designed to obtain reasonable assurance that those internal controls on which audit reliance is to be placed are in effect. Substantive procedures are designed to obtain evidence as to the completeness, accuracy and validity of the data produced by the accounting system." In certain cases, the client may employ a third party to carry out any of its transactions in respect of capital and/ or reserves. For example, it is quite common for listed companies to outsource the administrative aspects related to allotment, issuance of share certificates, share transfer, maintenance of records of shareholders, etc. In such situations, the auditor, as required by Auditing and Assurance Standard (AAS) 24, "Audit Considerations Relating to Entities Using Service Organisations", should also consider how such arrangements affect the client's accounting and internal control system so as to plan and develop an effective audit approach. 8. In the case of non-corporate entities, the auditor needs to ascertain general terms and conditions regarding contribution of capital, interest payable on capital, interest chargeable on withdrawals, limits imposed on withdrawals, etc. In respect of corporate entities, the auditor should particularly review the following aspects of internal controls relating to capital and reserves: (a) Proper authorisation of transactions: All transactions in the capital and reserves accounts such as issue of fresh shares and allotment, buy back of shares, forfeiture, making calls on the shares, should be properly authorised as required by the Companies Act, 1956. Outsourcing of any services, e.g., depository services should also be with the proper authorisation of a competent authority. The authority to sign the share certificates may be delegated to a person as per the laws applicable to the entity. (b) Proper control over issue and custody of share certificates: In case where shares are in the physical form, the auditor is required to examine that proper internal control system exists to ensure that the share certificates are pre-numbered, proper accounts are maintained for certificates cancelled due to defacement, wear out, exhaustion of cages to record transfer particulars, dematerialisation. The auditor should examine whether blank share certificates are under the lock and control of the company secretary or some other responsible officer of the entity. He should also examine whether at least one officer of the entity personally signs the share certificates issued, though other signatures can be facsimile type and whether such

Part II : Guidance Notes

II.69

a signing officer also verifies the register of share certificates, wherein the issue particulars are recorded. It may be noted that share certificates are generally issued for a fixed lot of shares (marketable lot, or some other predetermined denomination). (c) Allotment and call intimations etc.: The auditor should examine whether allotment of shares and calls is done pursuant to a resolution of the Board and that proper internal controls exist for despatch of allotment advices and call letters. (d) Internal control on receipts and accounting of application, allotment and call money: Internal controls applicable for receipt and accounting of money received on application, allotment and calls need to be evaluated. Proper records should be maintained for recording the said transactions. Periodical reconciliation of bank accounts opened specially for transactions in capital account have to be made. (e) Maintenance of adequate records: The auditor should verify whether proper system of internal controls for documentation is in operation. It includes maintenance of proper and adequately detailed records in respect of the details of members, share certificate stock ledger, duplicate certificates, cancelled certificates, etc. (f)

Proper control over issue of instructions to depository participants: There should exist proper controls over issue of instructions to and for execution of requests received from the depository participants for the dematerialisation/re-materialisation of shares and proper records are required to be maintained for recording such transactions.

Internal Controls relating to Outsourced Activities 9. For the efficient carrying out of the day to day transactions like issue of share certificates/ instructions to depository participants for the credit of shares on allotment, either on public issue or rights issue, issue of call letters, etc., authority may be delegated, at the general meeting, to registrars and share transfer agents. In such cases, the auditor should follow the procedures described by the AAS 24. Verification 10. Verification of capital and reserves may be carried out employing the following procedures: (i)

examination of records;

(ii)

examination of compliance with laws and regulations and terms of issue/ contract, if any; and

(iii) examination of presentation and disclosure. 11. The nature, timing and extent of substantive procedures to be performed is, however, a matter of professional judgment of the auditor which is based, inter alia, on the auditor's evaluation of the effectiveness of the related internal controls.

II.70

Advanced Auditing & Professional Ethics

Entities Other Than Partnerships And Sole Proprietorships Examination of Records Capital Authorised Capital 12. The authorised capital shown in the balance sheet should be checked with the Memorandum of Association in case of a company, registered byelaws in case of a cooperative society, relevant statute or the Government Order in case of a statutory corporation or other body corporate. The auditor may also refer the audited balance sheet of the immediately preceding year. 13. The minutes of the general meeting and/ or Board should be examined to see, if any, change in the capital structure has taken place since the last balance sheet and whether it is properly authorised. A company, having a share capital, in terms of the provisions of Section 94 of the Companies Act, 1956 may change its share capital as follows: (i)

increase its share capital by such amount as it thinks expedient by issuing new shares

(ii)

consolidate or divide all or any of its share capital into shares of larger amount than its existing shares

(iii) convert all or any of its fully paid up shares into stock, and reconvert that stock into fully paid-up shares of any denomination (iv) sub-divide its shares, or any of them, into shares of smaller amount than is fixed by the memorandum (v) cancel shares which, at the date of passing of the resolution in that regard, have not been taken or agreed to be taken by any person, and diminish the amount of its share capital by the amount of the shares so cancelled In such cases, the auditor should also examine the copy of the documents filed with the Registrar of Companies in relevant form along with the specified fee pursuant to the requirements of Section 97 of the Companies Act, 1956. In addition to the situations envisaged in Section 94 of the Companies Act, 1956, the auditor should also enquire whether the Central Government has, under Section 81(4) ordered or directed under Section 94A(2) of the Companies Act, 1956, the conversion of debentures or loans into share capital, resulting in an increase in the authorised capital of the company. The authorised capital may also undergo a change, as a consequence of a merger or a demerger. Similarly, in case of statutory corporations, amendments made to the statute governing the entity or the Government Order in case of other public sector bodies should be enquired into. Issued and Subscribed Capital

Part II : Guidance Notes

II.71

14. Issued Capital: The following records/documents would ordinarily provide necessary evidence for issued capital: (a) The minutes of the general and/ or board meetings for further issue of shares, e.g., under Section 81 of the Companies Act,1956; (b) Offer documents, if any, filed with the Securities and Exchange Board of India (SEBI)/Registrar of Companies (ROCs) and Reserve Bank of India (RBI) in respect of permission in case of ADR/GDR issue. (c) Return of allotment filed with the Registrar of Companies. 15. Subscribed Capital: Shares subscribed in response to the issue of capital can be verified by reviewing the applications received for the subscription of shares. The subscribed capital is the capital for which the application money is received. The subscribed share capital cannot exceed the issued capital. Paid up capital 16. Periodical reconciliation of outstanding shares held in demat and physical form as on book closure/ record date should also be done. 17. The auditor should review the minutes books of Board of Directors and the members and also any amendments made to the statutory register to ascertain whether any changes have taken place in the capital of the entity, for example – A.

Increase in capital due to: (i)

Fresh issue of shares/ADR/GDR.

(ii)

Allotment of shares pursuant to merger/amalgamation or acquisition of property or services.

(iii) Part/full conversion of loans or debentures (iv) Allotment of shares pursuant to exercise of option either by the promoters or the employees or other option holders. (v) Allotment of Bonus shares (vi) Rights issue B.

Decrease in capital due to: (i)

Forfeiture

(ii)

Buy-back of shares

(iii) Redemption of redeemable preference shares (iv) Reduction of capital (v) Surrender of shares as in the case of Co-operative societies (vi) De-merger

II.72

Advanced Auditing & Professional Ethics

18. A list of members, together with shares held by them and the amounts paid-up thereon, should be available with the company/entity as at the balance sheet date and the aggregate of these should agree, with the details of capital shown in the balance sheet. A copy of the annual return for the previous year filed under the Companies Act, 1956 or any other statue or a list of members prepared for issuing dividend warrants may also be examined. If the auditor chooses to verify the list of members as per the annual return or list of members prepared for issuing dividend warrants, he should also check the reconciliation with the amount as at the balance sheet date, with the changes occurred during the period from the date of balance sheet and record date/ book closure date. Where the registration work is carried out by independent specialised agencies, a certificate, containing the list of members, the number of shares held, including those in the demat form and physical form and amount paid up on these shares and calls in arrears, if any, should be obtained and reconciliation of the particulars with the amount credited as paid up in the share capital account of the General Ledger be checked on a test basis. 19. If a change in the capital has taken place during the year under audit, inquiries should be made to ascertain that it is properly authorised in the manner prescribed by the Articles and appropriate resolutions have been passed with requisite majority. 20. The auditor should enquire whether the Central Government has passed any order under Section 108 or Section 250 of the Companies Act, 1956 freezing the voting rights of any shareholders. It may be noted that there are provisions in the Banking Regulation Act, 1949 limiting the voting rights of a person. Similarly, the Co-operative Societies Act, 1912 provides for issue of two types of shares, one having voting rights and other not having voting rights. The Companies Act, 1956 also provides for issue of shares with non voting rights. These matters have a bearing while examining the validity of the resolutions passed by the members of the entity. The auditor should, therefore, also check that the classes of shares have been appropriately disclosed. Subscription in Cash and Kind 21. The law requires a distinction to be made between shares subscribed for in cash and shares subscribed for consideration other than in cash. Shares subscribed for in cash should include only the following kinds of subscription: (a) where the subscription amount is received either in cash or by cheque; (b) where the amount is adjusted against a bona fide debt payable in money at once by the company. There might be situations where a company has taken a loan under a stipulation that in case of default in repayment of the loan, the loan would get converted into shares. In such a situation, on a default in repayment of the loan by the company, if the loan gets converted into shares in the company, such shares would be considered as having been allotted for cash. Where shares are allotted against credit balance in a person's account, inquiry should be made as to how the credit balance in that account has arisen, whether it was for a valid consideration and whether the amount was due for payment at the time of issue.

Part II : Guidance Notes

II.73

22. The Department of Company Affairs28 has clarified through its circular No. 8/32(75) 77CL-V dated 13th March, 1978, that a genuine debt adjusted against the amount receivable towards share capital can be treated as amount paid in cash. The extracts from the advice received from an eminent Counsel in this regard are given as Appendix A to this Guidance Note. 23. Where the subscription for share capital is paid into a bank account in a foreign country, it should be verified that the amount deposited in the foreign currency is in accordance with the terms of issue and such an amount as, if remitted into India on the day on which the deposit is made in the foreign country, would have realised in Indian rupees a sum equal to the amount credited as paid up and premium, if any, on the shares. The auditor should verify that the guidelines issued by SEBI for inviting, collecting and recording of foreign capital have been complied with by the company. The foreign exchange fluctuations, if any, should be accounted for in the balance with bank in accordance with the provisions of Accounting Standard 11, Accounting for the Effects of Changes in Foreign Exchange Rates. 24. Issue of Shares for Consideration Other than Cash: Shares may also be issued for a consideration other than cash, e.g., for supply of machinery or technical know-how. The auditor should examine the underlying agreement in respect of the same and verify whether the agreement has been properly approved. The auditor should treat the shares issued for consideration other than cash separate from those issued against cash in his audit approach. He needs to verify that the consideration for which shares are issued, viz., supply of machinery or technical know-how is prima facie fully received. 25. Further, as per the provisions of Section 75 of the Companies Act, 1956, whenever company having a share capital makes any allotment of its shares, the company has to comply with the following conditions: i.

It has to file with the Registrar of Companies, a return of the allotment, stating the number and nominal amount of shares comprised in the allotment, the names, addresses and occupations of the allottees, and the amount if any, paid or due and payable on the shares.

ii.

In case of shares allotted for other than cash, it has to produce before the Registrar, inter alia, a contract in writing, constituting the title of the allottee to the allotment together with any contract of sale, or a contract for services or other consideration in respect of which allotment was made.

26. The auditor may examine the following records to the extent they are applicable to the particular circumstances, in case of increase in paid-up capital: (a) Final price determined in case of offer through book building process29. 28

Now known as the Ministry of Company Affairs.

Book Building Process: Listed companies can also issue shares through Book Building Process. Book Building is a process wherein the issuer of securities asks investors to bid for his securities at different prices. These bids are within an indicative price-band, decided by the issuer. Here, investors bid for different quantity of shares, at different prices,

29

II.74

Advanced Auditing & Professional Ethics (b) Scheme of compromise or arrangement as referred to in Section 394 of the Companies Act, 1956, approved by the Court. (c) Compromise proposal with creditors and the consequential Order of the Court or an Order of Central Government under Section 397 of the Companies Act, 1956. (d) Procedure and terms of reissue of forfeited shares.

27. In case the payment is allowed to be made on allotment and/ or also in instalments of one or more calls, the auditor has to verify the resolution of the Board for making calls, amount received against the calls and the posting of the amount to the correct member's account/folio. A schedule of allotment money and a schedule for each call have to be verified on test check basis and reconciled with total amount received and due on allotment and each call. If the accounting work relating to the share capital is outsourced to a Registrar and Share Transfer Agent, the auditor should follow the principles enunciated in AAS 24. If the Articles of Association permit and the terms of issue state that in the event of delay in payment of either allotment money or calls, the investor has to pay interest, the auditor should verify whether such interest is collected and properly accounted for in the books of account. The auditor should review the schedules of calls in arrears and calls in advance, and ensure that interest is provided in accordance with the Articles of Association, Offer Documents/Terms of Issue. The auditor may verify the Board Resolution, if any, for waiver of interest on calls in arrears. Interest on calls in arrears may be accounted at the time of receipt, with proper disclosure in the balance sheet for deviating from the accrual principle. The schedule of calls in arrears should show separately the amounts, if any, due from the directors. Similarly, the auditor should also examine the payment of interest on calls received in advance, if any, made by the company. He should verify whether any such payment of interest on calls received in advance is permitted by the articles of association of the company. He should also examine the Board resolution in this regard. 28. In case shares are issued at discount, the auditor has to verify the compliance of Section 79 of the Companies Act, 1956. 29. Generally, employees are offered shares at a price lesser than the market rate. Sections 79 and 79A of the Companies Act, 1956 and SEBI (Employee Stock Option Scheme and Employees Stock Purchase Scheme) Guidelines, 1999 (ESOS and ESPS), Employee Stock Option Scheme for Public Sector Enterprises and others statues governing the entity have to be complied with. Transactions relating to options are to be accounted as required by the said scheme or the Accounting Standards and provisions of any relevant statute, if any, in force, on treatment of discount etc., on ESOS/ESPS. 30. Issue of Sweat Equity: Section 79A of the Companies Act, 1956 deals with the issue of sweat equity by the company to its employees and directors, at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual Considering these bids, the issuer determines a cut off price, which is the price at which the securities are allotted. SEBI has issued guidelines on issue of shares through Book Building Process. The auditor has to verify whether the company has complied with all the guidelines issued by SEBI in this regard and also that the basis of determination of the floor price and the final price by the company is consistent with the provisions in that regard.

Part II : Guidance Notes

II.75

property rights or value additions, by whatever name called. SEBI has also issued SEBI (Issue of Sweat Equity) Regulations, 2002 for issue of the sweat equity by the listed companies. The issue of sweat equity by unlisted companies is governed by Unlisted Companies (Issue of Sweat Equity Shares) Rules, 200330. The auditor must verify that if the company has issued any sweat equity, whether the provisions of Section 79A of the Companies Act, 1956 and the Rules applicable to the company, depending whether listed or not, have been complied with. 31. Companies are now allowed to buy-back their own shares. Sections 77 A and 77B of the Companies Act, 1956 lay down the conditions and procedures for buy-back of the shares of a company. In case of private limited and unlisted companies, the Private Limited Company and Unlisted Public Limited Company (Buy-back of Securities) Rules 1999, and in case of listed companies, SEBI (Buy-back of Securities) Regulations, 1998 have to be complied with. The auditor should verify particularly that the funds employed for the buy-back are from the resources as permitted by the law. The reconciliation of entries in escrow account or the bank account separately opened for payment of purchase consideration have to be verified with the number of shares bought back and price paid. The auditor should also verify the entries made in the concerned books/registers with regard to destruction of share certificates and extinguishments of dematerialised shares and a reconciliation of these two to arrive at the total number of securities purchased under buy- back process. 32. Registered Byelaws of the Co-operative Societies specify the terms and conditions for surrender of all or certain class of shares. Generally, surrender of shares is allowed only at par. The auditor has to verify the certificates surrendered vis-a-vis the payment made and the entries made in the Register of members, share certificate ledger etc. 33. In case of reduction of capital is by way of reduction of the nominal value of the shares, either by cancelling unpaid portion of the partly paid shares, or extinguishing some part of the paid up capital, the auditor has to verify that the High Court Order under Section 100 of the Companies Act, 1956 for reduction of capital has been complied with. Further, he has to verify the share certificates surrendered and the statement of corresponding new share certificates issued. In case reduction is achieved by cancelling fully paid shares proportionately, the auditor should also verify the surrendered shares/issue of stickers/intimation to the depositories visa-vis the amount reduced. 34. It may be noted that the buy-back of shares under Section 77 A and redemption of redeemable preference shares under Section 80 do not attract the provisions of Section 100 of the Companies Act, 1956. Application Money 35. Schedule VI to the Companies Act, 1956 does not prescribe the manner of disclosure of share application money. However, as a matter of prudence and better disclosure, share application money should be shown separately between "Share Capital" and "Reserves & Surpluses' in the Balance Sheet till the time share application money is transferred to the 30

Issued by the Ministry of Company Affairs vide Notification number GSR 923E dated 4th December, 2003.

II.76

Advanced Auditing & Professional Ethics

Share Capital Account. However, in the following situations, the share application money would be disclosed separately under the head "Current Liabilities" in the Balance Sheet: •

invalid or revoked applications;

•

excess application money received due to over subscription; and

•

when minimum subscription stated in the offer document is not received.

36. The auditor has to verify whether application money stated is fully backed by the share application forms/certificate from the Share Transfer Agent and applications are received pursuant to a resolution of the appropriate authority for issue of capital. Amount received without satisfying any of the above conditions should be refunded by the company. 37. Share application money accepted by the company, if not backed by the application form/Registrar's certificate alongwith the resolution of the Board as stated above, should be treated as unsecured loan. The auditor should verify that the application money received in excess of capital offered for subscription, if any, has been stated under Current Liabilities. The auditor may examine the reasonableness of the period for which the share application money remains pending allotment. 38. In case of refund of excess application money/revoked applications, the auditor should verify the same and apply the similar audit procedures as applied for audit of any other liability. The auditor should also verify whether the company has complied with the Guidelines prescribed by SEBI with regard to time schedule and payment of interest in case of delay in such refunds. Calls Received in Advance 39. The auditor should examine whether the calls received in advance and payment of interest, if any, thereon is in accordance with the provisions contained in the Articles of Association in this regard. Schedule of calls received in advance is to be reviewed with reference to the amounts deposited in the bank. 40. Interest, if any, paid on the amount received in advance of calls should be verified and the audit procedure to be employed is same as in case of payment of interest on borrowings. General 41. The auditor should examine whether proper accounts have been maintained with regard to amounts received on application, allotment and calls and the payments by way of refunds/interest and all other relevant accounts are duly reconciled. Where shares are issued at a premium, the auditor should ensure that such sums are accounted for separately. In case of buy back, reissue or redemption of preference shares and reduction of capital by payment of money, the auditor should examine whether these have been properly accounted and duly reconciled with payments made for the same. 42. Proviso to Section 383A of the Companies Act, 1956 requires certain companies to obtain a certificate of compliance with the provisions of the Companies Act, 1956 from a practicing company secretary. The auditor of such companies may review the same.

Part II : Guidance Notes

II.77

Reserves 43. Reserves should be distinguished from provisions. For this purpose, reference may be made to the definitions of the expressions, "provision" and "reserve", etc., in the Guidance Note on Terms Used in Financial Statements issued by the Institute. The definition of the term "reserve" as given in the said Guidance Note is explained in paragraph 3. It is important to remember that any amount provided in excess of the requirements is in the nature of reserve and should be shown as such. 44. It is also necessary to make a distinction between capital reserves and revenue reserves in the accounts. A Revenue Reserve is ordinarily available for distribution as dividend. 45. Reserves may also contain amount received from the Government. These grants may be in the nature of promoters' contribution or related to any specific fixed asset. The auditor should verify that the principles of Accounting Standard 12, Accounting for Government Grants for recognition, presentation, refund, if required, and disclosure of the grant have been appropriately complied with. 46. A reserve account is styled as Reserve Fund only when such reserves are represented by specifically earmarked assets or investments. 47. In case of amalgamations and mergers, reserves of the amalgamated /merged company have to be treated as prescribed in Accounting Standard 14, Accounting for Amalgamations issued by the Institute. However, the auditor, especially in cases of amalgamations/ mergers, may come across a situation where the relevant Court/ Tribunal has made an order sanctioning an accounting treatment different from that prescribed by an Accounting Standard. In such a situation, the attention of the members is drawn to the announcement of the Council of the Institute in this respect. The Council has recommended that the following disclosures be made in the financial statements for the year in which different treatment has been given: (i)

A description of the accounting treatment made alongwith the reason that the same has been adopted because of the Court/ Tribunal order.

(ii)

Description of the difference between the accounting treatment prescribed in the Accounting Standard and that followed by the Company.

(iii) The final impact, if any, arising due to such a difference. Capital Reserves Capital Redemption Reserve 48. In terms of the provisions of Sections 77 A and 80 of the Companies Act, 1956, if the company redeems the preferential share capital or buys back its own shares, using the retained earnings, the amount equivalent to the nominal value of the shares redeemed/bought back have to be transferred to the capital redemption reserve, and such reserve can be utilised only for issue of bonus shares to the members of the company.

II.78

Advanced Auditing & Professional Ethics

Securities Premium Account 49. Any premium realised on issue of securities should be transferred to Securities Premium Account and utilised only for the purposes laid down in Section 78 of the Companies Act, 1956. Government Grants 50. Grants, contributions and subsidies received from Government specifically for acquisition of assets have to be treated and disclosed in the financial statements as laid down in Accounting Standard 12, issued by the Institute. Revaluation Reserve 51. Reserves arising out of revaluation of fixed assets are to be transferred to the Revaluation Reserve account. The treatment and utilisation of these reserves is governed by the "Guidance Note on Treatment of Reserve Created on Revaluation of Fixed Assets" and "Guidance Note on Availability of Revaluation Reserve for Issue of Bonus Shares" issued by the Institute. Statutory Reserves 52. Section 17 of the Banking Regulation Act, 1949 and certain provisions in the Cooperative Societies Act, 1912 provide for creation and utilisation of certain specific reserves. Laws governing other entities may contain similar provisions as to the creation and utilisation of such reserves. The regulators may also direct the entities to create some specific reserves, for example, the Reserve Bank of India has directed all banking companies to create and transfer certain amount of profits earned on trading of investments to Investment Fluctuation Reserve and has also stipulated the purpose for which such reserve can be utilised. The auditor should familiarise himself with such regulatory directions with respect to creation and utilization of such specific reserve and verify compliance therewith. Revenue Reserves 53. A revenue reserve is a reserve, which is available for distribution as dividend. The auditor should examine the legal provisions governing the entity with regard to transfer of certain percentage of profits to reserves, for example, the requirements of Section 205 (2A) of the Companies Act, 1956, the Reserve Bank of India Directions in case of Non Banking Financial Companies, etc. 54. Certain other statutes may require transfer of profits to reserves. For example, the Income tax Act, 1961 may require creation of certain reserves and provide for rules for utilisation of such reserves to claim certain fiscal benefits. The auditor should examine the need for transfer of profits to reserves and utilisation of such transfers. Examination of Compliance with Laws and Regulations 55. Auditing and Assurance Standard (AAS) 21, Consideration of Laws and Regulations in an Audit of Financial Statements requires that "when planning and performing audit procedures and in evaluating and reporting the results thereof, the auditor should recognise that non compliance by the entity with laws and regulations may materially affect the financial

Part II : Guidance Notes

II.79

statements." The auditor should therefore acquire sufficient knowledge of the legal and regulatory framework within which the client operates. This assumes added importance in cases of audit of capital and reserves of companies since the matters relating to the share capital and reserves are governed by the provisions of the Companies Act, 1956, especially the provisions contained in Sections 69 to 116, Section 177C, Section 205(2A) of the said Act. For example, Sections 69 to 116 of the Companies Act, 1956 regulate the matters relating to issue and allotment of shares, Section 205 (2A) and Section 177C of the Companies Act, 1956 contain provisions relating to creation and utilisation of certain reserves and Section 187C deals with the situation where the beneficial owner of the shares of the company is different from the person whose name is appearing in the shareholders' register of the company. Guidelines issued by the Securities and Exchange Board of India from, time to time also contain the matters relating to the issue and allotment of shares in case of public offer and substantial acquisition of shares in case of existing listed companies. Moreover, the Articles of Association of the entity may also have provisions relating to share capital and reserves. The Companies Act, 1956 requires compliance with the Articles of Association in so far as they are not contradictory to the provisions of the Act. Hence, it is very important to verify the compliance with the laws and regulations governing the entity. 56. The State Co-operative Societies Acts may have conditions as to minimum paid up capital and also minimum number of members for cooperative societies and with regard to creation and utilisation of various reserves. Statutes governing the entity may contain similar provisions with regard to the number of members and minimum amount of capital. The auditor should be familiar with the laws governing the entity. The auditor has to carefully examine the compliance of such legal requirements. 57. The auditor has to examine the compliance with the various rules and regulations, for example: (a) Government Order, if any, the Memorandum and the Articles of Association of the company or the Rules and Regulations governing the entity. (b) Terms of issue attached or subsequently approved in case of conversion of loans or convertible preference shares. (c) Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 and Guidelines on Euro Issues. (d) Rules and Regulations relating to issue and buy back of ADR/GDR. (e) Chapter XIII of SEBI (Disclosure and Investor Protection) Guidelines 2000 in case of preferential issue. (f)

Unlisted Public Companies (Preferential Allotment) Rules, 2003.

(g) Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003. (h) Any other Rules and Regulations prescribed by Government/ SEBI from time to time.

II.80

Advanced Auditing & Professional Ethics

Examination of Presentation and Disclosure 58. The laws governing the entity may prescribe the format for disclosure of information relating to the Capital and Reserves in its Balance Sheet. For example, the Companies Act, 1956, the Banking Regulation Act, 1949, the Electricity Act, 2003 and Insurance laws prescribe the format of Balance Sheet and the manner of disclosure of the capital and reserves in the financial statements. The auditor should examine compliance with such disclosure requirements and adequacy thereof. Where the relevant statute lays down any disclosure requirements in this behalf, the auditor should examine whether the same are complied with, for example, SEBI requires that in case of public issue and preferential issue of shares and/or partly/fully convertible debentures, purpose for which these monies are utilised and the manner in which the unutilised money is invested should be disclosed. Sometimes, it may be necessary to disclose the information either in the Significant Accounting Policies and Notes on Accounts to clarify the matters, for example, any employee options outstanding, etc. The auditor should examine such necessity and consider whether appropriate disclosures such as those listed below have been made: •

Aggregate number and class of shares allotted as fully paid up pursuant to contract(s) with or without payment being received in cash

•

Aggregate number and class of shares allotted as fully paid by way of bonus shares

•

Aggregate number and class of shares bought back

•

Source of issuance of bonus shares during the year, if any

•

Preference Share Capital, including terms of redemption or conversion

•

Shares with differential rights.

Special Considerations Applicable To Partnership Entities 59. The most significant document underlying the partnership form of organisation is the Partnership Deed. 60. The Partnership Deed generally provides the capital required to be contributed by the partners and their respective share in profits and losses and interest, if any, on the capital contributed or balances to their credit. The Partnership Deed may also provide for the treatment of excess capital contributed by any partner and their respective rights relating to the withdrawals from capital/drawing accounts. 61. It may be possible that one or more partners contributes the capital in kind rather than in cash. For example, the premises required for the business may be provided by a partner as his capital contribution. If such contributions are in kind at the time of admission of the partners, the value of such assets is generally mentioned in the Partnership Deed. If the value is not mentioned in the Partnership Deed, the auditor may request for a declaration of the value in writing by all the partners. He should also obtain necessary audit evidence for supporting the valuation. 62. The partnership deed may also provide for fixed capital contribution and timing of contribution by each partner. The auditor should examine whether the capital contributed by

Part II : Guidance Notes

II.81

each of the partners is in accordance with the Partnership Deed and the capital is maintained at the level mentioned in the Partnership Deed throughout the period of audit. 63. If the Partnership Deed places any restrictions on the drawings of the partners, the auditor should examine whether the drawings have been within the permissible limit. 64. The auditor has to verify the, correctness of the interest, if any, credited or debited to the partners' capital or drawings account. 65. Generally, remuneration, interest on capital; interest on drawings, profits or losses are adjusted in the capital accounts or the drawing accounts of the partners, and Reserve accounts are not maintained in case of partnership accounts. However, if fiscal or any other law require any reserve has to be created for claiming any benefit, a reserve with appropriate title may be created out of the profits of the firm. The rules for utilisation of the reserve may be provided in the relevant laws. In such event, the auditor should examine the compliance with the same. Sometimes, the partners may decide to create and utilise certain reserves due the exigencies of the business, in which case the auditor has to verify the compliance of the decision of the partners. In case the entity has not complied with the prescribed reserve utilization requirements, he should consider the effect of the same on his audit report in terms of the principles laid down in the AAS 21, Consideration of Laws and Regulations in an Audit of Financial Statements. 66. Special Reserves, created to meet the requirements of any law, may be credited to the Partners' Capital Accounts on fulfilment of such statutory requirements or the terms of creation of such reserves. 67. Government grants and subsidies received shall have to be accounted for in accordance with Accounting Standard 12. 68. Where either investments or drawings have come from Non Resident Indians or foreign sources involving foreign currency, the auditor has to verify the compliance of RBI regulations as well as the provisions of the Foreign Exchange Management Act, 1999 in this regard. 69. All transactions in the partners' capital account and drawings account have to be vouched for their correctness. 70. The auditor has to verify that the distribution of profit/loss is as per the terms of Partnership Deed. It may be noted that if any minor is admitted to the benefits of partnership, no loss should be apportioned to the share of minor. 71. If a partner dies/retires during the year, the partnership entity may prepare accounts up to the date of such death/retirement to ascertain the claim of heirs/retiring partner. In such event, the auditor has to verify the apportionment of the profit/loss for both the periods. Special Considerations Applicable To A Sole Proprietary Entity 72. The audit of capital account of the sole proprietor poses considerable problems, as the capital account is generally maintained as a current account. Generally, the entries in the capital account are many, when compared with other forms of entities. The capital introduced by the proprietor in the entity may be in cash or in kind. The introduction of capital can take

II.82

Advanced Auditing & Professional Ethics

place at number of times, depending upon the need for the working capital in the entity. Similarly, the drawings are made for various personal expenses. 73. It may also be possible that the personal expenses of the proprietor are booked in the accounts of the business without appropriately reflecting them in those accounts. 74. Generally, internal control procedures are inadequate or absent in many sole proprietary entities. Hence, the auditor should be careful while examining the accounts of such entity. Though the auditor needs to obtain the same level of assurance in order to express an unqualified opinion on the financial statements of both small and large entities, however, many internal controls which would be relevant to large entities are not practical in the small business. For example, in small businesses, accounting procedures may be performed by a few persons who may have both operating and custodial responsibilities, and therefore segregation of duties may be missing or severely limited. Inadequate segregation of duties may, in some cases, be offset by a strong management control system in which owner/manager supervisory controls exist because of direct personal knowledge of the entity and involvement in transactions. In circumstances where segregation of duties is limited and audit evidence of supervisory controls is lacking, the audit evidence necessary to support the auditor's opinion on the financial statements may have to be obtained entirely through the performance of substantive procedures. He should apply his professional judgment based on the knowledge of the business he has acquired to determine whether the expenditure recorded is in fact relevant and appropriate to the business and also all expenditures are recorded in the books of account. 75. The auditor should examine the nature of assets included in the balance sheet of the entity and verify whether such assets are relevant and appropriate to the nature of the business and recorded at fair value. 76. Generally profits or losses are adjusted in the capital account or the drawings account of the proprietor, and reserve accounts are not maintained in case of sole proprietorship accounts. However, if fiscal laws require any reserve to be created for claiming any fiscal benefit, a reserve account with appropriate title may be created out of the profits of the firm. The rules for utilisation of the reserve account may be provided in the same fiscal laws. In such event the auditor should examine the compliance with such laws. 77. Special Reserves created, if any, pursuant to fiscal laws, upon fulfilment of the terms of such reserves, have to be transferred to the capital account of the sole proprietor. 78. Government grants and subsidies received shall have to be accounted for in accordance with Accounting Standard 12. Management Representations 79. The auditor should obtain from the management of the entity, a written representation on significant aspects of capital and reserves accounts, viz., that all the transactions in the capital and reserves have been recorded and recorded at correct values; that there are no unrecorded transactions in the capital and reserves accounts, that the year end balances (including any notes to the accounts in respect thereof) of the capital and reserves accounts have been appropriately presented and disclosed in accordance with applicable financial

Part II : Guidance Notes

II.83

reporting framework, in the financial statements, that the management has complied with all the applicable rules and regulations while undertaking transactions relating to capital and reserves. Documentation 80. The auditor should maintain adequate working papers documenting significant aspects of audit such as: (a) the nature, timing, extent and results of the audit procedures performed to comply with AASs and applicable legal and regulatory requirements; (b) the audit evidence obtained; (c) the conclusions reached on significant matters; and (d) in relation to audit procedures designed to address identified risks of material misstatement, conclusions that are not otherwise readily determinable from the procedures performed or audit evidence obtained. However, it may be noted that the extent of documentation is a matter of professional judgment since it is neither necessary nor practical that every observation, consideration or conclusion is documented by the auditor in his working papers. Appendix A Extracts from Counsel's Opinion Referred to in Para 22 - "Subscription in Cash and Kind" "The ratio of Spargo's case is that if there is on the one side a bona-fide debt payable in money at once by the company (hereinafter called "debt"), and on the other side a bona-fide liability to pay money on allotment of shares, so that if bank notes are handed from one side of the table to other in payment of calls, they may legitimately be handed back in payment of the debt. The law does not make it necessary that the formality should be gone through of the money being handed over be taken back again, and if the two demands are set off against each other the shares have been paid for in cash. This is still good law and on facts similar to those of Spargo's case it would be right for a company to show in its accounts the shares as having been allotted for cash. It is the necessary implication of Section 227(1A)(f) that shares may be correctly stated to have been allotted for cash even though cash may not have been actually received in respect of such allotment........... If the Auditors find that the case is covered by the ratio of the decision in Spargo's case, no comment would be required from the Auditors and the statement in the Balance Sheet and other accounts that the shares were allotted for cash must be accepted as correct, regular and not misleading, although no cash had been actually received by the company........... The function of Section 75(1) is merely to impose an obligation on the company to file a Return of the Allotments with the Registrar. Now, the expression "share allotted for cash" is an

II.84

Advanced Auditing & Professional Ethics

ambiguous expression. It may mean shares allotted for cash actually received by the Company, or it may mean shares allotted for cash not actually received but adjusted against a debt. In order that this ambiguity may be removed and the Registrar may know the precise factual position, Section 75 (1)(a) requires that in the Return of Allotments to be filed with the Registrar shares should not be shown as having been allotted for cash if cash has not been actually received. This, however, does not prevent the company from stating in the Return that shares not shown in the Return as having been allotted for cash were in fact allowed against adjustment of a debt, and consequently such shares would be shown in the company's accounts as having been allotted for cash." 12. GUIDANCE NOTE ON AUDIT OF PAYMENT OF DIVIDEND The following is the text of the Guidance Note on Audit of Payment of Dividend issued by the Auditing and Assurance Standards Board of the Council of the Institute of Chartered Accountants of India. This Guidance Note should be read in conjunction with the Auditing and Assurance Standards issued by the Institute. 1. Paragraph 2.1 of the "Preface to the Statements on Standard Auditing Practices" issued by the Institute of Chartered Accountants of India states that the "main function of the Auditing Practices Committee (APC) is to review the existing auditing practices in India and to develop Statements on Standard Auditing Practices (SAPs) so that these may be issued by the Council of the Institute". Paragraph 2.4 of the Preface states that the "APC will issue Guidance Notes on the issues arising from the SAPs wherever necessary"31. 2. The Auditing and Assurance Standards Board has also taken up the task of reviewing the Statements on auditing matters issued prior to the formation of the Board. It is intended to issue, in due course of time, AASs or Guidance Notes, as appropriate, on the matters covered by such Statements which would then stand withdrawn. Accordingly, with the issuance of this

With the formation of Auditing and Assurance Standards Board {earlier known as Auditing Practices Committee {APC)}, the Council of the Institute has been issuing a series of Auditing and Assurance Standards (AASs){earlier known as Statements on Standard Auditing Practices (SAPs)), Auditing and Assurance Standard lay down the principles governing an audit. These principles apply whenever an independent audit is carried out. Auditing and Assurance Standards become mandatory on the date specified in the respective AAS. Their mandatory status implies that, while discharging their attest function, it will be the duty of the members of the Institute to ensure that the AASs are followed in the audit of financial information covered by their audit reports. If, for any reason, a member has not been able to perform an audit in accordance with the AASs, his report should draw attention to the material departures therefrom.

31

The Auditing and Assurance Standards Board has also been issuing from time to time, guidance notes on issues arising from AASs. The Guidance Notes provide guidance on procedures to be employed by an auditor in order to comply with the principles laid down in AASs. It is recognised that in determining the nature, timing and extent of audit procedures to be employed in a specific situation, an auditor will have to exercise his professional judgement. The Guidance Notes, therefore, are recommendatory. A member should ordinarily follow the recommendations in a guidance note relating to an auditing matter except where he is satisfied that, in the circumstances of the case, it may not be necessary to do so.

Part II : Guidance Notes

II.85

Guidance Note On Audit of Payment of Dividend, paragraphs 8.19 to 8.24 of the "Capital and Reserve" Section of "Statement on Auditing Practices" shall stand withdrawn32. Introduction 3. Guidance Note on Terms Used in the Financial Statements, issued by the Institute, defines dividend as "A distribution to shareholders out of profits or reserves available for this purpose". 4. Dividend means a return on shares held in an entity and payable out of distributable surplus. The dividend, which is paid on winding up, is in fact distribution of the entity's assets and not of profits, even if those assets include some profit earned on winding up of the entity. However, the proviso to Section 205(3) of the Companies Act, 1956 permits a company to capitalise its profits by issuing fully paid bonus shares or paying up any amount being unpaid on shares held by its members. Further, under Section 205(3) of the Companies Act, 1956, no dividend is payable otherwise than in cash. 5. Dividend includes any interim dividend. It may also be noted that in case of a company, provisions of Sections 205, 205A, 205C, 206, 206A and 207 of the Companies Act, 1956 apply to interim dividend as well. 6. In any "auditing situation, the auditor employs appropriate procedures to obtain reasonable assurance about various assertions as laid down in paragraph 6 of the Auditing and Assurance Standard 5, "Audit Evidence". In carrying out the audit of payment of dividend, the auditor's primary objective is to obtain sufficient appropriate audit evidence to satisfy himself that dividend has been declared and paid in accordance with the applicable provisions, if any, of the relevant laws and regulations applicable to the entity and that all the transactions relating to declaration and payment of dividend have been properly accounted for and disclosed. The auditor's scope of examination would, therefore, include: (a) verifying whether dividend has been declared out of distributable surplus after proper authorisation, as required under law; (b) evaluating the internal control system regarding procedure of preparation and issuance of dividend warrants /instructions for direct transfer of funds to the shareholders' accounts and also check the timeliness of dispatch of warrants and deposition of the dividend amount in the separate bank account, if any, maintained for this purpose; (c) examining compliance with the requirements of the relevant laws and regulations relating to payment of dividend, for example, mandatory transfer to a reserve fund or transfer to other funds, such as Unclaimed Dividend Account, Investor Education and Protection Fund, etc., as applicable to the entity; and

32

With the withdrawal of section 8 ''Capital and Reserves" of the Statement on Auditing practices pursuant to the issuance of Guidance Note on Audit of Capital and Reserves and the Guidance Note on Audit of Payment of Dividend, the entire Statement on Auditing Practices, issued by the Institute stands withdrawn.

II.86

Advanced Auditing & Professional Ethics (d) examining the system for recording and appropriate disclosure of transactions during the year relating to payment of dividend.

Internal Control Evaluation 7. The auditor should ascertain whether the governing charter, e.g., Articles of Association in case of a company, or any similar document of the entity, permits payment of dividend to the members by the entity. For example, a company formed under Section 25 of the Companies Act, 1956 is prohibited under the said Section itself from paying any dividend to its members. 8. The auditor should study and evaluate the system of internal control relating to payment of dividend to determine the nature, timing and extent of his other audit procedures. He should particularly review the following aspects relating to payment of dividend: (a) whether all transactions in the dividend account have been authorised by the competent authority; (b) whether the registers containing the details of members and dividend have been properly maintained by the entity; (c) whether there is an effective system of segregation of duties in place. Special attention should be given to the segregation of the duties towards maintenance of shareholders' register, preparation of dividend warrants and maintenance of warrant dispatch register; (d) the internal control procedures with regard to preparation of dividend warrants and posting them to the members, or the instructions given for electronic transfer of funds or any other mode of payment of dividend to the members, and records maintained to record the details of unclaimed dividend. Separate records of unclaimed dividend should be maintained for each year's dividend/interim dividend; (e) the procedures for payment of unclaimed dividend and should satisfy himself that they are not paid without adequate safeguards being taken as to identification of the payee, checking of the payee's claim, etc. In case, the above activities are outsourced, the auditor should evaluate the activities of the service organisation and if finds them significant, he should obtain sufficient information to understand the accounting and internal control systems of the service organisation and assess control risk at either the maximum or a lower level, as appropriate, if tests of control are performed. For detailed guidance in this respect, reference may be made to Auditing and Assurance Standard 24,' "Audit Considerations Relating to Entities Using Service Organisations". Verification 9. Verification of payment of dividend may be carried out by performing the following procedures: (a) examination of compliance with laws and regulations and such other relevant information having a bearing on payment of dividend; and

Part II : Guidance Notes

II.87

(b) examination of the system of maintenance of records. 10. The auditor should verify the compliance with laws and regulations, provisions contained in the governing charter, e.g., Articles of Association in case of companies, bye-laws or rules and directions/instructions issued by any regulatory authority applicable to the entity and/or the terms of the banks/financial institutions which may lay down certain restrictions or conditions on declaration of dividend. For example: (a) In case of companies, the following conditions have to be complied with before declaration of dividend: *

It has provided for depreciation for any previous financial year(s) which fall(s) after the commencement of the Companies (Amendment) Act, 1960 [Section 205(1)] and further that such

*

depreciation has been computed in accordance with the requirements of Section 350 and other provisions of Section 205(2) of the Companies Act, 1956.

*

It has provided for any losses incurred in any previous financial year(s) which fall(s) after the commencement of the Companies (Amendment) Act, 1960 [Section 205(1)].

*

Where the company has declared dividend for any financial year out of the profits for that year, it has also transferred to a reserve such percentage (or a higher percentage) of profits as may be prescribed in the Companies (Transfer of Profits to Reserves) Rules, 1975 [Section 205(2A)].

*

It has complied with the requirements of Section 80A, dealing with redemption of irredeemable preference shares etc., of the Companies Act, 1956.

(b) Under the Banking Regulation Act, 1949, dividend cannot be paid without first writing off intangible assets and transferring certain percentage of profits to statutory reserves unless permitted by the Central Government to do so. Section 17 of the Banking Regulation Act, 1949 requires that a banking company incorporated in India must transfer twenty per cent of its annual profits to a reserve fund before any dividend is distributed unless a specific exemption has been obtained from the Central Government. (c) State Co-operative laws lay down that certain percentage of profits have to be transferred to various reserves and a minimum percentage of profit has to be paid as dividend. 11. The auditor has to verify that the dividend is declared only out of distributable surplus. For example, in case of a company, under Section 205 of the Companies Act, 1956, dividends can be distributed out of profits for the year in which dividend is declared, accumulated profits of any preceding year or under any guarantee given by Central or any State Government. 12. The auditor should verify that a specific resolution for payment of dividend has been duly passed at the meeting of the Board or any similar authority. In case of interim dividend, the dividend declared by the Board of Directors or similar authority is final. In case of final

II.88

Advanced Auditing & Professional Ethics

dividend, the auditor should also verify that the recommendations of the Board have been approved by the members at the annual general meeting. It may, however, be noted that in case of companies, the members can reduce the amount of dividend or decide for nonpayment of dividend but they can not increase the dividend recommended by the Board. 13. If the entity has non-voting shares and/or shares with variable rights and/or preference shares with various options like, cumulative, participatory, etc., the resolution declaring the dividend should also specify different rates of dividend on the shares having variable rights or preferential rights as to dividend. In such cases, the auditor has to verify that the dividend paid is in accordance with the terms of the resolution and also the resolution is in accordance with the terms attached to these shares. 14. Other laws and regulations, relating to payment of dividend, governing the entity may impose similar or other restrictions. The auditor has to be familiar with the laws and regulations governing the entity and verify whether these laws and regulations have been complied with. For example, the auditor has to examine the compliance with provisions of the Foreign Exchange Management Act, 1999 for the payment of dividend in foreign currency pursuant to issue of shares to non- residents and issue of ADR/GDR. Appendix to this Guidance Note contains relevant extracts of the provisions of various statutes having a bearing on the declaration and payment of dividend. 15. In case of a listed company, the auditor should also verify whether the provisions of the Listing Agreement as to declaration of dividend, e.g., prior intimation to the Stock Exchange about the Board meeting at which declaration/recommendation of dividend is to be considered intimation to Stock Exchanges of all dividends and/or cash bonuses recommended or declared or the decision to pass any dividend or interest payment at the Board meeting, have been complied with or not. 16. The nature, timing and extent of substantive procedures to be performed by the auditor is, however, a matter of professional judgment of the auditor which is based, inter alia, on the auditor's evaluation of the effectiveness of the related internal controls. 17. The auditor should examine that the mandatory transfer of the amount specified to a separate fund, where so required by the relevant laws and regulations, have been made before payment of dividend. 18. The auditor has to verify that the dividend is paid in accordance with the terms prescribed in resolution by the Board/members. 19. The auditor should verify that the dividend warrants have been dispatched to the members within the time limit prescribed. 20. If an interim dividend is declared, the auditor has to verify whether the same is approved in a general meeting of the members and the provisions contained in the Articles of Association or bye-laws or other statutes governing the body corporate permit it to pay interim dividend. In case of statutory corporations and nationalised banks, the Board may be empowered to declare and pay the dividend and resolution by the members may not be necessary. In case of companies, the auditor should verify that the financial statements have been prepared and presented before the Board and the Board while considering the interim

Part II : Guidance Notes

II.89

dividend, has taken into account the depreciation to be provided for the full year, profit to be transferred to reserves under Companies (Transfer of Profits to Reserves) Rules, 1975 and the dividend payable to preference shareholders. 21. If the laws and regulations applicable to the entity require it to deposit the amount of dividend, interim and/or final, in a separate bank account, the auditor has to verify whether such transfer of funds to the separate account has been made within the prescribed time limit. The auditor should also verify the compliance of law with regard to unclaimed dividend. For example, in case of companies, the dividend declared has to be deposited within prescribed period in a separate bank account and if dividend is not claimed within such number of days, of such transfer, as may be specified by the Companies Act, 1956 or rules made thereunder and the amount remaining in the separate bank account has to be transferred to unpaid dividend account separately opened with any scheduled bank and the amount remaining in that account after the expiry of such period of opening such unpaid dividend account, as may be prescribed together with interest accrued thereon, if any, has to be transferred to Investor Education and Protection Fund Account established under the Companies Act, 1956. It may be noted, that within specified number of months prior to the transfer of unclaimed dividend to Investor Education & Protection Fund, the company has to give notice to individuals who have not claimed such dividend. If the auditor finds that the amounts required to be transferred as above have a material effect on the financial statements, and have not been properly reflected in the financial statements, the auditor should assess the impact of such non-compliance on his audit report. 22. The auditor should verify that adjustment, if any, made in the dividend payable, towards calls in arrears or any other sums due from members is in accordance with the terms of issue, laws and regulations applicable to the entity. 23. The auditor may verify the total amount of dividend transferred to a separate bank account is in agreement with the statement prepared by the entity reconciling the total dividend payable on shares in physical form, dematerialised form, and dividend withheld in respect of shares pending for registration of transfer and adjustments, if any, made for the calls in arrears and other dues from the members. 24. The listed companies are required to electronically transfer dividend to bank accounts of the shareholders, wherever Electronic Clearing Services (ECS) facility is available and the members/depositories furnish details of the respective bank accounts of the members and in respect of others, distribute the dividend through dividend warrants. In such cases, in addition to test checks for individual payments, the auditor should examine the overall reconciliation of the total payment made through electronic transfer and payment made through dividend warrants. 25. The auditor should verify that the dividend is paid: (a) (i)

in respect of shares held in electronic form, to those persons whose details as on record date/book closure date are furnished by the depositories; and/or

II.90

Advanced Auditing & Professional Ethics (ii)

in respect of shares held in physical form, to the members whose names are appearing on the record date/ immediately after effecting the transfers submitted till the date of book closure; and

(b) in respect of share warrants to the holders of share warrants. 26. The auditor should apply the analytical procedures before forming any overall conclusion so as to find out any material fluctuations and deviations from the relevant information that he has gained during the course of audit. Such analytical procedures may be regarding the changes in the shareholding pattern, dividend payout ratio, ratio of gross dividend payable to the paid up share capital or ratio of net dividend payable with the gross dividend payable by the entity. In case of listed companies, the auditor may also review the minutes of the meetings of the Investors' Grievances Committee, wherever such Committee exists, to have an overview of the nature and number of complaints related to dividend as the same would provide the auditor an additional evidence as to the efficacy of the internal control system in relation to payment of dividend. 27. The auditor should verify that the total amount remaining in the unclaimed dividend account, for example, because of dispute about ownership on account of court cases etc., or the amount not claimed by shareholders, tallies with the schedule of unclaimed dividend for each year for which dividend remains unclaimed. 28. The auditor has to verify that in case the entity proposes to pay dividend out of its accumulated reserves, whether the same has been paid after complying with the statutory requirements, if any. For example, a company can pay dividend out of its accumulated reserves only after complying with the provisions of sub-Section (3) of Section 205A of the Companies Act, 1956 and the Companies (Declaration of Dividend out of Profits) Rules, 1975. These Rules provide for the maximum amount that can be paid as dividend. In cases where the company declares dividend that is not in accordance with these Rules, the auditor must verify that the company has obtained prior approval from the Central Government for the same. Similar provisions, if any, in the laws applicable to other entities have to be complied with. 30. The auditor should also verify that: (a) If capital profits are distributed as dividend: (i)

the Articles or the bye-laws or other rules and regulations applicable to the entity, permit such distribution;

(ii)

it has been realised in cash; and

(iii) the Board or similar authority is satisfied that net aggregate value of the assets remaining after distribution of that profit will not be less than the book values so that share capital and reserves remaining after the distribution will be fully represented by the remaining assets. (b) Capital surplus arising on the revaluation of fixed assets is not directly or indirectly available for distribution as dividend.

Part II : Guidance Notes

II.91

(c) Any reserve in the nature of capital reserve arising on acquisition of a business as a going concern or on amalgamation in the nature of purchase and securities premium collected on the issue of securities can not be utilised for declaration of dividend. Disclosure 30. Proposed dividend should be shown as appropriation of profit in the Profit and Loss Account and as provision under" Provisions" in the Balance Sheet. 31. Unclaimed dividend should be shown in Balance Sheet under the head "Current Liabilities". 32. In respect of companies, all arrears of cumulative preference dividend should be shown as a contingent liability. Management Representation 33. The auditor should obtain representation from the management of the entity about the amount retained in unclaimed dividend account by reason of disputes pending in various courts of law and also that it has complied with all laws and regulations applicable to the provisioning and payment of dividend including transfer to Unclaimed Dividend Fund or any other fund such as Investors Education and Protection Fund, where so required, and that the dividend has been paid to the persons entitled to it. Documentation 34. The auditor's working papers should contain the plan devised for verification of payment of dividend. Among other papers, he should maintain in his audit file, the management representations and any other relevant document, such as copy of the Board resolution authorising payment of dividend, etc. He should ensure that all significant matters that require the exercise of his professional judgment, together with the auditor's conclusion thereon have been properly included in his working papers. Appendix Provisions of Certain Acts and Rules With Regard to Declaration and Payment of Dividend33 Companies Act, 1956 205. Dividend to be Paid only out of Profits - (1) No dividend shall be declared or paid by a company for any financial year except out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-Section (2) or out of 33 The Acts and Rules specified in this Appendix are only illustrative in nature and are not meant to be exhaustive for the purposes of the laws dealing with the payment of dividend by different entities.

II.92

Advanced Auditing & Professional Ethics

the profits of the company for any previous financial year or years arrived at after providing for depreciation in accordance with those provisions and remaining undistributed or out of both or out of moneys provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government: Provided that – (a) if the company has not provided for depreciation for any previous financial year or years which falls or fall after the commencement of the Companies (Amendment) Act, 1960 (65 of 1960) it shall, before declaring or paying dividend for any financial year provide for such depreciation out of the profits of that financial year or out of the profits of any other previous financial year or years; (b) if the company has incurred any loss in any previous financial year or years, which falls or fall after the commencement of the Companies (Amendment) Act, 1960 (65 of 1960) then, the amount of the loss or an amount which is equal to the amount provided for depreciation for that year or those years whichever is less, shall be set off against the profits of the company for the year for which dividend is proposed to be declared or paid or against the profits of the company for any previous financial year or years, arrived at in both cases after providing for depreciation in accordance with the provisions of subSection (2) or against both; (c) the Central Government may, if it thinks necessary so to do in the public interest, allow any company to declare or pay dividend for any financial year out of the profits of the company for that year or any previous financial year or years without providing for depreciation: Provided further that it shall not be necessary for a company to provide for depreciation as aforesaid where dividend for any financial year is declared or paid out of the profits of any previous financial year or years which falls or fall before the commencement of' the Companies (Amendment) Act, 1960 (65 of 1960). (1A) The Board of directors may declare interim dividend and the amount of dividend including interim dividend shall be deposited in a separate bank account within five days from the date of declaration of such dividend. (1B) The amount of dividend including interim dividend so deposited under sub-Section (1A) shall be used for payment of interim dividend. (1C) The provisions contained in Sections 205, 205A, 205C, 206, 206A and 207 shall, as far as may be, also apply to any interim dividend. (2) For the purpose of sub-Section (1), depreciation shall be provided either (a) to the extent specified in Section 350; or (b) in respect of each item of depreciable asset, for such an amount as is arrived at by dividing ninety-five per cent of the original cost thereof to the company by the specified period in respect of such asset; or

Part II : Guidance Notes

II.93

(c) on any other basis approved by the Central Government which has the effect of writing off by way of depreciation ninety-five per cent of the original cost to the company of each such depreciable asset on the expiry of the specified period; or (d) as regards any other depreciable asset for which no rate of depreciation has been laid down by this Act or any rules made there under, on such basis as may be approved by the Central Government by any general order published in the Official Gazette or by any special order in any particular case: Provided that where depreciation is provided for in the manner laid down in clause (b) or clause (c), then, in the event of the depreciable asset being sold, discarded, demolished or destroyed the written down value thereof at the end of the financial year in which the asset is sold, discarded, demolished or destroyed, shall be written off in accordance with the proviso to Section 350. (2A) Notwithstanding anything contained in sub-Section (1), on and from the commencement of the Companies (Amendment) Act, 1974 (41 of 1974), no dividend shall be declared or paid by a company for any financial year out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of subSection (2), except after the transfer to the reserves of the company of such percentage of its profits for that year, not exceeding ten per cent, as may be prescribed: Provided that nothing in this sub-Section shall be deemed to prohibit the voluntary transfer by a company of a higher percentage of its profits to the reserves in accordance with such rules as may be made by the Central Government in this behalf. (2B) A company which fails to comply with the provisions of Section 80A shall not, so long as such failure continues, declare any dividend on its equity shares. (3) No dividend shall be payable except in cash: Provided that nothing in this sub-Section shall be deemed to prohibit the capitalization of profits or reserves of a company for the purpose of issuing fully paid-up bonus shares or paying up any amount, for the time being unpaid, on any shares held by the members of the company. (4) Nothing in this Section shall be deemed to affect in any manner the operation of the Section 208. (5) For the purposes of this Section (a) "specified period" in respect of any depreciable asset shall mean the number of years at the end of which at least ninety-five per cent of the original cost of that asset to the company will have been provided for by way of depreciation if depreciation were to be calculated in accordance with the provisions of Section 350; (b) any dividend payable in cash may be paid by cheque or warrant sent through the post directed to the registered address of the shareholder entitled to the payment of the dividend, or in the case of joint shareholders, to the registered address of that one of the joint shareholders which is first named on the register of members, or to

II.94

Advanced Auditing & Professional Ethics such person and to such address as the shareholder or the joint shareholders may in writing direct.

205A. Unpaid dividend to be transferred to special dividend account (1) Where, after the commencement of the Companies (Amendment) Act, 1974 (41 of 1974), a dividend has been declared by a company but has not been paid, or claimed, within thirty days from the date of the declaration, to any shareholder entitled to the payment of the dividend, the company shall, within seven days from the date of expiry of the said period of thirty days, transfer the total amount of dividend which remains unpaid or unclaimed within the said period of thirty days to a special account to be opened by the company in that behalf in any scheduled bank, to be called "Unpaid Dividend Account of ............. Company Limited/ Company (Private) Limited". Explanation: In this sub-Section, the expression "dividend which remains unpaid" means any dividend the warrant in respect thereof has not been encashed or which has otherwise not been paid or claimed. (2) Where the whole or any part of any dividend, declared by a company before the commencement of the Companies (Amendment) Act, 1974 (41 of 1974), remains unpaid at such commencement, the company shall within a period of six months from such commencement, transfer such unpaid amount to the account referred to in sub-Section (1). (3) Where, owing to inadequacy or absence of profits in any year, any company proposes to declare dividend out of the accumulated profits earned by the company in previous years and transferred by it to the reserves, such declaration of dividend shall not be made except in accordance with such rules as may be made by the Central Government in this behalf, and, where any such declaration is not in accordance with such rules, such declaration shall not be made except with the previous approval of the Central Government. (4) If the default is made in transferring the total amount referred to in sub-Section (1) or any part thereof to the unpaid dividend account of the concerned company, the company shall pay, from the date of such default, Interest on so much of the amount as has not been transferred to the said account, at the rate of twelve per cent per annum and the interest accruing on such amount shall ensure to the benefit of the members of the company, in proportion to the amount remaining unpaid to them. (5) Any money transferred to the unpaid dividend account of a company in pursuance of this Section which remains unpaid or unclaimed for a period of seven years from the date of such transfer shall be transferred by the company to the fund established under subSection (1) of Section 205C. (6) The company shall, when making any transfer under sub-Section (5) to the Fund established under Section 205C any unpaid or unclaimed dividend, furnish to such authority or committee as the Central Government may appoint in this behalf a statement in the prescribed form setting forth in respect of all sums included in such transfer, the nature of the sums, the names and last known addresses of the persons entitled to

Part II : Guidance Notes

II.95

receive the sum, the amount to which each person is entitled and the nature of his claim thereto, and such other particulars as may be prescribed. (7) The company shall be entitled to a receipt from the authority or committee under subSection (4) of Section 205C for any money transferred by it to the Fund and such a receipt shall be an effectual discharge of the company in respect thereof. (8) If a company fails to comply with any of the requirements of this Section, the company and every officer of the company who is in default, shall be punishable with fine which may extend to five thousand rupees for every day during which the failure continues. 205 B. Payment of unpaid or unclaimed dividend- Any person claiming to be entitled to any money transferred under sub-Section (5) of Section 205A to the general revenue account of the Central Government, may apply to the Central Government for an order for payment of the money claimed; and the Central Government may, if satisfied, whether on a certificate by the company or otherwise, that such person is entitled to the whole or any part of the money claimed, make an order for the payment to that person of the sum due to him after taking such security from him as it may think fit: Provided that nothing contained in this Section shall apply to any person claiming to be entitled to any money transferred to the fund referred to in Section 205C on and after the commencement of the Companies (Amendment) Act, 1999. 205C. Establishment of Investor Education and Protection Fund- (1) The Central Government shall establish a fund to be called the Investor Education and Protection Fund (hereafter in this Section referred to as the "Funds). (2) There shall be credited to the Fund the following amounts, namely: (a) amounts in the unpaid dividend accounts of companies; (b) the application moneys received by companies for allotment of any securities and due for refund; (c) matured deposits with companies; (d) matured debentures with companies; (e) the interest accrued on the amounts referred to in clauses (a) to (d); (f)

grants and donations given to the Fund by the Central Government, State Governments, companies or any other institutions for the purposes of the Fund; and

(g) the interest or other income received out of the investments made from the Fund: Provided that no such amounts referred to in clauses (a) to (d) shall form part of the Fund unless such amounts have remained unclaimed and unpaid for a period of seven years from the date they became due for payment. Explanation: For the removal of doubts, it is hereby declared that no claims shall lie against the Fund or the company in respect of individual amounts which were unclaimed and unpaid for a period of seven years from the dates that they first became due for payment and no payment shall be made in respect of any such claims.

II.96

Advanced Auditing & Professional Ethics

(3) The Fund shall be utilised for promotion of investor's awareness and protection of the interests of investors in accordance with such rules as may be prescribed. (4) The Central Government shall, by notification in the Official Gazette, specify an authority or committee, with such members as the Central Government may appoint, to administer the Fund, and maintain separate accounts and other relevant records in relation to the Fund in such form as may be prescribed in consultation with the Comptroller and Auditor General of India. (5) It shall be competent for the authority or committee appointed under sub-Section (4) to spend moneys out of the Fund for carrying out the objects for which the Fund has been established. 206. Dividend not to be paid except to registered shareholders or to their order or to their bankers- (1) No dividend shall be paid by a company in respect of any share therein, except (a) to the registered holder of such share or to his order or to his bankers; or (b) in case a share warrant has been issued in respect of the share in pursuance of Section 114, to the bearer of such warrant or to his bankers. ' (2) Nothing contained in sub-Section (1) shall be deemed to require the bankers of a registered shareholder to make a separate application to the company for the payment of the dividend. 206A. Right to dividend, right shares and bonus shares to be held in abeyance pending registration of transfer of shares- Where any instrument of transfer of shares has been delivered to any company for registration and the transfer of such/shares has not been registered by the company, it shall, notwithstanding anything contained in any other provisions of this Act, (a) transfer the dividend in relation to such shares to the special account referred to in Section 205A unless the company is authorised by the registered holder of such share in writing to pay such dividend to the transferee specified in such instrument of transfer; and (b) keep in abeyance in relation to such shares any offer of rights shares under clause (a) of sub-Section (1) of Section 81 and any issue of fully paid-up bonus shares in pursuance of sub-Section (3) of Section 205. 207. Penalty for failure to distribute dividends within thirty days – Where a dividend has been declared by a company but has not been paid, or the warrant in respect thereof has not been posted, within thirty days from the date of declaration, to any shareholder entitled to the payment of the dividend, every director of the company shall, if he is knowingly a party to the default, be punishable with simple imprisonment for a term which may extend to three years and shall also be liable to a fine of one thousand rupees for every day during which such default continues and the company shall be liable to pay simple interest at the rate of eighteen per cent per annum during the period for which such default continues:

Part II : Guidance Notes

II.97

Provided that no offence shall be deemed to have been committed within the meaning of the foregoing provisions in the following cases, namely: (a) where the dividend could not be paid by reason of the operation of any law; (b) where a shareholder has given directions to the company regarding the payment of the dividend and those directions cannot be complied with; (c) where there is a dispute regarding the right to receive the dividend; (d) where the dividend has been lawfully adjusted by the company against any sum due to it from the shareholder; or (e) where, for any other reason, the failure to pay the dividend or to post the warrant within the period aforesaid was not due to any default on the part of the company. Companies (Transfer of Profits to Reserves) Rules, 1975 [GSR 426 (E), Dated 24-7-1975] In exercise of the powers conferred by sub-Section (2A) of Section 205, read with clause (a) of subSection (1) of Section 642, of the Companies Act, 1956 (1 of 1956), the Central Government hereby makes the following rules, namely: Short title 1.

These rules may be called the Companies, (Transfer of Profits to Reserves), Rules, 1975.

Percentage of profits to be transferred to reserves 2.

No dividend shall be declared or paid by a company for any financial year out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-Section (2) of Section 205 of the Act, except after the transfer to the reserves of the company of a percentage of its profits for that year as specified below: (i)

where the dividend proposed exceeds 10 per cent but not 12.5 per cent of the paidup capital, the amount to be transferred to the reserves shall not be less than 2.5 per cent of the current profits;

(ii)

where the dividend proposed exceeds 12.5 per cent but does not exceed 15 per cent of the paid-up capital, the -amount to be transferred to the reserves shall not be less than 5 per cent of the current profits;

(iii) where the dividend proposed exceeds 15 per cent but does not exceed 20 per cent of the paid-up capital, the amount to be transferred to the reserves shall not be less than 7.5 per cent of the current profits; and (iv) where the dividend proposed exceeds 20 per cent of the paid-up capital, the amount to be transferred to reserves shall not be less than 10 per cent of the current profits.

II.98

Advanced Auditing & Professional Ethics

Conditions governing voluntary transfer of a higher percentage 3.

Nothing in rule 2 shall be deemed to prohibit the voluntary transfer by a company of a percentage higher than 10 per cent of its profits to its reserves for any financial year, so however, that: (i)

Where a dividend is declared, (a) a minimum distribution sufficient for the maintenance of dividends to shareholders at a rate equal to the average of the rates at which dividends declared by it over the three years immediately preceding the financial year, or (b) in a case where bonus shares have been issued in the financial year in which the dividend is declared or in the three years immediately preceding the financial year, a minimum distribution sufficient for the maintenance of dividends to share holders at an amount equal to the average amount (quantum) of dividend declared over the three years immediately preceding the financial year, is ensured:

Provided that in a case where the net profits after tax are lower by 20 per cent or more than the average net profits after tax of the two financial years immediately preceding, it shall not be necessary to ensure such minimum distribution, (ii)

where no dividend is declared, the amount proposed to be transferred to its reserves from the current profits shall be lower than the average amount of the dividends to the shareholders declared by it over the three years immediately preceding the financial year.

Penalty 4.

If a company fails to comply with any of the provisions contained in these rules, the company and every officer of the company in default, shall be punishable with fine which may extend to five hundred rupees, and, where the contravention is a continuing one, with a further fine which may extend to fifty rupees for every day, after the first, during which such contravention continues. Companies (Declaration of Dividend out of Reserves) Rules, 1975 [GSR No. 427 (E), Dated 24-7-1975]

In exercise of the powers conferred by sub-Section (3) of Section 205A, read with clause (a) of sub-Section (1) of Section 642, of the Companies Act, 1956 (1 to 1956), the Central Government hereby makes the following rules, namely: Short title 1.

These rules may be called the Companies (Declaration of Dividend out of Reserves) Rules, 1975.

Part II : Guidance Notes

II.99

Declaration of dividend out of reserves 2.

In the event of inadequacy or absence of profits in any year, dividend may be declared by a company for that year out of the accumulated profits earned by it in previous years and transferred by it to the reserves, subject to the conditions that– (i)

the rate of the dividend declared shall not exceed the average of the rates at which dividend was declared by it in the - five years immediately preceding that year or ten per cent of its paid up capital, whichever is less;

(ii)

the total amount to be drawn from the accumulated profits earned in previous years and transferred to the reserves shall not exceed an amount equal to one-tenth of the sum of its paid-up capital and free reserves and the amount so drawn shall first be utilised to set off the losses incurred in the financial year before any dividend in respect of preference or equity shares is declared; and

(iii) the balance of reserves after such drawal shall not fall below fifteen per cent of its paid-up share capital. Explanation: For the purposes of this rule, "profits earned by a company in previous years and transferred by it to the reserves" shall mean the total amount of net profits after tax, transferred to reserves as at the beginning of the year for which the dividend is to be declared; and in computing the said amount, the appropriations out of the amount transferred from the Development Rebate Reserve [at the expiry of the period specified under the Income-tax Act, 1961 (43 of 1961) shall be included and all items of Capital Reserves including reserves created by revaluation of assets shall be excluded. Insurance Act, 1938 Restriction on dividends and bonuses 49. (1) No insurer, being an insurer specified in sub-clause (a) (ii) or sub-clause (b) of clause (9) of Section 2, who carries on the business of life insurance or any other class or subclass of insurance business to which Section 13 applies, shall, for the purpose of declaring or paying any dividend to shareholders or any bonus to policy-holders or of making any payment in service of any debentures, utilize directly or indirectly any portion of the life insurance fund or of the fund of such other class or sub class of insurance business, as the case may be, except a surplus shown in the valuation balance-sheet in such form as may be specified by the regulations made by the Authority submitted to the Authority as part of the abstract referred to in Section 15, as a result of an actuarial valuation of the assets and liabilities of the insurer; nor shall he increase such surplus by contributions out of any reserve fund or otherwise unless such contributions have been brought in as revenue through the revenue account applicable to that class or sub-class of insurance business on or before the date of valuation aforesaid, except when the reserve fund is made up solely of transfers from similar surpluses disclosed by valuations in respect of which returns have been submitted to the Authority under Section 15 of this Act or to the Central Government under Section 11 of the Indian Life Assurance Companies Act, 1912 (6 of 1912):

II.100

Advanced Auditing & Professional Ethics

Provided that payments made out of any such surplus in service of any debentures shall not exceed fifty per-cent of such surplus including any payment by way of interest on the debentures, and interest paid on the debentures shall not exceed ten per-cent of any such surplus except when the interest paid on the debentures is offset against the interest credited to the fund or funds concerned in deciding the interest basis adopted in the valuation disclosing the aforesaid surplus: Provided further that the share of any such surplus allocated to or reserved for the shareholders (including any amount for the payment of dividends guaranteed to them, whether by way of first charge or otherwise), shall not exceed such sums as may be specified by the Authority and such share shall in no case exceed ten per-cent of such surplus in case of participating policies and in other cases the whole thereof. (2) For the purposes of sub-Section (1), the actual amount of income-tax deducted at source during the period following the date as at which the last preceding valuation was made and preceding the date as at which the valuation in question is made may be added to such surplus after deducing an estimated amount for income-tax on such surplus, such addition and deduction being shown in an abstract of the report of the actuary referred to in sub-Section (1) of Section 13. Declaration of interim bonuses 112. Notwithstanding anything to the contrary contained in this Act, an insurer carrying on the business of life insurance shall be at liberty to declare an interim bonus or bonuses to policy-holders whose policies mature for payment by reason of death or otherwise during the intervaluation period on the recommendation of the investigating of actuary made at the last preceding valuation. The Banking Regulation Act, 1949 15. Restrictions as to Payment of Dividend (1) No banking company shall pay any dividend on its shares until all its capitalised expenses (including preliminary expenses, organisation expenses, share-selling commission, brokerage, amounts of losses incurred and any other item of expenditure not represented by tangible assets) have been completely written off. (2) Notwithstanding anything to the contrary contained in sub-Section (1) or in the Companies Act, 1956 (1 of 1956), a banking company may pay dividends on its shares without writing off (i)

the depreciation, if any, in the value of its investments in approved securities in any case where such depreciation has not actually been capitalised or otherwise accounted for as a loss;

(ii)

the depreciation, if any, in the value of its investments in shares, debentures or bonds (other than approved securities) in any case where adequate provision for such depreciation has been made to the satisfaction of the auditor of the banking company;

Part II : Guidance Notes

II.101

(iii) the bad debts, if any, in any case where adequate provision for such debts has been made to the satisfaction of the auditor of the banking company. 17. Reserve Fund (1) Every banking company incorporated in India shall create a reserve fund and shall, out of the balance of profit of each year, as disclosed to the profit and loss account prepared under Section 29 and before any dividend is declared, transfer to the reserve fund a sum equivalent to not less than twenty per cent of such profit. (1A) Notwithstanding anything contained in sub-Section (1), the Central Government may, on the recommendation of the Reserve Bank and having regard to the adequacy of the paidup capital and reserves of a banking company in relation to its deposit liabilities, declare by order in writing that the provisions of sub-Section (1) shall not apply to the banking company for such period as may be specified in the order: Provided that no such order shall be made unless, at the time it is made, the amount in the reserve fund under sub-Section (1), together with the amount in the share premium account is not less than the paid-up capital of the banking company. (2) Where a banking company appropriates any sum or sums from the reserve fund or the share premium account, it shall, within twenty-one days from the date of such appropriation, report the fact to the Reserve Bank, explaining the circumstances relating to such appropriation: Provided that the Reserve Bank may, in any particular case, extend the said period of twentyone days by such period as it thinks fit or condone any delay in the making of such report. The Regional Rural Banks Act, 1976 21. Disposal of profits- After making provisions for bad and doubtful debts, depreciation in assets, contributions to staff and super annuation funds and all other matters for which provision is, under law, necessary or which are usually provided for by banking companies, a Regional Rural Bank may, out of its net profits, declare a dividend. The Multi-State Co-Operative Societies Act, 2002 62. Funds not to be divided by way of profit- (1) No part of the funds, other than net profits, of a multi-State co-operative society shall be divided by way of bonus or dividend or otherwise distributed among its members. (2) The net profit of a multi-State co-operative society referred to in subSection (1) in respect of a society earning profits shall be calculated by deducting from the gross profits for the year, all interest accrued and accruing in relation to amounts which are overdue, establishment charges, interest payable on loans and deposits, audit fees, working expenses including repairs, rent, taxes and depreciation, bonus payable to employees under the law relating to payment of bonus for the time being in force, and equalization fund for such bonus, provision for payment of income-tax and making approved donations under the Income-tax Act, 1961 (43 of 1961), development rebate, provision

II.102

Advanced Auditing & Professional Ethics

for development fund, bad debt fund, price fluctuation fund, dividend equalization fund, share capital redemption fund, investment fluctuation fund, provision for retirement benefits to employees, and after providing for or writing off bad debts and losses not adjusted against any fund created out of profit: Provided that such society may add to the net profits for the year interest accrued in the preceding years, but actually recovered during the year: Provided further that in the case of such multi-State co-operative societies, as do not have share capital, the surplus of income over expenditure shall not be treated as net profits and such surplus shall be dealt with in accordance with the bye-laws. 63. Disposal of net profits- (1) A multi-State co-operative society shall, out of its net profits in any year. (a) transfer an amount not less than twenty-five per cent to the reserve fund; (b) credit one per cent, to co-operative education fund maintained, by the National Cooperative Union of India Limited, New Delhi, in the manner as may be prescribed; (c) transfer an amount not less than ten per cent, to a reserve fund for meeting unforeseen losses. (2) Subject to such conditions as may be prescribed, the balance of the net profits may be utilised for all or any of the following purposes, namely: (a) payment of dividend to the members on their paid-up share capital at a rate not exceeding the prescribed limit; (b) constitution of, or contribution to, such special funds including education funds, as may be specified in the bye-laws; (c) donation of amounts not exceeding five per cent of the net profits for any purpose connected- with the development of co-operative movement or charitable purpose as defined in Section 2 of the Charitable Endowments Act, 1890 (6 of 1890); (d) payment of ex-gratia amount to employees of the multi-State cooperative society to the extent and in the manner specified in the byelaws. 64. Investment of funds- A multi-State co-operative society may invest or deposit its funds– (a) in a co-operative bank, State co-operative bank, co-operative land development bank or Central co-operative bank; or (b) in any of the securities specified in Section 20 of the Indian Trusts Act, 1882; or (c) in the shares or securities of any other multi-State co-operative society or any cooperative society; or (d) in the shares, securities or assets of a subsidiary institution or any other institution; or (e) with any other bank; or (f)

in such other mode as may be provided in the bye-laws.

Part II : Guidance Notes

II.103

Explanation: For the purposes of clause (e), "bank" means any banking company as defined in clause (c) of Section 5 of the Banking Regulation Act, 1949, and includes (a) the State Bank of India constituted under the State Bank of India Act, 1955; (b) a subsidiary bank as defined in clause (k) of Section 2 of the State Bank of India (Subsidiary Banks) Act, 1959; (c) a corresponding new bank constituted under Section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 (5 of 1970) or a corresponding new bank constituted under Section 3 of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1980 (40 of 1980). Multi-State Co-operative Societies Rules, 2002 24. Distribution of profit to members (1) No part of the funds, other than net profits of a multi-State co operative society shall be distributed by way of bonus or dividend or otherwise among its members. (2) Payment of dividend to the members on their paid-up share capital shall be as specified in the bye-laws. . (3) The bye-laws of a multi-State co-operative society may provide for distribution of patronage bonus to its members in consonance with the transactions of a member with the society. (4) Every multi-State Co-operative society may also provide for in their bye-laws the subjects and purposes for which the reserve fund will be utilised. 13. (REVISED) GUIDANCE NOTE ON REPORTS IN COMPANY PROSPECTUSES34 Legal Aspects 1.1 The purpose of this Guidance Note is to provide guidance on compliance with the provisions of the Companies Act, 1956 (hereinafter referred to as "the Act" unless otherwise specified), and the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000 (herein after referred to as the "DIP Guidelines"), relating to the reports required to be issued by chartered accountants in prospectus/statement in lieu of prospectus issued by the companies for the offerings made in India. 1.2 The relevant provisions of the Act dealt with in this Guidance Note are: (a) Section 2(36) - definition of prospectus; (b) Section 44(1)(b) - requirements to be complied with by a private company which becomes a public company by altering its Articles of Association;

With the issuance of this Guidance Note, the Guidance Note on Audit Reports Certificates on Financial Information in Offer Documents, issued by the Institute in January, 1997 shall stand withdrawn.

34

II.104

Advanced Auditing & Professional Ethics

(c) Sections 55 to 68B - relating to issuance, contents and other matters with respect to prospectus; (d) Sections 603 to 608 - relating to prospectus issued by companies incorporated outside India; and (e) Schedules II, III and IV, containing details of contents required to be stated and reports to be set out in a prospectus or in a statement in lieu of prospectus. The Guidance Note also deals with relevant aspects of SEBI (DIP) Guidelines, 2000. 1.3 Section 2 (36) of the Companies Act, 1956 defines 'Prospectus' as any document described or issued as a prospectus and includes any notice, circular, advertisement or other document inviting deposits from the public or inviting offers from the public for the subscription or purchase of any shares in, or debentures of, a body corporate. The object of issuing a prospectus is, therefore, to invite the public to invest their moneys in the company. In order to enable the potential investors to take a well-informed decision in the matter, the Act and chapter VI of the DIP Guidelines spell out, in details, the information to be given in a prospectus. Furthermore, to ensure that the information required to be stated in a prospectus is truthfully disclosed, the relevant statutes prescribe severe penalties for untrue statements in a prospectus, the object of the law being to protect the potential investors. 1.4 Schedule II to the Act deals with the matters to be specified in the prospectus and the reports to be set out therein. Schedules III and IV to the Act contain similar provisions with regard to statement in lieu of prospectus required to be delivered to the Registrar35. Requirements of Schedule II to the Act and Chapter VI of the DIP Guidelines are to be complied with when a company invites the public to subscribe its shares or debentures. Schedule III to the Act applies to a Company, which issues a statement in lieu of prospectus, or which has issued a prospectus but has not proceeded to allot any of the shares offered to the public for subscription. Schedule IV to the Act is applicable to a private company which becomes a public company by altering its Articles of Association. The provisions of Schedules II, III and IV are broadly similar. Part I of each of these Schedules specifies the matters to be stated; Part II, the reports to be set out; and Part III, the provisions which apply to Parts I and II. 1.5 Clauses 1, 2, 3, 4, and 5 of Part lIB of Schedule II deal with the reports to be set out in a prospectus and clauses 1 and 2 of Part II of Schedule III and Schedule IV deal with the reports to be set out in a statement in lieu of prospectus. Clauses 1, 2, 3 of Part lIB of Schedule II require a report by the auditors of the company, containing the particulars specified in the said clauses. Clauses 4 and 5 of Part lIB of Schedule II and clauses 1 and 2 of Part II of Schedule III and Schedule IV under the circumstances specified therein require a report, containing the 35

Attention of the members is drawn to notification no. 56(E) of February 10, 2006, issued by the Ministry of Company Affairs. In terms of the said notification, a new sub-rule (3) has been inserted in Rule 3 of the Companies (Central Government's) General Rules and Forms, 1956. Pursuant to this insertion, e-filing of the forms mentioned in Annexure A to this sub rule is permitted. Form No. 2A which has been prescribed for providing the salient features of the prospectus is also one of the forms which can be e-filed. The conditions subject to which such e-filing of forms can be done have also been given in aforementioned notification.

Part II : Guidance Notes

II.105

specified particulars, by accountants, as named in the prospectus or the statement in lieu of prospectus. Clauses 6.10.2.1 to 6.10.2.5 of Chapter VI of the DIP Guidelines require the same reports to be set out in the prospectus as provided in clauses 1 to 5 of Part lIB of Schedule II to the Companies Act, 1956. Who Are Eligible To Make The Reports 1.6 The report to be included in a prospectus under Clauses 1, 2, 3 of Part lIB of Schedule II should be made by the auditors of the Company. In case the Company has joint auditors, the report should be signed by all the joint auditors in accordance with the principles enunciated in Auditing and Assurance Standard (AAS) 12, Joint Auditors. The report under clauses 4 and 5 should be made by the accountant(s) who shall be named in the prospectus. According to clause 21(a) of Part III of Schedule II to the Act, the accountant shall be a person qualified under the Act for appointment as auditor of the Company. Clause 21(b) of Part III of Schedule II further states that the report shall not be made by any accountant who is an officer or servant or a partner or in the employment of an officer or servant of the Company or of the Company's subsidiary or holding company or of a subsidiary of the Company's holding company. It has been clarified that the expression "Officer" does not include an auditor. Schedules III and IV to the Act also contain identical provisions. 1.7 Further, in terms of Section 226(3)(d) and (e) of the Act, a chartered accountant who is indebted to the Company for an amount exceeding one thousand rupees, or who has given any guarantee or provided any security in connection with the indebtedness of any third person to the Company for an amount exceeding one thousand rupees or holds any security of that Company, is disqualified for appointment as its auditor. "Security" for this purpose means any instrument which carries voting rights. 1.8 From the above paragraph, it is clear that the intention of the Act is that even the 'accountant' should not have incurred any disqualification mentioned in Section 226 (3) of the Act. Fees For Issuing The Reports 1.9 Clause 1 of Part IIB of Schedule II and clause 6.10.2.1 of the DIP Guidelines state that the report shall be made by the auditor(s) of the Company. An auditor appointed under Section 224 of the Act at the annual general meeting holds office until the conclusion of the next annual general meeting on a fee fixed under Section 224(8) of the Act. In terms of Section 224 (8) of the Act, the remuneration of the auditor is fixed in such manner as the company in a general meeting may determine. Normally, the shareholders at the general meeting authorize the Board of Directors to fix up the fee of the auditor(s). The fees for issuance of the reports in the company prospectus is a part of the remuneration of the statutory auditor in terms of Section 224(8) of the Act. It is, therefore, advisable for the members to ensure, before accepting the appointment for issuing the report in the prospectus, that the Board of Directors have requisite authority with them to fix the auditor's fee. The amount of fee for making the reports is a matter of agreement between the company and the reporting member and is determined on the basis of factors such as the quantum of work involved, extent of the reporting auditor's/accountant's responsibility, etc.

II.106

Advanced Auditing & Professional Ethics

Signing The Report 1.10 Where the report is issued in a firm name, it should be signed by the member in his individual name, as partner/proprietor, as the case may be, for and on behalf of the firm, as in the case of other company audit reports, along with his membership number as required under Auditing and Assurance Standard (AAS) 28, "The Auditor's Report on Financial Statements", issued by the Institute. Consent Letters 1.11 Section 60(3) of the Act requires that a prospectus delivered to the Registrar of Companies for registration, should be accompanied by the consent, in writing, of the persons named therein as the auditor, legal adviser, attorney, solicitor, banker or broker of the Company, to act in that capacity. Section 60(1) of the Act requires that the prospectus should have an endorsement thereon, or attached thereto, any consent required by Section 58 from any person who is an expert in terms of Section 58 of the Act. As stated above, a chartered accountant whose report is included in the prospectus is to be treated as an expert. According to Section 58, the expert should give his written consent to the issue of the prospectus, with his statement or report included in the form and context in which it is included. The prospectus should further state that he has not withdrawn his consent as aforesaid. A specimen format of the consent letter has been given in Appendix 1 to the Guidance Note. Comfort Letters 1.12 In certain circumstances, the issuer company may request the auditor(s) to provide a comfort letter on the financial information of the company to the Lead managers, legal counsel etc. The purpose of comfort letter is to assist Lead managers, legal counsels, etc., in performing a "due diligence review" process of the prospectus. The scope of comfort letter needs to be agreed with the underwriters, lead managers, etc. Comfort letters are not required under the DIP Guidelines, 2000 and copies of the same are not required to be filed with SEBI. It may, however, be noted that issuance of comfort letters is in the nature of an assurance engagement and thus, the fees received on account of issuance of comfort letter would not be considered in the ceiling on fees from an individual client. A brief overview of the concept of comfort letters, has been provided in Appendix 2 to the Guidance Note. Liability For Misstatement In Prospectus 1.13 In terms of the requirements of Section 65 of the Act, a statement in the prospectus is deemed to be untrue, if it is misleading in the form and context in which it is included. Section 65 further provides that where the omission from a prospectus of any matter is calculated to mislead, the prospectus shall be deemed, in respect of such omission, to be a prospectus in which an untrue statement is included. However, a person liable to pay compensation may claim contribution as provided in Section 62(5) of the Act. Further, Section 15HB of the Securities and Exchange Board of India Act, 1992, also provides that whoever fails to comply with any of the provisions of the aforementioned Act, the rules or the regulations made there under or directions issued by SEBI there under, for which no separate penalty has been provided, shall be liable to a penalty which may extend to one crore rupees.

Part II : Guidance Notes

II.107

1.14 Every person who authorizes the issue of the prospectus is, in terms of Section 62 of the Act, liable to pay compensation to every person who subscribes for shares or debentures on the faith of the prospectus, for any loss or damage that the latter may have sustained by reason of any untrue statement included therein. However, a chartered accountant giving his consent under Section 58 or 60(3), shall be liable, only in respect of an untrue statement, if any, made by him in his capacity as an expert provided he fulfils the obligations mentioned in that Section. 1.15 The reporting auditor/accountant while carrying out such engagements, should also comply, to the extent practicable, with the principles enunciated in the Auditing and Assurance Standards (AASs) issued by the Institute. Since such types of engagements are subject to peer review requirements of the Institute, the auditor should properly document all the working papers necessary to provide evidence of the procedures performed and the basis of his conclusions therefrom. The member would also need to ensure compliance with the requirements of the Code of Ethics issued by the Institute of Chartered Accountants of India. Reports And Certificates 1.16 Clause 1 of Part IIB of Schedule II begins with the words "a report by the auditor............", but later in the paragraph below sub-clause (b) of the said clause 1, the words "together with certificate from the auditor" have been used. The certificate as to the correctness referred to therein is required to be issued in respect of broken period only. Accordingly, the auditor may be required to apply additional and/or more extensive procedures to be able to certify the correctness of the financial statements for the broken period. The concept of broken period has been explained further in paragraph 1.24. Rights And Powers 1.17 The next point for consideration is the rights and powers which a Chartered Accountant enjoys for performing his onerous duties in such engagement. In this connection it should be noted that only the report required by clauses 1, 2 and 3 of Part IIB of Schedule II and clauses 6.10.2.1, 6.10.2.2 and 6.10.2.3 of the DIP Guidelines is to be made by the Company's auditors; all other reports (clauses 4 and 5 of Part IIB of Schedule II and clauses 6.10.2.4, and 6.10.2.5 of the DIP Guidelines; clauses 1 and 2 of Part II of Schedules III and IV) are to be made by accountants to be named in the prospectus or statement in lieu of prospectus, and not necessarily by the Company's auditors. 1.18 In cases falling under clauses 1, 2 and 3 of Part II of Schedule II to the Act, the report is to be given by the auditors, who, in turn, are empowered, by Section 227(1) of the Act, to have a right of access at all times to the books and accounts of the company and to require from the officers of the Company, necessary information and explanations. Thus, they are vested with sufficient powers to discharge their duties. As mentioned in clause 21 of Part III of Schedule II to the Act, the reporting accountant envisaged in clauses 4 and 5 of Part IIB of Schedule II should be a Chartered Accountant but not an officer or a servant of the company. It may also be noted that such accountant has no statutory powers. Therefore, he should ensure that necessary authority is given to him by the Board of Directors to discharge his duties and must mention the need for such powers in the engagement letter issued by him for this engagement.

II.108

Advanced Auditing & Professional Ethics

To Whom Should The Report Be Made 1.19 There are no provisions either in the Act or in the DIP Guidelines as to whom the report should be made. The usual practice is to address the report to the Board of Directors of the Company. Overview Of Part Ii Of Schedules Ii, Iii And Iv Of The Act 1.20 For convenience, IIB (1, 2 & 3) will denote clauses 1, 2 and 3, respectively of Part II of Schedule II to the Act and IIB (4) and IIB (5) will denote clauses 4 and 5 of Part II of Schedule II to the Act, respectively. Similarly, III (1) and III (2) will denote clauses (1) and (2) of Part II of Schedule III to the Act, respectively, and IV (1) and IV (2) will refer to clauses (1) and (2) of Part II of Schedule IV to the Act, respectively. Clause IIB (1, 2 & 3) deals with a company, and its subsidiaries, if any. Clauses lIB (4), III (1) and IV (1) deal with the purchase of a business. The variations in the detailed requirements among these clauses have been dealt separately. Clauses lIB (5), III (2) and IV (2) deal with acquisition of a subsidiary company. Financial Information Of The Issuer Company 1.21 Clause lIB (1) of the Act and clause 6.10.2.1 of the DIP Guidelines require that the prospectus issued by the Issuer Company should contain a report by its auditors with respect to: (a) profits and losses and assets and liabilities, in accordance with sub clause (2) or (3), as the case may require (these have been dealt with in paragraph 1.26 and 1.27, respectively); and (b) the rates of dividends, if any, paid by the issuer company in respect of each class of shares in the issuer company for each of the five financial years immediately preceding the issue of the prospectus, giving particulars of each class of shares on which such dividends have been paid and particulars of the cases in which no dividends have been paid in respect of any class of shares for any of those years. Clause IIB(1) also requires that where no accounts have been made up in respect of any part of the period of five years ending on a date three months before the issue of the prospectus, a statement of that fact should also be given. The report should also be accompanied by a statement of the account of the Issuer Company in respect of that part of the said period up to a date not earlier than six months of the date of issue of the prospectus indicating the profit or loss for that period and the assets and liabilities position as at the end of that period together with a certificate from the auditors that such account has been examined and found correct by them. The said statement may indicate the nature of provision or adjustments made or are yet to be made. 1.22 It may be noted that though the law requires the auditors to certify the correctness of the financial statements of the broken period, yet having regard to the fact that such financial statements would invariably involve accounting and other estimates, the members should make it clear in their reports on prospectus that they have carried out their examination of the financial statements for the broken period in accordance with the AASs. The AASs require that the auditor plan and perform the audit to obtain reasonable assurance in respect of the

Part II : Guidance Notes

II.109

subjected financial statements/ information. Further, the AASs also provide that while performing the audit procedures to obtain such reasonable assurance, the auditor should also consider the concept of materiality. 1.23 In general, the requirement is to give the figures of profits and losses for the five financial years preceding the issue of the prospectus or statement in lieu of prospectus. If the entity has been carrying on business for less than five financial years, the figures are to be given for the actual period. Where the five financial years immediately preceding the issue of the prospectus cover a period less than five years, i.e., 60 months (this can happen if the Company has changed its accounting period), the report should cover as many financial years as may be necessary, so that the aggregate period covered is not less than five years (60 months) having regard to Clause 19 of Part III of Schedule II which states that if the five financial years cover a period less than 5 years then financial year would be substituted by year. 1.24 The Company Law Board in consultation with the Ministry of Law has clarified vide its communication no. 5/72, CL VI, 65 dated 11th November 1968, that the period of "five years" refers to simple period of five years ending on a date three months before the issue of the prospectus. Hence, every company will have to furnish in the prospectus, accounts up to a date not earlier than six months from the date of issue of the prospectus, irrespective of the fact whether or not the financial year of the Company closes on a date three months before the issue of the prospectus. To illustrate, suppose a Company's accounting year ends on 31st March, 2006 and it issues a prospectus when its accounts for the year ended March, 2006 have been made up. In such case, no accounts for the part of the period is required to be given if the prospectus is issued before 30th September 2006. The auditor is required to give his report on simple five years, equivalent to sixty months, irrespective of number of financial years, in case company changes its accounting period. To illustrate, let us assume that the accounting periods of the company are as follows: I

April 2004 - March 2005

:

12 months

II

June 2003 – March 2004

:

10 months

III

October 2002 - May 2003

:

8 months

IV

April 2002 - September 2002

:

6 months

V

October 2000 - March 2002

:

18 months

VI

April 2000 - September 2000

:

6 months

In present case though going backward, five financial years end on Oct 2000, the report should take into account another accounting year to complete period equivalent to 60 months. In this case, another accounting year consists of 6 months only. However, even if it consists of more than six months say 12 months, say ending on October, 1999 (exceeding period of 60 months), the auditor will have to report for the entire accounting period i.e., upto October, 1999, and not restrict to the fraction of the year.

II.110

Advanced Auditing & Professional Ethics

However, if the accounts for the year ended March, 2006 have not been made up, then if the prospectus is issued, say on 30th June, 2006, the Company would be required to give a statement of account made up to at least 31st December, 2005 and if the prospectus is issued on or after 1st July, 2006, say on 31st July, a statement of accounts made up to, at least, 31st January, 2006 is required to be given. 1.25 Sections 60(1)(b)(ii) and 70(2), Clause 2036 of Part III of Schedule II of the Act and clause 6.10.2.7 (b) of the DIP Guidelines require that the auditor's report should also, either: (a) indicate by way of note, any adjustments as regard the figures of any profits or losses or assets and the liabilities dealt with by the report which appear necessary to the persons making the report; or (b) make these adjustments and indicate that adjustments have been made. In the case of (b), the reporting auditor/accountant should also give a signed statement setting out the adjustments and the reasons therefor and such statement is to be delivered to the Registrar along with the prospectus. For an illustrative statement of adjustments, members are requested to refer to Annexure IV of Appendix 6 to the Guidance Note. 1.26 In terms of clause IIB (2) of the Act and clause 6.10.2.2 of the DIP Guidelines, if the issuer Company has no subsidiaries, the report issued should cover the following: (a) the profits or losses of the issuer Company (distinguishing items of a non- recurring nature) for each of the five financial years immediately preceding the issue of the prospectus; and (b) the assets and liabilities of the issuer company at the last date to which the accounts of the issuer Company were made up. 1.27 Clause IIB(3) of the Act and clause 6.10.2.3 of the DIP Guidelines provide that if the issuer company has subsidiaries, the report issued would cover: (a) separately, the Issuer Company's profits or losses as provided above in paragraph 1.26 and in addition, deal either: (i)

as a whole with the combined profits or losses of its subsidiaries, so far as they concern the members of the issuer Company; or

(ii)

individually with the profits or losses of each subsidiary, so far as they concern the members of the issuer Company.

Alternatively, instead of dealing separately with the issuer Company's profits or losses, the report may deal as a whole with the profits or losses of the issuer Company, and with the combined profits or losses of its subsidiaries so far as they concern the members of the issuer Company; and It may be noted that section 60 of the Act refers to clause 32 of Schedule II which has since been amended and the new clause number is 20 of Part III of Schedule II.

36

Part II : Guidance Notes

II.111

(b) separately, the issuer Company's assets and liabilities as provided above in paragraph 1.28 and in addition, deal either: (i)

as a whole with the combined assets and liabilities of its subsidiaries, with or without the issuer Company's assets and liabilities; or

(ii)

individually with the assets and liabilities of each subsidiaries;

In addition, the report should also indicate as respects the assets and liabilities of the subsidiaries, the allowance to be made for persons other than the members of the issuer Company. 1.28 From the provision of the Act and DIP Guidelines as stated in paragraph 1.27 above, it can be seen that there are various methods for incorporating the financial information of the issuer Company and its subsidiaries in the prospectus. The methods are explained below: (a) Consolidated financial information in respect of the issuer Company along with the issuer Company's interest in the subsidiary Companies, and stand alone financial information of the issuer Company; or (b) Information of the issuer Company and issuer Company's interest in the subsidiary Companies be combined for all such subsidiaries; or (c) Information of the issuer Company and issuer Company's interest in the subsidiary Companies to be given individually in respect of each such subsidiary. However, presenting the information as per method (a) should be preferred as it is in line with the requirements of Accounting Standard (AS) 21, "Consolidated Financial Statements" and the consolidation should be done in accordance with the principles outlined in AS 21. 1.29 It may be noted that the DIP guidelines and Schedule II are silent as to the interest in partnership(s), joint ventures, and associates. It is recommended that wherever consolidated financial statements are presented, accounting in respect of investments in joint ventures and associates should be done as per the requirements of Accounting Standard (AS) 23 "Accounting for Investments in Associates" and Accounting Standard (AS) 27 "Accounting for Investments in Joint Ventures" and a suitable disclosure of the same should be made in the financial statements. It is also recommended that in case where consolidated financial statements are not required to be presented, the issuer Company should also disclose interest in the joint ventures and associates. 1.30 There may be cases where the holding company has been in existence for a period shorter than the subsidiary. In such cases, the figures have to be given for the holding company for the period it has been in existence, and for the subsidiary only for the period for which it has been such holding Company's subsidiary company or partnership firm. 1.31 It may be noted that as per Clause 6.10.3 of the DIP Guidelines, the issuer Company is required to disclose information with respect to its group companies, but the auditor is not required to report on the same. 1.32 Clause IIB(4) and clause 6.10.2.4 of the DIP Guidelines also require a report made by an accountant (who would be named in the prospectus) in case the proceeds, or any part of the

II.112

Advanced Auditing & Professional Ethics

proceeds, of the issue of the shares or debentures are, or is, to be applied directly or indirectly: (a) in the purchase of any business; or (b) in the purchase of an interest in any business and by reason of that purchase, or anything to be done in consequence thereof, or in connection therewith; the issuer Company will become entitled to an interest as respects either the capital or profits and losses or both, in such business exceeding fifty percent, thereof. The above-mentioned report would cover the following aspects: (i)

the profits or losses of the business of each of the five financial years immediately preceding the issue of the prospectus; and

(ii)

the assets and liabilities of the business at the last date to which the accounts of the business were made up, being a date not more than one hundred and twenty days before the date of the issue of the prospectus.

1.33 Similarly, clause 111(1) requires an accountant's report on specified aspects in case where the issuer company proposes to acquire a business. The accountant's report should cover the following aspects: (a) the profits or losses of the business in respect of each of the five financial years immediately preceding the delivery of the statement in lieu of prospectus to the Registrar; and (b) the assets and liabilities of the business at the last date to which the accounts of the business were made up. 1.34 Also, in terms of clause IV(1), where the unissued shares or debentures of the Company are to be applied in the purchase of a business, the prospectus should also contain an accountant's report upon: (a) the profits or losses of the business in respect of each of the five financial years immediately preceding the delivery of the statement in lieu of prospectus to the Registrar; and (b) the assets and liabilities of the business at the last date to which the accounts of the business were made up. 1.35 The above clauses are similar to the extent they deal with the acquisition of a business. The accountant is required to report on the profits or losses of the business for each of the five financial years immediately preceding the issue of the prospectus or the delivery of the statement in lieu of prospectus to the Registrar, as the case may be. The reporting accountant should also report upon the assets and liabilities of the business at the last date to which the accounts of the business are made up. Clause IIB(4) and clause 6.10.2.4 of DIP Guidelines stipulate that such date should not be more than 120 days prior to the date of issue of the prospectus. However, there is no such period for the reports under clauses III (1) and IV (1).

Part II : Guidance Notes

II.113

1.36 Further, the proceeds, or any part of the proceeds of the issue of the shares or debentures, are or is to be applied directly or indirectly, (i) in the purchase of any business, or (ii) in the purchase of an interest in any business, and by reason of that purchase or anything to be done in consequence thereof, or in connection therewith, the Company will become entitled to an interest, as respects either the capital or profits and losses or both, in such business exceeding fifty per cent thereof. Clause IV (1) prescribes the following further condition for the clause to apply: "If unissued shares or debentures of the company are to be applied in the purchase of a business." Therefore, it may appear that if the business is to be acquired by allotting shares or debentures; (i.e., not by cash payment), clause IIB(4) would not apply. Similarly, if the business is to be 'acquired by cash payment, clause IV(1) will not apply. However, the interpretation as to the non-applicability of clause IIB(4) if the business is acquired by allotting shares or debentures, does not seem to be correct since even in such cases, the shares or debentures so allotted will have to be serviced and the potential investors must know about these matters. Therefore, having regard to the purpose of the accountants' report, the clause should be interpreted liberally, and thus, the constructive receipt of cash and the application thereof for the acquisition of the business (which is implicit in the allotment of shares or debentures for acquiring a business), should be viewed as application of the "proceeds" of the issue. Further, clause (10) of Part IIC of Schedule II requires the disclosure of details of "the amount paid or payable in cash, shares or debentures to the vendor" in respect of any property "purchased or acquired by the company or proposed to be purchased or acquired which is to be paid for wholly or partly out of the proceeds of the issue offered for subscription." In view of this, it would appear that if the business (or interest therein) is acquired by the allotment of shares or debentures then also the accountants should report upon the profits and losses and assets and liabilities of the business, as explained in paragraph 1.35 above. A point to be noted is that the particulars are required only if the Company's interest in the capital, or the profits/losses of the business, or both, exceeds 50% thereof; anything up to and including 50% does not require such a report. It also appears that investment in a partnership or a joint venture, or a lease of a business will be covered by the expression "interest in a business." 1.37 Further, in terms of the requirements of clause IIB(5) of the Act and clause 6.10.2.5 of the DIP Guidelines: (a) If: (i)

the proceeds, or any part of the proceeds, of the issue of the shares or debentures are or is to be applied directly or indirectly in any manner resulting in the acquisition by the issuer Company of shares in any other body corporate; and

(ii)

by reason of that acquisition or anything to be done in consequence thereof or in connection therewith, that body corporate will become a subsidiary of the issuer Company; the prospectus should also contain a report made by accountants (who shall be named in the prospectus) upon: (i)

the profits or losses of the other body corporate for each of the five financial years immediately preceding the issue of the prospectus; and

II.114

Advanced Auditing & Professional Ethics (ii)

the assets and liabilities of the other body corporate at the last date to which its accounts were made up.

The clause also requires that the report should: (i)

indicate how the profits or losses of the other body corporate dealt with by the report would, in respect of the shares to acquired, have concerned members of the issuer company and what allowance would have fallen to be made, in relation to assets and liabilities so dealt with for holders of other shares, if the issuer company had at all material times held the shares to be acquired; and

(ii)

where the other body corporate has subsidiaries, deal with the profits or losses and the assets and liabilities of the body corporate and its subsidiaries in the manner provided by subclause (a)(ii) above in relation to the issuer company and its subsidiaries.

1.38 Clause III(2) states that where the Issuer Company proposes to acquire shares in a body corporate which by reason of the acquisition or anything to be done in consequence thereof or in connection therewith will become a subsidiary of the company, a report should be made by the accountant with respect to the profits and losses and assets and liabilities of the other body corporate in accordance with sub-clause (2) or (3) of this clause, as the case may require, indicating how the profits or losses of the other body corporate dealt with by the report would, in respect of the shares to be acquired, have concerned members of the company, and what allowance would have fallen to be made, in relation to assets and liabilities so dealt with, for holders of other shares, if the company had at all material times held the shares to be acquired. If the other body corporate has no subsidiaries, the report referred to in sub-clause (1) should – (a) deal with the profits or losses of the body corporate in respect of each of the five financial years immediately preceding the delivery of the statement to the Registrar; and (b) deal with the assets and liabilities of the body corporate as at the last date to which the accounts of the body corporate were made up. If the other body corporate has subsidiaries, the report referred to in sub-clause (1) should– (a) deal separately with the other body corporate profits or losses as provided by sub-clause (2) and in addition deal either– (i)

as a whole with the combined profits or losses of its subsidiaries so far as they concern members of the other body corporate; or

(ii)

individually with the profits or losses of each subsidiary, so far as they concern members of the other body corporate;

Alternatively, instead of dealing separately with the other body corporate's profits or losses, the report may deal as a whole with the profits or losses of the other body corporate, and so far as they concern members of the other body corporate, with the combined profits or losses of its subsidiaries; and

Part II : Guidance Notes

II.115

(b) so far as regards assets and liabilities, deal separately with the other body corporate's assets and liabilities as provided by sub-clause (2) and, in addition, deal either (i)

as a whole with the combined assets and liabilities of its subsidiaries, with or without the other body corporate's assets and liabilities; or

(ii) individually with the assets and liabilities of each subsidiary; and shall indicate, as respects the assets and liabilities of the subsidiaries, the allowance to be made for persons other than members of the company. 1.39 Clause IV (2) states that if unissued shares or debentures of the company are to be applied directly or indirectly in any manner resulting in the acquisition of shares in a body corporate which by reason of the acquisition or anything to be done in consequence thereof or in connection therewith will become a subsidiary of the company, a report should be made by accountants (who shall be named in the statement) with respect to the profits and losses and assets and liabilities of the other body corporate in accordance with sub-clause (2) or (3) of this clause, as the case may require, indicating how the profits or losses of the other body corporate dealt with by the report would, in respect of the shares to be acquired, have concerned members of the company, and what allowance would have fallen to be made, in relation to assets and liabilities so dealt with, for holders of other shares, if the company had at all material times held the shares to be acquired. If the other body corporate has no subsidiaries, the report referred to in sub-clause (1) should– (a) deal with the profits or losses of the body corporate in respect of each of the five financial years immediately preceding the delivery of the statement to the Registrar; and (b) deal with the assets and liabilities of the body corporate as at the last date to which the accounts of the body corporate were made up. If the other body corporate has subsidiaries, the report referred to in sub-clause (1) should– (a) deal separately with the other body corporate's profits or losses as provided by subclause (2), and in addition deal either– (i)

as a whole with the combined profits or losses of its subsidiaries, so far as they concern members of the other body corporate; or

(ii)

individually with the profits or losses of each subsidiary, so far as they concern members of the other body corporate;

Alternatively, instead of dealing separately with the other body corporate's profits or losses, the report may deal as a whole with the profits or losses of the other body corporate and, so far as they concern members of the other body corporate, with the combined profits or losses of its subsidiaries; and (b) so far as regards assets and liabilities, deal separately with the other body corporate's assets and liabilities as provided by sub-clause (2) and in addition, deal either– (i)

as whole with the combined assets and liabilities of its subsidiaries, with or without the other body corporate; assets and liabilities; or

II.116 (ii)

Advanced Auditing & Professional Ethics individually with the assets and liabilities of each subsidiary; and shall indicate, as respects the assets and liabilities of the subsidiaries, the allowance to be made for persons other than members of the company.

1.40 The clauses mentioned in paragraphs 1.39 are similar in nature as they deal with the acquisition of shares in any other body corporate which would lead to making it a subsidiary company of the Issuer Company. The accountants are required to report on the profits or losses of the said subsidiary for each of the five financial years immediately preceding the issue of the prospectus or the delivery of the statement in lieu of prospectus. The reporting accountant should also report upon the assets and liabilities of the subsidiary at the last date to which its accounts were made up. It may be noted that these clauses, unlike Clause IIB(4), do not prescribe a ceiling on the time-lag between the date to which the accounts are made up, and the date of the prospectus (or the delivery of the statement in lieu of prospectus). The relevant rules also require that the accountant's report should deal with the subsidiaries, if any, or the subsidiary to be acquired, in the same manner as stated in Clause IIB (3). Accounting And Auditing Aspects 2.1 As stated earlier in preceding paragraphs, the reporting auditor/accountant is required to report on the profits and losses (distinguishing items of non-recurring nature) for the preceding five years and on the assets and liabilities, after making such adjustments as explained in paragraph 2.2 below. The term non-recurring has not been defined either in the Act or in the DIP Guidelines. The reporting accountant should therefore keep in mind the object of the law viz., the protection of potential investors, and accordingly, his report should provide the information that he considers will be relevant for a reader to make decisions regarding investment in the Company. Since what constitutes "non recurring" has been defined neither in the Act nor the DIP guidelines, members should draw guidance in this regard from the Accounting Standard (AS) 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies. 2.2 The Statements of Assets and Liabilities and Profit and Loss Account or any other financial information needs to be adjusted in the following manner. (a) Adjustments for all incorrect accounting practices or failure to make provisions or other adjustments, which resulted in audit qualification. It is relevant to note here that in case of prospectus, the auditor/ accountant reports on the Statement of Assets and Liabilities and the Profit and Loss Account extracted from the audited financial statement and approved by the Board of Directors to which further adjustments may be required. Accordingly, it is expected that all quantifiable adjustments are carried out and only nonquantifiable qualifications remain unadjusted. Any non-quantifiable qualification should, however, be dealt with in the auditor's/accountant's report appropriately in accordance with the provisions of AAS 28. (b) As per DIP Guidelines, material amounts relating to adjustments for previous years should be adjusted in arriving at the profits for the years to which they relate irrespective of the year in which event triggering the profit or loss has occurred. In other words, where there are material facts which would have been taken into consideration while preparing

Part II : Guidance Notes

II.117

the accounts for the respective years, had those facts been known at that time, the same should be considered in the year to which it relates. The auditor should, therefore, review the relevant information in respect of earlier years, such as, settlement of significant litigations items already reported as prior period adjustments, extraordinary items identified and adjusted in the respective years etc. (c) Where there has been a change in accounting policy, the profits or losses of the earlier years (required to be shown in the prospectus) and of the year in which the change in accounting has taken place should be recomputed to reflect the profits or losses of those years that would have been if a uniform accounting policy was followed in each of these years. It should be noted that, if for any of these years, the change is not quantifiable, the same needs to be brought out in the report of the auditor/accountant. It is likely that the companies would have changed accounting policies to comply with several of the Accounting Standards that have become mandatory in the recent past. The Standards become applicable from a particular date specified in the Standard and some Standards have transitional provisions as well. In this regard, the date when the Standard became mandatory should be ignored and the same should be applied as if the Standard was mandatory throughout the period covered by the auditor/accountant. However, in case of practical problems in adoption of a Standard in earlier years for making the adjustment, the fact should be adequately brought out in the auditor's/accountant's report as an emphasis of matter paragraph or a qualification, as may be necessary, depending upon the facts and circumstances of each case. (d) Statement of profit or loss should disclose both the profit or loss arrived at before and after considering the profit or loss from extraordinary items. The turnover disclosed in the Profit and Loss Statement should be bifurcated into: (i)

turnover of products manufactured by the issuer company;

ii)

turnover of products traded in by the issuer company; and

(iii) turnover in respect of products not normally dealt in by the issuer company but included in (ii) above, should be mentioned separately. Further, in all cases where other income (net of related expenses) exceeds 20% of the net profit before tax, then the details of such income is also required to be disclosed. Such disclosure should include: (i)

the sources and other particulars of such income; and

(ii)

an indication as to whether such income is recurring or non recurring, or has arisen out of business activities/ other than the normal business activities.

(iii) The statement of assets and liabilities should be prepared after deducting the balance outstanding on revaluation reserve account both from fixed assets and reserves and the net-worth arrived at after such deductions. 2.3 In addition to above, clause 6.10.2.7 of the DIP Guidelines requires the following other information to also be disclosed by the issuer Company:

II.118

Advanced Auditing & Professional Ethics

(i)

the changes (with quantification, wherever possible) in the activities of the issuer company which may have had a material effect on the statement of profit/ loss for the five years, including discontinuance of lines of business, loss of agencies or markets and similar factors.

(ii)

the accounting and other ratios for each of the accounting periods for which the financial information is given. These ratios, as explained below are computed on the basis of restated financial statement. a.

Earnings per Share: This ratio is calculated after excluding extra ordinary items and as per the provisions of Accounting Standard (AS) 20 "Earnings Per Share".

b.

Return on Net Worth: This ratio is calculated excluding revaluation reserves as Section 2(29A) of the Act defines net worth as the sum total of paid up share capital and free reserves and free reserves do not include reserves created by revaluation of assets, write back of depreciation provisions and amalgamation. Further, the debit balance of profit and loss account, if any, should be adjusted against the free reserves before calculating the ratio.

c.

Net Asset Value Per Share: This ratio is calculated excluding revaluation reserves.

(iii) A Capitalisation Statement showing total debt, net worth, and the debt/equity ratios before and after the issue is made. The same is sometimes not possible as the post issue capitalization can only be determined after final pricing of the issue based on the book building process and this fact needs to be disclosed. Also, in case of any change in the share capital since the date as of which the financial information has been disclosed in the prospectus, a note explaining the nature of the change should be given. An illustrative capitalization statement is given in Appendix 3 to the Guidance Note. (iv) The break-up of total outstanding unsecured loans taken by the issuer company along with the terms and conditions, including interest rates and the repayment schedule. Further, the fact whether the loan can be recalled by the lenders at any time needs to be disclosed in the risk factors. (v) The following disclosures along with explanations for understanding the future tax incidence on the Company: (i)

permanent differences and timing differences

(ii)

timing differences which can be reversed in the future, for example, the difference between book depreciation and tax depreciation.

The term tax shelter has not been defined in any of the statutes. However, the dictionary meaning of the term is "an investment intended to reduce the income tax liability". Tax shelter statement requires to disclose tax at the notional rate and other adjustments which could be in the nature of permanent and timing differences as identified in accordance with Accounting Standard (AS) 22 "Accounting for Taxes on Income". These adjustments may be verified with the income tax returns and other records giving effect of the appeal and other assessment orders in those respective assessment years. In nutshell, the tax shelter statement is a reconciliation between provision for tax according

Part II : Guidance Notes

II.119

to the Income-tax Act, 1961 and tax expense as explained in AS 22 after considering the effect of permanent differences. (vi) The issuer company, if it so desires, may include in the prospectus, the financial statements prepared on the basis of more than one accounting practice, subject to disclosure of the material differences arising because of different accounting practices. (vii) The accountant will have to consider whether all the Significant Accounting Policies and Notes on Accounts appearing in the published accounts need to be reproduced. It may well be that many of them can be omitted. It may equally be found necessary to add certain new items. In any case, all significant accounting policies and standards followed in the preparation of the financial statements based on which the Statement of Assets and Liabilities and Statement of Profit and Loss has been extracted should be disclosed. It must be appreciated that the usual Profit and Loss Account and Balance Sheet are general-purpose financial statements. While using such financial statements for a specific purpose, it may be necessary to make certain adjustments in view of the nature of information required. Such adjustments, however, do not imply any criticism of the accounts as originally drawn up since the adjustments are to be made because of the differences in perspective. In making the adjustments, the accountant should exercise his professional judgment and independence. (viii) As the figures to be given in the financial information are to be given for five financial years (minimum of 60 months), therefore, there may be accounts which have not been audited by the auditor giving report at the time of issue of prospectus. Accordingly, in such cases, reports from the auditors of the respective periods covered in the period of 60 months will have to be taken and the same would be relied upon by the auditor giving the final report. The audit procedures to be followed in such case should be in line with the procedures stated in the Auditing and Assurance Standard (AAS) 10 "Using the Work of Another Auditor". The fact that the financial statements audited by other auditors have been relied upon for reporting in the prospectus needs to be disclosed in the report given by the auditor. (ix) Similar disclosure as in (viii) would also be required in case of branch accounts, project operations, associate companies, joint ventures, partnership firms and subsidiary companies which have been incorporated in the financial information or which have been stated in the report set out in the prospectus and which have been audited by the auditors other than that/those issuing the report in the prospectus. (x) Report given by the accountant also would disclose reliance, if any, on the accounts audited by other auditor(s) as the accountant may not be the auditor of the Company or the business/body corporate being purchased/acquired. (xi) The law does not specify whether the report should show the profits before or after taxes. The usual practice, and the recommended procedure, is to show the profit before tax, the charge for tax, and the profit after tax. 2.4 As explained in paragraph 1.23, it may become necessary to prepare accounts for part of the current accounting period. This need should be identified as early as possible so that there

II.120

Advanced Auditing & Professional Ethics

is adequate time to organise for the preparation of accounts for such broken period and for their audit. In preparation of accounts for the broken period, the recognition and measurement principles laid down in Accounting Standard (AS) 25 'Interim Financial Reporting' should be applied. AS 25 requires that an enterprise should apply the same accounting policies in its interim financial statements as are applied in its annual financial statements, except for accounting policy changes made after the date of most recent audited financial statements that are to be reflected in the next annual financial statements. The preparation of interim financial statements should not affect the measurement of its annual results. Revenues that are received seasonally or occasionally within a financial year should not be anticipated or deferred as of an interim date if anticipation or deferral would not be appropriate at the end of the enterprise's financial year. Similarly, costs that are incurred unevenly during an enterprise's financial year should be anticipated or deferred for the broken period if, and only if, it is also appropriate to anticipate or defer that type of cost at the end of the financial year. If it is identified during the preparation of the interim financial statement that there is a change in the accounting policy or that there is an error of the past, the same needs to be adjusted not only in the Statement of Profit or Loss or Statement of Assets and Liabilities or other financial information for the broken period but also in the years being reported upon by the auditor/ accountant in the same principles as set out in paragraph 2.2 above. 2.5 The report on profits to be included in the prospectus is usually fairly detailed, starting from the sales turnover, and showing the cost of sales with varying degrees of detail, ending up with profits before tax, provision for taxation and profits after tax. The statement of assets and liabilities may be so arranged that liabilities are deducted from the assets ending with the owner's funds (share capital and reserves). Refer Appendix 3 to the Guidance Note for the format prescribed in the DIP Guidelines. A specimen format of the report of auditors in Company prospectuses is given as Appendix 4 to this Guidance Note. Also, in case of a report by an accountant who is not the auditor, the same format can be modified as necessary. A specimen format of the report of auditors' on consolidated financial statements and information in the Company Prospectus is given as Appendix 5 to the Guidance Note. An illustrative format of the restated financial statements to be given in the prospectus is given as Appendix 6 to the Guidance Note. 2.6 In the interest of both client and auditor, the auditor/reporting accountant should send an engagement letter, preferably before the commencement of the engagement, to help avoid any misunderstandings with respect to the engagement. In this regard, the auditor/ reporting accountant should conform to the requirements of Auditing and Assurance Standard (AAS) 26, "Terms of Audit Engagement' issued by the Institute. An illustrative format of the Engagement letter is given as Appendix 7 to the Guidance Note. 2.7 The auditor should obtain evidence that management acknowledges its responsibility for the appropriate preparation and presentation of financial information and that management has approved the financial information including the restatement as detailed in paragraph 2.2 above. In this regard it is advisable to get the financial information adopted by the Board of Directors. The auditor should also obtain other representations from management, as considered appropriate in terms of Auditing and Assurance Standard (AAS) 11, "Representations by Management” issued by the Institute. Since the reporting accountant

Part II : Guidance Notes

II.121

would, in due course, be required to give his consent to the inclusion of his report in the prospectus in the form and context in which it is so included. For this purpose, he should study the prospectus carefully and also take note of: (a) the manner in which the directors, in their estimate of current and future profits, would deal with figures shown in the accountant's report and with matters to which attention has been drawn in that report; (b) the manner in which the directors have dealt with any special circumstances, where the reporting accountant has decided that no reference thereto is necessary in his report. He should also obtain the necessary management certificates and representations as stated above and only after satisfying himself of the above, should he provide the Company with the consent letter. 2.8 If, after giving his report but before the issue of the prospectus, or after the issue of the prospectus and before allotment thereunder, the reporting accountant/auditor becomes aware of any important information which significantly affects the report given by him, he would need to consider whether he should withdraw his consent by writing to the company, the Registrar of Companies, the stock exchanges, and through suitable press publicity. The subject is complex and it will be prudent for the members to seek legal advice in case such a situation arises. 2.9 For a further reading on some common issues associated with prospectus, readers are requested to refer Appendix 8 to the Guidance Note, containing an extract of some frequently asked questions in respect of prospectus as prepared and answered by SEBI. Appendix 1 Specimen Format of the Consent Letter (Refer paragraph 1. 11) [Date] The Board of Directors [Name and Address of the Company] Dear Sirs, Proposed Offering of securities in India by [name of the issuer] (the "Issuer") We hereby consent to use in this Draft Red Herring Prospectus, the Red Herring Prospectus and the Prospectus of [name of the issuer] (the "Issuer") to be submitted/filed with the Securities Exchange Board of India (SEBI) and the Registrar of Companies (ROC) our reports dated [date] relating to [financial information prepared under SEBI (Disclosure and Investor Protection) Guidelines, 2000, as amended (the "Guidelines") and Part lIB of Schedule II to the Companies Act, 1956, Statement of Tax Benefits, and specify others], which appears in such Prospectus.

II.122

Advanced Auditing & Professional Ethics

We also consent to the references to us as ["Auditors"] or ["Reporting Accountant"]' under the headings "[Definitions and Abbreviations]", "[General Information]", and "[other Sections]" in such Prospectus37. The above consents are subject to the condition that we do not accept any responsibility for any reports or matters (including information sent to Merchant Bankers) or letters included in the offer documents. Neither we nor our affiliates shall be liable to any investor or merchant bankers or any other third party in respect of the proposed offering. Further, the Company agrees to indemnify us and our affiliates and hold harmless from all third party (including investors and merchant bankers) claims, damages, liabilities and costs arising consequent to our giving consent. For ABC and Co. Chartered Accountants Signature [Name of the Member] Designation38 Membership Number Place of Signature: Date: Appendix 2 Comfort Letters (Refer Paragraph 1.12) 1. A prospectus is issued with the intention of inviting the public to subscribe to the securities being offered by the issuer. The decision to invest in the securities is dependent to a large extent on the financial and other information contained in the prospectus. To help investors make an informed decision, the prospectus contains huge amounts of data, prepared with the help of a number of experts. Over the period, a number of mechanisms have developed in the securities market to provide the general public easier and fair access to securities of the issuer. The need for comfort letters has arisen mainly due to the emergence of the concept of underwriting. Therefore, before understanding the concept of "comfort letters" it may be useful to understand what is underwriting. 2. Underwriting involves selling of securities from the issuer to the public to ensure successful distribution. There can be two types of underwriting agreements, one, hard underwriting and two, soft underwriting. Hard underwriting is when an underwriter agrees to

Chartered Accountants providing consents separately as 'Auditors" and as "Reporting Accountant" should provide consents by issuing two separate consent letters.

37

38

Partner or proprietor, as the case may be

Part II : Guidance Notes

II.123

buy his commitment at its earliest stage. The underwriter guarantees a fixed amount to the issuer from the issue. Thus, in case the shares are not subscribed by investors, the issue is devolved on underwriters and they have to bring in the amount by subscribing to the shares. The risk borne by the underwriter in case of hard underwriting is much higher as compared to that in soft underwriting. Soft underwriting is when an underwriter agrees to buy the shares at later stages as soon as the pricing process is complete. He then, immediately places those shares with institutional players. The risk faced by the underwriter as such is reduced to a small window of time. Also, the soft underwriter has the option to invoke a force majeure clause in case there are certain factors beyond the control that can affect the underwriter's ability to place the shares with the buyers39. 3. From the above, it is clear that the underwriters and lead managers (hereinafter referred to as "requesting parties") to the issue face a lot of risk while dealing in public issues. Added to this is the fact that the regulator of the securities markets are normally very sensitive in the matters of ensuring free, fair and transparent issue process so that no body is able to obtain an undue advantage of the offer. Accordingly, most of the securities regulations provide heavy penalties in case any of the market players is found wanting on the grounds of the issue process or the information provided to the investors in the prospectus. For example, Section 15HB of the Securities and Exchange Board of India Act, 1994 provides for penalty upto Rupees one crore. As a consequence, underwriters and lead managers normally undertake a due diligence process on the information contained in the prospectus. As a part of that process, they also seek to obtain an added level of comfort from the auditors on a various aspects of the prospectus (in the form of a comfort letter), in addition to the report of the auditors already contained in the prospectus. This comfort letter is not to be filed with the regulator/ stock exchange(s). Normally, the need for a comfort letter is set out as a precondition in the underwriting agreement itself. 4. Since the auditor's association with the financial information contained in the prospectus is limited to the five financial years and the broken period, the requesting parties usually seek comfort letters in respect of such financial information in respect of which there is no report by the auditor but where for the requesting parties need a due diligence to be carried out to ensure correctness of such information. The extent of examination required to be done in respect of such financial information as would satisfy the requesting parties would need to be decided by themselves. The auditor(s) should carefully read the underwriting agreement and the agreement with the lead manager(s) to ascertain the scope of the comfort letter. 5. The comfort provided by the auditor would, however, be subject to certain limitations. One of the major limitations is that the auditor can comment in their professional capacity only on matters to which their professional expertise is substantially relevant. The second limitation is that the auditor would be able to provide only negative assurance on the information subjected to such examination. Thus, the requesting parties run a risk that the auditors might have provided negative assurance in respect of such conditions or matters that may later prove to have existed.

39

Source: SEBI.

II.124

Advanced Auditing & Professional Ethics

Process for Issuing a Comfort Letter 6. The auditor should obtain a copy of the agreement containing the request for a comfort letter and the scope thereof to adjudge whether they will be able to furnish a comfort letter as a desired in the agreement. The auditor should hold a meeting with the client as well as the requesting parties to discuss the scope of the comfort letter. Such a discussion would also help in clarifying as to the procedures that the latter expects to be followed by the auditor. The auditor should, however, make it clear that his acceptance of the engagement to provide a comfort letter does not in any way indicate his assurance about the sufficiency of the procedures that the requesting parties expect the auditor to perform. The fact should also be adequately brought out in the comfort letter issued by him. Further, the auditor should not agree to provide in the comfort letter any kind of assurance on his report already issued on the financial information contained in the prospectus. 7. In the interest of the auditor, client and the requesting parties, it is advisable that the auditor furnishes a draft comfort letter in accordance with the scope of such a letter as specified in the underwriting agreement. The draft comfort letter, to the extent possible, should cover all such matters as are to be covered in the final comfort letter, using exactly the same terms as to be used in the final letter. The auditor should, however, make it adequately clear: (i)

that the letter is a draft comfort letter; and

(ii)

that the comments that would be contained in the final comfort letter cannot be given until the auditor has performed the underlying procedures.

The draft comfort letter provides an opportunity to the concerned parties to discuss further the expected procedures to be followed by the auditor, as indicated in the draft comfort letter and request additional procedures. Where the additional procedures so requested are within the professional competence of the auditor, he would normally, be willing to perform them. It is advisable that the auditor then also furnishes a revised draft of the comfort letter. The fact that the requesting parties have accepted the draft comfort letter and subsequently, the final comfort letter, is an indication enough for the auditor that the former accept the auditor's procedures as being sufficient for their purposes. Thus, it is essential that the auditor's procedures are clearly set out in the draft as well as the final comfort letter. As mentioned earlier, the auditor does not undertake to assess the sufficiency or otherwise of the procedures that the underwriter/ lead manager expects the former to perform. Accordingly, statements, whether express or implied, to the effect that the auditor has carried out such procedures as they consider necessary should, normally, be avoided since this may create misunderstanding as to the responsibility for sufficiency of the procedures for the purposes of the requesting parties. Following is an illustrative wordings of the necessary caveats that may used in a draft comfort letter: "This draft is furnished solely for the purpose of indicating the form of letter that we would expect to be able to furnish________ [name of underwriter] in response to their request, the matters expected to be covered in the letter, and the nature of the procedures that we would expect to carry out with respect to such matters. Based on our discussions with ________ [name of underwriter], it is our understanding that the procedures outlined in this draft letter are those they wish us to follow. Unless [name of underwriter] informs us

Part II : Guidance Notes

II.125

otherwise, we shall assume that there are no additional procedures they wish us to follow. The text of the letter itself will depend, of course, on the results of the procedures, which we would not expect to complete until shortly before the letter is given and in no event before the cut-off date indicated therein.” 8. Further, before agreeing to provide a comfort letter, the auditor should also obtain a written representation from the requesting parties to the effect that they are aware of their responsibility to carry out a due diligence process and that and that the comfort letter provided by the auditor would not be a substitute for such a due diligence process required to be carried out by them. Thus, the representation letter issued by the requesting parties should, inter alia, clearly mention that: (a) the requesting parties are knowledgeable with respect to the due diligence review process required under Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000, as amended; and (b) in connection with the offering of Securities, the review process performed by the requesting parties is substantially consistent with the due diligence review process required under Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000, as amended. This fact also should be brought out in the comfort letter. The representation letter may also make references to the review process to be undertaken by the requesting parties in connection with the prospectus. This specific reference is necessary because the extent of that review (carried out in accordance with the principles enunciated in AAS 33, Engagements to Review Financial Statements) is fairly well understood by chartered accountants, lead managers, lawyers etc., and would provide the auditors with an objective basis against which the auditor can determine the level of assurance that he is willing to provide to the underwriter, given the inherent legal risk involved in being associated with a public offering of securities. Auditors should agree to provide negative assurance only where the requesting parties provide them with such a representation. In case the requesting parties refuse to provide such a representation, the auditors should, ordinarily, not undertake to provide a negative assurance in their comfort letters. In such a case, the procedures to be performed by the auditor should be agreed between the auditor and the requesting parties and adequately brought out in the engagement letter as well as the comfort letter. Thus, in the latter situation, the auditor would also need to bear the principles enunciated in the AAS 32, Engagements to Perform Agreed upon Procedures regarding Financial Information". A specimen representation letter is given in Annexure A to this Appendix. Engagement Letter 9. The terms of the engagement letter should clearly mention that the procedures do not constitute an audit conducted in accordance with the Auditing and Assurance Standards issued by the Institute of Chartered Accountants of India and that, accordingly, the same might not reveal all matters of significance. As a corollary, the engagement letter should clearly bring out the caveats associated with the procedures to be performed by the auditor, whether for providing a negative assurance as in case of a review or as agreed between the auditor and the requesting parties.

II.126

Advanced Auditing & Professional Ethics

10. In case the comfort letter is being issued by a member who was not the auditor of the financial statements of the immediately preceding year, he should obtain knowledge about the internal controls of the company over financial reporting. 11. Comments regarding subsequent changes typically relate to whether there has been any change in paid up share capital, increase in long-term debt or decreases in other specified financial statement items during a period, known as the "change period," subsequent to the date and period of the latest financial statements included (incorporated by reference) in the Prospectus. These comments would also address such matters as subsequent changes in the amounts of (a) net current assets or stockholders' equity and (b) net sales. The member will ordinarily be required to read minutes and make inquiries of company officials relating to the whole of the change period. For the period between the date of the latest financial statements made available and the cut-off date, the members must base their comments solely on the limited procedures actually performed with respect to that period (which, in most cases, will be limited to the reading of minutes and the inquiries of company officials) and their comfort letter should make this clear. 12. The underwriting agreement or other arrangements with requesting parties usually specifies the dates as of which, and periods for which, data at the cutoff date and data for the change period (change period is period in which changes subsequent to the date and period of the latest balance sheet occurred and it ends on cut off date) are to be compared. For balance sheet items, the comparison date is normally that of the latest balance sheet included (that is, immediately prior to the beginning of the change period). 13. For income statement items, the comparison period or periods might be one or more of the following: (a) the corresponding period of the preceding year, (b) a period of corresponding length immediately preceding the change period, (c) a proportionate part of the preceding fiscal year, or (d) any other period of corresponding length chosen by the underwriter. Whether or not specified in the underwriting agreement, the date and period used in comparison should be identified in the comfort letter in both draft and final form so that there is no misunderstanding about the matters being compared and so that the underwriter can determine whether the comparison period is suitable for their purposes. 14. The member should ensure that comments are made only with respect to information: (a) that is expressed in reporting currency (or percentages derived from such rupee amounts) and that has been obtained from accounting records that are subject to the entity's controls over financial reporting or (b) that has been derived directly from such accounting records by analysis or computation. The member may also comment on quantitative information that has been obtained from an accounting record if the information is subject to the same controls over financial reporting as the reporting currency amounts.

Part II : Guidance Notes

II.127

15. The member generally should not comment on matters: (a) merely because they happen to be present and are capable of reading, counting, measuring, or performing other functions that might be applicable. Examples of matters that, unless subjected to the entity's controls over financial reporting (which is not ordinarily the case), should ordinarily not be commented on by the member include the square footage of facilities, number of employees (except as related to a given payroll period), etc. (b) like tables, statistics, and other financial information relating to an unaudited period unless: (i)

they have performed an audit of the client's financial statements for a period including or immediately prior to the unaudited period or have completed an audit for a later period or

(ii)

they have otherwise obtained knowledge of the client's internal control. For example for the proper understanding of the control they should take some additional procedures, like, opening balances. In addition, the member should not comment on information subject to legal interpretation, such as beneficial share ownership.

Members are further advised to not include any such matter in the comfort letter, which is already covered in their report on the financial information contained in the prospectus. 16. To avoid ambiguity, the specific information commented on in the letter should be identified by reference to specific captions, tables, page numbers, paragraphs, or sentences. Descriptions of the procedures followed and the findings obtained may be stated individually for each item of specific information commented on. 17. In comments concerning tables, statistics, and other financial information, the expression "true and fair view" (or a variation of it, for example, "presented fairly") should not be used, as it is not an audit. That expression, when used by member, ordinarily relates to presentations of financial statements and should not be used in commenting on other types of information. 18. At times, it may happen, there is a time lag between the date the balance sheet/ accounts for the broken period are signed and the date of comfort letter exceeds more than 90 days period. Since no review-audit have been applied on financial information flowing from this period, it is suggested that the review procedures should be carried out for this period (at least for the quarter subsequent to reported period) before concluding on the comfort letter. Use of Services of Other Auditors 19. There may be situations in which more than one auditor is involved in the audit of the financial statements of an entity and in which the reports of more than one auditor appears in the Prospectus. For example, certain significant divisions, branches, or subsidiaries may be audited by other auditors, or during the 5 years' period there might have been a change in the' auditors also. In such a case, either of the following is possible: (a) separate comfort letters in respect of such past years are issued by the respective past auditors for submission as such to the requesting parties;

II.128

Advanced Auditing & Professional Ethics

(b) comfort letters are issued in respect of such past years by the respective past auditors and submitted to the principal auditor who in turn considers these comfort letters while issuing the comfort letter in respect of the entire five years; (c) the past auditors express their inability to provide comfort letters in respect of the financial statements of the past years audited by them. In case of (a) and (b) above, the client should, at the earliest practicable date, advise such other auditors as to the Comfort Letter that may be required from them and should arrange for them to receive a draft of the underwriting agreement so that they (other auditors) may make necessary arrangements at an early date for the preparation of a draft of their letter (a copy of which should be furnished to the principal auditors) and for the performance of their procedures. The principal auditors when asked to give a comfort letter with regard to information expressed on a overall basis, should read the letters of such other auditors. Such letters should contain statements similar to those contained in the comfort letter prepared by the principal auditor, including statements about their independence. The principal auditor should state in their comfort letters that (a) reading letters of the other auditors was one of the procedures followed, and (b) the procedures performed by the principal auditors (other than reading the letters of the other auditors) relate solely to companies audited by the principal auditor and to the overall financial statements. In case of (c) above, the principal auditor would need to carry out procedures necessary to provide the comfort letter for all the past five years; including such years in which he was not the auditor. Elements of a Comfort Letter 20. A comfort letter normally includes the following elements: (i) Addressee - The comfort letter should be addressed only to the client and the party requesting the comfort letter (for example, the underwriters). (ii)

A statement as to the independence of the auditors.

(iii) Introductory paragraph - The introductory paragraph of the comfort letter should draw attention to the report of the auditor on the financial information contained in the prospectus, adequately identifying the financial information as well in the prospectus. The auditor should not, however, reproduce his said report in the comfort letter. The introductory paragraph should also make a reference to any other report issued by the auditor in connection with the prospectus, identifying adequately the subject matter of the report. (iv) Scope paragraph - This paragraph would outline the scope of work of the auditor and the procedures to be performed by him, as agreed with the client and the parties requesting the comfort letter. Any limitations, agreed among the parties, subject to which the procedures would be performed, should also be appropriately brought out in this paragraph. However, where the auditor has been requested to provide negative assurance (i.e., carry out a review) in respect of certain information, it is not necessary for the auditor to describe the procedures performed by him. (v) Report paragraph - This paragraph should contain the findings or opinion reached by the auditor after performing the procedures outlined in the scope paragraph. Any limitations, in

Part II : Guidance Notes

II.129

addition to those described in the scope paragraph should also be disclosed in the report paragraph alongwith the impact, if any, of such limitations. (vi) Concluding paragraph - In order to avoid misunderstanding as to the purpose and intended use of the comfort letter, it is advisable that the comfort letter also includes a paragraph as to the purpose and intended use of the comfort letter. (vii) Signatures of the auditor (viii) Date (ix) Place An illustrative format of a comfort letter is given in the Annexure B to this Appendix. Annexure A Specimen Format of Representation Letter (Refer paragraph 7 of Appendix II) [Name and Address of the Chartered Accountant] Dear Sirs: [Name of the Financial Intermediary], each, as principal or agent, in the placement of [identify securities] to be issued by [name of issuer] (the "Issuer"), will be reviewing certain information relating to the Issuer that will be included in the Draft Red Herring Prospectus/ Red Herring Prospectus/ Prospectus which may be accessible to prospective investors and utilized by them as a basis for their investment decision. This review process, applied to the information relating to the Issuer, is (will be) consistent with the due diligence review process that we are required to perform in connection with the filing of the Draft Red Herring Prospectus/ Red Herring Prospectus/ Prospectus pursuant to the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000, as amended (the "Guidelines"). We are knowledgeable with respect to the due diligence review process under the Guidelines. We would require you to deliver us "comfort" letters as and when requested by us concerning the [financial statements] of the Issuer and certain statistical and other data included in the Draft Red Herring Prospectus/ Red Herring Prospectus/ Prospectus. We will contact you to identify the procedures we wish you to follow and the form we wish the comfort letters to take. This letter is solely for the information and use of [name of the Chartered Accountant Firm] in issuing comfort letters in connection with the proposed offering of securities in India of the Issuer and it is not to be used, circulated, quoted or otherwise referred to in the Draft Red Herring Prospectus/ Red Herring Prospectus/ Prospectus or any other document. Yours sincerely, [Name of the Lead Manager/ Underwriter] [Name of the Lead Manager/ Underwriter] as representatives of the several underwriters Place Date

II.130

Advanced Auditing & Professional Ethics Annexure B Specimen Format of the Comfort Letter

(Refer paragraph 18 of Appendix II) [Name of the Company & Address]40 and [Name of the LM 1 & Address] and [Name of the LM 2 & Address] and [Name of the LM 3 & Address] and [Name of the LM 4 & Address] The latter four addressees above is referred to herein as Lead Managers and on behalf of the several Managers (as defined below) Dear Sirs: Proposed Offering of________ Equity Shares of Rs ._______ each (the "Securities") pursuant to an Initial Public Offering in India of [Name of the Company] (the "Company") We have audited the [consolidated] financial statements of [Name of the Company] (the "Company") as of [dates] and also for each of the [no. of years] years in the period ended [last date audited] and [no. of months in interim period, if any] period ended [interim periods ended last date for current year and previous year] included in the Company's [Draft Red Herring Prospectus/Red Herring Prospectus].( State number of years not audited by the Principal Auditor and state the reliance placed on the work done by other auditors) We did not audit the financial statements of certain subsidiaries, whose financial statements reflect total assets of Rs. xxx as at [dates] and total revenues of Rs. xxx for the years ended on [dates] respectively. Further, we did not audit the financial statements of associates and Joint ventures whose financial statements reflect the consolidated entities' share of profits of Rs. xxx for the years ended [dates] respectively. These financial statements have been audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to the amounts included in respect of such subsidiaries, associates and joint ventures, is based solely on the report of the other auditors41. The consolidated financial statements referred to above have been prepared in accordance with the generally accepted accounting principles in India and are included in the [Draft Red Herring Prospectus I Red Herring Prospectus] for the proposed offering of securities pursuant to an Initial Public Offering in India of the Company. Our reports with respect thereto are also included in the [Draft Red Herring Prospectus / Red Herring Prospectus]. The [Draft Red Herring Prospectus / Red Herring Prospectus] dated [xxx] is herein referred to as the [DRHP / RHP]. This letter is being furnished in reliance upon your representation to us that:

40

The letter is addressed to the company for information only.

This paragraph is applicable only in cases where all the entities are not audited by principal auditor and has relied on other auditors.

41

Part II : Guidance Notes

II.131

a.

You are knowledgeable with respect to the due diligence review process required under Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000, as amended.

b.

In connection with the offering of Securities, the review process you have performed is substantially consistent with the due diligence review process required under Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000, as amended.

In connection with the [DRHP / RHP]: 1.

We are independent Chartered Accountants with respect to the Company.

2.

We have not audited any financial statements of the Company as of any date or for any period subsequent to [latest audited date]; although we have conducted an audit for the year ended [latest audited date], the purpose (and therefore the scope) of the audit was to enable us to express an opinion on the [consolidated] financial statements as of [latest audited date] and for the year then ended, but not on the financial statements for any interim period within that year. Therefore, we are unable to and do not express any opinion on the unaudited [consolidated] balance sheet as of [latest interim review date] and the unaudited [consolidated] statements of income and cash flows for the [no. of months for which limited review is done] periods ended [latest interim review date and the corresponding previous period date] in the DRHP / RHP, or on the financial position, results of operations, or cash flows as of any date or for any period subsequent to [latest audited date].

3.

For purposes of this letter, we have read the [mention the year] minutes of the meetings of the shareholders, the Board of Directors, and (include other appropriate committees, if any) of the Company and [its subsidiaries] as set forth in minute books as of [cut-off date - generally three business day before the date of the comfort letter], officials of the Company having advised us that the minutes of all such meetings through that date were set forth therein (except for the minutes of the [dates] Board of Directors meeting which were not approved in final form, for which drafts were provided to us; officials of the Company have represented that such drafts include all substantive actions taken at such meeting), and have carried out other procedures to [cut-off date] (our work did not extend to the period from [cut-off date to date of comfort letter], inclusive), as follows: a.

With respect to the [mention no. months] periods ended [current period and corresponding previous period], we have performed the procedures (completed on [mention date of limited review opinion]) specified by the listing agreements of respective stock exchanges and as described in Auditing and Assurance Standard (AAS) 33, Engagements to Review Financial Statements issued by the Institute of Chartered Accountants of India, on the unaudited [ consolidated] balance sheet as of [latest interim review date] and the unaudited [ consolidated] statements of income and of cash flows for the [no. of months for which limited review is done] periods ended [latest interim review date and the corresponding previous period date] in the DRHP / RHP.

II.132 b.

Advanced Auditing & Professional Ethics

With respect to the period from [date after the latest interim review date] to [agreed period end], we have: (i)

read the unaudited [consolidated] financial data of the Company for [the periods] of both [latest year] and [previous year], furnished to us by the Company, officials of the Company having advised us that no such financial data as of any date or for any period subsequent to [agreed period end], were available. The financial information for [the periods] of both [latest year] and [previous year] is incomplete in that it omits the statements of cash flows and other disclosures.

(ii)

inquired of certain officials of the Company who have responsibility for financial and accounting matters whether the unaudited financial data referred to in b(i) are stated on a basis substantially consistent with that of the audited financial statements [included or incorporated by reference] in the DRHP / RHP.

The foregoing procedures do not constitute an audit made in accordance with Auditing and Assurance Standards in India. Also, they would not necessarily reveal matters of significance with respect to the comments in the following paragraph. Accordingly, we make no representations regarding the sufficiency of the foregoing procedures for your purposes. 4. Nothing came to our attention as a result of the foregoing procedures, however, that caused us to believe that: a.

any material modifications should be made to the unaudited [consolidated] financial statements described in 3a. for them to be in conformity with generally accepted accounting principles, or (i)

at [agreed period end], there was any change in paid-up capital, increase in longterm debt or any decrease in [consolidated] net current assets (working capital) or shareholders' equity of the Company and subsidiaries [consolidated] as compared with amounts shown on the [latest interim review date] unaudited [ consolidated] balance sheet included in the DRHP/RHP, or

(ii)

for the period from [date after the latest interim review date] to [agreed period end], there were any decreases, as compared to the corresponding period in the preceding year, in total [consolidated] net sales, income from operations or net income, except in all instances for increases or decreases that the DRHP/RHP discloses have occurred or may occur.

5. As mentioned in 3b, Company officials have advised us that no [consolidated] financial data as of any date or for any period subsequent to [agreed period end], are available; accordingly, the procedures carried out by us with respect to changes in financial statement items after [agreed period end], have, of necessity, been even more limited than those with respect to the periods referred to in 3. We have inquired of certain officials of the Company who have responsibility for financial and accounting matters whether (i) at [cut off date] there was any change in the paid-up capital, increase in long-term debt or decrease in [consolidated] net current assets (working capital) or shareholders' equity of the Company as compared with amounts shown on the [latest interim review date] unaudited [consolidated] balance sheet included in the DRHP/RHP; or (ii) for the period from [date after the latest interim review date] to [cut-off date], there were any decreases, as compared with the

Part II : Guidance Notes

II.133

corresponding period in the preceding year, in total [consolidated] net sales, income from operations or net income42. On the basis of these inquiries and our reading of the minutes as described in 3, nothing came to our attention that caused us to believe that there was any such change, increase or decrease, except in all instances that the DRHP/RHP discloses have occurred or may occur. 6. For purposes of this letter, we have also read the items identified by you on the attached copy of the [DRHP / RHP] and have performed the following procedures, which were applied as indicated with respect to the letters explained below. a.

Compared the amount identified to a corresponding amount in the Company's audited consolidated financial statements, included in the [DRHP / RHP] for the period indicated and found such amount to be in agreement.

b.

Compared the amount identified to a corresponding amount included in the Company's accounting records for the period indicated and found such amount to be in agreement.

c.

Compared the amount identified to a schedule prepared by the officials of the Company from its accounting records for the period indicated and found such amount to be in agreement. We (a) compared the amounts on the schedule to the corresponding amounts appearing in the accounting records and found such amounts to be in agreement and (b) determined that schedule was mathematically correct. However, we make no comment with respect to classification of items included on the schedule and with respect to reasons given for the changes between periods.

d.

Recomputed the mathematical accuracy of the amounts, total, percentage and ratio for the period indicated from amounts appearing in the financial statements or accounting records, as defined in the [DRHP / RHP). However, we make no comment as to the appropriateness with respect to classification of such item and with respect to reasons given for the changes between periods.

e.

Proved the arithmetic accuracy of the conversion of the corresponding amount in Rupees to US dollars (as rounded off), or vice versa, at the applicable exchange rate and found them to be in agreement.

Member should exercise judgment on what level of comfort i.e. item (a) to (e) above can be given to a particular information according to the circumstance of each case. Wherever reliance has been placed on the work done by other auditor, it is advisable that reference of same should be made specifically and copy of the comfort letter should also be enclosed. 7. Our audits of the consolidated financial statements for the periods referred to in the introductory paragraph of this letter comprised audit tests and procedures deemed necessary for the purpose of expressing an opinion on such financial statements taken as a whole. For none of the periods referred to therein, or any other period, did we perform audit tests for the purpose of expressing an opinion on individual balances of accounts or summaries of selected

In the absence of information, it may not be possible to provide comforts and hence care needs to be taken under this paragraph while reporting on many of the information. Therefore, comfort should be provided only where information has been provided appropriately.

42

II.134

Advanced Auditing & Professional Ethics

transactions such as those enumerated above and, accordingly, we express no opinion thereon. 8. The procedures enumerated in paragraphs 6 do not constitute an audit conducted in accordance with Auditing and Assurance Standards in India. Accordingly, we make no representations regarding the sufficiency of the foregoing procedures for your purposes. 9. It should be understood that we make no representations regarding questions of legal interpretation or regarding the sufficiency for your purposes of the procedures enumerated in the preceding paragraphs; also, such procedures would not necessarily reveal any material misstatement of the amounts or percentages listed above. Further, we have addressed ourselves solely to the foregoing data as set forth in the DRHP/RHP and make no representations regarding the adequacy of disclosure or regarding whether any material facts have been omitted. It should be noted that certain information contained in the [DRHP / RHP] are not measures of operating performance or liquidity as defined by generally accepted accounting principles and may not be comparable to similarly titled measures presented by other companies. We make no comment about the Company's definitions, calculations or presentations of the above-mentioned information in the [DRHP / RHP] or its usefulness for any purpose. 10. This letter is solely for the information of the addressees and to assist the Lead Managers in conducting and documenting its investigation of the affairs of the Company in connection with the proposed offering of securities covered by the DRHP/RHP solely in India, and it is not to be used, circulated, quoted, or otherwise referred to for any other purpose, including but not limited to the registration, purchase or sale of securities, nor is it to be filed with or referred to in whole or in part in the DRHP/RHP or any other document, except that reference may be made to it in any list of closing documents pertaining to the proposed offering of securities covered by the DRHP/RHP. 11. This letter has not been prepared in connection with, nor is it intended for use in connection with, any offer or sale of the securities outside India. We will accept no duty or responsibility to and deny any liability to any party in respect of any use of this letter in connection with an offer or sale of the Securities outside India/any other specific jurisdiction. For ABC and Co. Chartered Accountants Signature [Name of the Member] Designation43 Membership Number Place of Signature: Date:

43

Partner or proprietor.

Part II : Guidance Notes

II.135

Appendix 3 Capitallsation Statement [Refer Paragraph 2.3(iii)] [Schedule XIII- Clause 6.10.2.7 (g) (iii)] (Rupees in lacs) Pre-issue as at 30.06.2006 Short-Term Debt

1870

Long Term Debt

4370

Post-issue position after adjustments44

Shareholders Funds Share Capital

4000

Reserves

14570

Total Shareholders Funds

18570

Long Term Debt/Equity

0:24:1

Note:

Appendix 4 Specimen Auditors' Report on Financial Information in Relation to Prospectus (on stand alone financial information of the issuer Company) (Refer paragraph 2.5) To The Board of Directors, .................................... Ltd. Dear Sirs, 1)

We have examined the attached financial information of.................................. Ltd (name of the Company), as approved by the Board of Directors of the Company, prepared in terms of the requirements of Paragraph B, Part II of Schedule II of the Companies Act, 1956 (“the Act") and the Securities and Exchange Board of India (Disclosure and Investor

In case the share price of issue is not known at the time of bringing out the prospectus then post issue position cannot be presented. In such case footnote explaining the same should be given.

44

II.136

Advanced Auditing & Professional Ethics

Protection) Guidelines, 2000 as amended to date (SEBI Guidelines) and in terms of our engagement agreed upon with you in accordance with our engagement letter dated XX.XX. 2XX5 in connection with the proposed issue of Equity shares of the Company. 2.

These information have been extracted by the Management from the financial statements for the year ended XX.XX.2XX1, 2XX2, 2XX3, 2XX4 and 2XX5. Audit for the financial year ended XX.XX.2XX1 and 2XX2 was conducted by previous auditors, XYZ & Co., and accordingly reliance has been placed on the financial information examined by them for the said years45. The financial report included for these years, i.e.., 2XX1 & 2XX2 are based solely on the report submitted by them. M/s XYZ & Co. have also confirmed that the restated financial information has been made after incorporating: (a) Adjustments for the changes in accounting policies retrospectively in respective financial years to reflect the same accounting treatment as per changed accounting policy for all the reporting periods. (b) Adjustments for the material amounts in the respective financial years to which they relate. (c) And there are no extra-ordinary items that need to be disclosed separately in the accounts and qualification requiring adjustments.

3.

We have also examined the financial information of the Company for the period XX.XX.2XX5 to XX.XX.2XX5 prepared and approved by the Board of Directors for the purpose of disclosure in the offer document of the Company mentioned in Paragraph (1) above (the broken period ending not before six months from the date of prospectus). The financial information for the above period was examined to the extent practicable, for the purpose of audit of financial information in accordance with the Auditing and Assurance Standards issued by the Institute of Chartered Accountants of India. Those Standards require that we plan and perform our audit to obtain reasonable assurance, whether the financial information under examination is free of material misstatement. Based on the above, we report that in our opinion and according to the information and explanations given to us, we have found the same to be correct and the same have been accordingly used in the financial information appropriately.

4)

In accordance with the requirements of Paragraph B of Part II of Schedule II of the Act, the SEBI Guidelines and terms of our engagement agreed with you, we further report that:

Applicable only when some of the reported financial years were audited by an auditor other than the current auditor.

45

Part II : Guidance Notes

II.137

(a) The Restated Summary Statement of Assets and Liabilities of the Company46, including as at XX.XX.2XX1, and 2XX2 examined and reported upon by M/s XYZ & Co., on which reliance has been placed by us, and as at XX.XX.2XX3, 2XX4, 2XX5 and 2XX5 examined by us, as set out in Annexure to this report are after making adjustments and regrouping as in our opinion were appropriate and more fully* described in Significant Accounting Policies, Note and Changes in Significant Accounting Policies (Refer Annexures). (b) The Restated Summary Statement of Profit or Loss of the Company for the year then ended, including for the year ended XX.XX.2XX1, and 2XX2 examined by XYZ & Co. and who have submitted their report on which reliance has been placed by us, and for the year ended XX.XX.2XX3, 2XX4 and 2XX5 and for the period XX.XX.2XX5 to XX.XX.2XX5 examined by us, as set out in Annexure to this report are after making adjustments and regrouping as in our opinion were appropriate and more fully described in Significant Accounting Policies, Note and Changes in Significant Accounting Policies (Refer Annexures). (c) Based on above and also as per the reliance placed on the reports submitted by the previous auditors, XYZ & Co. for the respective years, we are of the opinion that that the restated financial information have been made after incorporating: (i)

adjustments for the changes in accounting policies retrospectively in respective financial years to reflect the same accounting treatment as per changed accounting policy for all the reporting periods.

(ii)

Adjustments for the material amounts in the respective financial years to which they relate.

(iii) And there are no extraordinary items that need to be disclosed separately in the accounts and qualification requiring adjustments. (d) We have also examined the following other financial information setout in Annexures prepared by the management and approved by the Board of Directors relating to the Company for the year ended XX.XX.2XX3, X4, X5 and period from XX.XX.2XX5 to XX.XX.2XX5. In respect of the years ended XX.XX.2XX1 and 2XX2 these informations have been included based upon the reports submitted by previous auditors XYZ & Co. and relied upon by us.

46

(i)

Statement of Dividend paid/proposed included in Annexure ______.

(ii)

Statement of Accounting Ratios included in Annexure ______.

(a) Members may note that in case the company is having subsidiaries but no consolidated accounts are prepared, the auditor should also provide opinion on the statement of assets and liabilities of subsidiary as required by paragraph 3 of part II of Schedule II to the Companies Act, 1956 and paragraph 6.10.2.3 of the DIP Guidelines.

(b)

At times, the issuer company may also request the auditor to provide his report on the cash flow statement included in the prospectus. In such circumstances, the members report would also include a reference to such cash flow statement examined by them.

II.138

Advanced Auditing & Professional Ethics (iii) Statement of Capitalisation as at XX.XX.2XX5 included in Annexure ______. (iv) Statement of Secured and Unsecured Loans included in Annexure ______. (v) Statement of Other Income included Annexure ______. (vi) Statement of Tax Shelter included in Annexure ______. In our opinion the financial information contained in Annexure to_____ of this report read along with the Significant Accounting Policies, Changes in Significant Accounting Policies and Notes (Refer Annexures) prepared after making adjustments and regrouping as considered appropriate have been prepared in accordance with Part lIB of Schedule II of the Act and the DIP Guidelines.

5)

Our report is intended solely for use of the management and for inclusion in the offer document in connection with the proposed issue of equity shares of the Company. Our report and should not be used for any other purpose except with our consent in writing. For ABC and Co. Chartered Accountants Signature [Name of the Member] Designation47 Membership Number

Place of Signature: Date: Appendix 5 Specimen Auditors' Report on Financial Information in relation to Prospectus (on consolidated financial information of the issuer Company) (Refer paragraph 2.5) To The Board of Directors, ................................ Ltd. Dear Sirs, 1)

47

We have examined the attached consolidated financial information of .......................Ltd (name of the Company) and its subsidiaries and joint ventures (include as applicable), as

Partner or proprietor

Part II : Guidance Notes

2)

3)

II.139

approved by the Board of Directors of the Company prepared in terms of the requirements of Paragraph B, Part II of Schedule II of the Companies Act, 1956 (the Act) and the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000 as amended to date (SEBI Guidelines) and terms of our engagement agreed with you in accordance with our letter dated XX.XX.2XX5 in connection with the proposed issue of Equity shares of the Company. These information have been prepared by the Management from the financial statements for the year ended XX.XX.2XX1, 2XX2, 2XX3, 2XX4 and 2XX5. Audit for the financial year ended XX.XX.2XX1, and 2XX2 was conducted by previous auditors, XYZ & Co.48" and accordingly reliance has been placed on the consolidated financial information examined by them for the said years. The financial report included for these years are based solely on the report submitted by them. We did not audit the financial statements of the subsidiaries, and joint ventures (as applicable) for the financial years ended ...................and ................... whose Financial Statements reflect total assets of Rs. XXX and total revenue of Rs. XXX (to be reported for each of the financial years). These financial statements have been audited by another firm of Chartered Accountants ABC & Co., whose reports have been furnished to us and our opinion in so far as it relates to the amounts included in these Consolidated Restated Summary Statement of Asset & Liabilities and Consolidated Restated Summary Statement of Profit & Loss Account are based solely on the report of other auditors. These other auditors (of the Company & Subsidiaries, Joint Ventures) have confirmed that the restated consolidated financial information has been made after incorporating: (i) adjustments for the changes in accounting policies retrospectively in respective financial years to reflect the same accounting treatment as per changed accounting policy for all the reporting periods. (ii) Adjustments for the material amounts in the respective financial years to which they relate. There are no extraordinary items that need to be disclosed separately in the accounts and qualification requiring adjustments. We have also examined the consolidated financial information of the Company and its subsidiaries and joint ventures (include as applicable) for the period XX.XX.2XX5 to XX.XX.2XX5 prepared and approved by the Board of Directors for the purpose of disclosure in the offer document of the Company mentioned in Paragraph (1) above (the broken period ending not before six months from the date of prospectus). The consolidated financial information for the above period was examined to the extent applicable for the purpose of audit of financial information in accordance with the Auditing and Assurance Standards issued by the Institute of Chartered Accountants of India. Those Standards require that we plan and perform our audit to obtain reasonable

Applicable only when some of the reported financial years where audited by an auditor other than the current auditor.

48

II.140

Advanced Auditing & Professional Ethics

assurance, whether the consolidated financial information under examination is free of material misstatement. Based on the above, we report that in our opinion and according to the information and explanations given to us, we have found the same to be correct and the same have been used in the consolidated financial information appropriately. We did not audit the financial statements of the subsidiaries and joint ventures for the period ended XX.XX.2XX5 whose Financial Statements reflect total assets of Rs. XXX and total revenue of Rs. XXX. These financial statements have been audited by another firm of Chartered Accountants, M/s ABC & Co., whose reports have been furnished to us and our opinion in so far as it relates to the amounts included in these Consolidated Summary Statement of Asset & Liabilities and Summary Statement of Profit & Loss Account are based solely on the report of other auditors. 4)

In accordance with the requirements of Paragraph B of Part II of Schedule II of the Act, the SEBI Guidelines and terms of our engagement agreed with you; we further report that: (a) The Consolidated Restated Summary Statement of Assets and Liabilities49 of the Company and its subsidiaries and joint ventures (include as applicable), including as at XX.XX.2XX1 and 2XX2 examined by XYZ & Co. and who have submitted their report on which reliance has been placed by us, and as at XX.XX.2XX3, 2XX4, 2XX5 and XX.XX.2XX5 examined by us, as set out in Annexure to this report are after making adjustments and regrouping as in our opinion were appropriate and more fully described in Significant Accounting Policies, Note and Changes in Significant Accounting Policies (Refer Annexures). (b) The Consolidated Statement of Restated Summary Statement of Profit or Loss of the Company and its subsidiaries and joint ventures (include as applicable) for the year than ended, including for the year ended XX.XX.2XX1, and X2 examined by XYZ & Co. and who have submitted their report on which reliance has been placed by us, and for the year ended XX.XX.2XX3, 2XX4, and 2XX5 and for the period XX.XX.2XX5 to XX.XX.2XX5 examined by us, as set out in Annexure to this report are after making adjustments and regrouping as in our opinion were appropriate and more fully described in Significant Accounting Policies, Note and Changes in Significant Accounting Policies (Refer Annexures). (c) Based on above and also as per the reliance placed on the reports submitted by the previous auditors, XYZ & Co., and other auditors, ABC & Co., for subsidiaries/joint ventures, for the respective years, we confirm that the restated financial information has been made after incorporating:

At times, the issuer company may also request the auditor to provide his report on the cash flow statement included in the prospectus. In such circumstances, the members' report would also include a reference to such cash flow statement examined by them.

49

Part II : Guidance Notes (i)

II.141

Adjustments for the changes in accounting policies retrospectively in respective financial years to reflect the same accounting treatment as per changed accounting policy for all the reporting periods.

(ii)

5)

Adjustments for the material amounts in the respective financial years to which they relate. (iii) Further, there are no extraordinary items that need to be disclosed separately in the accounts and qualification requiring adjustments. (a) We have also examined the following consolidated other financial information setout in Annexures prepared by the management and approved by the Board of Directors relating to the Company and its subsidiaries and joint ventures for the year ended XX.XX.2XX3, 2XX4, and 2XX5 and for the period XX.XX.2XX5 to XX.XX.2XX5. In respect to the year ended XX.XX.2XX1 and 2XX2 these informations have been included based upon the reports submitted by the previous auditors, XYZ & Co., and relied upon by us. (i) Statement of Dividend paid/proposed included in Annexure _____. (ii) Statement of Accounting Ratios included in Annexure _____. (iii) Statement of Capitalisation as at XX.XX.2XX5 included in Annexure _____. (iv) Statement of Secured and Unsecured Loans included in Annexure _____. (v) Statement of Other Income included Annexure _____. (vi) Statement of Tax Shelter included in Annexure _____. (Please include additional statements, if any on which the assurance is provided) In our opinion the financial information contained in Annexure to of this report read along with the Significant Accounting Policies, Notes and Changes in Significant Accounting Policies (Refer Annexure) prepared after making adjustments and regrouping as considered appropriate have been prepared in accordance with Part lIB of Schedule II of the Act and the DIP Guidelines. Our report is intended solely for use of the management and for inclusion in the offer document in connection the proposed issue of equity shares of the Company. Our report and should not be used for any other purpose except with our consent in writing. For ABC and Co. Chartered Accountants Signature [Name of the Member] Designation50

50

Partner or proprietor, as the case may be

II.142

Advanced Auditing & Professional Ethics Membership Number

Place of Signature: Date:

Part II : Guidance Notes

II.143

Appendix 6 Illustrative Format of Restated Financial Statements (Refer Paragraph 2.5) Annexure 1 : Summary Statement of Assets and Liabilities, as restated (Amount INR '000) PARTICULARS

31-Mar-05 31-Mar-04 31-Mar-03 31-Mar-02

31-Mar-01

Gross Block

3,085,112

3,134,793

2,273,697

1,785,194

1,719,217

Less: Depreciation

-1,184,634 -1,060,145

- 715,210

- 559,755

-438,106

Net Block

1,900,478

2,074,648

1,558,487

1,225,439

1,281,111

- 61,265

-77,929

-95,725

- 111,976

- 128,227

1,839,213

1,996,719

1,462,762

1,113,463

1,152,884

71,472

16,552

82,147

70,845

14,375

INTANGIBLE ASSETS

261,822

314,738

4,115

5,601

7,293

INVESTMENTS

274,291

459,743

495,659

314,555

394,409

Inventories

1,983,713

1,536,933

660,523

500,250

496,885

Sundry Debtors

1,557,715

1,078,605

1,147,991

646,138

333,616

151,696

158,651

347,300

92,288

38,641

Other Current Assets

26,535

19,978

6,498

4,034

4,825

Loans and Advances

740,559

816,193

1,056,870

691,939

550,148

6,907,016

6,398,712

5,264,465

3,439,113

2,993,676

2,264,892

2,987,191

2,630,611

1,559,968

1,307,826

FIXED ASSETS

Less: Revaluation Reserve (See Note No.5 of Annexure IV) Net Block after adjustment for Revaluation Reserve Capital Work in Progress including Capital Advances

CURRENT ASSETS, LOANS AND ADVANCES

Cash and bank Balances

Total LIABILITIES & PROVISIONS Secured Loans

II.144

Advanced Auditing & Professional Ethics

Unsecured Loans

584,190

208,606

73,626

71,240

129,800

Current liabilities

1,388,424

1,668,535

1,381,579

777,778

538,701

37,735

21,585

6,334

5,181

18,995

–

32

545

545

1,204

288,184

285,910

252,879

–

–

Total

4,563,524

5,171,859

4,345,574

2,414,712

1,998,526

Net Worth

2,343,591

1,226,853

918,891

1,024,401

997,150

126,174

103,233

103,224

103,224

103,224

2,278,682

1,206,155

919,892

1,047,607

1,048,625

Less: Revaluation Reserve(See Note No.5 of Annexure IV)

–61,265

–77,929

–95,725

–111,976

–128,227

Reserves & Surplus (Net of Revaluation Reserves)

2,217,417

1,128,226

824,167

935,631

920,398

–

–4,606

–8,500

–14,454

–26,472

2,343,591

1,226,853

918,891

1,024,401

997,150

Provisions Deferred Payments Deferred Tax liability

New worth represented by Share Capital Reserves & Surplus

Less: Miscellaneous Expenditure (to the extent not written off or adjusted) Net Worth Note :

The above statement should be read with the notes on Adjustments to Restated Financial Statements, Significant Accounting policies and notes to Accounts as appearing in Annexures IV and IV-A. Annexure II

Summary Statement of Profits and Losses, as restated (Amount in INR ’000) Particulars

31-Mar-05

31-Mar-04

31-Mar-03

31-Mar-02

31-Mar-01

7,147,143

7,001,201

3,864,767

2,216,922

2,47,1449

240,751

73,510

17,526

45,310

32,900

9,180

0

0

0

0

INCOME Contract Revenue Other Income Unspent Liabilities written

Part II : Guidance Notes

II.145

back-ISP Division (see Note No. 8a of Annexure IV

0

0

0

0

0

65,000

0

0

0

0

7,462,074

7,074,711

3,882,293

2,262,232

2,504,349

1,887,500

1,953,553

1,238,261

864,216

694,302

861,818

613,888

260,135

193,537

255,565

9,300

13,403

12,310

9,108

7,198

3,900,301

3,293,146

1,786,409

786,839

1,067,241

368,987

437,479

284,278

230,157

211,989

Miscellaneous Expenditure Written Off

23,052

11,171

5,954

12,019

10,497

Depreciation/Amortization

358,909

353,273

131,299

113,302

104,963

7,409,867

6,675,913

3,718,646

2,209,223

235,1755

PROFIT BEFORE TAX

52,207

398,798

163,647

53,009

152,594

PROVISION FOR TAX

0

0

0

0

0

Current Tax

16,031

49,799

32,500

11,250

35,587

Deferred Tax

–4,540

30,118

26,263

0

0

TOTAL

11,491

79,917

58,763

11,250

35,587

NET PROFIT BEFORE ADJUSTMENTS

40,716

318,881

104,884

41,759

117,007

–66,971

–12,891

29,386

–21,256

50,632

Current Tax Impact of Adjustments

36,198

25,369

–18,728

2,693

–29,726

Deferred Tax impact of Adjustments

–6,814

–2,913

2,366

0

0

–37,587

9,565

13,024

–18,563

20,906

Waiver of funded interest (See Note No. 13 of Annexure IV-B Total Income EXPENDITURE Materials Consumed and Cost of Goods Sold Staff Cost Selling and Distribution Expenses Operating and Administrative Expenses Interest

Total Expenditure

Adjustments (See Note No. 2 of Annexure IV

Total adjustments after Tax Impact

II.146

Advanced Auditing & Professional Ethics

NET PROFIT AS RESTATED

3,129

328,446

117,908

23,196

137,913

764,834

420,224

326,066

562,573

470,179

Transfer From Debenture Redemption Reserve

41,652

0

0

0

0

Transfer From Foreign Project Utilised Reserve

7,500

76,750

0

0

0

817,115

825,420

443,974

585,769

608,092

10,000

31,000

12,500

4,000

10,000

0

3,750

11,250

5,000

11,250

Reserve

0

2,513

0

10,050

10,050

Dividend

0

0

0

0

0

9,119

20,646

0

0

12,903

Interim Dividend

0

0

0

7,226

0

Tax on Dividend

1,279

2,678

0

737

1,316

20,398

60,586

23,750

27,013

45,519

796,717

764,834

420,224

558,756

562,573

Profit and loss amount at the beginning of the year

Balance available for appropriation, as restated APPROPRIATIONS Transfer to General Reserve Transfer to Foreign Project Reserve Transfer to Debenture Redemption

Equity

TOTAL BALANCE CARRIED FORWARDS RESTATED Note: 1.

The above statement should be read with the Notes on Adjustments to Restated Financial Statements, Significant Accounting Policies and Notes to Accounts as appearing in Annexures IV and IV-A.

2.

The reconciliation between the audited and restated accumulated profit and loss balance as at April 01, 2000 is given in Note No.6 of Annexure IV.

*

The company adopted Accounting Standard 22, (AS 22) - Accounting for Taxes on Income issued by the Institute of Chartered Accountants of India for the first time in preparing the financial statements for the year ended March 31, 2003. The above amount is after adjusting Rs. 232691 thousand related to Deferred Tax Liability for earlier years.

Part II : Guidance Notes

II.147

Annexure III : Statement of Cash Flows, As Restated (Amount in INR'000) 31-Mar-05 31-Mar-06 31-Mar-03 31-Mar-02

Cash Flow From Operating Activities Profit before Tax -14,765 385,907 193,033 31,754 Adjustment for 0 0 0 0 Depreciation/ Amortization 306,768 358,661 154,225 120,486 (Including Goodwill) Miscellaneous Expenditure written 4,606 29,616 5,953 12,019 off Loss on Sale of Fixed Assets (Net) 28,644 1,702 4,040 7,193 (Profit/Loss on sale of Long Term Investments (Net) -71,596 20,115 0 6,940 Interest Income - 12,428 - 4,542 - 2,579 -1,331 Waiver of Funded Interest - 65,000 0 0 0 Dividend on Long Term Investments - 2,564 -697 - 3,242 -13,550 Depletion in value of Long Term Investment 688 0 0 0 Amortisation/Depletion in value of Inventory 4,113 0 0 0 Interest Income 346,774 450,795 290,117 228,904 Provision for Doubtful Debtors (Net) 4,150 0 0 0 Provision for Doubtful Debts and Advances (Net) 0 456 0 0 Operating Profit before working capital changes 529,390 1,242,013 641,547 392,415 Movements in Working Capital (Increase)/Decrease in Sundry Debtors - 483,261 82,131 - 501,852 -312,523 (Increase)/Decrease in Loans and Advances 165,642 351,890 - 375,878 -117,003 (Increase )/Decrease in Other Current Assets 4,084 - 13,365 - 1,779 -60 (Increase )/Decrease in Inventories - 450,893 - 858,792 -160,273 - 3,365 (Increase )/Decrease in Current Liabilities and Provisions - 276,875 145,290 603,717 242,312

31-Mar-01

203,227 0 111,627 10,498 29,265 0 - 8,686 0 - 7,365 0 0 166,426 0 0 504,992

- 53,479 -47,172 0 -19,324 173,776

II.148

Advanced Auditing & Professional Ethics

(Increase )/Decrease in Miscellaneous Expenditure 0 0 0 Cash generated from operations -511,913 949,167 205,482 Direct Tax Refunds /Paid (Net) - 54,895 -108,991 - 40,282 New cash from/(Used in) Operating Activities - 566,808 840,176 165,200 Cash flow from investing Activities Purchase of Fixed Assets -261,977 -277,133 - 534,365 Purchase of Investments - 28,079 - 96,671 -181,105 Proceeds from Sale of Investments 284,439 46,125 0 Proceeds from sale of Fixed Assets 82,067 1,901 16,387 Dividend Received 2,564 697 3,242 Interest Received 1,787 4,427 1,894 Exchange Fluctuation Reserve - 3,572 - 1,062 -390 Net Cash From (used in) Investing activities 77,229 - 321,716 - 694,337 Cash flows from Financing Activities Proceeds of Share Capital 22,941 0 0 Proceeds of Securities Premium 1,100,031 0 0 Increase/(Decrease) in Working Capital Loans - 242,283 - 254,344 155,923 Increase/(Decrease) in secured -415,016 108,573 928,054 Term Loans Redemption of Debentures - 6,060 -19,393 -19,393 Increase/(Decrease) in Unsecured Loans 381,644 -88,795 8,446 Increase/(Decrease) in Deferred Payments -32 -513 0 Interest Paid - 345,697 - 449,724 - 288,880 Dividend Paid - 12904 - 7,741 0 Net Cash From/(Used in) Financing activities 482,624 -711,937 784,150 Net increase in Cash and Cash Equivalents (A+B+C) -6,955 -193,477 255,013 Cash and Equivalents

0 201,776 - 34,799

-15,208 543,585 -34,114

166,977

509,471

-155,715 - 6,377 79,291 12,678 13,550 2,181 0

- 236,973 - 204,411 0 31,462 7,365 6,273 0

- 54,392

- 396,284

0 0

0 0

229,683

172,982

36,001

-46,419

-19,394

0

- 52,500

- 67,444

-659 -231,941 -20,129

0 - 164,429 - 12,903

- 58,939

- 118,213

53,646

- 5,026

Part II : Guidance Notes inflow consequent to merger Cash and Cash Equivalents at the beginning of the year Cash and Cash Equivalents at the end of the year Components of Cash and Cash Equivalents Cash in Hand Balance with Scheduled Banks Current Account EEFC Account Fixed Deposits Balances with Non Scheduled Banks Current Accounts EEFC Account

II.149

0

4,828

0

0

0

158,651

347,300

92,288

38,642

43,668

151,696

158,651

347,301

92,288

38,642

12,676 11,228 0 0 66,951 115,843 0 0 15,452 49,124 61,201 92,396

4,914 0 39,952 0 11 30,377

3,707 0 19,415 0 1,363 13,921

0 17,034 0

0 236 0

10,687 0 31,214 0 5,039 13,763 0 15,129 75,864

0 2,371 0

0 78,711 0

Note: 1.

The Cash Flow Statement has been prepared under indirect method as set out in Accounting Standard-3 on Cash Flow Statement issued by the Institute of Chartered Accountants of India.

2.

Negative figures have been shown in brackets. Annexure IV Notes on Adjustments for Restated Financial Statements

1. The Company adopted Accounting Standard 22, (AS 22)Accounting for Taxes on Income as issued and required by the Institute of Chartered Accountants of India for the first time in preparing the financial statements for the year ended March 31, 2003. For the purpose of this statement, AS-22 has not been applied for the years ended March 31, 2002 and 2001 as the same was not applicable in those years. Consequently, the deferred tax impact on account of timing difference has not been recognized in this statement for the year ended March 31, 2002 and 2001. 2. Below mentioned is the summary of results of restatement made in the audited accounts for the respective years and its impact on the profits of the company.

II.150

Advanced Auditing & Professional Ethics 31-Mar-05 31-Mar-04 31-Mar-03 31-Mar-02

Adjustments for Gain on foreign currency transactions (See Note No. 3a below. Depreciation on gain on foreign currency transactions (See Note No. 3a below) Provision for leave encashment (See Note No. 3b below Work in Progress Projects (See Note No. 3c below Change in Accounting treatment of Scaffolding Materials (See Note No. 4a below) Fixed assets Capitalized related to earlier years (See Note No. 4b below) Change in the rate of depreciation on fixed assets (See Note No. 4c below) Prior period items (See Note No. 4d below) Unspent liabilities written-back (See Note No. 4e below) Interest on hire purchase (See No. 4f below) Deferred revenue expenditure See Note No. 4g below) Accounting of Unincorporated JV (See Note No. 4h below) Provision for doubtful debts (See Note No. 4i below) Accounting of insurance claims (See Note No. 4j below) Contract revenue (See Note No. 4k below) Works contract tax (See Note No. 4l below) Interest on Claims (Auditor Qualification) (See Note No. 9a

31-Mar-01

0

(1,800)

0

0

0

180

1

0

0

0

0

4,864

(749)

(542)

(1,294)

(61,223) (10,333)

4,621

(4,587)

0 (29,077)

16,348

16,120

(1,268)

(1,190)

1617

(604)

(411)

(335)

(157)

0

0

0

0

0

0

27,010

(6,186)

(7,996)

(7,585)

58,281

(26,288)

(9,951) (13,294)

(827)

(32,210)

19,672

2,730

1,545

3,180

18,860

(9,898)

(5,834)

1,253

45,563

18,446

(18,446)

0

0

0

(26,231)

21,530

6,964

0

0

(28,803)

0

28,803

0

0

(15,204)

13,365

1,779

61

0

0

0

0

(6,164)

0

0

2,579

6,453

863

17,529

(32,830)

0

0

0

0

Part II : Guidance Notes below) Sub Total Current tax impact (See Note No. 4m below) Deferred tax impact (See Note No. 4n below) Sub Total Total 3.

(66,971)

(12,890)

29,385 (21,256)

36,198

25,369 (18,728)

(6,814)

(2,913)

29,385 (37,587)

II.151

50,632

2,693

(29,726)

0

0

22,456 (16,362) 2,693 9,566 13,024 (18,563)

(29,726) 20,906

2,367

Changes in Accounting Policies51 a.

Gain of Foreign Currency Transactions During the year ended March 31, 2004, the Company had accounted for gain arising on restatement / settlement of liabilities incurred for acquiring fixed assets in Profit and Loss Account in compliance with the AS-11 issued by Institute of Chartered Accountants of India. Since the consequential change was not brought by the legislature in Schedule VI to the Companies Act, 1956 and on subsequent clarification by the Institute of Chartered Accountants of India that requirement of Schedule VI shall prevail, the same has been restated and adjusted to the cost of the fixed assets. Accordingly, depreciation on the same has been recomputed for the years ended March 31, 2005 and 2004.

b.

Provision For Leave Encashment During the year ended March 31, 2004, provision for leave encashment was made on the basis of actuarial valuation in compliance of the Accounting Standard - 15 issued by the Institute of Chartered Accountants of India, which was earlier accounted for on cash basis. Accordingly, provision for leave encashment has been recomputed on actuarial valuation basis for each preceding year and consequently the adjustments have been made in the expense for leave encashment for the years ended March 31, 2004, 2003, 2002 and 2001 and the brought forward balance in Profit and Loss Account as at April 1, 2000.

c.

WORK IN PROGRESS. PROJECTS Till the year ended March 31, 2003, Work in progress projects was valued on the basis of the percentage completion method at the rates provided in the contract reduced by an estimated percentage towards expected profit. From the year ended March 31, 2004, Work in progress- projects to the extent of work done but not billed is valued at net realizable value without reducing estimated percentage towards expected profit. Accordingly, the figures have been restated for the years ended March 31, 2003, 2002 and 2001 and the brought forward balance in Profit and Loss Account as at April 1, 2000.

51

The list is illustrative only.

II.152 4.

Advanced Auditing & Professional Ethics

Other Adjustments a.

Accounting Treatment Of Scaffolding Materials During the year ended March 31, 2005, the Company has decided to reclassify scaffolding materials as inventory and to value these at cost less amortization charge based on the estimated useful life, which is determined as ten years by the management. Hitherto, such material was capitalized as fixed assets in some years while in some other years, it was charged to revenue, based on the management's perception of the same being of capital or revenue nature. Consequent to this change, the Company has decapitalised the fixed assets and recognized the same as inventories and also brought back to books the materials charged off in earlier years and amortised the same on the basis stated above. As a result of the above, adjustments for inventory earlier shown as fixed assets or expensed off to Profit and Loss account have been made to the financial statements, as restated, for the years ended March 31, 2004, 2003, 2002 and 2001 and the brought forward balance in Profit and Loss Account as at April 1,2000.

b.

Fixed Assets Capitalised Related To Earlier Years During the year ended March 31, 2005, certain fixed assets have been identified by the Company, which were required to be capitalised in earlier years, since these were acquired and put to use in those years. The same have now been capitalised and related in the years in which these were actually put to use. Consequently the depreciation on these fixed assets, so capitalised, has also been charged in the relevant years.

c.

Change In The Rate Of Depreciation On Fixed Assets Till the year ended March 31, 2003, certain fixed assets were mistakenly identified with the inappropriate group of assets and accordingly depreciation on such assets was charged at the rates as applicable to such group of assets, as per policy of the Company. During the year ended March 31, 2004, such fixed assets were so identified and were accordingly reclassified under the appropriate group of assets and depreciation thereon was charged at the appropriate applicable rates of depreciation. Accordingly, depreciation has been recomputed and adjusted based on the revised rates of depreciation on such fixed assets for the year ended March 31, 2003, 2002 and 2001 and the brought forward balance in Profit and Loss Account as at April 1, 2000.

d.

Prior Period Items In the financial statements for the years ended March 31, 2005, 2004, 2003, 2002 and 2001, certain items of income/expenses have been identified as prior period items. For the purpose of this statement, such prior period items have been appropriately adjusted in the respective years.

e.

Unspent Liabilities Written Back

Part II : Guidance Notes

II.153

In the financial statements for the years ended March 31, 2005, 2004, 2003, 2002 and 2001, certain liabilities created in earlier years were written back. For the purpose of this statement, the said liabilities, wherever required, have been appropriately adjusted in the respective years in which the same were originally created. f.

Interest On Hire Purchase Till the year ended March 31, 2004, hire purchase charges were charged off evenly throughout the term of Hire Purchase. During the year ended March 31, 2005, hire purchase charges have been re-calculated and charged off on the basis of internal rate of return (IRR) and accordingly, adjustments relating to earlier years have been made in the year ended March 31, 2005. Accordingly Hire Purchase charges have been adjusted for the years ended March 31, 2004, 2003, 2002 and 2001 and the balance brought forward in Profit and Loss Account as at April 1,2000.

g.

Deferred Revenue Expenditure Deferred Revenue Expenditure brought forward in relation to restructuring of loan taken from ICICI Bank was charged to Profit & Loss Account in the year ended March 31, 2005. This deferred revenue expenditure has been reapportioned to year ended March 31, 2004 and year ended March 31, 2005 on the basis of amount of loan repaid during the respective years and accordingly adjustments have been made to the financial statements, as restated, for the years ended March 31, 2005 and 2004.

h.

Accounting Of Unincorporated Joint Venture The Company had entered into an unincorporated joint venture on 50:50 sharing basis with XYZ Co. on September 20, 2002 for execution of a pipeline construction contract in Turkey. Such arrangement was inappropriately identified as 'jointly controlled entity' by the Company and thus the Company's share of income, expenses, assets and liabilities in the joint venture were not recognized in the Company's financial statements in respective years. During the year ended March 31, 2005, such arrangement has been appropriately identified as 'joint controlled operation' and consequent to such change in identification, the financial results of the joint venture from September 20, 2002 till March 31, 2005 have been incorporated in the year ended March 31, 2005. For the purpose of this statement, the revenue, expenses, assets and liabilities for the years ended March 31, 2005, 2004 and 2003 have been restated on the basis of the audited financial statements of the joint venture for the respective years.

i.

Provision For Doubtful Debts Debts, which were considered doubtful and written off in the year ended March 31, 2003 and which have been subsequently recovered during the year ended March 31, 2005, have been adjusted in the years when such debts were originally written off. Accordingly, adjustments have been made to the summary statement of profits and losses, as restated, for the years ended March 31, 2005 and 2003.

II.154 j.

Advanced Auditing & Professional Ethics Accounting Of Insurance Claims The Company is following the policy of accounting for insurance claims on settlement with the insurers. For the purpose of this statement, the said income has been appropriately adjusted in the respective years in which the claims were lodged. Accordingly, adjustments have been made to the financial statements, as restated, for the years ended March 31, 2005, 2004, 2003 and 2002.

k.

Contract Revenue The Company had accounted for extra claims made on the customers at the time of their acceptance in principle by the customers. For the purpose of this statement, the said income has been appropriately adjusted in the respective years in which such claims were made. Accordingly, adjustments have been made to the financial statements, as restated, for the years ended March 31, 2002 and the balance brought forward in Profit and Loss Account as at April 1, 2000.

l.

Works Contract Tax The Profit and Loss Accounts of some years include amounts paid/ provided for in respect of shortfall/ excess works contract tax arising out of assessments, appeals etc. The same has now been restated and accordingly adjustments have been made to the financial statements, as restated, for the years ended March 31, 2005, 2004, 2003, 2002 and 2001 and the balance brought forward in Profit and Loss Account as at April 1, 2000.

m.

Income Tax Refunds/ Provision The Profit and Loss Account of some years include amounts paid/ provided for or refunded/written back, in respect of shortfall/ excess income tax arising out of assessments, appeals etc. which has now been adjusted in the respective years. Also, income tax (current tax and deferred tax) has been computed on adjustments made as detailed above and has been adjusted in the restated profits and losses for the years ended March 31, 2005, 2004, 2003, 2002 and 2001 and the balance brought forward in Profit and Loss Account as at April 1, 2000.

5.

Asset Revaluation Reserve In accordance with Clause 6.10.2.7 (b) (vi) of the Disclosure & Investor Protection Guidelines, 2000 issued by Securities and Exchange Board of India (SEBI), the statement of assets and liabilities as restated has been prepared after deducting the balance in revaluation reserve from the carrying amount of fixed assets and reserves & surplus.

Part II : Guidance Notes 6.

II.155

Profit And Loss Account As At April, 01,2000 (Restated) (Amount in INR'000)

Particulars Profit and Loss Account as at April 01, 2000 (Audited)

Amount XXXX

Provision for leave encashment (See Note No. 3b above)

(2,279)

Work in Progress- Projects (See Note No. 3c above)

71,523

Change in accounting Treatment of scaffolding Materials(See Note No. 4a above)

(934)

Fixed assets capitalized related to earlier years (See Note No, 4b above)

(110)

Change in date rate of depreciation on fixed assets (See Note No. 4c above)

(5,244)

Prior period items (See Note No. 4d above)

(7,922)

Unspent liabilities written-back (See Note No. 4e above) Interest on hire purchase (See Note No. 4f above) Contact revenue (See Note No. 4k above)

5,083 (49,944) 6,163

Works contract tax (See Note No. 41 above)

(27,423)

Current tax impact (See Note No. 4m above)

(2,267)

Profit and Loss Account as at April, 2000 (Restated)

XXXX

7.

Material Regrouping

a.

Upto the year ended March 31, 2004, retention money, which is realizable on the satisfactory completion of the project, was included under the group Advances Recoverable in cash or in kind or for value to be received and hence classified as part of Loans and Advances. During the year ended March 31, 2005, the same has been classified under the head Sundry Debtors. In the statement of Assets and Liabilities as restated, for the years ended March 31, 2004, 2003, 2002 and 2001, such retention money has been regrouped and disclosed accordingly.

b.

Upto the year ended March 31, 2004, share application money (paid) was classified under the head investments. During the year ended March 31,2005, the same has been shown as Advances for Proposed Investments and grouped under the head Loans and Advances. In the statement of Assets and Liabilities as restated, for the years ended March 31, 2004, 2003, 2002 and 2001, such share application money has been regrouped and disclosed accordingly.

II.156

Advanced Auditing & Professional Ethics

8.

Non Adjustment Items

a.

UNSPENT LIABILITIES WRITTEN BACK– ISP DIVISION During the year ended March 31, 2004, ISP Division of PQR Co. has been merged with the Company with effect from April 01, 2003. During the year ended March 31,2005, certain liabilities of earlier years of the ISP Division were written back which are related to the period prior to merger. For the purpose of this statement, the said liabilities have not been adjusted in the respective years as ISP Division was not a part of the Company's operation in those years.

b.

Unused Materials During the year ended March 31, 2005, certain unused materials at construction sites closed during the year have been transferred to other sites/ central warehouse at the lower of cost and estimated realizable values as against the hitherto followed for of transferring these at Nil values in earlier years. Adjustments on this account have not been made in the financial statements for the years ended March 31,2005, 2004, 2003, 2002 and 2001 and the brought forward balance in Profit and Loss Account as at April 1,2000 in the absence of available information. However, in the opinion of the Company, the impact of the same on the summary statement of profits and losses, as restated, is not material.

Auditor's Qualifications: a.

The Company had executed two projects of Sulphur Recovery Units (SRU) of ABC Co. in an earlier year on back-to-back basis for LMN Co. who was the main contractor. ABC Co. had withheld payments from LMN Co. on account of duties and taxes and LMN Co. had in turn withheld Rs.1,55,358 thousand in an earlier year, which are outstanding as debts at the close of the year ended March 31, 2005. LMN Co. had gone into arbitration against ABC Co and lodged claims for recovery of above amount along with interest and also some other claims amounting to Rs.1,93,542 thousand. During the year ended March 31, 2005, the Company has initiated the arbitration proceedings for recovery of withheld amounts and other claims including interest. The arbitration proceedings are in advanced stages and the Company has been advised legally that it entitled to the recovery of amount withheld along with interest. Accordingly, the Company, during the year, has taken a credit for interest of Rs. 32,830 thousand on conservative estimated basis. The statutory auditors' have qualified their opinion on the financial statements for the year ended March 31, 2005 on account of credit taken for interest of the abovementioned amount, which is not in accordance with Accounting Standard 9 on Revenue Recognition issued by the Institute of Chartered Accountant of India. Accordingly, adjustments are made to the statement of financial statements, as restated for the year ended March 31,2005 to reverse such credit of internal income.

b.

Other Audit qualifications, which do not require any corrective adjustment in the financial information are as follows:

Part II : Guidance Notes i.

II.157

Financial year ended March 31,2005 CARO, 2003 Due to physical verification not being carried out at Georgia branch, discrepancies, if any, with the books could not be ascertained. Internal Control in respect to accounting of purchase of inventory and fixed assets needs strengthening. Coverage of the internal audit system requires to be enlarged to cover controls over information technology (IT) related risks. There are delays in the early part of the year, which are not serious, in depositing undisputed statutory dues including provident fund, investor education and protection fund, employees state insurance, income tax, sales tax, wealth tax, service tax, custom duty, excise duty and cess.

ii.

Financial period ended March 31, 2004 CARO, 2003 The company is regular with some delays in depositing with appropriate authorities, undisputed statutory dues including Provident Fund, Investor Education Protection Fund, Employees' State Insurance, Income Tax, Sales Tax, Wealth Tax, Custom Duty, Excise Duty, Cess and other statutory dues applicable to the company. Long-term funds (retained profit) have been used for short-term purposes. Annexure IV A Significant Accounting Policies For The Year Ended March 31, 2005

(a) Basis of preparation The Company maintains its accounts on accrual basis following the historical cost convention, (except for the revaluation of certain fixed assets), and in accordance with Accounting Standards referred to in Section 211(3c) of the Companies Act, 1956 and other requirements of the Act. The accounting policies have been consistently applied by the Company and are consistent with those used in previous period. (b) Use of estimates The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent liabilities as at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

II.158

Advanced Auditing & Professional Ethics

(c) Fixed assets Fixed assets are stated at cost, (other than some fixed assets which are stated at values as determined by the valuer), less accumulated depreciation and impairment losses, if any. Cost comprises the purchase price and any attributable cost of bringing the asset to its working condition for its intended use. Financing costs relating to acquisition of fixed assets are also included to the extent they relate to the period till such assets are ready to be put to use. The carrying amount of fixed assets are reviewed at each balance sheet date if there is any indication of impairment based on internal vs. external factors. An impairment loss is recognized wherever the carrying amount of an asset exceeds its recoverable amount. The recoverable amount is the greater of the asset's net selling price and value in use. In assessing the value in use, the estimated future cash flows are discounted to their present value at the weighted average cost of capital. (d) Method of depreciation (i)

Depreciation on the fixed assets is charged on straight line method, at the rates specified in Schedule XIV of the Companies Act, 1956, (except to the extent stated in para ii and vi below), which are based on the useful lives of the assets.

(ii)

Depreciation on the following fixed assets of Internet Service division is charged on straight-line method at the rates, based on useful lives of the assets as estimated by the management, which are equal to or higher than the rates specified by Schedule XIV. Asset Description

Depreciation Rate

Plant and machinery

10%

Networking equipment*

10%

Office equipment

10%

Ducts and optical fiber cables*

4.75%

*Included under Plant & Machinery. iii)

Amount added to assets on account of foreign exchange fluctuation is depreciated prospectively over the remaining useful lives of the respective assets.

iv)

No amortization is made for leasehold land, which is under perpetual lease.

v)

Assets costing less than Rs. 5,000 each are depreciated @ 100 %

vi)

Depreciation on Company's share of fixed assets of an unincorporated joint venture is provided on straight-line method at the following rates based on their useful lives as estimated by the management of the joint venture. Asset Description

Depreciation Rate

Buildings

10%

Plant & Machinery

10%

Part II : Guidance Notes Vehicles

20%

Furniture, fixtures & office equipments

20%

II.159

Appendix 7 Illustrative Format of the Engagement Letter for the Entire Engagement to Issue Report on the Prospectus (refer paragraph 2.6) Date Name of Company Address Letter of Engagement Dear Sirs, We are writing to confirm our understanding of the scope and limitations of the work to be performed by us in connection with ______ [Draft Red Herring Prospectus/Red Herring Prospectus/Prospectus ("DRHP/RHP/ Prospectus"), dated ______ [Date] prepared in connection with the filing of an offer document a proposed issue of ______ [Insert name and type of security] (the "Equity Shares/Notes/Security") by ______ (name of the company) (the "Company") with the Securities and Exchange Board of India ("SEBI") and the Registrar of Companies, ______ [Insert name of the State]. This letter is not to be used in connection with the sale of securities in the ______ (name of the Country). We accept no duty or responsibility to and deny any liability to any party in respect of any use of this letter in connection with the sale of securities in the ______ (name of the country) As part of the offer document, the Company will prepare financial information for the period from ______ to ______ and for the quarter ended ______ along with the adjusted profits (i.e., after adjustments as required by the SEBI {Disclosure and Investor Protection) Guidelines 2000 ('the Guidelines')} for each of the five years ended ______ and for the quarter ended ______ in a manner consistent with the accounting policies being adopted for the quarter ended ______ Further, the Company will prepare financial information of its subsidiaries for the period from ______ to ______ along with the recasted financial information (as per the Guidelines) for each of the 5 years ended ______ and for the quarter ended ______ in a manner consistent with the accounting policies being adopted for the quarter ended ______. The Company will prepare other financial information to be included in the offer document as required by the Guidelines issued by the SEBI in pursuance of Section 11 of the Securities and Exchange Board of India Act, 1992. A.

Accordingly, we will examine the following information to be included in the offer document of the Company (together with the 'Financial Information') as required by Part II of Schedule II to the Companies Act, 1956:

II.160

Advanced Auditing & Professional Ethics

(a) adjusted profits of the Company for each of the five financial years ended ______ and for the quarter ended ______ assets and liabilities of the Company as at ______ and significant accounting policies and notes thereto (b) dividend declared by the Company for each of the five years ended ______ and for the quarter ______ (c) adjusted profits of each subsidiary company of the Company for each of the five financial periods/years ended ______ and quarter ended ______ assets and liabilities of each subsidiary company of the Company as at ______ along with significant accounting policies and notes thereto. (d) Cash flow statement for each of the five financial year ended ______ and for the quarter ended ______ (e) Statement of tax shelters for the Company for each of the ----financial year ended ______ (f)

Capitalisation statement for the Company as at______

(g) Accounting ratios for the Company for each of the five financial years ended ______ and for the quarter ended______ (h) Details of secured and unsecured loans as at ______ and for the five years ended______ and In connection with the offering of Equity Shares/Notes/Security, we will perform all necessary procedures, in order to issue an auditors' report to the Company, in accordance with the Guidance Notes on Reports in Company Prospectuses, issued by the Institute of Chartered Accountants of India ('the Guidance Note). Our work and findings shall not in any way constitute advice or recommendations (and we accept no liability in relation to any advice or recommendations) regarding any commercial decisions associated with the issue of the ______ (name of the security). B.

Upon completion of our examination, we will provide you with our report on the adjusted Financial Information referred to above, and bring to your attention any material errors of which we become aware during our examination.

C.

It should be understood that we make no representation regarding questions of legal interpretation or regarding the sufficiency for your purposes of the procedures enumerated above; also, such procedures would not necessarily reveal any material misstatement of the amounts or percentages listed above. Further, we will address ourselves solely to the foregoing data as set forth in the offer document and will make no representation regarding the adequacy of disclosure or regarding whether any material facts have been omitted or appropriateness of comparative information for evaluation.

D.

We will conduct our examination in accordance with auditing standards generally accepted in India and the Guidance Note. Those standards require that we plan and perform our engagement to obtain reasonable assurance that the Financial Information, are free of material misstatement whether caused by errors or fraud. However, having

Part II : Guidance Notes

II.161

regard to the test nature of our examination, persuasive rather than conclusive nature of audit evidence together with any inherent limitations of any accounting and internal control system, there is an unavoidable risk that even some material misstatements of the Financial Information, resulting from fraud, and to a lesser extent error, if either exists, may remain undetected. Also, our examination is not designed to detect error or fraud that is immaterial to the Financial Information. As part of our examination, we will consider, solely for the purpose of planning our work and determining the nature, timing, and extent of our audit procedures, the Company's internal control environment. This consideration will not be sufficient to enable us to provide assurance on internal control or to identify all reportable conditions. We will determine that appropriate members of management are informed of fraud and illegal acts, unless they are clearly inconsequential, of which we become aware in the regular course of our examination focused on the Financial Information. In addition, we will inform appropriate members of management of significant adjustments and of reportable conditions noted during our examination. EF or our examination, we will place reliance on the following: i)

The financial statements of ABC Ltd for the year ended ______ which have been audited and reported upon by us, vide our reports dated ______ respectively.

ii)

The financial statements of ABC Ltd for the financial years ended ______ which have been audited and reported upon by ______ Chartered Accountants hereafter referred as ______ {if required}

iii)

The financial statements of below mentioned subsidiaries for the year ended ______ which have been audited and reported by us, vide our reports mentioned there against, hereafter referred as the ______ Subsidiaries Financial Statements: Name of subsidiaries

iv)

Auditor report's date

The financial statements of the below mentioned subsidiaries of ABC Ltd which have been audited and reported upon by their auditors, the names of which and the period of their audit are mentioned there against. Name of subsidiaries

Name of the Auditors

II.162 v)

Advanced Auditing & Professional Ethics

The unaudited financial statements of below mentioned subsidiaries of ABC for the quarter ended ______ Name of subsidiaries

Our audit of the financial statements for the period referred to in paragraphs F (i) and F (iii) of this letter comprises such audit tests and procedures as deemed necessary for the purpose of expressing an opinion on such financial statements taken as a whole. For none of the other periods referred to in paragraph F we will perform audit tests for the purpose of expressing an opinion on individual balances of accounts or summaries of selected transactions such as those enumerated above and accordingly, we express no opinion thereon. F.

Consent letters

We will issue consent letters to act as an auditor and to permit the inclusion of our report in the offer document. In connection with the issuance of our consent, we will perform certain procedures as required by professional standards. These include, but are not limited to, the following: (a) Reading the offer document; and (b) Obtaining a representation letter from management (and other matters as appropriate) Based on the results of our procedures, we will consider whether the Financial Information referred above and/or our auditors' report needs to be modified in order to consent to the inclusion of our reports in the offer document. G.

Management's responsibilities and representations

The Financial Information are the responsibility of the management of the Company, which is also responsible for establishing and maintaining effective internal control, for properly recording transactions in the accounting records, for safeguarding assets, for prevention and detection of fraud and error, for complying with accounting standards and for the overall fair presentation of the Financial Information and Other Financial Information. Management of the Company is also responsible for identifying and ensuring that the Company complies with the laws and regulations applicable to its activities. Management is responsible for adjusting the Financial Information to correct material misstatements and for affirming to us in its representation letter that the effects of any unadjusted differences identified by us during the work are immaterial, both individually and in the aggregate, to the Financial Information taken as a whole. As an integral part of our procedures and as required by auditing standards generally accepted in India, and the Guidance Notes, we will request letters of representation from

Part II : Guidance Notes

II.163

officers and other executives, including the chief executive, financial, and accounting officers, responsible for financial and accounting matters of the Company. This includes making specific inquiries of management about the representations contained in the Financial Information and the effectiveness of the internal control structure. The responses to those inquiries, written representations and the results of our examination tests comprise the evidential matter we intend to rely upon in forming an opinion on the Financial Information. Because of the importance of management's representations to effective examination and review, the Company agrees to release [Auditor Name], Chartered Accountants and its personnel from any liability and costs relating to our services under this letter attributable to any misrepresentations by management. In order to enable us to fulfil our responsibilities, you agree on request, to provide us with complete, accurate and timely information and to carry out any obligations ascribed to or undertaken by you or others under your' control. Management's failure to provide requisite information on a timely basis may cause us to delay our report, modify our procedures, or even terminate our engagement. You agree that any commercial decisions that you make, are not within the scope of our duty of care and in taking such decisions you should take into account the restrictions on the scope of our work and other factors, commercial and otherwise, of which you and your other advisers are, or should be, aware from sources other than our work. H.

Other Terms (a) If you intend to publish or otherwise reproduce the Financial Information together with our report (or otherwise make reference to our firm) in a document other than that which contains other information, you agree to (i) provide us with a draft of the document to read, and (ii) obtain our approval for inclusion of our report, before it is printed and distributed. (b) Under this arrangement, we have no responsibility to update our reports for events and circumstances occurring after the date of our report. (c) The working papers prepared in conjunction with our examination's are the property of our firm, constitute confidential information and will be retained by us in accordance with our firm's polices and procedures.

I.

Fees and Billing arrangements

Our fees for the engagement covered under this letter of engagement will be _________ [insert amount]. We will also charge for any expenses incurred during the engagement and we will add applicable taxes to charges and expenses. Any fee estimate agreed with you is necessarily based on the assumption that the information required for our work is made available in accordance with agreed timetables, and that your key executives and personnel are available during the course of our work. If delays or other unanticipated problems which are beyond our control occur this may result in additional fees for which invoices will be raised.

II.164

Advanced Auditing & Professional Ethics

Should the scope of our work require any modification, including reporting on the financial statements or financial information for any broken period subsequent to [insert period-end date], we will discuss the matter with you immediately and only proceed to incur additional fees with your prior approval. We will be entitled to submit invoices for services provided and expenses incurred on an interim basis as the work progresses. Invoices are payable upon presentation. We reserve the right, where fees have been invoiced and payment is outstanding to us, to exercise a lien in respect of those outstanding fees over any documents belonging to you which may be in our possession. Our billing is payable upon the presentation of our fee note. Our fees, expenses and applicable taxes are payable by the Company. We shall be grateful if you will acknowledge receipt of this letter by signing and returning to us the duplicate copy of this letter, which is enclosed. If the contents are not in accordance with your understanding of our agreement, we shall be pleased to receive your further observations and to give you any further information you require. We also wish to draw your attention to the fact that our examination process is subject to peer review under the Chartered Accountants Act, 1949. The reviewer may examine our working papers during the course of the peer review. . For ABC and Co. Chartered Accountants Signature [Name of the Member] Designation52 Membership Number Place of Signature: Date: By: _________________ [Name] _________________ [Title] _________________ [Date] 8

52

Partner or proprietor, as the case may be

Part II : Guidance Notes

II.165

Some Frequently Asked Questions on Public Issues (refer paragraph 2.9) Note: The following questions and answers have been extracted from the website of the Securities and Exchange Board of India (SEBI) and have been included in this publication for the ease of understanding and knowledge of the readers. The Institute of Chartered Accountants of India is not liable for any action taken or not taken on the basis of these questions and answers. The complete text of the following and other related questions can be found at the website of SEBI (www.sebi.gov.in). Q1. What are the different kinds of issues? Primarily, issues can be classified as a Public, Rights or preferential issues (also known as private placements). While public and rights issues involve a detailed procedure, private placements or preferential issues are relatively simpler. The classification of issues is illustrated below:

Public issues can be further classified Into Initial Public offerings and further public offerings. In a public offering, the issuer makes an offer for new investors to enter its shareholding family. The issuer company makes detailed disclosures as per the DIP guidelines in its offer document and offers it for subscription. The significant features are illustrated below: Initial Public Offering (IPO) is when an unlisted company makes either a fresh issue of securities or an offer for sale of its existing securities or both for the first time to the public. This paves way for listing and trading of the issuer's securities.

II.166

Advanced Auditing & Professional Ethics

A Further public offering (FPO) is when an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, through an offer document. An offer for sale in such scenario is allowed only if it is made to satisfy listing or continuous listing obligations Rights Issue (RI) is when a listed company which proposes to issue fresh securities to its existing shareholders as on a record date. The rights are normally offered in a particular ratio to the number of securities held prior to the issue. This route is best suited for companies who would like to raise capital without diluting stake of its existing shareholders unless they do not intend to subscribe to their entitlements. A private placement is an issue of shares or of convertible securities by a company to a select group of persons under Section 81 of the Companies Act, 1956 which is neither a rights issue nor a public issue. This is a faster way for a company to raise equity capital. A private placement of shares or of convertible securities by a listed company is generally known by name of preferential allotment. A listed company going for preferential allotment has to comply with the requirements contained in Chapter XIII of SEBI (DIP) Guidelines pertaining to preferential allotment in SEBI (DIP) guidelines which inter alia include pricing, disclosures in notice etc, in addition to the requirements specified in the Companies Act. A Qualified Institutions Placement is a private placement of equity shares or securities convertible in to equity shares by a listed company to Qualified Institutions Buyers only in terms of provisions of Chapter XIlIA of SEBI (DIP) guidelines. The Chapter contains provisions relating to pricing, disclosures, currency of instruments etc. Q2. What are "DIP" guidelines? The primary issuances are governed by SEBI in terms of SEBI (Disclosures and Investor protection) guidelines. SEBI framed its DIP guidelines in 1992. Many amendments have been carried out in the same in line with the market dynamics and requirements. In 2000, SEBI issued "Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000" which is compilation of all circulars organized in chapter forms. These guidelines and amendments thereon are issued by SEBI India under Section 11 of the Securities and Exchange Board of India Act, 1992. SEBI (Disclosure and investor protection) guidelines 2000 are in short called DIP guidelines. It provides a comprehensive framework for issuances buy the companies. Q3. What is the difference between an offer document, RHP, a prospectus an abridged prospectus, letter of offer, abridged letter of offer and Placement document? What does it mean when someone says "draft offer doc"? "Offer document" means Prospectus in case of a public issue or offer for sale and Letter of Offer in case of a rights issue which is filed Registrar of Companies (ROC) and Stock Exchanges. An offer document covers all the relevant information to help an investor to make his/her investment decision. "Draft Offer document" means the offer document in draft stage. The draft offer documents are filed with SEBI, at least 21 days prior to the filing of the Offer Document with ROC/ SEs.

Part II : Guidance Notes

II.167

SEBI may specifies changes, if any, in the draft Offer Document and the issuer or the Lead Merchant banker shall carry out such changes in the draft offer document before filing the Offer Document with ROC/ SEs. The Draft Offer document is available on the SEBI website for public comments for a period of 21 days from the filing of the Draft Offer Document with SEBI. "Red Herring Prospectus" is a prospectus which does not have details of either price or number of shares being offered or the amount of issue. This means that in case price is not disclosed, the number of shares and the upper and lower price bands are disclosed. On the other hand, an issuer can state the issue size and the number of shares are determined later. An RHP for and FPO can be filed with the RoC without the price band and the issuer, in such a case will notify the Frequently Asked Questions on Issues and use of ECS for Refunds - For Reference Only 6 floor price or a price band by way of an advertisement one day prior to the opening of the issue. In the case of bookbuilt issues, it is a process of price discovery and the price cannot be determined until the bidding process is completed. Hence, such details are not shown in the Red Herring prospectus filed with ROC in terms of the provisions of the Companies Act. Only on completion of the bidding ,process, the details of the final price are included in the offer document. The offer document filed thereafter with ROC is called a prospectus. "Abridged Prospectus" means the memorandum as prescribed in Form 2A under subSection (3) of Section 56 of the Companies Act, 1956. It contains all the salient features of a prospectus. It accompanies the application form of public issues. "Letter of offer" means the offer document prepared by company for its rights issue and which is filed with the Stock Exchanges. The letter of offer contains all the disclosures as required in term of SEBI(DIP) guidelines and enable shareholder in making an informed decision. "Abridged letter of offer" means the abridged version of the letter of offer. Listed company is required to send the abridged letter of offer to each and every shareholder who is eligible for participating in the rights issue along with the application form. A company is also required to send detailed letter of offer upon request by any Shareholder. "Placement Document" means document prepared by Merchant Banker for the purpose of Qualified Institutions placement and contains all the relevant and material disclosures to enable QIBs to make an informed decision. Q4. Who decides the price of an issue? Indian primary market ushered in an era of free pricing in 1992. Following this, the guidelines have provided that the issuer in consultation with Merchant Banker shall decide the price. There is no price formula stipulated by SEBI. SEBI does not play any role in price fixation. The company and merchant banker are however required to give full disclosures of the parameters which they had considered while deciding the issue price. There are two types of issues one where company and LM fix a price (called fixed price) and other, where the company and LM stipulate a floor price or a price band and leave it to market forces to determine the final price (price discovery through book building process).

II.168

Advanced Auditing & Professional Ethics

What are Fixed Price offers? An issuer company is allowed to freely price the issue. The basis of issue price is disclosed in the offer document where the issuer discloses in detail about the qualitative and quantitative factors justifying the issue price. The Issuer company can mention a price band of 20% (cap in the price band should not be more than 20% of the floor price) in the Draft offer documents filed with SEBI and actual price can be determined at a later date before filing of the final offer document with SEBI/ROCs. What does "price discovery through book building process" mean? "Book Building" means a process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built up and the price for the securities is assessed on the basis of the bids obtained for the quantum of securities offered for subscription by the Frequently Asked Questions on Issues and use of ECS for Refunds - For Reference Only 8 issuer. This method provides an opportunity to the market to discover price for securities. Q5. Book Building in Detail: How does Book Building work? The logic: Book building is a process of price discovery. Hence, the Red Herring prospectus does not contain a price. Instead, the red herring prospectus contains either the floor price of the securities offered through it or a price band along with the range within which the bids can move. The applicants bid for the shares quoting the price and the quantity that they would like to bid at. Only the retail investors have the option of bidding at 'cut-off. After the bidding process is complete, the 'cut-off price is arrived at on the lines of Dutch auction. The basis of Allotment (Refer Q. 15.j) is then finalized and letters allotment/refund is undertaken. The final prospectus with all the details including the final issue price and the issue size is filed with ROC, thus completing the issue process. What is a price band? As stated in the answer to Q. 7.a above, the red herring prospectus may contain either the floor price for the securities or a price band within which the investors can bid. The spread between the floor and the cap of the price band shall not be more than 20%. In other words, it means that the cap should not be more than 120% of the floor price. The price band can have a revision and such a revision in the price band shall be widely disseminated by informing the stock exchanges, by issuing press release and also indicating the change on the relevant website and the terminals of the syndicate members. In case the price band is revised, the bidding period shall be extended for a further period of three days, subject to the total bidding period not exceeding thirteen days. Who decides the price band? It may be understood that the regulatory mechanism does not play a role in setting the price for issues. It is up to the company to decide on the price or the price band, in consultation with Merchant Bankers.

Part II : Guidance Notes

II.169

The basis of issue price is disclosed in the offer document. The issuer is required to disclose in detail about the qualitative and quantitative factors justifying the issue price. What is firm allotment? A company making an issue to public can reserve some shares on "allotment on firm basis" for some categories as specified in DIP guidelines. Allotment on firm basis indicates that allotment to the investor Frequently Asked Questions on Issues and use of ECS for Refunds For Reference Only 9 is on firm basis. DIP guidelines provide for maximum % of shares which can be reserved on firm basis. The shares to be allotted on "firm allotment category" can be issued at a price different from the price at which the net offer to the public is made provided that the price at which the security is being offered to the applicants in firm allotment category is higher than the price at which securities are offered to public. Q6. Understanding the role of intermediaries: Who are the intermediaries in an issue? Merchant Bankers to the issue or Book Running Lead Managers (BRLM), syndicate members, Registrars to the issue, Bankers to the issue, Auditors of the company, Underwriters to the issue, Solicitors, etc. are the intermediaries to an issue. The issuer discloses the addresses, telephone/fax numbers and e-mail addresses of these intermediaries. In addition to this, the issuer also discloses the details of the compliance officer appointed by the company for the purpose of the issue. Who is eligible to be a BRLM? A Merchant banker possessing a valid SEBI registration in accordance with the SEBI (Merchant Bankers) Regulations, 1992 is eligible to act as a Book Running Lead Manager to an issue. What is the role of a Lead Manager? (pre and post issue) In the pre-issue process, the Lead Manager (LM) takes up the due diligence of company's operations/ management/ business plans/legal etc. Other activities of the LM include drafting and design of Offer documents, Prospectus, statutory advertisements and memorandum containing salient features of the Prospectus. The BRLMs shall ensure compliance with stipulated requirements and completion of prescribed formalities with the Stock Exchanges, RoC and SEBI including finalisation of Prospectus and RoC filing. Appointment of other intermediaries viz., Registrar(s), Printers, Advertising Agency and Bankers to the Offer is also included in the pre-issue processes. The LM also draws up the various marketing strategies for the issue. The post issue activities including management of escrow accounts, coordinate noninstitutional allocation, intimation of allocation and dispatch of refunds to bidders etc are performed by the LM. The post Offer activities for the Offer will involve essential follow-up steps, which include the finalization of trading and dealing of instruments and dispatch of certificates and demat of delivery of shares, with the various agencies connected with the work such as the Registrar(s) to the Offer and Bankers to the Offer and the bank handling refund business. The merchant banker shall be responsible for ensuring that these agencies

II.170

Advanced Auditing & Professional Ethics

fulfil their functions and enable it to discharge this responsibility through suitable agreements with the Company. A merchant banker is required to do the necessary due diligence in case of QIP mechanism. What is the role of a registrar? The Registrar finalizes the list of eligible allottees after deleting the invalid applications and ensures that the corporate action for crediting of shares to the demat accounts of the applicants is done and the dispatch of refund orders to those applicable are sent. The Lead manager coordinates with the Registrar to ensure follow up so that that the flow of applications from collecting bank branches, processing of the applications and other matters till the basis of allotment is finalized, dispatch security certificates and refund orders completed and securities listed. What is the role of bankers to the issue? Bankers to the issue, as the name suggests, carries out all the activities of ensuring that the funds are collected and transferred to the Escrow accounts. The Lead Merchant Banker shall ensure that Bankers to the Issue are appointed in all the mandatory collection centers as specified in DIP Guidelines. The LM also ensures follow-up with bankers to the issue to get quick estimates of collection and advising the issuer about closure of the issue, based on the correct figures. Question on Due diligence The Lead Managers state that they have examined various documents including those relating to litigation like commercial disputes, patent disputes, disputes with collaborators etc. and other materials in connection with the finalization of the offer document pertaining to the said issue; and on the basis of such examination and the discussions with the Company, its Directors and other officers, other agencies, independent verification of the statements concerning the objects of the issue, projected profitability, price justification, etc., they state that they have ensured that they are in compliance with SEBI, the Government and any other competent authority in this behalf. Q7. Guide to understand an Offer Document This Section basically tries to tell the reader about the structure of presentation of the content in the Offer Document. This is with a view to help the reader navigate through the content of an offer document. Cover Page The Cover Page of the offer document covers full contact details of the issuer company, lead managers and registrars, the nature, number, price and amount of instruments offered and issue size, and the particulars regarding listing. Other details such as Credit Rating, IPO Grading, if opted for, risks in relation to the first issue, etc are disclosed if applicable. Risk Factors Here, the issuer's management gives its view on the Internal and external risks faced by the company. Here, the company also makes a note on the forward looking statements. This

Part II : Guidance Notes

II.171

information is disclosed in the initial pages of the document and it is also clearly disclosed in the abridged prospectus. It is generally advised that the investors should go through all the risk factors of the company before making an investment decision. Introduction The introduction covers a summary of the industry and business of the issuer company, the offering details in brief, summary of consolidated financial, operating and other data. General Information about the company, the merchant bankers and. their responsibilities, the details of brokers/syndicate members to the Issue, credit rating (in case of debt issue), debenture trustees (in case of debt issue), monitoring agency, book building process in brief and details of underwriting Agreements are given here. Important details of capital structure, objects of the offering, funds requirement, funding plan, schedule of implementation, funds deployed, sources of financing of funds already deployed, sources of financing for the balance fund requirement, interim use of funds, basic terms of issue, basis for issue price, tax benefits are covered. About us This presents a review of on the details of the business of the company, business strategy, competitive strengths, insurance, industry-regulation (if applicable), history and corporate structure, main objects, subsidiary details, management and board of directors, compensation, corporate governance, related party transactions, exchange rates, currency of presentation dividend policy and management's discussion and analysis of financial condition and results of operations are given. Financial Statements Financial statement, changes in accounting policies in the last three years and differences between the accounting policies and the Indian Accounting Policies (if the Company has presented its Financial Statements also as per Either US GAAP/IAS are presented. Legal and other information Outstanding litigations and material developments, litigations involving the company and its subsidiaries, promoters and group companies are disclosed. Also material developments since the last balance sheet date, government approvals/licensing arrangements, investment approvals (FIPB/RBI etc.), all government and other approvals, technical approvals, indebtedness, etc. are disclosed. Other regulatory and statutory disclosures Under this head, the following information is covered: authority for the Issue, prohibition by SEBI, eligibility of the company to enter the capital market, disclaimer clause, disclaimer in respect of jurisdiction, distribution of information to investors, disclaimer clause of the stock exchanges, listing, impersonation, minimum subscription, letters of allotment or refund orders, consents, expert opinion, changes in the auditors in the last 3 years, expenses of the issue, fees payable to the lead managers, fees payable to the issue management team, fees payable to the registrars, underwriting commission, brokerage and

II.172

Advanced Auditing & Professional Ethics

selling commission, previous rights and public issues, previous issues for cash, issues otherwise than for cash, outstanding debentures or bonds, outstanding preference shares, commission and brokerage on, previous issues, capitalization of reserves or profits, option to subscribe in the issue, purchase of property, revaluation of assets, classes of shares, stock market data for equity, shares of the company, promise vis-a-vis performance in the past issues and mechanism for redressal of investor grievances. Offering information Under this head, the following information is covered: Terms of the Issue, ranking of equity shares, mode of payment of dividend, face value and issue price, rights of the equity shareholder, market lot, nomination facility to investor, issue procedure, book building procedure if applicable, bid form, who can bid, maximum and minimum bid size, bidding process, bidding bids at different price levels, escrow mechanism, terms of payment and payment into the escrow collection account, electronic registration of bids, build up of the book and revision of bids, price discovery and allocation, signing of underwriting agreement and filing of prospectus with SEBI/ROC, announcement of statutory advertisement, issuance of confirmation of allocation note("can") and allotment in the issue, designated date, general instructions, instructions for completing the bid form, payment instructions, submission of bid form, other instructions, disposal of application and application moneys, interest on refund of excess bid amount, basis of allotment or allocation, method of proportionate allotment, dispatch of refund orders, communications, undertaking by the company, utilization of issue proceeds, restrictions on foreign ownership of Indian securities, etc. Other Information This covers description of equity shares and terms of the Articles of Association, material contracts and documents for inspection, declaration, definitions and abbreviations, etc., Q8. I have heard a lot about these new terms. What do they mean? Green-shoe Option A Green Shoe option means an option of allocating shares in excess of the shares included in the public issue and operating a post-listing price stabilizing mechanism for a period not exceeding 30 days in accordance with the provisions of Chapter VIllA of DIP Guidelines, which is granted to a company to be exercised through a Stabilizing Agent. This is an arrangement wherein the issue would be over allotted to the extent of a maximum of 15% of the issue size. From an investor's perspective, an issue with green shoe option provides more probability of getting shares and also that post listing price may show relatively more stability as compared to market. Safety Net Any safety net scheme or buy-back arrangements of the shares proposed in any public issue shall be finalized by an issuer company with the lead merchant banker in advance and disclosed in the prospectus. Such buy back or safety net arrangements shall be made available only to all original resident individual allottees limited up to a maximum of 1000 shares per allottee and the offer is kept open for a period of 6 months from the last date of

Part II : Guidance Notes

II.173

dispatch of securities. The details regarding Safety Net are covered under Clause 8.18 of DIP Guidelines. Syndicate Member The Book Runner(s) may appoint those intermediaries who are registered with the Board and who are permitted to carry on activity as an 'Underwriter' as syndicate members. The syndicate members are mainly appointed to collect and enter the bid forms in a book built issue. Hard underwriting Hard underwriting is when an underwriter agrees to buy his commitment at its earliest stage. The underwriter guarantees a fixed amount to the issuer from the issue. Thus, in case the shares are not subscribed by investors, the issue is devolved on underwriters and they have to bring in the amount by subscribing to the shares. The underwriter bears a risk which is much higher in soft underwriting. Soft underwriting Soft underwriting is when an underwriter agrees to buy the shares at later stages as soon as the pricing process is complete. He then, immediately places those shares with institutional players. The risk faced by the underwriter as such is reduced to a small window of time. Also, the soft underwriter has the option to invoke a force Majeure (acts of God) clause in case there are certain factors beyond the control that can affect the underwriter's ability to place the shares with the buyers. Cut Off Price In Book building issue, the issuer is required to indicate either the price band or a floor price in the red herring prospectus. The actual discovered issue price can be any price in the price band or any price above the floor price. This issue price is called "Cut off price". This is decided by the issuer and LM after considering the book and investors' appetite for the stock. SEBI (DIP) guidelines permit only retail individual investors to have an option of applying at cut off price.

QUESTION BANK

Auditing Standards, Statements and Guidance Notes 1.

2.

3. 4. 5.

6. 7

8.

State your views on the following: (a) “Auditor’s assessment of materiality may be different at the time of planning the engagement than at the time of evaluating the results of his audit procedures.” [Nov,1997,Question 3(a); 10 marks] (b) “The auditor should take into account the aggregate of all uncorrected misstatements, including those involving estimates.” [Nov,1997, Question 3(b); 6 marks] (a) Indicate briefly the purposes for which analytical procedures are applied by the Auditor. [May, 1999, Question 6(a); 6 marks] (b) “The extent of reliance on analytical procedures depends on several factors.” – Explain. [May, 1999, Question 6(b); 10 marks] “An auditor while analysing the errors in a sample need not consider the qualitative aspects of errors detected.” Please comment. [Nov, 2001, Question 3(b), 8 marks] Explain what is meant by “Representations by Management” and indicate to what extent an auditor can place reliance on such representations. [May, 2002, Question 3(b), 6 marks] The auditor “should take into account the aggregate of all uncorrected misstatements including those involving estimates in his assessment of materiality in audit”. [May, 2002, Question 4(b), 8 marks] What are the responsibilities of Joint Auditors as laid down in SAP-12? [Nov,2003,Question 3(b), 8 marks] (a) What are ‘Initial Audit Engagements’? (b) In an Initial audit engagement the auditor will have to satisfy about the sufficiency and appropriateness of ‘Opening Balance’ to ensure that they are free from misstatements, which may materially affect the current financial statements. Lay down the audit procedure, you will follow in cases (i) when the financial statements are audited for the preceding period by another auditor; and (ii) when financial statements are audited for the first time. (c) If, after performing the procedure, you are not satisfied about the correctness of ‘Opening Balances’; what approach you will adopt in drafting your audit report in two situations mentioned in (b) above? [Nov, 2004, Question 3,2+7+7=16 marks] Answer the following (a) Enumerate the basic principles governing an audit. [Nov, 2005, Question 3(a); 5 marks]

III.2

9.

Advanced Auditing and Professional Ethics (b) While examining the going concern assumption of an entity, what important indications should be evaluated and examined? Nov, 2005, Question 3(c); 6 marks] Short Notes (a) Management representations [ May, 1996, Question 8(c); 4 marks] (b) Audit Evidence [May, 1997, Question 8(a); 4 marks] (c) Analytical Review Procedures [Nov, 1997, Question 8(b); 4 marks] (d) Management Representation Letter [Dec, 1999, Question 8(b); 3 marks] (e) Financial indications to be considered for evaluating the assumption of going concern [Nov, 2001, Question 8(b), 4 marks] (f) Substantive Procedures [Nov, 2001, Question 8(c), 4 marks] (g) Auditor's responsibilities regarding comparatives. [Nov., 2003 Question 8(a), 4 marks] (h) Reporting on the compilation engagement. [Nov., 2003 Question 8(b), 4 marks] (i) Human Resource Accounting [May, 2004, Question 8(b); 4 marks] (j) Treatment of foreign currency monetary items on balance sheet date. [May, 2004, Question 8(d); 4 marks] Audit Strategy, Planning and Programming

1.

2.

3.

4.

5.

6.

State your views on the following requests made by the management of X Ltd: The teaming and lading detected was subsequently deposited by the Executive Director of the company and therefore need not be reported upon. [Nov, 1999, Question 1(c); 4 marks] “Materiality and Audit Risk is determined at the time of Audit Planning and should not be changed during the course of audit.” Please offer your comments on the statement. [Nov, 1999, Question 3(a); 4 marks] (a) Explain the concept of audit evidence? [Dec, 1999, Question 3(a); 2 marks] (b) What factors affect choice of audit evidence? [Dec, 1999, Question 3(b); 4 marks] (c) Indicate briefly the methods usually employed by the auditor in the collection of audit evidence. [Dec, 1999, Question 3(c); 10 marks] Comment on the following: “The auditors need not review Accounting Policies unless there is a change in the basis of Accounting.” [May, 2000, Question 4(a); 8 marks] You have been appointed the statutory auditor of a private limited company for the first time. Apart from adopting the conventional audit procedures such as posting, casting and vouching, what other auditing techniques would you employ for conducting the statutory audit? [May, 2001, Question 6, 16 marks] (a) As an internal auditor for a large manufacturing concern, you are asked to verify whether there are adequate records for identification and value of Plant and Machinery, tools and dies and whether any of these items have become obsolescent and not in use. Draft a suitable audit programme for the above. [May, 2005, Question 6(a), 10 marks]

Question Bank 7.

8. 9.

III.3

Comment on the following: “Obtaining audit evidence in performing compliance and substantive procedures. [May, 2005, Question 7(b); 10 marks] When can a company be said to have ‘Not maintained’ proper books of account? Draft a suitable audit programme for the above. Short Notes Enquiry. [Nov., 2003 Question 8(c), 4 marks] Risk Assessment and Internal Control

1. 2.

3. 4.

5. 7.

“Flow chart is one of the very important tools for testing the effectiveness of the Internal Control System of an organisation.” Discuss. What are the salient features of an ideal flow chart? [May, 1996, Question 5; 10+6 marks] State your views on the following request made by the management of X Ltd: Inspite of the internal control weakness commented upon by the audit manager, no further tests need to be carried out, as the purchase and sales figure as a percentage of gross profit was same as in the previous year. The audit manager’s comments were in regard to control over purchase and sales. [Nov, 1999, Question 1(a); 4 marks] Briefly discuss the compliance procedures and their use in evaluation of internal controls. [Nov, 2001, Question 3(a), 8 marks] A partnership firm is engaged in the business of manufacturing and distribution of Mineral Water in a metro city. It is keen in having internal control system established in its main areas of activity i.e., (i) Purchases of Raw Material (ii) Sales of Mineral Water You are required to enumerate at least 8 points for each of the above two areas for the consideration of the management. [Nov, 2002, Question 6, 16 marks] “Surprise Checks” help the auditors to ascertain whether the internal control system is operating effectively in a Company or not. Discuss. [May, 2003, Question 3(a), 8 marks] Short Notes (a) Control Risk [Nov, 1997, Question 8(a); 4 marks] (b) Audit Risks [May, 2002, Question 8(b); 4 marks] (c) Underwriting function and its internal control procedures [May, 2003, Question 8(a); 4 marks] (d) Flow chart technique for evaluation of internal control [May, 2004, Question 8(c); 4 marks] (e) Factors relevant in evaluation of Inherent Risk

III.4

Advanced Auditing and Professional Ethics Audit under Computerized Information System (CIS) Environment

1.

What are the limitations of a Computer System? How can they be remedied? [May, 1996, Question 6; 16 marks] 2. Discuss the advantages and disadvantages of computer audit programmes. [Nov, 1996, Question 7(b); 8 marks] 3. The use of audit software systems increases the probability of detecting fraud. [May, 1997, Question 3(c);4 marks] 4. “The method of collecting audit evidence and evaluating the same, changes drastically under the EDP auditing.” Discuss the correctness of the said statement. [Nov, 1997, Question 7; 16 marks] 5. Draw up a check list for evaluation of output controls on accounts maintained under EDP system. [Nov, 1998, Question 7(b); 8 marks] 6. (a) Outline the special points that are required to be considered in establishing and evaluating a system of internal control for Computer applications processed at a service bureau. [May, 1999, Question 4(a); 12 marks] (b) What are the advantages and disadvantages of using the service bureau from Auditor’s point of view? [May, 1999, Question 4(b); 4 marks] 7. Comment on the following: “Where the Financial Accounting System has not been computerised, the auditor need not verify Computerised Management System.” [May, 2000, Question 4(b); 8 marks] 8. (a) Describe the role of Computer-assisted Audit Techniques in EDP Environment. [May, 2000, Question 6(a); 10 marks] (b) Briefly explain the uses of test packs while conducting examination of accounts in the absence of audit trail. [May, 2000, Question 6(b); 6 marks] 9. What is an Audit Trail? Briefly describe the special audit techniques using the computer as an audit tool. [Nov, 2000, Question 3(a), 8 marks] 10. A limited company having turnover of approximately Rs.50 crore uses a tailor made accounting software package. In the said package, all transactions are recorded, processed and the final accounts generated from the system. The management tells you that in view of the voluminous nature of day books, there is no need to print them and that audit can be conducted on the computer itself. The management further assures you that any 'query based reports' as required can be generated and printed. As a statutory auditor of the company, enumerate the procedures you would adopt to conduct the audit. [May, 2001, Question 3, 16 marks] 11. “On-line real time processing system and batch processing system have their inherent strengths and weaknesses.” Please comment. [Nov, 2001, Question 5(a), 8 marks] 12. Indicate the control procedures which the auditor should adopt in applying CAAT (Computer Assisted Audit Technique) in an audit under EDP environment. [May, 2002, Question 7, 16 marks]

Question Bank

III.5

13. (a) The role of an Auditor in collecting evidence under the EDP system is more complex than under the Manual System. Discuss. (b) What are the characteristics of an on-line computer system? [Nov, 2002, Question 4(a) & (b), each 4 marks] 14. Discuss the control procedures which the auditor should adopt in applying CAAT (Computer Assisted Audit Technique) in an audit under EDP environment. [Nov.,2003 Question 4(a), 8 marks] 15. State the important characteristics of an effective computer audit program system. [May, 2004, Question 4(a); 8 marks] 16. (a) State the specific problems, which may arise in the implementation of internal control in an EDP system. (b) What are the characteristics of ‘On-line Computer System’? (c) Explain : Tagging and Tracing [Nov, 2004, Question 5(a), (b)&(c); 8+4+4 marks] 17. In determining whether to use Computer Assisted Auditing Techniques (CAATs), what are the factors that a statutory auditor has to consider? [Nov., 2005, Question 7(b), 8 marks] 18. Enumerate the risks and internal control characteristics in an audit conducted in Computer Information system (CIS) environment. [Nov.,2005, Question 7(b), 8 marks] 19. Short Notes (a) Tagging and Tracing [May, 1998, Question 8(a); 4 marks] (b) Systems Development Control [May, 1998, Question 8(b); 4 marks (c) Decision Tree [Nov, 2000, Question 8(i), 4 marks] (d) Utility Routine [Nov, 2000, Question 8(iv), 4 marks] (e) Walk Through Tests [May, 2005, Question 8(a) 4 marks] Special Audit Techniques 1.

How does an Auditor apply Statistical Sampling in auditing?{Nov. 2003, Question 3(a), 8 marks] The Company Audit

1.

As an auditor state your views on the following situations: (i) Where the company has changed the format relating to items of income and expenditure to be disclosed in the profit and loss account. [Nov, 1996, Question 1(a)(i); 4 marks] (ii) Where the company has charged depreciation on straight line method while computing net profit for the determination of managerial remuneration. [Nov, 1996, Question 1(a)(ii); 4 marks] (iii) A company having several departments with separate payrolls and where payments of wages are spread over several days, makes lump-sum deposits of estimated amounts

III.6

2.

3.

4.

5.

6.

Advanced Auditing and Professional Ethics of provident fund and Employees State Insurance dues and adjusts the excess or deficit against the following month’s deposit. [Nov, 1996, Question 1(a)(iii);4 marks] Enumerate the procedure for vouching in respect of the following items: (a) Legal Charges (b) Preliminary Expenses (c) Dividends Received/Receivable on Shares (d) Carriage outwards [Nov, 1996, Question 8(a),(b),(c)&(d); 4×4 = 16 marks] In the previous year ‘Y’ Ltd. has made a provision of 10% of the contract value on an ongoing project. The actual loss on completion of the contract in the subsequent year was 11%. The management adjusted the difference in the previous year’s account. As an Auditor, state your views on the above subject. [May, 1997, Question 1(b); 8 marks] Comment on the following statement: Any violation of the provisions of the Income-tax Act will make the payment of dividend illegal. [May, 1997, Question 3(b); 4 marks] As an auditor, state your views on the following situations: A well-established manufacturing public limited company proposes to issue fully paid bonus shares: (i) in lieu of dividend; (ii) without converting partly paid up shares into fully paid up shares. [May, 1997, Question 7(b); 6 marks] As an auditor state your views on the following situations: (a) To set up the marketing and distribution division, a company carried out trading activities during the construction period. The company capitalised all general administrative expenses as it had not commenced commercial production [Nov, 1997, Question 1(a); 5 marks] (b) A computerised machinery was purchased by two companies jointly. The price was shared equally. It was also agreed that they would use the machinery equally and show in the Balance Sheets, 50% of the value of the machinery and charge 50% of the depreciation in their respective books of account. [Nov, 1997, Question 1(b); 5 marks] (c) X Ltd. prior to receipt of their management consultants suggestions, had been valuing its stock consistently by adding factory overheads to its prime cost. The consultants had recommended a better procedure which would ensure a fair allocation of overheads. The company intends to adopt the new basis but unwilling to accept the fact that this was a change in the basis as stated by their consultants. [Nov, 1997, Question 1(c); 5 marks] (d) Y Ltd. purchased an existing bottling unit. The method of charging depreciation on machinery of the acquired unit, was different from that followed by the company in its other units. The company wants to continue to charge depreciation for the acquired unit, in the method followed earlier by them and which was not consistent with their own method. [Nov, 1997,, Question 1(d); 5 marks]

Question Bank 7.

III.7

Excel Ltd. is a Manufacturing Company in durable consumer goods with an annual turnover of Rs.1,000 lakhs. The company receives orders from its commission agents all over the country, but goods are despatched directly to the customers. The documents including transport bills are sent through the bank for collection. At the end of the year, it is found that documents covering the despatch of goods worth Rs.100 lakhs were still lying with the banks not cleared by the customers even though the normal collection period of 20 days from the date of despatch has expired. Should Revenue be recognised in the above case/ [May, 1998, Question 1(d); 5 marks] 8. As an auditor, state your views on the following situations: (a) The debenture trust deed executed by Trust Me Ltd. stipulated the creation of a sinking fund for redemption of debentures. In terms of the Trust Deed, a specific amount was to be transferred to the sinking fund from out of the profits of each year. In spite of substantial profits in the year 1997, no amount is found transferred to the Sinking Fund Account. [May, 1998, Question 2(a); 4 marks] (b) A suit for damages of Rs. 1 lakh for breach of contract of sale (breach occurred in 1995) was decreed in favour of May Ltd. in March, 1997. The company has included the amount in its turnover for the financial year, 1997. [May, 1998, Question 2(b); 4 marks] (c) Note No.7 of Published Accounts of December Ltd. is as follows: “The cost of work-in-process materials estimated to remain in several pots of smelting plant is not taken into account, both at the beginning and at the end of the year for the following three reasons: (i) The cost of work-in-process material put into the pots immediately before commissioning of the smelting plant stood capitalised. (ii) The quantity of work-in-process materials is expected to be the same at any point of time. (iii) It is extremely difficult to measure exactly the amount of fill in the pots”. [May, 1998, Question 2(c); 4 marks] (d) In the course of audit of a manufacturing company, it comes to light that it has outstanding forward contracts for purchase of raw materials at a price, which is higher than the current market price. However, there is no mention of this in the financial statements of the year. [May, 1998, Question 2(d); 4 marks] 9. Discuss with reference to the Accounting Standards the nature of classification and disclosure requirements in the statement of Profit & Loss of an entity in the following cases: (a) Losses sustained as a result of enemy action. (b) Disposal of Long-term investments of a trading entity. (c) Setting up of group gratuity scheme where there was none. (d) Payment of arrears of Bonus for the earlier year as a result of settlement with the workers in the current year. [May, 1998, Question 5(a),(b),(c)&(d); 4×4 = 16 marks] st 10. (a) For the year ended 31 March, 1998 directors of Akash Ltd. want to declare dividend at 20% on the paid up equity capital of Rs.50 lakhs. They also want to transfer 15% of the profits to Reserves. Other informations are as follows: (i) Profit after tax for the relevant year is Rs.40 lakhs.

Advanced Auditing and Professional Ethics

III.8

(b)

(c)

11. (a)

(b)

(ii) Average rate of dividend in the immediately preceding three years is 21%. (iii) Average amount of dividend in the immediately preceding three years is Rs.10.5 lakhs. (iv) Average amount of profit after tax in the immediately preceding two years is Rs.55 lakhs. (v) There was bonus issue of shares in one of the immediately preceding three years. Advise the Directors on the proposed transfer to reserves . [Nov, 1998, Question 2(a); 6 marks] Little Ruck Ltd. was incorporated on 1.4.97. During the year ended 31st March, 1998 there was no manufacturing or trading activity except raising of share capital, purchase of land, acquisition of plant and machinery and construction of factory sheds. Therefore the Chief Accountant of the company contends that for the relevant year there was no need to prepare a statement of profit or loss or any other similar statement except a Balance Sheet as at 31st March, 1998. Give your comments on the views of Chief Accountant. [Nov, 1998, Question 2(b); 5 marks] Alert Ltd. based in India has branches in London. The Vice-President Accounts is of the opinion that the net exchange difference of Rs.20 lakhs on the translation of items in financial statements of London Branches should be credited to the profit and loss account of the company and disclosed as follows: Favourable exchange difference on items other than fixed assets Rs.50 lakhs Less: Unfavourable exchange difference on account of increase in Term liability on purchase of fixed assets Rs.30 lakhs Net exchange difference transferred to profit and loss account Rs.20 lakhs Do you agree with the views of Vice-President Accounts? Give brief reasons for your answer. [Nov, 1998, Question 2(c); 5 marks] At the Annual General Meeting of a Public Limited Company held on April 1, 1996. M/s Bat and Ball a firm of chartered accountants was appointed to audit the accounts of the company for the calendar year, 1996. However the next Annual General Meeting of the company did not take place until January 1, 1999. M/s Bat and Ball insist that they alone are entitled to audit the accounts not only for the year 1996, but also for the years 1997 and 1998 respectively. Advise the company on the contention of M/s Bat and Ball. [May, 1999, Question 1(c); 5 marks] The Chief Accountant of Stumps Ltd. is of the opinion that before declaration of dividends it would not be necessary to set off the carried forward amount of debit balance in the Profit and Loss Account against current revenue profits but the same could be set off against existing revaluation reserve – Do you agree? [May, 1999, Question 1(d); 5 marks]

Question Bank

III.9

12. As an Auditor, state your opinion on the following situations: (a) Note No.6 of Published Accounts of Kambakadi Ltd. reads as follows: “The company being a manufacturer of pollution control equipments has entered into collaboration agreements with foreign manufacturers for technical know-how comprising the supply of drawings and designs and training of personnel for manufacture of different types of pollution control equipments. These agreements were concluded after the commencement of production at the beginning of the year. The collaboration amount of Rs.100 lakhs is payable in five annual instalments. The company has amortised the entire cost of technical know-how as a depreciable asset and has shown the same in the schedule of fixed assets.” [May, 1999, Question 2(a); 5 marks] (b) Note No.7 to the Balance Sheet of RNR Ltd. as on 31-12-98 is as follows: “The company had a large engineering contract with a Foreign Government, work to be carried out in foreign country and payments to be received in dollars. The work was completed in the year 1995 and the entire contracted amount was duly recorded in the books of the company at the prevalent exchange rate on the date of completion of the work. However, payments to the extent of Rs.20 crores could not be released by the foreign Government because of temporary foreign exchange crisis in that country. This Rs.20 crores unrealised at the end, if converted at the year end rate would amount to Rs.20.50 crores. The company has adopted and follows the following accounting policy: In respect of foreign currency transactions, current assets and current liabilities are revalued at year end rates. However, if there is net loss due to exchange difference, the same is charged off to the profit and loss account but if there is net gain the same is ignored in view of the prudent accounting principle of not recording unrealised gains due to exchange rate fluctuations.” Comment on the appropriateness of above. [May, 1999, Question 2(b); 5 marks] (c) A Public Charitable Institution registered u/s 25 of the Companies Act, 1956 is running a printing press and a transport system as feeder of funds to carry on charitable activities. The accounting policies by way of notes to accounts are stated as follows: (i) Accounts are maintained on cash basis. (ii) Accounting Standards are not being followed as they are considered to be inapplicable to Charitable entities. [May, 1999, Question 2(c); 6 marks] 13. State with reasons whether the following proposition is true or false: Special Audit can be ordered by the Central Government u/s 233A of the Companies Act, 1956 if a company sustained losses continuously for two years and the special auditor may not be a chartered accountant in practice. [May, 1999, Question 3(a); 4 marks] 14. State your views on the following requests made by the management of X Ltd.: (a) Proposed Dividend does not represent a liability and therefore, no provision need be made. [Nov, 1999, Question 1(d); 4 marks] (b) Revaluation Reserve is available for issue of Bonus Shares. [Nov, 1999, Question 1(e); 4 marks]

III.10

Advanced Auditing and Professional Ethics

15. The Board of Directors of Fair Brother Ltd. seek your advice in the finalisation of financial statements for the year ended 30-6-99. On a review of financial statements, it is noticed that: (i) The company has written up its fixed assets by Rs.50 lakhs and the accumulated depreciation of Rs.10 lakhs stands transferred to profit and loss account. [Nov, 1999, Question 3(c)(i); 3 marks] (ii) Research and development cost of Rs.15 lakhs which was charged to profit and loss account a few years before is written back to profit and loss account of the current year. [Nov, 1999, Question 3(c)(ii); 3 marks] (iii) Sale of goods costing Rs.54,000 with a profit margin of 10% on selling price is included in the inventory as delivery of goods was postponed at buyer’s request. [Nov, 1999, Question 3(c)(iii);3 marks] Advise the company on changes to be effected in the draft financial statements. Give reasons in support of your advice. There is no necessity to discuss disclosure requirements in this regard. 16. As an Auditor state your views on the following situations: (a) During the year ended 31-10-99 Long Ltd. sent its application to the excise authorities for refund of duty and grant of cash assistance amounting to Rs.50 lakhs in pursuance of a scheme yet to be finally approved by the authorities. The Chief Accountant of the company would like to include the said amount of Rs.50 lakhs in the income statement for the year ended 31-10-99. [Dec, 1999, Question 1(a); 5 marks] (b) Short Ltd. purchased an equipment for Rs.100 lakhs against which it received government grant of Rs.40 lakhs. The prescribed rate of depreciation for the equipment is 10% p.a. The accountant of the company insists that the amount of grant should be credited to capital Reserve and Depreciation on the original cost should be charged. [Dec, 1999, Question 1(b); 5 marks] (c) Tall Ltd. valued at the year end its stock of goods ready for export at realisable value yielding a margin of 10% on cost. Further the company wants to include in the value of stock the amount of export incentives to which it may be entitled. [Dec, 1999, Question 1(c); 5 marks] (d) In the draft balance sheet of Small Ltd. long term unquoted investments were valued at Rs.80 lakhs. During the course of audit it transpired that there has been a decline in the value of investments which is other than temporary as at the date of the balance sheet. The Chief Accountant contends that such diminution should not be taken into account. [Dec, 1999, Question 1(d); 5 marks] 17. (a) Briefly mention the statutory requirements for payment of dividends out of current profits. [Dec, 1999, Question 6(a); 12 marks] (b) In what circumstances dividends may be declared out of accumulated reserves? [Dec, 1999, Question 6(b); 4 marks] 18. As an auditor state your views on the following situations: (a) T Ltd. purchased goods on credit for Rs.5 crores for export from ABC Ltd. Upon the export order being cancelled T Ltd. decided to sell the same in the domestic market at a

Question Bank

III.11

discounted price. Accordingly ABC Ltd. was requested to offer a price discount of 25%. ABC Ltd. wants to adjust the sales figure to the extent of discount requested by T Ltd. [May, 2000, Question 1(a); 5 marks] (b) During the year under audit, Z Ltd. credited to the Profit and Loss Account, the entire profit of Rs.20 lakhs on the sale of land not required for its use. You are informed that the directors would like to propose dividend out of the above profit. [May, 2000, Question 1(b); 5 marks] (c) Y Ltd. provided Rs.25 lakhs for inventory obsolescence in 1998-1999. In the subsequent year, it was determined that 50% of such stock was usable. The company wants to adjust the same through prior period adjustment account as the provision was made in the earlier year. [May, 2000, Question 1(c); 5 marks] (d) VV Ltd. announced a voluntary retirement plan for its employees on January 1, 2000. The scheme is scheduled to close on June 30, 2000. The scheme envisaged an initial lump sum payment of maximum of Rs.2 lakhs and monthly payments over the balance period of service of employees coming under the plan. 200 employees opted for the scheme as on March 31, 2000. The total lump sum payment for these employees would be Rs.250 lakhs and the aggregate of future payments to them would amount to Rs.1,500 lakhs. However, no payment had been made to the employees under the scheme up to 31st March, 2000. Nor the company made any provision in its accounts towards any liability under the scheme. [May, 2000, Question 1(d); 5 marks] 19. You have been appointed a statutory auditor of a limited company engaged in the manufacture of chemicals. What would be your views on the following? (a) The management tells you that the work in process is not valued since it is difficult to ascertain the same in view of the multiple processes involved and in any case the value of opening and closing work in process would be more or less the same. (b) The company has a turnover exceeding Rs.5 crores for a period of three consecutive financial years immediately preceding the financial year concerned, but does not have any internal audit system. (c) The management tells you that there is no need for them to follow accounting standards specified by the Institute of Chartered Accountants of India as these are for the auditor to follow. (d) The company has suffered a net loss for the year. The directors however declared and paid an interim dividend @ 30% based on the half-yearly performance. [May, 2001, Question 1(a),(b),(c),(d), 20 marks] 20. Answer the following: (a) Briefly describe the auditor’s responsibility regarding subsequent events. [May, 2001, Question 2(a), 10 marks] (b) Briefly describe the reporting requirements by a statutory auditor of a company for personal expenses of directors. [May, 2001, Question 2(b), 6 marks]

III.12

Advanced Auditing and Professional Ethics

21. Comment on the following: (a) The Accounting Standards issued by the Institute of Chartered Accountants of India need to be followed only by limited companies and not by partnership firms or proprietorships. [May, 2001, Question 4(a), 4 marks] (b) For Excise Duty on finished goods in stock as at the end of the year, there is an option available to provide for the same or to show the same as a Contingent liability. [May 2001, Question 4(c), 4 marks] 22. As a statutory auditor of a Public Limited Company, how would you deal with the following situations? (a) The company has sold some old machinery for Rs. one crore. The details of the cost of such machinery are not available since the entire records relating to fixed assets have been destroyed in an earthquake. [May 2001, Question 7(a), 5 marks] (b) The company had subscribed to shares of associate companies amounting to Rs.5 crores. These associate companies have incurred substantial losses and have been referred to BIFR for being declared as sick companies. The company does not want to make any provision for the fall in the value of the investments. [May 2001, Question 7(b), 5 marks] (c) As at the beginning of the year, the company has a capital of Rs.2.50 crores, free reserves of Rs.0.50 crores and Revaluation Reserve of Rs.4.50 crores. In the relevant year under audit the company has incurred a loss of Rs.4 crores. The company proposes to adjust the loss with the Revaluation Reserve. [May 2001, Question 7(c), 6 marks] 23. As an auditor state your views on the following situations: (a) Included under Current Assets of XYZ Ltd. is inventory aggregating to Rs.20 crores. A part of the said inventory manufactured for export had to be sold earlier at a discounted price off-shore due to moisture content present at the time of delivery. A part of similar inventory is included in Rs.20 crores. [Nov, 2001, Question 1(a), 5 marks] (b) A construction company accounted for a contract entered into with a Government Department on completed contract method and that with a Private Sector Company on percentage of completion method. Both the contracts were for development of a township. [Nov, 2001, Question 1(b), 5 marks] (c) X Ltd. entered into a contract with Y Ltd. to despatch goods valuing Rs. One lakh every month for six months upon receipt of entire payment. Y Ltd. accordingly made the payment. In 3rd month due to a natural calamity, Y Ltd. requested X Ltd. not to despatch until further notice. X Ltd. accounted Rs. two lakhs as sales and transferred the balance to Advance Receipt against sales. [Nov, 2001, Question 1(c), 5 marks] (d) XYZ Ltd. entered into a collaboration agreement with a U.S. based company to acquire knowhow for both manufacturing process and design, drawing of the factory at a total cost of Rs.10 crores. 75% of the knowhow cost was for design and drawings. XYZ Ltd. capitalised the cost of drawings, etc., with factory building and cost for manufacturing process with the cost of machinery. [Nov, 2001, Question 1(d), 5 marks]

Question Bank

III.13

24. Answer the following: (a) Briefly describe the Auditor’s responsibilities regarding disqualification of Directors. [Nov, 2001, Question 4(a), 8 marks] (b) Briefly describe how an auditor can use the work of an expert. [Nov, 2001, Question 4(b), 8 marks] 25. Y Ltd. Has accumulated losses of Rs.12 crores. The Reserves and Surplus of the said company also include “Share Premium Account” of Rs. 15 crores. The company intends to adjust the accumulated losses against the “Share Premium Account”. Is the company permitted to do so under the provisions of the Companies Act, 1956? [Nov, 2001, Question 7(b), 6 marks] 26. As an auditor, state your view on the following: (a) M Ltd. manufactures machinery used in Steel Plants. It quotes prices in various tenders issued by Steel Plants. As per terms of contract, full price of machinery is not released by the steel plants, but 10% thereof is retained and paid after one year if there is satisfactory performance of the machinery supplied. The company accounts for only 90% of the invoice value as sales income and the balance amount in the year of receipt to the extent of actual receipts only. (b) A company had imported raw materials worth US dollars 2,50,000 on 15th January, 2002 when the exchange rate was Rs.46 per US dollar. The company had recorded the transaction at that rate. The payment for the imports was made only 15th April, 29002 when the exchange rate was Rs.49 per US dollar. However, on 31st March, 2002 the rate of exchange was Rs.50 per US dollar. The company passed an entry on 31st March, 2002 adjusting the cost of raw materials consumed for the difference between Rs.49 and Rs.46 per US dollar. (c) A Public Company defaulted in the repayment of deposits together with interest on the due date for more than a year and the Chief Accountant contends that the auditor need not report on the default committed by the company. [Nov, 2001, Question 1(a), (b) & (d), each 5 marks] 27. (a) Following is the data regarding six segments of Z Ltd.: (Rs. in ‘000s) Particulars

A

B

C

D

E

F

Segment Revenue (Rs.)

150

310

40

30

40

30

Segment Result (Rs.)

25

(95)

5

5

(5)

15

Segment Assets (Rs.)

20

40

15

10

10

5

The Finance Director is of the view that it is sufficient that segments A and B alone be reported. Advise. (b) Y Ltd. wishes to obtain a machine tool costing Rs.20 lakhs by way of lease. The effective life of the machine tool is 12 years but the company requires it only for the first five years. It enters into an agreement with R Ltd. for a lease rental of Rs.2 lakhs p.a.

III.14

Advanced Auditing and Professional Ethics

The Finance Director of Y Ltd. is not sure about the treatment of these lease rentals and hence requests your assistance in proper disclosure of the same. For calculation purposes, the implicit rate of interest may be taken at 15%. Discount factors : 0.87, 0.76, 0.66, 0.57 and 0.50. [May, 2002, Question 2(a) & (b) each 4 marks] 28. As a Statutory Auditor, how would you deal with the following? (a) X Ltd. Acquired a machine costing Rs.50 lakhs on a finance lease on 1st October, 2001. The terms of payment were Rs.5.50 lakhs every six months for a period of 5 years. While preparing the accounts for the year ended 31st March, 2002, the Directors of the company debited the amount paid to Lease Charges Account that was finally charged to the Profit and Loss Account. (b) A machinery costing Rs.1 lakh and presently having book value of Rs.20,000 is not put to active use by the company for various reasons. The machinery has been identified for disposal and is reasonably expected to realise Rs.5,000 on sale. Pending the disposal, in the Balance Sheet as on 31.3.2002, the said machinery stands included with other Plant and Machinery and shown at book value. (c) The total sales of a partnership firm for the year ended 31.3.2002 are Rs.41 lakhs, which include Rs.2 lakhs for sale of a car. The partners of the firm are of the opinion that their firm is not subject to tax audit Section 44AB of the Income Tax Act, 1961. (d) Y Ltd. Decided on 31st March, 2002, to convert a part of its Fixed Assets consisting of land and building acquired before 30 years into “stock-in-trade”. The book value of the said Land and Building on 1.4.2001 was Rs.5 lakhs and the same is converted into “stock-in-trade” at its market value of Rs.500 lakhs on the date of its conversion. The difference of conversion of Rs.495 lakhs was credited to the Profit and Loss Account. From the final profit after tax of Rs.400 lakhs the company has declared a Dividend of Rs.300 lakhs. [May, 2002, Question 1(a), (b), (c) & (d) each 5 marks] 29. As a statutory auditor, how would you deal with the following? (a) ABC Ltd., is a company engaged in the business of construction of roads and bridges. It follows completed contract method for all its projects and therefore revenue is recognised only when the contract is completed or substantially completed. For the year ended 31st March, 2001, the ABC Ltd., has earned a sum or Rs. 25 lakhs as interest on short-term deposits with their bank. These deposits are made out of advances received from the customers towards the projects that they are executing. ABC Ltd. while filing their Return of Income for the year 31st March, 2001 with the tax authority declared NIL income for that year. While calculating progress payments at the year-end, the interest of Rs.25 lakhs earned was considered as part of the funds received for the project. Is the treatment given by ABC Ltd. with regard to the interest earned on short-term deposit correct? (b) XYZ Ltd., as part of overall cost cutting measure announced voluntary retirement scheme (VRS) to its employees, to reduce the employee strength. During the first half year ended 30.9.2002 the company paid a compensation of Rs.72 lakhs to those who availed the scheme. The Chief Accountant has reflected this payment as part of regular salaries and wages paid by the company. Is this correct?

Question Bank (c)

III.15

During the course of statutory audit of an investment company dealing in shares and securities, inspite of repeated reminders by the statutory auditor, the company officials did not provide the investments held by the company at the Balance Sheet date for verification and also did not provide the details for valuation of unlisted shares as on the Balance Sheet date. The statutory auditor, in his final audit report to the shareholders, reported as follows: “Subject to the verification of the existence and value of the investments, the Balance Sheet shows a true and fair view.” Is the report made by the statutory auditor correct? [May, 2003, Question 1(a), (b) & (c) each 6 marks] 30. As a Statutory Auditor, how would you deal with the following? (a) A husband and wife are controlling 34% of voting power in XY Company Limited. They are having a separate partnership firm, which supplies mainly the raw material to the Company. The Management says that the above transaction need not be disclosed. (b) While commencing the statutory audit of B Company Limited, the auditor undertook the risk assessment and found that the detection risk relating to certain class of transactions cannot be reduced to acceptance level. (c) While auditing accounts of a public limited company for the year ended 31st March, 2003, an auditor found out an error in the valuation of inventory, which affects the financial statement materially – Comment as per auditing and assurance standards. (d) At the statutory audit of TOR Limited, the physical verification of fixed assets was conducted. However the auditor was not able to confirm the existence of valuables and important machinery. In this connection, the auditor obtained a certificate from the management to prove its existence and value and accepted the same blindly without any further procedures. [Nov, 2003, Question 1(a), (c) 5 marks & (b) (d), 4 marks] 31. An old car of a company having a nominal book value has found a buyer, who is willing to pay Rs. 1 lakh for it. The company proposes not to sell the car, but to neglect its valuation in its accounts at Rs. 1 lakh. Should the auditor permit the company to do so? [Nov. 2003, Question 3 (b), 8 marks] 32. As a Statutory Auditor how would you deal with the following cases? (a) During the course of audit of ABC Ltd. it is noticed that out of Rs. 12 lakhs of provident fund contribution accounted in the books, only Rs. 2 lakhs has been remitted to the authorities during the year. On enquiry the Chief Accountant informed that due to financial problems they have not remitted but will remit the same as and when the position improves. (b) National Tourism Ltd., a wholly owned Government Company approaches you to give a revised report on the revised accounts, as the original accounts has undergone changes consequent to the audit of Comptroller and Auditor General of India. (c) M/s LNK's group gratuity scheme's valuation by actuary shows wide variation compared to the previous year's figures.

III.16

Advanced Auditing and Professional Ethics

(d) In the books of accounts of M/s OPQ Ltd. huge differences are noticed between the control accounts and subsidiary records. The Chief Accountant informs that this is common due to huge volume of business done by the company during the year. [May, 2004, Question 1(a),(b),(c) & (d); each 4 marks] 33. State the salient features of Investors Education and Protection Fund. [May, 2004, Question 3(b), 8 marks] 34. What are your views on the following? (a) A Ltd. Was under audit for the year ended 31.03.2004. An appeal filed by A Ltd. Against the demand of Excise Duty of Rs. 26 crores was pending before the Supreme Court for which neither provision was made nor was disclosed in the notes to the financial statements. On 12th Jully, 2004, the auditor came to know through paper reports that the point involved in the appeal of A Ltd. was adjudicated by the Supreme Court in the case of some other assessee, which is in favour of the department of Excise Duty. The auditor insisted that provisions be made of Rs. 26 crores in the financial statements. The Management was of the view that since its own case is still pending, no provision is called for. It was also of the view that the event does not have any effect on the financial position of the company on the date of the Balance Sheet. Is the view of the Management tenable? (b) Kevin Industries Ltd. has a paid up capital of Rs. 20 crores divided into equity shares of Rs. 10 each as on 31.03.2003. During the financial year 2003-04 it has issued bonus shares in the ratio 1:1. The net profit after tax for the years 31.03.2003 and 31.3.2004 is Rs.10 crores and Rs 15 crores respectively. The Earnings Per Share (EPS) disclosed in the financial statements for the above two years is Rs. 5.00 and Rs. 3.75 respectively. Is the disclosure correct? (c) An auditor of Sagar Ltd. was not able to get the confirmation about the existence and value of certain machineries. However, the management gave him a certificate to prove the existence and value the machinery as appearing in the books of account. The auditor accepted the same without any further procedure and singed the audit report. Is he right in his approach? (d) A firm of a father and a son is receiving Rs. 2 lakhs towards job work done for XYZ Ltd. during the year ended on 31.03.04. The total job work charges paid by XYZ Ltd. During the year over Rs. lakhs. The father is a Managing Director of XYZ Ltd. having substantial holding. The Managing Director told the auditor that since he is not involved in the activities of the firm and since the amount paid to it is insignificant; there is no need to disclose the transaction. He further contended that such payment made in the last year was not disclosed. Is Managing Director right in his approach? [Nov, 2004, Question 1(a), (b), (c) & (d); each 5 marks] 35. Do you approve of the following? If not, why? (a) A firm of Chartered Accountant was appointed by a company to evaluate the costs of the various products manufactured by it for its information system. One of the partners of the firm was a Non-Executive Director of the company.

Question Bank

III.17

(b) Mr. Qureshi, Chartered Accountant, in practice died in a road accident. His widow proposes to sell the practice of her husband to Mr. Pardeshi, Chartered Accountant, for Rs. 5 lakhs. The price also includes right to use the firm name-Qureshi and Associates. Can widow of Qureshi sell the practice and can Mr. Pardeshi continue to practice in that name as a proprietor? (c)

Trimurthy Pan Masala (P) Ltd. Was incurring heavy losses in the last several years since it could not withstand the competition in the market. The State in which the company had its registered office and also its major sales had moved a bill in the State Assembly to ban manufacture and sale of all kinds of Pan Masalas in the State. While finalizing the accounts for the year ended 31-03-2004, the CFO of the company created a Deferred Tax Asset for the tax benefits that would arise in future years from the earlier years losses that had remained unabsorbed in Income Tax.

(d) Big Ltd. has borrowed Rs. 30 lakhs from State Bank of India during the financial year 2003-04. The borrowings are used to invest in shares of Small Ltd., a subsidiary company of Big Ltd., which is implementing a new project estimated to cost Rs. 50 lakhs. As on 31st March, 2004, since the said project was not complete, the directors of Big Ltd. Resolved to capitalize the interest accruing on borrowings amounting to Rs. 4 lakhs and add it to the cost of investments. [Nov, 2004, Question 1(a),(b),(c) & (d); each 4 marks] 36. Miranda Spinning Mills Ltd. Is a sick company and has accumulated losses of Rs. 10 crores. The company has Rs. 12 crores in its share Premium Account. The Management desires to adjust the accumulated losses against the share premium balance. Advice the company giving your reasons. [Nov., 2004, Question 6(b), 8 marks] 37. A company has paid interim dividend at 10% based on its half-yearly performance while at the end of the year suffered a net loss. How you will deal with the matter in your audit report as a statutory auditor? [Nov., 2004, Question 7(b), 4 marks] 38. As a Statutory Auditor, how would you deal with the following? (a) The Managing Director of the Company has committed a “Teeming and Lading” Fraud. The amount involved has been however subsequently after the year-end deposited in the company. (b) P Pvt. Ltd. was amalgamated with PQR Ltd. with effect from 1st April, 2004. As per the scheme of amalgamation approved by the High Court, the amalgamation was to be accounted by the “Pooling of Interests Method”. The scheme further provided that the balance in Revaluation Reserve of P Pvt. Ltd. As on 31st March, 2004 was to be treated as a General Reserve on amalgamation. During the financial year 2004-05, PQR Ltd. Issued bonus shares out of General Reserves (which included the amount of revaluation reserve of P Pvt. Ltd.) (c) B Pvt. Ltd., implements a Voluntary Retirement Scheme (VRS) for its employees. It follows a policy of amortising the expenditure over 10 years. As at 1st April, 2004, the unamortised VRS expenditure was Rs. 15 lakhs. During the year 2004-05, it incurred further Rs. 12 lakhs as VRS. For the year ended 31st March, 2005, the company

Advanced Auditing and Professional Ethics

III.18

proposes to revise the period of amortisation to 5 years. It also proposes to follow the revised period for the opening balance. (d) The accountant of C Ltd. has requested you, not to send balance confirmations to a particular group of debtors since the said balances are under dispute and the matter is pending in the Court. [May, 2005, Question 1(a), (b), (c) & (d), 4+5+5+4 marks] 39. Answer the following: (a) Enumerate, in brief, the important aspects to be evaluated by the external auditor in determining the efficiency and extent of reliance to be placed on the work and function of an Internal Auditor. (b) While compiling the financial statements of a concern, you observed that the input information supplied by the concern is incomplete, incorrect and few of the Accounting Standards have not been followed. Describe, in brief, the procedure you will follow in the above. (c)

You have been appointed the sole statutory auditor of a company where you were one of the joint auditors in the immediately preceding year. The concerned joint auditor has not been reappointed. What are the various steps you would take to ascertain the compliance of the requirements of the Companies Act, 1956 before accepting the audit? [May, 2005, Question 3 (a)(b)&(c); each 6+5+5 marks] 40. Comment on the following: A company has a branch office, which recorded a turnover of Rs. 1,90,000 in the financial year 2004-05. No audit of the branch has been carried out. The statutory auditor of the company has made no reference of the above branch in his report. The total turnover of the company is Rs. 10 crores for the year 2004-05. 41. As a Statutory Auditor, how would you deal with the following? (a) ABC Ltd. Commenced construction of a flyover in Mumbai in January, 2004 under BOLT scheme. The same was completed in February, 2005. Due to seasonal heavy rains in July, 2004 in the area, the work on the flyover had to be suspended for 1 month. The company accordingly suspended borrowing costs of Rs. 12.50 lakhs for that month from capitalization. (b) LM Ltd. has 2 divisions L and M. The finished products of division L are transferred to division M where further processing is carried out before sale of customers. To achieve transparency and accountability between the divisions, division L raises an invoice on division M at cost plus normal margins. At the year end the unrealized profits on interdivision stocks are eliminated. However, the transfers are recorded at the invoice value as sales and purchases in the respective divisions for the purpose of preparing the Profit and Loss Account. Suitable disclosures, for this are given in then ‘Notes to Accounts’. (c) T Pvt. Ltd is an unlisted closely held company with turnover less than Rs. 50 crores. While finalizing the accounts, Mr. M the Director (finance) disputed the applicability of As 20 to the company. [Nov, 2005, Question 1(a)(b), (c)&(d); 5+5+5+3 marks]

Question Bank 42

III.19

Short Notes (a) Special Audit under the Companies Act. [May, 1996, Question 8(a); 4 marks] (b) Non-provision of tax liability in the accounts. [May, 1996, Question 8(b); 4 marks] (c) Payment of unpaid/unclaimed dividend to shareholders. [May, 1996, Question 8(d); 4 marks] (d) Interim dividend. [May, 1996, Question 8(e); 4 marks] (e) Verification of Ownership Flats. [May, 1997, Question 8(b); 4 marks] (f) Personal Expenses of Directors. [May, 1997, Question 8(e); 4 marks] (g) Provision for Unpaid Excise Duty [May, 1998, Question 8(e); 4 marks] (h) Revaluation Reserve and its uses. [Nov, 1998, Question 8(c); 4 marks] (i) Non-provision of proposed dividend in the Profit and Loss Account [Nov,1998,Question 8(d); 4 marks] (j) Depreciable assets as defined in AS-6. [Nov, 1998, Question 8(e); 4 marks] (k) Permanent Difference and Timing Difference. [May, 1999, Question 8(d); 4 marks] (l) Accounting for CDT [Nov, 1999, Question 8(d); 4 marks] (m) Interest as Deferred Credits [Dec, 1999, Question 8(a); 4 marks] (n) Cut-off Procedures [May, 2000, Question 8(d); 4 marks] (o) Personal Expenses of Directors [Nov, 2002, Question 8(c); 4 marks] (p) Personal Expenses of Directors [May, 2003, Question 8(d); 4 marks] (q) Suspension of capitalisation of borrowing costs [Nov, 2001, Question 8(a), 4 marks] (r) Monetary items and its treatment on balance sheet date [Nov, 2001, Question 8(d), 4 marks] (s) Divisible Profits [May, 2002, Question 8(c), 4 marks] (t) Interim Dividend [Nov, 2003, Question 8(d); 4 marks] (u) Record of Audit Assignments (as required by ICAI regulations) (v) Capital Reserves [Nov, 2001, Question 8(d), 4 marks] Liabilities of Auditors

1. 2.

One of the three joint auditors of a company differs from the views of the other two auditors with regard to certain matter to be covered by the report. Discuss his rights and duties in this regard. [May, 1997, Question 4(b); 6 marks] The liability of audit fees of a company has been outstanding since last two years. This year after completion of audit, the auditor informs to the secretary of the company over phone to bring the cheque of all the three years and take delivery of the audit report. Discuss briefly the above statement in the context of the right of the auditor to receive remuneration. [May, 1997, Question 6(a); 4 marks]

III.20 3. 4. 5.

6.

7.

8.

9.

Advanced Auditing and Professional Ethics Can the Statutory Auditor rely upon the work of an internal auditor? Discuss. [May, 1998, Question 3; 16 marks] “The responsibilities of Joint Auditors are Joint and Several” – Discuss. [May, 1998, Question 7; 16 marks] A large business entity belonging to a partnership firm has several component units spread all over the country. You are appointed as auditor of the entity as a whole but the component units are to be audited by other auditors. (a) state any six procedures to be adopted by in using the work of other auditors and [Nov, 1998, Question 6(a); 12 marks] (b) the reporting considerations that should receive your attention as principal auditor. [Nov, 1998, Question 6(b); 4 marks] State your views on the following requests made by the management of X Ltd.: The branch accounts were audited by another firm of chartered accountants and therefore, they could rely on the same and only check the consolidation. [Nov, 1999, Question 1(b); 4 marks] You have signed the Audit Report of XYZ Ltd. and handed over the same to the company. After some time the company informs you that the accounts have been amended and requests you to make a report on the Amended Accounts. Discuss the issues involved. [Nov, 2002, Question 3(a); 8 marks] Section 274 of the Companies Act, 1956 is applicable to appointment of Directors. Briefly explain your duty as a statutory auditor in this connection. [Nov, 2004, Question 7(a); 8 marks] Short Notes (a) Responsibility of Joint Auditors Audit Report

1.

An Accountant’s Report on the profits of a company for three years ending 31.3.1996 and on its assets and liabilities as on 31.3.1996 has been requested for inclusion in a prospectus to be issued for a public issue of shares. The following matters of material importance are noticed by the Chartered Accountant in the course of the investigation: (i) Some of the expenditure incurred in 1993 and later years on repairs to the building has been charged against reserves created out of profits of the earlier years. (ii) During 1992 and 1993, work was completed on a contract containing a costing clause but negotiations as to the final price were prolonged. A considerable additional sum was received in 1995 and included in the profit and loss account for that year. (iii) New service agreements providing for increased remuneration from 1.4.1996 have been entered into with the directors. (iv) On 31.3.1996, the market value of the company’s quoted investments was below the value at which they appeared in the Balance Sheet.

Question Bank

2.

3.

4.

5.

6. 7.

8.

9.

III.21

You are required to explain how, according to you, these matters should be dealt with by the Chartered Accountant. [May, 1997, Question 1(a); 12 marks] The management of S Ltd. requested its auditors to issue a separate report to the Board of Directors in addition to his report to the shareholders under Section 227 of the Companies Act, 1956. State the matters the auditors could and should include in the said report. [May, 1997, Question 5(a); 6 marks] As an auditor state your views on the following situations: (i) A qualified opinion [Nov, 1997, Question 4(i); 6 marks] (ii) An adverse opinion [Nov, 1997, Question 4(ii); 5 marks] (iii) A disclaimer of opinion [Nov, 1997, Question 4(iii); 5 marks] As a chartered accountant, you are asked to conduct a review of “profit forecast” prepared by a company in connection with its request for Term Loan from a scheduled bank. (a) Can you accept the offer? [Nov, 1998, Question 3(a); 4 marks] (b) Mention any six important matters that should receive your attention in carrying out the review of “profit forecast”. [Nov, 1998, Question 3(b); 12 marks] The business of CRY Ltd. a chit fund company also consisted of granting of loans and advances on the basis of security of shares and debentures. The audit report under MAOCARO, 1988 as applicable to chit fund companies should specifically state whether adequate documents and records are kept in respect of such loans and advances. (a) As an auditor, how do you satisfy yourself about the adequacy of documents and records? [Nov, 1998, Question 4(a); 12 marks] (b) Should you give a qualified report if proper accounts were not maintained during a part of the accounting period? [Nov, 1998, Question 4(b); 4 marks] The phrase to the best of our information and according to the explanations given to us” which is usually found in the Auditor’s Report on Financial Statements limits the liability of the auditor in one sense but extends it in another sense. [May, 1999, Question 3(b); 4 marks] (a) Distinguish between Audit Certificate and Audit Report. [May, 1999, Question 5(a); 4 marks] (b) Discuss the requirements regarding Auditor’s Certificate on profit forecast included in the “Offer Documents”. [May, 1999, Question 5(b); 12 marks] (a) Define Propriety Audit. [Nov , 1999, Question 4(a); 4 marks] (b) In the context of such audit, state in general terms the principles of propriety. [Nov , 1999, Question 4(b); 4 marks] (c) Briefly indicate the propriety elements that are found in MAOCARO 1988. [Nov , 1999, Question 4(c); 8 marks] A leading finance company engaged in giving finance leases seeks your advice in the preparation of its draft financial statements. You are required to forward a suitable report to the management highlighting the important aspects to be covered in the financial statements. [Dec, 1999, Question 7; 16 marks]

III.22

Advanced Auditing and Professional Ethics

10. Indicate the precise nature of Auditor’s liability in the following situations and support your views with authority, if any: (a) (i) A misstatement had occurred in the prospectus issued by the company. [May, 2000, Question 3(a)(i); 4 marks] (ii) Certain weaknesses in the internal control procedure in the payment of wages in a large construction company were noticed by the statutory auditor, who in turn brought the same to the knowledge of the Managing Director of the company. In the subsequent year a Huge Defalcation came to the notice of the Management. The origin of the same was traced to the earlier year. The management wants to sue the auditor for negligence and also plants to file a complaint with the Institute. [May, 2000, Question 3(a)(ii); 4 marks] (iii) Based upon the legal opinion of a leading advocate, X Ltd. made a provision of Rs.5 crores towards Income Tax liability. The assessing authority has worked out the liability at Rs.15 crores. It is observed that the opinion of the advocate was inconsistent with legal position with regard to certain revenue items. [May, 2000, Question 3(a)(iii); 4 marks] (b) Y Ltd. obtained an actuarial valuation for Gratuity liability at the year end. The actuary changed certain basic assumptions for working out the liability at this year and as compared to the ones adopted by him in the preceding year. State Auditor’s responsibility in this matter. [May, 2000, Question 3(b); 4 marks] 11. (a) H.W.P. Private Ltd. Is having only two members H and W. During the audit of accounts for the year ended 31st March, 2000, you as auditor find that: (i) H, who is incharge of purchase has introduced fictitious purchase bills of Rs.50 lakhs. (ii) W, who is incharge of sales has sold goods worth Rs.1 crore without bringing the same in the books of account. You raise the matter with H and W in their capacity as directors. They contest that as this is a position known to them and within their own fold, you should not report the same under the Companies Act, 1956. Discuss whether the above arguments are acceptable under the Companies Act, 1956 for non-reporting. If not, state the reasons and the manner of reporting. [Nov, 2000, Question 1(c), 6 marks] (b) Under the Manufacturing and Other Companies (Auditor’s Report) Order, 1988, an auditor is required to report on the regularity of payment of Provident Fund and Employees State Insurance dues. Give alternative drafts of the report on this clause mentioning the circumstances of reporting. [Nov, 2000, Question 1(d), 6 marks] 12. Is the auditor of a company supposed to refer any paragraph in Director’s report in his own report to the shareholders of the company? State your views in this regard. [Nov, 2000, Question 2(b), 8 marks]

Question Bank

III.23

13. (a) How is an auditor concerned under the guidelines issued by Securities and Exchange Board of India relating to the following matters, while certifying financial information included in offer documents? (i) Transactions with companies in promoter group (ii) Bifurcated turnover (iii) Return on net worth (iv) Price earning ratio [Nov, 2000, Question 4(a), 8 marks] (b) On 30th September, 2000 a company’s issued and paid up capital was Rs.25 crores comprising of fully paid equity shares of Rs.10 each. This included Rs.50,00,000 capital issued for cash; Rs.4,50,00,000 capital issued for purchase of a business; Rs.20 crores on issue of bonus shares from time to time by capitalising various reserves including Rs.5 crores by capitalising capital redemption reserve. The company had fixed assets costing Rs.2 crores on which depreciation provision was Rs.1.95 crores, which was equal to the full cost of depreciable assets. The balance Rs.5 lakhs represented the cost of land. It has discontinued its operations for last many years. The company had made investments in various companies to the tune of Rs.30 crores. Unfortunately all these investee companies have turned out to be BIFR cases. Nothing is expected to be realised on such investments. The company has dues from customers totalling to Rs.4.95 crores of which Rs.4.90 crores are due from business which have become defunct. The balance Rs.5 lakhs are due for over 3 years. The accumulated losses are Rs.10 crores. The amounts due to suppliers are Rs.3 crores and they are overdue. The balancing figure in the Balance Sheet refers to loan from Financial Institutions. Workers who had put in long years of service have lodged claims for termination benefits of Rs.10 crores, which have been decreed in their favour. No accounting entry has been passed for the same since the decree on 1.1.1997. In the light of Statement on Standard Auditing Practices (SAP) 16, relating to Going Concern, you are asked to write appropriate paragraph of audit report. Give reason for supporting your report. [Nov, 2000, Question 4(b), 8 marks] 14. As an auditor, state your view on the following: The Statutory Auditors of a Government Company have issued a qualified Audit Report on the Accounts of the company. In his supplementary audit, the Comptroller and Auditor General of India (C & AG) has also made further qualifications on the accounts of the company. [May, 2002, Question 1(c), 5 marks] 15. In an Audit Report, the phrase, “to the best of our information and according to the explanations given to us” is normally used. Comment on the appropriateness of the same. [Nov, 2002, Question 5(b), 4 marks] 16. What is your understanding of the term “true and fair view” in a statutory audit report of a company? [May, 2003, Question 7(a), 8 marks] 17. Distinguish with suitable examples - Between a case where an auditor is obliged to state in his report to the members of a company that the accounts do not show a true and fair

III.24

Advanced Auditing and Professional Ethics

view, and a case where he states that he is unable to form an opinion as to whether or not the accounts give a true and fair view. [Nov., 2003, Question 6(b), 8 marks] 18. As Chartered Accountant you are required to give your reports on various financial statements under Companies Act, 1956 which are as under: (i) Report to the shareholders under Section 227; (ii) Report to be sent out in prospectus under Section 60(3); (iii) Report to be given to the Central Govt. as special auditor under Section 233 A; (iv) Report to be given on voluntary winding up under Section 488 (1) Explain the significance of each of these reports and your functional approach very briefly. [May, 2004, Question 3(a), 8 marks] 19. (a) Enumerate the ‘Basic Elements of Audit Report’ as enshrined in AAS-28. (b) Bring out the significance of the following two illustrative paragraphs found in the statutory auditor’s report in recent days. (i) Opening Paragraph: “We have audited the attached Balance Sheet of ………as at 31st March, 2xxx and also the Profit and Loss Account for the year ended on that date annexed thereto. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements”. (ii) Scope Paragraph: “We conducted our audit in accordance with the auditing standards generally accepted in India. Those standards require that we plan and perform the audit to obtain reasonable assurance whether the financial statements are free of material statement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial presentation. We believe that our audit provides a reasonable basis for our opinion.” [Nov, 2004, Question 4(a), (b), 8+8 marks] st 20. (a) A Pvt. Ltd. Is incorporated on 1 July, 2004. During the year ended 31st March, 2005, it had issued shares (fully paid up) of Rs. 40 lakhs, had borrowed Rs. 7.5 lakhs each from 2 financial institutions and its turnover (Net of excise Rs. 50 lakhs which is credited to a separate account) is Rs. 475 lakhs. Will Companies Auditors Report Order, 2003 (CARO) be applicable to A Pvt. Ltd? (b) As the statutory auditor of B Ltd. To whom CARO, 2003 is applicable, how would you report in the following situations? (i) The company has stood guarantee to its sister concern, whose financial condition was not healthy for a sum of Rs. 20 lakhs borrowed from a bank. (ii) Physical verification of only 50% (in value) of items of inventory has been conducted by the company. The balance 50% will be conducted in next year due to lack of time and resources.

Question Bank

III.25

(iii) Accumulated losses of the company are 50.9% of its net worth and its is incurring continuous cash losses since last 2 years. [May, 2005, Question 4(a)&(b), 4+12 marks] 21. Answer the following: (a) What are the statements of facts that an auditor has to report u/s 227 of the Companies Act, 1956? (b) Illustrate, as a statutory auditor, how would you give a report where all qualifications are not quantifiable. (c) Under CARO, 2003 how, as a statutory auditor would you comment on the following: (i). Fixed assets comprising 1/3rd of the total assets have been disposed off during the year. (ii). A Term Loan was obtained from a bank for Rs. 75 lakhs for acquiring R&D equipment, out of which Rs. 12 lakhs was used to buy a car for use of the concerned director, who was overlooking the R&D activities. [May, 2005, Question 4(a), (b)&(c), each 4 marks] 22. Short Notes (a) Propriety Elements in MAOCARO, 1988 [May, 2002, Question 8(c), 4 marks] (b) Audit Certificate as Distinguished from Audit Report [May, 2002, Question 8(d), 4 marks] (c) Disclaimer Opinion [Nov, 2002, Question 8(a), 4 marks] (d) Areas of propriety audit under Section 227(1A) of the Companies Act, 1956. (e) Certificate for Special Purposes vs. Audit Report [May, 2004, Question 8(e), 4 marks] Audit Committee and Corporate Governance 1. 2.

Explain the Constitution and functions of Audit Committee under Section 292A of the Companies Act, 1956. [May, 2004, Question 7(b); 8 marks] Short Note (a) Corporate Governance [Nov, 2004, Question 8(g), 4 marks] (b) Audit Committee [Nov,2000, Question 8(iii), 4 marks] Audit of Consolidated Financial Statements

1.

Short Notes (a) Consolidated Financial Statements

[Nov, 2000, Question 8(ii), 4 marks]

Audit of Banks 1.

Mention the special points that will receive the attention of Bank’s auditor in verification of advances against Life Insurance Policies. [Nov, 1999, Question 3(b); 3 marks]

III.26 2.

3.

5. 6.

7.

8.

Advanced Auditing and Professional Ethics As a Central Statutory Auditor of a Bank, you have noticed that: (i) Bank is reluctant to classify those accounts as NPA’s, where no stock statements have been received. (ii) 5 borrowal accounts have been regularised by sanction of fresh term loan, which had been earlier declined by the bank. Please state your views on the above approach by the Bank. [Nov, 1999, Question 5(b)(i)&(ii); 4×2=8 marks] As an auditor state your views on the following situations: (a) Citizen Bank has classified an advance of Rs.50 lakhs given to a public sector company as Non-performing Asset in its 1994-95 accounts. Further, in the bank books, a sum of Rs.12 lakhs is recorded as due from the said company towards interest on this advance for the earlier period. The advance is guaranteed by the Statement. (b) An industrialist with surplus funds decided to form a Private Sector Bank. What are the guidelines issued by the Reserve Bank for formation of private sector Banks? [Nov, 1996, Question 1(b); 8 marks] 4. Describe the procedure for verification of the following balances reflected in the Balance Sheet of a bank: (i) Branch adjustment account. [Nov, 1996, Question 4(a)(i); 4 marks] (ii) Documentary bills purchased account. [Nov, 1996, Question 4(a)(ii); 4 marks] Draw up an audit programme of income and expenditure items of a nationalised Bank situation in a metropolitan city. [May, 1997, Question 7(a); 10 marks] Your firm has recently been appointed as a Concurrent Auditor of a nationalised bank. Your principal has asked you to prepare an audit programme for the following areas: (a) Advances; and [Nov, 1997, Question 5(a); 10 marks] (b) Foreign Exchange Transactions. [Nov, 1997, Question 5(b); 6 marks] State briefly, the steps you would include in the audit programme. (a) As Statutory Central Auditors of a Nationalised Bank, mention the aspects that are to be commented upon in the Long-form Audit Report in relation to (i) Bad and Doubtul Debts and (ii) Vigilance. [May, 1998, Question 4(a)(i)&(ii); 8 marks] Your firm has been appointed as Central Statutory Auditors of a Nationalised Bank. The bank follows financial year as accounting year. State your views on the following issues which were brought to your notice by your Audit Manager: (a) In computing the aggregate of Funded and Non-funded exposure of a constituent for purpose of assigning risk weight in regard to capital adequacy, the bank “Netted off” the credit balance of Rs.10 lakhs in their Current Account against the total exposure of Rs. 1 crore. [May, 2000, Question 5(a); 4 marks] (b) The bank has recognised on accrual basis income from Dividends on Securities and Units of Mutual Funds held by it as at the end of financial year. The Dividends on Securities and Units of Mutual Funds were declared after the end of financial year . [May, 2000, Question 5(b); 4 marks]

Question Bank (c)

11.

12.

13.

14. 15

16. 17. 18.

III.27

The bank is a consortium member of Cash Credit Facilities of Rs.50 crores to X Ltd. Bank’s own share is Rs.10 crores only. During the last two quarters against a debit of Rs.1.75 crores towards interest the credits in X Ltd’s. account are to the tune of Rs.1.25 crores only. Based on the certificate of lead bank, the bank has classified the account of X Ltd. as performing. [May, 2000, Question 5(c); 4 marks] (d) In case of all such advances which have been classified as non-performing for the first time during the Current Financial Year, only the last date of the financial year has been reckoned as the date of account becoming non-performing. [May, 2000, Question 5(d); 4 marks] 9. How is the income recognised in the case of ‘non-performing’ assets of bank? [Nov, 2000, Question 1(a) 4 marks] 10. Describe the procedure for verification of the following balances appearing in the account books of a bank: (i) Drafts paid without advice [Nov, 2000, Question 2(a)(i) 4 marks] (ii) Branch adjustment account [Nov, 2000, Question 2(a)(ii) 4 marks] As a branch auditor of a nationalised bank, how would you verify the following? (i) Advances to DOT COM Companies. [May, 2001, Question 5(a)(I), 4 marks] (ii) Balances in account of a bank situated in a foreign country. [May, 2001, Question 5(a)(ii), 4 marks] As statutory central auditors of a Nationalised Bank, what special points are to be borne in mind in the audit of compliance with “Statutory Liquidity Ratio” (SLR) requirements? [May, 2002, Question 5(a); 8 marks] As an auditor of a bank, how would you verify the following? (i) Advances against Life Insurance Policy (ii) Documentary bills purchased (iii) Advance against FDRs [Nov, 2002, Question 5(a); 8 marks Discuss the scope of “concurrent audit” in the banks. [May, 2003, Question 3(b), 8 marks] As statutory central auditors of a Nationalized bank, what special points are to be borne in mind in the audit of compliance with "Statutory Liquidity Ratio" (SLR) requirements? [Nov. 2003, Question 6 (a), 8 marks] How will you evaluate the internal control system in the area of credit car operations in a bank? [May, 2004, Question 5(a); 8 marks] What are the exceptions to the general rule of treating advances as Non-performing Assets (NPAs)? [May, 2005, Question 5(c), 4 marks] Short Notes (a) Cash and Cash Equivalents [May, 1998, Question 8(b); 4 marks] (b) Permanent Investments in the case of Banks [May, 1998, Question 8(c); 4 marks] (c) Disclosure requirement in the case of Banks regarding “Balances with other banks and Money At Call and Short Notice” [May, 1999, Question 8(e); 4 marks] (d) Statutory Liquidity Ratio [Dec, 1999, Question 8(c); 4 marks]

III.28

Advanced Auditing and Professional Ethics (e) Long form Audit Report [Dec, 1999, Question 8(d); 4 marks] (f) Principal Enactments Governing Bank Audit [Nov, 2004, Question 8(f), 4 marks] (g) Vostro and Nostro Accounts [May, 2005, Question 8(b); 4 marks] (h) Valuation of Investments “held to maturity” by banks [Nov, 2005, Question 8(c), 4 marks] Audit of General Insurance Companies

1.

As an auditor state your view on the following situation: Excell Insurance Co. Ltd. has made a provision of 30 percent for Unexpired Risks Reserve in its accounts. [May, 1996, Question 1(b); 5 marks] 2. State the procedure for verification of Agents’ Balances in the course of Audit of General Insurance Company. [May, 1998, Question 4(b); 8 marks] 3. (a) What are the steps to be taken while auditing re-insurance transactions in an Insurance Company? [Nov, 2000, Question 3(b) 8 marks] (b) Enumerate the steps to be taken by an auditor for the verification of the premium income received by a general insurance company [May, 2001, Question 5(b), 4 marks] 4. In the context of audit of general insurance business, state the provisions regarding management expenses. [Nov, 2001, Question 5(a), 8 marks] 5 Enumerate the steps to be taken by an auditor for the verification of Re-insurance outward by a General Insurance Company. [Nov. 2003, Question 6 (b), 8 marks] 6. What are the specific areas to which you will give your attention while examining “Claims Paid” by a General Insurance Company. [May, 2004, Question 5(b); 8 marks] 7. State the procedure for verification of Agents’ Balances in the course of audit of a General Insurance Company. [Nov, 2004, Question 7(c), 4 marks] 8. “In an audit of an insurance company, the Receipts and Payments Account is also subjected to audit”. Comment on this statement in brief. [May, 2005, Question 5(b), 6 marks] 9. What are the steps to be taken by an auditor for the audit of re-insurance ceded? [Nov, 2005, Question 6(b), 8 marks] 10. Short Notes (a) Co-insurance [Nov, 1997, Question 8(d); 4 marks] (b) Unexpired Risk Reserve [Nov, 1997, Question 8(e); 4 marks] (c) Management Expenses of Insurance Companies [May, 1999, Question 8(c); 4 marks] (d) Co-insurance [Nov, 1999, Question 8(c); 4 marks] (e) Expenses of Management [Dec, 1999, Question 8(e); 4 marks] (f) Incoming and Outgoing Co-insurance [May, 2000, Question 8(e); 4 marks]

Question Bank

III.29

Audit of Co-operative Societies 1.

2. 3.

4.

5. 6.

7.

As an auditor state your views on the following situations: A Cooperative Society decided to pay bonus to its members after transferring 9 percent, of its projects to Reserve Fund. [May, 1996, Question 1(c); 5 marks] Discuss the circumstances in which an auditor of a cooperative society is required to submit a special report to the Registrar of cooperative societies. [Nov, 1996, Question 4(b); 4 marks] Your assistant has just completed the audit of a Cooperative Society. You are going to submit the audit report. State in this connection the requirement of any additional information to be given in attached schedules with your main audit report. [May, 1997, Question 5(b); 5 marks] A major part of the business of Cooperative Housing Society is to avail loans from Housing Finance Corporation and in turn give loans and advances to its members for construction of houses. Indicate any eight (8) points that will receive your attention as auditor of the Cooperative Housing Society. [Nov, 1999, Question 4; 16 marks] An auditor of a Cooperative Society governed by Cooperative Societies Act, 1912 is required to attach schedules giving certain information. Please list the information required to be given in the schedules. [Nov, 2000, Question 5(b), 8 marks] Mention the duties of Auditor of Cooperative Societies in regard to the following: (i) Over-due interest (ii) Compliance with provisions of Cooperative Act and Rules thereunder (iii) Special Report to Registrar of Cooperative Societies [May, 2002, Question 6(a), 9 marks] State the special features of Co-operative Societies Audit.[May, 2004, Question 7(a); 8 marks] Audit of Non- Banking Financial Companies

1.

2.

As the Auditor of a NBFC, which is engaged in the acquisition of securities and trading in such securities? List out the special points that may be covered in your audit. [May, 2003, Question 6, 16 marks] Short Notes (a) Categories of Non-Banking Finance Companies (NBFCs) [Nov., 2005, Question 8(a), 4 marks] Audit under Fiscal Laws

1.

(a) As an auditor of a public charitable trust, you are required to prepare an audit programme. [Nov, 1996, Question 6(a); 12 marks] (b) Also specify the requirements of audit report in form 10B prescribed by the Income Tax Act in case of public trusts. [Nov, 1996, Question 6(b); 4 marks]

III.30 2.

Advanced Auditing and Professional Ethics Mr. Robertoson, the Marketing Manager of R.B.C. Ltd. of Calcutta had made for trips to Bangalore during the previous year ended 31st March, 1997. His expenditure for stay at Bangalore during these trips were as follows: No. of Days

3. 4.

5.

6. 7.

8.

Amount Rs. st 1 Trip 3 3,600.00 nd 2 Trip 4 6,400.00 rd 3 Trip 5 6,500.00 th 5 9,000.00 4 Trip Total 17 25,500.00 As Tax Auditor of the company, what should be your comment in respect of the above situation? [May, 1997, Question 6(c); 4 marks] State with reasons whether an auditor conducting tax audit ‘certifies’ or ‘reports’ on information contained in the statement of particulars to the tax audit report under Section 44 AB of Income-tax Act, 1961. [Nov, 2000, Question 1(b), 4 marks] A public charitable Trust earns ‘income of Rs.10 lakhs from Unit Trust of India, which is not taxable under Section 10(33) of Income-tax Act, 1961. It spends Rs.7 lakhs on its activities. The entire expenditure is vouched and is in accordance with the trust objects and is fully allowable as ‘application’. As Auditor of the Trust, would you require the trust to make any provision for tax in its accounts? [Nov, 2000, Question 6(a), 4 marks] (a) Mr X, who conducts the tax audit u/s 44AB of the Income-tax Act, 1961 of M/s ABC, a partnership firm has received the entire audit fees of Rs.25,000 in April, 2000 in respect of the tax audit for the year ended 31.3.2000. The audit report was however signed in September, 2000. [May, 2001, Question 4(b), 4 marks] (b) Mr P carries on the business of dealing and export of diamonds. For the year ended 31st March, 2000, you as the tax auditor, find that the entire exports are to another firm in U.S.A., which is owned by Mr P's brother. [May, 2001, Question 4(d), 4 marks] In the context of tax audit under Section 44AB of the Income-tax Act, 1961, discuss the provisions of Section 145 of the said Act regarding the method of accounting and accounting standards notified thereunder. [Nov, 2001, Question 8(b), 8 marks] A leading jewellery merchant used to value his inventory at cost on LIFO basis. However, for the current year, in view of requirements of AS-2, he changed over to FIFO method of valuation. The difference in value of stock amounted to Rs.55 lakhs which is higher than that under the previous method. In such a situation, what are the reporting responsibilities of a Tax Audit under Section 44AB of Income Tax Act, 1961? [May, 2002, Question 6(b), 7 marks] XYZ Private Limited is engaged in the wholesale business of buying and selling silk sarees. The accounts are maintained under the Companies Act from 1st October to 30th September each year. The Chief Accountant of the Company is requesting the tax auditor to conduct tax audit U/S 44AB of the I.T. Act for the period for which accounts have been maintained under the Companies Act. As the tax auditor of XYZ Private Limited, how will you react to the Chief Accountant’s request? [May, 2003, Question 7(b), 8 marks]

Question Bank

III.31

9. As a tax auditor, which are the accounting ratios required to be mentioned in the report in case of manufacturing entities? Explain in detail any one of the above ratios and how does it help the tax auditor in his analytical review. [May, 2003, Question 6(a), 8 marks] 10. What is your understanding about the term "Audit of Indirect Taxes"? Explain the steps involved in the Indirect Tax Audit. [Nov.,2003, Question 7(a), 8 marks] 11. Enumerates some of the areas o concern in an audit of indirect taxes. [ Nov 2005, Question 5(b), 6 marks] 12. Short Notes (a) Recognition of Deferred Tax Assets Cost Audit 1. 2.

3.

4. 5.

Comment on the advisability of combining Cost Audit and Financial Audit to produce a Composite Audit requirements. [May, 1997, Question 6(b); 8 marks] State with reasons whether the following proposition is true or false: It is not possible to merge Cost Audit with Financial Audit to have a Composite Audit. [May, 1999, Question 3(c); 4 marks] State briefly the matters on which the Cost Auditor has to give his observations and conclusions to be included in the Annexure to his report under the Cost Audit (Report) Rules, 1968. [Nov, 1999, Question 5(a); 8 marks] For what purposes the Cost Auditor refers to financial records while conducting Cost Audit of an entity? [May, 2002, Question 5(b); 8 marks] Short Notes (a) Propriety elements in Cost Audit Report. [Nov, 1998, Question 8(a); 4 marks] (b) Reconciliation of cost and financial accounts {May, 2003, Question 8(c); 4 marks] (c) Advantages of Cost Audit to Government [Nov, 2004, Question 8(e), 4 marks] (d) “Like every other audit, a systematic planning for cost audit is also necessary”. Indicate the matters to be included in a Cost Audit Programme. [ Nov, 2005, Question 5(a), 10 marks] Special Audit Assignments

1.

2.

Your client has been recently registered as a stock broker under the Securities and Exchange Board of India Act, 1992. You are instructed to prepare a report indicating his obligations and responsibilities for maintenance of the prescribed books of account, records, etc. [Nov, 1996, Question 7(a); 8 marks] As an auditor state your view on the following situation (a) Citizen Bank has classified an advance of Rs.50 lakhs given to a public sector company as Non-performing Asset in its 1994-95 accounts. Further, in the bank books, a sum of

III.32

3.

4. 5.

Advanced Auditing and Professional Ethics Rs.12 lakhs is recorded as due from the said company towards interest on this advance for the earlier period. The advance is guaranteed by the Statement. [May, 1996, Question 1(a); 5 marks] (b) A member of stock exchange communicates to its constituents orally daily purchases and sales of scrips as recorded in the Sauda Book followed by periodical statement indicating the amount due to/due by as the case be. No stamp is affixed on the periodical statement. [May, 1996, Question 1(d); 5 marks] Your client has been recently registered as a stock broker under the Securities and Exchange Board of India Act, 1992. You are instructed to prepare a report indicating his obligations and responsibilities for maintenance of the prescribed books of account, records, etc . [Nov, 1996, Question 7(a); 8 marks] What are the key functions of an Energy auditor? [May, 2004, Question 4(b); 8 marks] Short Notes (a) Odd Lot Dealers [Nov, 1997, Question 8(c); 4 marks] (b) Bought out deal [Nov, 1999, Question 8(a); 4 marks] (c) Carry Forward System [Nov, 1999, Question 8(e); 4 marks] (d) Rolling Settlements [May, 2000, Question 8(a); 4 marks] (e) Carry Forward system [May, 2000, Question 8(b); 4 marks] (f) Hit or take orders [May, 2002, Question 8(a); 4 marks] (g) Bought Out Deal [Nov, 2002, Question 8(b); 4 marks] (h) Contract notes. [Nov, 2003, Question 8(e); 4 marks] (i) Rolling Settlement [May, 2004, Question 8(a); 4 marks] (j) Sauda Book [Nov, 2004, Question 8(c), 4 marks) (k) Margins (Under Stock Exchange Trading Regulations) [May, 2005, Question 8(f); 4 marks] (l) Probable format of environmental statement. [Nov, 2003, Question 8(d); 4 marks] (m) Contract Notes (Under Stock Exchange Trading Regulations) [Nov., 2005, Question 8(d), 4 marks] Audit of Public Sector Companies

1. 2. 3.

Discuss the various areas of propriety covered under the provisions of Sections 227(1A) and 227(4A) of the Companies Act, 1956. [May, 1996, Question; 16 marks} Comment on the following statement: Propriety audit has an inherent element of subjectivity [May, 1997, Question 3(a); 8 marks] State the salient features of the directions to the Auditors of Government Companies issued by the Comptroller and Auditor General of India u/s 619(3) of the Companies Act, 1956 in relation to: (a) System of Accounts; and [May, 1998, Question 6(a); 10 marks]

Question Bank

4.

5.

6. 7. 8.

III.33

(b) System of Financial Control [May, 1998, Question 6(b); 6 marks] State with reasons whether the following propositions true or false: Problems in Propriety Audit however arise mainly because of its distinct nature. [May, 1999, Question 3(d); 4 marks] State your views on the following: (a) “The objectives and scope of public enterprise audit is different from a statutory audit.” [Nov, 1999, Question 7(a); 8 marks] (b) “Problems of Proprietary audit dampen management initiative.” [Nov, 1999, Question 7(b); 4 marks] What are the principles involved regarding ‘Propriety Audit’ in the case of Public Sector Undertaking? [Nov, 2000, Question 6(b), 8 marks] Define Propriety Audit? What are the principles involved regarding Propriety Audit in Public Sector undertakings? [Nov., 2003, Question 5(b), 8 marks] Short Notes (a) Committees on Public Undertakings [May, 1997, Question 8(d); 4 marks] (b) Objectives and scope of Public Enterprises Audit [May, 1999, Question 8(b); 4 marks] (c) True and Fair Cost of Production [May, 2001, Question 8(c), 4 marks] (d) Propriety Audit [May, 2001, Question 8(d), 4 marks] (e) Propriety Audit [May, 2003, Question 8(b); 4 marks] Internal Audit, Management and Operational Audit

1.

2.

3. 4.

5. 6.

Management auditor is often regarded by line staff as a critic, fault finder and private spying authority of the top management and hence they do not cooperate with him. As a Management auditor suggest the ways and means to inspire confidence to secure their cooperation. [May, 1996, Question 3; 16 marks] “Much good work gets lost because the auditor’s report fails to evoke the interest of the reader.” Discuss the above statement in the context of the report of the operational auditor. [Nov, 1996, Question 5; 16 marks] You have been appointed as an internal auditor of a departmental store. State briefly, how you will you plan your work. [May, 1997, Question 4(a); 10 marks] “Operational Auditing is not different from Internal Auditing, it is merely an extension of Internal Auditing into operational areas.” State your views on the above statement. [Nov, 1997, Question 6; 16 marks] Mention the nature and causes of behavioural problems likely to be faced by Management auditor. [Nov, 1998, Question 7(a); 8 marks] (a) Explain the concepts of Management Audit and Operational Audit. [May, 1999, Question 7(a); 8 marks]

III.34

Advanced Auditing and Professional Ethics (b) What are the differences between these two Audits?

7. 8.

9.

10. 11. 12. 13. 14.

[May, 1999, Question 7(b); 8 marks] (c) Summary Written Report [May, 2000, Question 8(c); 4 marks] Draft a suitable questionnaire for a Management auditor in evaluation of over-all systems and procedures prevailing in a Trading Organisation. [Nov, 1999, Question 6(b); 11 marks] Internal Audit is said to be an “Independent appraisal activity within an organisation for review of Accounting, Financial and other operations as a basis of service to the organisation, it is a managerial control which functions by measuring and evaluating the effectiveness of other controls” – Explain briefly. [May, 2000, Question 7(b); 8 marks] You have been appointed to carry out Management-cum-Operational Audit of a Public Ltd. Company. State whether the use of Quantitative ratios is more effective than the use of Financial ratios to gain real insight into the Financial Statements. [May, 2000, Question 7(a); 8 marks] What are the Management Audit Questionnaires? Give a sample questionnaire for Audit of Inventory. [Nov, 2001, Question 7(a), 10 marks] “Operational Auditing is no different from internal Auditing”. Discuss. [May, 2002, Question 4(a); 8 marks Explain in brief the behavioral aspects encountered in the management audit and state the ways to solve them. [May, 2004, Question 6(b); 8 marks] Briefly explain the objectives of Operational Audit [Nov, 2005, Question 3(b); 5 marks] Short Notes (a) Objectives of Operational Auditing [May, 1998, Question 8(d); 4 marks] (b) Objectives of Operational Audit [May 2001, Question 8(a), 4 marks] (c) Can a statutory auditor act as a book-keeper and as an internal auditor? [May, 2003, Question 8(e); 4 marks] Investigation and Due Diligence

1.

2.

3. 4.

A well-established manufacturing public limited company proposes to take over a small SSI unit engaged in the business of soaps and detergents. The managing director of the said company has approached you to make a detailed study and advise him about the said take over. Discuss the major areas which you would cover in your investigation. [May, 1996, Question 7; 16 marks] A company engaged in the manufacturing and in trading of small tools is recording higher sales value but declining net profits. Discuss the possible reasons for this situation and the procedure to be followed to investigate the causes of such an anomalous situation. [Nov, 1996, Question 3; 16 marks] Outline the steps in order of sequence that are usually applicable for the conduct of investigation. [Nov, 1999, Question 6(a); 5 marks] (a) “Both auditing and investigation are fact finding techniques, but their basic nature and objectives differ from each other” – Discuss. [Dec, 1999, Question 5(a); 12 marks]

Question Bank

5.

6.

7.

8.

9. 10.

11.

12.

III.35

(b) Can the investigator place reliance on the already audited statement of accounts? [Dec, 1999, Question 5(b); 4 marks] Sri Raghav is above 80 years old and wishes to sell his proprietary business of manufacture of speciality chemicals. C Ltd. wants to buy the business and appoints you to carry out a due diligence audit to decide whether it would be worthwhile to acquire the business. What procedures you would adopt before you could render any advice to C Ltd.? [May, 2002, Question 3(a); 10 marks] An American Company engaged in the business of manufacturing and distribution of industrial gases, is interested in acquiring a listed Indian Company having a market share of more than 65% of the industrial gas business in India, request you to conduct a “Due Diligence” of this Indian Company and submit your Report. As due Diligence Auditor, what key areas you will cover in your review? List out the contents of your Due Diligence Review Report that you will submit to your USA based Client. [May, 2003, Question 4, 16 marks] A nationalised bank received an application from an export company seeking sanction of a term loan to expand the existing sea food processing plant. In this connection, the General Manager, who is in charge of Advances, approaches you to conduct a thorough investigation of this limited company and submit a confidential report based on which he will decide whether to sanction this loan or not. List out the points you will cover in your investigation before submitting your report to the General manager. [May, 2003, Question 5, 16 marks] You are the internal auditor of AB Manufacturing Co. Ltd. The Managing Director has asked you to enquire into the causes of abnormal wastage of raw materials during the month of September, 2003.The wastage percentages are as follows: June, 2003

1.2%

July, 2003

1.1%

August, 2003

1.3%

September, 2003

3.6%

How will you proceed to carry out the Assignment? [Nov., 2003, Question 4(b), 8 marks] What are the important steps involved while conducting Investigation on behalf of an Incoming Partner? [Nov., 2003, Question 5 (a), 8 marks] Mr. Clean who proposes to buy the proprietary business of Mr. Perfect, engages you as investigating account. Specify the areas, which you will cover in your investigation. [May, 2004, Question 6(a); 8 marks] You have been appointed Management Auditor of a large manufacturing company suffering from working capital crunch. Enlist and discuss the related areas which you would probe into to overcome the company’s problem. [Nov., 2004, Question 6(a) 8 marks] (a) Your client is contemplating taking over a manufacturing concern and desires that in the course of due diligence review, you should look specifically for any hidden liabilities and overvalued assets. State (in brief) the major areas you would examine for the above. [Nov., 2005, Question 7(a), 8 marks]

III.36

Advanced Auditing and Professional Ethics

13. Short Notes (a) Audit and Investigation (b) Audit and Investigation (c) Audit vs. Investigation

[May, 1997, Question 8(c); 4 marks] [May, 2001, Question 8(b), 4 marks] [Nov, 2004, Question 8(b), 4 marks] Peer Review

1.

Short Notes Preliminary Report under Peer Review

[May, 2005, Question 8©; 4 marks]

Professional Ethics 1.

2.

Is there professional misconduct committed in the following cases in the context of the provisions of Chartered Accountants Act and its regulations? (a) Mr Ram, a practising Chartered Accountant from Rameshwar, has entered into partnership with Rahim, a practising chartered accountant of a recognised professional body for sharing fees of their partnership within India. [May, 1996, Question 2(a); 4 marks] (b) Mr. Clever, apractising chartered accountant, accepts appointment as a full time lecturer in a Commerce College affiliated to the Bombay University. [May, 1996, Question 2(b); 4 marks] (c) Miss Moongi, a practising chartered accountant, accepts her appointment as a valuer of goodwill of a business for the purpose of determining the value of gift under the Gift Tax Act on the condition that she would be paid 5% of the value of the goodwill so determined as her fees. [May, 1996, Question 2(c); 4 marks] (d) Mr. John, a practising chartered accountant, entered into partnership with Mr Salim a qualified chartered and cost accountant, holding certificate of practice as a Cost Accountant. [May, 1996, Question 2(d); 4 marks] Is there professional misconduct in the following cases in the context of the provisions of Chartered Accountants Act and its regulations? (i) Mr Rajesh has accepted his appointment as an auditor immediately after intimating his appointment over the phone to the previous auditor. [Nov, 1996, Question 2(i); 4 marks] (ii) Mr Rahul has accepted his appointment as an auditor at a lower fee than the audit fee demanded by the previous auditor on the ground that the volume of work had increased. [Nov, 1996, Question 2(ii); 4 marks] (iii) The client of Mr Rajgopal complains that he has charged an excessive fee for a professional assignment. [Nov, 1996, Question 2(iii); 4 marks] (iv) Mr Jaydev has charged a fee for representing his client in an Income Tax appeal based on the expected relief to his client as a result of the appeal. [Nov, 1996, Question 2(iv); 4 marks]

Question Bank 3.

4.

5.

III.37

Is there professional misconduct committed in the following cases in the context of the provisions of Chartered Accountants Act, 1949 and its regulations? (a) Mr. Fair, a practising Chartered Accountant, was appointed to carry out a Balance Sheet Audit of a Non-profit Organisation. The Internal Auditors detected certain irregularities at one of the Branches of the organisation which Mr Fair had failed to detect. [Nov, 1997, Question 2(a); 4 marks] (b) Mr False had been appointed by True Ltd., to represent them before the taxation authorities and to prepare statements required for the purpose, based on data to be provided by the management. The taxation authorities felt that claims made through the statements prepared by Mr False were incorrect and misleading. [Nov, 1997, Question 2(b); 4 marks] (c) Mr Brilliant, a practising chartered accountant, received a major professional assignment. To complete the said assignment he was required to buy for computers. Due to his inability to provide funds for acquiring the same he borrowed money from a firm, where one of the Articled Clerk’s and his father were interested. [Nov, 1997, Question 2(c); 4 marks] (d) Mr Extraordinary, a practising Chartered Accountant, had failed to report regarding a material claim against the company of which he was aware and which the management intentionally did not include in their financial statements, as it would affect the price of their shares on the Stock Exchange. [Nov, 1997, Question 2(d); 4 marks] (a) Mr K a Chartered Accountant not in practice was employed by Do-well Ltd. on salaried basis as Chief Internal Auditor to be in charge of internal control and internal audit department of the company. Mr K largely relied on the work of other unqualified employees of the company. The statutory auditor subsequently found that the internal control was weak, that there were omissions to record Cash Sales and collections from Debtors and the statements attested by the Chief Internal Auditor were all either untrue or false. The company seeks your advice whether any action could be taken against Mr K under provisions of Chartered Accountants Act. [May, 1998, Question 1(a); 5 marks] (b) A Chartered Accountant in practice entered into partnership with his uncle in Textile business which, however, did not take off. Will he be held guilty of professional misconduct? [May, 1998, Question 1(b); 5 marks] (c) A search under Section 132 of the Income-tax Act (i) In the premises of a leading merchant led to the discovery of two sets of account books – One set to record all the income correctly and another set to record only limited income. A chartered accountant has issued the Tax Audit Report on the basis of second set of account books. Is he liable to the Income-tax Department in the above circumstance? [May, 1998, Question 1(c)(i); 3 marks] (ii) Would your answer be different, if the first set of account books carried evidence of checking by the chartered accountant? [May, 1998, Question 1(c)(ii); 2 marks] Examine whether there is professional misconduct in the following circumstances: (a) A chartered accountant in practice appearing on television on budget proposals was introduced to the viewers, on the basis of the bio-data furnished by him, as the senior

Advanced Auditing and Professional Ethics

III.38

(b)

(c)

(d)

6.

(a)

(b)

7.

most partner of M/s Tick and Tag, a leading firm of chartered accountants established in Delhi in 1948. [Nov, 1998, Question 1(a); 5 marks] A practising chartered accountant agreed to select and recruit personnel, conduct training programmes and work studies for and on behalf of a client. [Nov, 1998, Question 1(b); 5 marks] A chartered accountant acting as liquidator of a company: (i) charged fees as a percentage of realisation of assets and (ii) refused to hand over accounting records and valuables of the company in liquidation to the successor appointed by the Court. [Nov, 1998, Question 1(a)(i)&(ii); 5 marks] A chartered accountant did not maintain books of account for his professional earnings on the ground that he was not obliged to keep them as his income did not exceed the limits prescribed under Section 44AA of Income Tax Act [Nov, 1998, Question 1(d); 5 marks] A chartered accountant in practice was engaged by a businessman to represent him before the tax authorities on current matters and in the course of such employment he came across certain documents pointing to commission of tax frauds in the preceding years for which the client was not represented by him. Is the member liable to disclose the existence and contents of the document to tax authorities? [May, 1999, Question 1(a); 5 marks] A chartered accountant in practice was alleged to have signed two balance sheets on two different dates for the same financial year, the first one with a clean report and the second one with a qualified report. In a criminal proceeding he made a statement before the magistrate that he had signed only the second balance sheet. Subsequently it was found that he had in fact given the clean report at a later date but signed the first balance sheet under an earlier date. Examine his conduct in the light of Chartered Accountants Act, 1949. [May, 1999, Question 1(b); 5 marks] Comment on the Auditor’s liability in the following cases: (a) Mr X, partner of X & Co. chartered accountants advised the Managing Director of True Ltd. to include in sales, orders under negotiation to reflect a better financial position for obtaining future bank loan. X & Co. are the internal auditors of True Ltd. (b) X & Co. chartered accountants, informed selected multinational oganisations, who are not their clients that Mr Y, the former partner-in-charge of Taxation of one of the largest accounting firms of the world, had joined them as a partner. (c) X & Co. chartered accountants were informed by True & Co. Ltd that they have been appointed as auditor of the company in place of ABC & Co., who have been removed, subject however to the approval of the shareholders in the ensuing Annual General Meeting. X & Co. accepted the appointment and commenced the work without their appointment being approved by shareholders of the company. (d) Mr X partner of X & Co. chartered accountants has compiled and signed the Balance Sheet of False Ltd. for submission to the bankers of the said company. Mr X has also compiled and signed at the request of the said company another

Question Bank

III.39

Balance Sheet inflating the value of assets by 20% for submission to a term lending institution. Both the Balance Sheets were not in conformity with the books of account maintained by the company as they were not uptodate. [Nov, 1999, Question 2(a),(b),(c) & (d); 4×4=16 marks] 8. State your views on the following: A chartered accountant in practice holding Law Degree can practise both as a chartered accountant and as a Lawyer. [Nov, 1999, Question 7(c); 4 marks] 9. Give your views on the following situations in the context of Chartered Accountants Act, 1949 and the regulations thereunder: (a) As auditor of cooperative society, Asha, agreed to charge 10% of the profits of the society as her audit fees. [Dec, 1999, Question 2(a); 5 marks] (b) Priya, a chartered accountant entered into professional partnership with a non-resident chartered accountant on the following terms: (i) Professional income arising in India is to be shared equally. (ii) Professional income arising outside India is to be retained exclusively by the nonresident partner. [Dec, 1999, Question 2(b)(i)&(ii); 5 marks] (c) Nandhini & Co. was appointed as auditors of a public sector company by the Central Government late in the financial year. The firm commenced work without communicating with the previous auditor as the financial year was almost coming to a close. {Dec, 1999, Question 2(c); 6 marks] 10. (a) A chartered accountant holding certificate of practice and having four articled clerks registered under him accepts appointment as a full time lecturer in a college. Also he becomes a partner with his brother in a business. Examine his conduct in the light of CA Act, 1949 and the regulations thereunder. [May, 2000, Question 2(a); 4 marks] (b) XYZ Co. Ltd. has applied to a bank for loan facilities. The bank on studying the Financial Statements of the company notices that you are the auditor and requests you to call at the bank for a discussion. In the course of discussions, the bank asks for your opinion regarding the company and also asks for detailed information regarding few items in the Financial Statements. The information is available in your working paper file. What should be your response and why? [May, 2000, Question 2(b); 4 marks] (c) A chartered accountant in practice, in spite of repeated requests from the Secretary of the Institute, fails to submit form 18. Is he liable for misconduct? [May, 2000, Question 2(c); 4 marks] (d) A chartered accountant availed a term loan of Rs.10 lakhs from a Nationalised Bank for furnishing his office. He issued two cheques for Rs.1 lakh each towards repayment of the loan. The cheques were dishonoured with the remark “Refer to Drawer”. Is the Chartered Accountant liable for misconduct? [May, 2000, Question 2(d); 4 marks] 11. Discuss briefly the role of a Statutory Auditor in relation to the unlawful acts by the clients. [May, 1997, Question 2(a); 8 marks]

III.40

Advanced Auditing and Professional Ethics

12. Is there professional misconduct in the following cases in the context of the provisions of Chartered Accountants Act and its regulations? (i) Mr. Ramana, a Chartered Accountant in practice and a lawyer agree to pay to each other 12 percent of the gross fees received by them from clients referred by them to each other. It is agreed that both of them will maintain a record in respect of such clients’ and the account will be settled at the end of each year. However, at the end of the first year, the Chartered Accountant refuses to receive or pay the referral fee as per the agreement and tells the lawyer that the agreement stands terminated. [May, 1997, Question 2(b); 4 marks] (ii) Mr. Sethi, a Chartered Accountant in practice, who is proposed to be removed as the auditor of a company, makes unsubstantiated and derogatory remarks against the management of the company in his representation under Section 225 of the Companies Act, 1956. [May, 1997, Question 2(b); 4 marks] 13. You are the auditor of a company, which raised finance from the capital market on the basis of a prospectus issued a few years back. The main object for raising the finance was specified to be setting up a project on information technology. The company advanced monies so raised to various parties ‘related’ to directors. These parties had no standing whatsoever with information technology. In the Balance Sheet, these advances appeared as a current asset under the head “loans unsecured – considered good”. There was no mention in the notes to accounts about nature and purpose of such advances. You have given routine audit report without any qualifications. One fine morning the directors and these ‘related’ parties disappear. The company has just vanished. Can you be hauled up for professional misconduct? Do you have any liability under any law? [Nov, 2000, Question 5(a), 8 marks] 14. Ajay is a practising Chartered Accountant. Vijay is a practising Advocate representing matters in courts of law. Ajay and Vijay agree to help each other in matters involving their professional expertise. Accordingly Ajay recommends Vijay in all tax litigations in courts of law. Vijay consults Ajay on all matters relating to finance and related matters, which come to him for arguing in various courts of law. Ajay seeks your advise on how he and Vijay should (i) remunerate each other (ii) ‘share’ the remuneration. [Nov, 2000, Question 6(c), 4 marks] 15. Discuss whether the following actions by a Chartered Accountant would amount to misconduct or not. (i) A Chartered Accountant practising in India enters into partnership with (a) A Certified Public Accountant in New York. (b) A Chartered Accountant from the Institute of Chartered Accountants in England and Wales in London, and in each case, the members concerned take the profits earned in their own country. Will it make any difference, if an Indian Chartered Accountant is practising outside India and becomes a partner with the aforesaid accountants?

Question Bank

III.41

(ii) A Chartered Accountant in service agrees to entrust the work of investment broker to Mr. X on the specific understanding that 20% of commission Mr. X earns would be paid to him. (iii) A practising Chartered Accountant uses a visiting card in which he designates himself, besides as Chartered Accountant, as (a) Tax Consultant (b) Cost Accountant. (iv) A Chartered Accountant in practice takes up the appointment as Managing Director of a Public Limited Company. (Nov, 2000, Question 7(I),(ii),(iii),(iv), 16 marks] 16. As a practising chartered accountant do you approve the following? If not, why? (a) In a representation to be submitted to a company under section 225(3) of the Companies Act, 1956, the partner of the firm of auditors wants to include the contributions made by the firm in strengthening the control procedures of the company during their association with the company. [Nov, 2001, Question 2(a), 4 marks] (b) A partner of a firm of chartered accountants during a T.V. interview handed over a biodata of his firm to the chairperson. Such bio-data detailed the standing of the international firm with which the firm was associated. It also detailed the achievements of the concerned partner and his recognition as an expert in the field of taxation in the country. The chairperson read out the said bio-data during the interview. [Nov, 2001, Question 2(b), 4 marks] (c) The Chairman of an Audit Committee of a Bluechip Company, who is a chartered accountant asked the firm in which he was previously a partner to quote their fee on a success fee basis so as to ensure that a professional work is assigned to such firm. [Nov, 2001, Question 2(c), 4 marks] (d) A firm of chartered accountants were appointed by a company to evaluate the costs of the various products manufactured by it for their information system. One of the partners of the firm of chartered accountants was a non-executive director of the company. [Nov, 2001, Question 2(d), 4 marks] 17. What is a comprehensive audit of public enterprises? Discuss some of the areas to be examined therein. [Nov, 2001, Question 6(a), 8 marks] 18. Is there any misconduct on the part of a Chartered Accountant in the following circumstances: (i) Mr. G, a chartered accountant in practice as a sole proprietor has an office in Mumbai near Church Gate. Due to increase in professional work, he opens another office in a suburb of MumbaI which is approximately 80 kilometers away from his existing office. For running the new office he employs three retired Income-tax Officers. (ii) The offer document of a listed company in which Mr. D, a practising Chartered Accountant is a director mentions the name of Mr. D as a director along with his various professional attainments and spheres of specialisation. [May, 2002, Question 2(c), 8 marks]

III.42

Advanced Auditing and Professional Ethics

19. How should an incoming auditor ascertain that the company has complied with the relevant provisions of the Companies Act, 1956 regarding his appointment as an Auditor? [Nov, 2002, Question 2(a), 10 marks] 20. Can a practising Chartered Accountant be held guilty of professional misconduct under the following circumstances? Give your views with reasons in brief. (a) A Chartered Accountant in practice has been appointed liquidator of a company and his fees has been fixed at 5% of the assets realised. (b) A Chartered Accountant is appointed as Statutory Auditor of a company in which his brother is a Director having substantial interest in the company. (c) Mr. X a Chartered Accountant enters into partnership with Y another Chartered Accountant and holding certificate of practice as ‘Company Secretary’ . (d) An Auditor of a company informs the Managing Director that audit report for the year ended 31.3.2002 is ready, but would be forwarded only on the receipt of audit fees. The auditor feels that the company may not pay his fees once he delivers the report. [Nov, 2002, Question 7(a), (b), (c) & (d), 16 marks] 21. Mr. X, a Chartered Accountant accepted his appointment as tax auditor of a firm under Section 44AB, of the Income-tax Act, and commenced the tax audit within two days of his appointment since the client was in a hurry to file Return of Income before the due date. After commencing the audit, Mr. X realised his mistake of accepting this tax audit without sending any communication to the previous tax auditor. In order to rectify his mistake, before signing the tax audit report, he sent a registered post to the previous auditor and obtained the postal acknowledgement. Will Mr. X be held guilty under the CA Act? [May, 2003, Question 2(a), 6 marks] 22. Mr. J started his practice as Chartered Accountant in 1996. During 1999, he got an offer for the post of Chief Accountant of a Software Development Company, as a fulltime employee, for a salary of Rs.60,000 per month. On accepting this offer, Mr. J converted his practice into a partnership firm by taking a fresh Chartered Accountant as his partner. Mr. J neither intimated the Institute nor obtained permission from the Institute about his employment. Will Mr. J be held guilty under the CA Act? [May, 2003, Question 2(b), 6 marks] 23 A Chartered Accountant in practice had confirmed in the application made by his articled clerk to the Council for permission to study that the normal working hours of his office were 11 a.m. to 6 p.m. and the hours during which the articled clerk was required to attend college classes were 7 a.m. to 9.30 a.m. On inquiry from Principal of College, it was ascertained that the articled clerk used to attend classes from 10 a.m. to 1.55 p.m. The Chartered Accountant pleaded ignorance about the articled clerk attending the college classes during office hours. Will the Chartered Accountant be held guilty of professional misconduct? [May, 2003, Question 2(c), 4 marks] 24. Can a Practicing Chartered Accountant be held guilty of Professional Misconduct under the following circumstances? Give your views with reasons in brief. (a) Z, a Chartered Accountant wrote several letters to Government Department, pointing out seniority of his firm, sending his life sketch and stating that he had a glorious record of service to the country as well as to the organization of accountancy profession with a view to get the audit work..

Question Bank

III.43

(b) W, a Chartered Accountant has sent letters under certificate of posting to the previous auditor informing him his appointment as an auditor before the commencement of audit by him. (c) P, a Chartered Accountant had accepted appointment as an auditor of QRS Company Limited without ascertaining from the Company whether the requirement of Sections 224 and 225 of the Companies Act had been complied with. However, he realized this defect only after acceptance. (d) The Cashier of a company committed a fraud and absconded with the proceeds thereof. This happened during the course of the accounting year. The Chief Accountant of the company also did not know about fraud. In the course of the audit, at the end of the year, the auditor failed to discover the fraud. After the audit was completed, however, the fraud was discovered by the Chief Accountant. Investigation made at that time indicate that the auditor did not exercise proper skill and car and performed his work in a desultory and haphazard manner. With this background, the Directors of the company intend to file disciplinary proceedings against the auditor. Discuss the position of the auditor with regard to the disciplinary proceedings. [Nov.2003, Question 2(a),(b),&(c) each 4 marks and (d) 6 marks] 25. Comment on the following with reference to Chartered Accountants Act, 1949 and schedules thereto: (a) Mr. Parekh, a Chartered Accountant was invited by the Chamber of Commerce to present a paper in a symposium on the issues facing Indian Leather Industry. During the course of his presentation he shared some of the vital information of his client's business under the impression that it will help the Nation to compete with other countries at International level. (b) Mr. Shah, a Chartered Accountant certified the financial statements of a company in which his wife is a Director holding substantial interest. (c) Mr. Joe, a Chartered Accountant during the course of audit of M/s XYZ Ltd. came to know that the company has taken a loan of Rs. 10 lakhs from Employees Provident Fund. The said loan was not reflected in the books of account. However, the auditor ignored this information in his report. (d) Mr. Jain, a Chartered Accountant certified the circulation of "Good Luck" a weekly magazine without examination of financial records and other required documents. [May, 2004, Question 2 (a)(b)(c)&(d); each 4 marks] (e) A charitable institution entrusted Rs. 10 lakhs with its auditors MIs Ram and Co., a Chartered Accountant firm, to invest in a profitable portfolio. The auditors pending investment of the money, deposited it in their Savings bank account and no investment was made in the next three months.

III.44

Advanced Auditing and Professional Ethics

26. Comment on the following with reference to the Chartered Accountants Act, 1949 and Schedules thereto: (a) L, a chartered accountant did not maintain books of account for his professional earnings on the ground that his income is less than the limits prescribed u/s 44AA of the Income Tax Act, 1961. (b) M/s. ABC, a firm of Chartered Accountants has taken a loan for acquiring computers, from a company whose Managing Directors' son is an Articled Trainee with A, a partner of M/s ABC. (c ) M/s XYZ, a firm of Chartered Accountants created a website "www.xyzindia.com”. The website besides containing details of the firm and bio-data of the partners also contains the photographs of all the partners of the firm. (d) Z, a Chartered Accountant, certifies a financial forecast of his client which was forwarded to the client's bank based on which the bank sanctioned a loan to the client. [May, 2005, Question 2 (a)(b)(c)&(d); 5+4+5+4 marks] 27. Comment on the following with reference to the Chartered Accountants Act, 1949 and Schedules thereto: (a) Mr. S, a Chartered Accountant published a book and gave his personal details as the author. These details also mentioned his professional experience and his present association as partner with M/s RST, a firm. (b) Mr C accepted the statutory audit of M/s PSU Ltd., whose net worth is negative for the year 2003-04.The audit was to be conducted for the year 2004-05. The audited accounts for the year 2004-05 showed liability for payment of tax audit fees of RS.15,000 in favour of Mr E, the previous auditor. (c) M/s PQR, a firm of Chartered Accountants with 5 partners has accepted the audit of ABC Pvt. Ltd. for 2004-05 at an audit fee of Rs.2,500. ABC Pvt. Ltd was incorporated in April, 2002, but had commenced operations in January, 2005. (d) Mr. P, a Chartered Accountant in practice entered into a partnership with Mr. L, an advocate for sharing of fees for work sent by one to the other. However, due to some disputes, the partnership was dissolved after 1 month without any fees having been received. [Nov, 2005, Question 2 (a)(b)(c)&(d); 5+5+4+4 marks] 28. Short Notes (a) Auditor’s Liability in case of unlawful acts or defaults by clients [Nov, 2000, Question 8(iv), 4 marks] (b) Other Misconduct [May, 2001, Question 8(c), 4 marks] (c) Other Misconduct [Nov, 2004, Question 8(d), 4 marks]