I

Revised Syllabus of M. Com. PART - II

Advanced Auditing-IV
Sr.No. Topics
1. Audit of Ledgers
General Considerations
Scrutiny of Ledgers of Assets, Personal, Revenue
Accounts.

2 The Company Audit

General consideration in a company audit
Special requirements of company audit
Audit report: Basic Elements of the Auditor’s Report,
Format of Audit
Report.(Including -Companies (Auditor’s Report) Order,
2003)

3. New Standards on Auditing (SAs)

SA 200 (Revised) :Overall Objectives of the Independent
Auditor and the Conduct of an Audit in Accordance with
Standards on Auditing
SA 210 (Revised): Agreeing the Terms of Audit
Engagements
SA 220 (Revised):Quality Control for an Audit of
Financial Statements
SA 230 (Revised): Audit Documentation
SA 240 (Revised): The Auditor’s Responsibilities
Relating to Fraud in an Audit of Financial Statements
SA 500 (Revised):Audit Evidence
SA 501 (Revised):Audit Evidence - Specific
Considerations for Selected Items
SA 505 (Revised): External Confirmations
SA 510 (Revised):Initial Audit Engagements—Opening
Balances
SA 610 (Revised):Using the Work of Internal Auditors
SA 200 A- Objective & scope of audit of Financial
Statement.
SA 300 Planning and Audit of Financial Audit
SA 520 Analytical Procedure
 II

4 Special Consideration in
Government audit
Miscellaneous audits
Audit of a sole trader
Audit of a firm
Audit of a small company
Audit of educational institutions
Audit of Hospital
Audit of Club
Audit of Hotels
Tax Audit
Audit of Insurance company
Audit of Banks

PATTERN OF QUESTION PAPER

Maximum Marks 100 Duration 3 Hours

No of questions to be asked 9
No of questions to be answered 6
Question No.01 Compulsory question 20 Marks
Question No.02 Compulsory Objective 16 Marks
Question No. 03 to Question No. 09 (Any 4) 16 Marks each

Notes:-
(1) From Question No. 03 to Question No.09 not more than one
question may be theory including short problems/questions.
(2) Student to answer any four out of Question No. 03 to
Question No.09 .
(3) Objective questions to be based on all topics and include
Inter alia questions like :-
(a) Multiple choice (b) Fill in the blanks
(c) Match the columns (d) True or False


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AUDIT OF LEDGERS

Unit Structure
1.0 Objective
1.1 Steps Involved in the Audit of Ledgers
1.2 Audit of Bought Ledger
1.3 Audit of Sales Ledger
1.4 General Ledger
1.5 Practical Illustrations
1.6 Audit of Main Journal
1.7 Balance Sheet Audit
1.8 Summing Up
1.9 Questions for Exercise

1.0 OBJECTIVES

After studying the unit the students will be able:

 To Provide Classified Financial Information
 To Provide Check On Arithmetical Accuracy
 To Help Ascertain Profit Or Loss
 To Help Reveal The Financial Position

1.1 STEPS INVOLVED IN THE AUDIT OF LEDGERS

The audit of ledgers normally involves the following steps:

(i) Internal check - Test the quality of internal check-regarding

timely and correct entries in the ledger.

(ii) Opening balances - Trace the opening balances from previous

year's audited balance sheet. In case, the entity is getting its
accounts audited for the first time since inception or it was audited
in previous year by some other auditor, follow the procedures given
in AAS-22"Initial Engagements - Opening Balances "issued by
ICAI.
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(iii) Postings - Check postings from cash book and other books of
prime entry (i.e., purchases book, sales book, journal, purchase
returns book, sales return book, bills receivable book, bill payable
book).

(iv) Control accounts - Total up the balances in the subsidiary

ledgers. Tally the totals with those in the control accounts.

(v) Verification of personal account balances - Verify

personal account balances with statements of account received
from the parties or by arranging direct confirmation. The procedure
of direct confirmation should be applied in the manner stated in
AAS-30 External Confirmations issued by ICAI.

(vi) Verification of Real accounts - The real account balances

should be verified by

 physical verification (as in the case of cash and

investments),
 checking the working papers of physical verification exercise
conducted by the management (as in the case of fixed
assets and inventories),
 inspection of documents (as in the case of intangible assets
such as patents and trade marks), and
 direct confirmation (as in the case of stocks lying with third
parties).

(vii) Scrutiny of individual accounts - Scrutinize individual

accounts. Examine the composition of balances. Examine age
analysis of various items outstanding.'

(viii) Totals - Check totals of ledger accounts, schedules of

balances, groupings etc.

(ix) Tracing into the final accounts - Trace the balances in

individual accounts on to the schedules, from thereon into the
groupings-and from the groupings into the final accounts.

( x ) Analytical Review - Examine the reasonability of balances by

applying analytical procedures e.g. comparison with opening
balances, debtors turnover ratio, creditors turnover ratio, current
ratio, fixed assets turnover ratio, working capital turnover ratio etc.

1.2 AUDIT OF BOUGHT LEDGER

Following is the procedure of the Audit the Bought Ledger

(Creditor's Ledger)
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Audit of bought ledger should be taken up only after vouching of
Purchase Journal, Purchase Returns Journal, cash book and
Journal and verification of bank reconciliation statement have been
completed and all the queries arising from these have been
satisfactorily resolved. The steps in audit of bought ledger are
generally the following:

( a ) Opening balances - Check the opening balances of all

suppliers accounts from the last year's audited schedule.

( b ) Postings - Check the postings from the books of prime entry

(i.e., purchase journal, purchase returns journal, cash book, bills
payable book, main journal).

(c) Totals - Check the totals of individual accounts of suppliers.

( d ) Agreement with control account - The total of balances of the

individual suppliers' accounts agree this total with the control
account of sundry creditors in the general ledger.

(e) Debit balances-

♦ Pay special attention to debit balances in suppliers' accounts.

Enquire into the reasons for such debit balances. These may be
advances against which supplies are yet to be received or they may
represent advances not adjusted against billing. Another possibility
could be that the payment to the supplier has been posted to his
debit but the entry for purchases (i.e., by debiting purchases and
crediting his account) has been omitted.

♦ Scrutinize advances against which deliveries are pending for long

time. See that these are genuine advances and not merely financial
accommodation of a favoured party. Whether the advance is a
genuine one or merely for financial accommodation should be
judged keeping in mind factors such as :
• the value of purchases;
• the proportion of value of purchases given as advance;
• the normal lead time for delivery;
• the normal trade practices; and
• whether the party is a sister concern.

These debit balances should not be netted off from credit

balances but shown separately on Assets side of the Balance
Sheet.

( f ) Composition o f balances - Scrutinize the composition of

balances by matching each credit (for supplies) with the
corresponding debit entry (for payment of bills). The unmatched
items should be enquired. If not, there may be cases where the
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opening balances or earlier credits are unpaid but the later ones
are paid. This may reveal any of the following possibilities:—
( i ) Remittances to creditors misappropriated.

(ii) Disputes regarding previous balances.

(iii) Liability regarding the amount no longer exists.
(iv) Fictitious liability created to suppress profits.
(v) Payment entry omitted from the books.

(g) Direct confirmation - The auditor should apply direct

confirmation procedures for creditors balances (at least a sample of
them) in the manner stipulated in AAS-30

External confirmations issued by ICAI.

(h) Tracing into the final accounts - Trace the balances from
the ledger accounts into the schedule of creditors and from
thereon into the groupings and then on to the final account

1.3 AUDIT OF SALES LEDGER

Following is the procedure of conducting the Audit of Sales

Ledger (Customer's Ledger)

The audit of the sales ledger (customer's ledger) should be

taken up only after the books of prime entry i.e., sales day book,
sales return book, main journal and cash book have been vouched,
Bank. reconciliation statement has been examined and queries
arising out of vouching and examination of BRS have been
satisfactorily resolved. The following steps will be generally
required in the audit of sales ledger:

( a ) Opening balances - Check the opening balances with the

audited balance sheet of last year.

( b ) Postings - Check the postings from sales day book, sales

return journal, credit notes register, debit notes register, main
journal, bills receivable book.

(c) Totals - Check totals i.e., castings of accounts of individual

customers.

( d ) Agreement with control accounts - Check the total of

balances of individual customers account. Tally this total with the
control account in the general ledger.

(e) Credit balances - Pay special attention to credit balances. It

may be that money has beet received in advance from a customer
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or that the sales entry (debiting customer and creditors: sales) must
have been omitted.

(f) Composition o f balances - Match each debit for sales to

customer with corresponding collection on the credit side. Many
customers (particularly big companies) send the remittance advices
showing the invoices against which payments have been made.
Refer to these while matching the payments against the respective
invoices. Unmatched items should be followed up with
management for explanations. Observe the patterns and enquire
about any change in it. For example, a customer who was making
payments in full in one stroke is now making part payments. This
may reflect that customer is having financial difficulties or that
teeming and leading is being practized.

( g ) Long outstanding balances - This has been listed as a

fraud risk factor by AAS-4 (Rev.). This could mean any of the
following possibilities :

♦ Bad debts requiring write-offs.

♦ Fictitious sales booked in previous year to bolster profits.
♦ Misappropriation of collections.
♦ Omission of postings for collections.
♦ In case of closely-held companies or firms, the money has been
paid to proprietor it partner or director who has deposited it in his
personal, account.

( h ) Foreign currency debtor balances - See that these are stated

in the balance sheet by converting the foreign currency receivable
into rupees by applying the closing rate (i.g., exchange rate on
balance sheet date). The differences arising i.g., exchange
differences should be adjusted in profit and loss account as per AS-
11 (Rev. 2003).

(i) Subsequent Collections - Verify the genuineness of the debtor

balances by checking whether they have been collected in the
following period.

(j) Direct confirmations - Obtain direct confirmations of debtor

balances by sending out confirmation requests in the manner
stipulated in AAS-30 External confirmations.

(k) Tracing into the final accounts - Trace the debtors balances
into the schedules of balances from thereon into groupings, from
thereon into final accounts.

( l ) Credit card receivables - In case company accepts payment

by credit cards, check reconciliation of receivables as per books
with credit card company's statements.
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1.4 GENERAL LEDGER

The General Ledger contains individual accounts of assets,

liabilities, income and expenses. Let us study (a) Why scrutiny of
general ledger is done (b) What is done before such scrutiny (c)
how scrutiny of general ledger is done.

 Why Scrutiny is Done

The objective of the scrutiny of general ledge is to obtain audit

evidence in the following matters.

1. Actuality: The assets and liabilities shown in the general

ledger actually exist at the year end. The transactions giving rise to
income and expenses recorded in the general ledger actually
occurred.

2. Complete Record: The general ledger records all the assets

legally owned by the concern at the year – end; all the liabilities
legally payable by the concern at the year – end; all the income
earned by the concern during the year; and all the expenses
incurred by the concern during the year.

3. Value: The closing balances of assets and liabilities are

properly valued. The transactions giving rise to income and
expenses have been recorded at the proper amounts.

4. Disclosure: The closing balances of assets and liabilities are

properly classified and disclosed in the balance sheet. The
amounts of income and expenses are properly disclosed in the
profit and loss account.

 What is done before scrutiny:

Before making a scrutiny of General Ledger, auditor should ensure

that the following audit procedures have been duly completed:

1. Study of Internal Control: Auditor should have studied and

evaluated the accounting system and internal audit

2. Vouching of Transaction: Then, based on the results of the

above study, the auditor should have vouched the transactions
which occurred during the year.

 How Scrutiny is done:

Audit of general ledger involves the following:

1. Checking opening Balances.
2. Checking posting from Registers, Books and Journals.
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3. Checking Castings and Totals of the ledger Accounts.
4. Scrutiny of Ledger Accounts.
5. Checking Summary and Groupings.

These steps are explained in detail below.

1. Checking opening Balances:

Opening Balances of the General Ledger should be verified

with reference to the audited accounts, the General Ledger and the
schedule of balance for the previous year.

1. In vouching, auditor checks the entry in the original books

such as Cash Book, Sales register, Bills Receivable Register,
Purchase Register, Bills Payable Register, Debit Note/ Credit Note
Register, Journal etc. The next step is to check the postings from
these books into the General Ledger. Auditor should check that the
correct amount is posted in the correct account on the correct side
of the account.

2. Posting may be checked on sample basis. Auditor may

check either all the postings for say 3 months or check posting into
selected accounts for the whole year.

3. The following aspects should be checked –

a. All entries are posted in sequences of dates i.e.
chronological order.
b. No entry is inserted in between two entries afterwards.
c. No entry is altered.
d. Against each entry, there is reference of the folio of the
original book or register.

2. Checking Casting
Auditor should check the totals of the ledger accounts. If an
account runs into many pages, he should check that the total of one
page is correctly carried forward to the next page.

3. Scrutiny of Ledger Accounts:

General Ledger contains accounts of Income, Expenses,
Assets or Liabilities. The scrutiny of Income and Expenses
Accounts is described below.

Sales Account:
1. In – depth Checking: Sales Account being the main source
of income is scrutinized in depth. The monthly summary is checked
from the Sales Register Debit / Credit Note Register. Posting from
cash / bank / journal are individual and not summary postings.
These are checked on sample basis.
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2. Cross – Checking: Sales amount is cross – checked with
figures of sales in the Sales Tax Returns, Excise Registers,
Returns with Government authorities like import and Export
authorities etc.

3. Cut – off Transactions: The cut off transactions are

checked in detail to ascertain whether (a) all goods dispatched
have been billed and (b) bills are raised only against goods
dispatched.

4. Transactions after balance Sheet date: The transactions

after the balnce sheet date e.g. goods retuned etc. are checked to
find out if they affect the sales account of the year under audit.

5. Analytical Review: The sales account should be

analytically reviewed; if the products and prices are standard and
constant during the year, sales should be equal to Quantity Sold x
Standard Price.

a. Sales for the current year should be compared with the sales
of the previous year. Any abnormal difference should be
investigated.
b. Sales Quantity should be reconciled. Thus, Sales Quantity
= Opening Stock + Production – Closing Stock.
c. Input – output ratio should be checked.
d. Various Turnover Ratios should be computed and compared
Viz. (a) Sales to Net Capital employed. (d) Sales to Fixed
Assets Employed. (c) Stock Turnover Ratio. (d) Debtors
Turnover Ratio etc. Further, the profitability ratios viz. (a) Gross
Profit to sales and (b) Net profits to sales should be
computed and investigated.

6. Book Entries: Auditor has to enquire (u/s 227) whether

transactions of sales etc. are not mere book entries. Thus, if large
sales are made to a concern towards year end and these goods are
returned immediately in the beginning of the next year, these may
be fictitious sales to inflate profits.

7. Sales to Group Concerns: Auditor has to ascertain whether

total sales to a group concern during the year exceed Rs. 50,000. if
so, he has to report whether the rates charged are reasonable
compared to the market rates for similar items.

8. Checking Trial Balance and Grouping: Auditor should

check the balance of Sales Account into the Trial Balance and the
Grouping. He should see that –
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a. No account in the nature of Miscellaneous income e.g.
Scrap sales is grouped under sales.
b. The debit balance in the Sales Return Account, if any, in
the ledger is deducted form the gross sales amount.

9. Schedule VI: Auditor should see that the sales are

classified as required by schedule VI of the Companies Act. The
value and quantities of major items are to be disclosed separately.
Earnings in foreign currency from export of goods on F.O.B. basis
should also be disclosed by way of a note to the final accounts.

Other Income Account:

1. Sample Checking: Other Income accounts e.g. Scrap
Sales, Rent Received, Dividends Received etc. being the incidental
and not the main sources of income are scrutinized on sample
basis.

2. Cross – Checking: Income amount is cross – checked with

details available from other memorandum registers such as Scrap
Sales Register, Property Register (for rent), Investment Register
(for dividends, interest etc.) etc.

3. Cut – Off transactions: The Cut – off transactions are

checked in detail to ascertain whether (a) income revised in
advance and (b) income accrued are adjusted.

4. Transaction after Balance Sheet Date: The transactions

after the balance sheet date e.g. sale of shares cum – dividend etc.
are checked to find out if they affect the income account of the year
under audit.

5. Analytical Review: The income account should be

analytically reviewed i.e.
 If the items of scrap and prices are standard and constant
during the year scrap sales should be equal to Quantity
sold x standard price.
 Scrap Sales for the current year should be compared with
the scrap sales of the previous year. Any abnormal
difference should be investigated.
 Scrap Sales Quantity should be reconciled. Thus scrap
sales quantity = Opening stock + Generation of Scrap –
closing Stock.
 Input – Output ratio should be checked from the Production
and cost records, to ascertain whether scrap generated is
normal or not.
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6. Book Entries: Auditor has to enquire (u/s 227 of the
companies act) whether transactions are not mere book entries.

7. Checking Trial Balance and Grouping: Auditor should

check the balance of the income account into the trial balance and
the grouping. He should ensure that any major item in the nature of
miscellaneous income is shown separately.

Income Accrued / Received in Advance:

1. Accrual Accounting: ‘Accrual” is the fundamental basis of

accounting. A limited company must maintains its accounts on
accrual basis. Under this basis, (a) income which has accrued is
booked even if not actually received and (b) amount which is
received in advance is not treated as income. This gives rise to (a)
Income Accrued and (b) Income Received in Advance.

2. Accounting standard: Auditor should follow the guidelines

contained in accounting standard 9 – Revenue Recognition –
issued by the Institute of Chartered Accountants of India (ICAI) for
this purpose.

3. Scrutiny of Income A/cs: Auditor should scrutinize all

income account (especially accounts like Service Charges
Recovered, Interest, Rent, Royalties and Dividends) to ascertain
the amounts accrued or received in advance.

4. General Rule: As a general rule, income should be booked

when it has accrued as per the terms of agreement between the
parties.

5. Service Charges: Income from service charges accrues

when the service is performed and complete. Thus income from job
work (i.e. processing of material supplied by others) accrues when
the job or processing is completed. If a job is complete at the year
end, but not yet billed, auditor should ensure that the income from
that job is shown as accrued and receivable in the books. On the
other hand, if any amount is received but the job is not complete as
at year end, it should be shown as income received in advance.

6. Interest Earned: Interest accrues on time basis at the rate

agreed. Thus if a loan agreement states that interest on a loan of
Rs. 1,00,000 is payable @20% per year, interest for an year would
be Rs. 20,000. if only Rs. 15,000 are received till the year end,
interest of Rs. 5,000 has accrued and must be booked. On the
other hand, if interest received is Rs. 25,000, Rs. 5,000 are
received in advance and pertain to the next year. Auditor should
scrutinize the interest account to ascertain the amount of interest
accrued or Interest Received in Advance.
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7. Rent: rent also accrues on time basis at the rate agreed.
Thus, if a rent agreement states that rent of Rs. 1,000 is payable
per month, rent for a year would be Rs. 12,000. If only Rs. 10,000
is received till the year end, rent of Rs. 2,000 has accrued and must
e booked. If on the other hand, Rs. 15,000 is received during the
year, Rs. 3,000 should be shown as Rent Receivable in advance.

8. Royalty: Royalty means the charges for use of know –

how, patents, trade marks and copyrights. Royalties accrue as per
the terms of the concerned agreement.

9. Dividends: Dividends on share accrue when the dividend is

declared by the shareholders. Auditor should enquire from the
client whether any such dividend has been declared on the shares
held as investment till the year end.

10. Prior Period Income: Prior Period Income means income

credited to the current year’s profit and loss account, though
relating to earlier years, due to the omission to treat such income
as income accrued during the concerned year. Such items should
be disclosed separately in the profit and loss account.

Purchase Account:

1. In – depth checking: Purchase Account being the main

item of expenditure is scrutinized in depth. The monthly summary is
checked from the purchase Register and the debit / credit note
register. Posting from cash/ bank/ journal are individual and not
summary postings. These are checked on sample basis.

2. Cross – Checking: Total Purchase amount is cross –

checked with figures of purchases in the sales tax returns, excise
registers, returns with government authorities like import and export
authorities etc.

3. Cut – off transactions: The cut – off transactions are

checked in detail to ascertain whether (a) all goods received have
been billed and (b) bills are booked only against gods received.

4. Transactions after balance sheet date: The transactions

after the balance sheet date e.g. debit notes received, goods
returned etc. are checked to find out if they affect the purchase
account of the year under audit.

5. Analytical Review: The purchase account should be

analytically reviewed i.e.
 If the raw material and prices are standard and constant
during the year purchases should be equal to Quantity x
rates.
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 Purchases for the current year should be compared with
the purchases of the previous year. Any abnormal
difference should be investigated.
 Purchases Quantity should be reconciled. Thus, purchase
quantity = Opening Stock + Consumption – closing stock.
 Input – output ratio should be checked, to ascertain
whether purchases, consumption, production and stocks
are consistent with each other.
 Purchase Ratios should be computed and compared viz.
purchase to sales, purchases to Creditors etc.

6. Book Entries: Auditor has to enquire (u/s 227 of the

companies act) whether transactions of purchases etc. are
not mere book entries. Thus, if large purchases are made
from a concern towards year end and these goods are
returned immediately in the beginning of the next year,
these may be fictitious purchases to suppress profits.

7. Purchases from Group Concerns: Auditor has to ascertain

whether total purchases from a group concern during the year
exceed Rs. 50,000. If so, he has to report whether the rates
charged are reasonable compared to the market rates for similar
items.

8. Checking Trial Balance and Grouping: Auditor should

check the balance of the purchase account into the Trial Balance
and the Grouping. He should see that –

a. no account in the nature of Miscellaneous purchase e.g.

gift articles purchased is grouped under purchases.
b. The purchases Returns Account, if any, in the ledger is
deducted from the gross purchases amount.

Other Expense Accounts:

1. Sample Checking: Other Expenses account e.g.

Manufacturing expenses, administrative and office expenses, sales
and distribution expenses etc. should be scrutinized on sample
basis.

2. Cross Checking: Expenses accounts should be cross –

checked with details available from other memorandum registers
such as excise Registers, sales Tax Returns, Provident fund
Returns, Insurance Registers etc.
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3. Cut – off Transactions: The cut off transactions are
checked in detail to ascertain whether (a) all outstanding expenses
and (b) all pre paid expense are adjusted.

4. Transactions after balance Sheet Date: Transaction after

the balance sheet date e.g. payment of expenses etc. are checked
to find out if they affect the expenses account of the year under
audit.

5. Analytical Review: The expenses account should be

analytically reviewed i.e.:

 If the items of stores and prices are standard and constant

during the year stores expenses should be equal to
Quantity x Rates.
 Major Expense for the current year should be compared
with their corresponding figures of the previous year. Any
abnormal difference should be investigated.
 Packing Material Quantity should be reconciled. Thus
packing materials consumed = opening stock + purchases
– closing stock.
 Major Expense Ratio should be computed e.g. (a)
Manufacturing Expenses to Sales or (b) selling and
distribution Expenses to sales. Any abnormalities should
be investigated.

6. Book entries: Auditor has to enquire (u/s 227 of the

Companies Act) whether transactions are not mere book
entries.

7. Checking Trial balance and Grouping: Auditor should

check the balance of the Expenses account into the trial
balance and the grouping. He should see that any major
item in the nature of miscellaneous expenses (i.e.
exceeding 1% of the turnover) is shown separately.

Outstanding / Pre – paid expenses:

1. Accrual Accounting: “Accrual” is the fundamental basis of

accounting. A limited company must maintain its accounts on
accrual basis. Under this basis,

a. Expenses which have accrued are booked even if not

actually paid, and

b. Amounts which are paid in advance are treated as per paid

expenses. This gives rise to (a) Outstanding expenses and (b) Pre
– paid expenses.
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2. Scrutiny of Expenses A/c: Auditor should scrutinize all
expense accounts (especially accounts like service charges paid,
interest, rent, salaries, royalties etc.) to ascertain the amounts
outstanding or prepaid.

3. General Rule: As a general rule, expenses should be

booked when they have accrued as per the terms of agreement
between the parties.

4. Service Charges: Services charges accrue when the

service is performed and complete. Thus, charges for job work (i.e.
processing by outsiders of materials supplied by the concern)
accrue when the job or processing is complete. If a job is complete
at the year end, but not yet billed, auditor should ensure that the
service charges are shown as accrued and payable in the books.
On the other hand, if any amount is paid but the job is not complete
as at year end, it should be shown as pre paid expenses.

5. Interest Due: Interest accrues on time basis at the rate

agreed. Thus, if a loan agreement states that interest on a loan of
Rs. 1,00,000 is payable @ 20% per year, interest for an year would
be Rs. 20,000. if only Rs. 15,000 are paid till the year end, interest
of Rs. 5,000 has accrued and must be booked as outstanding
expenses. On the other hand, if interest paid is Rs. 25,000, Rs.
5,000 are paid in advance and pertain to the next year. Auditor
should scrutinize the interest account to ascertain the amount of
Interest Outstanding or Interest Pre-paid.

6. Rent: Rent also accrues on time basis at the rate agreed.

Thus, if a rent agreement states that rent of Rs. 1,000 is payable
per month, rent for a year would be Rs. 12,000. If only Rs. 10,000
is paid till the year end, rent of Rs. 2,000 has accrued and must be
booked as outstanding expenditure. If on the other hand, Rs.
15,000 is paid during the year, Rs. 3,000 should be shown as Pre
– paid expenses.

7. Royalty: Royalty means the charges for use of know –

how, patents, trade marks and copyrights. Royalties accrue as per
the terms of the concerned agreement.

8. Salaries and Wages: Normally, salaries and wages of the

last month of the accounting year would be outstanding at the year
end. These amounts would be paid in the next month. While
making the provision, provisions should be made for the gross
salaries and wages i.e. including the employer’s contribution to
provident fund, ESIS etc.

9. Commission on Sales: Commission may be payable to

sales staff, or outside agents. The amount of commission would
depend upon the terms of agreement and the amount of sales. The
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auditors hold verifies the computation of commission and ascertain
the commission outstanding or pre – paid as on the year end.
Auditor should verify that the appointment and terms of a sole
selling agent are approved by the shareholders in a geranial
meeting (s.294 of the companies Act) Schedule VI requires that
commission to sloe selling agents and must be disclosed
separately.

10. Commission to Directors: Commission to directors must be

in accordance with the provisions of the companies act.

11. Opening Balance: Auditor should check that the opening

balance brought forward from the previous year in the outstanding
expenses account is squared off during the current year. The
difference between the provision for outstanding expenses brought
forward and the actual payment in the next year must be properly
adjusted.

12. Prior Period Income: Prior Period expenses are expenses

debited to the current year’s profit and loss account, though relating
to earlier years, due to the omission to treat such expenses as
outstanding expenses during the concerned year. Such items
should be disclosed separately in the profit and loss account.

1.5 PRACTICAL ILLUSTRATIONS

Q.1 Why and how will you as an auditor, make a scrutiny of the
following ledger account? What conclusions will you draw from
such scrutiny?
Ajay’s Ledger
Vineet’s Account (LF No. 21)
Dr. Cr.
Date Particulars F. Amount Date Particulars F. Amount
2001 2001
Apr.01 By balance 400
b/d
2002 2002
Mar.2 To A 1 1,000 Mar.1 By A 1 5,000
Purchase Purchases
Returns
Mar.7 To Payment A 2 4,000 Mar.5 By B 3 4,500
Purchases
Mar.7 To B 3 900 Mar.26 By C 6 9,000
Purchase Purchases
Returns
Mar.9 To Payment B 5 3,000 Mar.27 By C 2 5,000
Purchases
Mar.31 To bal. c/d 15,000
23,900 23,900
 16
Q.2 Why and how will you, as an auditor, make a scrutiny of
the following ledger account? What conclusions will you draw from
such scrutiny?
Lallan’s Ledger
Mala’s Account (LF No. 21)
Dr. Cr.
Date Particulars F. Amount Date Particulars F. Amount
2002 2002
Jan.1 To bal. b/d A 10,000 Jan.1 By A 1 16,000
Purchase
a/c
Jan.17 To A 1 500 Mar.31 By bal. c/d B 20,000
purchase
(CN for
excess
rate)
Jan.20 To bank A 2 5,000
To discount A 2 500

Mar.25 To bank a/c B 3 20,000

36,000 36,000

Q.3 Why and how will you, as an auditor, make a scrutiny of

the following ledger account? What conclusions will you draw from
such scrutiny?
Reema’s Ledger
Madhumita’s Account (LF No. 2)
Dr. Cr.
Date Particulars F. Amount Date Particulars F. Amount
2001 2001
Jan.1 To bal. b/d A 6,000 Jan.1 By Bills A 1 4,000
Rec.
May25 To sales B 1 5,000 By Returns A 1 1,000
Sep.08 To bills rec. C 3 2,500 By Bank A 1 950
To interest C 3 500 By Discount A 1 50
To sales C 3 7,000 Jan.5 By Bank B 3 2,350
Dec.12 To bills rec. D 6 8,000 By discount B 3 150
To interest D 6 400 By Bills B 3 2,500
Rec.
Dec.15 To sales E 7 5,000 Sep.8 By Cash C 6 2,000
By Bills C 3 8,000
Rec.
Dec.14 By Cash D 7 8,400
Dec.31 By Bal. c/d E 5,000
34,400 34,400

Q.4 Why and how will you, as an auditor, make a scrutiny of

the following ledger account? What conclusions will you draw from
 17
such scrutiny?
Riya’sLedger
Bills Receivable Account (LF No. 28)
Dr. Cr.
Date Particulars F. Amount Date Particulars F. Amount

2001 2001
Jan.1 To balance A 10,000 Apr.30 By Bank A 1 10,000
b/d
May1 To Ram B 5,000 June2 By Bank B 1 4,900
June6 To Balaram C 10,000 By Discount B 1 100
Aug.18 To Shyam D 7,500 Aug.20 To Bank D 1 7,500
(Collection)
Sep.10 To Balaram E 10,200 Sep.9 By Balaram C 3 10,000
Dec.1 To Sitaram F 5,000 Dec.1 By Atmaram F 3 5,000
Dec.29 To G 7,000 Dec.31 By Balance 17,200
Sangoram c/d
54,700 54,700

Q.5 Why and how will you, as an auditor, make a scrutiny of

the following ledger account? What conclusions will you draw from
such scrutiny?
ABC Ltd.’s Ledger
Loan to Asha Ltd. Account (LF No. 2)
Dr. Cr.
Date Particulars F Amount Date Particulars F Amount
2002 2002
st
Jan.1 To Bank 2 60,000 June30 By Bank (1 ½ 10 15,000
yrly Installment)

Dec.31 By Balance c/d 45,000

60,000 60,000

Q.6 Why and how will you, as an auditor, make a scrutiny of

the following ledger account? What conclusions will you draw from
such scrutiny?
Surya Ltd.’s Ledger
Donation & Charity Account (LF No. 77)
Dr. Cr.
Date Particulars F Amount Date Particulars F Amount
2003 2003
Jan.1 To SARS BF6 60,000 Mar.31 By P&L A/c JB8 1,50,000
Relief Fund (transfer)
Mar.10 To BJP BF9 50,000
Fund
Mar.20 To National BF9 40,000
Defense
Fund
1,50,000 1,50,000
 18
Q.7 Why and how will you, as an auditor, make a scrutiny of
the following ledger account? What conclusions will you draw from
such scrutiny?
Sadhabahar Ltd.’s Ledger
Provision for Tax Account (LF No. 30)
Dr. Cr.
Date Particulars F Amount Date Particulars F Amount
2002 2002
June1 To JF8 1,40,000 Apr.1 By 1,20,000
Advance Balance
Tax A/c b/d (A)
(A) [2001- [2001-02]
02]
June1 To JF8 12,000 June1 By P & L JF8 32,000
Liabilities A/c (A)
for Tax A/c
(A)
2003 2003
Mar.31 To 1,60,000 Mar.31 By P & L JF9 1,60,000
Balance A/c (B)
c/d [B]
3,12,000 3,12,000

1.6 AUDIT OF MAIN JOURNAL

The main journal contains :

(i) Adjusting entries.
(ii) Closing entries.
(iii) Rectification entries.
(iv) Entries which cannot be accommodated in any other subsidiary
book or journal (e.g., credit sale of fixed asset, credit purchase of
fixed asset, share allotment, share capital, creation of capital
redemption reserves, and initial recognition of finance lease)

Points to be kept in mind while auditing the main journal:

(1) Opening entries- Verify opening entries with the audited

balance sheet of the previous year.

(2) Rectification entries - Refer to the original vouchers in respect

of which error was committed to ensure that rectification entries are
genuine and rectification entries have been correctly passed.

The auditor should not assume that every rectification

journal entry is an innocent rectification of an innocent error. He
should exercise enough professional skepticism in this matter.
 19
For Example : Cheque received from A. Shah is credited to A.
Saha's account. Then after 10 days, the "mistake" is
discovered. It is "rectified" by debiting A. Saha and crediting
A. Shah. Only thing is that the data entry man had a "setting"
with A. Shah who told him that he won't be able to send his
cheque within the time allowed for availing cash discount and
further, if somehow he is allowed the cash discount, he would
"share" it with him. Accordingly the above 'mistake' was
committed to give A. Saha the discount which he was not
entitled to.

(3) Supporting - Examine the supporting (e.g., correspondence,

contracts, minutes)

(4) Adjusting entries - Adjusting entries are passed for—

(a) expenses accrued till the balance sheet date but not paid e.g.,
rent, electricity, etc.

(b) income accrued but not received e.g., interest accrued but not
matured for receipt.

By the time of audit, some of the liabilities provided for may have
already been paid off. The payments may be more than the
provision. But as long as these were estimated on a reasonable
basis, the auditor need not insist on adjusting the difference
between the provision and the payments.

Since adjustment entries are supported by internally

prepared statements, the auditor should obtain independent
evidence for corroborating them.

If the difference between amount provided for and amount

settled is material, the auditor should insist on management
increasing the provision amount.

5) Journal entries not supported by any vouchers like bills,

contracts, etc. - If any journal entries are not supported by
vouchers (except opening entries rectification entries, adjusting
entries and closing entries) the auditor should see whether these
are transactions represented merely by book entries prejudicial to
the interest of the company [section 227(1 A)(b) of the Companies
Act, 1956].

6) Proper authorization -The auditor should ensure that journal

entries are passed with proper authorization.

7) Non-standard journal entries - Performing tests of non-

standard journal entries to confirm that they are adequately
supported and reflect underlying events and transactions. This may
 20
help in identifying fictitious entries or aggressive recognition
practices. Non-standard journal entries are generally the financial
statement changes or entries made in the books and records
(including computer records) of the entries that are :

♦ Usually initiated by management level personnel; and

♦ Not routine or associated with normal processing of transactions.

1.7 BALANCE SHEET AUDIT

MEANING OF BALANCE SHEET AUDIT

Until recently, test checking was confined to confirming

balances in a few nominal account such as stocks and stores,
amount of sales and other similar records relevant to trading
transaction, which were voluminous but of similar nature. Now-a-
days test checks are being applied widely for verification of income
and expense accounts and assets and liabilities as well. This is due
to two reasons:
(i) Increase in the size of business units, and
(it) Computerization of accounting.

DEFINITION –
A balance sheet audit consists of the verification of all the
balance sheet items along with the examination of expense and
income accounts which are so closely related to those items that it
cannot be properly verified without such analysis and test.

Balance sheet audit will include

(i) Examination of partnership deed, the memorandum and articles

of association, minute books and the system of accounting in force.
(ii) Verification of ownership or enterprise's control over assets
shown in the balance sheet.
(iii) Proof that all assets owned or controlled by the enterprise are
included.
(iv) Inclusion of assets in the balance sheet is in accordance with
the generally accepted principles of accounting (valuation of
assets).
(v) Proof that all liabilities are included and at proved amounts.
(vi) Examination of closing and adjusting entries and any other
entries relevant to the preparation of balance sheet.
(vii) Distinction between capital expenditure and revenue
expenditure on the basis of accepted accounting principles.
 21
(viii) Proof that share capital issues have been made in compliance
with requirements of law and they are correctly recorded in the
financial books.
(ix) An analysis of the charges and credits to the profit and loss
accounts and the inclusion of the resultant balance in the balance
sheet.

1.8 SUMMING UP

The ledger is a permanent book of record which contains a

number of accounts of different subjects. Its purpose is, therefore to
provide classified financial information about the subjects such as a
person, asset and an expense or income. The fundamental double-
entry principle provides that debit is always equal to credit or vice
verse. Since the ledger account is prepared under the double-entry
system, it helps to prepare a Trial balance that provides a check on
the arithmetical accuracy of the recording transactions in the books
of accounts. The ledger is a book of accounts relating to all the
financial transaction of the business. It contains the accounts of all
expenses, losses, incomes and gains. Therefore it helps to prepare
the profit and loss account of the business so as to ascertain the
profit earned or loss suffered during a specified period. The ledger
also contains the accounts of the financial transactions relating to
capital, all liabilities and assets of the business. With the help of the
balances of these accounts and profit and loss of the business, a
balance sheet may be prepared to show its financial position at a
certain point in time.

1.9 QUESTIONS FOR EXERCISE

1) Discuss Importance and objective of Audit of ledger.

2) How as an auditor scrutiny of bought ledger is done.
3) How as an auditor scrutiny of Sales ledger is done.





 22

2
THE COMPANY AUDIT I

Unit structure:

2.1 Introduction
2.2 Preparation, Presentation of Accounts and Audit thereof
2.3 Audit of Certain Payments
2.4 Disclosure of Accounting Policies
2.5 Audit of Liabilities
2.6 Audit of Share Capital
2.7 Issue of bonus Shares
2.8 Audit of Forfeiture of Shares
2.9 Redemption of Preferences Shares
2.10 Audit of Share Transfer
2.11 Buy-Back of Shares
2.12 Alteration of Share Capital
2.13 Sweat Equity Shares
2.14 Audit of Debentures

2.1 INTRODUCTION

U/S 209 every company shall keep at its registered office or

any other place in India after complying with relevant prescribed
procedures proper books of account to record (i) all sums of money
received and spent & related matters. (ii) all sales and purchases
(iii) all assets and liabilities (iv) such cost records prescribed by
Central Government (CG) in case of Cos engaged in production,
processing, manufacturing or mining activities.

Further, if there are branches, then proper summarized

quarterly returns of transactions occurred are to be sent to
registered office.

Sec 209 (3) has laid two conditions for proper books of
account viz. (i) True and fair view of the company performance &
consequent state of affairs explaining its transactions & (ii) Double
Entry And Accrual basis of accounting.
 23

Sections 210 to 223 of the Co’s Act, 1956 deal with the
preparation & presentation of the final accounts of Cos.

The books of account (with vouchers) for prior/proceeding

eight years should be preserved. The Annual Accounts of profits &
loss (or Income & Expenditure as case may be) and Balance Sheet
together with Directors Report must be laid by the Board of
Directors (BOD) before every Annual General Meeting (AGM)
relating to period called “financial year” which may be less, equal or
more than a calendar year with maximum 18 months AND the
ending date of the financial statements of final accounts shall
generally proceed not the date of the AGM by more than 6 months
UNLESSS permitted by the Registrar of Companies (ROC). The
responsibility for complying with the provisions of the Cos Act is
that of the Directors or competent reliable duly authorized persons.

In addition to the books of account, a company has to

maintain certain relevant statutory books as follows:-

(i) Register of Members (ii) Index of Members (iii) Register &

Index of Debenture holders (iv) Register of Charges (v) Minute
Books (vi) Register of Directors (vii) Register of Investment made in
shares, (viii) Register of Investments (ix) Register of Loans UNDER
DIFFERENT SECTIONS/PROVISIONS APPLICABLE.

2.2 PREPARATION, PRESENTATION OF

ACCOUNTS AND AUDIT THEREOF

2.2.1 PREPARATION OF FINAL ACCOUNTS

(i) The Balance Sheet and the Profit & Loss Account (B/S &
P/L) may be presented in either traditional horizontal format or the
modern vertical format with main items therein & detailed items in
supporting schedules thereto AND must comply with the
requirement of Part I and Part II of schedule VI AND relevant
accounting standards (AS) respectively disclosing the prescribed
assets & liabilities and revenues & expenses respectively.

(ii) Disclosure of the following aspects pertaining to non-

compliance of AS by ICAI or National Advisory Committee thereon
in its final accounts viz. B/S & P/L viz. (a) Deviations (b) Reasons
(c) Effects.

(iii) Exceptions to the above applicable provisions to be

complied by companies:-

(a) Special/Class of Cos like Banking, Insurance, Electricity

governed by separate Laws/Acts appropriate to them.
 24

(b) Where and when Central Government (CG) exempts any

companies or modifies the requirement/disclosures.

(iv) Abridged Accounts:- Form & Contents of B/S & P/L and Reports
of Auditors & Directors.

2.2.2 GENERAL CONSIDERATION IN A COMPANY AUDIT

The statement of Auditing practices issued by the ICAI lays

down the following general considerations in a company Audit.

1) True and Fair

The Audited Financial Statements must clearly show the
results of the c\working of the company for the year and it should
be in accordance with the provisions of schedule VI of the
Companies Act, 1956. The profit or loss for the year must disclose
True & Fair view.

2) Materiality
Every material fact must be properly disclosed for e.g. prior
period adjustments non-recurring or unusual items of
income/losses. The judgment of materiality needs auditors
professional experience.

3) Analytical Study
While giving previous year figures a proper scrutiny should
be made. Scrutiny can be made with the help of various ratios and
proper explanations must be sought from the client if there is any
significant variation.

4) Account Policies
The accounting policies followed by the client must be in
conformation with the Accounting Standards and recommendations
of the ICAI. The policies must be in consistency with the basic
accounting principles.

5) Internal Control
The auditor should carefully examine the existing internal
control before preparing Audit programme. He may use Flow
Charts and Internal Control Questionnaire.

6) Auditor’s Approach
His approach should be professional independence and
without prejudice to his statutory duties. He must follow
professional ethics in discharge of his duties.

7) Disclosure
The Auditors should ensure that there is proper disclosure of
all relevant facts and information, matters required by Company
 25

Law and Accounting Standards. Contingent Liabilities must be

properly disclosed.

8) Proper Books of Accounts

Section 209 & Section 541 of the Companies Act, 1956
requires the Auditor to report whether proper books of Accounts
have been kept by the company or not.

9) Objectives
a. Assets - The Auditor’s objective in regards to assets
generally is to satisfy that the assets are existing, and they belong
to the client. They are in possession of the client and they are not
subject to any charge and they are properly valued.

b. Liabilities – Auditor should satisfy himself that all the

liabilities are properly recorded classified and disclosed. He should
also satisfy himself that the liabilities are actual liabilities and are
not mere book entries.

10) Working Papers

Auditor must maintain proper and adequate working papers
showing clearly work done by him/his assistants. Explanations and
information given by the client and whether he satisfied with such
information.

11) Computerized Accounts

If the accounts are computerized then he should modify his
Audit programme and Audit work accordingly

12) Reporting
This is the final and most important stage of Auditing. He
should take great care in drafting the report. If he feels necessary to
qualify his reports then he must qualify the same without any
hesitation but with almost care. The form of Audit Report is
prescribed by the statute.

2.2.3 PRE-COMMENCEMENT CONSIDERATIONS

According to the ‘Guide to Company Audit’ issued by the

ICAI before commencing the Audit the auditor should make him
familiar with:
a) Accounting year
b) Nature of company’s business (examine the incidence of any
other statue, of the company e.g. The Banking Regulations Act,
1949. The Insurance Act, 1938)
c) Status of the company with reference to sections 3,4,25 43A and
617 of the companies Act
 26

d) Constitution and composition of the Board of Directors

e) Important provisions of Memorandum and Articles
g) List of books of Accounts
h) Compliance to section 224, 224A, 225, 619 and 619B
i) Communication with previous Auditor if the appointment is in
replacement of existing auditor
j) Review of previous Audit notes and Audit Report
k) Whether the statement issued by the Institute or Accounting
Standards have been considered.
l) Whether his independence can any way be affected in his duties.

2.2.4 VERIFICATION OF THE CONSTITUTION AND POWERS

A) Registration Documents
The Auditor should examine
i) The Memorandum of Association
ii) The Articles of Association

B) Decision only in Board Meetings

As per section 292 following decisions must be taken in the
Board Meetings and supported by proper Board Resolutions.
i) Making calls
ii) Issue of Debentures/Securities
iii) Borrowing money
iv) Investing the funds of the company
v) Taking loans
vi) Appointment of first Auditors and filling up of casual
vacancies.
No. iv & v can be delegated to committee of Directors,
Managing Director, Manager or any other principal officers.

C) Decision only in General Meetings

i) Appointment & fixation of remuneration of Auditors
ii) Declaration of dividends
iii) Appointment of relatives of Directors to place of profit
(section 314)
iv) Sale, lease or disposal of companies undertaking

D) Minute Books
The Auditor must verify the Minute Books regarding
i) Loans to Director properly sanctioned by the Central
Government (Section 295)
ii) Appointment of Directors
iii) Disqualifications of Directors
iv) General Powers of the Board (Section 291)
v) Donation to political parities , if any (section 293A)
 27

vi) Participating in voting by interested Director (section 300)

vii) Disclosure of interest by Directors (section 299)
viii) Register of Contract, Firms or companies in which
Directors are interested (section 301)
ix) Remuneration of Directors (section 309)
x) Restrictions on Directors holding place of profit (section
314)
xi) Restriction on compensation for loss of office to a Director
(section 318 to 321)
xii) Restriction on loans to company under same
management (section 370)
xiii) Inter-corporate loans & investments

2.3 AUDIT OF CERTAIN PAYMENTS

According to the guidance note on Audit of payments issued

by the ICAI, the auditor should carry out appropriate Audit
procedure in respect of following items.

A) Managerial Remuneration

i) Articles of Association or Resolution-

The Auditor should see that the remuneration paid/payable
to the managing director, whole time director is determined by the
Articles of Associations of the company or by Resolution passed in
General Meetings of the company.

ii) Company’s Act-

The Auditor should confirm that the managing remuneration
is with in the limits laid down under section 198 and schedule XIII of
the Companies Act ,1956, he should also see that it is in
compliance with provisions of section 309, 349 & 350

B) Charity, Donations & Similar Contributions

i) Companies Act, 1956-

If the donations/contributions are made by the company to
charitable or other funds not directly related to the business of the
company or for welfare of the company then

a) It should be according to section 293 i.e. it should be passed in

General Meeting & should not exceed Rs.5000/- or 5% of average
Net Profit of the company made during immediately preceding three
financial years whichever is higher.

b) It should be specifically stated in the objects clause of the

Memorandum of Association of the company.
 28

c) He should obtain a detail statement of such contribution (as per

section 292)

C) Political Contributions

i) Companies Act, 1956-

Should be within the limits prescribed under section 293A

ii) If the Auditor is not satisfied he should qualify his report

accordingly
iii) He should obtain a certificate from Board of Directors stating that
such contributions are as per section 293A and are included in the
books of accounts.

D) Contributions to Defence Funds

i) Companies Act, 1956

Any contribution to National Defence Fund or any other fund
approved by Central Government must be as per provision of
section 293B. Such donations need not be empowered by the
memorandum of Association of the company.

ii) The total amount of such contribution must be properly disclosed

in the profit & loss statement.

E) Director’s Remuneration

i) Appointment referred to the resolution of General Meetings or

Board Meeting for appointment & his remuneration.

ii) Examine the Articles of Association & General Meeting

Resolution and verify the mode of payment i.e. monthly, quarterly,
yearly, etc.

iii) Check the Agreements with the Director

iv) Verify the director’s attendance in the Board Meetings

v) Check compliance with sections 198, 309, 349, 350 and

schedule XIII

vi) As per revised schedule VI there are no disclosure requirement

for Director Remuneration

vii) Verify the receipts issued by the Director

 29

F) Directors’ Commission

i) Articles of Association must be checked regarding rules for

payment of commission to Directors

ii) Check the agreement with the Director to verify the rate of
commission

iii) Check the compliance with section 198, 309, 349,350, 351 &
schedule XIII of Companies Act, 1956

iv) Check the calculation of the commission paid

v) Verify the receipts issued by the Director

G) Director’s Sitting Fees

i) The payment of Directors Fees should be as per Articles of
Association of the company

ii) Also verify the Board Resolution fixing the amounts of fees per
meetings

iii) Check the minute book, Directors attendance register, Dates of

the meetings.

iv) Check the calculation & verify the signatures of the Director

H) Interest on Capital during Construction

i) A company which issues share capital for the purpose of
construction of a building or installation of plant can pay interest on
such paid –up capital subject to section 208 of the Companies Act,
1956.

ii) The Auditor should verify

a) That such payment is as per Articles of Association or Special
Resolution
b) Must be sanctioned by the Central Government

iii) It must not exceed the construction period

iv) The rate of interest should not exceed the sanction rate
v) Such interest should be added to the cost of asset generated out
of capital

I) Payment of Dividend (profit made by a company is

distributed to shareholders by way of dividend)
a) Verification of procedures
1) Examination of compliance with laws, regulations, and other
relevant information
2) Examination of records
 30

 Examination of Compliance with provisions of compliance

with Companies Act, 1956.

Section 205(1)- dividend can be declared and paid by a company

- out of current year’s profit after providing for depreciation,
profits of previous year/years, after providing for
depreciation.
- out of current years profit after providing for any losses
incurred in the previous financial years.
- out of money provided by the Central or State Government
for the payment of dividend in pursuance of guarantee.

Section 205(2A) and (3)

- After transfer of certain % of profits for that year, not
exceeding 10% as may be prescribed.
- A voluntary transfer at higher percent may be mode in
accordance with the rules
- If the rate of dividend declared is less than 10%, the
company need not transfer any profit to reserve
- Dividend shall be paid in cash only.

Section 205(A)
- Unclaimed and unpaid dividend.
- Dividend must be paid / dividend warrants must be posted to
all eligible shareholders within 30 days of declaration of
dividend.
- Dividend remaining unclaimed on unpaid for 7 days after the
expiry of 30 days from the date declaration should be
transferred to a separate bank account with a scheduled
bank.
- Such amount should be kept in that account for a period of 7
years. On expiry of years, any such unpaid dividend should
be transferred to a fund named as “Investor Education and
Protection Fund”.
- Such dividend should be disclosed under “Other Current
Liabilities” in the Balance Sheet.

 FEMA-
The Auditor must verify compliance with provisions of
Foreign Exchange Management Act, 1999, in case if the shares are
issued to non-residents or issue of ADR/GDR
 31

 Listing Agreement
The Auditor must verify that prior intimation regarding Board
Meeting for declaring the dividend was given to the stock
exchange.

 Interim Dividend-
The Auditor must verify
- It is approved in the General Meeting of the members
- It is as per the Articles of Association/byelaws.
- The financial statements have been prepared and presented
before the board
- The depreciation for the full year has been provided
- Transfer to reserve has been complied
- Dividend payable to preference share holders is
paid/provided

 Audit Procedure for Dividend

- The Auditor should examine
- Minute Book or Board and General Meeting to check the rate
of dividend
- Legal provisions relating to dividend have been fully
complied with
- Pass books / bank Statement for the amount paid as
dividend
- Amount transferred to special bank account for
unpaid/unclaimed dividend
- Reconciliation of Balances and special bank A/C’s with the
unclaimed dividend account shown under the heading other
liabilities in the Balance Sheet
- Relevant journal entries and its posting penalty for failure to
distribute dividend. (Sec.207)
- If the dividend so declared as not paid within 30 days from
declaration then every director of the company who
knowingly as a party to default shall be punishable with
simple imprisonment extending up to 3 years and with fine.

This penalty is not applicable if dividend is not paid due to

- Operation of law
- There is no profit of company
- Dividend is legally adjusted against any sum due from
shareholder
- The shareholder has given certain specific instruction
- There is a certain dispute under arbitration
 32

 Disclosure
- Proposed dividend should be shown as appropriation of
profit in the Profit & Loss Statement and as provision under
provisions in the Balance Sheet
- Unclaimed dividend should be shown in Balance Sheet
under the heading current liabilities.
- In respect of companies, all arrears of cumulative preference
dividend should be shown as contingent liability

 Dividend out of Capital Profits

If capital profits are distributed as dividend, the Auditor
should also verify that:
- The Article of the byelaws or other laws & regulations
applicable to the entity, permit such distribution.
- It has been realized in cash
- The board or similar authority as satisfied that net aggregate
value of the assets remaining after distribution of that profit
will not be less than book values so that share capital &
reserves remaining after the distribution will be fully
represented by remaining assets
- Capital surplus arising on the revaluation of fixed assets is
not directly or indirectly available for distribution as dividend.
- 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 & securities
premium collected on the issue of securities cannot be
utilized for declaration of dividend.

2.4 DISCLOSURE OF ACCOUNTING POLICIES

2.4.1 A.S.I: -
Accounting Policies are specific accounting principles and methods
of applying those principles adopted by the company in the
preparation & presentation of final statements.

Following are the areas in which different accounting policies are

adopted by the different companies.
- Methods of depreciation/amortization.
- Valuation of fixed assets
- Valuation of investments.
- Valuation & treatment goodwill.
- Valuation of inventory
- Treatment of retirement benefits.
- Conversion of foreign currency items.
 33

- Revenue recognition in case of long term contacts.

- Treatment of expenditure doing construction.
- Treatment of contingent liabilities.

2.4.2 Manner of Disclosure

- Should form part of financial statements.
- Should be disclosed at one place.

Charge in Accounting Policies

- If any change which materially affects current or future
period should be disclosed
- if the affected amount is ascertainable the disclosure to that
extent is required.
- If it is not ascertainable than it should be indicating.

2.4.3 Disclosure not required

- If fundamental accounting assumption are followed that is
growing concern, consistency and accrual are followed than
no separate disclosure is required.

2.4.4 Major considerations in application of accounting

policies

i) Prudence – Due to existence of future uncertainties of events

profits are not anticipated but are recognized only when realized.
All known losses and liabilities are provided even through the
amount cannot be determined with certainty.

ii) Substance over form – The accounting treatment and

presentation in financial statement of transactions and events
should be governed by their substance and not merely by the legal
form.

iii) Materiality – All material items should be disclosed in the

financial statements i.e. items the knowledge of which might
influence the decisions of the users of the financial statements.

2.5 AUDIT OF LIABILITIES

In addition to routine procedures following procedures

should be adopted by the auditor.
1) Borrowing Powers:- Check Memorandum of association and
Articles of Association as regards borrowing powers of the
directors/company and also examine compliance with section 292
and 293I1)(d).

2) Register of Charges:- The auditor should see that charges

created have been duly registered and properly recorded in the
 34

register of charges. Proper disclosure of such charges has been

made in the balance sheet.
3) Deposits:- if the company has accepted any fixed deposits from,
the public then the company must comply with provision of section
58A of Companies Act, 1956 and regulation / guidelines issued by
Reserve Bank of India.
4) Outstanding Taxes, duties, etc :- Any undisputed amount
payable under income tax, wealth tax, custom duty, excise duty, vat
etc. payable as on the Balance Sheet date, for a period of more
than 6 months from the date they became payable should be
properly reported
5) Group Loans:- The auditor should examine that all loans taken
from bodies corporate under the same management or from a
company firm or other party in which any director is interested and
determine whether in his opinion the rate of interests and other
terms and conditions of the loans are prima facie not prejudiced to
the interest of the company.

2.6 AUDIT OF SHARE CAPITAL

2.6.1 MEANING
Share capital means the capital raised by the issue of
shares. it is the amount invested by the shareholders towards the
face value of shares. Total amount invested by the shareholders is
collectively known as share capital.
2.6.2 DIFFERENT ASPECTS OF SHARE CAPITAL
The following chart discloses the different aspects of
Company’s Share Capital.

Authorized Capital

Issued Capital Unissued Capital

Subscribed Capital Unsubscribed Capital

Called Up Capital Uncalled Capital Reserve Capital

Paid Up Capital Calls in Arrears

 35

Authorized Share Capital

Authorized share capital is the maximum that the company
can raise during its lifetime. It is also called as the registered capital
or nominal capital of the company. It is maximum that the company
can raise. It should be verified with reference to

i) Memorandum of Association in Capital clause for amount

ii) Articles of Association for its break-up in various class (i.e. equity
& preference)
iii) Audited financial statements of the previous years.

Issued Capital
Issued capital is that part of authorized capital which is
offered for subscription. It is calculated at nominal value i.e. face
value.

It includes shares issued for cash, for consideration other

than cash, bonus shares, rights shares.

Subscribed Capital
Subscribed capital is that part of the issued capital which has
been subscribed or taken up by the public i.e. the capital which is
allotted. Subscribed may be or may not be equal to issued capital,
but it cannot be more than issued capital.

Called Up Capital
The company may not need the entire capital offered to be
subscribed by the public. The company may therefore, decide to
collect it in installments.

The called up capital is that portion of the subscribed capital

which has been called or demanded by the company to be paid.

Paid up Capital
It is the part of called up capital which has been actually paid
up by the members. There may be some members who may have
not paid up the calls made. Paid up capital is equal to called up less
calls in arrears.

2.6.3 TYPES OF SHARE CAPITAL:

Section 05 to 90 deals with kinds of share capital. The
provision of this section 85 to 90 does not deal with private
company unless it is a subsidiary of public company. Section 86
says that capital of a limited company is divided into two categories:
1. Equity Share Capital
2. Preference Share Capital
 36

1. Equity Share Capital:

Section 85 defines equity share capital, it is defined as
“Share Capital which is not Preference Share Capital”

Equity share capital is called “Risk Capital” or “Venture

Capital.” They are risk bearer of the company. They are the last
one to receive their money during liquidation of the company..

Section 87 confers voting rights upon every member of a

company. However these rights may be differential in nature i.e. a
company may issue shares which carry voting rights which are not
proportional to paid up capital.

2. Preference Share Capital:

Section 85(1) has defined preference share capital which
carries preference with reference to

a) Payment of dividend which may be either a fixed amount

or an amount calculated at fixed rate and

b) Repayment of capital during the winding up of the

company.

2.6.4 AUDIT OF ISSUE OF SHARES FOR CASH

The companies Act and SEBI guidelines have laid down

detailed legal provisions for various stages in issue of shares for
cash. These stages are:

a) Application Stage: In this stage application of shares in

received along with application money.

b) Allotment Stage: Here allotment of shares is done, allotment

letters are issued to successful applicants and allotment money is
called for and received. Letters of regret are issued along with
refund cheque to unsuccessful applicants.

c) Calls: Calls are made and amount due is received.

 Application Money Received

1. Auditor should examine the resolution of board of directors and
that of members approving the terms of issue of shares.

2. The auditor should examine original applicators for shares and

check the entries in the application and allotment book with the help
of these applications.
3. The auditor should check the entries in the application register
and cross check with cash book and pass book for application
money received.
 37

4. He should also verify letter of regret issued to unsuccessful

applicant along with refund of application money and cross verify
cash book for the same.

5. He should verify the amount of over subscription and pro-rate

allotment, as to what is done with excess application money
received.

6. He should see that application money is not less than 5% of the

face value.

 Allotment of Shares
1. The auditor should ensure that above legal requirements laid
down by companies Act 1956 and other requirements of Articles of
Association have been complied with.

2. The auditor should examine the resolution of the board of

directors relating to allotment of shares.

3. He should see the copies of letter of allotment and letter of

regret.

4. Auditor should sample check the entries in application and

allotment book and verify the same with cash book for allotment
money received.

5. He should check if money received on allotment has been

transferred to share capital.

6. He should check the posting in the register of the amount

received on allotment with the allotment book.

7. The auditor should also check relevant journal entries for excess
amount received on application is properly adjusted on allotment.

 Calls on shares
1. Auditor should examine the resolution passed by the board as to
making the calls from the minutes book.

2. Auditor should check the entries in the call book from the copies
of the call letters, cash receipts and bank statement.

3. For calls in arrears, he should ensure that the amount is correctly

calculated with reference to any excess (if any) received during
allotment or application.
4. For calls in advance, the auditor should examine if the amount is
properly adjusted to calls. The articles should allow the company to
receive calls in advance.
 38

5. Auditor should also examine that interest on calls in advance is

calculated with reference Articles or table A.

6. Auditor should examine the calculation of interest or calls in

arrears.

7. Auditor should also examine the amount with Bank Statement.

2.6.5 AUDIT OF SHARES ISSUED FOR CONSIDERATION

OTHER THAN CASH

Company may issue shares for consideration other than

cash. Such shares may be issued by the company towards
payment of purchase consideration or towards payment of
purchase of fixed assets, to promoters towards preliminary
expenses incurred by them for bringing the company into legal
existence to underwrite as underwriters commission.

 Audit procedure to be adopted for the issue of shares for

consideration other than cash:

1. The auditor should examine the prospectors for details of shares

issued to promoters, its number and class and also for shares
issued to underwriters as underwriting commission.

2. The auditor should examine the contracts with vendors,

underwriters, promoters for the shares issued. The auditor should
ascertain weather the consideration against which the shares are
issued has been received in full. It helps to determine the terms and
the nature of issue.

3. The auditor should examine the resolution of the board of

directors relating to the allotment of shares.

4. The auditor should verify complain with section 75 (I) (b) of the
Companies Act.

5. The auditor should examine that proper journal entry is passed

for share issued for consideration other than cash. He should also
examine the posting and disclosure in Balance Sheet.

2.6.6 SHARES ISSUED AT PREMIUM

 MEANING
Section 78 of companies Act, 1956, deals with issue of
securities at a premium. Any amount, over and above the nominal
value of shares received in cash or otherwise shall be credited to a
separate account called as “Security Premium Account.”
 39

 Audit procedure to be followed for shares issued at

premium:
1. The auditor should examine the prospectus for the rate of
premium at which shares are issued.

2. The auditor should examine the Articles of Association to see

whether they permit the issue of shares at a premium.

3. The auditor should examine the minutes of meetings of Board of

directors and also verify the rate of premium.

4. The auditor should examine the legal provisions regarding the

issue of shares at premium.

5. The auditor should examine that security premium is shown

repeatedly on liability side of the Balance Sheet under the head
“Reserve and Surplus.”

2.6.7 ISSUE OF SHARES AT DISCOUNT

 MEANING
When the shares are issued at a price less than the face value it is
said to be issued at discount.

 CONDITIONS
According to section 79, a company can issue shares at
discount only if the following conditions are fulfilled:

1. Issue of shares at discount should be authorized by resolution

passed by the company in a general meeting and sanctioned by
Company Law Board.

2. The resolution should specify the maximum rate of discount at

which the shares are to be issued. The rate of discount cannot
exceed 10% unless the Central Government is of the opinion that a
higher percentage of discount should be allowed in special
circumstances.

3. At least one year must have elapsed since the date on which
company was entitled to commerce business and the issue of
shares at discount.
4. Share should be of the class of shares which are issued earlier
and that issue was not at discount.

 Audit procedure for Issue of Shares at Discount

1. The auditor should examine the prospectors for issue of shares

at a discount. The prospectus must contain the particulars of
discount on issue of shares.
 40

2. The auditor should examine that all legal provisions of section 79

are fulfilled.

3. The auditor should examine that the resolution is passed at

general meeting of the shareholders and the sanction is received
from the Company Law Board.

4. The auditor should examine the Articles of Association to find out

whether the company is authorized to issue shares at a discount.

5. The auditor should examine that discount allowed is correctly

debited to “Discount on Issue” A/C. It should not be debited to Profit
& Loss A/C.

2.6.8 CALLS RECEIVED IN ADVANCE

 MEANING
A company, if authorized by its Articles of Association,
accepts from its members the whole or a part of the amount
remaining unpaid on any shares held by him, although call on such
amount is not made. However such an amount so received can not
be treated as part of the capital for the purpose of any voting rights.

Also according to section 93, the company may, if so

authorized by its Articles, pay dividend on calls in advance.

 Audit procedure regarding calls in advance

1. The auditor should examine the Articles of Association to see if it
authorizes the acceptance of calls in advance. He should also see
whether interest is payable on calls received in advance.

2.The auditor should also examine the prospectus for any

information on calls in advance.

3.The auditor should examine the cash book for the amount
received on calls in advance.

4. The auditor should obtain a list of all the members from whom
calls in advance are received.

5. The auditor should verify that calls in advance are correctly

credited to calls in advance and are not credited to share capital
A/c.

2.6.9 CALLS IN ARREARS

 MEANING
An unpaid amount on calls is known as “Calls in Arrears.”
 41

 Audit Procedure for calls in arrears:

1. The auditor should examine the Articles Association for any
interest chargeable on such arrears. If the Articles are silent or
interest on calls on arrears then provisions in Table ’A’ are
applicable. According to Table ‘A’ interest on calls in arrears should
not exceed 5%.

2. The auditor should verify the amount of calls in arrear from

statements and Cash Book for receipt of allotment and call money.

3. The auditor should obtain a list of member director from whom

calls are in arrears.
4. The auditor should verify the journal entries of allotment and calls
during which calls are in arrears. The amount should be crossed
verified with cash book.

5. The auditor should examine that calls in arrears are properly

shown on the liability side of Balance Sheet under the head, ‘share
capital’. It should be deducted from the called up capital.

2.7 ISSUE OF BONUS SHARES

2.7.1 MEANING
The Articles of Association may authorize the company to
capitalize profits or reserves and issue fully paid shares of a
nominal value, equal to amount capitalized to the shareholders.
Such an issue is called as “Bonus Issue” and shares are known as
“Bonus Shares”.

i) Section 205 (3) states that profits or reserves of a company may

be used in issuing fully paid bonus shares or paying up any amount
for the time being unpaid on any shares held by the members of the
company.

ii) If the Articles does not provide for bonus issue then the Articles
needs to be altered for the said issue.

2.7.2 Audit Procedure

1. The auditor should examine that all the legal provisions relating
to bonus issue are complied with

2. The auditor should examine the resolution passed by the

directors in their board meeting. He should also examine the
resolution passed by the shareholders at the general meeting
approving the resolution passed by the directors.

3. The auditor should see that SEBI Guidelines relating to issue of

bonus shares have been complied with.
 42

4. The auditor should examine the register of members for bonus

issue.

5. The auditor should examine the journal entries relating to bonus

issue. Bonus issue should be added to share capital and should be
covered in authorized share capital.

6. The auditor should examine the source from which bonus shares
have been issued.

7. the audit should see that approval of the company law board of
SEBI and the RBI have been obtained.

2.8 AUDIT OF FORFEITURE OF SHARES

2.8.1 MEANING
Sometimes shareholders fails to pay allotment money or any
call thereafter on the day’s fixed for payments. The directors may
serve a notice to the defaulting member to pay the unpaid amount
along with interest accrued. If even after such a notice, the
shareholder fails to pay within the specified time, the directors may
decide to forfeit the shares.

Articles of Association should authorize the board of

directors to forfeit the shares.

2.8.2 Audit procedure for forfeiture of shares:

1. The auditor should examine the provision of Articles relating to

forfeiture of shares. If Articles are silent then regulation 29 to 35 of
Table A are applicable for forfeiture of shares.

2. The auditor should see that proper notice had been given to the
shareholders to pay the calls in arrears.

3. The auditors should examine the minutes of board meeting to

verify that proper resolution for forfeiture of the shares is duly
passed.

4. The auditor should verify the journal entry passed to check of

share capital is correctly debited with called up amount and share
forfeiture is added with paid up capital.

5. The shareholder should examine the Register of Members to

check that their names are deleted from register and they are no
longer in the list of members of the company.
 43

6. The auditor should examine the share forfeiture account. If the

shares cannot re-issued, it should be disclosed in Balance Sheet
on liability side under the head, ‘Share Capital’.

7. The shares forfeited can be re-issued by board. The discount on

re-issue should not exceed the paid up value of shared forfeited.
The auditor should carefully audit these.

2.9 REDEMPTION OF PREFERENCES SHARES

2.9.1 MEANING
Preference shares, as defined earlier, are those shares who have a
preference in payment of dividend and repayment of capital on
liquidation of the company.

According to the Companies Act, 1956, a company cannot

issue irredeemable preference shares or recallable after the expiry
of a period of 20 yrs from the date of its issue.
Sec 80 and section 80A prescribe the conditions for the
redemption of preference shares.

2.9.2 Redemption of preference shares shall be subject to

following conditions:

1. Only fully paid up preference shares can be redeemed.

2. Shares can be redeemed either out of the proceeds of a fresh

issue of shares made for the purpose of redemption or out of the
profits that would otherwise be available for payment of dividends.

3. In case of redemption out of profit that would otherwise be

available for dividend, an amount equivalent to the nominal value of
preference shares redeemed must be transferred to “Capital
Redemption Reserve (CRR).” CRR can be utilized for issuing fully
paid bonus shares”.

4. Premium, if any, on the redemption of preference shares can be

provided either out of the securities premium account or out of the
profit that can otherwise be available for distribution of dividend.
Capital profit realized in cash can also be utilized for this purpose.

2.9.3 Audit procedure

1. The auditor should ensure that legal provisions of sections 80
and section 80A have been complied with.

2. The auditor should examine that the issue and redemption of

preference shares is authorized by the Articles of Association.
 44

3. The auditor should verify that the money received on issue of

preference shares and redemption of preference shares with that of
cash book.

4. The auditor should examine the journal entries and see that
Capital Redemption Reserve is correctly created with the amount of
profit which would otherwise be available for dividend in case
redemption is done out of such profits.

5. The auditor should examine the minutes of meeting to check that

proper resolution is passed by the Board of Directors.

2.10 AUDIT OF SHARE TRANSFER

Shares are transferred from one person to another and such

transfer is to be notified through the company.

2.10.1 Audit Procedure

1. The auditor should examine the A/A and find out the procedure
for transfer of shares.
2. The transfer form should be scrutinized in respect of the
following:

i) It should be complete, properly signed, dated in the

prescribed format, properly stamped, and presented to the
company in time.

ii) The details of the transfer form should be checked with

the entries in the share Register.

2.10.2 Before approval of Transfer

1. The transfer fees must be deposited in a scheduled bank. The
auditor should check that.

2. The auditor should ensure that notice is sent to the transferor

and no objection is received from them.
3. In case of transfer of partly paid up shares notice should be sent
to the transferee and there is no objection received within two
weeks from the date of service of notice.

2.10.3 Approval of transfer

1. The auditor should examine the minute book of director’s
meeting and see that the transfer has been sanctioned.

2. If the transfer is to a limited company, the auditor should

examine the A/A and see that the company is allowed to invest in
the shares.
 45

3. The auditor should check that the transferee has not incurred
any disqualification to become a member.

4. In case the share certificate is not available the letter of

indemnity should be examined.

2.11 BUY-BACK OF SHARES

2.11.1 Procedure
Buy-back means purchase by a company of its own
securities. Auditor should keep in mind the following points while
examining this item:

a) S. 77A – The buy-back should be in accordance with S. 77A of

the Companies Act, 1956 (as amended by the Companies
Amendment Act, 2000).

b) Securities – A company may buy-back its own shares or other

specified securities, which includes employee stock options or any
other security notified by the Central Government from time to time.

c) Sources of Funds – A company can purchase its securities only

from out of its free reserves or its securities premium account
(including share premium account) or the proceeds of an earlier
issue of shares other than fresh issue made specifically for buy-
back purpose.

d) Authorized by A/A – The buy-back should be authorized by the

Articles of Association.

e) Authorized by special resolution – The buy-back should be

authorized by passing a special resolution in a general meeting of
the shareholders of the company.

f) Limit on amount – The amount of buy-back should not exceed

25% of the total paid up capital and free reserves of the company.
g) Debt-equity ratio – The debt-equity ratio after the buy-back
should not exceed 2:1.

h) Fully paid-up shares – The shares of the company subject to

buy back must be fully paid-up.

i) Regulations of SEBI – The buy-back must be in accordance

with the regulations made in this regard by the Securities Exchange
Board of India (SEBI).

j) Explanatory Statement – The explanatory statement sent along

with the notice of the meeting at which the special resolution
 46

allowing buy-back is proposed to be passed should contain the

following details: (i) A full and complete disclosure of all material
facts; (ii) The necessity for buy-back; (iii) the class of security
intended to be purchased; (iv) the amount to be invested under
buy-back; (v) The time-limit for completion of the process of buy-
back;

k) Time limit for completion – Buy-back should be completed

within twelve months from the date of passing the special
resolution.

l) Method – Buy-back can be done by any of the following

methods: (i) From the existing security-holders on a proportionate
basis; (ii) From the open market; (iii) From odd lots (i.e., lots
smaller than the market lots); (iv) From the securities issued under
schemes for employees stock option or sweat equity.

m) Declaration of solvency – Before making any purchase, the

board of directors should file a declaration of solvency in the
prescribed form with the Registrar of Companies (ROC) and the
Securities Exchange Board of India (SEBI). The declaration shall
affirm that the board of director has made a full inquiry into the
affairs of the company and that the company is fully capable of
meeting its liability and will not become insolvent within one year.
The declaration shall be signed by two directors, one of whom must
be the managing director, if any. The declaration need not be filed
with SEBI in the case of a company whose shares not listed on any
recognized stock exchange.

n) Return – After buy-back the company should file a Return in the

prescribed form with the ROC and the SEBI, within 30 days of the
completion of the buy-back.

o) Register of buy-back – The Company should keep a register of

securities bought, the price paid, the data of cancellation of such
securities and other prescribed details.

p) Destroy Securities after buy-back – After the buy-back, the

company should extinguish and physically destroy the securities so
bought back, within 7 days of the completion of the buy-back.

q) NO further issue after buy-back – A company shall not make a

further issue of securities within 24 months from the buy-back,
except by way of bonus shares or in order to comply with the terms
of issue of existing securities by way of conversion of share
warrants, stock option schemes, sweat equity or conversion of
preference shares/debentures into equity.
 47

r) Buy-back prohibited – Buy-back is prohibited under the

following circumstances: (i) Through any subsidiary companies
including the company’s subsidiaries; (ii) Through any investment
company or group of investment companies; (iii) A subsisting
default in repayment or redemption of deposit, debentures,
preference shares or term loan to any financial institution or bank.

2.11.2 Auditor’s Duties

a) Legal procedures – Auditor should check compliance with the

above legal procedures under Section 77A and 77B of the
Companies Act, 1956; in case of private limited and unlisted
companies, the Private Limited Company and Unlisted Public
Limited Company (buy-back of securities) Regulations, 1998.

b) Authorization of amount used for buy-back – The auditor

should verify particularly that the funds employed for the buy-back
are from the resources as permitted by the law.

c) Reconciliation of amount paid for buy-back – 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.

d) Reconciliation of number for shares bought back – The

auditor should also verify the entries made in the concerned
books/registers with regard to destruction of share certificates and
extinguishments of dematerialized shares and a reconciliation of
these two to arrive at the total number of securities purchased
under buy-back process.

2.12 ALTERATION OF SHARE CAPITAL

2.12.1 MEANING
Section 4 of the Companies Act, 1956, deals with the power
of a limited company to alter its share capital. If authorized by its
Articles, a Limited Company can alter its share capital. It means it
can increase, consolidate, or divide or split its shares, convert
shares into stock and vice versa. It can also cancel the unissued
shares.

2.12.2 Auditor’s Duties

The Auditor should
i) Verify the Articles to confirm whether the company is
authorized to alter the share capital.

ii) See that the provision of the Articles and Sections 94 and 95
are compiled with.
 48

iii) Verify the minutes of the meeting of directors and the minutes
of the shareholders authorizing the alteration.
iv) Verify the entries in the books of accounts, the register of
members and other register.
v) See that notice is given to Registrar of Companies and that
the Registrar has altered the Memorandum or the Articles of
both.
vi) Compare the cancelled share certificates with the counterfoils
of the new certificates issued.

2.13 SWEAT EQUITY SHARES

2.13.1 MEANING
Sweat equity means equity shares issued by the company to its
employees or directors at a discount or for consideration other than
cash. Such shares may be issued for providing know-how or for
making available property rights or value additions.

2.13.2 CONDITIONS
Section 79A of the Companies Amendment Act 1999 lays down the
following conditions for sweat equity.
i) Such shares must be of the class already issued.
ii) Such issue must be authorized by a special resolution passed
by the company in the general meeting.
iii) The special resolution must specify the number of shares, the
market price, consideration (if any) class of share, and the director
or employee name to whom such issue is made.
iv) If such an issue is done by the company whose shares are
listed on the stock exchange then such issue should be in
accordance with the regulations made by the Security Exchange
Board of India.

2.14 AUDIT OF DEBENTURES

2.14.1 Meaning
Debenture is written acknowledgement under the seal of a
company, of a debt due. It also contains the provisions as to
payment of interest and repayment of capital. The debentures may
be of following types:
a) Simple or naked
b) Fixed or floating charge
c) First mortgage or second mortgage
d) Convertible or Non-convertible
 49

2.14.2 Audit Procedure for issue of Debentures

The auditor should take following steps for the audit of
allotment of debentures.

i) The auditor should examine Articles of Association to verify

that the company has power to borrow funds through issue of
debentures.

ii) The auditor should examine that relevant resolutions are

passed by the directors and the shareholders and guidelines of
SEBI are followed.

iii) The auditor should see whether prospectus or a statement in

lieu of prospectus has been filed with the Registrar of Companies.

iv) The auditor should verify that an application is made to one

or more recognized stock exchanges before the offer of debentures
to the public for subscription by the issue of a prospectus.

v) The auditor should examine the powers of directors whether

there is any restriction under Section 293.

vi) Section 117A has now made it compulsory for filing of

debenture trust deed. The trust deed shall be open for inspection
and can be made available on payment.

vii) Section 117B bad made it compulsory for creation of

Debenture Redemption Reserve. Such an amount cannot be
utilized for any other purpose except for redemption of debentures.

viii) If the debentures are secured by charge on any assets, then

the auditor should verify that the charge is registered with the
Registrar and such a charge is also recorded in the separate
register to maintaing the details of such charges.

ix) The auditor should examine the entries in the counterfoils of

debentures issued with the debenture register.

x) The auditor should also examine the journal entries for

application and allotment and also verify that if it is posted correctly
and verify the same with debenture register.

2.14.3 DEBENTURES ISSUED AT DISCOUNT

 MEANING
When debentures are issued at a price less than it’s nominal value,
debentures are said to be issued at discount. Section 76(2) lays
down the provisions for issue of debentures at a discount.
 50

 Audit Procedure
i) The auditor should examine the Articles of Association to
verify that it authorizes the issue of debentures at discount.

ii) The auditor should examine the minutes of board meeting to

verify the resolution passed by the board for issue at discount.

iii) The auditor should examine that the interest is payable on

nominal value even if shares are issued at discount.

iv) The auditor should examine the journal entries to see if the
discount is debited to “Discount on Issue” A/c and not to Profit &
Loss A/c.

v) The discount should be written off proportionately to the

amount utilized. The writing off should not be for years more than
the tenure of debentures.

2.14.4 DEBENTURES ISSUED AT PREMIUM

 MEANING
When debentures are issued at the price in excess of its nominal
value then the debentures are said to be issued at premium. The
company can issue debentures at a premium.

 Audit Procedure
i) The auditor should examine the Articles to verify whether
debentures can be issued at premium.

ii) The auditor should examine the minutes of Board Meeting to

verify that the resolution to issue debentures is passed.

iii) Interest should be payable on nominal value of debenture

and not at issue price.

iv) The auditor should examine the journal entry to verify that
premium on issue has been credited to securities premium account
and not credited to Profit & Loss Account.

v) The auditor should examine that security premium has been

disclosed under the head “Reserves and Surplus” on the liability
side of the Balance Sheet.

vi) The premium so collected can be utilized for writing off

debenture issue expenses, for redemption of debentures of for
writing off preliminary expenses.
 51

2.14.5 REDEMPTION OF DEBENTURES

The debentures can be redeemed at par or at premium.

The premium payable on redemption can be provided in either of

the following ways:

i) The premium payable on redemption may be debited to “loss

on Issue A/c” on the date of issue itself. Such a loss should be
disclosed in Balance Sheet on asset side. It should be carried
forward and should be written off in proportion to the amount
utilized every year. It should be written off over the tenure of the
debenture.

ii) The second option is to write off the premium on redemption

to profit and loss account in the year the debentures are redeemed.

 Audit Procedure
i) The auditor should examine the Articles for the provisions for
redemption of debentures.

ii) The auditor should examine the minute book for the
resolution passed in Board Meeting authorizing redemption of
debentures.

iii) The auditor should verify the journal entries and also see
that they are properly posted.

2.14.6 INTEREST ON DEBENTURES

Debentures are instruments of debt. A fixed rate of interest is
payable on such instrument. Interest payment is a charge against
income.

i) Payment of interest is revenue expenditure. It should be

paid even if there is no profit.

ii) The auditor should examine the journal entry and verify that
interest is transferred to Profit & Loss A/c.

iii) The auditor should examine Bank statement for the payment
made to debenture holders towards interest.

iv) Interest paid on debentures should be disclosed as a

separate item in Profit & Loss Statement.

iv) The auditor should examine the Articles for the provisions for
redemption of debentures.
 52

2.14.7 ISSUE OF DEBENTURES AS COLLATERAL SECURITY

 MEANING
The debentures can be issued as a collateral security for any loan
obtained from financial institutions, or banks or creditors or other
parties.

Collateral security means security given which can be

realized by the party to whom such security is issued or is holding,
in the event if the original loan is not repaid on specified time
according to the agreement between the parties.

The amount is issued as loan and not against debentures

issued as collateral security. The amount of debentures issued may
be more than or less than the amount of loan. When the loan is
repaid, the security is taken back and extinguished. The security
can be sold if the loan is not paid on time.

 Audit Procedure
i) The auditor should examine the loan agreement and verify
the amount of collateral security to be issued.

ii) The auditor should examine that the loan amount has been
received by the company and is properly accounted for.

iii) The auditor should examine that issue of debentures as

collateral security is entered in register of mortgages.

iv) The auditor should see that the Registrar of Companies is

intimated for registration of charge. When the loan is repaid the
satisfaction of the charge should be informed to the Registrar of
Companies.





 53

3
THE COMPANY AUDIT II

Unit Structure
3.0 Objectives
3.1 Introduction to Revised Schedule VI
3.2 Key Features of Revised Schedule VI – Balance Sheet
3.3 Key Features of Revised Schedule VI – Statement of Profit &
Loss
3.4 Comparative Analysis Between Old Schedule VI And
Revised Schedule VI
3.5 Format of Revised Schedule VI
3.6 Questions on the Company Audit Part I and Part II

3.0 OBJECTIVES

After studying the unit the students will be able:

 To explain the revised schedule VI
 Distinguish between old schedule VI and revised schedule VI

3.1 INTRODUCTION TO REVISED SCHEDULE VI

Every company registered under the Act shall prepare its

Balance Sheet, Statement of Profit and Loss and notes thereto in
accordance with the manner prescribed in Schedule VI to the
Companies Act, 1956. To harmonize the disclosure requirements
with the Accounting Standards and to converge with the new
reforms, the Ministry of Corporate Affairs vide Notification No. S.O.
447(E), dated 28th February, 2011 replaced the existing Schedule
VI of the Companies Act, 1956 with the revised one.

Governments vide Notification No. F.N. 2/6/2008 – C.L.V

dated 30th March, 2011 made the revised Schedule VI applicable
to all companies for the financial year commencing from 01st April
2011. The requirements of the Revised Schedule VI however, do
not apply to companies as referred to in the provision to Section
211(1) and Section 211(2) of the Act, i.e. any insurance or banking
company,, or any company engaged in the generation or supply of
electricity or to any other class of company for which a form of
 54

Balance Sheet and Profit & Loss account has been specified in or
under any other Act governing such class of company.

3.2 KEY FEATURES OF REVISED SCHEDULE VI –

BALANCE SHEET

• The revised schedule contains General Instructions. Part I –

Form of Balance Sheet; General Instruction for Preparation of
Balance Sheet, Part II – Form of Statement of Profit & Loss;
General Instructions for Preparation of Statement of Profit & Loss.

• The Revised Schedule VI has eliminated the concept of

‘schedule’ and such information is now to be furnished in the notes
to accounts.

• The Revised Schedule gives prominence to Accounting

Standards (AS) i.e. in case of any conflict between the AS and the
Schedule, AS shall prevail.

• The revised schedule prescribes a vertical format for

presentation of balance sheet therefore, no option to prepare the
financial statement in horizontal format. It ensures application of
uniform format.

• All assets and liabilities classified into current and non-

current and presented separately on the face of the Balance Sheet.

• Number of shares held by each shareholder holding more

than 5% shares now needs to be disclosed.

• Details pertaining to aggregate number and class of shares

allotted for consideration other than cash, bonus shares.

• Any debit balance in the Statement of Profit and Loss will be

disclosed under the head “Reserves and Surplus.” Earlier, any
debit balance in Profit & Loss Account carried forward after
deduction from uncommitted reserves was required to be shown as
the last item on the asset side of the Balance Sheet.

• Specific disclosures are prescribed for Share Application

money. The application money not exceeding the capital offered for
issuance and to the extent not refundable will be shown separately
on the face of the Balance Sheet. The amount in excess of
subscription or if the requirements of minimum subscription are not
met will be shown under “Other current liabilities”.
 55

• The term “sundry debtors” has been replaced with the term
“trade receivables.” ‘Trade receivables’ are defined as dues arising
only from goods sold or services rendered in the normal course of
business. Hence, amounts due on account of other contractual
obligation can no longer be included in the trade receivables.

• The Old Schedule VI required separate presentation of

debtors outstanding for a period exceeding six months based on
date on which the bill/invoice was raised whereas, the Revised
Schedule VI requires separate disclosure of “trade receivables
outstanding for a period exceeding six months from the date the
bill/invoice is due for payment.”

• “Capital advances” are specifically required to be presented

separately under the head “Loans & Advances” rather than
including elsewhere.

• Tangible assets under lease are required to be separately

specified under each class of asset. In the absence of any further
clarification, the term “under lease” should be taken to mean assets
given on operating lease in the case of lesser and assets held
under finance lease in the case of lessee.

• In the Old Schedule VI, details of only capital commitments

were required to be disclosed. Under the Revised Schedule VI,
other commitments also need to be disclosed.

3.3 KEY FEATURES OF REVISED SCHEDULE VI –

STATEMENT OF PROFIT & LOSS

• The name has been changed to “Statement of Profit & loss”

against ‘Profit & Loss account’ as contained in the Old Schedule VI.

• Unlike the Old Schedule VI< the Revised Schedule VI lays

down a format for the presentation of Statement of Profit and Loss.
This format of Statement of Profit and Loss does not mention any
appropriation item on its face. Further, the Revised Schedule VI
format prescribes such ‘below the line’ adjustment to be presented
under “Reserves and Surplus” in the Balance Sheet.

• As per revised schedule VI, any item of income or expense

which exceeds one per cent of the revenue from operations or Rs.
1,00,000 (earlier 1% of total revenue or Rs.5,000), whichever is
higher, needs to be disclosed separately.
• In respect of companies other than finance companies,
revenue from operations need to be disclosed separately as
revenue from (a) sale of products, (b) sale of services and (c) other
operating revenues.
 56

• Net exchange gain/loss on foreign currency borrowings to

the extent considered as an adjustment to interest cost needs to be
disclosed separately as finance cost.

• Break-up in terms of quantitative disclosures for significant

items of statement of profit & loss, such as raw material
consumption, stocks, purchases and sales have been to be
decided based on materiality and presentation of true and fair view
of the financial statements.

3.4 COMPARITIVE ANALYSIS BETWEEN OLD

SCHEDULE VI AND REVISED SCHEDULE VI

PARTICULARS OLD SCHEDULE VI REVISED SCHEDULE VI

Parts Part I (Balance Sheet), Only two parts – Part I
Part II (Profit and Loss (Balance Sheet) and Part II
Account), Part III (Statement of Profit and
(Interpretation) and Part Loss)
IV (Balance Sheet Part III (Interpretation) and
abstract of company’s Part IV (Balance sheet
general business profile) Abstract of Company’s
general business profile)
omitted.
Format of Horizontal and Vertical Only vertical format is
Balance Sheet formats are prescribed. prescribed.
Rounding off (a) Turning of less than (a) Turnover of less than
(R/Off) of Figures Rs. 100 Crs – R/off to Rs. 100 Crs – R/off to the
appearing in the nearest Hundreds, nearest Hundreds,
financial thousands or decimal thousands, lakhs or millions
statement thereof or decimal thereof
(b) Turnover of Rs. 100
Crs or more but less (b) Turnover of Rs. 100 Crs
than Rs. 500 Crs – R/off or more – R/off to the
to the nearest Hundreds, nearest lakhs, millions or
thousands, lakhs or crores,or decimal thereof.
millions or decimal
thereof
(c) Turnover of Rs. 500
Crs or more – R/off to
the nearest Hundreds,
thousands, lakhs,
millions or crores, or
decimal thereof
 57

Net Working Current assets & Assets & Liabilities are to be

Capital liabilities are shown bifurcated into current &
together under non-current and to be
application of funds. The shown separately. Hence,
net working capital net working capital will not
appears on balance be appearing on Balance
sheet Sheet
Fixed Assets There was no bifurcation Fixed assets to be shown
required into tangible & under non-current assets
intangible assets. and it has to be bifurcated in
to Tangible & Intangible
assets.
Borrowings Short term & long term Long term borrowing to be
borrowings are grouped shown under non-current
together under the head liabilities and short term
Loan funds sub-head borrowings to be shown
Secured/Unsecured under current liabilities with
separate disclosure of
secured/ unsecured loans.
Finance lease Finance lease Finance lease obligations
obligation obligations are included are to be grouped under the
in current liabilities head non-current liabilities
Deposits Lease deposits are part Lease deposits to be
of loans & advances disclosed as long term
loans & advances under the
head non-current assets
Investments Both current & non- Current and non-current
current investments to investments are to be
be disclosed under the disclosed separately under
head investments current assets & non-
current assets respectively
Loans & Loans & Advance are Loans & Advances to be
Advances disclosed along with broken up in long term &
current assets short term and to be
disclosed under non-current
& current assets
respectively.
Deferred Tax Deferred Tax Deferred Tax assets/
Assets/ Liabilities assets/liabilities to be liabilities to be disclosed
disclosed separately under non-current assets/
liabilities as the case may
be.
 58

Cash & Bank Bank balance to be Bank balances in relation to

Balances bifurcated in scheduled earmarked balances, held
banks & others as margin money against
borrowings, deposits with
more than 12 months
maturity, each of these to
be shown separately.
Profit & loss (Dr. P & L debit balance to Debit balance of Profit &
Balance) be shown under the Loss Account to be shown
head Miscellaneous as negative figure under the
expenditure & losses head Surplus. Therefore,
reserve & surplus balance
can be negative.
Sundry Creditors Creditors to be broken It is named as Trade
up in to micro & small payables and there is no
suppliers and other mention of micro & small
creditors enterprise disclosure.
Other current No specific mention for Current liabilities of long
liabilities separate disclosure of term debt to be disclosed
Current maturities of under other current
finance lease obligation liabilities. Current maturities
of finance leas obligation to
be disclosed.
Separate line Any item under which Any item of income/expense
item Disclosure expense exceeds one which exceeds one per cent
criteria per cent of the total of the revenue from
revenue of the company operations or Rs. 1,00,000,
or Rs. 5,000 whichever whichever is higher; to be
is higher; shall be disclosed separately
disclosed separately
Expense Function wise & nature Expenses in Statement of
Classification wise profit and loss to be
classified based on nature
of expenses
Finance cost Finance cost to be Finance cost shall be
classified in fixed loans classified as interest
& other loans expense, other borrowing
costs & Gain/loss on foreign
currency transaction &
translation
 59

3.5 FORMAT OF REVISED SCHEDULE VI

The ministry of Corporate Affairs specified the format of

Schedule VI as follows:

A. General Instructions
B. Part I – Form of Balance Sheet
C. General Instruction for Preparation of Balance Sheet
D. Part II – Form of Statement of Profit and Loss
E. General Instructions for Preparation of Statement of Profit
and Loss

A. General Instructions

1. Where compliance with the requirements of the Act,

including the Accounting Standards as applicable to companies,
requires any change in treatment or disclosure including addition,
amendment, substitution or deletion in the head/sub-head or any
changes inter se, in the financial statements or statements forming
part thereof, the same shall be made and the requirements of the
Schedule VI shall stand modified accordingly.

2. The disclosure requirements specified in Parts I and II of this

Schedule are in addition to and not in substitution of the disclosure
requirements specified in the Accounting Standards prescribed
under the Companies Act, 1956. Additional disclosures specified in
the Accounting Standards shall be made in the notes to accounts or
by way of additional statement unless required to be disclosed on
the face of the Financial Statements. Similarly, all other disclosures
as required by the Companies Act, 1956 shall be made in the notes
to accounts in addition to the requirements set out in this Schedule.

3. Notes to accounts shall contain information in addition to that

presented in the Financial Statements and shall provide where
required:
a) Narrative descriptions or disaggregation of items
recognized in those statements and
b) Information about items that do not qualify for recognition
in those statements.

Each item on the face of the Balance Sheet and the

Statement of Profit and Loss shall be cross-referenced to any
related information in the notes to accounts. In preparing the
Financial Statements including the notes to accounts, a balance
shall be maintained between providing excessive detail that may
not assist users of financial statements and not providing important
information as a result of too much aggregation.
 60

4. Depending upon the turnover of the company, the figures

appearing in the Financial Statements may be rounded off as
below:

Turnover Rounding Off

(i) less than one hundred crore rupees To the nearest hundreds,
thousands, lakhs or millions, or decimals thereof.
(ii) one hundred crore rupees or more To the nearest lakhs,
millions or crores, or decimals thereof.
Once a unit of measurement is used, it should be used uniformly in
the Financial Statements

5. Except in the case of the first Financial Statements laid

before the Company (after its incorporation), the corresponding
amounts (comparatives) for the immediately preceding reporting
period for all items shown in the financial Statements including
notes shall also be given.

6. For the purpose of this Schedule, the terms used herein

shall be as per the applicable Accounting Standards.

This part of Schedule sets out the minimum requirement for

disclosure on the face of the Balance Sheet and the Statement of
Profit and Loss (hereinafter referred to as “Financial Statements”
for the purpose of this Schedule and Notes. Line items, sub-line
items and sub-totals shall be presented as an addition or
substitution on the face of the Financial Statements when such
presentation is relevant to an understanding of the Company’s
financial position or performance or to cater to industry/sector
specific disclosure requirements or when required for compliance
with the amendments to the Companies Act, 1956 or under the
Accounting Standards.

B. Part I: Form of Balance Sheet

Name of the Company

Balance Sheet as at 31 March, 20X2
Particulars Note No. As at 31 March, 20X2 As at 31
March, 20X1
Rs. Rs.

A EQUITY AND LIABILITIES

1 Shareholder’s funds
(a) Share Capital
(b) Reserves and surplus
(c) Money received against share Warrants
2 Share application money pending allotment
 61

3 Non-current liabilities
(a) Long-term borrowings
(b) Deferred tax liabilities (net)
(c) Other long-term liabilities
(d) Long-term provisions
4 Current Liabilities
(a) Short-term borrowings
(b) Trade payables
(c) Other current liabilities
(d) Short-term provisions
TOTAL

B ASSETS
1 Non-Current assets
(a) Fixed Assets
(i) Tangible assets
(ii) Intangible assets
(iii) Capital work-in-progress
(iv) Intangible assets under development
(v) Fixed assets held for sale
(b) Non-current investments
(c) Deferred tax assets (net)
(d) Long-term loans and advances
(e) Other non-current assets
2 Current assets
(a) Current investments
(b) Inventories
(c) Trade receivables
(d) Cash and cash equivalents
(e) Short-term loans and advances
(f) Other current assets
TOTAL

C. General Instructions for Preparation of Balance Sheet

1. An asset shall be classified as current when it satisfies any

of the followings criteria:
(a) it is expected to be realized in or is intended for sale or
consumption in the company’s normal operating cycle;
(b) it is held primarily for the purpose of being traded;
(c) it is expected to be realized within twelve months after the
reporting date; or
(d) it is cash or cash equivalent unless it is restricted from being
exchanged or used to settle a liability for at least twelve months
after the reporting date:
 62

All other assets shall be classified as non-current.

2. An operating cycle is the time between the acquisition of

assets for processing and their realization in cash or cash
equivalents. Where the normal operating cycle cannot be identified,
it is assumed to have duration of 12 months.

3. A liability shall be classified as current when it satisfies any

of the following criteria:
(a) It is expected to be settled in the company’s normal
operating cycle;
(b) It is held primarily for the purpose of being traded;
(c) It is due to be settled within twelve months after the reporting
date; or
(d) The company does not have an unconditional right to defer
settlement of the liability for at least twelve months after the
reporting date. Terms of a liability that could, at the option of the
counterparty, result in its settlement by the issue of equity
instruments do not affect its classification.

All other liabilities shall be classified as non-current.

4. A receivables shall be classified as a ‘trade receivable’ if it is

in respect of the amount due on account of goods sold or services
rendered in the normal course of business.

5. A payable shall be classified as ‘trade payable’ if it is in

respect of the amount due on account of goods purchased or
services received in the normal course of business.

6. A company shall disclose the following in notes to accounts:

6A. Share Capital

Clauses (a) to (i) of notes 6A deal with disclosures for Share
Capital and such disclosures are required for each class of share
capital (different classes of preference share to be treated
separately).

a. The number and amount of shares authorized.

b. The number of shares issued, subscribed and fully paid, and

subscribed but not fully paid
c. Par value per share

d. A reconciliation of the number of shares outstanding at the

beginning and at the end of the reporting period
 63

e. The rights, preferences and restriction attaching to each class of

shares including restriction on the distribution of dividends and the
repayment of capital.

f. Shares in respect of each class in the company held by its

holding capacity or its ultimate holding company or the ultimate
holding company in aggregate

g. Shares in the company held by each.

h. Shareholders holding more than 5 per cent shares specifying

the number of shares held

i. Shares reserved for issue under options and contracts/

commitments for the sale of shares/disinvestments, including the
terms and amounts.

j. For the period of five years immediately preceding the date as at

which the balance sheet is prepared:

i. Aggregate number and class of shares allotted as fully

paid up pursuant to contract(s) without payment being
received in cash.
ii. Aggregate number and class of shares allotted as fully
paid up by way of bonus shares.
iii. Aggregate number and class of shares bought back.

k. Terms of any securities convertible into equity/preference shares

issued along with the earliest date of conversion in descending
order starting from the farthest such date

l. Calls unpaid (showing aggregate value of calls unpaid by

directors and officers)

6B. Reserves and Surplus

(i) Reserve and surplus shall classified as follows
a) Capital Reserves
b) Capital Redemption Reserve
c) Securities Premium Reserve
d) Debenture Redemption Reserve
e) Revaluation Reserve
f) Share Options Outstanding Account
g) Other Reserves (Specify the nature and purpose of
reserve and the amount in respect thereof)
h) Surplus i.e. balance in Statement of Profit & Loss
disclosing allocations and appropriations such as dividend,
bonus shares and transfer to/from reserves, etc
(Additions and deductions since the last Balance Sheet to be
shown under each of the specified head)
 64

(ii) A reserve specifically represented by earmarked investments

shall be termed as a ‘fund’.

(iii) Debit balance of statement of profit and loss shall be shown as

a negative figure under the head ‘Surplus’. Similarly, the balance of
‘Reserves and Surplus’, after adjusting negative balance of surplus,
if any, shall be shown under the head ‘Reserves and Surplus; even
if the resulting figure is in the negative.

6C. Non-Current Liabilities

a. Long-term borrowings:
• Long-term borrowings shall be classified as:
(a) Bonds/debentures;
(b) Term Loans;
• From banks;
• From other parties

(c) Deferred payment liabilities;

(d) Deposits;
(e) Loans and advances from related parties;
(f) Long term maturities of finance lease obligations;
(g) Other loans and advances (specify nature).

• Borrowings shall further be sub-classified as secured and

unsecured. Nature of security shall be specified separately in each
case.

• Where loans have been guaranteed by directors or others,

the aggregate amount of such loans under each head shall be
disclosed. The word “others” used in the phrase “directors or
others” would mean any person or entity other than a director.

• Bonds/debentures (along with the rate of interest and

particulars of redemption or conversion, as the case may be) shall
be stated in descending order of maturity or conversion, starting
from farthest redemption or conversion date, as the case may be.
Where bonds/debentures are redeemable by installments, the date
of maturity for this purpose must be reckoned as the date on which
the first installment becomes due.

• Particulars of any redeemed bonds/debentures which the

company has power to reissue shall be disclosed.

• Period and amount of continuing default as on the Balance

Sheet data in repayment of loans and interest shall be specified
separately in each case.
 65

b. Other Long-term liabilities

This should be classified into:
a) Trade payables; and
b) Others.

c. Long-term Provisions
This should be classified into
a) Provision for employee benefits and
b) Others specifying the nature.

6D. Current Liabilities

a. Short-term borrowings;
(i) (a) Loans repayable on demand
• From banks;
• From other parties.
(b) Loans and advances from related parties;
(c) Deposits;
(d) Other loans and advances (specify nature)
(ii) Borrowings shall further be sub-classified as secured and
unsecured. Nature of security shall be specified separately in
each case.
(iii) Where loans have been guaranteed by directors or
others, the aggregate amount of such loans under each
head shall be disclosed.
(iv) Period and amount of default as on the Balance Sheet
date in repayment of loans and interest shall be specified
separately in each case.

b. Other current liabilities

The amounts shall be classified as:
(a) Current maturities of long-term debt;
(b) Current maturities of finance lease of obligations;
(c) Interest accrued but not due on borrowings;
(d) Interest accrued and due on borrowings;
(e) Income received in advance;
(f) Unpaid dividends;
(g) Application money received for allotment of securities
and due for refund and interest accrued thereon;
(h) Unpaid matured deposits and interest accrued
thereon;
(i) Unpaid matured debentures and interest accrued
thereon;
(j) Other payables (specify nature)

The portion of long term debts/lease obligation, which is due

for payments within twelve months of the reporting date is required
to be classified under “Other Current Liabilities” while the balance
amount should be classified under Long-term Borrowings. Other
 66

Payables would include amounts in the nature of statutory dues

such as Withholding taxes, Service Tax, VAT, Excise Duty, etc.

c. Short-term provisions
The amounts shall be classified as:
(a) Provision for employee benefits;
(b) Others (Specify nature).

6E. Non-Current Assets

a. Tangible assets
(i) Classification shall be given as:
(a) Land.
(b) Buildings.
(c) Plant and Equipment
(d) Furniture and Fixtures
(e) Vehicles.
(f) Office Equipment
(g) Others (Specify nature).
(ii) Assets under lease shall be separately specified under each
class of asset.

(iii) A reconciliation of the gross and net carrying amounts of each

class of assets at the beginning and end of the reporting period
showing additions, disposals, acquisitions through business
combinations and other adjustments and the related depreciation
and impairment losses/reversals shall be disclosed separately.

(iv) Where sums have been written off on a reduction of capital or

revaluation of assets or where sums have been added on
revaluation of assets, every balance sheet subsequent to date of
such write-off, or addition shall show the reduced or increased
figures as applicable and shall by way of a note also show the
amount of the reduction or increase as applicable together with the
date thereof for the first five years subsequent to the date of such
reduction or increase.

b. Intangible assets
(i) Classification shall be given as:
(a) Goodwill.
(b) Brands/trademarks.
(c) Computer software.
(d) Mastheads and publishing titles.
(e) Mining rights.
(f) Copyrights, and patents and other intellectual property
rights, services and operating rights.
(g) Recipes, formulae, models, designs and prototypes.
(h) Licenses and franchise.
(i) Others (specify nature).
 67

(ii) A reconciliation of the gross and net carrying amounts of each

class of assets at the beginning and end of the reporting period
showing additions, disposals, acquisitions through business
combinations and other adjustments and the related amortization
and impairment losses/reversals shall be disclosed separately.

(iii) Where sums have been written off on a reduction of capital or

revaluation of assets or where sums have been added on
revaluation of assets, every balance sheet subsequent to date of
such write-off, or addition shall show the reduced or increased
figures as applicable and shall by way of a note also show the
amount of the reduction or increase as applicable together with the
date thereof for the first five years subsequent to the date of such
reduction or increase.

c. Non-current investments
(i) Non-current investments shall be classified as trade investments
and other investments and further classified as:

(a) Investment property;

(b) Investments in Equity Instruments;
(c) Investments in preference shares
(d) Investments in Government or trust securities;
(e) Investments in debentures or bonds;
(f) Investments in Mutual Funds;
(g) Investments in partnership firms;
(h) Other non-current investments (specify nature)

Under each classification, details shall be given of names of

the bodies corporate (indicating separately whether such
bodies are (i) subsidiaries, (ii) associates, (iii) joint ventures,
or (iv) controlled special purpose entities) in whom
investments have been made and the nature and extent of
the investment so made in each such body corporate
(showing separately investments which are partly paid).

In regard to investments in the capital of partnership firms,

the names of the firms (with the names of all their partners,
total capital and the shares of each partner) shall be given.

(ii) Investments carried at other than at cost should be

separately stated specifying the basis for valuation thereof.

(iii) The following shall also be disclosed:

(a) Aggregate amount of quoted investments and market
value thereof;
(b) Aggregate amount of unquoted investments;
(c) Aggregate provision for diminution in value of
investments
 68

d. Long-term loans and advances

(i) Long-term loans and advances shall be classified as:
(a) Capital Advances;
(b) Security Deposits;
(c) Loans and advances to related parties (giving
details thereof);
(d) Other loans and advances (specify nature).

(ii) The above shall also be separately sub-classified as:

(a) Secured, considered good;
(b) Unsecured, considered good;
(c) Doubtful.

(iii) Allowance for bad and doubtful loans and advances shall
be disclosed under the relevant heads separately.

(iv) Loans and advances due by directors or other officers of the

company of any of them either severally or jointly with any
other persons or amounts due by firms or private companies
respectively in which any director is a partner or a
director or a member should be separately stated.

6F. Current Investment

a. Current Investments
(i) Current Investments shall be classified as:
(a) Investments in Equity Instruments;
(b) Investment in Preference Shares
(c) Investments in government or trust securities;
(d) Investments in debentures or bonds;
(e) Investments in Mutual Funds;
(f) Investments in partnership firms
(g) Other investments (specify nature).

Under each classification, details shall be given of names of

the bodies corporate (indicating separately whether such bodies
are (i) subsidiaries, (ii) associates, (iii) joint ventures, or (iv)
controlled special purpose entities) in whom investments have been
made and the nature and extent of the investment so made in each
such body corporate (showing separately investments which are
partly paid).

(ii) The following shall also be disclosed:

(a) The basis of valuation of individual investments
(b) Aggregate amount of quoted investments and
market value thereof;
(c) Aggregate amount of unquoted investments;
(d) Aggregate provision made for diminution in value
of investments.
 69

b. Inventories
(i) Inventories shall be classified as:
(a) Raw materials;
(b) Work-in-progress;
(c) Finished goods;
(d) Stock-in-trade (in respect of goods acquired for
trading);
(e) Stores and spares;
(f) Loose tools;
(g) Others (specify nature)
(ii) Goods-in-transit shall be disclosed under the relevant sub-head
of inventories. Mode of valuation shall be stated.

c. Trade Receivables
(i) Aggregate amount of Trade Receivables outstanding for period
exceeding six months from the date they are due for payment
should be separately stated.

(ii) Trade receivables shall be sub-classified as:

(a) Secured, considered good:
(b) Unsecured considered good;
(c) Doubtful.
(iii) Allowance for bad and doubtful debts shall be disclosed under
the relevant heads separately.

(iv) Debts due by directors or other officers of the company or any

of them either severally or jointly with any other person or debts
due by firms or private companies respectively in which any director
is a partner or a director or a member should be separately stated.

d. Cash and cash equivalents

(i) Cash and equivalents shall be classified as:
(a) Balances with banks’
(b) Cheques, drafts on hand;
(c) Cash on hand;
(d) Others (specify nature)

(ii) Earmarked balances with banks (for example, for unpaid

dividend) shall be separately stated.

(iii) Balances with banks to the extent held as margin money or

security against the borrowings, guarantees, other commitments
shall be disclosed separately.

(iv) Repatriation restrictions, if any, in respect of cash and bank

balances shall be separately stated.

(v) Bank deposits with more than 12 months maturity shall be

disclosed separately.
 70

e. Short-term loans and advances

(i) Short-term loans and advances shall be classified as:
(a) Loans and advances to related parties (giving details
thereof);
(b) Others (specify nature).

(ii) The above shall also be sub-classified as:

(a) Secured, considered good;
(b) Unsecured, considered good;
(c) Doubtful.

(iii) Allowance for bad and doubtful loans and advances shall
be disclosed under the relevant heads separately.

(iv) Loans and advances due by directors or other officers of the

company or any of them either severally or jointly with any other
person or amounts due by firms or private companies respectively
in which any director is a partner or a director or a member shall be
separately stated.

f. Other current assts (specify nature).

This is an all-inclusive heading, which incorporates current
assets that do not fit into any other asset categories.

6G. Contingent liabilities and commitments (to the extent not

provided for)
(i) Contingent liabilities shall be classified as:
(a) Claims against the company not acknowledged as
debt;
(b) Guarantees;
(c) Other money for which the company is
contingently liable

6H. The amount of dividends proposed to be distributed to equity

and preference shareholders for the period and the related amount
per share shall be disclosed separately. Arrears of fixed cumulative
dividends on preference shares shall also be disclosed separately.

6I. Where in respect of an issue of securities made for a specific

purpose, the whole or part of the amount has not been used for the
specific purpose at the balance sheet date, there shall be indicated
by way of note how such unutilized amounts have been used or
invested.

6J. If, in the opinion of the Board, any of the assets other than fixed
assets and non-current investments do not have a value on
realization in the ordinary course of business at least equal to the
amount at which they are stated, the fact that the Board is of that
opinion, shall be stated.
 71

D. Part II – Form of Statement of Profit and Loss

Name of the Company

Statement of Profit and Loss for the year ended 31 March, 20X2
Particulars Note
No. For the year ended 31 March, 20X2 For the year ended
31 March,20X1
Rs. Rs.
A CONTINUING OPERATIONS
1 Revenue from operations (gross)
Less: Excise duty
Revenue from operations (net)
2 Other Income
3 Total revenue (1+2)
4 Expenses
(a) Cost of materials consumed
(b) Purchases of stock-in-trade
(c) changes in inventories of finished goods, work-in-
progress and stock-in-trade
(d) Employee benefits expense
(e) Finance costs
(f) Depreciation and amortization expense
(g) Other expenses
Total Expenses
5 Profit/(Loss) before exceptional and extraordinary items and
tax (3-4)
6 Exceptional items
7 Profit/(Loss) before extraordinary items and tax (5 + 6)

8 Extraordinary items
9 Profit/(Loss) before tax (7 + 8)
10 Tax Expense:
(a) Current tax expense for current year
(b) (Less): MAT credit (where applicable)
(c) Current tax expense relating to prior years
(d) Net current tax expense
(e) Deferred tax
11 Profit/(Loss) from continuing operations (9 + 10)

B DISCONTINUING OPERATIONS
12.i Profit/(Loss) from discontinuing operations (before tax)

12.ii Gain/(Loss) on disposal of assets/settlement of liabilities

attributable to the discontinuing operations
12.iii Add/(Less): Tax expense of discontinuing operations

(a) On ordinary activities attributable to the discontinuing

operations
 72

(b) on gain/(loss) on disposal of assets/settlement of

liabilities
13 Profit/(Loss) from discontinuing operations (12.i + 12.ii +
12.iii)
C TOTAL OPERATIONS
14 Profit/(Loss) for the year (11 + 13)
15 Earnings per equity share:
(1) Basic
(2) Diluted

E. General Instructions for Preparation of Statement of Profit

and loss
1. The provisions of this Part shall apply to the income and
expenditure account referred to in sub-section (2) of Section 210 of
the Act, in like manner as they apply to a statement of profit and
loss.

2. (A) In respect of a company other than finance company revenue

from operations shall disclose separately in the notes revenue from
(a) Sale of products;
(b) Sale of services;
(c) Other operating revenues;
Less:
(d) Excise duty

(B) In respect of a finance company, revenue from operations shall

include revenue from
(a) Interest; and
(b) Other financial services

Revenue under each of the above heads shall be disclosed

separately by way of notes to accounts to the extent applicable.

3. Finance Costs: Finance costs shall be classified as:

(a) Interest expense;
(b) Other borrowing costs;
(c) Applicable net gain/loss on foreign currency
transactions and translation
4. Other Income: Other income shall be classified as:
(a) Interest income (in case of a company other than a
finance company);
(b) Dividend Income;
(c) Net gain/loss on sale of investments
(d) Other non-operating income (net of expenses directly
attributable to such income).

5. Additional Information: A company shall disclose by way of

notes additional information regarding aggregate expenditure and
income on the following items:-
 73

(i) (a) Employee Benefits Expense [showing separately (i) salaries

and wages, (ii) contribution to provident and other funds, (iii)
expense on Employee Stock Option Scheme(ESOP) and Employee
Stock Purchase Plan (ESPP), (iv) staff welfare expenses].
(b) Depreciation and amortization expense;
(c) Any item of income or expenditure which exceeds 1% of the
revenue from operations or Rs. 1,00,000, whichever is higher;
(d) Interest Income;
(e) Interest Expense;
(f) Dividend Income;
(g) Net gain/loss on sale of investments;
(h) Adjustments to the carrying amount of investments;
(i) Net gain or loss on foreign currency transaction and translation
(other than considered as finance cost);
(j) Payments to the auditor as (a) auditor, (b) for taxation matters,
(c) for company law matters, (d) for management services, (e) for
other services, (f) for reimbursement of expenses; (k) Details of
items of exceptional and extraordinary nature;
(l) Prior period items;

(ii) (a) In the case of manufacturing companies,-

(1) Raw material under broad heads.
(2) Goods purchased under broad heads.
(b) In the case of trading companies, purchases in respect of goods
traded in by the company under broad heads.
(c) In the case of companies rendering or supplying services, gross
income derived from services rendered or supplied under broad
heads.
(d) In the case of a company, which falls under more than one of
the categories mentioned in (a), (b) and (c) above, it shall be
sufficient compliance with the requirements herein if purchases,
sales and consumption of raw material and the gross income from
services rendered is shown under broad heads.
(e) In the case of other companies, gross income derived under
broad heads.

(iii) In the case of concerns having works in progress, works-in-

progress under broad heads.

(iv) (a) The aggregate, if material, of any amounts set aside or

proposed to be set aside, to reserve, but not including provisions
made to meet any specific liability, contingency or commitment
known to exist at the date as to which the balance-sheet is
made up.
(b) The aggregate, if material, of any amounts withdrawn from such
reserves.
 74

(v) (a) The aggregate, if material, of the amounts set aside to

provisions made for meeting specific liabilities, contingencies or
commitments.
(b) The aggregate, if material, of the amounts withdrawn from such
provisions, as longer required.

(vi) Expenditure incurred on each of the following items, separately

for each item:-
(a) Consumption of stores and spare parts.
(b) Power and fuel.
(c) Rent.
(d) Repairs to buildings.
(e) Repairs to machinery.
(f)Insurance.
(g) Rates and taxes, excluding, taxes on income.
(h) Miscellaneous expenses.

(vii) (a) Dividends from subsidiary companies.

(b) Provisions for losses of subsidiary companies.

(viii) The profit and loss account shall also contain by way of a note
the following information, namely:-

a) Value of imports calculated on C.I.F. basis by the company

during the financial year in respect of –
I. Raw Materials
II. Components and spare parts
III. Capital goods;

b) Expenditure in foreign currency during the financial year on

account of royalty, know-how, professional and consultation fees,
interest, and other matters;

c) Total value if all imported raw material, spare parts and

components consumed during the financial year and the total value
of all indigenous raw materials, spare parts and components
similarly consumed and the percentage of each to the total
consumption;

d) The amount remitted during the year in foreign currencies on

account of dividends with a specific mention of the total number of
non-resident shareholders, the total number of shares held by
them on which the dividends were due and the year to which the
dividends related;

e) Earnings in foreign exchange classified under the following

heads, namely:-
I. Export of goods calculated on F.O.B. basis;
II. Royalty, know-how, professional and consultation fees;
 75

III. Interest and dividend;

IV. Other income, indicating the nature thereof.

3.6 QUESTIONS ON THE COMPANY AUDIT PART I

AND PART II

State whether the following statements are ‘True’ or ‘False’:

1. Auditor should verify the authorized capital of a company shown

in the Balance Sheet with the Articles of Association.

2. Under Section 210 the Companies Act, the Board of Directors

have to lay before every Annual General Meeting the Balance
sheet, the Profit and Loss account and the Directors Report.

3. The Companies Act, 1956, does not prescribe any format for
Balance Sheet.

4. The value of imports of raw material by the company during the

financial year calculated on C.I.F. basis is to be disclosed
separately in the notes to accounts.

5. Issued capital is always higher than authorized capital.

6. Under Section 210 of the Companies Act, the Managing

Director has to lay before every Annual General Meeting the
Balance Sheet, the Profit & Loss Account and the Directors
Report.

7. When minimum subscription stated in the offer documents is not

received, the entire application money should be shown under
unsecured loans in the Balance Sheet till the time share
application money is refunded.

8. The value of imports of components and spare parts by the

during the financial year calculated on C.I.F. basis is to be
disclosed separately in the notes to accounts.

9. Shareholders are not entitled to receive Interest from the

company on calls paid in advance.

10. The maximum capital that the company can issue during its life
time is known as Authorized Capital.

11. Under Section 210 of the Companies Act, the Auditors have to
lay before every Annual General Meeting the Balance sheet, the
Profit & Loss Account and the Cash Flow Statement.
 76

12. A share issued at a price above its face value is known as

issue at premium.

13. No dividend is payable otherwise than in cash.

14. The value of imports of capital goods by the company during the
financial year calculated on C.I.F. basis is to be disclosed
separately in the notes to accounts.

15. A single resolution can be passed for the approval of the

annual accounts and the payment of final dividends.

16. Section 209 provides that every Balance Sheet of the company
shall give a true and fair view of State of Affairs of the company
as at the end of the financial year.

17. Goodwill is a fictitious asset.

18. In case of interim dividend, the dividend declared by the Board

of Directors is subject to the approval of the shareholders.

19. A share issued at a price lower than the face value is known as
issue at premium.

20. Equity shares are those shares which are not preference
shares

21. In case of final dividend, the dividend declared by the Boards of

Directors is final.

22. Under Section 210 of the Companies Act, the share holders
have to lay before every Annual General meeting the Balance
Sheet, the Profit and Loss Account and the Directors Report.

23. Section 211 requires Profit and Loss A/c of company should
give a true and fair view of Profit & Loss of the company for the
financial year.

24. Arrears of cumulative preference dividend are a contingent

liability.

25. Payment of interest is a charge against the profits.

26. The capital that can be issued only when the company goes for
winding is known as “Reserve Capital”.

27. In case of companies the members can decide that no payment

of dividend be made even if the board has recommended
payment of dividend.
 77

28. A instrument acknowledging a debt carrying fixed value of

interest is known as debenture.

29. The Board is authorized by Articles of Association to make a

call.

30. Section 78 of the Companies Act, 1956 deals with the issue of
securities at premium.

31. Minimum application money should be 5% of nominal value of

shares issued.

32. Depreciation is to be provided on investments annually.

33. Section 79 deals with issue of securities at discount

34. Section 94 deals with alteration of share capital.

35. Section 100 deals with reduction of share capital.

36. The company deposits the application money in any bank.

37. Calls in advance cannot be accepted by a company, unless

authorized by Articles.

38. Call made should be uniform on all shares of the same class.

39. The provisions of SEBI are applicable only to first issue and not
subsequent issue.

40. Surplus on the re-issue of forfeited shares standing to the credit

of share forfeited account can be distributed as dividend.

41. Security premium is a revenue gain & should be transferred to

Profit and Loss A/c.

42. Reduction of share capital requires special resolution to be

passed by shareholders.

43. Security premium should be disclosed in Balance Sheet on

liability side under the head ‘Reserves and Surplus’.

44. Issue of securities at discount requires sanction from the

Company Low Board.

45. Subdivision of shares into smaller amount is an example of

alteration of share capital.

46. Any new company can issue shares at discount.

 78

47. Under CARO, 2003 auditor has to report on the valuation or

revaluation of all the assets.

48. Rate of discount cannot exceed 10% unless authorized by the

Central Government.

49. Reduction of share capital requires special resolution to be

passed by shareholders.

50. Interest on calls in arrears cannot exceed 5% according to

Table A.

51. Interest on calls in advance cannot exceed 6% according to

Table A.

52. Debt equity ratio should be 2:1 after buy-back.

53. The value of exports of goods by the company during the

financial year calculated on C.I.F. basis is to be disclosed
separately in the notes to accounts.

54. A right of person who under an agreement with the company

has an option to subscribe for shares of the company is known
as right issue.

55. Buy-back should not exceed 40% of total of paid up capital and
free reserves.

56. Dividend is an appropriation and not a charge against the

profits.

57. CARO, 2003 Auditor has to report if a substantial part of fixed

assets have been disposed off during the year, whether it has
been done for a reasonable price.

58. Cash system of accounting means recording income &

expenses when they are received or paid.

59. Capital Reserve is a revenue profit.

60. Transfer of shares due to death or bankruptcy of a shareholder

is known as transmission of shares.

61. Issue of right shares should be authorized by Articles.

62. CARO, 2003 does not apply to a foreign company.

63. Security premium can be utilized for buy-back of shares.

 79

64. Debentures can be issued at a premium.

65. Unclaimed or unpaid dividend should be transferred to special

account which should be operative for 7 years.

66. Investment in subsidiary companies is valued at cost or not

realizable value whichever is lower.

67. Issues of shares by capitalization of profit are known as bonus

issue.

68. Interest on debentures is a capital expenditure.

69. Unclaimed or unpaid dividend should be transferred to special

account which should be operative for 7 years.

70. The Companies Act requires accounts to be maintained on cash

system.

71. Discount on issue of debentures should be written over the

tenure of debentures issued.

72. The qualifications by the auditor should appear in the Notes of

Accounts.

73. Stores & spares are disclosed under the head ‘fixed assets’.

74. Sweat equity share are issued by the company to employees,

directors at a discount for consideration other than cash.

75. Capital Reserve is a revenue profit.

76. The observations or comments of the auditors which have any

adverse effects on the functioning of the company shall be
printed in the auditor’s report in capital letters.
77. The dividend so declared should be paid within the period of 30
days from the date of such declaration.

78. Section 209 of the Companies Act, 1956, contemplates that the
company should maintain A/c to disclose true & fair view.

Answer:
True – 2, 4, 8, 10, 2, 13, 14, 20, 23, 24, 25, 26, 27, 28, 29, 30, 3, 33, 34, 35, 37,
38, 40, 42, 43, 44, 45, 48, 49, 50, 51, 56, 58, 60, 61, 63, 64, 65, 67, 69, 71, 74,
77, 78.

False – 1, 3, 5, 6, 7, 9, 11, 15, 16, 17, 18, 19, 21, 22, 32, 36, 39, 41, 46, 47, 52,
53, 54, 55, 57, 59, 62, 66, 68, 70, 72, 73, 75, 76.
 80

Select the correct alternative:

1. The maximum amount that the company can issue is known

as:
a) Issued capital b) Authorized capital
b) Subscribed capital d) Issued capital

2. Shares can be issued

a) For cash b) For consideration other than cash
c) Both a & b d) None of the above

3. The form of balance sheet is prescribed by

a) Schedule VI, Part I b) Schedule I, Part VI
c) Schedule VI, Part VI d) Schedule I, Part I

4. Select the stages in right order.

a) Allotment, application, calls
b) Application, allotment, calls
c) Calls, application, allotment
d) Calls, allotment, application.

5. The value of imports by the company during the financial

year
a) Are disclosed in notes to accounts on FOB basis
b) Are disclosed in notes to accounts on CFF basis
c) Are not disclosed in notes to accounts if not used
or consumed during the year
d) Are disclosed in notes to accounts only in foreign
currency.

6. The capital that can be called only when the company goes
into liquidation.
a) Reserve Capital b) Capital Reserve
c) Subscribed Capital d) Issued Capital

7. A company is guided by
a) The Companies Act, 1931
b) The Companies Act, 1956
c) The Companies Act, 1934
d) The Companies Act, 1932.

8. A share that carries the right to a fixed amount of dividend at

a fixed rate is known as
a) Ordinary share b) Preference share
c) Equity share d) Equity share held by
promoters
 81

9. Share Capital of the company is classified under

a) Authorized Capital b) Issued Capital
c) Subscribed Capital d) All of the above

10. The earnings in foreign exchange from export of goods

a) Are disclosed in notes to accounts even if not
received
b) Are disclosed in notes to account on FOB basis
c) Are disclosed in notes to accounts on CIF basis
d) Need not be disclosed at all.

11. The fundamental objective of an external audit of a limited

company is to
a) Prevent and detect frauds
b) Provide an opinion on the financial statements
c) Prevent and detect errors
d) To help the directors

12. Schedule VI provides that

a) The Balance Sheet of the company is primary
document
b) Profit & Loss A/c shown first & then the Balance
Sheet
c) Nothing as such has been provided
d) Balance Sheet should be shown first & then Profit
and Loss account

13. Sec. 86 provides for following two classes of shares

a) Equity & Ordinary b) Equity & Preference
c) Ordinary & Bonus d) Ordinary & Right

14. Shares which are not preference shares are known as

a) Bonus Shares b) Equity Shares
c) Preference Shares d) Sweat Shares

15. Shares given a preference on repayment of capital and

payment of dividend
a) Equity Shares b) Ordinary Shares
c) Preference Shares d) Right Shares

16. Issue of shares to employees/directors at discount for

consideration other than cash is known as
a) Bonus Shares b) Subscribed Shares
c) Right Shares d) Sweat Equity Shares

17. Which section deals with maintenance of Books of Accounts

a) 209 b) 208
c) 217 d) 227
 82

18. Noncurrent assets include the following except

a) Tangible assets b) Fixed Assets
c) Trade Investment d) Long term loans & advances

19. The rate of dividend on equity shares is recommended by

a) Board of Directors b) Auditors
c) Shareholders d) Managing Director

20. Company’s Accounts according to section 209 should be

maintained on
a) Capital Redemption Reserve
b) Dividend Equalization Reserve
c) Profit & Loss Account
d) Securities Premium

21. Company’s Accounts according to section 209 should be

maintained on
a) Single Entry System b) Receipt basis
c) Cash basis d) Accrual basis

22. The maximum amount of call of the shares must not exceed.
a) 10% b) 20%
c) 25% d) 30%

23. Current Assets include the following except

a) Sundry Debtors b) Capital work in progress
c) Cash & Bank Balance d) Short Term Investment

24. The maximum rate of discount at which shares can be

issued, unless provided by Central Government
a) 10% b) 5%
c) 15% d) 2%

25. The following are the examples of tangible fixed assets

except
a) Land & Building b) Goodwill
c) Motor Vehicle d) Plant & Machinery
26. The objective of revising Schedule VI is /are
a) Make it transparent & use friendly
b) Make it compatible with Income Tax Act
c) Make it error free & Fraud Proof.
d) None of the above.
27. Bonus shares can be issued out of
a) Capital Redemption Reserve
b) Securities Premium
c) General Reserve
d) All of the above
 83

28. Debenture issued by company is

a) Loan b) Capital
c) Current Liabilities d) Contingent Liability

29. Unpaid interest on debentures should be shown as

a) Loan b) Current Liability
c) Contingent Liability d) Provision

30. Divisible Profit means

a) Net profit before interest & tax
b) Profit which can be distributed as dividend
c) Profit which is transferred to General Balance
d) Profit & Loss appropriation account

31. Buy-back of equity share is governed by

a) Section 117C b) 77 A & 77B
c) Section 80 d) Section 100

Answers
1 – b, 2 – c, 3 – a, 4 – a, 5 – b, 6 – a, 7 – a, 8 – b, 9 – d, 10 – a, 11 – b, 12
– c, 13 – b, 14 – b, 15 – c, 16 – d, 17 – a, 18 – c, 19 – a, 20 – a, 21 – d, 22
– c, 23 – b, 24 – a, 25 – b, 26 – a, 27 – d, 28 – a, 29 – a, 30 – b, 31 – b.




 84

4
AUDITOR’S REPORT

Unit Structure
4.1 Introduction and Meaning
4.2 Unqualified Opinion
4.3 Qualified Opinion Report
4.4 Adverse Opinion Report
4.5 Auditor’s report under Companies Act 1956
4.6 Companies (Auditor’s Report) Order, 2003 (Caro)
4.7 Audit report vs. political contribution
4.8 Questions

4.1 INTRODUCTION AND MEANING

The Auditor’s Report is a formal opinion, or disclaimer

thereof, issued by either an internal auditor or an independent
external auditor as a result of an internal or external audit or
evaluation performed on a legal entity or subdivision thereof (called
an “auditee”). The report is subsequently provided to a “user” (such
as an individual, a group of persons, a company, a government, or
even the general public, among others) as an assurance service in
order for the user to make decisions based on the results of the
audit.

An auditor’s report is considered an essential tool when

reporting financial information to users, particularly in business.
Since many third-party users prefer, or even require financial
information to be certified by an independent external auditor, many
auditees rely on auditor reports to certify their information in order
to attract investors, obtain loans, and improve public appearance.
Some have even stated that financial information without an
auditor’s report is “essentially worthless” for investing purposes.

It is important to note that auditor’s reports on financial

statements are neither evaluations nor any other similar
determination used to evaluate entities in order to make a decision.
The report is only an opinion on whether the information presented
is correct and free from material misstatements, whereas all other
determinations are left for the user to decide.
 85

There are four common types of auditor’s reports, each one

presenting a different situation encountered during the auditor’s
work. The four reports are as follows:

4.2 UNQUALIFIED OPINION

4.2.1 MEANING
An opinion is said to be unqualified 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
Auditor gives a clean opinion of Unqualified Opinion when he or he
does not have any significant reservation in respect of matters
contained in the Financial Statements. The most frequent type of
report is referred to as the Unqualified Opinion. This type of report
is issued by an auditor when the financial statements presented are
free of material misstatements and are represented fairly in
accordance with the accounting principles, which in other words
means that the company’s financial condition, position, and
operation s are fairly presented in the financial statements. It is the
best type of report an auditee may receive from an external auditor.

4.2.2 An Unqualified Opinion indicates the following:

(1) The Financial Statements have been prepared using the
accounting principles which have been consistently applied;
(2) The Financial Statements comply with relevant statutory
requirements and regulations;
(3) There is adequate disclosure of all material matters relevant
to the proper presentation of the financial information subject
to statutory requirement, where applicable;
(4) Any changes in the accounting principles of in the method of
their application and the effects thereof have been properly
determined and disclosed in the Financial Statements.

The Report consists of a title and header, a main body, the

auditor’s signature and address, and the report’s issuance date.
Traditionally, the main body of the unqualified report consists of
three main paragraphs, each with distinct standard wording and
individual purpose, however certain auditors have since modified
the arrangement of the main body (but not the wording) in order to
differentiate themselves from other audit firms.

The first paragraph (commonly referred to as the

introductory paragraph) states the audit work performed and
identifies the responsibilities of the auditor and the auditee in
relation to the financial statements. The second paragraph
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(commonly referred to as the scope paragraph) details the scope

of audit work, provides a general description of the nature of the
work, examples of procedures performed, and any limitations the
audit faced based on the nature of the work. This paragraph also
states that the audit was performed in accordance with the
country’s prevailing generally accepted auditing standards and
regulations. The third paragraph (commonly referred to as the
opinion paragraph) simply states the auditor’s opinion on the
financial statements and whether they are in accordance with
generally accepted accounting principles.

4.3 QUALIFIED OPINION REPORT

A Qualified Opinion report is issued when the auditor encountered

one of two types of situations which do not comply with generally
accepted accounting principles, however the rest of the financial
statements are fairly presented. This type of opinion is very similar
to an unqualified or “clean opinion”, but the report states that the
financial statements are fairly presented with a certain exception
which is otherwise misstated.
The two types of situations which would cause an auditor to issue
this opinion over the Unqualified opinion are:

1. Single deviation from accounting principles – this type of

qualification occurs when one or more areas of the financial
statement do not conform with accounting principles (e.g. are
misstated), but do not affect the rest of the financial statements
from being fairly presented when taken as a whole.

2. Limitation of scope – this type of qualification occurs when the

auditor could not audit one or more areas of the financial
statements, and although they could not be verified, the rest of
the financial statements were audited and they conform
accounting principles.

The wording of the qualified report is very similar to the

Unqualified opinion, but an explanatory paragraph is added to
explain the reasons for the qualification after the scope paragraph
but before the opinion paragraph. The introductory paragraph is left
exactly the same as in the unqualified opinion, while the scope and
the opinion paragraphs receive a slight modification in line with the
qualification in the explanatory paragraph.

“Except as discussed in the following paragraph, we

conducted our audit.”
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For a qualification arising from a deviation from accounting

principles, the following phrase is added to the opinion paragraph,
using the depreciation example mentioned above:

“In our opinion, except for the effects of the Company’s

incorrect determination of depreciation expense, the financial
statement referred to in the first paragraph presents fairly, in all
material respects, the financial position of…”

For a qualification arising from a scope of limitation, the

following phrase is added to the opinion paragraph, using the
inventory example mentioned above:

“In our opinion, except for the effects of such adjustments, if

any, as might have been determined to be necessary had we been
able to perform proper tests and procedures on the company’s
inventory, the financial statement referred to in the first paragraph
presents fairly, in all material respects, the financial position of…”

Due to the phrases added to the scope and opinion

paragraphs, many refer to this report as the Except-For Opinion.

4.4 ADVERSE OPINION REPORT

An Adverse Opinion is issued when the auditor determines

that the financial statements of an auditee are materially misstated
and , when considered as a whole, do not confirm with accounting
principles. It is considered the opposite of an unqualified or clean
opinion, essentially stating that the information contained is
materially incorrect, unreliable, and inaccurate in order to assess
the auditee’s financial position and results of operation. Investors,
lending institutions, and governments very rarely accept an
auditee’s financial statements if the auditor issued an adverse
opinion, and usually request the auditee to correct the financial
statements and obtain another audit report.

Generally, an adverse opinion is given only if the financial

statements pervasively differ from accounting principles. An
example of such a situation would be failure of a company to
consolidate a material subsidiary.

The wording of the adverse report is similar to the qualified

report. The scope paragraph is modified accordingly and an
explanatory paragraph is added to explain the reason for the
adverse opinion after the scope paragraph but before the opinion
paragraph. However, the most significant change in the adverse
report from the qualified report is in the opinion paragraph, where
the auditor clearly states that the financial statements are not in
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accordance with accounting principles, which means that they, as a

whole, are unreliable, inaccurate, and do not present a fair view of
the auditee’s as a whole, are unreliable, inaccurate, and do not
present a fair view of the auditee’s position and operations.

“In our opinion, because of the situation mentioned above (in

the explanatory paragraph), the financial statements referred to in
the first paragraph do not present fairly, in all material respects, the
financial position of…”

4.5 AUDITOR’S REPORT UNDER COMPANIES ACT

1956

Auditor has to compulsorily inquire and comment in his Report.

Section 227 (1A) requires auditor to inquire and report on the

following matters:

4.5.1 Contents of auditor’s report are discussed below:

(a) whether loans and advances made by the company on the

basis of security have been properly secured and whether the
terms on which they have been made are not prejudicial to the
interests of the company or its members;

(b) whether transactions of the company which are represented

merely by book entries are not prejudicial to the interest of the
company;

(c) where the company is not an investment company within the

meaning of section 372 or a banking company, whether so much of
the assets of the company as consist of shares, debentures, and
other securities have been sold at a price less than that at which
they were purchased by the company;

(d) whether the loans and advances made by the company have
been shown as deposits;

(e) whether personal expenses have been charged to revenue

account;

(f) where it is stated in the books and papers of the company

that any securities have been allotted for cash, whether cash has
actually been received in respect of such allotment, and if no cash
has actually been so received, whether the position as stated in the
account books and the balance sheet is correct, regular and not
misleading.
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4.5.2. Auditor shall report whether the accounts give a true

and fair view
The auditor has an obligation towards the members of the
company to make a report to them on the account examined by
him, and on every balance sheet and profit and loss account, which
are placed before the company in annual general meeting during
his tenure of office. The auditor has to state whether in his opinion
and to the best of his information and according to the explanations
given to him, the said accounts give the information required by this
Act in the manner so required and give a true and fair view:-

(i) in the case of the balance sheet, of the state of the

company’s affairs as at the end of its financial year; and

(ii) in the case of the profit and loss account, of the profit or loss
for its financial year.

The auditor’s report shall also state:-

(a) whether he has obtained all the information and explanation
which to the best of his knowledge and belief were necessary for
the purposes of his audit;

(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;

(c) whether the report on the accounts of any branch office

audited under section 228 by a person other than the company’s
auditor has been forwarded to him as required by section 228(3)(c)
and how he has dealt with the same in preparing the auditor’s
report;

(d) whether the company’s balance sheet and profit & loss
account dealt with by the report are in agreement with the books of
account returns;

(e) whether, I his opinion, the profit and loss account and
balance sheet comply with the accounting standards referred to in
section 211 (3C);

(f) in thick type or in italics the observations or comments of the

auditors which have any adverse effect on the functioning of the
company;

(g) whether any director is disqualified fro being appointed or re-

appointed as director under clause of sub-section (1) of section
274;
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(h) whether the cess payable under section 441A has been paid
and if not, the details of amount of cess not so paid;

Moreover, where matter as stated in (a)(b) and further in (a)

to (e) are answered in negative or with qualification, the auditor’s
report shall state the reasons for the answer.

4.5.4 Requirement to give comments in the Auditor’s Report

as per the Companies (Disqualification of Directors under
section 274(1)(g) of the Companies Act, 1956) Rules, 2003

As per the Companies (Disqualification of Directors under

section 274(1)(g) of the companies Act, 1956) Rules 2003 is it
provided in rule 4 that:-

(a) it shall be the duty of the statutory auditor of the appointing

company as well as the 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 or re-appointed as
director under section 274(1)(g) and to furnish 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 or reappointment as a director or not.

(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 appointed or
reappointed as director in another company under section 274(1)(g)
of the Act.

4.5.5 Auditors are required to make independent

investigations at to disqualification of director u/s 274(1)(g)

Before reporting a particular person as being disqualified, an

auditor must seek for the views and /or representations of the
director concerned or any person as to whether he was a director of
the defaulting company as mentioned in section 274. auditor’s
report really affects a particular persons right as his civil rights or
status is necessarily declared in a negative way by the auditor by
his fact finding. The rules of natural justice demand that before a
person’s right is affected, he/she should be given opportunity to
explain his or her position.

4.5.6 Obligation on the Auditor’s to comment on the

compliance of the Accounting Standards, in the case of failure,
the Auditor has to face the consequences
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The Department has issued a Press Note which states that

the provisions of section 227 of the Companies Act, 1956 have
been amended with effect from 31-10-1998, with an obligation on
the part of the auditors of the companies to include a para in their
report under section 227 of the Act to the member of the company,
stating whether in their opinion the profit and loss account and the
balance sheet comply with accounting standards referred to tin sub-
section (3C) of section 211. It further states that auditors of the
companies are, therefore, advised to ensure that such a clause is
added to their reports to the member failing which this Department
will be constrained to take penal action against the auditors as well
as refer the matter to the ICAI for initiating disciplinary proceedings
against them.

4.5.7 Signature of the Auditor’s Report, etc

Only the person appointed as auditor of the company, or
where a firm is so appointed in pursuance of the provision to sub-
section (1) of section 226, only partner in the firm practicing in
India, may sign the Auditor’s Report, or sign or authenticate any
other document of the company required by law to be signed or
authenticated by the auditor.
[Section 229]

4.5.8 COMPANIES (AUDITOR’S REPORT) ORDER, 2003

The auditor’ Report shall include a statement on the matters

specified in Companies (Auditor’s Report) Order, 2003 (CARO).

The Central Government has issued on 12th June, 2003,

Companies (Auditor’s Report) Order, 2003 effective from 1st July,
2003 which has superseded the earlier Manufacturing and Other
Companies (Auditor’s Report) Order, 1998. The Central
Governments vide Notification dated 25th November, 2004 has also
made certain amendments in the CARO.

4.5.9 Obligation to report the breach of law

The Companies Act lays down detailed provisions regarding
various matters and casts an obligation upon officers and directors
of the company to carry out the requirements of the law. Generally
speaking, it is the duty of the directors and the management to
ensure that the provisions of the Companies Act have been
complied with. However, where there is contravention of legal
requirement by a company, which has a bearing on the accounts
and transaction of the company, the auditor would in the normal
course of his inquiry become aware of them and it would need to be
brought to the notice of the shareholders.

The auditor should, however, not merely state the facts,

leaving it to be inferred that a contravention of legal requirements
 92

has taken place, but he should clearly point out that in his opinion a
contravention of the law has occurred. For example if any loans are
given in contravention of section 295 of the Act, the auditor should
report the matter irrespective of the fact that the concerned loans
have been repaid after the balance sheet.

4.6 COMPANIES (AUDITOR’S REPORT) ORDER,

2003 (CARO)

4.6.1 Article Details:

Some additional responsibilities are being placed on the auditor

under CARO-2003, the discussion in this article is mainly restricted
to the new items added under this new order.

4.6.2 Applicability:

1 CARO came into force on 1-7-200. It applies to all

Companies, including foreign companies’ defined u/s. 591 of the
Companies Act (Act). It is, however, provided that this offer shall
not apply to following companies:

(i) A banking company

(ii) An insurance company
(iii) A company registered
U/s.25 of the Act
(iv) A private limited company which satisfies the following
conditions:
(a) Its paid up capital and reserves do not exceed Rs.50 lacs;
(b) It has not accepted any public deposits;
(c) Its turnover does not exceed Rs.5 cores; and
(d) Its outstanding loan from any bank or financial institution
does not exceed Rs. 10 lacs.
If any of the above conditions are not satisfied, the above order will
apply to the private limited company.

2. It may be noted that MAOCARO-1988, did not apply to

banking, insurance and S.25 companies. However, CARO gives
relief to small private limited companies which satisfy the above
conditions. If we analyze the above conditions, the following
conclusions can be drawn:
 93

(i) The term ‘Reserves’ is not defined. Therefore, revaluation

reserves, capital reserves, etc. will have to be included. However,
the credit balance of Profit & Loss Account will not be included.
(ii) The expression ‘Public Deposits’ is not defined. Therefore,
meaning given to this term u/s.58A of the Act can be assigned to
this term.
(iii) The term ‘Turnover’ is not defined. Therefore, the term as
defined by ICAI for the purpose of Schedule VI and for other
accounting purposes can be considered for this purpose also.
(iv) The outstanding loan from banks or financial institutions
should not exceed Rs. 10 lacs. It is not clarified whether this
position is to be considered as at the end of the accounting year.
This will require clarification from the Government or ICAI. In the
absence of such clarification, the order will apply if the outstanding
balance at any time during the year exceeds Rs.10lacs. Further,
such loan may be on account of overdraft, cash credit, packing
credit, term loan, etc.
3 As stated earlier, MAOCARO-1988 applied to companies
engaged in manufacturing, trading, service and financial activities.
On the same lines CARO applies to all such companies, excluding
private companies which satisfy the above conditions. Para 2 of the
above order, therefore, defines the terms manufacturing and mining
company, processing company, trading and service company,
finance and investment company and chit fund company, etc. in the
same manner as defined in Para 2 MAOCARO.

4 Para 4 of CARO states that the Auditor’s report u/s 227 shall
include specific statement on matters listed in this Para. Therefore,
as in MAOCARO, the auditor will have to give his opinion on all the
matters listed in this Para.

4.6.3 Fixed Assets:

1 The reporting requirement under CARO with reference to
maintenance of proper records showing particulars and location of
fixed assets, physical verification by management at reasonable
intervals and treatment of material discrepancies in the books of
accounts is the same as in MAOCARO.

2 MAOCARO required the auditor to state about revaluation

and basis of revaluation of the fixed assets during the year. This
requirement is now deleted.

3 CARO now requires the auditor to state whether the ‘going

concern’ concept is affected if a substantial part of the fixed assets
have been disposed off during the accounting period under report.
The auditor will now be required to examine the reasons for
disposal of a substantial part of the fixed assets and to give his
 94

opinion whether the reporting on financial statements on going

concern concept is proper.

4.6.4 Inventories:

1 The reporting requirement under CARO in respect of

following matters relating to inventories is the same as in
MAOCARO:

(i) Whether physical verification of inventories is conducted by

the management at reasonable intervals.

(ii) Whether procedure for physical verification of inventories is

reasonable and adequate. If not, inadequacies to be reported.

(iii) Whether material discrepancies noticed on physical

verification are properly dealt with in the books of accounts.

2 CARO requires the auditor to report whether the company is

maintaining proper records of inventories. This is a new
requirement. Hitherto, the auditor was required to examine whether
proper records for inventories were maintained as part of his audit
procedure. Now he will have to make a specific mention about
adequacy of these records in his audit report.

3 MAOCARO required the auditor to report whether the

valuation of inventories was proper in accordance with normally
accepted accounting principles and whether this was on the same
basis as in the preceding year. If there was any deviation which had
material effect in the accounts, the same was required to be
reported. Now, this reporting requirement is deleted. This is
because AS-2 dealing with valuation of inventory has now become
mandatory u/s.211 (3C) of the Act and material effect due to
change in the method of valuation is required to be reported.

4.6.5 Loans given or taken by company:

1 The reporting requirement under this head according to

MAOCARO and CARO in respect of the following items is more or
less the same:

(i) Secured or unsecured loans granted or taken by the

company to or from companies, firms of other parties in which
directors are interested and are covered by S.301 of the Act.

(ii) Whether rate of interest and other terms and conditions of

such loans are prima facie prejudicial to the interest of the
company.
 95

2 CARO requires the auditor to now report on the following

items relating to the above loans:

(i) The auditor has to give the number of persons and the
amount involved in the transactions required to be entered in the
register maintained u/s.301. It appears that this information is to be
given in respect of all such parties even if the rate of interest and
other terms and conditions are prima facie not prejudicial to the
interest of the company.

(ii) Whether payment of the principal amount and interest are

also regular. In this clause the word ‘payment’ is used. It appears
that the intention is for reporting the regularity of repayment of the
principal and payment of interest on loan.

(iii) Whether the company has taken reasonable steps for

recovery or payment of principal and interest if any loan granted or
taken is overdue and the amount exceeds Rs. 1 lakh.

(iv) The above information is to be given in respect of loans

granted or taken by the company separately.

(v) Whether transactions that need to be entered into the

register in pursuance of S.301 of the Act have been so entered.
This will require the auditor to verify all transactions with
companies, firms and other parties in which directors are interested
and to examine whether these transactions have been recorded in
the register maintained u/s.301 of the Act.

(vi) If the total value of the transaction with any one party
covered by the requirement of S.301 of the Act in any financial year
exceeds Rs. 5 lacs, the auditor will have to report whether each of
these transactions has been made at prices which are reasonable
having regard to the prevailing market prices at the relevant time.
This will mean that the auditor will have to obtain list of such parties
in which directors are interested as provided in S.297 and S.299 of
the Act, and determine whether transactions for sales, services,
purchases expenditure etc. with these parties are at market prices.
In MAOCARO this limit was Rs.50,000/- for each party for financial
year. Further, the auditor could consider the prices charged in
similar transactions with other parties while determining the market
prices. This flexibility is not given in CARO.

3 Para 4(A) (ix) of MAOCARO required the auditor to examine

transactions of loans or advances in the nature of loans and report
whether the parties are repaying such loans and interest thereon as
per the stipulated terms. This Para applied to all loans and
advances in the nature of loans. This requirement applied to parties
other than those covered by S.301. This requirement is now
 96

deleted subject to information to be given in respect of parties

covered by S.301 as stated above.

4.6.6 Internal control

Procedure:
The requirements of reporting on the existence of internal
control procedures commensurate with the size of the company
and the nature of business, for purchase of inventory and fixed
assets and for sale of goods is the same in CARO as in
MAOCARO. In addition, CARO provides that the auditor should
report whether there is continuing failure to correct major
weaknesses in internal control procedures.

4.6.7 Internal audit system:

MAOCARO provide that the auditor should report whether
the company has an internal audit system commensurate with its
size and nature of business. This requirement applied in respect of
a company having paid up capital exceeding Rs.25 lacs as at the
commencement of the financial year or having an average turnover
exceeding Rs. 2 crores for a period of three consecutive financial
years immediately proceeding the relevant financial year. CARO
now provides that this reporting requirement about internal audit
system will apply to any of the following companies:

(i) Listed company

(ii) Any other company with paid up capital and reserves
exceeding Rs.50 lacks for a period of 3 consecutive financial year,
or
(iii) Any company having an average turnover exceeding Rs. 5
crores for a period of 3 consecutive financial years immediately
preceding the relevant financial year.

It may be noted that in (ii) above, the reserves will include all
reserves but will not include credit balance of profit and loss
account.

4.6.8 Acceptance of public deposits:

The reporting by the auditor with regard to public deposits
accepted by a company u/s. 58A/58AA or any contravention, is the
same under MAOCARO and under CARO. There is one additional
requirement under CARO, under which the auditor has to report
whether the company has complied with any order passed by the
Company Law Board in respect of such public deposit.

4.6.9 Maintenance of cost records:

The reporting requirements with regerd to maintenance of
cost records by the company as prescribed u/s.209 (1)(d) of the Act
are the same under MAOCARO and CARO.
 97

4.6.10 Statutory dues:

1 The requirement of reporting whether undisputed statutory
dues such as Provident Fund, Investor Education and Protection
Fund, ESIC< Income-tax, Wealth Tax, Sales Tax, Customs Duty,
Excise Duty, Cess, etc. with various statutory authorities have been
deposited regularly, and the extent of outstanding dues in arrears
as on the last day of the of the financial year for a period exceeding
six months, as in MAOCARO, has been retained in CARO more or
less in the same form, items of Investor Education Protection Fund,
Cess and other statutory dues, if any, have been added in CARO.

2 CARO puts additional reporting requirement with regard to

disputed taxes viz., Income Tax, Wealth Tax, Sales Tax, Customs
Duty, Excise Duty and Cess, which have not been deposited by
company. The auditor will have to report about the amounts
involved in such disputes and the forum where the dispute is
pending. For this purpose, a mere representation to the Department
will not constitute the dispute. In other words, if a dispute is raised
before any appellate authority, statutory authority, court, etc., only
then it will constitute a dispute. It appears that the disputed taxes
will include interest due thereon and penalty, if any, levied and
disputed.

4.6.11 Accumulated losses:

1 MAOCARO required the auditor to report whether the
company was Sick Company u/s.3(1)(b) under SICA-1985. This
requirement is deleted in CARO.

2 However, CARO provides that the auditor should report, in

the case of a company which has been registered for a period of
not less than 5 years, whether the accumulated losses of the
company at the end of the relevant financial year are not less than
50% of its net worth and whether it has incurred cash losses in that
financial year and immediately preceding such financial year. This
is a new requirement which will give signal about the impending
financial sickness of the company. The terms ‘Net Worth’ and ‘Cash
Losses’ have not been defined in CARO and we will have to give
them the normal meaning as understood by accountants. It may be
noted that in the guidance note on terms used in Financial
Statements issued by ICAI, the term ‘Net Worth’ is explained as
‘The excess of the book value of assets (other than fictitious
assets) of an enterprise over its liabilities’. In the above guidance
note the term ‘Cash Loss’ is explained to mean the ‘net loss’ as per
accounts after excluding non-cash costs, such as depreciation,
amortization, etc.
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4.6.12 Repayment of dues of banks, etc. and creation of

securities:
1 CARO has put additional responsibilities on auditors who will
now have to report about defaults in repayment of dues to a
financial institution, bank or debenture holders. If there is any
default, the period and amount involved in the default should be
reported. This reporting requirement will require the auditor to
ascertain the due dates for repayment of loans taken from the
banks and financial institutions as well as loans taken against
debentures. If there is any delay in repayment, it will have to be
reported even if the delayed payment is made before the end of the
accounting year. The requirement under this clause is about
repayment of dues. Therefore, it appears that default or delay in
payment of interest to banks, financial institutions or debenture
holders is not required to be reported.

2 The auditors now have to report whether the company has

created securities required to be created in respect of debentures
issued by the company.
4.6.13 Transactions prejudicial to the interest of the company:
1 CARO now requires the auditor to report whether the
company has given any guarantee for loans taken by others from a
bank or financial institution where the terms and conditions are
prejudicial to the interest of the company. In other words, if any loan
taken by a staff member or an associate concern is guaranteed by
the company, the auditor will have to examine whether any counter
guarantee is taken by the company and whether such counter
guarantee gives sufficient comfort against any liability that may
arise if the lender invokes the guarantee.

2 The auditor has also to report under CARO whether the

price at which shares issued by the company under preferential
allotment to parties or companies covered u/s.301 of the Act is
prejudicial to the interest of the company. For this purpose, the
auditor will have to study the share price movement if the shares of
the company are quoted or to work out the intrinsic price of the
shares if they are not quoted in the stock exchange, and compare
the same with the issue price under the preferential allotment.
4.6.14 End use of borrowed funds:
CARO has placed additional responsibility on the auditor
who will now have to report about end use of the borrowed funds in
the following cases. For this purpose, the auditor will have to
examine the cash flow statement in greater detail so that any
diversion of funds can be ascertained.
 99

(i) If any ‘term loan’ is taken by the company, whether such

loan is used for the purpose for which it is taken. For this purpose,
the loan documents, sanction letters and other relevant
correspondence will have to be studied by the auditor.

(ii) If the company has raised “short-term’ funds, the auditor will
have to report if such funds are used for long-term investment.
Similarly, if ‘long-term’ funds are raised and they are used for short-
term investments, the auditor will have to report. He will have to
indicate the nature of loan defined in CARO. The auditor will have
to use his judgment for this purpose.

(iii) When the management has disclosed about the use of

money raised by a public issue, the auditor will have to report that
he has verified such end use.

4.6.15 Reporting about frauds:

CARO requires the auditor to report whether during the
financial year any fraud on the company is noticed. Similarly, he
has also to report whether he has noticed that the company has
committed any fraud on others. If the auditor has not noticed any
such fraud, but the same is reported to the company or by the
company, he will have to refer to such report in the audit report.
The reporting of the fraud may be in the media. It appears that the
auditor will have to take note of such media reports also and refer
to the same in his audit report, if such reports are found to be
authentic.

The auditor has to state in the audit report the nature of such
fraud and the amount involved. There is no requirement to report
about the steps taken by the company in respect of such fraud.

4.6.16 Some of the MAOCARO items deleted:

1 In the MAOCARO, various reporting items in Para 4 were
divided in four parts, viz.
(A) Manufacturing and processing companies,
(B) Service companies,
(C) Trading companies and
(D) Finance, investment, chit fund, nidhi or mutual benefit
companies.

This classification is absent in CARO and therefore all items in Para

4 of CARO will apply to all companies to the extent applicable.

2 The following reporting items contained in MAOCARO do not

find place CARO:

(i) The unserviceable or damaged stores, raw materials or

finished goods whether determined and adequately provided in the
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accounts. This deletion is because this item is now covered in AS-2

(Valuation of Inventories).

(ii) Maintenance of reasonable records about sale and disposal

of realizable by-product and scrap. This deletion is also in view of
AS-2 which is now mandatory.

(iii) Personal expenses charged to revenue account. This

deletion is because the auditor has to report on this item u/s.227
(1A) of the Act.

(iv) In the case of Service Company, it was necessary to report

consumption of materials and stores and about allocation of man-
hours to the job. This item is now deleted.

(v) In the case of trading company, it was necessary to report

about determination and provision for damaged goods. This is
deleted in view of mandatory nature of AS-2.

4.6.17 Finance, investment, chit fund, nidhi or mutual benefit

companies:
As stated earlier, separate classification for such companies
made in Para 4(D) of MAOCARO has now been deleted. But the
following reporting requirements contained in Para 4(D) of
MAOCARO have been retained more or less in the same manner
and will apply to other companies also to the extent applicable:

(i) Whether adequate documents and records are maintained in

cases where the company has granted loans and advances on the
basis of security by way of pledge of shares, debentures and other
securities. Under CARO, apart from the above, it is necessary to
point out in the report the deficiencies in the maintenance of above
documents and records.

(ii) Whether the provisions of any special statute applicable to

chit fund have been duly complied with.

(iii) As regards Nidhi and Mutual benefit funds/societies, CARO

provides that the auditor should report on the following matters:

(a) Whether the net owned fund to liability ratio is more than
1:20 as at the balance sheet date.

(b) Compliance with the prudential norms on income recognition

and provisioning against sub-standard, default and loss assets.

(c) Adequate procedures for appraisal of credit proposals/

requests, assessment of credit needs and repayment capacity of
borrowers.
 101

(d) Whether repayment schedule of various loans granted by

the Nidhi is based on repayment capacity of borrower and would be
conducive to recovery of the loan amount.

(iv) if the company if dealing or trading in shares, securities,

debentures and other investments, whether proper records have
been maintained, timely entries are made and such investments
are in the name of the company.

4.6.18 Form of Audit Report:

CARO requires that the auditor should make a statement of
the matters contained in the order. This requirement applies even
where the answers to any of the questions are unfavourable or
qualified. In such cases, the auditor should state his unfavourable
answers and the reasons for the same. If the auditor is not able to
express his opinion about any of the items contained in the order
he should indicate such fact, and give reasons as to why he is
unable to express an opinion.

4.7 AUDIT REPORT VS. POLITICAL CONTRIBUTION

Where a company contributes any amount directly or

indirectly to any political party and the auditor is satisfied that
political contribution has been made in excess of the limit
prescribed in section 293A, he should qualify his audit report,
mentioning the excess amount involved, if ascertainable. Also
where such contributions made by the company are within the limit
but the facts regarding such contributions are not properly
disclosed, the auditor should qualify his report and state the
relevant facts. Where he is in doubt about the applicability of
section 293A, he should disclose this fact in his report. An auditor’s
duty as such is to examine and report on the accounts of the
company in accordance with the requirements of section 227. the
auditor therefore has no specific duty to make any special enquiry
to unearth cases of unauthorized political contributions if they are
not readily apparent from the examination of the accounts made in
the normal course of the audit. If any unauthorized political
contribution (of such contribution in excess of the permissible limit,
as the case may be) has been skillfully concealed by a company or
it has not come to the notice of the auditor in the normal course of
his audit, an auditor would be responsible only to the extent it can
be established that in the conduct of the audit he acted without
reasonable care and skill.

Views of the Department

(1) According to a Press release, dated 18th June 1962, the
Department has impressed upon the Chartered Accounts, acting as
statutory auditors of companies, through the ICAI, that it was their
 102

duty to comment on all such material violations of the law or sound

account practice as might reasonable be expected to affect directly
or indirectly the fortunes of the company’s accounts.

(2) The requirements of the Act are that the auditors should
specifically certify whether the published accounts give a true view
of the company’s state of affairs and of the profit and loss for the
financial year (as compared with the requirements of certification as
true and correct under the 1913 Act).

4.8 QUESTIONS

A. Select the correct alternative

1. Scope of audit is communicated to the client in
a) Audit Report c) Representation Letter
b) Engagement Letter d) Annual Report
2. The auditor has to give a statement of fact u/s 227(3) on
a) Proper Book of Accounts c) Less Payable
b) Accounting Standards d) None of the above

3. The date of Audit Report should not be

a) Date of AGM
b) Date of approval of accounts
c) Both (a) & (b)
d) None of the above

4. The client changed the method of depreciation. It is

disclosed as a note. It has immaterial effect on current
financial statement. Which opinion should the auditor
express?
a) Unqualified opinion c) Disclaimer of opinion
d) Qualified opinion d) Adverse opinion

5. Under CARO 2003, the auditor is not required to report

on
a) Arrears of preference dividend
b) Preferential allotment of shares to related party
c) Disposal of fixed assets
d) Unsecured loans granted to related party.

6. Auditor Report is given in prescribed format as per

a) AAS 28 c) AAS 27
b) AAS21 d) None of the above

7. A good report must be

a) Factual c) Unbiased
b) Convincing d) All of the above
 103

8. The Report which expresses that financial statements are

as per GAAP is
a) Qualified c) Modified
b) Unqualified d) Adverse

9. Audit Report is qualified when

a) Wrong method of depreciation is followed
b) Company law is violated
c) The auditor is unable to obtain information
d) All of the above.

10. A company auditor addresses his report to:

a) Board of Directors c) Members
b) M.D. d) Company Secretary

11. The CARO shall apply to a company, which is engaged

or proposes to be engaged in the following activities.
a) Manufacturing, mining or processing
b) Supplying and rendering services
c) Trading
d) All of the above

[Ans. (1 - b), (2 - c), (3 - b), (4 - a), (5 - a), (6 - a), (7 - d),

(8 - b), (10 - c), (11 - d)]

B. Fill in the blanks with proper word

1. _____ is a statement of collected and considered facts
about the accounts.
2. ____ ____ is an instrument through which the auditor
expresses his opinion.
3. Audit Report should not be ______.
4. Audit Report is in the nature of ______.
5. The scope of Audit Report is ______ than the scope of
Audit Certificate.
6. ______ provides for Audit Report.
7. Audit Report is addressed to the _____.
8. The Report must be ______ by the Auditor.
9. The report which says that financial statements company
with GAAP is an _____ Report

[Ans. (1) Audit Report; (2) Audit Report; (3) biased; (4)
Verification; (5) wide; (6) A 528; (7) members; (8) signed;
(9) unqualified]
 104

C. Match the following

Group ‘A’ Group ‘B’

1. Audit Report a) Whether financial

statements comply with
legal requirements

2. Section 227 (2) b) Modified Report

3. Opinion Paragraph c) Report to the members

4. SA 700 d) Qualified opinion

5. Qualified Report e) Addressed to the

members

D. State with reasons whether following statements are

true or false.
1. Auditors is an expert in Accounts.
2. Audit Report must be factual.
3. Audit Report should be biased.
4. There is no difference in Audit Report and Audit
Certificate
5. AS 28 provides for Audit Report.
6. Audit Report is qualified when important books are
maintained.
7. Audit Report need not be qualified even if wrong method
of depreciation is followed.
8. A company limited by shares has to hold a Statutory
Meeting.
9. The Auditor has to express his opinion about the books
of accounts.
10. An Audit Report is a certificate of accuracy of accounting
records and financial statements.
11. An Auditor’s opinion in any auditing situation involves
exercise of judgment.

[Ans. True: 1, 2, 5, 8, 9, 11; False: 3, 4, 6, 7, 10]


 105

5
NEW STANDARDS ON AUDITING
AUDITING STANDARDS 200 AND 200 A,
210 AND 220

Unit structure:
5.0 Objectives
5.1 Introduction.
5.2 Need for Audit standards.
5.3 Procedure for Setting Standards
5.4 Auditing standard 200
5.5 Auditing standard 200A.
5.6 Auditing standard 210.
5.7 Auditing standard 220.
5.8 Summary.
5.9 Questions.

5.0 OBJECTIVES

After studying the students will be able to understand:

 The need for Audit standards.
 The procedure for setting standards.

5.1 INTRODUCTION

As long as the business unit was small and was managed by

one owner : there was neither any need for maintaining accounts or
Audit. However with the increase in the size of the business and
emergence of partnerships and Joint stock company organizations
there, was separation between ownership and management of
business unit, there arose need for maintaining detailed account of
the business transactions. Books of accounts were maintained by
the employees and the owners like partners in a partnership firm
and shareholders in a Joint Stock Company, are to be assured that
these accounts are properly maintained. So, Audit of these
accounts by an independent expert in the field was found
necessary. Thus the profession of Auditors was slowly evolved.

An audit is defined as an examination of accounting records to

establish their reliability and the reliability of statements drawn
 106

thererom, It involves verification of accounting data, to determine

their accuracy and reliability. It involves examination of books of
accounts and vouchers. The Institute of Characters Accountants of
India defines Auditing as “Independent examination of financial
information of any entity, whether profit oriented or not and
irrespective of size or legal form, when such an examination is
conducted with a view to expressing an opinion there on”.

Auditors’ reports are read by owners like shareholders,

Creditors, Bankers who want to lend money or investors in
the shares of the company etc. If the accounts are audited, It is
not a guarantee as to the future viability of an enterprise. Similarly
auditors report does not guarantee that the business is being
conducted or managed efficiently. Still There is a general feeling in
the minds of the public that Nothing can go wrong with an
organization who’s Accounts have been audited. So, it is extremely
important that the auditors carryout their assignments with ut most
Professional care and sincerity to uphold this faith reposed by the
public in them.

In view of the importance of the audit, it was felt necessary

that there should be some set standards for the conduct of the audit
so that there is some uniformity in the conduct of audit. Every
auditor will conduct the audit In the same manner and the reader of
the audit report can presume that accounts have been properly
audited even through they are audited by anybody.

5.2. NEEDS FOR AUDIT STANDARDS

International response to Auditing needs

To uphold the faith of the public in the profession of auditors.

International Federation of Accounts (IFAC) was established in
1973. Its object was “worldwide development and enhancement of
the accountancy profession… of high quality in the public interest”.
The International Auditing and Standard Board (IAASB) was
established to improve the quality and uniformity of practice
throughout the world. This Board issued International Standards on
Auditing (ISA). IT also issued guidelines on the application of the
ISAS.

At national level we have the Institute of Chartered

Accountants of India Establish in 1949 to regulate the profession of
Chartered Accountancy in India. This institute has taken numerous
steps to ensure that its members discharge their duties with due
professional care, competence and sincerity. It established Auditing
practices committee or Auditing and Assurance Standards Board in
September 1982. This issues standards on Auditing to be followed
 107

by all the Auditors in India. These standards are mandatory i.e.

compulsory and every auditor has to follow them while auditing the
accounts of any business entity. The Institute has so far issued 35.
Audit standards and your syllabus contains the study of 12 out of
them.

In this chapter, we will be studying the first three standards

namely SA 200 dealing with basic principles that govern Audit and
SA 200 A dealing with objectives and scope of the Audit of
Financial statements SA 210 on agreeing the terms of audit
engagements and SA 220 on quality control for an audit of financial
statements.

In short Auditing standards represent a codification of the

best practices of the profession, which already exist. These
standards help the auditors in proper discharge of their professional
duties. They also promote uniformity in practice as also facilitate
comparability.

5.3 PROCEDURE FOR SETTING STANDARDS

Auditing and Assurance Standards Board of the Institute of
chartered Accountants of India formulates these standards.

This Board first identifies the areas where such standards

are necessary and prepares a list according to the priority. There
are study groups of the Institute to help this board in its work. A
draft auditing standard is first prepared and comments on the same
are called for from the members. Taking into account these
comments and suggestions of the members, standards are
prepared and submitted to the council of the Institute. Council then
takes a final decision on the same and then issues the standards.
While finalizing the standards the board also takes, in to account
the applicable laws, customs, Usages and business environment in
the country.
Institute of Chartered Accountants of India is a member of
the International Federation of Accountants. So, ICAI takes care to
see that standards issued by it are in harmony with the International
Standards on Auditing. International Federation has so far issued
39 standards and our Institute has issued 35 standards on the
same lines and 3 more are in the pipeline.
As stated earlier, every auditor has to compulsorily follow
these standards and where he cannot, he must give satisfactory
explanation for the same. Otherwise he will be held guilty of
professional misconduct and punished accordingly.
 108

CHECK YOUR PROGRESS

a) What is meant by Audit?
b) Explain the need for standards in Audit?
c) Who frames Audit standards at national and international
level?
d) How many standards are prepared so far by International
Federation of Accountants and Institute of Chartered
Accountants?
e) Are these standards optional or mandatory?

5.4 AUDIT STANDARD 200

Basic Principles that govern an audit:

This standard came in to effect on 1st April 1985. It deals

with professional responsibilities of an auditor. It should be followed
while conducting any audit.

An audit is the independent examination of financial

information of any entity. The Unit may be run to earn profit or not.
It may be small or large. It may taken any legal form like sole
trader, partnership firm with limited or unlimited liability or a Joint
stock company. It may also be a government or a semi-government
organization or corporation. The Auditor is expected to express his
frank opinion on the financial statements. The Auditor should adopt
a proper auditing procedure. He should present his report in the
required format if any format is prescribed by any law, applicable to
that particular business. In preparing his report, the auditor should
take in to account the special needs of the concern. The Auditors
report should be drafted in clear and unambiguous terms and in
simple language.

The Auditor should be straight forward and honest. He must

be fair and unbiased. He should be impartial. He should not have
any vested interests.

Integrity requires that the auditor should be honest and

frank. He should express his thoughts without any fear or favour.
Of course he must not disclose confidential matters. During the
course of his duties, he comes across number of confidential
matters of the business like margin of profit, formula for preparation
of a product etc. He must not disclose this information to anybody
including the competitors of is clients.

There is no doubt that the auditor should be a person of

integrity. But it will be difficult rather impossible to regulate the
characteristic of integrity of auditor by issuing audit standards
Therefore integrity is subjective and cannot be standardized by
 109

making law or by setting standards. As a matter of principle the

auditor should be a person of integrity. He should not only be
impartial but appear to be so. He should be free of any personal
interest so that the society does not doubt his integrity. This
standard was revised in 2008.

Skills and Competence :

Auditor should have adequate training and experience. He
should have good general education, technical knowledge and
practical experience. He is concerned with business which is
dynamic. There are lot of changes in the business and various laws
and rules and regulations about the same. He should keep himself
aware of latest developments, rules and regulations and statutory
requirements. In short he must be up to date in his knowledge
concerning his job. As for as the auditor of a joint stock company is
concerned, there is a legal requirements that he should have
passed the C. A. Examination conducted by the Institute of
Chartered Accountants of India. In case of sole trader or
partnership, though there is no prescribed legal qualification he
should be adequately qualified for his job. Auditor should prepare
his report with professional care. Auditor should insist that the
management adopts appropriate accounting system and adopt
proper policies in preparing financial statements.

Work performed by others :

When the auditor delegates work to assistants or uses
work performed by other auditors and experts, he will continue
to be responsible for expressing his opinion on the financial
information. So, before delegating work to subordinates and others,
he should give them proper detailed instructions about the
performance of the job and properly supervise the work done by
them. Because ultimate responsibility rests on him. However, he
will be entitled to rely on the 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. Indian companies Act
1956 permits audit of branches by other auditors. So, if any branch
audit is conducted by any other auditor, he must clearly mention
this fact in his report.

In short the Auditor cannot escape from the liability on the

pretext that he/ she delegated the work to his/her assistants who
did not do the work properly. The auditor continues to be liable or
responsible for the work performed by his assistants. He should
exercise due care in supervising the work of his assistants.

Documentation :
After the audit of a concern is complete, if anybody else
wants to check whether the work is done properly or not, he will
refer to the documents collected and used by the auditor while
 110

auditing the accounts of the concern. So, the auditor should

maintain systematically the audit working papers, vouchers etc.

Planning :
Auditor should properly plan his work before starting his
audit. For preparing a plan, he must study the special features of
the business of the client. He must get himself satisfied that. The
client is following a proper accounting procedure. If he finds any
defects in the system, he must suggest changes in the system.

To prepare a proper plan of his work :

a) He must study the internal check or control system and decide

how much he should rely on it.

b) The plan should be such as to co-ordinate. The work of

different subordinates. He should distribute the work amongst
his assistants in such a way that each one is capable of
handling the work allotted to him. As far as possible, work
should be distributed according to the liking of the
subordinates. Auditor should take into account the
qualifications experience and capacity of each subordinates
while allotting him the work.
c) Plan once prepared should be meticulously followed. However,
when there are any major changes in the circumstances which
warrant changes in the plan, Such changes should be done in
time.

Taking in to account the internal check system prevailing in

the business, the auditor should decide whether to check 100%
items or he can adopt test checking.

Audit evidence
The Auditor should insist on proper evidence. He should
design a proper procedure to obtain evidence. Evidence
produced should be complete, accurate and reliable.
Audit completion and reporting :
The end result of the auditing is the audit report and
conclusion. Auditor’s report should be based on evidence
obtained.
Auditor should finally report that :
a) Financial statements have been prepared after following
proper accounting policies. Policies should be consistently
followed. They should not be changed, unless there is a strong
reason for it. Whenever there is any such change in the
policies, auditor’s report should specifically mention the same
in his report.
 111

b) Auditor should report whether all statutory requirements have

been complied with or not.
c) He should also report that there is adequate disclosure of all
material facts.

Auditor’s report should be in a proper form. If any form is

prescribed by any law applicable to that business, it should be in
that form. e.g. Reports at Bank audit, Tax Audit etc. are to be
prepared in a particular form prescribed by the concerned Acts.

In the report, the Auditor should express his frank and

honest opinion.

When he has to give a qualified report, he should give his

reasons for the same.

CHECK YOUR PROGRESS

1) What are the contents of S.A. 200?

2) When was it introduced?
3) How the auditor should prepare a plan of his work?
4) What is the responsibility of the auditor for the work
performed by others?

5.5 S. A. 200 A

Objectives and scope of the audit of financial

statements :

Financial statements include balance sheet. Profit and loss

Account, cash flow statement and explanatory notes on the same.
In short general purpose financial statements prepared by every
business unit at the end of the year.

SA 200 A became operative from 1st April 1985 :

Financial statements are issued for the use of shareholders,

members, creditors, employees and the public at large.

Objectives of an Audit :

Following are the objectives of an Audit .

1) To make sure that financial statements are prepared after

following all accounting policies and practices and legal
requirements.
 112

2) To get convinced that the financial statements represent true

and fair view of the financial position and operating results, of
the enterprise. It should be remembered that the Auditors
opinion is only on the financial statements. Reader should not
assume that it is an opinion on the successful management of
the enterprise.

Financial statements are prepared by the management.

They should maintain proper books of the accounts. There should
be effective internal control system. Accounting standards
prescribed by the Institute of Chartered Accountants should be
meticulously followed. Assets should be properly safeguarded.
Audit of the financial statements does not relieve the management
of its responsibilities in this regard. That is why, it is said that
Auditing begins where accounting ends. i.e. with the preparation of
the final accounts.
Auditors’ opinion helps determination of the true and fair
view of the financial position and operating results of an enterprise.

Scope of Audit :
Scope of Audit is decided by the terms of engagement of
the auditor and relevant legal requirements, if any. Auditors
appointed for different types of organizations have to perform
different types of duties as per the laws applicable to respective
organizations. e.g. Auditor of a bank is expected to perform his
duties as prescribed by the Banking companies Act or Auditor of a
co-operative society has to perform his duties as per co-operative
Act etc. where there is no such special law, scope of his work is
decided by the letter of appointment or an agreement entered into
between the client and the auditor. In case where there is a special
law governing the affairs of the concern, the appointing authority
can increase the scope of audit of the Auditor but it cannot be
restricted.

Information contained in the records should be sufficient for

the auditor to form is opinion on the financial statements. Auditor
should be satisfied that the information contained in them is
reliable.
Before starting his work, Auditor should go through the
prevailing internal control system in the organization. If he comes
across any lacuna or defects in it, he must suggest suitable
changes in it.

Financial statements should disclose information properly.

Auditor should insist that accounting policies should be consistently
followed. Information should be properly classified and suitably
presented.
 113

Audit cannot be relied upon to ensure discovery of all frauds

and errors. As it is said the Auditor is a watch dog and not a blood
hound. If there is any indication of error or fraud. Auditor should
suitably change his method and reveal the same in his report. The
Auditor is primarily concerned with material (important) items.
Material items are those, which influence the decision. The Auditor
can decide what is material and what is not, on the basis of his
professional experience and judgment.

It should be remembered that the Auditor is not a technical

expert. He is only a financial expert. So he should express his
opinion only on the financial aspects.

Auditor should carry out enquiries and verify accounting

transactions. He should ensure that necessary information is
properly disclosed in the financial statements. He must compare
the financial statements. He must compare the data in the books of
accounts with the available evidence.

If the management has done any estimates in the financial

statements, auditor should get himself convinced that these
estimates are done on proper lines. The conclusions are drawn by
the auditor, on the basis of the evidence made available to him. So,
he is only expected to draw reasonable conclusions from it
Absolute certainly in auditing is rarely attainable. So, the auditors
report always starts with the words like “on the basis of the
evidence produced before me…… etc”.

The Auditor should be convinced that the financial

statements reflect a true and fair view of the financial position and
the operating results of the business unit.

Test checks are usually adopted in the conduct of the audit.

So, the Auditor can never guarantee 100% correctness of the
accounts or absence of any frauds. If he suspects anything fishy
during the course of his verification, he should go deep into the
matter. If the auditor is not fully satisfied, he should be bold enough
to qualify his report and explain his position clearly.

Audit procedure should be so organized as to cover all

aspects of the enterprise and all statutory requirements are
complied with. Auditor should satisfy himself that the financial
statements reflect the true and fair view of the financial position and
operating results of the enterprise.
 114

CHECK YOUR PROGRESS

1. What is an objective and scope of audit?

2. Who is responsible for the preparation of the financial
statements?
3. From what date SA 200 A is made applicable?

5.6 S.A. 210 (Revised)

Agreeing on the terms of auditing engagements:

Introduction :

The purpose of these revised standards on Auditing (SA) is

to establish standard on (a) agreeing the terms of the engagements
with the client and (b) the auditors’ response to a request by a client
to change the terms of an engagements to one that provides a
lower level of assurance.

This standard is made effective from 1st of April 2010 in its

revised form.

It deals with the Auditor’s responsibilities. Just like the

auditor has certain duties and responsibilities the managements
has also to fulfill certain responsibilities. Auditor should not accept
the appointment unless the management agrees to accept
responsibilities on its part. Examples of responsibilities of
management are like preparation of the financial statements in the
required form, there should be proper internal check system in the
organization, management should take proper care of the different
assets in the organization etc. It should always be remembered that
Audit begins where accounts end and the responsibility of
maintaining accounts is on the management.

The management should ensure that there are no material

(major or important) misstatements in the financial statements
prepared by it. Such material misstatements may be due to fraud or
error Frauds are purposely or knowingly committed whereas
mistakes may be honest mistakes due to negligence or lack of
knowledge. Auditors should ensure that there are no misstatements
due to both these causes.

Auditor should be provided with all relevant information by

the management. Management should also provide additional
information to the auditor as and when he seeks it. He should have
free access to all authorities including the top authorities, in the
organization. He should have the right to ask any questions to them
and seek information and explanation from any of them such free
 115

access is necessary for the auditor to collect all necessary relevant

evidence, to perform his work efficiently. If the management tries in
any way to restrict the scope of his work the auditor should refuse
to accept such assignment, if he feels that the restrictions are not
legitimate or reasonable.

The Auditor and the client should agree on the terms of

engagement. There should be a separate letter of appointment or a
regular contract. Such a letter or a contract should be executed
preferably before the actual commencement of the audit work. This
will avoid any misunderstanding at a subsequent stage. Such letter
of appointment should contain in detail. The objectives of the audit
duties and rights of the auditor and also the management
responsibilities like maintaining proper books of accounts, following
regularly all Accounting standards prescribed by the Institute of
chartered Accountants and consistently following certain
accounting policies. Accounting policies once accepted should not
be frequently changed. They should be changed only when there
is a strong and compelling reason for it. When the auditor comes
across such change in the accounting policy in any particular year
he should specifically mention the same in his report. The auditor
should be provided free access to all books of accounts and other
relevant records like correspondence etc. If necessary such letter of
appointment or contract, should also contain the details of the plan.
If at a later stage the auditor or the management feels that any
change is necessary in the terms and conditions of appointments,
the same may be made with the consent of both the parties.

Powers and duties of the auditor are decided by this letter of

engagement where audit of accounts is not legally mandatory. In
such cares sometimes, the managements may try to restrict his
powers or enlarge his duties. The auditor should not agree for such
change or restrictions, If he finds them unreasonable. If necessary
he should even give up the appointment, rather than accept any
unreasonable terms. In such circumstances the auditor should
resign and report the reasons that led to his resignation frankly to
the concerned persons. He should not succumb to the pressure of
any body. He should maintain his dignity and independent status at
any cost.

If there is any special law, under which the auditor is

appointed, the concerned law provides for his duties and
responsibilities. In such cases there is no need for special mention
of these things in the letter of the engagements. e.g. Auditor
appointed under Indian Companies Act 1956 or Banking
Regulations Act 1949 etc.

Many a times, the same auditor is appointed or reappointed

every year. In such subsequent or recurring appointments, the
 116

parties man consider afresh about the terms and conditions of

engagement. In such cases, a fresh agreement may be entered
into.

In the case of appointment of the auditor for a State or

Central Government or companies partly or fully owned by them,
there are special Acts which prescribed the duties and
responsibilities of the auditor. So there is no need to mention them
specially in the letter of engagements.

While reappointing the same auditor next year, if there are

any changes in the business of the concern, changes in the policies
or personal or a legal requirement, complete information about
these matters, should be given to the auditor by the management.

Though this standard SA 210 is primarily meant for the

appointment of auditor for the financial statements, it is also
applicable to related services offered by the auditing firms like
taxation matter management consultancy etc. For such services it
is better to have a separate letter of engagements contents of such
letters may be different for different clients depending upon the
nature of the business of each client. Such appointment letter may
also contain the basis on which the fees of the auditor are to be
calculated. Letter may also make mention about the taking of
services of some experts like valuers, internal auditors etc if any.

Auditors Report :

In some cases, the form of the auditor’s report is prescribed

by a special law applicable to specific kinds of organizations. In
such cases, the auditor should submit his report in that form only. If
he feels necessary, he is free to add further details to this report.

Letter of engagement is issued by the Auditor to the client. A

copy of the same may be returned to the auditor as an
acknowledgement. Though this is not compulsory, it’s an advisable
practice. Because it means that the terms and conditions in the
letter are known to the client and he has given his consent to them.

CHECK YOUR PROGRESS :

a) What is the need for the audit engagement letter?

b) What are the contents of such letter?
c) Should auditor accept changes in the terms once agreed upon?
d) Is the acknowledgement of the audit engagement letter by
the client necessary?
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5.7 AUDITING STANDARD 220

Quality control for Audit Work:

This standard deals with maintaining Quality in the audit

work. Quality is important in every walk of life and the Audit cannot
be an exception to it. Audit plays a very important part in any
business activity and importance of quality control in the same,
need not be over emphasized.

Audit is a group task. It involves following four types of people.

a) The Auditor means a person with final responsibility for the
entire audit work and audit report.

b) Audit Firm means either the partners of a firm providing audit

services or a sole practiomer providing Audit services. In
practice audit firms are more common than individuals providing
such services. This may be due to some inherent advantages in
the partnership firm specially in such types of professions.

c) Personnel means all partners and professional staff engaged in

the audit work of the firm or in other words, the staff actually
performing the job.

d) Assistants means personal involved audit, other than the

Auditor i.e. Persons like Articled clerks or regular employees in
the audit firm.

All these persons in the group have to follow the rules of

quality control to produce quality job.

This standard SA220 was made effective from 1st April 1999
in its revised form.

Special and conscious efforts are necessary to maintain

quality in the Audit work. Special policies are to be evolved and
meticulously followed by all the concerned. Such policies are to be
implemented at both (a) the level of Audit firm and (b) on individual
audits.

The Auditor has the final responsibility for the Audit. Audit
firms may be owned by a partnership firm or a sole trader. These
Audit firms have a number of assistants who actually do the
work of audit. All of them, may or may not be fully qualified
Chartered Accountants but they should be educated enough
and must be familiar with the audit work and the normal
procedure to be followed .
 118

Every Audit firm should implement quality control policies

and procedure to ensure that all audits are conducted in
accordance with Auditing standards. So, quality control policies
should be communicated to all the four categories of the above
personnel involved in audit. Role of each one of them is equally
important. This will ensure that the audit works is conducted
according to the prescribed standards.

Everybody concerned should understand thoroughly these

policies and actually implement them while conducting the audit
work.

The objectives of quality control policies

1) Every Audit Firm should adhere to the principles of

Independence, Integrity, Objectivity, confidentiality and
professional behavior as stated in SA 200. The Auditor should
be an independent person. He should not have any vested
interests in the firm whose books & accounts he is auditing. He
must not disclose secret information about the firm to outsiders.
As it is said, the Auditor should have his eyes and ears open but
his mouth shut. His professional behavior should be of a highest
degree.

2) The firm should have necessary skills and competence.

Personnel in the firm should be duly qualified as per legal
requirements and are competentt to undertake the work of audit.

3) The audit work is distributed by the auditor amongst his different

assistants. While dividing the work amongst different assistants,
the auditor should ensure that every assistant is duly qualified
and possess necessary skill and experience and is competent
enough to discharge the duties allotted to him.

4) While delegating the work, the chief Auditor should give proper
instructions and directions to all his assistants. Subsequently he
should supervise and review their work from time to time. While
so distributing or delegating the work, the Auditor should not
forget the famous principle of delegation in management that
only physical work can be delegated but the responsibility or
rather the final responsibility still continues to be on him. It
cannot be delegated. In other words, if the assistant commits
any mistakes in his work, the boss i.e. The Auditor is held
responsible for them. He cannot escape his responsibility saying
that he had delegated that work to his assistant. For success or
failure in the war, the army chief is responsible though he may
not have been on the actual war field.
 119

Here the recent action of the Institute of Chartered

Accountants is worth nothing. The Institute has permanently
debarred the Auditor of Sattyam Group of companies on account of
not detecting the scam.

5) The Auditor should discuss about the work with all his
Personnel from time to time. As and when there is any important
matter, he may also discuss the matter with the outside experts
in the field. There is nothing wrong in consulting or discussing
the matter with the outside experts. He should not a make it a
prestige issue. Quality of the work to be performed is of utmost
importance.

6) The Audit Firm should adopt proper personnel policies and

maintain good public relations. The existing clients should be
retained and all efforts should be made to secure new clients. In
retaining the existing clients and securing new ones, the auditor
should always adopt a decent policy. He must always remember
that Auditing is an honorable profession and he should always
maintain the dignity of the profession. He should secure new
clients without adopting any unfair means and without
compromising on his dignity.

7) Lastly the above quality control policies should be properly

monitored.

While distributing the work amongst different assistants,

Auditor should see that the right job is allotted to a right person.
Every person to whom a particular job is allotted, should be
properly qualified and competent to perform that job. Each one
should be allotted, as far as possible, the job of each choice, so
that he can do it sincerely and with utmost interest. Work should be
a pleasure for everyone.

In other words, personal likes and dislikes, should be taken

in to account while distributing the work amongst different
assistants.

Before assigning the job, the Auditor should fully explain to

him the job to be performed. He should be given detailed and
proper instructions necessary to do the job. Procedure to be
followed should be explained to him. He should also be given an
idea about the possible difficulties he may encounter while
performing those tasks. Overall Audit plan should be explained to
him and importance of his job in the overall plan should also be
explained to him.

The Auditor should then supervise the work being done by

his assistants. He should give them guidance as and when found
 120

necessary. Finally the work performed by them should be reviewed

by him from time to time.

Supervisor should monitor the progress of the work.

Whenever there are any differences between the professional
judgments of two persons, the supervisor should resolve the
difference. There should be open discussion or a consultation
amongst different assistants from time to time. Help of the outside
expert should also be sought if found.

Audit Review :

The work performed by each assistant should be reviewed

by competent persons. He should convince himself that the work
has been completed according to the earlier decided audit program
and the work done has been properly documented. Matters
discussed and resolved during the audit work should be recorded.
The objectives of the audit should have been fully achieved and the
audit conclusions are adequately supported by available evidences.

Audit program is prepared before the commencement of the

audit. However, this program should be reviewed from time
to time as there are possible changes in the circumstances. In
the case of large audits this review of the work may be
done by an outside independent expert completely or
partially .

Sometimes, one partner of the Audit Firm completes the

audit work but the same has to be finally certified by another
partner in the absence of the partner completing the work like his
death or any other compelling reason. In such circumstances the
partner actually certifying, should not blindly sign the documents
presuming that everything must have been properly done by the
previous partner. He should personally review the work done by the
previous partner. He should personally review the work done, go
through the relevant work papers and then sign the report and other
documents only if he is personally satisfied.

The purpose of this standard is to establish standards on the

quality control of policies and procedure of audit. Quality control is
necessary at individual as well as firm level. Rules regarding
professional requirements for the auditor should be strictly followed
delegation of work to the assistants should be done on scientific
basis. Work performed by the assistants should be reviewed by the
supervisors.

The Audit program is an important tool for the

communication of audit directions. Time budgets and overall audit
plan is also useful in communicating audit directions.
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CHECK YOUR PROGRESS

1) What are the different personnel involved in audit work?

2) What is the importance of quality control in audit work?
3) Date from which this SA 220 became effective?
4) What are the objectives of quality control policies?
5) Discuss the importance of proper distribution of job
amongst different assistants?
6) What is the importance of supervision and review in the
process of quality control policies?

5.8 SUMMARY
In this lesson you have studied the importance of standards
on Auditing and details about the following in three standards.
1) SA 200 which deals with basic principles governing Audit and
objective and scope of the Audit of financial statements.
2) SA 210 on agreeing the terms of Audit Engagements.
3) SA 220 Quality control for Audit work.

In view of the importance of the Audit, need for setting

standards for its conduct was felt necessary at international and
national level. At international level federation of Accountants
frames such standards and at national level Institute of Chartered
Accountants frames them. So far our Institute has issued 35
standard and they are all mandatory.

SA 200 deals with basic principles of audit like integrity,

independence, skills and competence, confidentiality, etc of the
Auditor. 200 A deals with objectives and scope of the audit of
financial statements. Financial Statements include Balance Sheet,
Profit and Loss Account, Cash Flow statements and other
explanatory notes on the same. The Auditor should be convinced
that the financial statements reflect a true & fair view of the financial
position and the operating results of the business unit.

SA 210 (Revised) deals with Agreement of terms of auditing

and engagements. The Auditor prepares this letter of engagement
stating, the terms and conditions of his appointment and actual
scope of his work. The method of calculation of his fees may also
be stated. This letter is prepared in duplicate and one copy is
returned back to the auditor by the client with his signature. This
means that the client agrees with all the terms stated there in.
Sometimes need may arise to amend the terms agreed upon or the
client or the auditor may seek for such change. Auditor should
agree for such changes only if he finds that they are reasonable.
Auditor should always maintain the dignity of his profession.
 122

The Auditor has a right to access to all books of accounts

and other relevant documents. He has access to all officials of the
concern and he can ask them explanation as and when he feels
necessary. While reappointing the same auditor next year, terms of
engagement may be changed if found necessary with mutual
consent.

SA 220 deals with quality control for Audit Work Quality

control procedures should be evolved for all the four concerned
personnel namely the Auditor Audit Firm, professional staff and
assistants. Every staff member engaged in the audit work should
be duly qualified and possess necessary experience in the field
Detailed instructions should be given to the assistants by the
auditor, while dividing the work amongst different assistants. Right
man should be given the night job. There should be strict
supervision over the work of the assistants and their work should
be reviewed by competent superiors from time to time. Help of
outside experts may also be taken as and when found necessary.
Old clients should be retained and new clients should be secured
maintaining the dignity of the profession. Progress of the work
should be monitored by the supervisor and time schedule framed
for audit work should be adhered to as far as possible.

5.9 QUESTIONS

1. What are the basic principles that govern an audit?

2. Explain the importance of maintaining confidentiality by the
auditor?
3. “Auditor should keep his eyes and ears open but his mouth
shut”. Explain.
4. Who is responsible for the preparation of financial statements?
5. Explain the importance of Letter of Engagement.
6. Fill in the gaps.
a) SA 200 deals with -------------
b) SA 210 discusses --------------
c) Quality control for Audit work is discussed by SA -----------------
d) SA 200 was made effective from -------------
e) SA 210 is applicable to all audits conducted on or after ---
----------
f) SA 220 is made effective from -------------
g) Audit standards are passed in India by --------------
h) So far ------------- standards on Audit have been prepared.



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6
THE STANDARDS ON AUDITING
230,240, AND 300
Unit Structure :
6.0 Objectives
6.1 Introduction
6.2 Audit Standard 230 (revised)
Audit Documentation.
6.3 Audit Standard 240 (revised)
The Auditor’s Responsibilities Relating to Frauds in an Audit
of Financial Statements.
6.4 Audit Standard 300 (revised)
Planning an Audit of Financial Statements.
6.5 Summary
6.6 Questions.

6.0 OBJECTIVES

After studying the unit the students will be able to understand:

 Utility or usefulness of working papers as per AS 230
 Matters arising after the date of auditor’s report as per AS
230
 Ownership of working papers as per AS 230
 Responsibility of Auditor for frauds and errors as per AS 240
 Definition and procedure for Audit Planning as per AS 300

6.1 INTRODUCTION:

In the earlier chapter you studied Audit Standards 200

(revised) dealing with Basic Principles that govern an Audit, S. A.
200A on objectives and scope of the Audit of Financial Statements,
SA 210 (revised) on agreeing the terms of auditing engagements
and SA 220 on quality control for Audit Work. In this chapter you
will be studying the next three standards on Audit namely SA 230
(revised)on Audit Documentation, SA 240 (revised) The Auditor’s
Responsibility is relating to Frauds in Financial Statements and
SA300 (revised) about planning an audit ofFinancial Statements.
Now let us study them one by one.
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6.2 AUDIT STANDARD 230 (REVISED) AUDIT

DUCUMENTATION:

This standard deals with documentations to be prepared for

Audit of Financial Statements. Documentation refers to the working
papers prepared and obtained by the Auditor. They are to be
retained by him. During the course of audit, auditor collects number
of papers, they are called documents or working papers and they
are to be retained carefully in a file.

Utility or usefulness of working papers:

Documentation means the evidences on the basis of which

the auditor draws his final conclusions. The auditor should maintain
such evidence to show that the audit was performed in accordance
with the set procedure prescribed by different SAs (Standards On
Auditing). These papers also prove that necessary legal
requirements have been properly fulfilled. These documents assist
the audit team to prepare their audit plan. As per SA 220 on quality
control, supervision and review of audit work is necessary.
Documentation facilitates the work of supervision and review of
audit work. This paper also facilitates the work of audit of the
auditor in subsequent years. They are also useful for controlling the
quality of the audit work done.

Audit documentation means the record of the audit

procedures performed, evidences obtained and the conclusions
drawn by the auditor. On their basis audit file may be prepared
storing all this necessary data. The file may be prepared in a
physical form or electronically as per the normal practice followed
by the auditor. However, the present trend is to prepare the file
electronically as it is more safe and convenient store and to refer
back as and when required.

For proper documentation, the auditor should have proper

knowledge of the audit process, knowledge of relevant standards
and the business environment of the particular business whose
accounts he is auditing. These documents should be prepared in
time, preferably during the course of audit or as soon as the audit is
completed. Such file should be prepared at the most within 60 days
of the completion of the audit. If there is delay in preparation, the
data collected may not be 100 percent correct.

Auditor should keep a proper record of all verification done

by him during the process of audit. He should keep a record of
various discussions on important points; he had with different
concerned officials of the client. He must also note down the
evidences he inspected and the conclusions he had arrived at.
 125

There should be a proper record of who performed the audit

with date and time of performance. Similarly there should also be
the name of the person who supervised and the name of the
person who reviewed the work with date and time. Such record will
be very useful to fix responsibility for any mistake committed when
any enquiry is conducted subsequently.

During the course of audit the auditor has to discuss different

matters with different authorities of the client. He should note down
important points of such discussion and the names and
designations of such officials with date and time. (If he discusses
certain matters with some outside experts, he should keep record
of such discussion with the name of the expert, date and time)

Sometimes, the auditor may have to follow a different

procedure for the audit of a particular firm. This procedure may be
different from the normal procedure followed in case of other audit.
In such circumstances, the auditor should give details of the
procedure he followed and justify giving reasons, his decision to
follow such a different procedure in this particular case.

The auditor should collect all necessary papers required by

him for his audit work promptly. This will help him in completing his
work in time and also help him to improve the quality of his work.

The form, content and extent of documentation depend upon

the size and complexity of the business of the client. It also
depends upon the nature of audit procedure adopted and the
significance of evidence collected etc.

Examples of documents to be collected are:

(a) Audit Programme

(b) Letter of confirmation of engagement
(c) Representation submitted to the management if any
(d) Other correspondence conducted during audit work etc.

The auditor may also record the different legal documents

agreements etc. that he verified during the course of his audit.

However it should be remembered that above documents

are not a substitute for regular books of accounts.

Audit documentation should be sufficient and appropriate in

the prevailing circumstances. There can not be any hard and fast
rule about the same. Auditor should use his discretion on the basis
of his past experience.
 126

Some standards on audit (SAs) have specifically prescribed

certain documentation. Such documents must be there in the file. In
addition the auditor may include some additional documents which
he feels necessary even though the SAs have not prescribed them.

These various documents in the file go to prove that the

audit work has been completed according to different standards
prescribed. However it is not necessary or practical to have
documents for every matter considered or judgement made by the
auditor. Only important points should be documented.

Audit plan in the file proves that the auditor has properly
planned his work. A copy of letter of engagement proves that the
terms of audit have been agreed upon by the auditor and the client.

Auditor should make documentation of all important

professional judgements he has made during the course of the
audit. Such records are useful to those who subsequently review
the work of audit. Similarly these documents are also useful to the
auditor who audits the accounts of the concern next year.

Management’s might have made some estimates in the

accounts. The decision of the auditor on the point of the
reasonableness or otherwise of these estimates is an example of
professional judgement. Auditor may also decide during the course
of audit, whether the evidences or documents produced before him
are authentic or not.

In case audit of large concerns it is not physically possible to

verify or check each and every item. It may also be not necessary if
there is a reliable internal check system. In such cases the auditor
adopts the method of test checking. For Example, he may decide to
check all items of purchases for a particular period or all purchases
for an amount above a particular figure etc. Thus he may adopt
some criteria in selecting the items for detailed checking. This fact
should be recorded in his notes.

If the size of the business entity audited is small, the

documentation required may also be on a small scale. However in
case of large concern, documentation may have to be done on a
large scale. SAs are designed to achieve overall objective of the
audit. So, the documentation requirement applies only to
requirements that are relevant in the circumstances. As seen earlier
there cannot be any hard and fast rule about the extent of
documentation in each case. The auditor has to use his discretion
and decide.
 127

Matters arising after the date of auditor’s report:-

During the course of audit sometimes the auditor misses

certain important items. They may come to his notice, after he
finalised his report. In such cases, he must recheck the accounts
and amend his report accordingly. He must record in writing
reasons for adopting this course of rechecking of accounts.
However such course is adopted only if the matters escaping his
attention earlier are important.

SA 220 on quality control requires that the auditor should

establish his policies and procedures at the very outset so that he
can complete the audit in time. All audit papers should be carefully
retained at least for a period of ten years after the completion of
audit report as per the provisions of Institute of Chartered
Accountants Act, 1949.

Working papers are evidences of the actual work done by

the auditor. They explain how the auditor arrived at his conclusions.
Efficiency of the work increases with the proper maintenance of the
audit papers. Work can be equitably distributed amongst different
assistants and the quality of the work done can be controlled. If any
mistakes are later noticed, responsibility for th mistake can be
easily fixed with the help of these working papers. Because, you
can easily find out from these papers, what part of the job is
performed by every assistant. If any court cases arise
subsequently, working papers can be produced as evidence of
work done.

Number and nature of working papers is decided by the size

and nature of business of the client. Audit papers may consist of
things like Memorandum of Association and Articles of Association
of the company, Partnership Deed in case of a partnership firm,
Minute Books of different meeting held in the company, Letter of
Engagement, Annual Financial Statements, etc. Some of these
papers are of permanent nature whereas others may pertain to the
affairs of the current year only.

I A permanent audit file normally includes the following:

(1) Information concerning the legal and organizational structure

of the entity. In the case of a company this includes-
(2) Memorandum and Articles of Association, in the case of a
statutory corporation, this includes the act and regulations
under which the corporation functions and in the case of
partnership firms the Deed of Partnership etc.
(3) Extracts of copies of all important legal documents,
agreements and minutes relevant to the audit.
 128

(4) Details about the internal control system in the organisation

(5) Copies of audited financial statements of previous years.
(6) Significant ratios and trends calculated.
(7) Letters issued by the management to the auditor
(8) Correspondence with retiring auditor if any.
(9) Details of accounting policies.
(10) Important audit observations of earlier years etc
(11) Name, nature and complexity of the business of the client.

II The current file may contain the following documents:

(1) A copy of the letter accepting annual reappointment.

(2) Minutes of Board Meetings and Shareholders’ General
Meetings in connection with accounts
(3) Current years’ Audit Programme
(4) Analysis of transactions and balances
(5) Audit procedure followed.
(6) Distribution of work amongst different assistants.
(7) Correspondence of the auditor with third parties, other auditor
and experts if any
(8) Details of matters discussed with the client and his different
officials
(9) Letter of representation or confirmation from the client etc.

Ownership of working papers:

There is a controversy about the ownership of the working

papers. Some people argue that it lies with the auditor as he has
prepared them. Others argue that as they contain important and
confidential information about the business of the client, ownership
is with the client. However now it is settled that ownership belongs
to the auditor only. But he is duty bound, not to disclose any
information in the working papers to outsiders. As per SA 200 and
code of conduct the auditor is expected to maintain secrecy about
the business of the client. If it is found that he discloses any secret
information to any outsider, the Institute of Chartered Accountants
can take action against him for violation of code of conduct or for
such unprofessional behaviour.

However, there is a decided case of Supreme Court on the

lien of auditor. In the case of R. D. Saxena v/s Balram Prasad
Sharma in 2000. The Supreme court has held that the auditor has
no lien on these papers and he cannot retain them with him for non
payment of his fees. If his fees are not paid, he can adopt regular
legal procedure to recover his dues.
 129

The normal practice is that the auditor keeps these

papers with him as they are useful to him to defend himself if any
case is filed against him subsequently for negligence in duty etc.
(however he should adopt a reasonable procedure for the safe
custody and confidentiality of these working papers).

If the accounts of the branches are audited by different

auditors, the principal auditor has no legal right to demand the
working papers of the branch. However, he can ask for Xerox
copies of certain documents as he prepares his final report on the
basis of the reports of the branch auditors. At any rate cooperation
and co-ordination between the principal and the branch auditor is
necessary for the smooth working of the audit process.

Some of the working papers like schedules etc may be

prepared by the client’s personnel. However the auditor should
accept such papers only after duly verifying their correctness.

In short the working papers should be sufficiently complete

and detailed and they should be properly designed and carefully
retained.

Auditor should finally prepare his report. At the conclusion of

the work, he should prepare a short report or summary of the work
he has done, what problems he faced and how he solved them etc.

In its original form the standard was made effective from 1st
July, 1985. However SA 230 was implemented in its revised form
from 1st April, 2009.

Audit Note Book,

In addition to the file of documents, usually the auditor

maintains a special note book or diary in which he notes down all
important figures and points he comes across during the course of
audit and the summary of important points on which he had
discussion with different officials of the client. Such note book will
help the auditor in preparing his find report. It can also be
presented as evidence in the court of law, if any case is filed
against him for negligence etc. Auditor can also get information
about the progress of the work from this note book.

CHECK YOUR PROGRESS

1) What is documentation?
2) What it is its importance?
3) Who has the ownership of working papers?
4) Examples of permanent documents and current papers.
5) Date from which the SA was made effective.
 130

6.3 AUDIT STANDARD 240 (REVISED)

(THE AUDITOR’S RESPONSIBILITIES RELATING TO
FRAUDS IN THE AUDIT OF FINANCIAL
STATEMENTS.)

The auditor is appointed to verify the correctness of the

accounts. It is his duty to detect and prevent errors and frauds. He
has to certify that the statements of accounts i.e. balance sheet,
profit and loss account, cash flow statements and other
accompanying documents, do not have any misstatements and
they reflect true and fair view of the financial position of the
concern.

However, we cannot say that the account statements

prepared by the auditor after auditing the accounts are hundred
percent correct and all the errors and frauds have been detected
and set right. After all the auditor is also a human being and there
are possibilities of errors and frauds in the account statements even
after they are audited. They may be noticed subsequently. After all
the auditor is not an insurer. This standard on audit deals with the
responsibility of the auditor if errors or frauds are subsequently
noticed in the statement of accounts.

Misstatements in the account statements are due to errors

and frauds in the accounts. So, let us now consider the difference
between errors and frauds.

Though both falsify the accounts, there is a basic difference

between the two. Errors are committed by the employees
inadvertently due to lack of knowledge of principles of accounts or
through oversight etc. but the frauds are committed by the
employees, management or other third parties connected with the
concern intentionally to make some illegal gain.

Let us consider further details about them.

ERRORS
Errors are unintentional misstatements in the financial
statements. They include omission of certain information or honest
mistakes in calculation of some data or incorrect estimate of some
figures through oversight. There may also be mistakes in
application of accounting principles or wrong classification or
presentation of data.
There are four types of errors.
(1) Errors of commission
(2) Errors of omission
(3) Errors of principles
(4) Compensating errors.
 131

(1) Errors of Commission.

Here a transaction is recorded wrongly in the books of
accounts. Examples of errors of commission are posting errors (like
posting a wrong amount or posting to a wrong side of the account
or posting to a wrong account etc), casting or totalling errors, carry
forward errors and errors of duplication. Error of duplication means
the same transaction is entered twice by mistake.

(2) Errors of omission.

Here a transaction is not recorded wholly or partially.
Example of partial error is posting an entry on one side only. Here
the trial balance will not agree. However if there is a total omission,
the trial balance will agree in spite of this error. So, comparatively it
is easier to detect a partial omission than to detect a complete
omission

(3) Errors of Principle.

Here a transaction is recorded in an incorrect manner. Such
errors may be committed due to lack of knowledge of accounting
principles. They may or may not affect profits. However, such errors
may also be intentionally committed to inflate or deflate the profits.
E.g. repairs to machinery may be debited to machinery account to
inflate profits or purchase of some small machinery may be debited
to machinery repairs account to deflate the profits. etc.

(4) Compensating errors.

Here one error is compensated by another error. Trial
balance here will agree. Such errors may or may not affect profits.
As the trial balance agrees it is rather difficult to detect such errors.
Possibilities of purposely committing such errors can not be ruled
out. Such errors may be committed to conceal some other major
fraud. So, the auditor should make extra efforts to detect such
errors.

All the above types of errors can be easily detected during

normal audit procedure if they are not intentionally committed.

Errors may be committed by the employees due to their

ignorance of the subject matter or mere carelessness.

FRAUDS

Definition:-

SA 240 defines the fraud as follows: “ fraud is a an

intentional act by one or more individuals among managements,
those charged with governance, employees or third parties
involving the use of deception to obtain an unjust or illegal
advantage”.
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Fraud is a broad legal concept. But the auditor here is

concerned with only frauds that cause material misstatement in the
financial statements. Fraud may involve misappropriation of asset
or only misstatement that affects the final conclusions to be drawn
from the financial statements.

Though this standard speaks only about frauds and errors in

the financial statements, special laws and regulations may require
the auditor to follow special procedure in respect of certain types of
concerns. The auditor, while planning his work, should evolve such
a procedure that misstatements errors and frauds are avoided and
duly corrected when detected.

Misstatements in the financial statements may arise from

frauds and errors. Errors are unintentional but frauds are committed
by some employee, management or some third party for deceiving
somebody to gain some illegal advantage. That way fraud is a
broad legal concept. Auditor is not expected to decide whether a
legal fraud has been committed or not. He is only concerned with
misstatement in the statement of account with fraudulent intention.
If the fraud is committed by the management it is called
management fraud and if the same are committed by the
employees they are called “employee frauds”. In both these cases,
some outside parties also might have played some role. Fraud may
involve misappropriation of cash or some other asset.

Here there is a misstatement or omission of an amount done

purposely to deceive the users of financial statements. There may
be manipulation, falsification or alteration in the account records.
Fraud may also be committed by producing false supporting
records or documents like bogus bills or vouchers etc on the basis
of which the accounts are prepared.

Misappropriation of assets means there may be theft of

some tangible assets. Payments may be made for the goods which
are not actually acquired or received. Furniture, air conditioners etc
purchased for office out of office funds may be actually used at
home by the people in the management. False records may be
prepared to conceal the facts.

Frauds are intentionally committed to gain some financial

benefit. Individuals commit frauds to live a luxurious life beyond
their means. Financial position of the business is shown better than
what it is to deceive the new investors or lenders like banks. This is
called window dressing in the technical terms. Secondly the
financial position may be shown worse than what it is to encourage
existing investors to sell off their shares. Profits may by suppressed
to avoid Government taxes like Income Tax etc.
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In fraud there is deliberate concealment of facts. Sometimes

the management is under some pressure to show achievement of
certain targets. When they fail to achieve these targets, they try to
falsify the accounts to present a wrong financial picture.

Responsibility of Auditor for frauds and errors

No doubt the auditor is appointed to find out the errors and
frauds in the accounts. It is his duty and he is paid for it. However it
should be remembered that the auditor is not an insurer. We cannot
say that audited accounts are free from any errors or frauds and
that they are hundred percent correct.

First thing we have to remember here is that primarily it is

the duty of the management to take all necessary steps to prevent
frauds. Management should arrange the things in such a way that
there is no scope for the employees as well as the management to
commit frauds. The vary atmosphere should be such as to be
deterrent to commit frauds. There should be a culture of honesty,
integrity and ethical behaviour in the organisation. There should be
effective internal check system and strict supervision on the staff so
that nobody can venture to commit fraud. As it is said, prevention is
always better than cure. Instead of spending time, money and
energy, subsequently on taking action against the persons
committing the frauds, it is always advisable to arrange the things in
such a way that there is no scope for committing frauds. There
should be checks and counter checks.

However the auditor is held responsible if he is negligent in

his duties. As per SA 200 the auditor shall maintain an attitude of
professional scepticism throughout the audit, recognising the
possibility that a material misstatement due to fraud could exist.
Normally the auditor may accept that the records and evidences
produced before him are genuine. However if he comes across any
slightest possibility of fraud, he must go deep in to the matter to find
out the truth.

The purpose of this standard is to establish standards on the

responsibility to consider frauds and errors in the audited financial
statements.

The auditor while planning his audit work should evolve such
a procedure that misstatements, errors and frauds are avoided.
Initially he must discuss the matter with the management and ask
them if they suspect frauds in any particular matter.

Auditor should always remember that the audited financial

statements are used by the shareholders, Government department
to assess tax liability, prospective lenders like banks and other
financial institutions and prospective investors. All these people
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believe that the statements of accounts certified by him are fully

correct. So, he must try his level best to live up to their
expectations.

It is the responsibility of the auditor to conduct the audit in

accordance with the various auditing standards accepted in India
and see that the statements of accounts are free from errors and
frauds and there are no material misstatements in the accounts.
Audit should act as a deterrent. However, the auditor can not be
always held responsible for prevention of frauds and errors as there
some are limitations of audit.

Limitations of Audit :
There are some inherent limitations of an audit. It is just
possible that even though the audit is properly planned and
conducted some frauds and errors may not be detected.
Sometimes the frauds are carefully planned and committed and
concealed by the management. In such cases they may not be
easily detected by the auditor in his routine checking. An audit does
not guarantee that all material misstatements will be detected. An
audit may only provide a reasonable assurance. The possibilities of
not detecting frauds are more than the possibilities of not detecting
errors. This is because the frauds are committed intentionally after
careful planning by the persons in authority. The usual audit
procedures followed for detecting errors, may not be equally
effective in detecting such frauds. As we have seen earlier, frauds
may be committed by the employees, management and even by
some connected third parties. Between the frauds by the
management and the employees it is easier to detect those
committed by the employees than those committed by the
management. If material misstatements are subsequently detected
in the account statements, it cannot be concluded that the auditor
has not properly planned his work or he was negligent in his duties
or he is incompetent or auditing standards have not been complied
with by him. In other words, in spite of the auditor doing his job,
carefully following the normal audit standards, the possibilities of
errors and frauds in the statements, cannot be completely ruled out.
Still the auditor should not always proceed with a presumption that
in every statement, there are bound to be errors and frauds and
that everybody dealing with the accounts is a crook. He must start
his work with an unbiased attitude. That is why the auditor is
described as a watch dog and not a blood hound. He should
generally go ahead in his work on the assumption tha all the
documents produced before him are genuine. However, if he
comes across any slightest suspicious matter, he must go deep in
to the matter and use all his experience and skill to find out whether
there is really any fraud committed in the accounts. Still an audit is
not intended and cannot be relied upon to disclose all irregularities
in the accounts. However, on his part the auditor should do his level
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best to ensure that all frauds and errors are discovered. The auditor
is required to conduct the audit by exercising reasonable care and
skill. He will be held liable only if he failed to exercise reasonable
care and skill expected from a man of his calibre. Auditor’s
performance is tested on the following criteria. He will be held
responsible only if

(1) He has not exercised reasonable care and skill or

(2) There was room for suspicion and still the auditor did not go
deep in to the matter to find out the truth, or
(3) He was not followed the normal audit procedure.

Auditor will not be held responsible, if he proves with the

help of his working papers that he has followed adequate
procedures and that the errors or frauds were carefully concealed.

If the auditor has identified a fraud, he should communicate

the same to the concerned persons in the management. If their
response to it is not reasonable he should even decide to withdraw
himself from the assignment. He must resign immediately and
convey his reasons for doing so to the management and in case of
joint stock company even to the shareholders who are the real
owners of the company. If then the management appoints a new
auditors in his place, such new auditor is expected to communicate
with the previous auditor before accepting the assignment as per
the professional code of conduct prescribed by the Institute of
Chartered Accountants of India. At that time, the auditor should
frankly convey to the new auditor his real reasons for withdrawing
from the assignment.

CHECK YOUR PROGRESS:-

(a) Meaning and kinds of errors

(b) Frauds
(c) Difference between the errors and frauds
(d) Auditor’s responsibilities in case errors and frauds
(e) Limitations of audit

6.4 AUDIT STANDARD 300 (REVISED)

(PLANNING AN AUDIT OF FINANCIAL
STATEMENTS.)

A simple definition of planning is thinking in advance or

thinking before doing. Planning is necessary, in all works of life and
auditing cannot be an exception. Planning or thinking before doing,
helps us in a number of ways. When we think in advance, we can
collect all necessary men and material to complete the job. We can
think in advance about the problems likely to arise while doing the
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job and think out the solution for these potential problems. We can
decide the time schedule for the job and complete it in time as per
the time table prepared. It its said that pre informed is pre armed.
So, if we know in advance the possible difficulties we are likely to
face, we can consult outside experts and discuss with them the
problem. If the work is planned in advance, th quality of the work is
also likely to better.

Definition of Audit Planning:-

This standard on audit deals with the preparation of audit

plan by the auditor. This AS came into effect from 1st April,2008.

Audit planning is defined as planning by the auditor to

enable him to conduct an effective audit in an efficient manner. It
includes planning about area, scope, depth of transaction to be
audited, time to be devoted, persons to be deployed for audit etc.

AS 200 which deals with the basic principle of audit states

that the auditor should plan his work to conduct an efficient audit in
an efficient and timely manner.

Process or procedure for Audit Planning:

To begin with the auditor should visit the client’s office and
factory if any and collect full information about the nature of the
business and process of manufacture. This information will be very
useful to him while doing his job. Then he must familiarise himself
with the different laws governing the client’s business. Auditor’s
knowledge about these laws and other regulations regarding this
business should be up to date. Then the auditor should study the
accounting method followed by the client and note down the names
of different officers and their duties. This information is very
important because, if he comes across any problem during the
course of audit, he can discuss it with the concerned official
directly. Auditor should also study the internal control system
prevalent in the organisation and on the basis of his knowledge and
past experience, decide how far this system is effective and to what
extent he can rely on it. If there is an internal auditor for the firm, he
should collect information about his duties. This will help him to
decide whether it is necessary to check each and every item or he
can adopt the system of test check, and thoroughly check few items
selected at random. With complete information about the business,
he should proceed to prepare a plan.

He should then assess the amount of total work to be

completed and how many persons are necessary to complete the
work as per the time schedule. After deciding the required number
of staff, he should identify the particular persons from his staff, ‘who
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are to be deployed for this work. Then the work to be completed is

distributed amongst the designated staff. In allotting the work to
different members of the staff, he should take in to account the
qualifications, experience and capacity of each staff member and
then allot to him the necessary job. Personal likes and dislikes of
the staff, in doing different types of work should also be taken in to
account.

Then he must prepare a time table and allot time for each
work and direct the members of the staff to complete the work
allotted to them in the given time. First he may fix dates for different
part of the work to be completed and then divide the time amongst
the staff and ask them f\to complete each part of the job as per the
time table.

Such a detailed time table or audit plan is an important

document and should be carefully preserved.

The plan prepared should not be rigid or unchangeable. It

should not be treated as sacro sanct. As and when there are major
changes in the circumstances, he should suitably alter the plan.
Though the plan is to be prepared before the commencement of the
work, the auditor should see to it as a continuous process
throughout the audit engagement. Before finalising the plan, the
auditor should discuss it with his staff and carefully consider the
suggestions if any, made by them. Because finally the success of
the plan will depend upon the performance of the staff only.
Secondly the auditor should also discuss the plan schedule with his
client and take in to account the convenience of the client.
Because, co-operation of the staff of the client is necessary
throughout the process of audit.

The objective of the auditor in preparing such plan is to

complete the assignment in an effective manner. An auditor shall
establish an overall audit strategy that sets the scope, timing and
direction of the audit. He should ascertain the objectives of his
engagement.

On the basis of his past experience he should decide the

important points where frauds and errors are likely to be committed.
Then he should direct more attention on those points. More detailed
scrutiny of such items must be done.

The audit plan should also provide for effective supervision

on the work of the subordinates. Their work should be reviewed by
the partners in the firm from time to time.

The nature and extent of planning will depend upon the size
and complexity of the business of the client.
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The auditor should take in to account last year’s plan and

taking into account the changes in the size and nature of the
business during the current year, modify the previous year’s plan
and make it suitable for the current year.

Initial Audit Engagement:-

When the auditor takes up the assignment of audit of an entity for
the first time, he must spend more time on understanding the
nature of the business of the firm. Here he must follow the
procedure prescribed by SA 220 regarding the audit engagement
like sending a letter of engagement containing in detail all terms
and conditions, the actual work to be done conditions of his
appointment, his duties and method of calculation of his fees etc.
and get it approved by the client.

Secondly, as per the rules prescribed by the Institute of

Chartered Accountants as code of conduct for its members, the
auditor should contact the earlier auditor and seek no objection
certificate from him. This is the normal practice followed by all
chartered accountants. Every auditor should meticulously follow
this procedure, every time he accepts a new assignment which was
audited earlier by a different person. If he fails to follow these rules,.
The institute may initiate action against him for the breach of code
of conduct.

We have number of laws applicable to different industries

and audit reports to be prepared for different industrial units also
vary. So, the auditor should know all these different laws and
amendments to them from time to time. He should prepare the
audit reports accordingly. The auditor should take into account
these different t laws while preparing the audit plan. If necessary an
auditor should take the assistance of different experts from outside.
He must assess the high risk areas and deploy more qualified and
experienced staff to do that job. The auditor has also to fix the
sequences of the different procedures to be followed i.e. which
work should be done first and which one next etc and follow it.

Audit of smaller entities:

The procedure of audit and the total work to be completed

will depend upon the size of the unit. So, naturally in the case of the
audit of smaller entities, the entire audit may be conducted by a
very small audit team. As the team here is small, co-ordination and
communication between the team members is rather simple.
Planning for such audit may not require more time. Time for
planning will always depend upon the size of the unit. A short
discussion with the owner and slight modification here and there of
last year’s audit plan may suffice.
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Audit of larger concerns:

In the case of larger concerns, a detailed plan may

have to be prepared. So the number of the staff doing the job will
also be more. Here frequent meetings of the staff may have to be
held to co-ordinate the work of different members.

Change in the plan:

Sometimes, during the course of audit there may be

changes in the condition. New evidence may be produced and
change in the audit plan and audit strategy may be found
necessary. Time schedule decided may also be required to be
changed. The auditor may come across new information during the
course of audit. Conclusions drawn earlier may have to be altered
or amended accordingly.

There is need for direction supervision and review of the

work done by the junior staff from time to time. If the partner of the
firm of chartered accountants is personally auditing any particular
business entity, then there is no need for any supervision and
review of work as he is duly qualified and expert in his job. The
question of supervision and review arises only when the job is
assigned to the junior staff or articled clerks.

Documentation:

During the course of audit the auditor should collect and

preserve the following documents:
(1) The detailed audit plan
(2) Key decisions taken during the course of audit
(3) If the audit plan is subsequently altered, the auditor should
record in writing the reasons for such changes.

Advantages of preparing an Audit Plan:

(1) Planning helps the auditor to devote appropriate attention to

important areas of the audit.
(2) Solutions may be found out in advance
(3) Audit work can be organized and managed in an efficient
manner.
(4) Audit assignment can be completed in time
(5) The staff is fully and properly utilised
(6) There is proper co-ordination between the work of different
assistants
(7) An audit programme is a good tool. For effective delegation
of work to assistants.
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Audit programme would be prepared for each major area like

verification of fixed assets and inventories, debtors and creditors
etc. In the case of debtors the auditor should confirm that they
actually exist. For what he should send confirmatory requests for all
high level debtors. Its is necessary to verify inventory and cash
balance of the last working day. But to do so at each and every
place, may not be physically possible. So, he must do it before or
after the year end as per his convenience and a roll forward or roll
backward as the case may be should be performed.

CHECK YOUR PROGRESS:

(a) Need for planning.

(b) What is an audit plan?
(c) What are its advantages?
(d) What is the procedure of preparing the plan?

6.5 SUMMARY:

In this chapter you have studied the following three

standards on auditing.

(1) SA 230 (revised) on audit documentation.

(2) SA 240 (revised) on auditor’s responsibilities relating to
frauds and errors in a audit of financial statements.
(3) SA 300 (revised) planning an audit of financial statements.

Documentation:

Documentation means working papers prepared and

collected by the auditor during the course of his audit procedure.
They help the auditor in the planning and performance of audit.
Documents are to be carefully preserved. They include audit plan,
audit procedure, important conclusions drawn, evidences obtained
etc. They are useful to the auditor to defend himself in the court if
any case is filed against him in future for negligence. They are
classified in to permanent and current audit files. They are the
property of the auditor.

Auditor’s responsibility for frauds and errors:

Frauds are purposely committed to gain some illegal benefit.

Errors are unintentional. Detecting them is the duty of the auditor.
However the primary duty of avoiding them is with the
management. Management should arrange for proper internal
check system to avoid frauds and errors. However, the auditor will
be held responsible for them if he has not followed the normal audit
 141

procedure and he is found to be negligent in his duties. There are

inherent limitations of audit.

Audit Planning:

Audit work should be properly planned in advance. Auditor

should first study the nature of the business of the client. Required
number of suitable staff should be deployed for the work. The
volume of work should be properly distributed amongst the
assistants, taking in to account their capacity, knowledge and
experience. Auditor should give them proper direction and
supervise and review their work from time to time. Plan once
prepared should be suitably altered if there is change in the
circumstances or new evidence comes to light. Auditor should also
prepare a time budget and follow the implementation of the time
budget from time to time.

6.6 QUESTIONS:

1. What is documentation? Why is it required?

2. Who is the owner and custodian of working papers?
3. What is a permanent and current audit file and what
documents they should contain?
4. Define fraud and errors and set out difference between the two
with examples
5. Whose primary responsibility is it to detect frauds and errors?
6. What is the auditor’s responsibility to prevent and detect
frauds and errors?
7. Why is audit planning required? What are its benefits?
8. What are the factors considered by the auditor while preparing
the audit plan?
9. Fill in the blanks.
a. SA 300 deals with ________.
b. SA 230 (revised) is in force from _______.
c. Working papers are classified into (i) ______ (ii) ________.
d. Audit plan is prepared ______ the commencement of the
audit.
10. Write short notes on
a. Audit note book and.
b. Audit of smaller entities.


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THE STANDARDS ON AUDITING 500, 501

AND 505
Unit Structure
7.0 Objectives
7.1 Introduction
7.2 Standard on Auditing 500 (Revised) Audit Evidence.
7.3 Standard on Auditing 501 (Revised)
Audit evidence – specific considerations for selected items
7.4 Standard on Auditing 505 (Revised)
External Confirmations
7.5 Summary
7.6 Questions

7.0 OBJECTIVES

After studying the unit the students will able to understand:

 Definition of Audit Evidence as per SA 500 (revised).
 The procedure of checking the correctness of the evidence
produced before the Auditor as per SA 500.
 Relevance and Reliability of the evidence as per SA 500
 Audit evidence-specific considerations for selected items as
per SA 501 revised.
 Definition of SA 505 revised.
 How to design the letter of request for confirmation.

7.1 INTRODUCTION:

In this chapter you will be studying next three standards on

auditing namely SA 500 (Revised), SA 501 (Revised) and SA 505
(Revised). All the three standards are concerned with different
types of audit evidences used by the Auditor during the course of
his audit. Now let us consider them one by one.
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7.2 SA 500 (REVISED): (AUDIT EVIDENCE)

The Auditor has to audit the annual statements of accounts

and certify that they reflect the true and fair picture of the state of
affairs of the concern. For this he has to follow a prescribed audit
procedure.

The Auditor should obtain sufficient, relevant of appropriate

and reliable evidence on the basis of which he can draw
reasonable conclusions regarding the account statements.

To begin with the Auditor should get assurance from the

management that effective internal control is in operation
throughout the year. He should also ensure that all assets and
liabilities actually exist on the given date. He should also insist that
the assets in existence are valued on some generally accepted
normal lines.

Definition of Audit Evidence:

Audit evidence refers to any information, verbal or written,

obtained by the Auditor, during the course of audit to arrive at the
conclusion on which he bases his opinion on financial statements.
E. g. sales invoices, purchase invoices, bank balance certificate
issued by the bank, correspondence with third parties etc are
examples of evidences.

Here, one thing should be clearly understood that audit

evidence is different from proof. While following the audit process,
the Auditor persuaded himself by gathering different evidences
from different sources at different times under different
circumstances. The purpose of collecting such evidence is to verify
to what extent the assertions made by the management are valid.
Therefore the audit process is called process of persuasion rather
that process of proof. An example will clarify the above discussion.
Suppose, the firm has purchase some furniture for the office. The
Auditor will verify the same with the purchase invoice received from
the furniture vendor. Purchase invoice is only an evidence and not
the final proof. Because it is just possible that the furniture might
not have been actually purchased. For confirmation of this
transaction the Auditor should personally physically verify the
existence of the furniture in the office of the client. That is the final
proof.

This standard explains what constitutes evidence in an audit

of financial statements. The Auditor is expected to collect and verify
sufficient evidence to form his opinion about the financial
statements. This SA deals with evidence in general. It is applicable
 144

to all evidences. Besides there are other standards which deal with
specific aspects of the audit.

This standard is made effective from 1st April, 2009 in its

Revised form.

It is obligatory on the part of the Auditor, to collect sufficient

reliable evidence, before forming his opinion on the correctness of
the financial statements. The Auditor is expected to collect
sufficient and appropriate evidences. He shall consider relevance
and reliability of the information to be used as audit evidence.
During the course of audit, the staff of the client will produce
different document to the Auditor in support of the entries in the
books of accounts and financial statements. It is the duty of the
Auditor to evaluate their reliability and sufficiency. Information
obtained should be correct and complete. Sometimes, the Auditor
is doubtful about the evidence produced before him or information
collected by him from different sources is not the same, then the
Auditor should collect additional and corroborative evidence from
some other source by making further detailed enquiries and get
himself convinced about the correctness of the information.

Audit evidence is necessary to support the opinion formal by

the Auditor and the report submitted by him. It is primarily obtained
during the course of audit. He may also obtain some information
from the audit report of the previous year. Accounting records are
an important source of audit evidence.

Audit procedure consists of obtaining and evaluating audit

evidence. There should be inspection of the audit evidence
produced. Auditor should conduct necessary inquiries to assess the
correctness of the evidence.

Audit procedure consists of obtaining and evaluating audit

evidence. There should be inspection of the audit evidence
produced. Auditor should conduct necessary inquiries to assess the
correctness of the evidence.

Evidence produced should be:

(1) Sufficient in quantity
(2) Should be appropriate and
(3) Should be true

(1) Sufficient in quantity:

On the basis of his past experience the Auditor should
decide the risk involved in each case risk involved will decide the
quantity of evidence where there is more risk, more evidence
should be collected. However, as it is always said that quality is
more important than quality. So the quantity of evidence is not the
 145

only criteria. It is more important that it should be of good quality.

Reliability of the evidence depends upon its source. The Auditor
should express his opinion only when adequate and quality or
satisfactory evidence is produced before him.

The Auditor can study the records produced before him and
prepare certain statements to check whether the records are
internally consistent and agree with the financial statements.
Evidence should always be collected from different sources and it
should tally with each other. The Auditor can go through the
accounting records, minutes of the meetings of directors or their
committees etc to check and recheck the genuineness of the
evidence. Some information may also be confirmed by the third
parties. E. g. balances of debtors and creditors. The Auditors may
send statements of their accounts to selected creditors and debtors
and request them toe confirm the correctness of their balance
directly to them.

Some evidence may be available in electronic record.

Electronic record may or may not be retained for a longer time. so,
the Auditor should ask the client to wipe it off only after his
inspection of the same. He may ask his client to take his
permission, before wiping out the information from the computer.

To check the correctness of the evidence produced

before him, the Auditor may adopt the following steps:
(1) Inspection
(2) External confirmation
(3) Recalculation
(4) Re-performance and
(5) Inquiry
Now let us consider these points one by one:-
(1) Inspection:-
Records and documents should be carefully inspected by
the Auditor. In the case of tangible assets like machinery, cash etc,
they should be physically verified. Mere inspection of the
documents may not be a conclusive evidence of their existence.

(2) External Confirmation:-

In the case of debtors and creditor’s balances, the Auditor
should send copies of their accounts to respective persons and ask
them to confirm their correctness or otherwise directly to him.

(3) Recalculation:-
Client’s staff might have made some calculations and
prepared and presented some documents to the Auditor.
Mathematical accuracy of these documents may be checked by the
Auditor by himself, by making these calculations one again.
 146

(4) Re-performance:-
Client’s staff might have prepared some documents like list
of closing stock etc. Auditor may follow the same procedure
independently to check their accuracy. He need not accept such
documents presented to him, as they are presuming that they must
have been prepared correctly.

(5) Inquiry:-
It means seeking information from knowledgeable persons
within or outside the entity. It is used throughout the audit
procedure. Inquiries may again be of two types. Written or oral.
These responses to the inquiries are then evaluated by the Auditor.
Such inquiry may provide fresh additional information or it may
confirm the information already collected.

Relevance and Reliability of the evidence:

The evidence collected by the Auditor should be relevant

and reliable. Relevance mans there should be logical connection
with the purpose of the audit procedure. Reliability of the evidence
mainly depends upon its source and nature. Reliability increases
when it is obtained from independent outside sources. Evidence
directly obtained by the Auditor from the third parties is more
reliable then the one obtained indirectly. E. g., balances confirmed
by the debtors and creditors. However, documents prepared by the
third parties but presented by the client like suppliers invoices etc
may not be as reliable as those confirmations directly received by
the Auditor.

Then evidence in documentary form is more reliable that the

one obtained orally. E. g., minutes of the meetings are more
reliable than subsequent oral representation of the matters
discussed in the meeting. Again, original documents are more
reliable than photo copies.

Persons preparing different accounting statements should be

well versed in their job. They must be thoroughly conversant with
the subject matter and experts in preparing such statements.
Estimates should be made only by experts in their respective fields.

Reliability of the evidence may be verified either by an expert

employee or by an outside independent expert. Outside expert is
always likely to be less under the pressure of the management than
an expert employee. So, the Auditor should insist upon verification
of the evidence by an outside expert so that the opinion given is
unbiased. The expert who is assigned the job should not have and
personal interest in the matter.
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The management of the entity should supply correct and

complete information to the Auditor.

The Auditor may audit each and every item i. e. 100% check
or selected specific items. He may also adopt random sampling
method. The Auditor will take a decision about this matter after
studying the internal check system prevalent in the organisation. If
the Auditor is convinced that the internal check system prevalent in
the organisation is sufficiently effective, he may adopt test check
system. Otherwise he may adopt 100% checking. Secondly if the
number of items is small and they are all of large value, he may
resort to 100% checking. Alternatively, the Auditor may select high
value or key items only for verification. Unusual or suspicious items
should always be selected for checking.

Audit evidence may be collected internally like goods

received notes, sales invoices etc or from outside like purchase
invoices. Insurance policy, bank balance certificate issued by the
bank etc. Examples of visual evidences are cash in hand, fixed
assets etc.

Internal evidence may not be as reliable as external

evidence. Reliability of the internal evidence depends upon the
effectiveness of the internal control system. In the case of
suspicious circumstances the Auditor should insist upon more
compelling and corroborative evidence to remove the doubts in his
mind.

For testing the correctness of the evidence, the Auditor may

make use of ratios and trends. In the case of bank reconciliation
statements the Auditor should ensure that there is segregation of
duties between the preparer of the bank reconciliation statement,
cashier and book keeper. Such statements should be prepared
promptly and regularly at the end of the period. The outstanding
items must be cleared regularly at an early date.

The Auditor may gain increased assurance when the

evidence is collected from different sources. There should be no
inconsistency between the evidence collected from different
sources. If the management depreciated the assets at a particular
rate and the rate is the normal rate followed by all units in the
industry, the Auditor need not bother. However if the rate of
depreciation followed by his client is different from the normal rate
followed in the industry, the Auditor should probe deep in to matter
and find out the reasons for the departure from the normal practice.
If he is satisfied by the reasons given it is alright. Otherwise he
must ask the client to make necessary changes.
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Finally, if the Auditor is not satisfied by the evidence

produced before him, he should not give a clean report. He should
be bold enough to give a qualified report.

Thus in short the Auditor should insist on sufficient, relevant

and correct evidence.

CHECK YOUR PROGRESS:-

1. What is evidence?
2. Explain the following:
a. Adequacy of evidence
b. Relevance of evidence
c. Correctness of evidence

7.3 SA 501 (REVISED): (AUDIT EVIDENCE –

SPECIFIC CONSIDERATIONS FOR SELECTED ITEMS)

Audit evidence-specific considerations for selected

items:
The earlier standard SA 500 that we have studied deals with
audit evidence in general. It is applicable to all types of items in the
financial statements. This SA 501 deals specially with four
important items in the financial statements. Application of this
standard and the guidance provided in it will assist the Auditor in
obtaining sufficient audit evidence in respect of these four important
items in the financial statements. Thus the SA 501 is divided in to
four 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. Segmented Information.

Let us now deal with these items one by one:

Part A. Attendance at physical inventory counting:

Inventory or closing stock constitutes one of the major items

in the financial statements. So, the Auditor should collect sufficient
satisfactory evidence about the same.
Closing stock may be of three types:
(1) In the case of dealers, it will be the unsold stock or stock
ready for sale.
(2) In the case of a manufacturer it may consist of three items
viz stock of raw material to be used in production, partly
finished goods or work in progress and finished goods.
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(3) in the case of service units, it may be stock of material used

in providing the service e. g. In the case of a garage it may
be oil, soap etc.

There are two systems of valuation of stock.

(1) Periodical inventory system and
(2) Perceptual inventory system.

Under periodical inventory system stock is generally valued

at the end of the year or as near the same as possible. Sometimes
it may not be possible for the business unit to value the inventory
on the last working day only. In that case, the same should be
valued a few days earlier or a few days later as per the
convenience of the unit.

In the case of perpetual inventory system, there are bin

cards and the different items of stock are verified or physically
counted and tallied with the book figures from time to time. If there
is any difference between the two, a suitable adjustment is made
and the causes for the difference are investigated if found
necessary i.e. the difference is more.

Some business units use both the systems at the same time.
For some items of inventory, perpetual inventory system is used
and for others the periodical inventory system is adopted.

Whichever method is used, the Auditor should study the

details of the system and see whether there ate any loopholes in
the same. Before actual stock taking process starts, the
management should evolve a procedure for the same and give
complete detailed instructions to the staff. In preparing these
instructions, the management may seek the advice of the Auditor.
In other words these instructions should be prepared in consultation
with the Auditor and issued to the staff in writing. The staff which
takes stock should be different from those dealing regularly with the
accounting of the inventory, to avoid possibility of frauds. The
Auditor should see that these instructions are being meticulously
followed by the staff. While counting the stock, slow moving and
obsolete stock should be separated from the regular stock and
valued appropriately. Sometimes some stock may be under the
control of any other party. E. g. goods on consignment or goods in
transit etc. In that case, the Auditor should insist on written
confirmation from these persons about its existence and condition.
He should verify the documentary evidence like warehouse receipt
etc. Goods sold but not delivered should be excluded and goods
purchased but still not received should be included.

When stock taking work is in progress, there should be

preferably no movement of stock. If production process can not be
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stopped and movement of goods is absolutely necessary, the

Auditor should keep a special watch on such movements.

The Auditor should attend personally and watch the process

of stock taking. If he can not attend due to any unavoidable
circumstances he should attend as early as possible and assess
the correctness of the valuation. He may make physical verification
of some of the stock at random and get himself convinced that the
set out procedure has been correctly followed.

In some cases, the stock may be at different location. Then

the Auditor should attend at any one place. This selection of place,
should be done by him on the basis of the value of the material at
different places, internal control system prevailing and possibility of
fraud. He may also ask some other Auditor to attend at other
places, if possible.

In short, he should see that there is reliable system of

recording movement of stock.

In some cases, the quantity may be only estimated and not

actually weighed or counted e. g. a coal pile. Here the Auditor
should be satisfied that the procedure adopted for estimation is
reasonable.

There should always be cross checking. For counting the

stock, prenumbered standardised printed forms should be used.

The Auditor has to mainly check 3 things:

(1) All recorded inventories actually exist on that day and are in
proper condition.
(2) They are owned by the client.
(3) They are valued on some sound accounting principles.

The Auditor should perform audit procedures designed to

obtain sufficient appropriate evidence during his attendance at
physical inventory counting.

Physical verification of inventory is primarily the

responsibility of the management. However, in view of the
importance of it in the financial statement the Auditor should also
collect as much satisfactory evidence about the same as possible.
He should obtain a written representation from the management
regarding completeness of information about inventory and that
prescribed procedure has been followed for its physical count.

If the Auditory fails to set satisfactory evidence about the

inventory he should mention this fact in his report. He should issue
a qualified opinion or give a suitably qualified report.
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Part B. Litigation and Claims:

Nobody likes to go to the court voluntarily. But still there are

crores of cases pending in the different courts. Many a times, the
circumstances are such that whether one likes or not, he may be
compelled to go to the court or somebody else may go against him
in the court and he is compelled to defend himself.

Specially, business men have to seek justice in the court in

number of cases. Many business firms have a separate legal
department to handle the cases of the firm.

Litigation and claims against the business may have material

effect on the financial statements. So, the Auditor should collect
sufficient and reliable evidence about the cases pending in different
courts, either filed by or against the firm and their financial
implications.

There is always uncertainty about the outcome of the cases

in the court. The court may take any view. Even there are
instances, wherein the same court has reversed its own decisions.
If the case is decided in the favour of the firm, the firm may gain a
lot financially on the other hand if the case goes against it, it may
loose financially. These days crores of rupies are spent by different
business units in the form of court fees and remuneration to
lawyers.

On the last working day, whatever cases are pending in the

court filed by or against the business unit, a mention of the same
should be done in the financial statements. The Auditor should
discuss the position of the different cases regarding the unit with
the legal department of the business if any or with the lawyers of
the entity. He may meet the lawyers of the entity with the
permission of the management of the concerned firm and take with
him a representative of the firm and discuss with them the actual
position of the pending cases for or against the firm. He must also
discuss with them about their estimates of the financial implications
of these pending cases.
Normally, clients permit the Auditor to discuss the matter
with their lawyer. However, if the client refuses such permission, it
gives room for suspicion and the Auditor should mention this fact in
his report.
The Auditor should take a written statement from the
management abut all cases concerning the unit, pending in
different courts up to the date of his report, their exact position and
estimate of the management about their financial implications. The
Auditor should carefully scrutinise the legal expenses account of
the firm also.
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Part C. Valuation of long term investments.

Long term investments are material to the financial

statements. So, the Auditor should obtain sufficient and appropriate
audit evidence regarding their valuation.

Definition:

There is a negative definition of the term long term

investment.

Current investment is the investment which is readily

realisable within a year. All investments other than current
investments are long term investment. In other words investments
which are for more than one year are classified as long term
investments.

Investments constitute a significant portion of the total assets

of certain entities like banks, insurance companies, investments
companies, etc. A detailed record of their acquisition and disposal
should be maintained. Their market value may keep on fluctuating.
Investment should be owned by the client and not held on behalf of
others. This fact should be confirmed by the Auditor.

The Auditor should study the internal control system relating

to their acquisition and disposal. Legal requirements should be
strictly followed. They should be properly protected.

The Auditor has to verify their physical existence and

ownership. Sometimes they may be deposited with some third party
like banks for safe custody. In that case, the Auditor should obtain a
written a statement from the bank about their existence. The
Auditor should also verify whether they are kept with the bank for
safe custody or mortgaged for obtaining loan.

Valuation:

Valuation of quoted investments creates no problem. Market

rate of these investments on the date of the financial statements
can be taken as their value. However, valuation of unquoted
investments is rather difficult. They may be valued by the client on
some generally accepted principles like (a) profit earning capacity
method (b) break up value method (c) capitalisation of yield method
(d) yield to maturity method etc. the Auditor has to see that the
method of valuation adopted by the client is reasonable and
consistently followed year after year.
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In the case of investments other than in the form of

securities, their market value may be taken. Wherever necessary,
services of expert valuers may also be sought.

If the Auditor is of the opinion that realisable value of the

various investment, is less than the one shown in the financial
statements, the Auditor must insist on suitable adjustment in their
value or make necessary provision in the accounts about possible
reduction in their value. If the management refuses to make such
provision, the Auditor should frankly express his opinion in his
report.

Finally the Auditor should obtain statement in writing from

the management about the completeness of the information
provided by them regarding valuation and disclosure of long term
investments and the adequate provision has been made for
diminution of their value wherever required. He should also take a
statement from the management that it intends to continue to hold
these investments as long term investments only.

Part D. Segment Information:

There should be appropriate disclosure of segment
information. So, the Auditor should perform audit procedures and
obtain appropriate audit evidence for proper disclosure of segment
information.

AS 17 issued by the Institute of Chartered Accountants has

prescribed the information to be disclosed in respect of different
segments in the financial statements. The Auditor should confirm
that all such information is disclosed in the account statements
prepared by the management such segment information is
important in financial reporting of many entities. So, the Auditor
should collect sufficient and appropriate audit evidence in this
respect. Segment means parts.

He will consider segment information in financial statement

taken as whole. Sufficient audit evidence is necessary in this
respect to enable the Auditor to form his opinion. Audit procedures
in respect of segment information generally consist of analytical
procedures and other appropriate audit tests.

He will discuss with the management the method used by it

in determining segment information. There should be proper
financial disclosures. The Auditor would consider sales, transfers
and charges between segments. Inter segment amount should be
eliminated. Budgets and expected figures should be compared. E.
g. operating profits as a percentage of sales. These figures are also
compared with the figures of the earlier years. There should be
adequate disclosure and consistency with the earlier figures.
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As in respect of other matters, here also the Auditor should

take a written representation from the management about the
completeness of information regarding segments and disclosure
there of, appropriateness of the segments selected often risks and
returns and the organisational structure of an enterprise. If there is
any deviation by the management in its financial reporting policy, it
should also be mentioned with the reasons for such deviation or
change.

Finally, if the Auditor fails to collect appropriate audit

evidence in this connection and is not fully satisfied, the must
frankly mention this fact in his report.

This standard SA 501 is effective from 1st April, 2005.

Mostly our standards on auditing are similar to the

international standards. However in case of this standard there are
differences between the two on following two points:
(1) In case of pending litigation, under Indian standard the
Auditor may or may not discuss the matter with the company’s
lawyers, however, under international standards, such consultation
is compulsory.
(2) Under Indian standard, each part of the SA requires written
representation from the management about its compliance. There
is no such requirement under the International Standards (ISA).

CHECK YOUR PROGRESS:

 Explain the following

1. Attendance at physical inventory
2. Litigation and claims
3. Valuation of long term investments
4. Segment information

7.4 SA 505 (REVISED): EXTERNAL CONFIRMATION

This standard is an extension of standard 500. SA 500 which

deals with audit evidence in general states that the reliability of the
audit evidence is influenced by its source and nature. It indicates
that audit evidence from external source is more reliable than the
audit evidence generated internally. Secondly written or
documentary evidence is more reliable than the audit evidence in
oral form. Considering all other circumstances and estimating the
risk involved, the Auditor should decide whether the external
confirmation is necessary in a particular case.

This standard deals with the use of external confirmation as

a means of obtaining audit evidence. On the basis of his past
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experience, the Auditor has to decide whether external confirmation

is necessary in a particular case to support certain evidence
collected from other sources. This method is used only in the case
of certain important type of items in the financial statements and the
Auditor is not completely satisfied with the internal control system
prevalent in the unit. The Auditor should adopt this system only in
consultation with the management and with its permission.

Written confirmation from the third party is always more

reliable evidence as they are not related to the unit. Such third party
has no personal interest in the matter. The information provided is
likely to be comparatively more correct and reliable and unbiased.

Definition:-

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 the management in the
financial statement.

Written confirmation from the third party is more reliable

evidence as they are not related to the unit. Such a method will
reduce the risk of the Auditor.

The Auditor here writes to the third party and requests the
same to send its unbiased frank opinion on a particular point. The
third part is requested to send his reply, directly to the Auditor and
not through the client. This will ensure that the third party expresses
its opinion frankly. For obtaining such confirmation, the Auditor
selects certain items which are important or material from his point
of view. Normally large and unusual items from the financial
statements are selected for confirmation. Usually, such
confirmation is sought in a particular form sent to the party. A letter
is sent to the third party and he is requested to send his
confirmation when such information is received by the Auditor, he
evaluates it on the basis of his professional scepticism and past
experience in the field of audit. This method is normally used in the
following cases:-

(1) Confirmation of balances in the accounts of debtors and

creditors or accounts payable and account receivable. They
may also be asked to send the details of all or some major
transactions.
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(2) Banks are requested to confirm the balance in the client’s

account.
(3) Stock held by others like goods in the hands of the
consignee or goods in the custody of the seller who has not
yet delivered them. etc.
(4) Title deeds of properties with the third parties. The client
may keep the title deeds of properties in a bank locker for
safe custody or he may borrow money from a third party by
depositing such title deeds with him.
(5) Investments purchased but not delivered. They may be in
the custody of the broker or seller.
(6) Balance of loans from the lenders.
(7) Long outstanding share money.
(8) Terms of agreement with the third parties, etc.

If the Auditor is of the opinion that the internal control system

is not fully reliable, he has to collect additional audit evidence to be
convinced about the correctness of the figures in the financial
statements. In such cases external confirmation may provide such
more reliable additional evidence.

Designing the letter of request for confirmation:

To get reliable information promptly from the third party, the

Auditor should design a proper form for request. The Auditor should
carefully design or prepare such letter of request for confirmation.
The language to be used should be simple and the letter should be
to the point. It should only seek such information, which is readily
and conveniently available to the other party. The Auditor should
prepare such a letter in such a form that the recipient has to make
minimum efforts to reply the same. He may have to fill in minimum
words in such a letter for reply. To facilitate his work, the Auditor
should enclose a self addressed envelope. Arrangements can also
be made with the post office to post the letter without any Retain
postal stamp. Postage will be paid by the addressee i. e. the
Auditor when he receives such a letter.

The Auditor should take in to account the characteristics of

the respondents. External confirmation redresses the inherent risks
in the internal control system.

The Auditor should use this system selectively only where he

finds it absolutely necessary. It should be invariably used for
unusual or complex transactions only and not for simple and minor
transactions.
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The Auditor should use all his intelligence and past

experience to draft such a letter so that he can get all necessary
information from the third party. His aim should be to get maximum
response from the third party to his letters.

In designing such letter of request for confirmation the

Auditor should consider the nature of information the other party will
be able to confirm readily. This will increase the resonse rate and
also the nature of the evidence obtained. E. g. sometimes
confirmation of a single transaction may be sufficient and the entire
account balance may not be necessary. Secondly sometimes the
respondent may be reluctant to confirm the entire or total
transaction.

The fact that permission to seek such information has been

obtained from the client should be invariably and prominently
mentioned in the letter. If there is no such mention respondents
may not respond readily or not respond at all.

The Auditor should also consider the competence of the

respondents. Certain parties may not provide an objective or
unbiased response. So, he should design his request in such a way
that the maximum number of persons will be able to respond.

It should always be remembered that if the respondent is

economically dependent on the client, he may not provide reliable
information.

Positive and Negative Response

Letters of confirmation may seek positive or negative response.

(1) Positive Response:

Here the respondents may be requested to confirm all

information give by the management in the financial statement on a
particular point. Alternately a form may be sent which is to be filled
in and returned. However such form should be so designed that the
respondent is expected spend very little time to fill the form. E. g.
he may be just asked to tick mark or score out certain words. This
is called positive confirmation. Positive confirmation is likely to
provide more reliable evidence. The system of filling in the blanks
may not get ready response as the party has to take more efforts.
Tick marking system is comparatively easy.

(2) Negative Confirmation:

Here the respondent is asked only to reply, if he disagrees.

Here the Auditor has no guarantee that the other party has actually
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verified the correctness of the information. So, such negative

confirmation provides less reliable evidence than the positive
response system. So, this system may be used only when the risk
of misstatement is less or there are large numbers of small items to
be confirmed. In short the Auditor will use this method only when he
is fairly satisfied with the state of affairs.

Secondly, here the Auditor may not know exactly, whether

the party received the letter or he received it but just neglected it.
So the Auditor should also use other audit procedures and try to
collect more evidence or corroborative evidence.

Positive and Negative or combination of the two:

Some Auditors use both the systems at the same time, when
there are large number of small items and small number of big
items and both are to be confirmed. He may use negative method
for the large number of small items and the positive method for
small number of big items. Thus combination of the two is a better
way.

Limitations:

External confirmation system has also certain limitation. Its

usefulness varies for different types of transactions. E. g. the
Auditor can send a letter to a debtor and receive from him the
confirmation of the correctness of the balance. However, he can not
confirm the quality of the debt i.e. possibility of its recovery. He
cannot ask the debtor whether he will surely clear his balance fully.
Similarly if the goods are with the third party, the Auditor can write a
letter and confirm the existence of these goods with him. But he
cannot confirm the correctness of the valuation of these goods. For
these things, he has to believe in the correctness of the valuation
made by the client only.

The Auditor cannot also verify whether there are any

unrecorded liabilities. For detecting such omissions, one way out is
to send confirmatory letters not only to the supplier who have a
balance in their account on the date of the financial statement but
to all regular suppliers of the client, even if there is no balance due
to them on that day. Such people also may be requested to supply
a copy of the account of the client in their books directly to the
Auditor.

Timing:
The date of confirmation of balance is usually the last
working day i.e. the date on which the financial statements are
prepared. Alternately, the Auditor may choose any other date as
near the last date as possible. However, in such cases, the Auditor
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should verify carefully the transactions after that date or up to that

date.

However, the Auditor can also choose some other date for
confirming the balanced in the accounts of debtors and creditors
and introduce a surprise element in the process.

External Confirmation Process:

The Auditor should have full control over this process. He

should select the names of the persons to whom confirmation,
letters are to be sent. He should also prepare the draft of the letter
to be sent and supervise the process of sending letters and
receiving the replies. The letters should be properly addressed and
duly stamped. Replies should be directly received by the Auditor
and even the undelivered letters should be returned to the Auditor.
He should make necessary enquiries and find out the real reason
for their non delivery. Where there is no response, the Auditor
should send one or two reminders.

If there is oral response, it should always be recorded or

documented by the Auditor in his working papers.

If the confirmation is received on Fax, it is not easy to detect

the source from where it is received. So, the Auditor should confirm
the same on phone with the concerned party. Sometimes the
management may request the Auditor to not to send letters of
confirmation to certain parties. The Auditor should ask the
management to put in writing the reasons for such action. If he is
satisfied by the reasons given, it’s alright. If not to safeguard his
interests, he must state this fact in his report. Sometimes, the debt
of a debtor is in dispute and the client might have filed a suit for
recovery of the same in court of law. Under such circumstance,
sending a letter of confirmation, may add to the bitterness between
the two parties. Here the management is justified in making such a
request to the Auditor.

Evaluation of the response received.

After the Auditor receives confirmation letter from the parties

concerned the Auditor should consider the reliability of such
responses. Sometimes, such responses received may not be
reliable. He should consider the authenticity of the response and
follow appropriate procedure to clear his doubts.

When the Auditor is not fully satisfied with the evidence he

has collected, he should undertake additional procedures. While
taking such a decision, he should consider the reliability of the
confirmation and the alternate procedures, implications of the
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figures both quantitative and qualitative and evidence provided by

other procedures. Considering these points, he must decide
whether additional audit procedure is necessary.

If he comes across any difference between the information

provided by the management and the one collected through letters
of confirmation, he should ask the management to reconcile the
discrepancies. Explanation give by the management on such
points, should also be further verified. He should also consider the
causes and frequency of exceptions reported by the respondents.
He should look deep in to the causes of misstatements in the
financial statements.

The Auditor should thus evaluate the results of the external

confirmation process and results from any other procedure followed
and decide whether sufficient reliable evidence is collected or not.

Difference between Indian and International Standard:

Normally both do not differ. But sometimes there are certain

minor differences between the two. Institute of Chartered Accounts
makes certain changes in the International Standards, taking in to
account the conditions in India. In this standard also there is some
such difference. E.g.

(1) Indian Standard expects the Auditor to take information from

earlier year’s audit reports also. ISA does not provide for such
verification.

(2) In the case of discrepancy found between the figures in the

financial statements provided by the management and the
information received from third parties, the Indian Standard requires
the Auditor to give an opportunity to the management to reconcile
the information. ISA does not provide for such requirement etc. This
standard on auditing is effective for a audit related to account
period beginning on or after 1.4.2003.

CHECK YOUR PROGRESS:

(a) Importance of external confirmation
(b) Its utility
(c) Drafting of the letter of confirmation
(d) Limitation of the system
(e) Procedure followed for external confirmation
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7.5 SUMMARY:

In this chapter, you have studied three standards on auditing

namely 500, 501 and 505.

SA 500 deals with the audit evidence in general. Before

expressing his opinion the Auditor should collect sufficient and
reliable audit evidence. Reliability of the evidence depends upon
the source and its nature. The Auditor should evolve a suitable
procedure to collect reliable audit evidence. Evidence collected
should be appropriate. Written evidence is more reliable than oral
evidence and evidence provided by the third party is more reliable
than the evidence generated internally.

SA 501 deals with audit evidence for some specific items

namely attendance at physical inventory counting, inquires
regarding litigation and claims valuation and disclosure of long term
investments and segment information. Physical counting of the
inventory is primarily the responsibility of the management. In all
these four cases the Auditor has to take a written representation
from the management that they have taken necessary steps before
including the relevant figures in the financial statements.

SA 505 deals with external confirmations. Here letter are

sent to third parties and they are requested to confirm the
correctness of different figures in the financial statements after
verifying their own records. Such evidence is supposed to be more
reliable as it is provided by the third party, which has no personal
interest in the matter and is given in writing.

In short the Auditor should not sign his report unless he

collects sufficient, appropriate and relevant evidence and he is fully
satisfied.

7.6 QUESTIONS:

1. What is Audit Evidence?

2. What are the different types of audit evidences?
3. What are the duties of the Auditor under SA 501 in respect of
attendance at physical inventory counting?
4. What are the duties of the Auditor under SA 501 in respect of
valuation and disclosure of long term investments?
5. Management certificate obtained by the Auditor is enough for
verification of inventories. State whether the statement is true or
false giving reasons in support of your answer.
 162

6. List the situations where external confirmation can be used.

7. Balance confirmation from Debtors/Creditors can only be
obtained for balances standing in their account at the year end.
Give your comments.
8. What is meant by external confirmation?
9. What are positive and negative external confirmations? In what
circumstances they are used?
10. Say whether the following statements are true or false.
a. The audit technique of confirmation is a formal inquiry from
insiders.
b. The managements refusal to provide a requested
representation also constitutes an audit evidence.




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8
NEW STANDARDS ON AUDITING SA 510
(REVISED), SA 520 AND
SA 610 (REVISED).
Unit Structure :

8.0 Objectives
8.1 Introduction
8.2 Audit Standard 510 (Revised)
Initial Audit Engagements – Opening Balances
8.3 Audit Standard 520
Analytical Procedures
8.4 Audit Standard 610 (Revised)
Using the work of Internal Auditors.
8.5 Summary
8.6 Questions

8.0 OBJECTIVES

After studying the unit the students will be understand:

 Various definitions as per AS 510 revised
 Meaning, purpose and definition of analytical procedures as
per AS 520

8.1 INTRODUCTION:

In this chapter you will be studying the details of next three

standards on audit namely AS 510 (Revised) on Initial Audit
Engagement, SS 520 on analytical procedures and SA 610
(Revised) on using the work of internal auditor. Let us now consider
these standards one by one.

8.2 STANDARD ON AUDIT 510 (REVISED): INTIAL

AUDIT ENGAGMENTS – OPENING BALANCES

This standard is made applicable to all audits conducted on

or after 1st April, 2010.
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This standard deals with the auditor’s responsibilities relating

to opening balances when conducting an initial audit engagement.

Opening balances means the balances which existed in the

beginning of the period, these are the same, which were closing
balances in the immediately proceeding year and brought forward
to the current period. Therefore these opening balances, carry the
effect of the previous periods.

If the same auditor had audited the accounts of the entity

last year there is no problem of checking the opening balances
because after all opening balances of this year, are the closing
balances of the previous year, which have already been verified by
him. The question of verifying the opening balances arises only in
the case of initial appointments.

Here, there are two possibilities:

(1) The accounts of the entity were so far not audited at all due
to its small size or any other reason. Such situation arises only in
the case of sole trader or partnership firms doing business on a
small scale. In the case of large scale business or in the case of
companies, audit of accounts by a chartered accountant is
compulsory under law. In their case, such contingency may arise
only in the first year of their business.

(2) The accounts of the business were audited last year by the
auditor of any other firm and the entity has changed it s auditor and
the work is allotted to a different auditor.

In either of the above contingencies, it becomes necessary

for the auditor to collect sufficient reliable evidence and check the
opening balances.

It should be remembered that the correctness of opening

balances is very important, because they are the basis on which
the financial statements of the current year are prepared. If the very
base is wrong, the financial statements of the current year are
bound to be also defective.

In addition to financial statement amount, opening balances

include matters requiring disclosures that existed at the beginning
of the period such as contingencies and commitments.

According to proposed SA 710 financial statements should

also include comparative financial information. When it comes in to
effect, the opening balances will also include these things, SA 710
is being revised in the light of corresponding international standards
on audit. Of course this S.A. is not included in your syllabus.
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Objective

In conducting an initial engagement, the objective of

the auditor with respect to opening balances is to obtain sufficient
appropriate audit evidence about whether

(a) Opening balances contain any misstatements that materially

affect the current periods’ financial statements and

(b) Appropriate accounting policies reflected in the opening

balances have been consistently applied in the current period’s
financial statements or changes there to are properly accounted for
and adequately and suitably presented and disclosed in
accordance with the applicable financial reporting frame work.

Definitions

(1) Initial Audit Engagement.

Initial Audit Engagement means an engagement in which
either financial statements for the prior period were not audited or
audited by a predecessor auditor

(2) Opening balances.

Opening balance are those account balances that existed at
the beginning of the period. They are the closing balances of the
previous period. They also include contingencies and
commitments.

(3) Predecessor Auditor

Predecessor Auditor is an auditor from a different audit firm
who audited the financial statements of the client in the prior period
and who has been replaced by the current auditor.

The purpose of this standard is to establish standards

regarding audit of opening balances in case of initial engagement
i.e. when the financial statements are audited for the first time by
the particular auditor.

Opening balances are that balances in different are those

balances in different accounts which existed at the beginning of the
period. The fact that, closing balances here has been properly
brought forward to the current period is confirmed. It is also verified
that there are no misstatements in the opening balances. That will
materially affect the financial statement of the current year and that
accounting policies are consistently applied. The auditor should
know the accounting policies of the client and study the audit report
of the previous year. He should assess the materiality of different
opening balances.
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Opening balances reflect the effect of transactions and other

events of the previous period and accounting policies applied in the
preceding period.

Audit Procedure
To begin with the auditor should read last year’s financial
statements and the auditor’s statements and the auditor’s report
there on, if the accounts of the client were audited by a different
auditor last year. To collect information about the opening balances
he should collect sufficient evidence to check the opening balances
in the current year’s financial statements. Last year’s closing
balances will naturally become the opening balances of this year.
He should check whether, last year’s all closing balances have
been properly carried forward in this year’s accounts or not. If there
are any changes made in the profit and loss account due to
changes in the accounting policies, they should be separately
shown.

At this stage, it should be remembered that normally

accounting policies once adopted, should not be changed. One
example of accounting policy is the method of writing off
depreciation. Because, change in the accounting policies, may
affect the final results of the concern. There will be changes in the
final profit or loss. This will make comparison of the accounts of two
years, difficult. So, as and when, the accounting policies are
changed, for any reason whatsoever, its effect on the final results of
the business should be disclosed in the accounts.

If the auditor finds that there are any misstatements in the

prior period financial statements which are likely to affect, this
year’s financial statements, he should perform additional audit
procedures, and determine their exact impact on this year’s
financial statements. If he finds that, similar misstatements are
there in this year’s financial statements also he should
communicate them to the management and get the statements duly
corrected.
In short, the auditor should collect sufficient audit evidence
to check whether accounting policies in the opening balances, have
been followed in the current year also and if not, their impact should
be prominently disclosed.
It should be remembered that the fact that preceding period
financial statements were not audited, does not in any way reduce
the auditor’s need to obtain sufficient evidence regarding opening
balances.

If the auditor fails to collect sufficient audit evidence

regarding opening balances he may give qualified opinion or add a
disclaimer to this effect.
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If he comes across any minor defects in the last year’s

auditor’s report and the same can be easily adjusted in the
accounts of the current year, he need not qualify his report.

Current Assents and Current Liabilities :

Some evidence can be collected from the books of accounts

only for some current assets and liabilities like the opening balance
of debtors and creditors. For the opening debtors there will be
collection during the year and for opening creditors, there will be
payments during the current year. Collections and payments, can
provide some evidence of existence of opening debtors and
creditors. The auditor can also take a total of opening balances of
each account of the debtor and creditor to check the accuracy of
the opening debtors and creditors. As regards opening inventory,
the closing balance of the inventory in the last year’s financial
statements may provide some evidence. Some additional
procedure will be advisable like observing current inventory count
and reconciling it with the opening inventory quantities, considering
gross profit, valuation of the opening inventory etc.

There is no difficulty in checking the bank balance and the

bank overdraft balance as the pass book and bank balance
certificates are readily available.

For non current assets and liabilities like long term debt
accounting records may be examined. He can also obtain
confirmation from the concerned parties, in respect of long term
debts and investments. Fixed assets register may provide evidence
regarding opening balance of fixed assets.

In short, this standard deals with collection of audit evidence

for verifying the opening balances in the case of initial engagement.

CHECK YOUR PROGRESS :

(a) What is initial engagement?

(b) What are opening balances?

8.3 AUDIT STANDARD 520 :

ANALYTICAL PROCEDURES

This standard is made effective from 1st April, 1997.

Meaning, purpose and definition of analytical procedures

The purpose of this standard on auditing is to establish

standards on the application of analytical procedures during an
audit. The auditor should apply analytical procedures at planning
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and overall review stage of the audit. They may also be applied at
other stages.

SA 500 on audit evidence defines analytical review as tests

of details which consist of studying significant ratios and trends and
investigating unusual fluctuations and items. Thus analytical
reviews are substantive audit procedures.

SA 520 on analytical procedures states that analytical

reviews are analysis of significant ratios and trends including
resulting investigation of fluctuations and relationships that are
inconsistent with other relevant information or which deviate from
predicted amounts.

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.

Analytical procedures are particular type of substantive test

to judge the overall reasonableness. 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
estimation of the auditor such as estimation of depreciations charge
for the year etc. Entity’s ratio of sales to trade debtors may be
compared with industry’s average or with other entities of the same
size in the industry. Gross margin percentages of different year or
different units in the industry for the same year may be compared
Auditor may use here financial as well as non financial information
for calculation of ratios. Example of non financial information is
number of employees and space used for sales etc. Pay roll costs
may be compared with number of employees or sales may be
compared with space occupied for sales etc. and soon.

Different methods may be used here. Sometimes very

simple methods may be used but where necessary even advanced
statistical techniques may also be employed: such study may be
made for the whole unit or its components like different divisions
departments etc.

The auditor selects the suitable method based on his past

experience. After all this is a professional judgement.

Analytical procedures include the following types of tests : -

1) Trend analysis :
Here financial information of the firm may be compared with
the information of the previous years.
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2) Comparative data analysis :

Entity’s financial information may be compared with
anticipated results.

3) Predictive estimate analysis :

Here the relationships between different figures anticipated
by the auditor are studied.

4) Inter firm analysis :

Key financial ratios of the entity are compared with other
firms of the same size in the industry or with the average of the
industry as a whole.

5) Financial ratio analysis :

Relationships among different financial information is studied
e.g. gross profit turnover ratio etc.

6) Key financial ratios :

Relationships among elements of financial and non financial
information is studied e.g. payroll costs to number of employees or
sales per employee etc.

The purpose of analytical procedures :

The purpose behind making a study of financial procedures

by the auditor can be summarised as follows :

1) To assist the auditor in planning the nature, timing and

extent of other audit procedures.

2) To serve as substantive procedures when there can be more

effective or efficient in reducing risk of financial statement
assertions.

3) To provide evidence as to the completeness accuracy and

validity of the data produced by the accounting system,
based on interrelationships between different financial data.

4) To provide a tooll to overall review of financial statements in

the final review of an audit.

Now let us consider two examples of use of analytical

procedures namely in the case of inventories and debtors and
loans and advances.

1) Inventories :
Quantity of opening stocks, purchases, production, sales
and stocks may be reconciled. Closing stock quantities may be
compared with the closing stock balance of the last year, stock
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turnover ratio of the current year may be compared with that of the
last year. Gross profit ratios of the two years may also be
compared.

2) Debtors, loans and advances :

Closing balances of debtors, loans and advances may be
compared with the figures of the last year. Industry’s standards can
also be considered, if the same are readily available. Actual figures
may be compared with the budgeted figures if the budgets are
prepared. Ageing schedule (outstanding periods) of the current
year may be compared with the corresponding figures of the
previous year.

Thus the above two examples will clarify how the method is
used in practice.

In some cases, documented information, useful for analysis

may not be available. In such cases, the auditor may obtain the
required information through discussion with the owner or manager
of the business entity.

Analytical procedures are often cost effective means of

obtaining audit evidence. The auditor studies the controls over the
collection of information prevalent in the unit. When such controls
are found to be satisfactory, the auditor will have more confidence
in the reliability of the information. Here the results of the analytical
procedures used will be naturally more reliable.

Analytical procedures may not be of much use in case of

small entities as the necessary reliable data for the purpose, may
not be available.

Following ratios are generally used in analytical procedures.

Turnover : Gross Profit Ratio

Debtor Turnover Ratio
Stock Turnover Ratio etc.

Trends used
Comparison to industry
Comparison to economy
Capacity utilisation
Warehouse capacity etc.

Finance and non finance relationships, salary expenses to number

of employees. Sales to quantity sold sales figure to capacity
utilised. Comparison of budgeted figures with actual figures etc.
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Analytical procedures can be used by the auditor at the following

stages of audit procedures.

(i) Planning the Audit or preparing an audit plan.

(ii) As substantive procedure.
(iii) In the overall review at the end.
(iv) Investigating unusual items.

Let us now consider the above points in further details.

I) Preparing an Audit Plan :

The Auditors can use analytical procedures at the planning

stage to understand thoroughly the nature of 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.

Analytical procedures at this stage may use both, financial

and nonfinancial information. E.g. the relationship between sales
and square footage of selling space or volume of goods sold. The
purpose of analytical procedures is to assist the auditor in planning
the nature, timing and extent of other audit procedures.

By applying analytical procedures at planning stage an

auditor can identify the area of potential risk, e.g. If there is wide
variation in gross profit ratio compared with previous year the
auditor may check sales and closing stock in greater details.

II) Analytical procedures as substantive procedure :

The auditor will rely on the analytical procedure to reduce
detection risk. The decision about which procedure to use will be
decided by the auditor on the basis of his audit objective. This is a
matter of professional judgement which is based on his knowledge
and previous experience.

He will discuss the reliability of the information with the

management. If the data is prepared by the expert staff of the
client, the auditor would use this method. He should be personally
satisfied about the ability of the staff to prepare reliable data.

Before taking such as decision, the auditor will consider the

following factors :

1) Objective of the analytical procedures.

2) The nature of the entity.
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3) Analytical procedure may be more effective when applied to

different sections or departments separately.
4) Whether the budgets are prepared with sufficient care?
5) Information used is reliable.
6) Source of information is reliable. Information collected by
independent source is more reliable than the one collected
internally by the client.
7) Knowledge gained during previous audits. Such knowledge
will help the auditor to decide about the effectiveness of this
method in this case.

III) Analytical procedures in the overall review at the end of

the Audit :

The Auditor should apply analytical procedure at or near the

end of the audit before finalising overall conclusions. The auditor
will take his final decision about the financial statements only after
following analytical procedures. The conclusions drawn from the
results of such procedures are intended to corroborate the opinion
formed by the Auditor earlier about the financial statements. In
some cases such a study may identify areas where further
procedures need to be applied.

The application of analytical procedures is based on the

expectation that the relationships among data exists and it will
continue. The data provided by the accounting system is checked
by such analytical procedures.

In making use of this system, the auditor will take in to

account the materiality of the items involved. The auditor will mainly
use this system for certain income and expenditure items.

IV) Investigating unusual items :

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.

The investigation of unusual fluctuations and relationships,

ordinarily begins with the inquiries of management followed by :

a) Corroboration of managements responses with the

knowledge of the business of the auditor.
b) Need of applying other audit procedures is also considered if
the management is unable to provide adequate satisfactory
explanation.
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Thus when significant variations are noticed, the auditor

should go in for detailed investigations.

Reliance

Reliance on analytical procedures depend upon the following

factors :

1) Materiality of the items involved :

a) When inventory balances are material, analytical reviews

alone will not be sufficient in forming the audit conclusions.
b) Where some individual items of income or expenditure are
not material, comparisons with previous year’s data may
provide sufficient audit evidence.

2) Other Audit Procedures.

When other audit procedures are used in the same area,
analytical reviews may provide confirmatory evidence.

3) Accuracy of predictions :
If the expected results of analytical procedures can be
predicted with reasonable accuracy, such procedures will be
more reliable. E.g. percentage of gross profit over various
periods would be consistent and gives more audit evidence
than research and development expenditure or advertising
expenditure etc.

4) Nature of risks :
The effect of analytical procedures also depends upon the
assessment of the inherent and control risks. E.g. If internal
control on sales order processing is weak, and hence control
risk is higher, more reliance will have to be placed on tests of
details of transactions and balances.

5) Efficient control :
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
auditor will have greater confidence in the reliability of the
information and in the results of analytical procedures.

The control over non-financial information should be tested

along with tests of accounting related control.

Check your progress :

a) What are analytical procedures?
b) When are they used?
c) How far they are reliable?
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8.4 SA 610 (REVISED) USING THE WORK OF

INTERNAL AUDITORS

This standard on auditing is applicable to all audits

conducted on or after 1st April 2010.

This standard deals with external auditor’s responsibility

regarding the work of internal auditor. External auditor is also called
statutory auditor as he is appointed according to the provisions of
different Acts such as Indian companies Act. Indian trusts act etc. It
is applicable when the external auditor decides that the function of
the internal auditor is relevant to his audit work. The purpose of this
standard is to provide guidance as to the procedures which should
be applied by the external auditor to assess the work of the internal
auditor. This will help him to decide whether and to what extent he
should rely on the work of the internal auditor.

What is Internal Audit?

Internal audit is a separate part of internal control system.

The objective of the internal audit is to determine whether other
internal control systems are well designed and are being properly
operated. He is appointed by the management of the client and is
part of a overall organisation system of internal control. The
management which makes his appointment also prescribes the
scope of his work.

That way appointment of internal auditor is not compulsory

under the law. Still all big business units appoint an internal auditor
because his appointment is beneficial to the unit. It helps the
organisation to detect and prevent errors and frauds at on early
date.

In some organisations, there is a separate internal audit

department. Some concerns appoint an outsider as an internal
auditor.

The scope and objectives of internal audit vary widely and

are dependent upon the size and structure of the entity and the
requirements of the management.

Internal audit is an independent management function which

involves a continuous and critical appraisal of the functioning of the
entity. Internal auditor suggests improvements and adds value to
and strengthen the overall governance mechanism of the entity and
internal control system. Internal audit therefore provides assurance
that there is transparency in reporting as a part of good
governance.
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Internal auditor performs the activities of the internal audit

function.

Revised SA 610 provides that the internal auditor should not

show his working papers to third party.

The nature of the responsibilities and his status in the

organisation vary widely. It depends upon the size and structure of
the entity and the requirements of the management.

Objectives of internal audit.

Normally the following are the objectives of internal audit.

1) Review of accounting system and internal control.

2) Examination of financial and operating system.
3) Examination of effectiveness and efficiency of financial
control.
4) Physical examination and verification.

The establishment of an adequate accounting system and

related control is always the responsibility of the management. It
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 controls. Internal
auditor has to suggest improvement in this system as and when
necessary. Internal auditor, verifies the physical existence and
condition of the different tangible assets of the entity.

Internal audit and CARO.

According to CARO (Company Audit Report Order) 2003 in

the case of listed companies the auditor is required to report
whether or not the internal audit system in a company is
commensurate with the size and nature of the business. This rule is
applicable only to the companies whose paid up capital plus free
reserves, exceed ` 50 lakhs at the commencement of the financial
year concerned or have an average turnover of ` 50 corres or more
for three consecutive financial years, immediately preceding the
financial year concerned. Thus in the case of comparatively large
size companies, the law expects them to have a satisfactory
internal audit system as a part of its organisational structure.
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Difference between internal and external auditor.

They differ on the following grounds

Internal Auditor External Auditor

Appointment
1) Management appoints the Shareholders appoint external
internal auditor auditor
Objectives
2) To ensure already laid down Express opinion on the
policies procedures and other financial statements as to
internal control system is whether, these statements are
functioning as desired showing true and fair view of
the financial position of the
concern.
Scope
3) The management prescribes Concerned law prescribes the
the scope of audit. scope.
Independence
4) Comparatively less More independent in reporting
independence as he is the part as he is an outsider
of the organisation
Format of Report
No format is prescribed. It Aspects to be covered in the
depends on the nature of the report are specifically
work, coverage and prescribed by law and I.C.A.I.
observations recommendations

Through there are above major differences, the method of

work of internal and external auditor are similar in many respects.
So the work of the internal auditor is useful to the external auditor.
E.g. internal auditors work is useful to the external Auditor in
determining the nature, timing and extent of his procedures. So, the
external auditor should, as part of his work, evaluate the internal
audit function. He should verify, to what extent he has followed
substantive procedures prescribed by the management.

Internal control system means all the policies and

procedures adopted by the management to assist in achieving the
objectives of the management. Internal audit as we have seen
earlier, is the part of the internal control system. Assets of the
business should be safeguardes. Frands and errors should be
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prevented. Accounting records should be accurate and complete.

Correct financial statements should be prepared in time. External
auditor will assist the internal auditor and guide him in his work from
time to time.

Can external auditor rely on the work of internal auditor?

The answer is yes but to a limited extent.

External auditor has the sole responsibility of his report.

However much of the work of the internal auditor may be useful to
him in his examination of financial statements. External auditor has
to decide, whether and to what extent to use the work of the
internal auditor and whether such work is adequate for his purpose.
When the external auditor uses the specific work of the internal
auditor, he shall document his conclusions regarding the evaluation
of the adequacy of the work of the internal auditor and the audit
procedures performed by him on that work.

Using the work of internal auditor

It should be remembered that through the external auditor

can use the work of the internal auditor, his responsibility of his
report is in no way reduced. So, he must evaluate the work of the
internal auditor and then decide as to what extent he can rely on
the same. While taking this decision, he must take in to account the
following factors : -

1) Whether internal audit is undertaken by an outside agency or

by a department within the organisation? Work of the outside
agency will be more reliable than the work of the internal
department.

2) Scope of the internal audit and to what extent the

management implements the suggestions made by the
internal auditor.

3) What are the qualifications of the internal auditor and how

much experience he has on this job?

4) Whether internal auditor takes due professional care and

whether his work is properly planned, supervised and
documented? There should be an audit manual to guide him
in his work.

Internal auditor should have proper status in the organisation

and he should be free to express his opinion frankly. He should
enjoy as much independence as possible and should not be
burdened with other responsibilities in the organisation.
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External auditor should also test the work of the internal

auditor on which he intends to rely. Such test may include sample
checking of some of the items, already checked by the internal
auditor. etc.

Co-ordination

There should be proper co-ordination between internal and

external auditors. They should meet from time to time and discuss
their common problems.

In short 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 on his work. However, the sole responsibility of
his report always rests on the external auditor only.

Check your progress :

a) What is internal audit?

b) Difference between the work of internal and external auditor.
c) Can external auditor rely on the work of the internal auditor?

8.5 SUMMARY

You have studied last three standards, from your syllabus viz
SA 510 (Revised), SA 520 and SA 610 (Revised) in this chapter.

SA 510 :

Initial audit engagements - opening balances. Initial audit

engagement may be either the appointment of the auditor by the
client for the first time or it may be due to change in the
appointment of the auditor. In either case the newly appointed
auditor has to verify opening balances in the financial statements.
Opening balances of the current year are the closing balances of
the last year. Verification is important because this year’s closing
balances will depend upon the opening balances brought forward
from last year. The auditor has to collect sufficient reliable evidence
to verify the correctness of these opening balances. The purpose of
this standard is to establish standards regarding the audit of
opening balances. Opening balances reflect the effect of last year’s
transactions. So to begin with the auditor should go through the last
year’s financial statements and auditor’s report. He should confirm
that the accounting policies are not changed during the year. If they
have been changed, their impact should be separately shown.
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Current assets and liabilities are verified from the books of

accounts and also by sending letters to the concerned parties for
the confirmation of their balances. Selection of persons to whom
such letters are to be sent is to be made by the auditor and their
response should be received directly by the auditor only. As far as
non current assets and long term liabilities, records may be
examined and wherever necessary, confirmatory letters may be
sent.

SA 520

Analytical procedure :
The purpose of this standard is to establish standards on the
application of analytical procedures during an audit. This method
can be used at 4 different audit stages viz. planning stage, as
substantive procedure, overall review and investigating unusual
items. Analytical procedures include calculation of different ratios
and making trend analysis.

SA 610 (Revised)

Using the work of internal auditors.

This standard deals with the responsibility of the external
auditor while using the work of internal auditors. The purpose or
objective of internal and external audit is different. But the
procedure followed by both is almost similar. So, much of the work
of the internal auditor is useful to the external auditor. However it
should be distinctly remembered that the sole responsibility of the
report is on the external auditor only. Thus using the work of the
internal auditor may reduce his physical labour but not his
responsibility. So, the external auditor should make a through study
of the internal auditor’s work, his independence or status in the
organisation, his educational qualifications and experience in the
field and then decide to select the work of the internal auditor on
which he can rely.

8.6 QUESTIONS

1) Write a short note on initial engagement,

2) What do you mean by initial engagements and opening
balances under SA 510?
3) What are the auditor’s duties in respect of opening
balances?
4) Analytical procedures are efficient and cost effective means
of auditing a small entity. Comment.
5) State the different types of analytical reviews carried out in
the verification of (i) inventories and (ii) debtors, loans and
advances?
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6) What is internal audit?

7) Explain the relationship between the statutory and internal
auditor.
8) State whether the following statements are true or false.
a) The auditor may apply analytical procedures at the planning
and overall review stages of the audit.
b) Internal audit report is the property of the internal auditor and
the statutory auditor has no right to inspect the same.
c) The old auditor must hand over his working papers to the
new auditor appointed in his place.
9) Can the statutory auditor rely on the work of internal auditor?
Discuss.

New standards on auditing at a glance :

SA No. Subject Effective

from
200 Overall objectives of the independent 1-4-1985
(Revised) auditor and the conduct of an audit an
accordance with standards on auditing
200 A Objectives and scope of audit of 1-4-1985
financial statements
210 Agreeing the terms of audit 1-4-2010
(Revised) engagements
220 Quality control for an audit of financial 1-4-1999
(Revised) statements
230 Audit documentation 1-4-2009
(Revised)
240 The auditors responsibilities relating to 1-4-2009
(Revised) frand in an audit of financial
statements
300 Planning and audit of financial audit 1-4-2008
500 Audit evidence 1-4-2009
(Revised)
501 Audit evidence-specific considerations 1-4-2005
(Revised) for selected items.
505 External confirmations 1-4-2003
(Revised)
510 Initial audit engagements opening 1-4-2010
(Revised) balances.
520 Analytical procedures 1-4-1997
610 Using the work of internal auditors 1-4-2010
(Revised)


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SPECIAL CONSIDERATION IN AUDIT I

GOVERNMENT AUDIT

Unit Structure
9.1 Introduction
9.2 Government Audit Introduction
9.3 Legal Framwork and Comptroller & Auditor General
9.4 Expenditure Audit
9.5 Audit of Receipts
9.6 Audit of Commercial Accounts
9.7 Reporting Procedures

9.1 INTRODUCTION

Every audit has its own unique features, requiring special

skills, Knowledge, related Statutory Provisions / Requirements,
peculiar accounting methods used etc. There are certain common
features with all types of audits. Auditors should include following
points in addition to usual / special requirements [these are
common points for most of Special points]

i) Audit Programme should be specially designed for such

entities, considering Accounting system, Internal controls and
it’s effectiveness, compliance of Legal Requirements, etc.
ii) The main Substantive procedures to be followed in any other
audit are also required to be followed in any special audit,
which are as under :

a) Obtain Appointment letter indicating nature of work & its scope

b) Determine overall audit objectives, True & Fair View, Legal
Requirements
c) Names of Executives, Accountants, Trustees, as the case may
be etc. their specimen signatures and their powers
d) Past Audit Reports, internal audit reports in any.
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e) Communication with previous auditor, in case of new

appointment
f) Past Financial statements.

After considering above, effectiveness of Inter Control, Auditor can

decide test checks on the following:

Opening balances, Vouching, Posting, Casting, Ledger

Scrutiny, Verifications of various Assets & Liabilities on date of year
end, Purchase and Sale of Fixed Assets. Fixed Assets Register,
Trial Balance or Receipts & Payments a/c, Final Accounts and its
Approval by appropriate Authorities.

However, it must be noted that the varying transactions of

every different entity have their special features which have to be
considered by the Auditor in drawing Audit programme.

9.2 GOVERNMENT AUDIT INTRODUCTION

In India, the function of government audit is discharged by

the independent statutory authority of the Comptroller and Auditor
General through the agency of the Indian Audit and Accounts
Department. Audit is a necessary function to ensure accountability
of the executive to Parliament, and within the executive of the
spending agencies to the sanctioning or controlling authorities. The
Comptroller and Auditor General (C & AG), in the discharge of his
functions, watches that the various authorities act in regard to
financial matters in accordance with the Constitution and the laws
made by Parliament, and conform to the rules or orders made there
under.

9.3 LEGAL FRAMWORK AND COMPTROLLER &

AUDITOR GENERAL

The Constitution of India contains specific provisions

regarding the appointment, salary and duties and powers of the C &
AG. The constitution guarantees the independence of the C & AG
of India by prescribing that he shall be appointed by the President
of India and shall not be removed from office except on the ground
of proven misbehavior or incapacity. The Constitution further
provides that the conditions of service of person serving in the
Indian Audit and Accounts Department and the administrative
powers of the C & AG shall be determined by the President after
consultation with him.

Article 149 states that the C & AG shall perform such duties
and exercise such powers in relation to the accounts of the Union
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and of the States and of any other authority or body as may be

prescribed by or under any law made by the Parliament. The
Comptroller & Auditor General’s (Duties, Powers and Conditions of
Services) Act, 1971 defined these functions and powers in detail.

Article 150 of the Constitution provides that the accounts of

the Union and of the States shall be kept in such from as the
President may on the advice of the C & AG prescribed.

Article 151 requires that the reports of the C & AG relating to

the accounts of the Union / State shall be submitted to the
President / Governor who shall cause them to be laid before House
of Parliament / State Legislature.

Duties of the C & AG:

i) Compile and submit Accounts of Union and States – The

Comptroller and Auditor General shall be responsible for compiling
the accounts of the Union and of each State from the initial and
subsidiary accounts rendered to the audit and accounts offices
under his control by treasuries, offices or departments responsible
for the keeping of such account.

The C & AG Act of 1971 has provisions for relieving him of

this responsibility to give information and render assistance to the
Union and States : The Comptroller and Auditor General shall, in so
far as the accounts, for the compilation or keeping of which he is
responsible, enable him so to do, give to the Union Government, to
the State Government or to the Governments of Union Territories
having Legislative Assemblies, as the case may be, such
information as they may, from time to time, require and render such
assistance in the preparation of the annual financial statements as
they may reasonably ask for.

ii) General Provision Relating to Audit – It shall be the duty

of the Comptroller and Auditor General –

a) To audit and report on all expenditure from the Consolidated

Fund of India and of each State and of each Union Territory
having a Legislative Assembly and to ascertain whether the
moneys shown in the accounts as having been disbursed
were legally available for and applicable to the service or
purpose to which they have been applied or charged and
whether the expenditure conforms to the authority which
governs it.
b) To audit and report all transactions of the Union and of the
States relating to Contingency Funds and Public Accounts.
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c) To audit and report on all trading, manufacturing profit and

loss accounts and balance-sheets and other subsidiary
accounts kept in any department of the Union or of a State.

iii) Audit of Receipts and Expenditure – Where any body or

authority is substantially financed by grants or loans from the
Consolidated Fund of India or of any State or of any Union Territory
having a Legislative Assembly, the Comptroller and Auditor
General shall, subject to the provisions of any law for the time being
in force applicable to the body or authority, as the case may be,
audit all receipts and expenditure of that body or authority and to
report on the receipts and expenditure audited by him.

Where the grant or loan to a body or authority from the

Consolidated Fund of India or of any State or of any Union Territory
having a Legislative Assembly in a financial year is not less than
rupees twenty-five lakhs and the amount of such grant or loan is
not less than seventy-five per cent of the total expenditure of that
body or authority, such body or authority shall be deemed, for this
purpose to be substantially financed by such grants or loans as the
case may be.

iv) Audit of Grants or Loans – Where any grant or loan is

given for any specific purpose from the Consolidated Fund of India
or of any State or of any Union Territory having a Legislative
Assembly to any authority or body, not being a foreign State or
international organisation, the Comptroller and Auditor General
shall scrutinise the procedures by which the sanctioning authority
satisfies itself as to the fulfillment of the conditions subject to which
such grants or loans were given and shall for this purpose have
right of access, after giving reasonable previous notice, to the
books and accounts of that authority or body.

v) Audit of Receipts of Union or States – It shall be the duty

of the Comptroller and Auditor General to audit all receipts which
are payable into the Consolidated Fund of India and of each State
and of each Union Territory having a Legislative Assembly and to
satisfy himself that the rules and procedures in that behalf are
designed to secure an effective check on the assessment,
collection and proper allocation of revenue and are being duly
observed and to make for this purpose such examination of the
accounts as he thinks fit and report thereon.

vi) Audit of Accounts of Stores and Stock – The Comptroller

and Auditor General shall have authority to audit and report on the
accounts of stores and stock kept in any office or department of the
Union or of a State.
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vii) Audit of Government Companies and Corporations –

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.

Powers of C & AG

The C & AG Act gives the following powers to the C & AG in

connection with the performance of his duties :

a) To inspect any office of accounts under the control of the

Union or a State Government including office responsible for
the creation of the initial or subsidiary accounts.
b) To require that any accounts, books papers and other
documents which deal with or are otherwise relevant to the
transactions under audit, be sent to specified places.
c) To put such questions or make such observations as he may
consider necessary to the person in charge of the office and to
call for such information as he may require for the preparation
of any account or report which it is his duty to prepare.

In carrying out the audit, the C & AG has the power to dispense
with any part of detailed audit of any accounts or class of
transactions and to apply such limited checks in relation to such
accounts or transactions as he may determine.

9.4 EXPENDITURE AUDIT

The audit of Government expenditure is one of the major

components of Government audit. The basic standards set for audit
of expenditure are to ensure that there is provision funds authorized
by competent authority fixing the limits within which expenditure
can be incurred.

These standards are :

i) That the expenditure incurred conforms to the relevant

provisions of the statutory enactment and in accordance with
the Financial Rules and Regulations framed by the competent
authority. Such an audit is called as the audit against ‘rules
and orders’.
ii) That there is sanction, either special or general, accorded by
competent authority authorizing the expenditure. Such an
audit is called as the audit of sanctions.
iii) That there is a provision of funds out of which expenditure
can be incurred and the same has been authorized by
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competent authority. Such an audit is called as audit against

provision of funds.
iv) That the expenditure is incurred with due regard to broad and
general principles of financial propriety. Such an audit is also
called as propriety audit.
v) That the various programmes, schemes and projects where
large financial expenditure has been incurred or being run
economically and are yielding results expected of them. Such
an audit is termed as the performance audit.

Each of the above audits is discussed in detail in the following

paragraphs.

1. Audit against Rules & Orders – Audit against rules and

orders aims to ensure that the expenditure conforms to the relevant
provisions of the Constitution and of the laws and rules made
thereunder. It also seeks to satisfy that the expenditure is in
accordance with the financial rules, regulations and orders issued
by a competent authority. These rules, regulations and orders
against which regularity audit is conducted mainly fall under the
following categories :

i) Rules and orders regulating the powers to incur and sanction

expenditure from the Consolidated Fund of India or of a State
(and the Contingency Fund of India or of a State)
ii) Rules and orders dealing with the mode of presentation of
claims against Government, withdrawing moneys from the
Consolidated Fund, Contingency Fund and Public Accounts of
the Government of the India and of the States, and in general
the financial rules prescribing the detailed procedure to be
followed by Government servants in dealing with government
transactions; and
iii) Rules and orders regulating the conditions of services, pay
and allowances, and pensions of Government servants.

It is the function of the executive government to frame rules,

regulations and orders, which are to be observed by its subordinate
authorities. The job of audit is to see that these rules, regulations
and orders are applied properly by the subordinate authorities. It is,
however, not the function of audit to prescribe what such rules,
regulations and orders shall be. But, it is the function of audit to
carry out examination of the various rules, regulations and orders
issued by the executive authorities to see that :

a) They are not inconsistent with any provisions of the

Constitution or any laws made thereunder;
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b) They are consistent with the essential requirements of audit

and accounts as determined by the C & AG;
c) They do not come in conflict with the orders of or rules made
by any higher authority; and
d) In case they have not been separately approved by
competent authority, the issuing authority possesses the
necessary rule-making power.

Audit of expenditure against regularity is of a quasi-judicial type of

work performed by the audit authorities. It involves interpretation of
the Constitution, statutes, rules, regulations and orders. The final
power of interpretation of these, however, does not vest with the C
& AG.

2. Audit of sanctions : The auditor has to ensure that each

item of expenditure is covered by a sanction, either general or
special, of the competent authority. The audit of sanctions is
directed both in respect of ensuring that the expenditure is properly
covered by a sanction, and also to satisfy that the authority
sanctioning it is competent for purpose by virtue of the powers
vested in it by the provisions of the Constitution and of the law,
rules or orders made there under, or by the rules of delegation of
financial powers made by an authority competent to do so.

3. Audit against provision of funds – Audit against provision

of funds aims at ascertaining that the expenditure incurred has
been on the purpose for which the grant and appropriation had
been provided and that the amount of such expenditure does not
exceed the appropriation made.

4. Propriety audit – According to ‘propriety audit’, the auditors

try to bring out cases of improper, avoidable, or in fructuous
expenditure even though the expenditure has been incurred in
conformity with the existing rules and regulations. With the passage
of time, it was felt that regularity audit alone was not sufficient to
protect properly the public interest in the spending of money by the
executive authorities. A transaction may satisfy all the requirements
of regularity audit insofar as the various formalities regarding rules
and regulations are concerned, but may still be highly wasteful. A
building may be constructed for installing a telephone exchange but
may not be used for the same purpose resulting in in fructuous
expenditure or a school building may be constructed but used after
five years of its completion a case of avoidable expenditure.

Audit should, therefore, try to secure a reasonably high

standard of public financial morality by looking into the wisdom,
faithfulness and economy of transactions. These considerations
have led to the evolution of audit against propriety which is now
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being combined by the audit authorities with their routine function of

regularity audit. It is hard to frame any precise rules for regulating
the course of audit against propriety. Such an objective of audit
depends for its acceptance on its appeal to the common sense and
straight logic of the auditors and of those whose financial
transactions are subjected to propriety audit. However, some
general principles have been laid down in the Audit Code, which
have for long been recognized as standards of financial propriety.
Audit against propriety seeks to ensure that expenditure conforms
to these principles which have been stated as follows:

1. The expenditure should not be prima facie more than the

occasion demands. Every public officer is expected to exercise
the same vigilance in respect of expenditure incurred from
public moneys as a person of ordinary prudence would exercise
in respect of expenditure of his own money.
2. No authority should exercise its powers of sanctioning
expenditure to pass an order which will be directly or indirectly
to its own advantage.
3. Public moneys should not be utilised for the benefit of a
particular person or section of the community unless :

i) The amount of expenditure involved is insignificant; or

ii) A claim for the amount could be enforced in a Court of law; or
iii) The expenditure is in pursuance of a recognized policy or
custom; and
iv) The amount of allowances, such as traveling allowances,
granted to meet expenditure of a particular type should be so
regulated that the allowances are not, on the whole, sources
of profit to the recipients.

It may be stated that it is the responsibility of the executive

departments to enforce economy in public expenditure. The
function of audit is to bring to the notice of the proper authorities of
wastefulness in public administration and cases of improper,
avoidable and infructuous expenditure.

5. Performance audit – The scope of audit has been extended

to cover efficiency, economy and effectiveness audit or
performance audit, or full scope audit. Efficiency audit look into
whether the various schemes / projects are executed and their
operations conducted economically and whether they are yielding
the results expected of them, i.e., the relationship between goods
and services produced and resources used to produce them; and
examination aimed to find out the extent to which operations are
carried out in an economical and efficient manner. Economy audit
looks into whether Government have acquired the financial, human
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and physical resources in an economical manner, and whether the

sanctioning and spending authorities have observed economy.
Effectiveness audit is an appraisal of the performance of
programmes, schemes, projects with reference to the overall
targeted objectives as well as efficiency of the means adopted for
the attainment of the objectives. Efficiency-cum-performance audit,
wherever used, is an objective examination of the financial and
operational performance of an organisation, programme, authority
or function and is oriented towards identifying opportunities for
greater economy, and effectiveness. The procedure for conducting
performance audit covers identification of topic, preliminary study,
planning and execution of audit, and reporting. While the trend
towards a comprehensive approach for conducting performance of
full scope audit is visible, the coverage and depth of evaluation vary
according to the statutory limitations, and the organisational
constraints of C & AG.

9.5 AUDIT OF RECEIPTS

The audit of receipts is neither all pervasive nor as old as

audit of expenditure but has come to stay in some countries. Such
an audit provides for checking ; (i) whether all revenues or other
debts due to Government have been correctly assessed, realisd
and credit to Government account by the designated authorities; (ii)
whether adequate regulations and procedures have been framed
by the department / agency concerned to secure an effective check
on assessment, collection and proper allocation of cases; (iii)
whether such regulations and procedures are actually being carried
out; (iv) whether adequate checks are imposed to ensure the
prompt detection and investigation of irregularities, double refunds,
fraudulent or forged refund vouchers or other loss of revenue
through fraud or willful omission or negligence to levy or collect
taxes or to issue refunds; and (v) review of systems and
procedures to see that the internal procedures adequately secure
correct and regular accounting of demands collection and refunds
and pursuant of dues up to final settlement and to suggest
improvement. The basic principle of audit of receipts is that it is
more important to look at the general than on the particular, though
individual cases of assessment, demand, collection, refund, etc. are
important within the area of test check. A review of the judicial
decisions taken by tax authorities is done to judge the effectiveness
of the assessment procedure.

The extent and quantum of audit required to be done under

each category of audit are determined by the C & AG. These are
neither negotiable nor questioned. The prescribed extent and
quantum of audit are structured in accordance with the design of
test check, random sampling, general review, in –depth study of
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specified areas, etc. as may be warranted by the nature of

transactions, its importance in the scheme of activities of a
department and the totality of its transactions, the frequency of
check and total plan of audit to be executed during a period.
Institutional mechanism provides for primary check by the auditor,
test check by the supervisor and control and direction by the group
leader. Planning, executing and reporting of work is directed and
monitored at middle and top levels of the audit hierarchy. There are
built-in arrangements within the C & AG to ensure that the work
assigned to each employee is carried out as prescribed. The audit
is conducted both centrally where accounts and original vouchers
are kept and locally where the drawing and disbursing functions are
performed depending on the organisational and institutional
arrangements obtaining.

9.6 AUDIT OF COMMERCIAL ACCOUNTS

Public enterprises are required to maintain commercial

accounts and are generally classified under three categories :

a) Departmental enterprises engaged in commercial and trading

operations, which are subject to the same laws, financial and
other regulations as other Government departments and
agencies;
b) Statutory bodies, corporations; created by specific statutes
mostly financed by Government in the form of loans, grants, etc.
and
c) Government companies set up under the Companies Act, 1956.

The audit of departmental concerns is undertaken in the

same manner as any department of Government where commercial
accounts are kept. Audit of statutory bodies or corporations
depends on the nature and type of the statute governing the bodies
or corporations. Both financial and accounts audit are conducted by
the C & AG, and where compilation of accounts is vested with the C
& AG, functions, norms and standards of works usually followed by
the professional auditors are adopted mutatis mutandis.
Government companies have their own auditors under the statute
appointed by C & AG. In addition, the C & AG conducts a
supplementary test audit of the accounts, as well as periodical
financial audit and appraisal of performance. The C & AG also
issues direction to the company auditors for reporting on specific
aspects of their audit work. These are reviewed, and condensed in
the audit reports to the Government / legislatures. C & AG has
adopted the mechanism of an Audit Board-comprising of
representatives of the audit and nominees of Government including
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functional specialists to process reviews or appraisals on

performance.

In the case of a Government company, the auditor of a

Government company shall be appointed or reappointed by the
Comptroller and Auditor General of India. The Comptroller and
Auditor-General of India shall have power under section 619(3) of
the Companies Act, 1956 as follows :

a) To direct the manner in which the company’s accounts shall be

audited by the auditor and to give such auditor instructions in
regard to any matter relating to the performance of his functions
as such;
b) To conduct a supplementary or test audit of the 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 be furnished to person or persons so
authorized, on such matters, by such person or persons, and in
such form, as the Comptroller and Auditor-General may be
general or special order, direct.

The C & AG shall direct the manner in which the company’s

accounts shall be audited by the statutory auditors and give such
auditors instructions in regard to any matter relating to the
performance of his functions as such. The directions under section
619(3) (a) broadly covers the system of book-keeping and
accounts, internal control etc.

The C & AG has power to conduct a supplementary or test

audit of the company’s accounts by such person as he may
authorize in this behalf and for the purposes of such audit require
information or additional information to be furnished to any person
or persons so authorized on such matters by such person or
persons and in such form as the C & AG may be general or special
order, direct.

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 impose a duty on the board of directors of a company to
give to 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).
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The general standards, principles, techniques and

procedures for audit adopted by the C & AG are a mixture of
Government audit and commercial audit as known and practiced by
professional auditors. The concepts of autonomy and accountability
of the institution / bodies / corporations / companies have
influenced the nature and scope of audit in applying the
conventional audit from the angle of economy, efficiency and
effectiveness.

9.7 REPORTING PROCEDURES

The effectiveness of an audit depends on reporting results to

the proper authority so that appropriate action may be taken to
rectify the irregularities or impropriety where possible or to prevent
re-occurrence. The right as also the obligation to report on the
results of audit findings is inherent to the institution of the Auditor
General and is usually safeguarded in the Constitution and related
enactments. Article 151 of the Indian Constitution enjoins that the C
& AG shall report on the accounts of the Union and of each of the
States to the President or the Governor concern and the letter shall
cause the report to be laid before the legislatures. The reports
should not only be presented to the legislatures but thereafter also
publicized adequately in order to create a proper climate of public
opinion for taking remedial action where necessary, on the findings
of the Auditor General. This may also constitute a more effective
safeguard in the future.

In India the reporting is factual and the conclusions are left to

be drawn by the reader. This is presumably to ensure total
objectivity. Nothing debars C & AG from making recommendations
in the audit report but traditionally this has been left to be done by
the Public Accounts Committee. The overall Indian position
regarding reporting standards contained in instructions issued by
the C & AG on the subject. Experience and professional judgment
ultimately determines what is to be included in the audit reports.
The auditor has to be a through professional and the audit reports
have to be prepared with great skill for both the presentation and
contents should compel readership.


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10

SPECIAL CONSIDERATION IN AUDIT II

Unit Structure
10.1 Audit of Sole Trader
10.2 Audit of a Partnership Firm
10.3 Reports on Accounts of Sole Traders and Partnership
10.4 Audit of Small Companies
10.5 Audit of Hospital
10.6 Audit of Club
10.7 Audit of Hotels
10.8 Tax Audit

10.1 AUDIT OF SOLE TRADER

Most businesses start out as sole trades. This is when an

individual starts to trade with a view to making a profit in his own
name. It is also associated with the term “self employed”.

A sole trader may be just one individual providing services or

the individual may have any number of employees working for him.
For many reasons a business may be structured as a sole trade. It
may depend on the age or size of the business or a professional
service provider may be required to operate as a non-limited liability
entity. Tax efficiency reasons can often play a role as well.

Sole trader accounts will be required for tax purposes as well

as being used for decision making and management purposes.
Accounts will also be needed for dealings with external bodies such
as banks, Government grant providers, etc.
The sole proprietor owns the business individually, it is
managed by him. He may have some paid staffs / workers to assist
him. He provides necessary capital to run the business. He may
borrow funds required for the business from banks, financial
institutions etc. A sole trader operates with unlimited liability. There
is no statutory requirement for getting his accounts audited;
however, sole traders audited accounts will be required for tax
purposes, for securing loans from banks and financial institutions
as well as being used for decision making and management
purposes.
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Account will also be needed to be Audited for dealings with

external bodies such as Banks, Government, Grant providers, etc.

A Sole Trader may get his accounts Audited for following

reasons :

1. Taxation Purposes (Income Tax, VAT, Services Tax etc.)

2. Borrowing from Banks etc.
3. More dependence on Employees (moral check on employees)
4. Business carried on at number of places
5. For valuation of Goodwill (in case of change in constitution)

Auditor should get appointment letter indicating scope of Audit

work. Audit Programme should be prepared specially designed for
such Sole Trader, considering Accounting system, Internal controls
and purpose for which audit to be carried on.

Auditor should insist that books of accounts are to be

maintained on Double Entry principles in case accounts are
maintained on single entry, Auditor should qualify his report that
books are maintained on single entry and its limitations to Sole
Trader.

In case Sole Trader decides audit work for particular

purpose then he should get in writing.

Auditor, depending up-on scope & nature of business,

should consider following :

a) Vouching of Cash / Bank transactions

b) Vouching of Sales & Purchases
c) Casting & Posting from original entry books to Ledger
d) Verification of various Assets & Liabilities
e) Trial Balance
f) Verify Cut-off procedure, whether properly followed
g) Final Account tally with Books of Accounts

Auditor should express his opinion in Audit Report that is to be

submitted to sole trader.
i) The financial statements are prepared using the generally
accepted accounting principles which have been consistently
applied.
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ii) There is adequate disclosure of all material matters and proper

presentation of financial information.

10.2 AUDIT OF A PARTNERSHIP FIRM

The auditor to a firm is usually appointed by the partners

either on the basis of a decision taken by them or to comply with a
condition in the partnership agreement. His remuneration is also
fixed by the partners. It is important that the letter of appointment
should clearly state the nature and scope of audit which is to be
carried out and particulars of limitations, if any, under which he
would have to function.

The Indian Partnership Act, 1932 does not prescribe audit of

a partnership firm. Nevertheless, for the verification of adjustment I
the accounts of partners made in respect of profits and losses,
interest and remuneration of partners, their contribution to capital,
etc. It is necessary that the auditor should have a knowledge of the
provisions in this regard under the Act – especially that of powers
and audit of partners and their right to profit and capital under
different situations and circumstances. The auditor may,
particularly, ensure application of accounting standards prescribed
by the institute. In case the firm is required to get its accounts
audited under the requirements of any statute, the auditor will have
to qualify the report in case of non-compliance with the accounting
standards. Alternatively, only disclosure of non-compliance with the
accounting standards would be sufficient without making it a
subject matter of qualification. Also, before starting the audit, he
should examine the partnership agreement and note the provisions
therein as regards the following matters :

1) The name and style under which the business shall be

conducted.
2) The duration of the partnership, if any, that has been agreed
upon.
3) The amount of capital that shall be contributed by each partner
– whether it will be fixed or could be varied from year to year.
4) The period at the end of which the accounts of the partnership
will be closed periodically and the proportions in which the profit
shall be divided among the partners or losses shall have to be
contributed by them; whether the losses shall be borne by the
partners or whether any of the partners will not be required to do
so.
5) The provisions as regards maintenance of books of account and
the matters which must be taken into account for determining
the profits of the firm available for division among the partners
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e.g., creating of reserves, provision for depreciation, etc. also

the period within which accounts can be reopened for correcting
a manifest error.
6) Borrowing capacity of the partnership (when it is not implied as
in the case of non-trading firms).
7) The rate at which interest will be allowed on the capitals and
loans provided by partners and the rate at which it will be
charged on their drawings and current accounts.
8) Whether any salaries are payable to the partners or withdrawals
are permitted against shares of profits and, if so, to what extent?
9) Duties of the partners as regards the management of business
of the firm; also, the partners who shall act as managing
partners.
10)Who shall operate the bank account of the firm? How will the
surplus funds of the partnership be invested?
11)Limitations and restrictions that have been agreed upon the
rights and powers of partners and on their implied authority to
pledge the firm’s credit or to render it liable.

In the absence of a partnership agreement, the provisions of the

Act which concern the auditor are the following :

i) Each partner is required to contribute an equal amount of

capital.
ii) The partners share equally in profits and losses.
iii) The partners are not entitled to any interest on capital.
iv) Where a partner is entitled to interest on the capital subscribed
by him, such interest will be payable only out of profits.
v) A partner is entitled to interest at 6 percent per annum on his
advances and loans over and above the capital.
vi) Every partner can take part in the management of the
business. A partner is, however, not entitled to receive any
remuneration for taking part in the conduct of the business.
vii) Every partner has the right to inspect and to take a copy of any
of the books of the firm.
viii) A partner is entitled to be indemnified for all payments made
and liabilities incurred by him in the ordinary course of
business or in the preservation of the firm’s property.
ix) The property of the firm must be held and used by the partners
exclusively for the purpose of business.
x) If a partner derives any profit for himself from any transaction
of the firm or from the use of the property or business
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connections of the firm or the firm name, he must account for

that profit and pay it to the firm; also the profit from any
competing business carried on by a partner without other
partners’ consent must also be accounted for and paid to the
firm.
xi) In the absence of any usage or custom of trade to the contrary,
the implied authority of partner does not empower him to :
a) Submit a dispute relating to the business of the firm to
arbitration;
b) Open a bank account on behalf of the firm in his own name;
c) Compromise or relinquish any claim or portion of a claim by the
firm;
d) Withdraw a suit or proceeding filed on behalf of the firm;
e) Admit any liability in a suit or proceeding against the firm;
f) Acquire immovable property on behalf of the firm;
g) Transfer immovable property belonging to the firm; or
h) Enter into partnership on behalf of the firm.
xii) The firm is liable to third parties :
a) If a partner, acting within the scope of his apparent authority,
receives money and misapplies it, or
b) If the firm in the ordinary course of the business receives
money, which is misapplied by a partner.
xiii) No person can be introduced as a partner without the consent
of the other partners.
xiv) Any differences arising as to ordinary matters connected with
the business are to be decided by the majority of the partners,
but no change can be made in the nature of the business
without the consent of all the partners.
xv) If, on the death or retirement of a partner, no final settlement
has been effected and the business is carried on by the
surviving or continuing partners, the outgoing partner or his
estate has the option of claiming :
a) Such share of prohts as may be attributable to his share of
assets or
b) Interest at 6% p.a. on this share of partnerships assets.
xvi) On dissolution of the partnership, every partner has the right to
have the goodwill of the business sold for the common benefit
of all the partners.
xvii) On a dissolution of the firm, the losses, including deficiencies
of capital must be made good :
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a) First out of profits;

b) Next out of capital; and
c) Lastly, by the partners individually in the proportion in which
they share profits.
xviii) On the dissolution of the firm , assets are to be applied in the
following order :
a) In paying the firm’s liabilities to third parties;
b) In repaying partner’s advances and loans;
c) In repaying partner’s capital; and
d) The residue if any, is to be divided amongst the partners in the
proportion in which they share profits.

Advantages – On broad considerations, the advantages of audit of

accounts of a partnership could be stated as follows :

1) Audited accounts provide a convenient and reliable means of

settling accounts between the partners and thereby, the
possibility of occurrence of a dispute among them is mitigated.
On this consideration, it is usually provided in and accepted by
the partners, shall be binding upon them, unless some
manifest error is brought to light within a specified period
subsequent to the accounts having been signed.
2) On the retirement or death of a partner, audited accounts,
which have been accepted by the partners constitute a reliable
evidence for computing the amounts due to the retiring partner
or to the representative of the deceased partner in respect of
his share of capital, profits and goodwill.
3) The accounts of a partnership, which have been audited, are
generally accepted by the Income Tax Department as the basis
for computing the assessable income of the partners and also
for the settlement of their liability in respect of Wealth Tax.
4) Audited statement of accounts are relied upon by the banks
when advancing loans, as well as by prospective purchasers of
the business, as evidence of the profitability of the concern and
its financial position.
5) Audited statements of account can be helpful in the
negotiations to admit a person as a partner, especially when
they are available for a number of past years.
6) An audit is an effective safeguard against any undue
advantage being taken by a working partner or partners
especially in the case of those partners who are not actively
associated with the working of the firm.
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Matters which should be specially considered in the audit of

accounts of a partnership :

i) Confirming that the letter of appointment, signed by a partner,

duly authorized, clearly states the nature and scope of audit
contemplated by the partners, specially the limitation, if any,
under which the auditor shall have to function.
ii) Studying the minute book, if any, maintained to record the
policy decision taken by partners specially the minutes relating
to audhorisation of extraordinary and capital expenditure,
raising of loans; purchase of assets extraordinary contracts
entered into and other such matters as are not of a routine
nature.
iii) Verifying that the business in which the partnership is engaged
is authorized by the partnership agreement; or by any
extension or modification thereof agreed to subsequently.
iv) Examining whether books of account appear to be reasonable
and are considered adequate in relation to the nature of the
business of the partnership.
v) Verifying generally that the interest of no partner has suffered
prejudicially by an activity engaged in by the partnership which,
it was not authorized to do under the partnership deed or by
any violation of a provision in the partnership agreements.
vi) Confirming that a provision for the firm’s tax payable by the
partnership has been made in the accounts before arriving at
the amount of profit divisible among the partners.
vii) Verifying that the profits and losses have been divided among
the partners in their agreed profit-sharing ratio.

From the foregoing steps involved in the audit of a

partnership it would be observed that like the audit of every other
commercial undertaking, it culminates in the verification of the
Balance Sheet and the Profit and Loss Account to ensure that
these exhibit a true and fair state of affairs of the firm.

The object of examining the partnership agreement, which is

an important feature of such a audit, is that the auditor may be able
to report to the partners if the interest of any partner has been
prejudicially affected, on account of the firm having engaged itself
in an activity which it was not authorized to do or violation of any
provision of the partnership agreement.
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10.3 REPORTS ON ACCOUNTS OF SOLE TRADERS

AND PARTNERSHIP

There is no statutory form of auditor’s report in the case of

sole traders and partnerships. Often the auditors of sole traders
and firms have nothing to say on the audited accounts except
“Audited and found correct” or “Examined and found correct”. This
form of reporting is not recommended as it gives no indication of
the extent of the examination of accounts that has been carried out.

The Guidance Note on Members Duties regarding

Engagements involving Compilation of Financial Statements to
provide guidance on the professional responsibilities of the
members of the Institute of Chartered Accountants of India, when
an engagement to compile financial statements or other financial
information is undertaken and the form and content of the report
issued in connection with such a compilation so that the association
of the name of the member with the financial statements is not
misconstrued by a user of the statements as the same having been
audited by him.

For the member, the objective of a compilation engagement

is to use accounting expertise, as opposed to auditing expertise, to
collect, classify and summaries 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 member to express any opinion 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 professional
competence and due care.

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 summarization of other financial
information. Engagements to provide limited assistance to a client
in the preparation of financial statements (for example, on the
selection of an appropriate accounting policy) do not constitute an
engagement to compile financial information.

It is essential that the member clearly brings out the nature

of association with the financial statements and the nature of the
work performed by him. The following recommendations are made
in this regard.
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i) The title of the report should be “ACCOUNTANT’S REPORT

ON UNAUDITED FINANCIAL STATEMENTS” AND NOT AN
‘AUDITOR’S REPORT”
ii) The report should be addressed to the appointing authority.
iii) The report should identify the financial information compiled,
also stating that it is based on the information provided by
the management.
iv) The report should clearly state that the financial statements
are not audited.
v) In describing the engagement, ambiguous terms such as
‘review’, ‘general review’, ‘check’ etc., should not be used.
vi) Date of the report should be mentioned.
vii) Name and address of the firm of the member appointed for
carrying out the compilation engagement should be
mentioned.
viii) Signatures and the designation (sole proprietor / partner)
and membership number should appear in the report.

An example of the report is given below :

Example of an Accountant’s Report on Unaudited Financial
Statements
To ….

On the basis of information provided by management we have

compiled the balance sheet of …. (name of the entity) as of March
31, XXXX and the statement of profit and loss for the period then
ended. The balance sheet and the statement of profit and loss are
in agreement with the books of account. We have not audited or
reviewed these financial statements and accordingly express no
opinion thereon.

Date :

For A & Co.

Signature (Name of the partner and membership number)
Partner
Chartered Accountants

10.4 AUDIT OF SMALL COMPANIES

The duties and responsibilities of the auditors in respect of

the individual small company client are the same as in larger audits
and the satisfactory accomplishment of the work requires the skilful
adaptation and application of the principles of auditing to the
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individual case. Because the relationship with the directors is

frequently less formal, it is particularly important that the
arrangement and scope of the work should be clearly defined and
recorded. A number of problems relating to small companies and
procedural matters of importance in this respect are, therefore,
given in the following paragraphs :

1) Letter of Engagement – It is advisable for the auditor to

submit to their client and to receive an acknowledgement of the
precise scope of their responsibilities both in respect of the audit
and any additional work to be undertaken. At the time of
engagement, the auditors should explain to the directors
management’s responsibilities for the preparation of the accounts
and establishing a system of internal control appropriate to the
needs of the business. The letter should also explain the reliance
which the auditors can place upon an effective system. This should
subsequently be confirmed in writing, possibly in the engagement
letter.
2) Internal control – At an early stage in the audit, the auditors
should take care to bring to the directors’ attention their findings on
the system of internal control.
Problems in small companies arise in the application of
auditing principles and procedures. Due to inadequate staff they
are unable to apply these principles in totality. These problems
mainly arise from :
a) Substantial domination of the accounting and financial
functions by one person; and
b) Limitations in the effectiveness from the audit point of view of
the system of internal control rendered inevitable by the small
number of employees.

Either or both of the above points can be present to a significant

extent in most of the small companies.

3) Letter of representations – After discussion with the

directors at the conclusion of the audit and before signing the
auditor’s report, a letter of representation on the company’s letter
head addressed to the auditors should be obtained. The purpose of
such letters is to place on record representation of management on
significant matters affecting the account such as the ownership and
basis of stating the amount of assets, liabilities, and contingent
liabilities such letters, however do not releive the auditors at any of
their responsibilities.
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10.5 AUDIT OF HOSPITAL

The special steps involved in such an audit are stated below

1) Vouch the Register of patients with copies of bills issued to

them. Verify bills for a selected period with the patients’
attendance record to see that the bills have been correctly
prepared. Also see that bills have been issued to all patients
from whom an amount was recoverable according to the rules of
the hospital.
2) Check cash collections as entered in the Cash Book with the
receipts, counterfoils and other evidence for example, copies of
patients bills, counterfoils of dividend and other interest
warrants, copies of rent bills, etc.
3) See by reference to the property and investment Register that
all income that should have been received by way of rent on
properties, dividends, and interest on securities settled on the
hospital, has been collected.
4) Ascertain that legacies and donations received for a specific
purpose have been applied in the manner agreed upon.
5) Trace all collections of subscription and donations from the
Cash Book to the respective Registers. Reconcile the total
subscriptions due (as shown by the Subscription Register and
the amount collected and that still outstanding).
6) Vouch all purchases and expenses and verify that the capital
expenditure was incurred only with the prior sanction of the
Trustees or the Managing Committee and that appointments
and increments to staff have been duly authorized.
7) Verify that grants, if any received from Government or local
authority have been duly accounted for. Also, that refund in
respect of taxes deducted at source has been claimed.
8) Compare the totals of various items of expenditure and income
with the amount budgeted for them and report to the Trustees or
the Managing Committee significant variations which have taken
place.
9) Examine the internal check as regards the receipt and issue of
stores; medicines, linen, apparatus, clothing, instruments, etc.
so as to insure that purchases have been properly recorded in
the Stock Register and that issues have been made only
against proper authorization.
10)See that depreciation has been written off against all the assets
at the appropriate rates.
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11)Inspect the bonds, share scrip, title deeds of properties and

compare their particulars with those entered in the property and
Investment Registers.
12)Obtain inventories, especially of stocks and stores as at the end
of the year and check a percentage of the items physically, also
compare their total values with respective ledger balances.

10.6 AUDIT OF CLUB

A club is usually constituted as a company limited by

guarantee. Therefore, various provisions of the Companies Act,
1956 relating to the audit of accounts of companies are also
applicable to its audit. The special steps involved in such as audit
are stated below :

a) Vouch the receipt on account of entrance fees with members’

applications, counterfoils issued to them, as well as on a
reference to minutes, of the Managing Committee.
b) Vouch member’s subscriptions with the counterfoils of receipt
issued to them, trace receipts for a selected period to the
Register of Members; also reconcile the amount of total
subscriptions due with the amount collected and that
outstanding.
c) Ensure that arrears of subscriptions for the previous year have
been correctly brought over and arrears for the year under audit
and subscriptions received in advance have been correctly
adjusted.
d) Check totals of various columns of the Register of members and
tally them across.
e) See the Register of Members to ascertain the Member’s dues
which are in arrear and enquire whether necessary steps have
been taken for their recovery; the amount considered
irrecoverable should be mentioned in the Audit Report.
f) Verify the internal check as regards members being charged
with the price of foodstuffs and drinks provided to them and their
guests, as well as, with the fees chargeable for the special
services rendered; such as billiards, tennis, etc.
g) Trace debits for a selected period from subsidiary registers
maintained in respect of supplies and services, to members to
confirm that the account of every member has been debited with
amounts recoverable from him.
h) Vouch purchase of sports items, furniture, crockery, etc. and
trace their entries into the respective stock registers.
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i) Vouch purchases of foodstuffs, cigars, wines etc. and test their

sale price so as to confirm that the normal rates of gross profit
have been earned on their sales. The stock of unsold provisions
and stores, at the end of year, should be verified physically and
its valuation checked.
j) Check the stock of furniture, sports material and other assets
physically with the respective stock registers or inventories
prepared at the end of the year.
k) Inspect the share scrip and bonds in respect of investments,
check their current values for disclosure in final accounts; also
ascertain that the arrangements for their safe custody are
satisfactory.
l) Examine the financial powers of the secretary and, if these have
been exceeded, report specific care for confirmation by the
Managing Committee.

10.7 AUDIT OF HOTELS

There are many problems involved in any hotel audit, some

of which are peculiar to the hotel industry such as control of cash
assume greater proportions.

Almost all sales points in a hotel make both cash and credit
sales. The auditor should reconcile the total sales reported with the
total of the bills issued by the sales point; this total may take the
form of a bill roll or a series of numerically controlled bills. This
numerical control must be checked to ensure that all bills are
included in the total. The cash element of the sales must then be
checked to the cash records and the credit sales in total and detail
to the guest’s bills.

The special problems in a hotel audit can be summarized as

follows:

1) Internal Controls – Pilfering is one of the greatest problems

in any hotel and the importance of internal control cannot be over
stressed. It is the responsibility of management to introduce
controls which will minimize the leakage as far as possible.
Evidence of their success is provided by the preparation of regular
perhaps weekly, trading accounts for each sales point and a
detailed scrutiny of the resulting profit percentages, with any
deviation from the anticipated form being investigated. The auditor
should obtain these regular trading accounts for the period under
review, examine them and obtain explanations for any apparent
deviations.
 206

If the internal control in a hotel is weak or perhaps breaks

down, then a very serious problem exists for the auditor. As a result
of the transient nature of many of his clients’ records, the auditor
must rely to a very large extent on the gross margin shown by the
accounts. As a result, the scope of his audit tests will necessarily
be increased and, in the event of a material margin discrepancy
being unexplained he will have to consider qualifying his audit
report.

2) Room Sales – The charge for room sales is normally posted

to guest bills by the receptionist or in the case of large hotels by the
night auditor. The source of these entries is invariably the guest
register and audit tests should be carried out to ensure that the
correct number of guests is charged for the correct period. Any
difference between the charge rates used on the guests’ bills and
the standard room rate should be investigated to ensure that they
have been properly authorized.

In many hotels, the housekeeper prepares a daily report of

the rooms which were occupied the previous night and the number
of beds kept in each room. This report tends not to be permanently
retained and the auditor should ensure that a sufficient number of
reports are available for him to test both with the guest register and
with the individual guest’s bill.

3) Stocks – The stocks in any hotel are both readily portable

and saleable particularly the food and beverage stocks. It is
therefore extremely important that all movements and transfers of
such stocks should be properly documented to enable control to be
exercised over each individual stores areas and sales point. The
auditor should carry out tests to ensure that all such documentation
is accurately processed.

Areas where large quantities of stock are held should be

kept locked, the key being retained by the departmental manager.
The key should be released only to trusted personnel and
unauthorized persons should not be permitted in the stores areas
except under constant supervision. In particular, any movement of
goods in or out of the stores should be checked, it is not unknown
for a full crate to be removed in error as an empty crate.

Many hotels use specialized professional valuers to take and

value the stocks on a continuous basis throughout the year. Such a
valuation is then almost invariably used as the basis of the balance
sheet stock figure at the year end. Although such valuers are
independent of the audit client, it is important that the auditor
satisfies himself of this the auditor should consider attending at the
physical stock taking and carrying out certain pricing and
calculation tests. The extent of such tests could well be limited
 207

since the figures will have been prepared independently of the

hotel.

4) Fixed Assets – The accounting policies for fixed assets of

individual hotels are likely to differ. however, many hotels account
for certain quasi-fixed assets such as silver and cutlery on stock
basis. This can lead to confusion between each stock items and
similar assets which are accounted for on a more normal fixed
assets basis. In such cases it is important that very detailed
definitions of stock items exist and the auditor should carry out tests
to ensure that the definitions have been closely followed.

5) Casual Labour – The hotel trade operates to very large

extent of casual labour. The records maintained of such wage
payments are frequently inadequate. The auditor should ensure
that defalcation on this account does not take place by suggesting
proper controls to the management.

6) Other Points :
i) For ledgers coming through travel agents or other booking
agencies the bills are usually made on the travel agents or
booking agencies. The auditor should that money are
recovered from the travel agents or booking agencies as per
the terms of credit allowed.
ii) Commission, if any, paid to travel agents or booking agents
should be checked by reference to the agreement on that
behalf.
iii) The auditor should ensure that proper records re-maintained
for booking of halls and other premises for special parties
and recovered on the basis of the tariff.
iv) The auditor should verify a few restaurant bills by reference
to K.O.T.s (Kitchen Order Tickets) or basic record. This
would enable the auditor to ensure that controls regarding
revenue cycle are in order.
v) The auditor should see that costs of renovation are treated
as deferred revenue expenditure, where as costs of major
alterations and additions to the hotel building and facilities
capitalised.
vi) The auditor should ensure that proper valuation of
occupancy-in-progress at the balance sheet date is made
and included in the accounts.
vii) The auditor should satisfy himself that all taxes collected
from occupants on food and occupation have been paid over
to the proper authorities.
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viii)In large hotels it is usual to operate a booth to facilitate

convertor of foreign currencies to Indian rupees. The auditor
should ensure compliance with the various applicable
provisions of Foreign Exchange Dealer’s Association.

10.8 TAX AUDIT

10.8.1 MEANING
1. Auditor audits financial statements to report about reliability
about earning & Financial position of the business entity. Share-
holders & interested in audit report. These financial statements
provide information to the readers to know about the operating
results and financial status of the business entity.

Profit & Loss a/c prepared by accountants discloses Book

Profit which is totally different than taxable profit. Such profit
requires lot of adjustments to find out taxable profit. e.g.
Depreciation allowable under I.T. Rules is different than that of
normal ways of calculating depreciation. Expenses / Income not
related to business are also considered in P & L A/c Income Tax
also permits deductions at prescribed percentages or full amount in
certain cases e.g. R & d Expenditure even though it amounts to
capital expenditure. Certain payments are totally disallowed while
computing taxable business income. Tax has to be deducted on
certain payments, to be reported to tax authorities and same has to
be remitted to the department within the prescribed time limit.
These reasons have created specific information requirements for
tax administration.

Income tax authorities do not have sufficient time to look for

all such requirements. This has given rise to TAX AUDIT. Tax
audit is a specific requirement under the Income Tax Act. It is
required in addition to financial audit, which does not fulfill the
specific requirements of the tax authority.

The Hon. Finance Minister introduced Compulsory Tax Audit

while presenting the Union Budget for 1984-85. The compulsory
tax audit is intended to ensure proper maintenance of books of
accounts and records. This facilities the tax authorities to tax true
income of assessed as well as it saves considerable time of
assessing officer for completing Income Tax Assessment.

The income tax act, 1961, contains a numbers of provisions

which require audit or certification for tax purposes, e.g. sections
12A.33AB, 33ABA, 35D 35E, 44AB, 44DA, 80HH, 80 HHB,
80HHNA, 80HHC, 80HHD, 80HHE, 80HHF, 80I, 80IA, 80IB, 80IC,
80JJA, 80LA, 115JB and 142[2A]
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10.8.2. Types of Tax Audit

Considering requirements of above sections, Tax Audit can

be classified in three types as under:
a) Compulsory Tax Audit u/s 44AB
b) Selective tax audit u/s 142[2A]
c) Tax Audit for claiming certain exemptions

10.8.3. Scope of Auditors Role under Income Tax Act:

Auditors Role under Income Tax Act can be broadly
summarized into:
a) Conducting compulsory Tax Audit u/c 44AB.
b) Certifying in prescribed form claiming certain
exemptions & deductions, under Income Tax Act
c) Conducting selective audit u/s 142 [2A]
d) Submitting Tax Audit Report under prescribed from
e) Advising clients about Tax planning

10.8.4. COMPULSORY TAX AUDIT

The tax audit was introduced by Section 11 of Finance Act,
1984. section 44AB was inserted in Income Tax Act, with effect
from assessment year 1985-86. The 44AB section stipulates that
every person carrying on business or profession is required to get
his accounts audited by a chartered accountant before the
“specified date” and furnish by that date the report of such audit, if
the total sales, turnover or gross receipts exceed Rs. 60 lakhs in
the case of business and gross receipts exceed Rs. 15 lakhs in the
case of profession - vide clauses (a) and (b) of section 44AB.

i) Clause (c) of section 44AB, inserted by the Finance Act 1997

w.e.f. assessment year 1998-99, provides that in the case of
an assessee carrying on a business of the nature specified in
sections 44AD, 44AE, tax audit will be required, if he claims his
income to be lower than the presumptive income deemed
under the said sections. Therefore, an assessee will be
required to get his accounts audited even if his turnover does
not exceed Rs.60 lakhs.

ii) The 44AB section stipulates that every person carrying on

business or profession is required to get his accounts audited
by a chartered accountant before the “specified date” and
furnish by that date the report of such audit, if the total sales,
turnover or gross receipts exceed Rs. 60 lakhs in the case of
business and gross receipts exceed Rs. 15 lakhs in the case of
profession – vide clauses (a) and (b) of section 44AB.

iii) Under the provisions of sections 44AD, an assessee can opt to

be assessed on presumptive basis, so long as the gross
receipts/total turnover from any of the business(es) do not
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exceed Rs. 60 lakhs. Once the total turnover/gross receipts

from any such business(es) exceed Rs. 60 lakhs, a tax audit
will be required under clause (a) of section 44AB. The
provisions of sections 44AA and 44AB shall not apply insofar
as they relate to the business plying, hiring or leasing goods
carriages as referred to in section 44AE(1) and business as
referred to in section 44AD(1). In computing the monetary
limits under sections 44AA and 44AB, the turnover/gross
receipts, or as the case may be, the income from the said
business shall be excluded.

iv) If a person is carrying on business(es) coming within the scope

of sections 44AD, 44AE, but he exercises his option given
under these sections to get his accounts audited under section
44AB, tax audit requirements would apply, in respect of such
business(es) even if the turnover of such business covered by
section 44AD, 44AE and opting for presumptive taxation, tax
audit requirement would not apply in respect of such
businesses. If such person is carrying on other business(es)
not covered by presumptive taxation, tax audit requirements
would apply in respect thereof, if the turnover of such
business(es), other than the business(es) covered by
presumptive taxation thereof, exceed Rs. 60 lakhs.

v) The first proviso to section 44AB stipulates that the provisions

of that section will not be applicable to a person who derives
income of the nature referred to in section 44B, 44BB, 44BBA
or 44BBB. Where the assessee is carrying on any one or
more of the businesses specified in section 44B or section
44BB or section 44BBA or section 44BBB referred to in the first
proviso to section 44AB, the sales/turnover/gross receipts from
such businesses shall not be included in the total
sales/turnover/gross receipts for determining the applicability of
section 44AB.

This section makes it obligatory for a person caring on

Business/Profession to get his accounts audited by a Chartered
Accountant and furnish tax audit report in the prescribed from by
the specified date, if the total turnover or gross receipts in business
in the relevant previous year exceed the prescribed limits. With
effect from assessment year 2011-2012, threshold turnover/gross
receipts limits for Compulsory Audit of accounts increased to Rs. 60
lakhs for business and business and Rs. 15 lakhs for profession.
Certain exceptions are provided under the selection in respect of
business even if gross receipts etc. exceed the specified limit. e.g.
assesses adopting for presumptive taxation. The following
assesses enjoying presumptive taxation are outside the preview of
compulsory tax audit. Scope of presumptive taxation extended to
small business with a turnover unto Rs. 60,00,000/- e.g.
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i) U/S.44B Non residents deriving income from shipping

business
ii) U/S.44BB Non residents deriving income from the business
of exploration of minerals oils
iii) U/S 44BBB foreign companies engaged in the business of
civil construction in certain turnkey projects
iv) U/S 44AD person engaged in civil construction business
v) U/S 44AE person engaged in the business of plying, leasing
or hiring trucks etc

10.8.5. Penalty for Non Compliance:

According to Section 271B, if a person fails to comply with
the provision as to compulsory audit U/S44AB of Income Tax Act or
fails to furnish such report, he will be required to pay by way of
penalty, as under:
i) A sum equal 0.5% of total sales, or gross receipts in
the relevant previous year, OR
ii) Rs. 1 lakh., Whichever is less.
However, section 273B provides that no penalty shall be
imposed if the assessee proves that there was reasonable cause
for such a non-compliance e.g. Strike in the Office., death of
Auditor just before signing audit report.

10.8.6. Definition of Tax Auditor:

The tax audit report has to be certified by Accountant’s
defined in the Income Tax Act. Accountant, means a practicing
Chartered Accountant within meaning of the Chartered Accountant
Act 1949. the Chartered Accountant must be holding certificate of
practice and also includes a person whou/s.226[2] of the
Companies Act 1956, is entitled to be appointed as an auditor of
company. t is not necessary that statutory Auditor should be
appointed as Tax Auditor. Any practicing Chartered Accountants
can be also be appointed as Tax Auditor. Name of the partner who
conducted audit % signed Audit Report should be stated along with
his membership number.

10.8.7. Appointment of Tax Auditor:

1. In case of a Company:
Board of Directors can appoint the Tax Auditor to audit
accounts of the company. There is no need or requirement of
approval by share-holders in A.G.M.
2. In case of Partnership firm:
A partner of the firm or a person authorized by partners on
their behalf can appoint Tax Auditor. Partnership Deed may have
clause for appointment of Auditors / Tax Auditor.
 212

3. In case Proprietorship concern:

The Proprietor or a person authorized by the proprietor can
appoint Tax Auditor.
4. In any other business concern:
Management of the organization or any other person
authorized by management, can appoint tax auditor.
5. The assessee may appoint two or more Chartered
Accountants as Joint Auditors for the purpose of carrying on tax
audit. In such a case all appointed Joint Auditors have to sign
Financial Statements as well as Tax Audit Report.

NOTE: The Institute of the Chartered Accountant of India has

prescribed a ceiling of 30 tax audits per Chartered Accountant as a
self regulatory measure among Chartered Accountants.

10.8.8. Persons who can not be appointed as Tax Auditor:

The Guidance Note on Tax Audit u/s 44AB issued by ICAI
has disqualified following persons who can not be appointed as Tax
Auditor:
a) Internal Auditor who is employee of the assesse.
b) A Chartered Accountant who is responsible for writing or
maintaining of books of accounts of the assessee.
c) A relative of a Director cannot be appointed as tax auditor of
the company.
d) A relative or an employee of assesse cannot be appointed as
tax auditor
e) The audit of accounts of professional firm of Chartered
Accountants u/s 44AB can not be conducted by any partner or
employee of the firm.

10.8.9. Removal of Tax Auditor:

Once Tax Auditor is appointed in the normal course, he

should not be removed during the period of his appointment.
However management can remove a tax auditor, if there are valid /
reasonable grounds for such removal. e.g. After his appointment
the said person becomes person of unsound mind., disturbing
clients day today work beyond tolerances.

10.8.10. The specified date:

The Tax Auditor has to furnish tax audit report in the
prescribed from by the specified date:

The specified date in relation to the account of previous year

relevant to an assessment year means:
 213

a) Where the assessee is a company, the 30th day of

November of the assessment year.
b) In any other case, the 31st day of October of the
assessment year.

10.8.11. Definition of Business / Profession / Vocation:

Business simply means production and/or distribution of
goods or services with a view to earn profit. Section 2[13] defines
the term “business” as: business includes any trade, commerce or
manufacture or any adventure or concern in the nature of trade,
commerce or manufacture. Business means any activity carried on
continuously and systematically with a view to earn profit.

Profession means an occupation involving intellectual work

requiring special knowledge and having professional qualification,
such as doctor, architect, cost accountant etc. As per Section 2[36]
Profession includes vocation. Vocation means an occupation
involving manual skill such as singing, dancing painting etc.
However Income Tax Act does not make any distinction between
Business or profession or vocation, method of computation of
taxable income in same.

Section 44B does not distinguish between two business or

profession carried on by the same assesse. If turnover of both the
proprietary concerns, combined together exceeds the prescribed
limits then such person has to get his books of accounts audited.

10.8.12. Meaning of Sales and Turnover:

The Income Tax Act does not define the term ‘Sale’ and
‘turnover’. The guidance note issued by the Institute of Chartered
Accountants of India [ICAI] on the subject suggests that:
i] These terms should be interpreted with reference to their normally
accepted commercial meaning, and
ii] The method of accounting followed by the assessee is also
relevant for the determination of ‘sales’ or ‘turnover’

On the basis of the interpretation of these terms, the ICAI, in

its earlier pronouncements, has adopted following view regarding
what constitutes sales:

a] Sales includes sale of by-product scrap even though such

sales are credited to ‘miscellaneous income a/c’

b] Sales should be net of trade discount turnover discount,

goods returned, price discount and cancellation of bills.
 214

c] Commission allowed to third parties, cash discount, bad

debts written off, Royalty, etc. should not be adjusted against sales
and should be debited separately to profit & loss a/c.

d] If sales price includes excise duty or sales tax [VAT], no

adjustment in respect thereof should be made. In case these taxes
are accounted separately, and taxes collected are credited to
Excise to Vat a/c and amount paid debited to excise or Vat a/c
Then excise duty or sales tax [vat] would not be included in the
turnover. Thus treatment of excise duty or sales tax [vat] depends
on the accounting practice usually followed.

e] If sales invoices /bills include extra and ancillary charges

such as packing, carriage etc. such bills are called composite bills,
then total billed amount is to considered as turnover. Incase extra
and ancillary charges are accounted separately [even though it
shown invoice separately] as reimbursements of costs, then it
should not be added to sales/turnover.

f] Sales/Turnover does not include sale proceeds of Fixed

Assets of property or Shares/Debentures/Securities, as
investments.

g] Sales by a commission agent or consignment basis,

should be treated as sale of such person only if the property in
goods belongs to him immediately before the transfer of such
goods by him to the buyer.

If the property in the goods continuously belongs to the

principal till time of sale then it should be included in sales. To
whom the property in goods belong at the of sale is a matter to be
determined by examining the facts of each case.

10.8.13. Meaning of ‘Gross Receipts’

According to the guidance notes on Tax Audit u/s 44AB of
the Income Tax Act, issued by the ICAI, Gross receipts refer to all
receipts arising from carrying on the business, which would
normally be assessable as business income under Income Tax
Law. The following items of income and/or receipts would be
covered by the term ‘Gross Receipts’.

1. Profit on sale of license granted under imports

2. Cash incentives for exports
3. Liquidation damages
4. Insurance claim except for Fixed Assets
5. Interest received by a moneylender
6. Hire charges of cold storage.
7. Sales proceeds of scrap, wastages unless treated as part
of sale of turnover
 215

8. Lease Rent.
9. Hiring charges and installments received in course of hire
purchase.

In case of money received as reimbursement of expanses

incurred, such as packing, forwarding, insurance etc. are credited
to a separate account only the net surplus on this account should
be added to turnover.

The following items would not from part of ‘Gross Receipts’

for purpose of Section 44 AB

a) Sale proceeds of fixed assets

b) Sales proceeds of asset held as investments.
c) Rental income unless the same is assessable as business
income
d) Dividend on shares except in case of assesses dealing in
Shares.
e) Income by way of interest unless assessable as business
income.
f) Reimbursement of custom duty and other charges collected by
a clearing agent.

In case of a professional, money received as reimbursement of

expenses incurred on behalf of client does not form part of his
gross receipts provided these are credited to a separate account
and are utilized for wholly & solely for the purpose of meeting
expenses incurred on behalf of client.

Similarly amount received from client does not from a part of

Gross receipt because services are yet to be rendered.
10.8.14 PROCEDURE TO CONDUCT A TAX AUDIT
Unlike Statutory audit, Tax Audit under section 44 AB is not
confined to only to Company Audit. Tax Auditor not only has to
certify about Financial Statements and report on that but also report
on various income tax compliances. Auditor should apply the
generally accepted practice and procedures of auditing.
The auditors should get the Financial Statements and other
particulars authenticated by the assesse before he starts Tax Audit.

The auditor should verify Internal Control system prevalent in

the entity and the materiality of various transactions. then he can
prepare audit programme and apply various audit techniques of test
checking or statistical sampling.

While conducting tax audit, auditor should keep in mind that

the primary object of tax audit, is to assist the tax authorities in
assessing the correct taxable income of the assessee. In
 216

conducting tax audit, Auditor has to develop skill of combination of

general auditing principles and various taxation Laws. Auditor has
to check the compliances of various mandatory accounting
standards issued by ICAI.

According to the guidance notes on tax Audit u/s 44 AB of

the Income Tax Act, issued by the ICAI, it is necessary that Auditor
should keep detail notes about the evidence, explanations got from
client, on which he relied while conducting the tax audit and like as
usual he should keep working papers. Auditor should note down
following points while conducting tax audit :

a) Nature of client’s business

b) Previous Financial Statements and Reports
c) Names of Account Officers & their performance & works
assigned to them
d) Auditor should prepare Tax Audit Questionnaire and ask the
client to answer it in writing, so auditor can get required
information for conduct of efficient audit, Questionnaire should
include :

i) Accounting Standards followed

ii) All significant accounting policies to be disclosed
iii) Any change in accounting policy, having material effect on
profit and / or financial position of the organization.
iv) Prior period item to be shown separately
v) Extraoradinary items of enterprise to be disclosed
vi) Change in method of valuation of inventory
vii) Change in method of charging depreciation

e) Audit work done & by whom

f) Information & explanation given to him during course of audit &
by whom.
g) Various certificates issued by client / management
h) Decisions taken by the management on various points affecting
tax audit

Above points can be noted, it helps auditors to prepare audit report

in from NO. 3CA, 3CB, AND 3CD
 217

1. FORMATS FOR TAX AUDIT

FORM NO. 3CA

[See rule 6G(1) (a)]
Audit report under section 44AB of the Income-Tax Act, 1961, in a case
where the accounts of the business or profession of a person have been
audited under any other law
*I/we report that the statutory audit of
Permanent Account No.
was conducted by *me / us / M/s
in pursuance of the provisions of the
Act, and *I/We annex hereto a copy of *my/our/their audit report dated
along with a copy each of –
1. a) The audited *profit and loss account / income and expenditure
account for the year ended on ;
b) The audited balance sheet as at ; and
c) Documents declared by the said Act to be part of, or annexed to, the
*profit and loss account / income and expenditure
account and balance sheet.
2. The statement of particulars required to be furnished under section 44 AB
is annexed herewith in Form No. 3 CD.
3. In *my / our opinion and to the best of *my/our information and according
to explanations given to *me/us, the particulars given in the said Form No.
3CD and the Annexure are true and correct

____________________
**Signed

Place : Name :
Date : 01/04/2012 Address :

Notes :
1. *Delete whichever is not applicable.
2. **This report has to be signed by –
i) A Chartered accountant within the meaning of the Chartered
Accountants Act, 1949 (38 of 1949); or
ii) Any person who, in relation to any State, by virtue of the provision of
sub-section (2) of section 226 of the Companies Act, 1956 (1 of
1956), entitled to be appointed to act as an auditor of companies
registered in that State; or
iii) Any person who is, by virtue of any other law, entitled to audit the
accounts of the assessee for the relevant previous year.
3. Where any of the requirements in this Form is answered in the negative
or with a qualification, give reasons therefore.
4. The person, who signs this audit report, shall indicate reference of his
membership number / certificate of practice number / authority under
which he is entitled to sign this report.
 218

FORM NO. 3CB

[See rule 6G(1) (b)]
Audit report under section 44AB of the Income-Tax Act, 1961, in the
case of a person perfect clause (b) of sub-rule (1) of rule 6G
st
*I/we have examined the balance sheet as at 31 March, and the
Profit and Loss Account / income expenditure account for the year ended on
that date, attached herewith, of

Permanent Account No.

2. I certify that the balance sheet and the Profit and Loss Account / income
and expenditure account are in agreement with the books of account
maintained at the head office at and ** branches.

3. a) I report the following observations / comments / discrepancies /

inconsistencies; if any :

b) Subject to above –
A. I have obtained all the information and explanations which, to the best of
ma knowledge and belief were necessary for the purpose of the audit.
B. In my our opinion, proper books of account have been kept by the head
office and branches of theassessee so far appears from my examinations
of the books.
C. In my opinion and to the best of information and according to the
explanations given to me the said accounts, read with notes thereon, if
any, give a true and fair view :
i) In the case of the balance sheet, of the sate of the affairs of the
st
assessee as at 31 March, and
ii) In the case of the Profit and Loss Account / income and expenditure
account of the Profit / Loss or surplus / deficit of assessee for the
year ended on that date.
4. The statement of particulars required to be furnished under section 44AB
is annexed herewith in Form No. 3CD.
5. In my opinion and to the best of my/our information and according to
explanations given to me, the particulars given in the said Form No. 3CD
and the Annexure thereto are true and correct.

____________________
**Signed

Place : Name :
Date : 01/04/2012 Address :

Notes :
1. *Delete whichever is not applicable.
2. **This report has to be signed by –
i) A Chartered accountant within the meaning of the Chartered
Accountants Act, 1949 (38 of 1949); or
ii) Any person who, in relation to any State, by virtue of the provision of
sub-section (2) of section 226 of the Companies Act, 1956 (1 of
1956), entitled to be appointed to act as an auditor of companies
registered in that State.
3. The person, who signs this audit report, shall indicate reference of his
membership number / certificate of practice number / authority under
which he is entitled to sign this report.
 219

FORM NO. 3CD

[See rule 6G(2)]
Statement of particulars required to be furnished under section
44ab of the income-tax act, 1961

PART – A

1. Name of the assessee :

2. Address :
3. Permanent Account Number :
4. Status :
5. Previous year ended :
6. Assessment year :

PART – B

7. a) If firm or Association of persons,

indicate Names of partners /
members and their Profit sharing
ratios.
b) If there is any change in the
partners / members or in their
profit sharing ratios since the
last date of the preceding year,
the particulars of such change.
8. a) Nature of business of profession Manufacturing Trading
(if more than one business or
profession is carried on during
Manufacturing Services
the previous year, nature of
cum trading
every business or profession).
Details :
Profession Others
b) If there is any change in the
nature of business or profession,
the particulars of such change.
9. a) Whether books of account are
prescribed under section 44AA, Yes No  N/A
if yes, list of books so
prescribed.
b) Books of account maintained.
(In case books of account are
maintained in a computer
system, mention the books of
account generated by such
computer system.)
c) List of books of account
examined.
10. Whether the Profit and Loss Account Yes No
includes any profits and gains  N/A
assessable on presumptive basis, if
yes, indicate the amount and the
relevant section (44AD, 44AE, 44AF,
44B, 44BB, 44BBA, 44BBB or any
other relevant section).
 220

11. a) Method of accounting employed  Mercantile cash

in the previous year.
Notes :
b) Whether there has been any Yes No
change in the method of  N/A
accounting employed vis-à-vis
the method employed in the
immediately preceding previous
year.
c) If answer to (b) above is in the Not Applicable
affirmative, give details of such
change, and the effect thereof
on the Profit or Loss.
d) Details of deviation, if any, in the Not Applicable
method of accounting employed
in the previous year from
accounting standards prescribed
under section 145 and the effect
thereof on the Profit or Loss
12. a) Method of valuation of closing Not Applicable
stock employed in the previous
year.
(if at cost market rates whichever is less rite 1, if at cost write 2, if at market
write 3, if not applicable write 4)
b) Details of deviation, if any, from `:
the method of valuation
prescribed under section 145A, Details :
ad the effect thereof on the
Profit or Loss
12 a) Give the following particulars of the capital asset converted into stock-in-
trade :
Sr. Description of Capital Date of acquisition Cost of Amount at
No asset acquisition which the asset
. is converted into
stock-in-trade

13. Amounts not credited to the

profit and Loss account, being -
a) The items falling within the
scope of section 28;
b) The proforma credits,
drawbacks, refunds of duty of
customs or excise or service tax,
or refunds of sales tax or value
added tax where such credits,
drawbacks or refunds are
admitted as due by the
authorities concerned;
c) Escalation claims accepted
during the previous year;
d) Any other item of income;
e) Capital receipt, if any.
 221

14. Particulars of depreciation allowable as per the Income-tax Act, 1961 in

respect of each asset of block of assets, as the case may be, in the following
form :
As per Annexure
15 Amount admissible under section Not Applicable
33AB, 33ABA, 33AC, 35, 35ABB,
35AC, 35CCA, 35CCB, 35D, 35E :
16. a) Any sum paid to an employee as
bonus or commission for
services rendered, where such
sum was otherwise payable to
him as profits or dividend.
[Section 36(1) (ii)].
b) Any sum received from
employees towards
contributions to any provident
fund or superannuation fund or
any other Fund mentioned in
section 2 (24) (x); and due date
for payment and the actual date
of payment to the concerned
authorities under section 36(1)
(va).
17. Amount debited to the Profit and Loss
Account, being :
a) Expenditure of capital nature;
b) Expenditure of personal nature;
c) Expenditure on advertisement in
any souvenir, brochure, tract,
pamphlet or the like, published
by a political party;
d) Expenditure incurred at clubs,
i) As entrance fees and
subscriptions,
ii) As cost for club services and
facilities used;
e) i) Expenditure by way of penalty
or fine for violation of any law for
the time being in force;
ii) any other penalty or fine;
iii) expenditure incurred for any
purpose which is an offence or
which is prohibited by law;
f) Amounts inadmissible under
section 40 (a);
g) Interests, salary, bonus,
commission or remuneration
inadmissible under section 40(b)
/ 40 (ba) and compulation
thereof;
 222

h) A. whether a certificate has Yes No

been obtained from the  N/A
assesses regarding payments
relating to any expenditure
covered under section 40A(3)
that payments were made by
account payee cheques drawn
on a bank or account payee
cheques drawn on a bank or
account payee bank draft, as the
case may be,
B. Amount inadmissible under
section 40 A(3) read with rule
6DD (with break up of
inadmissible amounts);
i) Provision for payment of gratuity
not allowable under section 40
A(7);
j) Any sum paid by the assessee
as an employer not allowable
under section 40 A(9);
k) Particulars of any liability of a `
cotingent nature.
Particulars :
l) Amount of deduction
inadmissible in terms of section
14A in respect of the
expenditure incurred in relation
to income which does not form
part of the total income.
m) Amount inadmissible under the
proviso to section 36(1) (iii)
Notes :
17. A. Amount of interest inadmissible
under section 23 of the Micro
Small And Medium Enterprises
Development Act, 2006
18. Particulars of payments made to `:
persons specified under section
40A(2)(b). Particulars :
19. Amounts deemed to be profits and `:
gains under section 33AB or 33ABA
or 33AC.
20. Any amount of Profit chargeable to `:
tax under section 41 and computation
thereof.
21. i) In respect of any sum referred to
in clause (a), (b), (d) or (e) of
section 43B, the liability for
which :
A. Pre-existed on the first day of
the previous year but was not
allowed in the assessment of
any preceding previous year and
 223

was
a) paid during the previous year; `:
b) not paid during the previous `:
year;

B. was incurred in the previous

year and was
a) paid on or before the due `:
date for furnishing the return of
income of the previous year
under section 139(1);
b) not paid on or before the `:
aforesaid date

*State whether sales tax, customs Yes No

duty, excise duty or any other indirect  N/A
tax, levy, cess, impost etc. is passed
through the profit and loss account
22. a) Amount of Modified Value Note :
Added Tax credits availed of or
`:
utilized during the previous year
and its treatment in the Profit
and Loss Account and treatment
of outstanding Modified Value
Added Tax credits in the
accounts.
b) Particulars of income or `:
expenditure of prior period
credited or debited to the Profit Particulars :
and Loss Account.
23. Details of any amount borrowed `:
on hundi or any amount due
thereon (including interest on Details :
the amount borrowed) repaid,
otherwise than through an
account payee cheque [Section
69D].
24. a) *Particulars of each loan or deposit in an amount exceeding the limit
specified in section 269SS taken or accepted during the previous year :

As per Annexure 24(a)

b) *Particulars of each repayment of loan or deposit in an amount exceeding
the limit specified section 269T made during the previous year :

As per Annexure 24(b)

c) Whether a certificate has been Yes No
obtained from the assessee  N/A
regarding taking or accepting
loan or deposit, or repayment of
the same through an account
payee cheque or an account
payee bank draft.
 224

25. a) Details of brought forward loss or depreciation allowance, in the following

manner, to the extent available :
Sr. Assessment Nature of loss Amount as Amount as Remarks
No Year / allowance returned assessed (give
. (in rupees) (in rupees) reference to
relevant order)

b) Whether a change in shareholding of the company has taken place in the

previous year due to which the losses incurred prior to the previous year
cannot be allowed to be carried forward in terms of section

Yes No  N/A
26. Section-wise details of deductions, if any, admissible under Chapter VIA.
Serial No. Section Amount

27. a) Whether the assessee has Yes No

complied with the provisions of  N/A
Chapter XVII-B regarding
deduction of tax at source and
regarding the payment thereof to
the credit of the Central
Government.
b) If the provisions to Chapter XVI-
B have not been complied with,
please give the following
details&, namely :
Sr. Tax deductible and not Shortfall on account Tax deducted Tax deducted
No deducted at all of leaser deduction late but not paid to
. than required to be the Central
deducted Government
28. a) In case of a trading concern, give
quantitative details of principal items of
goods traded :
i) Opening Stock :
ii) Purchases during the previous year :
iii) Sales during the previous year :
iv) Closing stock :
v) Shortage / excess, if any :
Notes :
b) In the case of a manufacturing concern,
given quantitative details of the principal
items of raw materials, finished products
and by-products :
A. Raw Materials :
i) Opening stock;
ii) Purchase during the previous year :
iii) Consumption during thy previous year
iv) Sales during the previous year;
v) Closing stock;
 225

vi) yield of finished products;

vii) percentage of yield;
viii) shortage / excess, if any :
Notes
B. Finished products / By-products :
i) Opening stock;
ii) Purchases during the previous year ;
iii) quantity manufactured during the
previous year;
iv) sales during the previous year;
v) closing stock;
vi) Shortage / excess, if any.
Notes :
29. In the case of a domestic company, details of tax on
distributed profits under section 115-O in the following
form :
a) Total amount of distributed ` :
profits;
b) Total tax paid thereon : `:
c) Dates of payment with amounts. Details :
30. Whether any cost audit carried out, if Yes No
yes, enclose a copy of the report of  N/A
such audit [See section 139 (9)]
31. Whether any audit was conducted Yes No
under the Central Excise Act, 1944, if  N/A
yes, enclose a copy of the report of
such audit.
32. Accounting ratios with calculations as
follows
a) Gross profit / Turnover; %
b) Net profit / Turnover; %
c) Stock-in-trade / turnover; %
d) Material consumed / finished %
goods produced.
Notes :

-------------------------------------
*Signed

Place Name :
Date Designation :
Address :

Note :
1. The annexure to this Form must be falling which from will be considered
as incomplete.
2. This form and the Annexure have to be signed by the person competent
to sign Form No. 3CA or Form No. 3CB, as the case may be.


 226

Note : *Please enter the relevant code pertaining to the main area of your business activity. The
codes are as follows

Sector Sub-Sector Code Sector Sub-Sector Code Sector Sub-Sector Code

1. Manufacturing Agro-based 0101 Wholesalers 0203 Forex Dealers 0706
industry industries
Automobile & Auto 0102 Others 0204 Hospitality 0707
parts services
Cement 0103 3. Commission General 0301 Hotels 0708
Agents commission
Diamond cuttings 0104 Agents I.T. enabled 0709
services,
Drugs & 0105 4. Builders Builders 0401 BPO service
Pharmaceuticals providers
Electronics including 0106 Estate Agents 0402 Security 0710
Computer Hardware agencies 0711
Software
development
Engineering goods 0107 Property 0403 Transporters 0712
Developers
Fertilizers, 0108 Others 0404 Travel agents, 0713
Chemical, Paints tour operators
Flour & Rice Mills 0109 5. Contractors Civil Contractors 0501 8. Financial Others 0714
Service Sector
Food Processing 0110 Excise 0502 Banking 0801
Units Contractors Companies
Marble & Granite 0111 Forest 0503 Chit Funds 0802
Contractors
Paper 0112 Mining 0504 Financial 0803
Contractors Institutions
Petroleum & 0113 Others 0505 Financial 0804
Petrocheicals service
providers
Power & Energy 0114 6. Professionals Chartered 0601 Leasing 0805
Accountants, Companies
 227

Printing & 0115 Auditors, etc Money Lenders 0806

Publishing
Rubber 0116 Fashion 0602 Non-banking 0807
designers Finance
Steel 0117 Legal 0603 Companies
professionals
Sugar 0118 Medical 0604 Share Brokers, 0808
professionals
Tea, Coffee 0119 Nursing Homes 0605 Sub-brokers,
etc.
Textiles, Handloom, 0120 Specialty 0606 Others 0809
hospitals
Powerlooms Others 0607 9. Entertainment Cable T.V. 0901
Industry productions
Tobacco 0121 7. Service Advertisement 0701 Film 0902
Sector distribution
Tyre 0122 Agencies Film 0903
laboratories
Vanaspati & Edible 0123 Beauty Parlours 0702 Motion Picture 0904
Oils
Others 0124 Consultancy 0703 Producers
services
2. Trading Chain Stores 0201 Courier Agencies 0704 Television 0905
Channels
Retailers 0202 Computer training 0705 Others 0906
/
Educational and 0705
Coaching
institutes
 228

ANNEXURE – I

PART – A

1. Name of the Assessee :

2. Address :
3. Permanent Account Number :
4. Status :
5. Previous year ended :
6. Assessment year :

PART – B

Nature of Business or Profession in respect of every business or profession carried on during the
previous year Code

Sr. Parameters Current Preceding Sr. Parameters Current Preceding

No. Year Year No. Year Year
1. Paid up share capital 0 0 9. Gross Profit 0 0
/ Capital of Partner /
Proprietor
2. Share Application 0 0 10. Commission received 0 0
Money / Current
Account of Partner or
Proprietor, if any,
3. Reserve and Surplus 0 0 11. Commission paid 0 0
/ Profit and Loss
Account
4. Secured Loans 0 0 12. Interest received 0 0
5. Unsecured Loans 0 0 13. Interest paid 0 0
6. Current liabilities and 0 0 14. Depreciation as per 0 0
provisions books of account
 229

7. Total of Balance 0 0 15. Net profit (or loss) 0 0

Sheet before tax as per Profit
and Loss Accountant
8. Gross turnover / 0 0 16. Taxes on income paid / 0 0
Gross receipts provided for in the
books

------------------------------------------------
Sign
Place : Name :
Date : Designation :
Address :

1. Particulars of depreciation allowable as per the Income Tax Act, 1961 in respect of each asset
or block of assets, as the case may be, in the following form :

Sr. Description of Rate of Actual Cost or Addition Modified Change in Rate Subsidy or Depreciation Written
No. Asset / Block of Depreciation Written Down Deductions Value of Exchange of Grant or Allowable down
Assets Value during the Added Tax Currency Reimburse value at
Year with credit ment the end of
Dates claimed the year
and allowed
under the
Central
Excise
rules, 1944
 230

ANNEXURE 24(A)

a) *Particulars of each loan or deposit in an amount exceeding the limit specified in section
269SS taken or accepted during the previous year :

Sr. Name and Address PAN Amount of loan Whether the loan or deposit Maximum amount Whether the loan or deposit
No. or deposit was squared up during the outstanding in the was taken or accepted
taken or previous year account at any time otherwise than by an account
accepted during the previous payee cheque or an account
year payee bank draft

ANNEXURE 24(B)

a) *Particulars of each repayment of loan or deposit in an amount exceeding the limit specified in
section 269T made during the previous year :

Sr. Name and Address PAN Amount or repayment Maximum amount Whether the repayment was
No. outstanding in the made otherwise than by an
account at any time account payee cheque or an
during the previous account payee bank draft
year


 231

11

AUDIT OF INSURANCE COMPANIES

Unit Structure
11.1 Introduction
11.2 Legal Framework
11.3 Register of Policies and Register of Claims
11.4 Requirements of Schedule B To the Irda Regulations, 2002
11.5 Exercise

11.1 INTRODUCTION

Insurance is a contract of indemnity between insurer and

insured. The insurance may be classified as life insurance and
general insurance. The business of insurance is now superintended
and regulated by Insurance Regulatory and Development Authority
(IRDA).

11.2 LEGAL FRAMEWORK

It is important for the auditor to familanise himself with

various statutes governing the insurance industry. The auditor while
familiarizing himself with various rules, regulations, relevant
notifications, should also look into the important aspects arising out
of those which might have an effect on determination of nature,
timing and extent of audit procedures, while performing his role as
an auditor.

The primary legislations which deal with the insurance

business in India are the Insurance Act, 1938 and the IRDA Act,
1999. Various aspects relating to audit are dealt with around the
framework of the following statutes and rules made there under:

(a) The Insurance Act, 1938 (including Insurance Rules, 1939);

(b) The Insurance Regulatory and Development Authority Act,
1999;
(c) The Insurance Regulatory and Development Authority
Regulations framed under the IRDA, Act, 1999;
(d) The Companies Act, 1956; and
 232

(e) The General Insurance Business (Nationalization) Act, 1972

(including Rules framed thereunder).

Some relevant statutory provisions are discussed below:

1. Insurer:
Section 2(9) of the Insurance Act, 1938 (hereinafter referred to as
the ‘Act’) defines the term ‘Insurer’ as:
(a) any individual or unincorporated body of individuals or body
corporate incorporated under the law of any country other than
India, carrying on insurance business not being a person specified
in sub-clause (c) of this clause which-
(i) carries on that business in India, or
(ii) has his or its principal place of business, employs a
representative, or maintains a place of business in India;

(b) anybody corporate not being a person specified in sub-

clause (c) of this clause carrying on the business of insurance,
which is a body corporate incorporated under any law for the time
being in force in India; or stands to any such body corporate in the
relation of a subsidiary company within the meaning of the Indian
Companies Act, 1973, (7 of 1913), as defined by sub-section (2) of
section 2 of that Act; and

(c) any person who in India has a standing contract with

underwriters who are members of the Society of Lloyd’s whereby
such person is authorized within the terms of such contract to issue
protection notes, cover notes, or other documents granting
insurance cover to others on behalf of the underwriters,
But does not include a principal agent, special agent, or an
insurance agent or a provident society.
2. Policy Holder:
Section 2(2) of the Insurance Act, 1938 defines the term
policy holder as a person to whom the whole of the interest of the
policy holder in the policy is assigned once and for all, but does not
include as assigner thereof whose interest in the policy is
defensible or is for the time being subject to any condition.
3. Requirements as to the Minimum Paid-up Capital:
The minimum paid-up equity share capital of an Indian
Insurance Company carrying on general insurance business should
be Rs 100 crores or more, excluding deposits under Section 7 of
the Insurance Act, 1938 and preliminary expenses incurred in the
formation and registration of company. The management of an
insurance company needs to certify the pattern of shareholding as
on every Balance Sheet date.
 233

4. Deposits:
Section 7 of the Insurance Act, 1938 requires every insurer,
carrying a general insurance business, to deposit and keep
deposited with RBI in it’s one of the offices in India a sum
equivalent to three percent of total gross premium written in India in
any financial year. The maximum limit of deposit under this section
is Rupees ten crores. The deposit is to be for and on behalf of the
Government of India.

5. Separation of Accounts and Funds

Where the insurer carries on business of more than one of
the following classes, namely, life insurance, fire insurance, marine
insurance or miscellaneous insurance, he shall keep a separate
account of all receipts and payment in respect of each such class of
insurance business.

6. Accounts and Balance Sheet

Every insurer, in respect of insurance business transacted
by him and in respect of his shareholders’ funds, shall, at the
expiration of each financial year, prepare with reference to that
year-
A balance sheet,
A profit and loss account,
A separate account of receipts and payments,
A revenue account in accordance with the regulations made by the
IRDA,
A separate account relating to funds of shareholders; and
A separate account relating to funds of policy-holders.
7. Audit
Every insurance company should keep separate account for
shareholders fund and the policy holders’ fund. The insurance
companies are required to prepare financial statements in
accordance with IRDA i.e. preparation of financial statements and
Auditors Report of Insurance Companies Regulations 2000. The
Schedule A to the Regulations contains provisions applicable to life
insurance business. Schedule B to the Regulations lays down
accounting principles, disclosures forming part of financial
statements, Schedule C lays down matter to be covered in
Auditor’s report of both life and general insurance business.
The balance sheet, profit and loss account, revenue account
and profit and loss appropriation account of every insurer, shall,
unless they are subject to audit under the Indian Companies Act,
be audited annually by an auditor, and the auditor shall in the audit
of all such accounts have the powers of, exercise the functions
vested in, and discharge the duties and be subject to the liabilities
and penalties imposed on auditors of companies by the Indian
Companies Act.
 234

11.3 REGISTER OF POLICIES AND REGISTER OF

CLAIMS

1. Register of Policies: Every insurer shall maintain a register of

record of policies, in which shall be entered, in respect of every
policy issued by the insurer, the name and address of the
policyholder, the date when the policy was effected and a record of
any transfer, assignment or nomination of which the insurer has
notice.

2. Register of Claims: Every insurer shall maintain a register or

record of claims, in which shall be entered every claim made
together with the date of the claim, the name and address of the
claimant and the date on which the claim was discharged, or, in the
case of a claim which is rejected, the date of rejection and the
grounds there for.

11.4 REQUIREMENTS OF SCHEDULE B TO THE

IRDA REGULATIONS, 2002

Preparation of Financial Statements and Auditors’ Report of

Insurance Companies

Preparation of financial statements by life insurer [IRDA

regulation 3]

An insurer carrying on life insurance business, after the

commencement of IRDA Regulation, must comply with the
requirement of Schedule A. Schedule A, is divided into 5 parts:

Part I : Accounting Principles for preparation of Financial

Statements.

Part II : Disclosures forming part of Financial Statements

Part III: General Instructions for preparation of Financial

Statements

Part IV: Contents of Management Report

Part V : Preparation of Financial Statements:
1. Revenue Account (Policyholders account) in Form A- RA
2. Profit and Loss Account (Shareholders Account) in Form
A-PL
3. Balance Sheet in Form A-B5
4. Receipts and Payment Account as per Direct Method
prescribed in AS-3 Cash Flow Statement issued by ICAI.
 235

PART I – ACCOUNTING PRINCIPLES FOR PREPARATION OF

FINANCIAL STATEMENTS

1. Applicability of Accounting Standards: Every Balance

Sheet, Receipts and Payments Account [Cash Flow Statement] and
Profit and Loss Account [Shareholders’ Account] of the insurer shall
be in conformity with the Accounting Standards (AS) issued by
ICAI, to the extent applicable to the insurers carrying on general
insurers carrying on general insurance business, except that:
(i) Account Standard 3 (AS 3) – Cash Flow Statements – Cash
Flow Statement shall be prepared only under the Direct Method.
(ii) Accounting Standard 13 (AS 13) – Accounting for
Investments, shall not be applicable.
(iii) Accounting Standard 17 (AS 17) – Segment Reporting –
shall apply to all insurers irrespective of the requirements regarding
listing and turnover mentioned therein.

2. Premium: Premium shall be recognized as income over the

contract period or the period of risk, whichever is appropriate.
Premium received in advance, which represents premium income
not relating to the current accounting period, shall be disclosed
separately in the financial statements.

A reserve for unexpired risks shall be created as the amount

representing that part of the premium written which is attributable
to, and to be allocated to the succeeding accounting periods and
shall not be less than as required under section 64 V(1)(ii)(b) of the
Act.

Premium Received in Advance, which represents premium

received prior to the commencement of the risk, shall be shown
separately under the head ‘Current Liabilities’ in the financial
statements.

3. Premium Deficiency: Premium deficiency shall be

recognized if the sum of expected claim costs, related expenses
and maintenance costs exceeds related reserve for unexpired risks.

4. Acquisition Costs: Acquisition costs, if any, shall be

expensed in the period in which they are those costs that vary with,
and are primarily related to, the acquisition of new and renewal of
insurance contracts. The most essential test is the obligatory
relationship between costs and the execution of insurance
contracts (i.e. commencement of risk).

5. Claims: The components of the ultimate cost of claims to an

insurer comprise the claims under policies and specific claims
 236

settlement costs. Claims under policies comprise the claims made

for losses incurred, and those estimated or anticipated under the
policies following a loss occurrence.

A liability for outstanding claims shall be brought to account

in respect of both direct business and inward reinsurance business.
The liability shall include:-
(a) Future payments in relation to unpaid report claims;
(b) Claims Incurred But Not Reported(IBNR) including
inadequate reserves [sometimes referred to as Claims Incurred but
Not Enough Reported (IBNER),

This will result in future cash/asset outgo for settling liabilities

against those claims. Change in estimated liability represents the
difference between the estimated liability for outstanding claims at
the beginning and at the end of the financial period.

The accounting estimate shall also include claims cost

adjusted for estimated salvage value if there is sufficient degree of
certainty of its realization.

6. Recognition of Surplus arising in non-participating

funds as profit/loss in the Profit & Loss Account: Authority vide
its CIRCULAR NO. IRDA/F&A/CIR/217/12/2010 dated December
12, 2010, has observed that there is no uniform approach followed
by the insurers for transfer of the surplus to the Profit & Loss
Account. A few of the insurers are doing it on quarterly basis while
a few are doing on yearly basis.

In view of the same, it is clarified that the surplus arising in

non-participating funds may be recognized as Profit & Loss
Account on quarterly basis provided that
a. Financial Statements are audited on quarterly basis
b. The surplus to be transferred to Profit & Loss Account must
be certified and recommended by the Appointed Actuary of
the company
c. A disclosure to this effect should be made in the financial
statement.
d. In any case the amount transferred must not exceed the
yearly profit. The difference if any must be adjusted in the 4th
quarter. In case the variation in the surplus is in excess of
10% or 5 crores, which is higher, then the company shall
submit to the Authority an explanation stating reasons for
variation along with the annual financial statement. The
explanation of variation so submitted shall be approved by
Board of Directors.
 237

In case of deficit, insurer will continue to follow the existing

practices of making the shortfall good by transferring the funds from
shareholders account for recognizing the deficit in the profit & loss
account on quarterly basis.

Actuarial Valuation of claim liability – in some cases

Claims made in respect of contracts where the claims

payment period exceeds four years shall be recognized on an
actuarial basis, subject to regulations that may be prescribed by the
Authority. in such cases, certificate from a recognized actuary as to
the fairness of liability assessment must be obtained. Actuarial
assumption shall be suitably disclosed by way of notes to the
account.

7. Procedure to determine the value of investments: An

Insurer shall determine the values of investments in the following
manner:

(a) Real estate – Investment property: Investment property shall

be measured at historical cost less accumulated depreciation and
impairment loss, residual value being considered zero and no
revaluation being permissible.

The Insurer shall assess at each balance sheet date whether

any impairment of the investment property has occurred.

An impairment loss shall be recognized as an expense in the

Reveune/Profit and Loss Account immediately.

Fair value as at the balance sheet date and the basis of its
determination shall be disclosed in the financial statements as
additional information.

(b) Debt Securities: Debt securities including government

securities and redeemable preference shares shall be considered
as “held to maturity” securities shall be measured at historical cost
subject to amortization.

(c) Equity Securities and Derivative Instruments that are traded

in active markets: Listed equity securities and derivative
instruments that are traded in active markets shall be measured at
fair value as at the balance sheet date. For the purpose of
calculation of fair value, the lowest of the last quoted closing price
of the stock exchanges where the securities are listed shall be
taken.
 238

The insurer shall assess on each balance sheet date

whether any impairment of listed equity security(ies) derivative(s)
instruments has occurred.

An active market shall mean a market, where the securities

traded are homogenous, availability of willing buyers and willing
sellers is normal and the prices are publicly available.

Unrealized gains/losses arising due to changes in the fair

value of listed equity shares and derivative instruments shall be
taken to equity under the head ‘Fair Value Change Account’. The
‘Profit on Sale of Investments’ or ‘Loss on Sale of Investment’, as
the case may be, shall include accumulated changes in the fair
value previously recognized in equity under the heading Fair Value
Change Account in respect of a particular security and being
security.

For the removal of doubt, it is clarified that balance or any

part thereof shall not be available for distribution as dividends. Also,
any debit balance in the said Fair Value Change Account shall be
reduced from the profits/free reserves while declaring dividends.

The insurer shall assess, at each balance sheet date,

whether any impairment has occurred. An impairment loss shall be
recognized as an expense in Revenue/Profit and Loss Account to
the extent of the difference between the premeasured fair value of
the security/investment and its acquisition cost as reduced by any
previous impairment loss recognized as expense in Revenue/Profit
and Loss Account. Any reversal of impairment loss earlier
recognized in Revenue/Profit and Loss Account shall be recognized
in Revenue/Profit and Loss Account.

(d) Unlisted and other than actively traded Equity Securities

and Derivative Instruments: Unlisted equity securities and
derivative instruments and listed equity securities and derivative
instruments that are not regularly traded in active market will be
measured at historical costs. Provision shall be made for diminution
in value of such investments. The provision so made shall be
reversed in subsequent periods if estimates based on external
evidence show an increase in the value of the investment over its
carrying amount. The increased carrying amount of the investment
due to the reversal of the provision shall not exceed the historical
cost.

For the purposes of this regulation, a security shall be

considered as being not actively traded, if as per guidelines
governing mutual funds laid down from time to time by SEBI, such
a security is classified as “thinly traded”.
 239

8. Loans: Loans shall be measured at historical cost subject to

impairment provisions. The insurer shall assess the quality of its
loan assets and shall provide for impairment. The impairment
provision shall not be lower than the amount derived on the basis of
guidelines prescribed from time to time by the Reserve Bank of
India that apply to companies and financial institutions.

9. Catastrophe Reserve: Catastrophe reserve shall be

created in accordance with norms, if any, prescribed by the
Authority. Investment of funds out of catastrophe reserve shall be
made in accordance with prescription of the Authority.

PART II: DISCLOSURES FORMING PART OF FINANCIAL

STATEMENTS

The following shall be disclosed by way of notes to the Balance

Sheet-
1. Contingent Liabilities:
(a) Partly-paid up investments
(b) Underwriting commitments outstanding
(c) Claims, other than those under policies, not acknowledged
as debts
(d) Guarantees given by or on behalf of the company
(e) Statutory demands/liabilities in dispute, not provided for
(f) Reinsurance obligation to the extent not provided for in
accounts
(g) Others (to be specified)

2. Encumbrances to assets of the company in and outside

India.
3. Commitments made and outstanding for Loans, Investments
and Fixed Assets.
4. Claims, less reinsurance, paid to claimants in/outside India.
5. Actuarial assumptions for determination of claim liabilities in
the case of claims where the claims payment period exceed
four years.
6. Ageing of claims – distinguishing between claims
outstanding for more than six months and other claims.
7. Premiums, less reinsurance, written from business in outside
India.
8. Extent of premium income recognized, based on varying risk
pattern, category wise, with basis and justification therefor,
including whether reliance has been placed on exterenal
evidence.
9. Value of contracts in relation to investments, for:
 240

(a) Purchases where deliveries are pending;

(b) Sales where payments are overdue.
10. Operating expenses relating to insurance business: basis of
allocation of expenditure to various classes of business.
11. Historical costs of those investments valued on fair value
basis.
12. Computation of managerial remuneration.
13. Basis of amortization of debt securities.
14. (a) Unrealized gain/losses arising due to changes in the
fair value of listed equity shares and derivative instruments
are to be taken to equity under the head ‘Fair Value Change
Account’ and on realization reported in profit & loss account.
(b) Pending realization, the credit balance in the ‘Fair
Value Change Account’ is not available for distribution.
15. Fair Value of investment property and the basis therefore.
16. Claims settled and remaining unpaid for a period of more
than six months as on the balance sheet date.

The following accounting policies shall form an integral part

of the financial statements-
1. All significant account policies in terms of the accounting
standards issued by the ICAI, and significant principles and
policies given in Part I of Accounting Principles. Any other
accounting policies followed by the insurer shall be stated in
the manner required under Accounting Standard AS 1
issued by the ICAI.

2. Any departure from the accounting policies as aforesaid

shall be separately disclosed with reasons for such
departure.

The following information shall also be disclosed-

1. Investments made in accordance with any statutory
requirement should be disclosed separately together with its
amount, nature, security and any special rights in and
outside India.

2. Segregation into performing/non performing investments for

purpose of income recognition as per the directions, if any,
issued by the Authority.
3. Percentage of business sector-wise.
4. A summary of financial statements for the last five years, in
the manner as may prescribed by the Authority.
 241

5. Accounting Ratios as may be prescribed by the Authority.

6. Basis of allocation of interest, Dividends and Rent between
Revenue Account and Profit and Loss Account.

PART III: GENERAL INSTRUCTION FOR PREPARATION OF

FININCIAL STATEMENTS
1. The corresponding amounts for the immediately preceding
financial year for all items shown in the Balance Sheet, Revenue,
Account, Profit and Loss Account and Receipts and Payment
Accounts should be given.

2. The figures in the financial statements may be rounded off to

the nearest thousands.
3. Interest, dividends and rentals receivable in connection with
an investment should be stated, as gross value, the amount
of income tax deducted at source being included under
‘advance taxes paid’.
4. Income from rent shall not include any notional rent.
5. For the purposes of financial statements, unless the context
otherwise requires-
(a) The expression ‘provision’ shall, subject to note II below
mean any amount written off or retained by way of providing for
depreciation, renewals of diminution in value of assets, or retained
by way of providing for any known liability or loss of which the
amount cannot be determined with substantial accuracy;
(b) The expression “reserve” shall not, subject to as aforesaid,
include any amount written or retained by way of providing for
depreciation, renewals or diminution in value of assets or retained
by way of providing for any known liability;
(c) The expression capital reserve shall not include any amount
regarded as free for distribution through the profit and loss account;
and the expression “revenue reserve” shall mean any reserve other
than a capital reserve;
(d) The expression “liability” shall include all liabilities in respect
of expenditure contracted for and all disputed or contingent
liabilities.

Where:
(a) any amount written off or retained by way of providing for
depreciation, renewals or diminution in value of assets, or

(b) any amount retained by way of providing for any known

liability is in excess of the amount which in the opinion of the
directors is reasonably necessary for the purpose, the excess shall
 242

be treated for the purposes of these accounts as a reserve and not

as a provision.

6. The company should make provisions for damages under

lawsuits where the management is of the opinion that the award
may go against the insurer.

7. Extent of risk retained and reinsured shall be separately

disclosed.

8. Any debit balance of Profit and Loss Account shall be shown

as deduction from uncommitted reserves and the balance if any,
shall be shown separately.

PART IV: CONTENTS OF MANAGEMENT REPORT

There shall be attached to the financial statements, a
management report containing, inter alia, the following duly
authenticated by the management –

1. Confirmation regarding the continued validity of the

registration granted by the Authority;

2. Certification that all the dues payable to the statutory

authorities have been duly paid;

3. Confirmation to the effect that the shareholding pattern and

any transfer of shares during the year are in accordance with the
statutory or regulatory requirements;

4. Declaration that the management has not directly orr

indirectly invested outside India the funds of the holders of policies
issued in India;

5. Confirmation that the required solvency margins have been

maintained;

6. Certification to the effect that the values of all the assets

have been reviewed on the date of the Balance Sheet and that in
his (insurer’s) belief the assets set forth in the Balance Sheets are
shown in the aggregate at amounts not exceeding their realizable
or market value under the several headings – “Loans”,
“Investments”, “Agents balances”, “Outstanding Premiums”,
“Interest, Dividends and Rents Outstanding”, “Interest, Dividends
and Rents accruing but not due”, “Amounts due from other persons
or Bodies carrying on insurance business”, “Sundry Debtors”, “Bills
Receivables”, “Cash” and the several items specified under “Other
Accounts”.
 243

7. Disclosures with regard to the overall risk exposure and

strategy adopted to mitigate the same;

8. Operations in other countries, if any, with a separate

statement giving the management’s estimate of country risk and
exposure risk and the hedging strategy adopted;

9. Ageing of claims indicating the trends in average claim

settlement time during the preceding five years;

10. Certification to the effect as to how the values, as shown in

the balance sheet, of the investments and stocks and shares have
been arrived at, and how the market value thereof has been
ascertained for the purpose of comparison with the values so
shown;

11. Review of asset quality and performance of investment in

terms of portfolios, i.e., separately in terms of real estate, loans,
investments, etc.

12. A responsibility statement indicating therein that:

(i) in the preparation of financial statements, the applicable
accounting standards, principles and policies have been followed
along with proper explanations relating to material departures, if
any;

(ii) the management has adopted accounting policies and

applied them consistently and made judgments and estimates that
are reasonable and prudent so as to give a true and fair view of the
state of affairs of the company at the end of the financial year and
of the operating profit and loss and of the profit or loss of the
company for the year;

(iii) the management has taken proper and sufficient care for the
maintenance of adequate accounting records in accordance with
the applicable provisions of the Insurance Act ,1938 (4 of 1938) /
Companies Act, 1956, for safeguarding the assets of the company
and for preventing and detecting fraud and other irregularities;

(iv) the management has prepared the financial statements on a

going concern basis;

(v) the management has ensured that an internal audit system

commensurate with the size and nature of the business exists and
is operating effectively.

13. A schedule of payments, which have been made to

individuals, firms, companies and organizations in which Directors
of the insurer are interested.
 244

PART V: PREPARATION OF FINANCIAL STATEMENTS

1. An insurer shall prepare the Revenue Account, Profit & Loss

Account [Shareholders’ Account] and the Balance Sheet in Form B-
RA, Form B-PL, and Form B-BS, or as near thereto as the
circumstances permit.
Provided that an insurer shall prepare Revenue Accounts
separately for fire, marine, and miscellaneous insurance business
and separate schedules shall be prepared for Marine Cargo,
Marine – Other than Marine Cargo and the following classes of
miscellaneous insurance and accordingly application of AS 17 –
Segment Reporting – shall stand modified.

1. Motor, 2. Workmen’s Compensation/Employer’s Liability,

3.Public /Product Liability, 4.Engineering, 5.Aviation, 6. Personal
Accident, 7.Health Insurance, 8.Others

2. An insurer shall prepare separate Receipts and Payments

Account in accordance with the Direct Method prescribed in AS3 –
“Cash Flow Statement “issued by the ICAI.

Appointment of Auditors – The appointment of statutory auditors

in the General Insurance Corporation of India, and its subsidiaries
and the division is made by the Comptroller and Auditor General of
India, as in the case of other public sector undertakings. The
appointment of auditors of the agencies abroad is made by the
Board of Directors of each company.

Rights and duties or Branch Auditors - It is a practice that the

divisional offices prepares a trial balance is in a manner that it
provide3 information required to be included in the various format of
financial statements prescribed in the Insurance Act. Each trial
balance, in which are incorporated the figures relating to the
branches of the divisions, is required to be audited and the report
thereon is furnished to the statutory auditors. The divisions of the
companies carrying on general insurance business are treated for
the purposes of the Companies Act, 1956 as their branches. It
follows that the branch auditor appointed to conduct the audit of the
divisions have the same rights and obligations under the statute as
those of the, statutory auditors to whom they are expected to
submit their report.

Auditor’s Report – The Authority has prescribed the matters to be

dealt with by the Auditors’ Report vide Regulation 3 under Schedule
C of IRDA (Preparation of Financial Statements and Auditor’s
Report of Insurance Companies) Regulations,2000. The Schedule
C is reproduced below –
 245

The report of the auditors on the financial statements of every

insurer shall deal with the specified herein –

1. (a) That they have obtained all the information and

explanation which, to the best of their knowledge and belief, were
necessary for the purposes of their audit and whether they have
found them satisfactory;

(b) Whether proper books of account have been maintained by

the insurer so far as appears from an examination of those books;

(c) Whether proper returns, audited or unaudited, from branches

and other offices have been received and whether they were
adequate for the purpose of their audit;

(d) Whether the Balance Sheet, Revenue Account and Profit &
Loss Account dealt with by the report and the Receipts and
Payments Account are in agreement with the books of account and
returns;

(e) Whether the actuarial valuation of liabilities is duly certified

by the appointed actuary, including to the effect that the
assumptions for such valuation are in accordance with the
guidelines and norms, if any, issued by the authority and/or the
Actuarial Society of India in concurrence with the Authority.

2. The auditors shall express their opinion on:

(a) (i) Whether the Balance Sheet gives a true and fair view
of the insurer’s affairs as at the end of the financial year/period;
(ii) Whether the Revenue Account gives a true and fair view of
the surplus or the deficit for the financial year/period;
(iii) Whether the Profit and Loss Account gives a true and fair
view of the profit or loss for the financial year/period;
(iv) Whether the Receipts and Payments Account gives a true
and fair view of the receipts and payments for the financial
year/period;

(b) The financial statements stated at (a) above are prepared in

accordance with the requirements of the Insurance Act, 1938 (4 of
1938), the Insurance Regulatory and Development Authority Act,
1999 (41 of 1999) and the Companies Act, 1956 (1 of 1956), to the
extent applicable and in the manner so required.

(c) Investments have been valued in accordance with the

provisions of the Act and the Regulations.
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(d) The accounting policies selected by the insurer are

appropriate and are in compliance with the applicable Accounting
Standards and with the accounting principles, as prescribed in
these Regulations or any order or direction issued by the Authority
in this behalf.

3. The auditors shall further certify that:

(a) they have reviewed the management report and that there is
no apparent mistake or material inconsistencies with the financial
statements; and
(b) the insurer has complied with the terms and conditions of the
registration stipulated by the Authority.

4. A certificate signed by the auditors (which is in addition to

any other certificate or report which is required by law to be given
with respect to the balance sheet) certifying that:
(a) they have verified the cash balances and the securities
relating to the insurer’s loans, reversions and life interests (in the
case of life insurers) and investments;

(b) the extent, if any, to which they have verified the investments
and transactions relating to any trust undertaken by the insurer as
trustee; and

(c) no part of the assets of the policyholders’ funds has been

directly or indirectly applied in contravention of the provisions of the
Insurance Act, 1938 (4 of 1938) relating to the application and
investments of the policyholders’ funds.”

Students may also note that auditors are required to follow the
format of report prescribed by the Institute.

Direction of C & AG – The comptroller and Auditor General of

India has the power to direct the manner in which the accounts
shall be audited and give such instructions in regard to any matter
relating to performance of function by the auditor and to conduct
the supplementary or test audit of the accounts of such companies
by such person or persons as may be authorized in this behalf. For
the purpose of such audit the C & AG may require him in terms of
Section 619 (4) of the Companies Act, 1956. The statutory auditors
are required to submit a copy of their report to the C & AG who has
the right to comment upon or supplement the audit report. By virtue
of the powers vested in him under Section 619 (3) (a) of the
Companies Act, 1956 the C & AG has recently directed that a
supplementary report be made by the auditors appointed under
Section 619 (2) of the said Act in case of companies carrying on
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general insurance business. The said report would be on matters

listed in the Appendix to this unit of the study.

Tax Audit - It is necessary for general insurance companies to get

their accounts audited under Section 44AB of the said Act. For this
purpose, the tax auditor(s) may be appointed by the company itself
by means of a resolution of the Board of Directors or by the
Chairmen/Managing Director if so authorized in this behalf. The
company is expected to fix separate remuneration for the auditor
(s0 appointed for this purpose. The Form of tax audit report
applicable would be Form 3C and the prescribed particulars would
have to be given in Form 3CD, in accordance with Rule 3C and the
prescribed particulars would have to be given in Form 3CD, in
accordance with Rule 6G the Income Tax Rules, 1962, pursuant to
Section 44AB of the Income Tax Act, 1961. It is recommended that
wherever applicable, a common audit programme be framed for
statutory audit and for certification of the prescribed particulars
under the aforesaid rules for tax audit.

Applicability of CARO, 2003 – As per Section 1(2) Companies

(Auditor’s Report) Order, 2003, (as amended in November 2004)
the provisions of CARO are not applicable to insurance companies.

Audit of Revenue Account: The important part of the business

operations of general insurance companies comprises the issuance
of policies for risks assumed and to indemnify the insured for
losses to the extent covered by such policies. In financial terms,
these operations get translated into the receipt and recording of
premiums and the recording and settlement of claims. Both
premiums and claims have a significant impact on the insurance
companies’ revenues, it would be an important part of the duty of
the auditor to satisfy himself that the financial transactions involving
both these operations have been fairly and properly recorded in the
relevant books of account. The auditor should also ensure that the
legal requirements as to the disclosure of these items are complied
within the financial statements.

Premium - Insurance premium is collected upon issuing policies. It

is the consideration for bearing the risk by the insurance company.
The assumption of the risk starts on the issue of receipt based on
the acceptance of proposal form or cover note by the respective
underwriting de3partent. This receipt is recorded as the premium
income in the books of the insurance company. Premium may be
accepted either in cash/cheque/Demand Draft/pay order, bank
guarantee, cash deposit, etc. The premium collections are credited
to a separate bank account and no withdrawals are normally
permitted from that account for meeting the general expenditure. As
per the policy of the insurance company, the collections are
transferred to the Regional Office or Head Office. As soon as the
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insurance policy is issued, an entry is made in the Register of

Policies showing all the relevant details.

No Risk Assumption without Premium - No risk can be

assumed by the insurer unless the premium is received. According
to Section 64 VB of the Insurance Act, 1938, no insurer should
assume any risk in India in respect of any insurance business on
which premium is ordinarily payable in India unless and until the
premium payable is received or is guaranteed to be paid by such
person in such manner and within such time, as may be prescribed
manner. The premium receipt of insurance companies carrying on
general insurance business normally arise out of three sources,
viz., premium received from direct business, premium received
from reinsurance business and the share of co-insurance premium.

Verification of Premiums – Verification of premium is of utmost

importance to an auditor. The auditor should apply, inter alia, the
following procedures for verification of premium.-

Before commencing verification of premium income, the

auditor should look into the internal controls and compliance thereof
as laid down for collection and recording of the premiums.

The auditor should ascertain that all the cover notes relating
to the risks assumed have been serially numbered for each class of
business. The auditor should also verify that there is an adequate
internal check on the issues of stationery comprising of cover
notes, policy documents, stamps, etc. The auditor may apply
sampling techniques for verification of larger volume of
transactions.

The auditor should ensure that premium in respect of risks

incepting during the relevant accounting year has been accounted
as premium income of that year on the basis of premium revenue
recognition discussed in this Chapter. The auditor, as part of his
audit procedures, should make an assessment of the reasonability
of the risk pattern established by the management. The auditor
should also see whether the premium received during the year but
pertaining to risk commencing in the following year has been
accounted for under the head ‘Pertaining to risk commencing in the
following year has been accounted for under the head ‘Premium
Received in Advance’ and has been disclosed separately.
Normally, such instances relate to the issue of cover notes and
certificates at the end of the accounting year relating to risks
commencing in the next accounting period. Generally, there is a
column in the Premium Register called “Commencement of Risk”,
indicating the date and time from which the risk under the policy
issued has commenced. The auditor should verify that policy
 249

documents have not been issued, or where issued, the company

was not at risk, in case :
a) Premium had not been collected at all;
b) Premium had been collected but the relevant cheque have been
dishonoured; (refer Cheque Dishonoured Book);
c) premium had not immediately been collected due to furnishing of
a bank guarantee or cash deposit but either the deposit or
guarantee had fallen short or has expired or the premium had been
collected beyond the stipulated time limit (i.e., there is a shortfall in
bank guarantee account or cash deposit account of the insured);
d) premium had not been collected due to risk cover being
increased or where stipulated limits have been exhausted in
respect of open declaration policies (i.e., where premium has
accrued but has not been received); and installments of premium
have not been collected in time in respect of certain categories of
policies. e.g. marine-cum-erection policies where facility has been
granted for premium being paid in installments (such facility is
normally available subject to certain conditions, e.g. that the first
equated installments is more by 5 per cent of the total premium
payable by installments).

The auditor should examine whether the reinsurance

company is not under a risk in respect of amount lying at credit and
outstanding as at the year-end in the following accounts:
a) Deposit Premium Account;
b) Premium Received in Advance Account;
c) Inspectors’ Deposits Account; and
d) Agent’s Premium Accounts
The auditor should verify the collections lodged by agents
after the balance sheet date to see whether any collection pertains
to risk commencing for the year under audit. The auditor should
also check that the premium has been recorded originally at the
gross figure. i.e. without providing of unexpired risks and
reinsurances.

In case of co-insurance business, where the company is not

the leader, because of the non-availability of the relevant
information in many cases the premium is not booked even though
the risk has commenced during the relevant accounting year. The
auditor should see that the company’s share of the premium has
been accounted for on the basis of the available information on
nature of risk and the provisional premium charged by the leading
insurer. The auditor should examine the communications issued to
the company by the leading insurers advising them of the
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company’s share of premium income. Such communications should

be seen even in respect of the post-audit period. Where the
company is the leader, the auditor should obtain a responsible
assurance that only the company’s own share of premium has been
shown as income and accounts of the other companies have been
credited with their share of the premium collected.

The auditor should check whether Premium Registers have

been maintained chronologically, for each underwriting department,
giving full particulars including service tax charged as per
acceptance advice on a day-to-day basis. The auditor should verify
whether the figures of premium mentioned in the register tally with
those in General Ledger.

Where policies have been issued with a provision to collect

premium periodically (i.e., under installment clause, special
declaration policy or periodical declaration under open policies in
marine insurance), the auditor should check whether premium are
collected as and when they become due.

The auditor should verify whether installments falling due on

or before the balance sheet date, whether received or not, have
been accounted for as premium income as for the year under audit.
Also examine whether installments of premium falling due in the
subsequent year have not been recognized in the accounts as
outstanding premium.

The auditor should verify the year and transactions to check

that amounts received during the year in respect of risks
commencing/installments falling due on or after the first day of next
financial year are not credited to premium account but credited to
Premium Received in Advance Account.

The auditor should verify the collections remitted by agents

immediately after the cut-off date to verify the risk assumed during
the year under audit on those collections.

The auditor should also check that in case of cancellation of

policies / cover notes issued, no risk has been assumed between
the date of issue and subsequent cancellation thereof.

Where premium originally received has been refunded, the

auditor should verify whether the agency commission paid on such
premium has been recovered.

The auditor should verify whether service tax has been

charged from the insured, the rates in force, on the total premium
for all classes of business other than those exempted under service
tax laws. Check whether service tax so collected is disclosed under
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‘Current Liabilities’ to the extent not deposited in Government’s

Account.

In the case of co-insurance business, the auditor should

verify whether service tax at the rates in force on the whole
premium has been charged or collected form the insured by the
company in case it is the leader.

Check that service tax so collected on premium charged

trained from the insured by the company have been regularly
deposited in the Government’s Account.

Claims- The components of the cost of claims to an insurer

comprise the claims under policies and claim settlement costs.
Claims under policies comprise the claims paid for losses incurred,
and those estimated or anticipated claims pending settlements
under the policies. Settlement cost of claims includes surveyor fee.
Legal expenses. etc. A liability for outstanding claims should be
brought to account on the following:
 Direct Business;
 Inward Reinsurance Business; and
 Co-Insurance business

The liability includes future payments in relation to unpaid

reported claims and claims incurred but not reported including
inadequate reserves which would result in future cash or asset
outgo for setting liabilities against those claims. Change in
estimated liability represents the difference between the estimated
liabilities for outstanding claims in respect of claims under policies,
whether due or intimated at the beginning and at the end of the
financial period. The accounting estimate also includes claims cost
adjusted for salvage value if there is sufficient degree of certainty of
its realization.

Check that service tax so collected on premium charged

trained from the insured by the company have been regularly
deposited in the Government’s Account.

Registers and Records : The following register and records are

generally prepared in respect of claims:
 Claims Intimation Register,
 Claims Paid Register,
 Claims Disbursement Bank Book;
 Claims Dockets, normally containing the following records:
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 Claim intimation, claim form, particulars of policy, survey

report, Photograph showing damage, repairer’s bills, letter of
subrogation, police report, fire service report, claim settlement
note, claim satisfaction note, salvage report, salvage disposal
note, claims discharge voucher, etc.;
 Report of quality assurance team; and
 Salvage register

The Claim Account is debited with all the payments including

repair charges, fire fighting expenses, police report fees, survey
fees, amount decreed by the Courts, travel expenses, photograph
charges, etc. The provision for claims incurred but not reported is
not made at Branch/Divisional Office level but at the Head Office
level.

Verification of Claims

Claims Provisions : The auditor should obtain from the

divisions/branches, the information for each class of business,
categorizing the claims value-wise before commencing verification
of the claims provisions, so that appropriate statistical sampling
techniques may be applied, to ensure that representative volume of
claims is verified for each class of business. The auditor should
determine the total number of documents to be checked giving due
importance to claim provisions of higher value.

The outstanding liability at the year-end is determined at the

divisions/branches where the liability originates for outstanding
claims. Thereafter, based on the total consolidated figure for all the
divisions/branches, the Head Office considers a further provision in
respect of outstanding claims. The auditor should satisfy himself
that the estimated liability provided for by the management is
adequate with reference to the relevant claim files/dockets, keeping
in view the following:

(i) that provision has been made for all unsettled claims as at
the year-end on the basis of claims lodged/communicated by
the parties against the company. The date of loss (and not
the date of communication thereof) is important for
recording/recognizing the claim as attributable to a particular
year. In certain circumstances, the claims are incurred by the
insurance company but are not reported at the balance
sheet date by the insured. Such claims are known as claims
incurred but not reported (IBNR). The auditor should check
the records for subsequent periods to ascertain that
adequate provision has been created for such claims also.
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(ii) that provision has been made for only such claims for which
the company is legally liable, considering particularly, (a) that
the risk was covered by the policy, if in force, and the claims
arose during the currency of the policy; and (b) that claim did
not arise during the period the company was not supposed
to cover the risk, e.g.; where the premium was not paid or
where cheques covering premium have been dishonoured
(refer section 64 VB of the Insurance Act. 1938) or where a
total loss under a policy has already been met/settled.
(iii) that the provision made is normally not in excess of the
amount insured except in some categories of claims where
matter may be sub-judice in legal proceeding s which will
determine the quantum of claim, the amount of provision
should also include survey fee and other direct expenses.
(iv) that in determining the amount of provision, events after the
balance sheet date have been considered. e.g., (a) claims
settled for a materially higher/lower amount in the post-audit
period; (b) claims paid by other insurance companies during
the year under audit and communicated to company after
the balance sheet date where other companies are the
leaders in co-insurance arrangements; and (c) further
reports by surveyors or assessors.
(v) that the claims status reports recommended to be prepared
by the Divisional Manager on large claims outstanding at the
year-end have been reviewed with the contents of relevant
files or dockets for determining excess/short provisions. The
said report should be complete as to material facts to enable
the auditor to take a fair view of the provision made.
(vi) that in determining the amount of provision, the average
clause; has been applied in case of under-insurance by
parties.
(vii) that provision made is net of payments made ‘on account’ to
the parties wherever such payments have been booked to
claims.
(viii) that in case of co-insurance arrangements, the company has
made provisions only in respect of its own share of
anticipated liability.
(ix) that wherever an unduly long time has elapsed after the filing
of the claim and there has been no further communication
and no litigation or arbitration dispute is involved, the
reasons for carrying the provision have been ascertained.
(x) that wherever legal advice has been sought or the claim is
under litigation, the provisions is made according to the legal
advisor’s view and differences, if any, are explained.
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(xi) that in the case of amounts purely in the nature of deposits

with courts or other authorities, adequate provision is made
and deposits are stated separately as assets and provisions
are not made net of such deposits.
(xii) that no contingent liability is carried in respect of any claim
intimated in respect of policies issued.
(xiii) that the claims are provided for net of estimated salvage,
wherever applicable.
(xiv) that intimation of loss is received within a reasonable time
and reasons for undue delay in intimation are looked into.
(xv) that provisions have been retained as at the year end in
respect of guarantees given by company to various Courts
for claims under litigation.
(xvi) that due provision has been made in respect of claims
lodged at any office of the company other than the one from
where the policy was taken, e.g. a vehicle insured at Mumbai
having met with an accident at Chennai necessitating claim
intimation at one of the offices of the company at Chennai.

In cases of material differences in the liability estimated by

the management and that which ought to be provided in the opinion
of the auditor, the same must be brought out in the auditor’s report
after obtaining further information or explanation from the
management. For determining the adequacy of the provisions in
respect of any category of business, the auditor may resort to the
method of testing the actual payments, wherever made, with the
provisions made earlier for that category of business. Whether such
liability has been estimated in the past on a fair and realistic basis
can, thus, be examined by looking into current yea’s payments
against provisions of the earlier year.

Claims Paid – The auditor may determine the extent of checking of

claims paid on the same line as suggested for outstanding claims.
Other aspects in respect of claims paid to be examined by the
auditors are as follows:
(i) that in case of co-insurance arrangements, claims paid have
been booked only in respect of company’s share and the
balance has been debited to other insurance companies.
(ii) That in case of claims paid on the basis of advices from
other insurance companies (where the company is not the
leader in co-insurance arrangements), whether share of
premium was also received by the company. Such claims
which have been communicated after the year-end for
losses which occurred prior to the year end must be
accounted for in the year of audit.
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(iii) That the claims payments have been duly sanctioned by the
authority concerned and the payments of the amounts are
duly acknowledged by the claimants;
(iv) That the salvage recovered has been duly accounted for in
accordance with the procedure applicable to the company
and a letter of subrogation has been obtained in accordance
with the laid down procedure;
(v) That the amounts of the nature of pure advances/deposits
with Courts, etc., in matters under litigation/arbitration have
not been treated as claims paid but are held as assets till
final disposal of such claims. In such cases, full provision
should be made for outstanding claims;
(vi) That payment made against claims partially settled have
been duly vouched. In such cases, the sanctioning authority
should be the same as the one which has powers in respect
of the total claimed amount;
(vii) That in case for final settlement of claims, the claimant has
given an unqualified discharge note, not involving the
company in any further liability in respect of the claim; and
(viii) That the figures of claims wherever communicated for the
year by the Division to the Head Office for purposes of
reinsurance claims, have been reconciled with the trial
balance-figure.

Commission – It is a well-known fact that insurance business is

solicited by insurance agents. The remuneration of an agent is paid
by way of commission which is calculated by applying a percentage
to the premium collected by him. Commission is payable to the
agents for the business procured through them and is debited to
Commission on Direct Business Account. There is a separate head
for commission on reinsurance accepted which usually arise in
case of Head Office. If may be noted that section 40 of Insurance
Act, 1938, no commission can be paid to a person who is not an
agent of the insurance company.

The auditor should, inter alia, do the following for verification

commission:
 Vouch disbursement entries with reference to the disbursement
vouchers with copies of commission bills and commission
statements.
 Check whether the vouchers are authorized by the officers-in-
charge as per rules in force and income tax is deducted at
source, as applicable.
 Test check correctness of amounts of commission allowed.
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 Scrutinize agents’ ledger and the balances, examine accounts

having debit balances, if any, and obtain information on the
same. Necessary rectification of accounts and other remedial
actions have to be considered.
 Check whether commission outgo for the period under audit
been duly accounted.

Operating Expenses Related to Insurance Business (Expenses

of Management) – All the administrative expenses in an insurance
company are broadly classified under 13 heads as mentioned in
Schedule 4. In so far as financial statements are concerned, this
Schedule is part of the Revenue Account to be prepared for
insurance business. Any other expenses are required to be
disclosed under the head ‘Others’. ‘Others’ would include foreign
exchange gains or losses as indicated in note ‘b’ of Schedule 4.
Any major expenses (Rs. 5 lacs or in excess of 1% of net premium,
whichever is higher) are required to be shown separately. Careful
reading of the words ‘expenses related to insurance business’
clearly indicate any expenses which do not have any direct relation
to insurance business are to be shown separately in the Profit and
Loss Account. Expenses relating to investment department,
brokerage, bank charges, transfer fees, etc. do not have a direct
relationship to the day-to-day working of the insurance business
and as such would not be included in the revenue account.

These expenses are first aggregated and then apportioned

to the Revenue Account of each class of business on a reasonable
and equitable basis. The accounting policy should clearly indicate
the basis of apportionment of these expenses to the respective
Revenue Accounts (i.e. fire, marine and miscellaneous) along with
the certificate that all expenses of management, wherever incurred,
directly or indirectly, read with the accounting policy, have been
fully debited to the respective Revenue Account as expenses.
Refer to Schedule 4 on Operating Expenses for specific items.

Legal and Professional Charges- As far as legal and

professional changes are concerned, attention is drawn to the head
‘Claims Incurred’ under Schedule 2 where it is clearly stated that
survey fees, legal and other expenses should form part of claim
cost, and therefore, are not to be included under the head Legal
and Professional Charges. Hence, all other expenses which are not
covered under the claims cost are required to be included under
this head.

Employees’ Remuneration and Welfare Benefits – The

employees’ remuneration includes all kinds of payments made to
employees in consideration of their services. The reimbursement of
medical expenses or premium in respect of employees’ health
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cover is covered under the employees’ remuneration and welfare.

Any medical fees incurred towards maintenance of health care
policies (which are not for employees) are required to be debited to
the claims cost under the health care and not to be included under
this head. Any expenses toward medical treatment of employees
incurred by the company should also be included under this head.
Non training expenses have to be shown separately.

Interest and Bank Charges- All expenses incurred towards

maintenance of Bank Account, interest and other charges levied by
bankers to the normal course of business other than bank
expenses relating to investments (interest, bank charges, custodial
charges, etc.) are shown under the head, “interests and bank
charges”. Any other interest charged on the borrowings which could
not form part f the Revenue Account not be included under this
head.

Depreciation- The rates of depreciation are governed by the

provisions of the Companies Act, 1956. Attention of the students is
also invited to Accounting Standard (AS) 6, Depreciation
Accounting, and Guidance Note on, Depreciation in Companies,
issued by the Institute of Chartered Accountants of India.

Interest, Dividend and Rent- An insurance enterprise, like any

other earns interest dividend and rent through its assets. The
interest, dividend and rent earned are to be apportioned between
Revenue Account and Profit and Loss Account. The regulations
require that basic of allocation of interest, dividend and rent
between the Revenue Account and Profit and Loss Account should
be clearly indicated in the company’s accounting policy. The
interest or dividend earned as against the policyholder’ funds is
required to be apportioned to the Revenue Account. The interest
earned on, say, grant of vehicle loans, housing loans, deposits with
banks of the shareholders, funds, rent received on let out properties
owned by the company, by way of investments shareholders,
funds, etc. are required to be shown under the profit and loss
account.

ITEMS RELATING TO BALANCE SHEET

Following are the broad classes of items in a balance sheet.

Investments – The legal requirements for investments by

enterprises carrying on general insurance business are provided
under sections 27B, 27C and 27D of the Insurance Act, 1938. Sub-
section (1) of section 27B lays down that no insurer carrying on
general insurance business can invest or keep invested any part of
its assets otherwise than in any of the approved investments
mentioned in the section. Sub-Section (3), however, gives a
leverage to an insurer to invest or keep invested any part of its
 258

assets otherwise than in an approved investment if the following

conditions are satisfied:

(a) such investments should not exceed 25% of the total

investments; and
(b) such investments are made with the consent of all the Directors.
The consent of Directors appointed under section 34C of the
Insurance Act, 1938 is not necessary. However, such Directors
should not object to the investments so made or continued.
Sub-section (4) of section 27B requires that an insurer should not
invest or keep invested any part of its assets of any one insurance
company or an investment company which constitutes more than
then ten percent of the total assets of the insurer or two percent of
the subscribed share capital or debentures of the insurance
companies or investment company concerned. Similar
considerations also apply to the investment in shares or debenture
of any other company not being an insurance companies or
investment company. In such cases, the limit of two percent of the
subscribed share capital or debentures of the insurance
companying company or the investment company concerned is to
be read as ten percent {sub-section(5)}. According to sub-section
(6), an insurer cannot invest in the shares or debentures of a
private company. It may noted that in case an investments has
been made in the partly paid up shares of a company, the uncalled
liability on the shares is to be added to the amount invested for the
purpose of computing the percentages referred to above.
The authority has been authorized to frame regulations
related to investments to be made by an insurer. Regulations 4 of
the amended Regulations on investments prescribes that every
insurer carrying on the business of general insurance should invest
and at all time keep invested its total assets in the following
manner:

(i) 20 percent for more of Central Government Securities

total assets
(ii) 30 percent or more of State Government Securities and
total assets other Guaranteed Securities
[including (i) above]
(iii) 5 percent or more of Housing and Loans to State
total assets Government for Housing and Fire
Fighting Equipment
(iv) 10 percent or more of Investment in approved securities
total assets (as specified in Schedule 11 to the
Regulations) under infrastructure
and social sector
 259

(v) Up to 55 percent of total Other securities (covered by

assets Exposure Norms specified in
Regulation 5). It may be noted that
investments in “other than
approved securities” can in no case
exceed 25 percent o the total
assets.

It may be mentioned here that with regard to (iv) above,

subscription/purchase of bonds or debentures issued by HUDCO,
National Housing Insurance Company or House Building
Institutions duly accredited by National Housing Banks, for house
building activities, duly guaranteed by Government or carrying
current fating of not less than ‘AA’ by an independent, reputed and
recognized agencies also qualify to be included in the limits [under
clause (iv)] above.

Audit Procedures: The auditor’s primary objective in audit of

investment is to satisfy himself as to their existence and valuation.
Examination of compliance with statutory and regulatory
requirements it also an important objective in audit of investments
in so far as non-compliance may have a direct and material affect
on the financial statements.

The auditor should verify the investment scrips physically at

the close of business on the date the balance sheet. In exceptional
cases where physical verification of investment scrips on the
balance sheet date is not possible, the auditor should carry out the
physical verification on a data as near to the balance sheet date as
possible. In such a case, he should take into consideration any
adjustments for subsequent transactions of purchase, sale, etc. he
should take particular care to see that only genuine investments are
produced before him, and that securities held by the insurance
company on behalf of others (e.g. those held as security this, the
auditor should –require that all investment scrips in the possession
of the insurance simultaneously. The auditor should keep them
under his control until he completes his checking. Normally, the
investments of an insurance company are held by the insurance
company itself or a depository (in case of dematerialized securities
other than government securities).

Investments are normally dealt with at the Head Office and

not at the branches. However, sometimes, for realization of interest,
etc. and other similar purposes, investments of an insurance
company may be held at Branch Offices also. In such cases, the
auditor should examine the record maintained at the Head Office to
record details of investments held at other locations and request
the respective branch auditors to physically verify such investments
 260

as apart of their audit. The auditors should obtain a written

confirmation to this effect from the branch auditors. in case the
verification has been done on the date other than the balance sheet
date, a statement showing the reconciliation of the investments
held at the time of physical verification with the investments held as
on the balance sheet date should also be obtained from the branch
auditors. The branch auditors should report whether adequate
records are maintained by the branch for the securities held by it on
behalf of the Head Office.

Investments should not normally be held by any other

person (as laid down in the City Equitable Fire Insurance Co. case).
If any investments are so held, proper enquiry should be made to
ensure that there is some justification for it, e.g., shares may be
held by brokers for the purpose of transfer or splitting-up, etc.
Shares may also be lodged with the companies concerned for
transfer etc. When investments are held by any other person on
behalf of the insurance company, the auditor should obtain a
certificate from him. The certificate should state the reason for
holding the investment (e.g., in safe custody or as security).

In respect of scripless dealings in investments through the

OTC Exchange of India, the auditor should verify the interim and
other acknowledgments issued by dealers as well as the year end
confirmation certificates of the depository organization.

The auditor should also examine whether securities lodged

for transfer are received back within a reasonable period. Similarly,
he should examine whether share certificates, etc. are received
within a reasonable period, of the lodging of the allotment advice.
Incase there is an unusual delay in registration of transfers, etc.,
the auditor should see that adequate follow-up action has been
taken. He may, in appropriate cases, also enquire from the issuers,
or their registrars, about the delays. In cases where the
issuer/registrar has refused to register the transfer of securities in
the name of the insurance company, the auditor should verify the
validity of the title of the insurance company over such securities.

The auditor should examine whether the portfolio of the

insurance company consists of any securities whose maturity dates
have already expired. It is possible that income on such
investments may also not have been received. In case the amount
of such investments or the income accrued thereon is material, the
auditor should seek an explanation from the management on this
aspect. He should also consider whether any provision for loss on
this account is required. Similarly, where income on any security is
long overdue, the auditor should consider whether provision is
required in respect of such income accrued earlier.
 261

Investments in securities now-a-days constitute a substantial

part of total assets of many insurance companies. Method of
valuation of investments followed by an insurance company may,
therefore, have a significant effect on its Balance Sheet and Profit
and Loss Account. The auditor should examine whether the method
of accounting followed by the insurance company in respect of
investments, including their year-end valuation, is appropriate.

The auditor should examine the manner of accounting for

investments and the accounting policy followed by the insurance
company in respect of investments. The audit of should examine
the appropriateness of accounting policies followed by the
insurance company. In case of any of the accounting policies is not
appropriate, the auditor should consider the effect of adoption of
such policy on the financial statements and, consequently, on his
audit report.

A change in the method of valuation of investments

constitutes a change in accounting policy and adequate disclosure
regarding the fact of the change along with its financial effect
should be made in the balance sheet.

The auditor should examine whether income from

investments is properly accounted for. This aspect assumes special
importance in cases where the insurance company has opted for
receipt of income through the Electronic Clearing Service.

There may be case where the certificates of tax deduction at

source (TDS) received along with the interest on investments are
found missing. This increases the incidence of tax on the insurance
company. The auditor should see that there is a proper system for
recording and maintenance of TDS certificates received by the
insurance company.

Cash and Bank Balances- Cash and Bank balances at Branch

Office/Divisional Office level also constitute significant items related
to balance sheet. The auditor should apply the following audit
procedures for verification of claims.
 The auditor should physically verify cash balance collection and
imprest for meeting day to day expenditures, postage stamps
balance, revenue, policy, license fees, franking machine
balance. The auditor should also obtain a certificate from the
management for the above mentioned balances as at the
balance sheet date. If for some reason, the physical verification
of the above on the balance sheet date is not possible then the
same can be done at a subsequent date and by way of
backward calculations, cash in hand at the balance sheet date
can be verified.
 262

 The auditor should also check whether late collections of cash

and cheques on the last working day of the financial year, which
could not be deposited into bank account on the same day,
have been identified and booked as Cash in Hand and Cheques
in Hand Account, respectively.
 The auditor may apply test check on the bank transactions.
 The auditor should also check Bank Reconciliation statement
and long outstanding entries therein.
 The auditor should obtain confirmation of Bank Balances for all
operative and inoperative accounts.
 The auditor should physically verify Term Deposit Receipts
issued by bankers.
 The auditor should verify the deposits and withdrawals
transactions at random and check whether the Account is
operated by authorized persons only.
 The auditor should verify the subsequent realizations for all
items appearing in the reconciliation.
 In case of funds, in-transit, he should verify that the same are
properly reflected as part of bank balance.

Outstanding Premium and Agents’ Balances – The following are

the audit procedures to be followed for verification of
outstanding premium and agents’ balances:
 Scrutinize and review control account debit balance and their
nature should be enquired into.
 Examine inoperative balances and treatment given for old
balances with reference to company rules.
 Enquire into the reasons for retaining the old balances.
 Verify old debit balances which may require provision or
adjustment. Notes of explanation may be obtained from the
management in this regard.
 Check age-wise, sector-wise analysis of outstanding premium.
 Verify whether outstanding premiums have since been
collected.
 Check the availability of adequate bank guarantee or premium
deposit for outstanding premium.

Provision for Taxation – The steps to be conducted by the audit

for audit and verification are given below:
 263

(i) The auditor should check whether the provision for taxation
has been made after taking into account the above specific
provisions applicable to insurance companies carrying on general
insurance business.
(ii) It should be seen by auditor whether for the purpose of
computation not only the profit as disclosed by the annual
accounts, copies of which are required under the Insurance Act,
1938 to be furnished to the Controller of Insurance, is taken but
also all the other accounts furnished by the company to the
Controller of Insurance is taken into account.
(iii) The auditor should assess the past trend regarding the
approach of the Income Tax Department, the decision of the
various appellate forums including the High Court and the Supreme
Court vis-à-vis the computation made.
(iv) The compliance with the provisions of Chapter III provisions
the Income Tax Act, 1961 which provides for income which do not
form part of total income is also to be seen.
(v) The auditor should see whether deductions under Chapter
VI A of the Income Tax Act, 1961 which provides for deduction
have been made in computing total income is properly taken into
account.
(vi) The auditor should examine whether income computation
relating to foreign branches and other income earned outside India
is dealt with properly as per the double taxation avoidance
agreement, if any, entered into with those countries.
(vii) It should be seen whether the exemption provision relating to
tax deducted at source from certain categories of income as
exempted under section 35A of the General Insurance (Business
Nationalization) Act, 1972 has been properly availed.
(viii) Also, the auditor should check whether the grossing up of
TDS relating to the income has been properly done for the propose
of computation of taxable income.
(ix) The auditor should ensure that the provisions of the Income
Tax Act, 1961 regarding the tax to be deducted at source have
been properly complied with, relating to the payments/credits for
which the TDS provisions of the Income Tax Act and applicable and
the amount so deducted are remitted within the stipulated time.
Also check TDS implication on the interest paid/payable and
included on claim settlement/outstanding claims.
(x) The auditor may also assess the applicability of the Wealth
Tax Act, 1957 with reference to the assets of the company at the
end of the year.
(xi) The auditor should see the system of service tax collection
and the payment to the statutory authorities and the internal system
including the filing of the statutory returns.
 264

(xii) The examination of sales tax implication on the sale of

salvage should also be seen as it is applicable to the respective
states and the past trend in this regard.
(xiii) The auditor should check the liability under the VAT and
whether provision for adequate amount has been made in the
books or not.
(xiv) The auditor should verify that adequate provision been made
for additional liability relating to earlier years for which demands
have been received in the current year and where the company has
gone into appeal, the fact that no provision has been made and that
an appeal has been preferred has to be disclosed in the notes to
accounts.

Unexpired Risks Reserve – The need for Unexpired Risks

Reserve arises from the fact that all policies are renewed annually
except in specific cases here short period policies are issued. Since
the insurers close their accounts on a particular date, not all risks
under polices expire on that date. Many policies which may occur
during the remaining term of the policy beyond the year end. The
effort involved in calculating unexpired portion of premium under
each policy is very time consuming therefore, a simple formula to
derive a percentage of premium income to be allocated to reserve
for unexpired risks is adopted. According to the requirements of the
Insurance Act, 1938, for the purpose of maintaining solvency
margin, it is sufficient if the provision is made for unexpired risks at
50 percent for Fire, Marine Cargo and Miscellaneous business
except for Marine Hull which has to be 100 percent. It ma be
mentioned that the insurance companies are governed by the
provisions of Section 44 of the Income Tax Act, 1961. In this regard
Rule 5 of the First Schedule to the Income Tax Rules-Computation
of Profit & Loss of General Insurance Business-provides for
creation of a reserve for unexpired risks as prescribed under Rule
6E of the said rules. According to this Rule, the insurance
companies are allowed a deduction of 50 percent of net premium
income in respect of Fire and Miscellaneous Business and 100
percent of the net premium income relating to Marine Insurance
business. In view of this, the reserves are created at the rates
allowed under the Income Tax Act.

REINSURANCE
A reinsurance transaction may be defined as an agreement
between a ‘ceding company and a ‘reinsurer’ whereby the former
agrees to ‘cede’ and the latter agrees to accept a certain specified
share of risk or liability upon terms as set out in the agreement. A
‘ceding company’ is the original insurance company which has
accept the risk and has agreed to ‘cede’ or pass on that risk to
another insurance company or the reinsurance company. It may,
however, be emphasized that the insured does not acquire any
 265

right under a reinsurance contract. In the event of loss, the

insured’s claim for full amount is against the original insurer only.
The original insurer in turn, lodges a claim with the reinsurer.

Verification of Re-Insurance Inward – Under Sub-regulation 4 of

the IRDA (General Insurance Reinsurance) Regulations, 2000
every insurer desirous of writing inward reinsurance business
should have a well defined underwriting policy. The decisions on
acceptance of re-insurance should be taken by persons with good
knowledge and experience, with the Authority, a note the following
verifications measures for re-insurance inward transactions:
 Re-insurance inward underwriting should be as per the norms
and guidelines prescribed by the Insurance Act, 1938 and IRDA
Regulations. It is necessary to ensure that the inward
reinsurance arrangements and acceptances, both Indian and
foreign are done as per the prescribed parameters applicable
for the particular year.
 The auditor should check that domestic inward acceptances are
in accordance with the approved programme.
 The auditor should verify whether re-insurance inward
acceptance, both Indian and foreign, are as per
arrangements/agreements entered into with Indian and foreign
insurance companies.
 The auditor should also verify whether the policy adopted for
booking the accounts is on “receipt” basis or “due” basis with
the appropriate basis of estimation towards accounts not
received and that the basis of estimation is fair and consistently
applied and properly disclosed.
 The auditor should examine whether proper system exists to
have control over the quantum of agreements existing at any
point of time and also that periodical accounting statements
received in connection with the agreements.
 The auditor should verify whether proper closing returns have
been received for premiums and claims for facultative
acceptances.
 The auditor should check the accounts for closure of any
underwriting year, with portfolio withdrawals as per the terms
and conditions agreed.
 The auditor should evaluate the system and practice adopted in
recognizing the foreign currency transaction and also whether it
is in accordance with the Accounting Standard (AS)-11,
Accounting for Effects of Changes in Foreign Exchanges Rates.
 The auditor should verify whether profit commission has been
calculated as per the agreement and terms and conditions and
all the statements rendered are properly taken into account.
 266

 The auditor should check whether there is any run off

claim/large claim of long chain in nature which requires any
provisioning.
 The auditor should also verify whether the Foreign Inward
acceptance components, consisting of premium, commission,
brokerage and other expenses, claims consisting of paid claims
opening and closing outstanding claims etc., have been
recorded and accounted as per the accounts rendered by the
companies. It is essential that the statement should be rendered
in the currency in which it was agreed to be transacted and the
conversion of foreign currency balances from the accounts
submitted have been done at the appropriate conversion rates
as per Accounting Standard (AS)-11.
 The auditor should examine whether the outstanding claim
figures have been properly obtained well in time, under proper
systematic arrangements and sufficient provisioning has been
made for all the outstanding claims. The auditor should see that
regarding foreign inward, appropriate provisioning is none after
adopting prescribed conversion rate to the India rupee. The
auditor should ensure that confirmation regarding the
outstanding claims have been received in respect of all inward
arrangements.
 As per IRDA (General Insurance-Reinsurance)
Regulations,2000 every insurer is required to make provision for
outstanding claims for all reinsurance arrangements accepted
on the basis of loss information advices received from
brokers/cedants and where such advices have not been
received, on an actuarial estimation basis. In addition, every
insurer has to make an appropriate provision for ‘Incurred but
Not Reported (IBNR)’ claims on its reinsurance accepted
portfolio on actuarial estimation basis. This aspect has to be
looked into as this may result in a lot of difference in the
financial results of the company.
 Closing balances of the re-insurer’s accounts should be
reconciled and the confirmation of balances should be obtained
from all the companies.
 The auditor must ensure that foreign inward accounts balances
have been re-stated at the prevailing value at the year end and
that difference arising out of re-statement has been taken to
Profit and Loss Account.
 The auditor should verify the requirement of provision/write off
of reinsurance inward balances based o the doubtful nature of
recovery, if any.
 The auditor should check whether Indian inward balances
including with the GIC have reconciled and identical balances
 267

arrived at and affect, if any, due co-insurance transactions

should also be looked into.

Verification of Re-Insurance Outward – The following steps may

be taken by the auditor in the verification of re-insurance outward:
 The auditor should verify that re-insurance underwriting returns
received from the operating units regarding premium, claims
paid, outstanding claims tally with the audited figures of
premium, claims paid and outstanding claims.
 The auditor should check whether the pattern of re-insurance
underwriting for outward cessions fits within the parameters and
guidelines applicable to the relevant year.
 The auditor should also check whether the cessions have been
made as per the stipulation applicable to various categories of
risk.
 The auditor should verify whether the cessions have been made
as per the agreements entered into with various companies.
 It should also be seen whether the outward remittances to
foreign re-insurers have been done as per the foreign exchange
regulations.
 It should also be seen whether the commission on cession has
been calculated as per the terms of the agreements with the re-
insurers.
 The auditor should verify the computation of profit commission
for various automatic treaty arrangements in the light of the
periodical accounts rendered and in relation to outstanding loss
pertaining to the treaty.
 The auditor should examine whether the cash loss recoveries
have been claimed and accounted on a regular basis.
 The auditor should also verify whether the Claims Paid item
appears in Outstanding Claims list by error. This can be verified
at least in respect of major claims.
 He should see whether provisioning for outstanding losses
recoverable on cessions have been confirmed by the re-insurers
and in the case of major claims, documentary support should be
insisted and verified.
 Accounting aspects of the re-insurance cession premium,
commission receivable, paid claims recovered, and outstanding
losses recoverable on cessions have to be checked.
 The auditor should check percentage pattern of gross to net
premium, claims paid and outstanding claims to ensure
comparative justification.
 268

 The auditor should also check that the re-insurers balance on

cessions and whether the sub ledger4 balances tallies with the
general ledger balances.
 The auditor should review the individual accounts to find out
whether any balance requires provisioning/write back.
 He should verify whether the balances with re-insurers are
supported by necessary confirmation obtained from them.
 He should verify whether the balances with re-insurers are
supported by necessary confirmation obtained from them.
 He should verify whether opening outstanding claims not paid
during the year find place in the closing outstanding claims vis-
à-vis the reinsurance inwards outstanding losses recoverable on
cessions appears in both opening and closing list. If not, the
reason for the same should be analyzed.
 Any major event after the Balance Sheet date which might have
wider impart with reference to subsequent changes regarding
the claim recovery both paid and outstanding and also ore-
insurance balances will need to be brought out suitably.

CO-INSURANCE
Where the insured chooses to have more than one insurer
for the same transaction of risk, it would amount to coinsurance.

The auditors should get information from the agreement

arrived at the Insurance Council, where the insurance companies
may chose to be the members. (Whether the concept of Insurance
Council is in place). Members of the Insurance Council could arrive
the mutually agreeable terms and norms of entering into
coinsurance agreement and the norms for settlement of dues. The
Insurance Council may recommend the following norms while
entering into coinsurance agreement:
 Settlement of commission
 Collection and Remittance of service tax
 Standard practices for settlement of dues
 Settlement of claims
 Reinsurance arrangement for the risk booked
 Exceptional booking and the powers thereof deviating from the
Council’s understanding.

The auditor should go through the understanding of the

Council and ensure that the risks are covered as per the terms and
conditions with adequate consideration and proper settlement.
 269

SOLVENCY MARGIN
Section 64A of the Insurance Act, 1938, inter alia, requires every
insurer to maintain an excess of the value of its assets over the
amount of its liabilities at all times. The excess is known as
‘Solvency Margin’. In the case of insurer carrying on general
insurance business, the solvency margin should be the highest of
the following amounts;

(a) fifty crore rupees (one hundred crores of rupees in case of a

reinsurer); or
(b) a sum equivalent to twenty percent of net premium income;
of
(c) a sum equivalent to thirty percent of net incurred claims,

Subject to credit for reinsurance in computing net premiums

and net incurred claims being actual but a percentage determined
by the regulation but not exceeding fifty percent. It may be noted
that conditions regarding maintenance of the above mentioned
solvency margin may be relaxed by the Authority in certain special
circumstances.

Maintenance of solvency margin has a great importance for

an insurance company considering their size and nature of
business and also involvement of public money. Sub-section (2C)
of Section 64A states that if an insurer fails to comply with the
requirements of the Insurance Act, 1938, it shall deemed to be
insolvent and may be wound up by the Court.

IRDA Regulations – Sub section (3) of Section 64V of the Act

requires that every insurer should value the assets and liabilities in
the manner laid down by the Section 64V and in accordance with
the regulations which may be made by the Authority in this behalf.

Every Insurer is required prepare a statement of value of

assets in “Form IRDA-Assets-AA”. A statement of the amount of
liabilities in case of general insurance business is to be prepared in
“Form HG” and a statement of Solvency Margin in “Form KG” as
specified in the Insurance Regulatory and Development Authority
(Assets, Liabilities and Solvency Margin of Insurers) Regulations.
The statement of assets, liabilities and solvency margin are to be
certified by an auditor and filed by the insurance company with the
Authority within six months from the end of the period to which they
refer to along with the audited accounts and statements. The
salient features pertaining to the valuation of assets are discussed
below:

Statement of Solvency Margin – Every insurer is required to

determine the required solvency margin, the available solvency
margin and the solvency ratio in the Form KG. The statement of
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solvency margin is to be prepared in accordance with Section 64

VA of the Insurance Act, 1938 and the same it to be certified by the
auditor.

Appendix I
Format of Financial Statements
Form B-RA
Name of Insurer:
Registration No. and Date of Registration with IRDA

Revenue Account for the year ended 31st March, 20..

(To be prepared separately fire, marine, and miscellaneous
insurance)

Particulars Schedule Current Year Previous Year

(Rs. ‘000) (Rs. ‘000)
1 Premiums earned (Net) 1
2 Profit/Loss on
sale/redemption of
investments
3 Others (to be specified)
4 Interest, Dividend & Rent-
Gross
Total (A)
1 Claims incurred (Net0 2
2 Commission 3
3 Operating Expenses related 4
to Insurance Business
4 Others – To be specified
Total (B)
Operating Profit/(Loss) from
Fire/Marine/Miscellaneous
Business (A-B)
Appropriations
Transfer to Shareholders’ Account
Transfer toe Catastrophe Reserve
Transfer to Other Reserves (to be
specified)
Total (C)
 271

FORM B-PL
Profit and Loss Account for the year ended 31st March 20…
Name of the Insurer:
Registration No. and Date of Registration with the IRDA

Particulars Schedule Current Year Previous Year

(Rs. ‘000) (Rs. ‘000)
1 Operating Profit/(Loss)
(a) Fire Insurance
(b) Marine Insurance
(c) Miscellaneous Insurance
2 Income from Investments
(a) Interest, Dividends &
Rent-Gross
(b) Profit on sale of
investments
LESS: Loss on sale of
investments
3 Other income (To be
specified)
Total (A)
4 Provisions (other than
taxation)
(a) For diminution in the
value of investments
(b) Four doubtful debts
(c) Others (to be specified)
5 Other Expenses
(a) Expenses other than
those related to Insurance
Business
(b) Bad debts written off
(c) Others (to be specified)
Total (B)
Profit Before Tax
Provision for Taxation
Appropriations
(a) Interim dividends paid during the
year
(b) Proposed final dividend
(c) Dividend distribution tax
(d) Transfer to any Reserves or
Other Accounts (to be specified)
Balance of profit/loss brought
forward from the last year
Balance carried forward to Balance
Sheet
 272

Note:
(a) Premium income received from business concluded in and
outside India shall be separately disclosed.
(b) Reinsurance premiums whether on business ceded or
accepted are to be brought into account gross (i.e. before
deducting commissions) under the head reinsurance
premiums.
(c) Claims incurred shall comprise claims paid, specific claims
settlement costs wherever applicable and change in the
outstanding provision for claims at the year-end.
(d) Items of expenses and income in excess of one percent of the
total premiums (less reinsurance) or Rs. 5, 00,000 whichever is
higher, shall be shown as a separate line item.
(e) Fees and expenses connected with claims shall be included in
claims.
(f) Under the sub-head “Others” shall be included items like
foreign exchange gains or losses and other items.
(g) Interest, dividends and rentals receivables in connection with
an investment should be stated as gross amount, the amount
of income tax deducted at source being included under
‘advance taxes paid and taxes deducted at source’..
(h) Income from rent shall include only realized rent. It shall not
include any notional rent.

Schedule 2
Claims Incurred (Net)

Particulars Current year Previous year

(‘000) (‘000)
Claims paid
Direct
Add : Reinsurance accepted
Less : Reinsurance Ceded
Net Claims paid
Add : claims Outstanding at the
end of the year
Less Claims Outstanding at the
beginning
Total Claims Incurred
 273

Notes :
a) Incurred But Not Reported (IBNR), Incurred But Not Enough
Reported (IBNER) claims should be included in the amount for
outstanding claims.
b) Claims include specific claims settlement costs but not
expenses of management.
c) The surveyor fees, legal and other expenses shall also form part
of claims cost.
d) Claims cost should be adjusted for estimated salvage value if
there is a sufficient certainty of its realization.

Schedule 3
Commission

Particulars Current year Previous year

(‘000) (‘000)
Commission paid
Direct
Add : Re-insurance Accepted
Less : Commission on Re-
Insurance Ceded
Net Commission
Note :
The profit / commission, if any are to be combined with the Re-
insurance accepted or Reinsurance ceded figures.

Schedule 4
Operating Expenses Related to Insurance Business

Particulars Current year Previous year

(‘000) (‘000)
1. Employees’ remuneration &
welfare benefits
2. Travel, conveyance and
vehicle running expenses
3. Training Expenses
4. Rents, rates & taxes
5. Repairs
6. Printing & stationery
7. Communication
 274

8. Legal & professional

charges
9. Auditors fees, expenses
etc.
a) as auditors
b) as adviser or in any
other capacity, in respect of
i) Taxation matters
ii) Insurance Matters
iii) Management services;
and
c) in any other capacity
10. Advertisement and publicity
11. Interest & Bank Charges
12. Others (to be specified)
13. Depreciation
Total

Note : Items of expenses and income in excess of one percent of

net premium or 5,00,000 whichever is higher, shall be shown as a
separate line item.

Schedule 5
Share Capital

Particulars Current year Previous year

(‘000) (‘000)
1. Authorised Capital
Equity Shares of ….. each
2. Issued Capital
Equity Shares of ….. each
3. Subscribed Capital
Equity Shares of ….. each
4. Call-up Capital
Equity Shares of ….. each
Less : Calls unpaid
Add : Equity Shares
Forfeited
(Amount originally paid up)
 275

Less : Par Value of Equity

Shares Brought Back
Expenses including
commission or brokerage
on Underwriting or
subscription of shares
Total
Notes :
a) Particulars of the different clauses of capital should be
separately stated.
b) The amount capitalized on account of issued of bonus shares
should be disclosed.
c) In case any part of the capital is held by a holding-company,
the same should be separately disclosed.

Schedule 5A
Share capital Pattern of Shareholding
(As certified by the Management)

Shareholder Current Year Previous Year

Number of % of Number of % of
Shares Holding Shares Holding
Promoters
Indian
Foreign
Others
Total

Schedule 6
Reserves and Surplus

Particulars Current year Previous year

(‘000) (‘000)
1. Capital Reserve
2. Capital Redemption reserve
3. Share Premium
4. General Reserves
Less : Debit balance in Profit
and Loss Account
Less : Amount utilized for
Buy-back
5. Catastrophe Reserve
6. Other Reserves (to be
specified)
7. Balance of Profit & Loss
Account
Total
 276

Notes :
a) Additions to and deductions from the reserves should be
disclosed under each of the specified heads.

Schedule 7
Borrowings

Particulars Current year Previous year

(‘000) (‘000)
1. Debentures / Bonds
2. Banks
3. Financial Institutions
4. Other (to be specified)
Total
Notes :
a) The extent to which the borrowings are secured shall be
separately disclosed stating the nature of the security under each
sub-head.
b) Amounts due within 12 months from the date of Balance Sheet
should be shown separately.

Schedule 8
Investment

Particulars Current year Previous year

(‘000) (‘000)
Long Term Investments
1. Government securities and
Government guaranteed
bonds including Treasury
Bills
2. Other Approved Securities
3. Other Investments
a) Shares
i) Equity
ii) Preference
b) Mutual Funds
c) Derivative Instruments
d) Debentures / Bonds
e) Other Securities (to be
specified)
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f) Subsidiaries
g) Investment Properties –
Real Estate
h) Investments in
infrastructure and Social
Sector
i) Other than Approved
Investments
Short Term Investments
1. Government securities and
Government guaranteed
bonds including Treasury
Bills
2. Other Approved Securities
3. Other Investments
a) Shares
i) Equity
ii) Preference
b) Mutual Funds
c) Derivative Instruments
d) Debentures / Bonds
e) Other Securities (to be
specified)
f) Subsidiaries
g) Investment Properties –
Real Estate
h) Investments in
infrastructure and Social
Sector
i) Other than Approved
Investments
Total
Investments
1. In India
2. Outside India
Total
 278

Schedule 9
Loans

Particulars Current year Previous year

(‘000) (‘000)
1. Security –Wise Classification
Secured
a) On mortgage of property
i) In India
ii) Outside India
b) On Shares, Bonds,
Government Securities
c) Others (to be specified)
Unsecured
Total
2. Borrower – Wise
Classification
a) Central and State
Governments
b) Banks and Financial
Institutions
c) Subsidiaries
d) Industrial undertakings
e) Others (to be specified)
Total
3. Performance-wise
Classification
Loans Classified as
standard
i) In India
ii) Outside India
Non-performing loans less
provisions
i) In India
ii) Outside India
Total
4. Maturity-Wise Classification
a) Short-term
b) Long Term
Total
 279

Notes :

a) Short-term loans shall include those, which are repayable within

12 months of the balance sheet date. Long-term loans shall be
the loans other than short-term loans.
b) Provisions against non-performing loans shall be shown
separately.
c) The nature of the security in case of all long-term secured loans
shall be specified in each case. Secured loans for the purposes
of this Schedule, means loans secured wholly or partly against
an asset of the company.
d) Loans considered doubtful and the amount of provision created
against such loans shall be disclosed.

Schedule 10
Fixed Assets (‘000)

Opening Additions Deductions Closing Upto For On sales / To As Previous

last the Adjustments Date at year
year year year
end

Goodwill
Intangibles
(specify)
Land
Freehold
Leasehold
property
Buildings
Furniture
and Fittings

Information
Technology
Equipment

Vehicles
Office
Equipment

Others
(Specify
nature)
Total
Work-in-
Progress
Grand Total

Previous
year

Note :
Assets included in land, building and property above exclude
Investment Properties as defined in note (e) to Schedule 8.
 280

Schedule 11
Cash and Bank Balances

Particulars Current year Previous year

(‘000) (‘000)
1. Cash (including cheques,
drafts and stamps)
2. Bank Balances
a) Deposit Accounts
(aa) Short –term (due
within 12 months)
(bb) Others
b) Current Accounts
c) Others (to be specified)
3. Money at Call and Short
Notice
a) with Banks
b) with other Institutions
4. Others (to be specified)
Total
Balances with non-scheduled
banks included in 2 and 3 above.
Notes :
Bank Balance may include remittances in transit. If so, the nature
and amount should be separately stated.

Schedule 12
Advances and Other Assets

Particulars Current year Previous year

(‘000) (‘000)
Advances
1. Reserve deposits with ceding
companies
2. Application money for
investments
3. Prepayments
4. Advances to Officers /
Directors
 281

5. Advance tax paid and taxes

deducted at source (Net
provisions for taxation)
6. Others (to be specified)
Total (A)
Other Assets
1. Income accrued on
investment
2. Outstanding Premiums
3. Agents Balances
4. Foreign Agencies Balances
5. Due from other insurance
entities (including reinsures)
6. Due from subsidiaries /
holding
7. Deposit with Reserve Bank of
India (Pursuant to Section 7
of Insurance Act, 1938)
8. Others (to be specified)
Total (B)
Total (A + B)

Notes :

i) The items under the above heads shall note be shown net of
provisions for doubtful amounts. The amount of provision
against each head should be shown separately.
ii) The term ‘officer’ should conform to the definition of the word
‘officer’ given under the Companies Act, 1956.
iii) Sundry debtors will be shown under item 8.
 282

Schedule 13
Current Liabilities

Particulars Current year Previous year

(‘000) (‘000)
1. Agents’ Balances
2. Balances due to other
insurance companies
3. Deposits held on re-
insurance ceded
4. Premiums received in
advance
5. Unallocated Premium
6. Sundry creditors
7. Due to subsidiaries / holding
company
8. Claims Outstanding
9. Due to Officers / Directors
10. Others (to be specified)
8. Others (to be specified)
Total

Schedule 14
Provisions

Particulars Current year Previous year

(‘000) (‘000)
1. Reserve for Unexpired risk
2. For taxation (less advance
tax paid and taxed deducted
at source
3. For proposed dividends
4. For dividend distribution tax
5. Other (to be specified)
Total
 283

Schedule 15
Miscellaneous Expenditure
(To the extent not written off or adjusted)

Particulars Current year Previous year

(‘000) (‘000)
1. Discount Allowed in issue of
shares / debentures
2. Others (to be specified)
Total

Notes :
No item shall be included under the head “Miscellaneous
Expenditure and carried forward unless :
1. Some benefit from the expenditure can reasonable be expected
to be received in future, and
2. The amount of such benefit is reasonable determinable.
b) The amount to be carried forward in respect of any item
included under the head “Miscellaneous Expenditure” shall not
exceed the expected future revenue / other benefits related to
the expenditure.

APPENDIX II
Directions under Section 619 (3) (a) of the Companies Act,
1956, applicable to Insurance Companies

I. System of Accounts
1. Examine the following systems and give your views as
regards their deficiencies alongwith suggestions for remedial
measures : -
a) Recording of receipts and expenditure.
b) Drawing periodical trial balance.
c) Compilation of accounts.
d) Reconciliation of inter-office accounts.
e) Reconciliation of registers / records relating to peroperty,
assets. Investments, premiums, claims, loans, etc., with
financial books.
f) Maintenance of up-to-date records in respect of assets,
which are pledged, encumbered or blocked in any way.
2. Are the bank accounts of the company reconciled with the
bank statements regularly? If not, describe the failures.
3. Are control accounts and subsidiary accounts up-to-date and
reconciled regularly? If not, describe the failures.
 284

4. Examine the accounting policies of the company. Are these

in conformity with the Accounting Standards (National and in
the absence of National Standards, the corresponding
International Standard? Give particulars of material
departures from these standards, if any, alongwith their
effect on the financial statements; quantify the impact
wherever possible.

II. System of Financial Control

1. Examine the delegation of financial powers and indicate
whether these are clearly and legally made within the
company. If not, describe the defects in the delegation of
powers and suggest remedial measures.
2. Indicate whether the cash and imprest balances were
physically verified during the year on a regular basis by an
authorized officer? Highlight the inadequacies in this regard,
if any.
3. Whether transfers of surplus funds are being made on a
timely basis and whether these are being properly
monitored?
4. Examine whether the system of the company insures
adequate control over issue and custody of critical items of
stationery, e.g., cover notes, policy documents receipts and
acknowledgements relating to risk accepted, etc? If not,
describe the inadequates.
5. Give your comments on Internal Audit system stating
whether its reporting status, scope of work, level of
competence, etc. are adequate? If not, describe the short-
comings thereof. Is there an adequate compliance
mechanism on internal audit observations?
6. Indicate the serious lacunae in the system of internal control
which have come to your notice during audit.

III. Investments (Applicable only at H.O.)

1. Indicate whether the Board of Directors of the company laid
down on investment policy? If yes, please indicate the
following : -
a) Is the policy in accordance with the laws, rules and
regulations applicable to the company?
b) In your opinion, are there any defects in the policy?
c) Has the company followed it in case of all material
investments made during the year?
 285

d) Were the investments made by the company in its best

interest?
2. Does the company have adequate system of periodic
physical verification of investments and reconciliation thereof
with books? Have the discrepancies been properly dealt
with?
3. Does the system of the company ensure proper recording of
rights, entitlements and options on investments held? Are
adequate records maintained in support of exercise / non
exercise of such rights, etc?
4. Does the system of the company ensure recording of accrual
of dividend, interest and other yields on investments and for
follow up of the amounts accrued but not received?
5. In the case of investments matured and income due but not
received / collected, is satisfactory explanation available for
non-receipt / non-collection?

IV. Loans (Applicable only at H.O.)

1. Indicate whether the Board of Directors of the company has
laid down a policy regarding of loans. If yes, please indicate
the following :
a) Is the policy in accordance with the laws, rules and
regulations applicable to the company?
b) In your opinion, are there any defects in the policy?
c) Has the company followed it in the case of all material
loans made during the years?
d) Were the loans made by the company in its best interest?
e) Has adequate provision been made in the accounts in
respect of bad and doubtful loans? If not, describe the
failures.
f) Does the company have an effective system of
identifying non-performing loans? Does the company
monitor such loans effectively?
g) Has the company taken adequate steps against the
defaulters during the year? If not, indicate significant
instances of failures.

V. Revenue Accounts
1. Does the company has an effective system to ensure that
premiums for risks assumed / accepted during the year
for various classes of business are properly computed
and accounted for?
 286

2. Is he system of collections of premium on policies issued

adequate? If not, give instances of major violations of
relevant legal provisions and prescribed procedures.
3. Have the norms for determining premium for non-tariff
business been laid down by the company and are these
followed by divisions / branches booking the business?
4. Have you come across instances of prohibited / declined
risks having been accepted in excess of the delegated
authority?
5. In respect of system relating to claims, comment on the
following aspects, giving instances of significant
deviations / failures in each case.

a) Are claims promptly recorded in the claims intimation

register for each class of business? Is the liability of
the company ascertained / assessed expeditiously?
b) Are surveyors appointed and their preliminary / final
survey reports obtained within a reasonable time?
c) Is collection and accounting of salvage as well as its
disposal expeditious?
d) Are close proximity claims, i.e., claims within a short
period after commencement of the risk, identified?
Are the procedures for processing of such claims
effective?
e) Are pending claims reviewed periodically and follow-
up action taken in appropriate cases?
6. Does the system of the company ensure that claims are
recorded net of co-insurance at the D.O./ branch and net
of re-insurance as per arrangement with other insurers at
the Head Office?
7. Is the system of monitoring the accepted or ceded
business and accounting of premiums and claims in
connection therewith adequate? Indicate major defects.
8. Are balances under accepted treaties periodically
reconciled and action taken for outstanding recoveries?
9. Does the system of the company ensure proper
recording of incoming and outgoing co-insurance
transactions and periodic reconciliation of co-insurers
balances?
10. Does the system of the company ensure periodic
reconciliation of ledger balances relating to premiums
and claims with the relevant figures as per the business
 287

and claims registers as communicated by divisions in the

underwriting returns for purpose of re-insurance?
11. Were the re-insurance treaties entered into by the
company in its best interest? Indicate cases of re-
insurance treaties which have resulted in heavy losses
continuously.

VI. Miscellaneous

1. Are the (i) Premium deposit accounts, (ii) Bank guarantee

account, (iii) Agent’s balance accounts (iv) Outstanding
premium accounts, (v) Amount due to and from other
persons / bodies carrying on insurance business accounts,
(vi) Treaty inwards and outwards control accounts, (vii)
sundry debtors and creditors accounts including outstanding
claims, regularly reviewed and pursued for clearance /
adjustment? Have confirmations been obtained of such
outstanding accounts? In the case of credit Balance
including premium deposits, sundry deposits and agents
balances, are appropriate premium adjustments made for
risks assumed, if any?
2. Were there any special features in the year which have
affected the results shown by the profit and Loss Account
substantially? If so, give details.
3. Are these any other significant matters which in your opinion
deserve the attention of the management?

Annexure – A
(This information is factual and should be obtained from the
Management)

11.5 EXERCISE

1. Indicate the areas where the company has computerized the

accounts system. Have the General and Application controls
been reviewed periodically to derive assurance that the system
is producing results that can be relied upon by the auditors?
State the deficiencies reported by internal auditors / statutory
auditors alongwith the remedial measures being taken by the
management.
2. Are the accounts of the company in arrears? If so, state the
reasons therefore and the action taken / being taken to bring the
accounts up-to-date.
3. Please comment on operation of foreign branches / agencies
with relevant details. In case of adverse results remedial
measures taken and results thereof should be described.
 288

4. What are non-performing investments? Please indicate the cost,

book value and market value of such investments.
5. What is the average yield on investments in last three years?
6. What percentage of loans was considered doubtful at the end of
each the three preceding years and the absolute amount
thereof?
7. Give age-wise break-up of outstanding claims for each class of
business (numbers and amount).
8. List out top 30 claims (above 5 lakhs each) provided / settled
during the year (10 for each class of business).
9. Have any cases of frauds / embezzlements / misappropriation
comes to light during the year? If so, give details.

1) In the case of firm letter of appointment of auditor must be

signed by
a) The partner b) The secretary
c) The Auditor’s himself d) All the partners

2) Formats of financial statements of a sole trader decided by

a) Banker b) Sole proprietor
c) Accountant d) All of the above

3) Admission fees of students can be checked from

a) Roll call b) Admission slip signed by the
principal
c) Office identity cart d) None of the above
4) The auditor of an educational body should verify that
increase in salary is minuted by
a) Principal b) Voice principal
b) Accountant d) Managing committee

5) The Auditor of a sole trade is appointed by

a) Banker b) Accountant
c) Proprietor d) None of the above

6) The auditors of educational body should ensure that any

income from special fund is credited to
a) Capital fund account b) Special fund account
c) Investment account d) Income & Expenditure
Account
7) The auditor of a firm must have knowledge of
a) Partnership Deed b) Provisions of Partnership
Act
c) Companies Act d) Both a & b
 289

8) Audit of a small company may be done by

a) Company Secretary b) Accountant
c) Chartered Accountant d) Cost Accountant

9) In audit of Sole trader auditor’s duties are defined by

a) Banker b) Companies Act
c) Accountant d) Contract between auditor
and client
10) In the case of hospital bills issued to patients is verified from
a) Invoices b) Investigation Reports
c) Register of patients d) Case papers

11) In the case of a soll trader payment of tax liabilities

a) Compulsory b) Optional
c) Determined by the banker d)None of the above

12) Inventory of an Educational Institution is verified from the

a) Stock Register b) Purchase Register
c) Bank Statement d) Cash Book

13) The auditor should ensure that the business of firm is

authorized by
a) Managing Partner b) Sleeping Partner
c) Partnership deed d) Memorandum of Association

14) In the case of a partnership firm

a) The partnership Act Prescribed audit
b) The partnership deed provides for audit
c) The companies act prescribed audit
d) The partnership Act does not prescribed audit

15) The auditor should ensure that the caution money and other
deposits from students are shown in the
a) Balance sheet on liability b) Balance sheet on asset
side side
c) Foot note to the Balance d) None of the above
sheet

16) The document which contains the provisions attesting the

accounts of a firm.
a) Memorandum of b) Lease deed
Association
c) Partnership deed d) Trust deed

17) The record of policies decision is

a) Agenda Book b) Minute Book
c) Cash Book d) Notice Book
 290

18) In absence of partnership deed frofits are shared by

partner’s in
a) Equally b) Ratio of time devoted by
partners
c) Ratio of Capitals d) As per seniority

19) Verification of grants from Government or Local authority

can be done from
a) Memo of Grants b) Principals letter
c) Managing committees d) Stock Register
minutes

20) In absence of partnership deed partners entitled to interst on

their advances/loans
a) 4% b) 6%
c) 12% d) 18%

21) In the case of Educational Institutions decision altecting the

accounts are recorded in
a) Accountants Diary
b) Principals Diary
c) Minutes of managing committee or Governing body
d) Financial Statements

22) The Certificates regarding completion of accounting records

and its accuracy should be obtained from
a) MD of the company b) Management of the
company
c) Accountant of the d) Owner of the company
Company

23) In the case of Educational Institutions, details about the

students can be obtained from
a) Attendance register b) Examination Report
c) Student Register d) General Register

24) In absence of partnership deed

a) Profits and Losses are shared equally
b) Profits and Losses are shared in the ratio of their capitals
c) Loss of the firm is not shared at all
d) Profit & Losses are shared in the ratio 3:2:1

25) In absence of partnership deed

a) Interest on Capital is gives at 18% p.a.
b) Interest on Capital Cannot be given
c) Interest on capital is given at 6% p.a.
d) Interest on capital is given at 12% p.a.
 291

26) Verification of free studentship and concessions granted can

be done from rulls prepared by
a) Staff b) Managing Committee
c) Student d) Principal

27) In view of the small size of a small company

a) In may be possible to check 100% of the entries
b) Only Balance sheet audit can be done
c) Audit of trial balance can be done
d) Only cash book can be audited

28) In the case of Educational Institutions, all the provisions

affecting the accounts are given in
a) Articles of association b) Memorandum of association
c) Trust deed d) Partnership deed

29) The tax auditor has to submit his report to

a) The assesses b) The Government
c) Income tax officer d) Income tax Commissioner

30) As per Income Tax Act Gross Receipts include

a) Wire charges of cold b) Lease Rant
storage
c) Cash incentives for d) All of the above
export

31) Form No. 3 CB is used carries on business/profession but

not required any law to get its account audited
a) The person who carries on business/profession but not
required any law to get its account audited
b) The person who carries on business but required to get
his accounts audited
c) A Limited Company
d) A person who is not a business man or professional

32) Tax audit is provided by section

a) 41 b) 42 A
c) 43 B d) 44 AB

33) Claims are verified by checking

a) Policies b) Claim form
c) Survey Report d) All of the above

34) The very first item in the balance sheet of a banking

company on asset side is
a) Cash & Balance with RBIb) Fixed Asset
c) Goodwill d) Investments
 292

35) Stock verification of hospital can be done from

a) Stock Register b) Admission card
c) Prescription issued d) Discharge card

36) As per Income Tax Act. Cross Receipts includes

a) Cash incentives for export b) Salle of fixed assets
c) Cash collected from debtors d) None of the above

37) Premium is verified by checking

a) Premium receipt issued b) Branch managers minutes
book
c) Claims settled book d) Survey Report

38) Tax audit is compulsory for those businessmen whose turn

over or gross receipts exceed
a) 20 lakh b) 40 lakh
c) 60 lakh c) 80 lakh

39) Stock of furniture, sports material and other assets should be

verified with the
a) Purchase Register b) Stock register
c) Cash book d) Sales Receipt Book

40) Every banking company in India has to transfer to Reserve

fund out of current year profit
a) 20% b) 25%
c0 30% d) 40%

41) Cash collection from patients can be verified from

a) Discharge card b) Case papers
c) Receipt issued to patient d) Investigation Report

42) The audit report is required to be furnished under section

44AB shall be
a) 3 CB b) ITR2
c) 3 CA d) Saral
43) The auditor should evaluate the internal control regarding
a) Receipt of cash b) Disbursting of cash
c) Billing to customers d) All of the above

44) While verifying 3 CD form it is advisable for the tax auditor to

consider
a) Cross references b) Difference of opinion
d) Law applicable d) All of the above

45) The auditor of a hotel should ensure

a) Articles of association b) provision of company law
c) Statutory compliance d) Rules of FEMA
 293

46) Every insurance company has to prepare every year

a) Balance sheet & Profit b) Statement of claims refected
& Loss A/c.
c) Undertaking for acknowledging claims
d) Fund flow statement

47) Reserve for unexpired risk is shown in the balance sheet of

a General Insurance company under
a) Capital & Reserves b) Current liabilities
c) Provision d) None of the above

48) In the case of club entrance fees can be verified from

a) Counterfoils issued b) Journal Entries
c) Members Entry book c) Secretaries minute book

49) Specified date by which tax audit should be done is

a) 31st October of A.Y. b) 31st December of A.Y.
st
c) 31 July of A.Y. d) 3oth September of A.Y.

50) The auditor of a hotel should ensure that proper provision is

made for
a) Redecoration b) Renovation
c) Repairs c) All of the above

51) Audit report to be given by the auditor of an insurance

company must be as per
a) Schedule of IRDA b) Form 3 CB & 3 CD
c) Schedule 6 of d) Provision of Income Tax Act
companies Act

52) Tax audit is compulsory for those professionals whose gross

receipts in any previous year exceed
a) 10 lakh b) 15 lakh
c) 20 lakh d) 25 lakh

53) Figures in final accounts of a bank are shown in

a) Rupees b) Hundreds
c) Thousands d) Lakhs

54) Outstanding premium is shown in the Balance sheet of an

insurance company under
a) Current asset b) Current liabilities
c) Other asset d) Misl. Expenditure

55) Payment to foreign collaborator should be as per

a) Terms of agreement b) Trust deed
c) Partnership deed d) Letter of credit
 294

56) Premium received in advance is shown in the balance sheet

of Insurance Company under the Lead
a) Current Asset b) Current liabilities
c) Other asset d) Misc. Expenditure

57) Special receipts from letting out the auditorium in the hotel
should be verified on the basis of
a) Counter fails of Receipt issued
b) Bank reconciliation statement
c) Articles of association
d) Memorandum Association

58) As per Income Tax Act, Sales include

a) Sale of scrap b) Sale of fixed asset
c) Sale of investment d) Sale of business

59) Insurance business is controlled by

a) IRDA b) Insurance rules
c) Insurance Act, 1938 d) All of the above

60) As per Section 44AA profession does not includes

a) Legal b) Banking
c) Medical d) Accountancy

61) For settlement of claim, Insurance Company

a) Ensures completion formalities
b) Decides genuineness of the claim
c) Survey Report
d) All of the above
62) The reserve for unexpired risk in respect of marine insurance
is
a) 20% of premium b) 25% of premium
c) 50% of premium c) 100% of premium

63) In case of under Insurance by parties

a) Interest clause applied b) Average clause applied
c) Claim clause applied d) All of the above

64) Inter office adjustment is shown in the bank balance sheet

under
a) Advances b) Either other assets of other
liabilities
c) Deposits d) Contra entries

65) Which of the following is generally the largest item of the

asset side of the bank balance sheet?
a) Loans & advances b) Other asset
c) Cash & bank balance with RBI
d) Deposits
 295

66) Bills for collection are shown in the balance sheet of a bank
under
a) Other asset b) Advances
c) Deposits d) Contingent liabilities

67) Endorsement are shown by banks under

a) Other assets b) other liabilities
c) Contingent liabilities d) Deposits

68) Bills payable are shown in the balance sheet of a bank under
a) Contingent liabilities b) Other liabilities & provisions
c) Advances d) Deposits

69) In case of Nationalized bank the auditor shall sent his report
to
a) President of India with a copy to RBI
b) Central Government
c) RBI
d) Managing Director of the bank

70) Discount on bills is shown by banks under schedule number

a) 12 b) 13
c) 14 d) 15

71) Rebate on bills discounted is shown in balance sheet of

bank under
a) Liability side b) Asset side
c) Asset & liabilities both d) None of the abve

72) Rebate on bills discounted is shown in balance sheet of

bank under
a) 4 b) 5
c) 9 d) 10

73) Letters of credit are shown under

a) Other assets b) Other liabilities
c) Contingent liabilities d) Advances

74) Unclaimed dividend is shown by banks under

a) Advances b) Deposits
c) Other assets d) Other liabilities

75) Banks should classify an account as NPA only if interest

charged during any quarter is not served fully with days from
the end of the quarter
a) 30 b) 60
c) 90 d) 120
 296

Answers:
1 – a, 2 – a, 3 – b, 4 – d, 5 – c, 6 – b, 7 – d, 8 – c, 9 – d 10 – c
11 – a, 12 – a, 13 – c, 14 – d, 15 – a, 16 – c, 17 – b, 18 – a, 19 – a, 20 – b,
21 – c, 22 – d, 23 – c, 24 – a, 25 – c, 26 – b, 27 – a, 28 – c, 29 – a, 30 – d,
31 – a, 32 – d, 33 – d, 34 – a, 35 – a, 36 – a, 37 – a, 38 – c, 39 – b, 40 – a,
41 – c, 42 – a, 43 – d, 44 – d, 45 – c, 46 – a, 47 – c, 48 – a, 49 – a, 50 – a,
51 – a, 52 – b, 53 – c, 54 – c, 55 – a, 56 – b, 57 – a, 57 – d, 60 – b, 61 – d,
62 – d, 63 – b, 64 – b, 65 – a, 66 – d, 67 – d, 68 – b, 69 – a, 70 – b, 71 – a,
72 – c, 73 – c, 74 – d, 75 – c.

Fill in the blanks

1) Bills payable is shown in the balance sheet of a bank under
______
2) Tax audit is provide by section _______
3) The Tax auditor has to submit is report to ______
4) Auditor of a sole trader is appointed by the ______
5) Auditor of a firm must have knowledge of ______
6) Auditor of a small company may be done by a sole _____
7) The auditor of a hotel should ensure _____
8) Bills purchased and discounted are shown in the balance
sheet of a bank under schedule of ______
9) In case of a sale trader _____ decides the scope of audit
10) Sale of scrap is included in gross ______
11) _____ contains provision affecting accounts of a firm
12) Admission fees of students can checked from ____
13) Bills for collection are shown in the balance sheet of a bank
under ______
14) ______ regulates the working of insurance companies
15) ______ shows inventory of the educational institutions
16) Forma of financial statements of a sole trader is decided by
______
17) Average clause is applicable in case of ______
18) In absence of partnership deep profit or loss is shared by
partners _____
19) In the case of hospitals cash collection from patients is
verified from ______
20) Reserve for unexpired risk in respect of fire insurance
is______
21) In the case of a club stock verification can be done
from______
22) Outstanding premium is shown in the balance sheet of an
insurance company under ______
23) Caution money is disclosed in the balance sheet on ______
24) In absence of partnership deed partners are entitled to
interest on loan at ______%
 297

Answers:
1) Other liabilities
2) 44AB
3) Assessee
4) Sole proprietor
5) Partnership deed/partnership act
6) CA 7) Statutory compliance
8) Advances/Schedule 9
9) Owner/proprietor
10) Receipts
11) Partnership deed
12) Admission slips/fee receipts
13) Contingent liabilities
14) IRDA
15) Stock Register
16) ICAI
17) Under Insurance
18) Equally
19) Cash bank
20) 50%
21) Stock register
22) Other assets
23) Liabilities side
24) 6%.


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
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12
BANKING COMPANY AUDIT

Unit Structure
12.1 Introduction
12.2 Role of the Reserve Banks of India as Central Bank
12.3 Appointment of Auditor
12.4 Structure of Internal Control Procedures in a Bank
12.5 Auditor’s Report
12.6 Powers of Auditor
12.7 Audit of Some Important Items
12.8 The Third Schedule to the Banking Regulation Act, 1949

12.1 INTRODUCTION

Banking means accepting, for the purpose of lending or

investment, of deposits of money from the public, repayable on
demand or otherwise, and withdrawal by cheque, draft or
otherwise.

A banking company means any company which transacts business

of banking in India

Presently, there are following four types of banking institutions in

India:
(a) Commercial banks;
(b) Regional rural banks;
(c) Co-operative banks; and
(d) Development banks (more commonly known as ‘term-
lending institutions’)

12.2 ROLE OF THE RESERVE BANKS OF INDIA AS

CENTRAL BANK

The RBI is the central bank of our country. As such, RBI is

responsible for development and supervision of the constituents of
the Indian financial system (which comprises banks and non-
banking financial institutions) as well as for determining, in
conjunction with the Central Government, the monetary and credit
policies keeping in with the need of the hour. Besides, RBI has also
been entrusted with the responsibility of regulating the activities of
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commercial and other banks. No bank can commerce the business

of banking or open new branches without obtaining license from
RBI. The RBI also has the power to inspect any bank.

The text of the notifications/circulars/guidelines, etc., issued

by RBI is normally also available on its website www.rbi.org.in.

A banking company needs to hold a license issued by RBI to

do the business of banking in India. There is an elaborate legal
framework governing the functioning of banks in India. The auditor
must have knowledge of all these acts.

The principal enactments which govern the functioning of

various types of banks are:
 Banking Regulation Act, 1949
 State Bank of India Act, 1955
 Companies Act, 1956
 State Bank of India (Subsidiary Banks) Act, 1959
 Banking Companies (Acquisition and Transfer of Undertakings)
Act, 1970
 Regional Rural Banks Act, 1976
 Banking Companies (Acquisitions and Transfer of Undertakings)
Act, 1980
 Information Technology Act, 2000
 Prevention of Money Laundering Act, 2002
 Securitisation and Reconstruction of Financial Assets and
Enforcement of Security Interest Act, 2002
 Credit Information Companies Regulation Act, 2005
 Payment and Settlement Systems Act, 2007

The auditor should also note that

 A banking company is not allowed to carry on any business
except those business which are permitted under sec 6 (1) of
the Act.
 No brokerage , discount or remmuration or sale of shares
exceed 2.5%
 A Bank cannot form a subsidiary company
 It cannot create a charge on its unpaid capital
 Prior approval of RBI is necessary for appointment or
reappointment of a MD, whole time director or manager or CEO.
 The banks have custody of large volumes of cash negotiable
instrument whose physical security has to be ensured. There
are many chances of misappropriation or fraud. The bank
engaged in a large volume and variety of transaction in terms of
both number and volumes therefore the branch must have
formal operating procedures, well defined limits for individual
discretion and rigorous system of internal control.
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 Banks normally operate though a wide network of branches and

department which are spread nationwide this involves a greater
decentralization of authority.

12.3 APPOINTMENT OF AUDITOR

A. The Reserve Bank of India appoints the auditor who is duly

qualified to be an auditor of company.

B. Compliance u/s. 226 (3) of Companies Act, 1956 with regard to

qualification and disqualifications of auditors.

None of the following persons shall be qualified for appointment as

auditor of a company-
a. A body corporate;
b. An officer or employee of the company;
c. A person who is a partner, or who is in the employment, of an
officer or employee of the company;
d. A person 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;
e. A person holding any security of that company after a period of
one year from the date of the companies (Amendment) Act,
2000. Internal Auditor cannot be statutory auditor for the same
financial year.
f. The nature of audit work has to be ascertained as to whether it
is Concurrent Audit, Stock Audit, Revenue Audit, Credit Risk
Auditor or any other Assignments of any branch of that bank.
g. Decision of Acceptance or Rejection of Assignment has to
communicated to the concerned authority
h. It should be ensured that minimum fees are set as per RBI
circular.

12.4 STRUCTURE OF INTERNAL CONTROL

PROCEDURES IN A BANK

The specific internal control procedures to be followed in an

enterprise depend on the nature, volume and complexities of its
operations and the management’s attitude towards control.
However, as in the case of other enterprises, the internal control
procedures relevant to assertions made in the financial statements
of bank generally fall under the following categories;
I. Segregation and Rotation of Duties
II. Authorization of Transactions
III. Maintenance of Adequate Records and Documents
IV. Accountability for, and Safeguarding of, Assets
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V. System Configuration and Account Mapping

VI. Independent Checks

 Remuneration of Auditor
The remuneration of auditor of a banking company is to be
fixed in accordance with the provisions of section 224 of the
Companies Act, 1956 (i.e., by the company in general meeting or in
such manner as the company in general meeting may determine).
The remuneration of auditors of nationalized banks and State Bank
of India is to be fixed by the RBI in consultation with the Central
Government. The remuneration of auditors of subsidiaries o State
Bank of India is to be fixed by the latter. In the case of regional rural
banks, the auditor’s remuneration is to be determined by the bank
concerned with the approval of the Central Government.

 Prior preparation of Audit:

The auditor has to ensure following before accepting the
bank audit
1. He should not accept the audit if he is concurrent auditor or
internal auditor
2. He should obtain NOC from the previous auditor
3. Exact location of branch /bank
4. Last date of submission of report
5. The banks normally do direct voucher posting to ledger
accounts. The auditor must understand the accounting
procedure of bank thoroughly well
6. The auditor should study the reports of previous auditor,
concurrent audit, internal auditor and compute system auditor
7. The auditor should also obtain study various notifications,
circulars and guide lines issued by the RBI from time to
time.and kept ready for reference.
8. Engagement Letter under AAS 26 has to be issued
9. There must be a Communication with joint auditor as per AAS
12
10. A list of accounting standards applicable to the branch must be
prepared
11. Copy of all circulars of RBI applicable to branch have to be
obtained and kept ready for reference.
12. Attending branch audit seminars could enhance the auditors
knowledge on bank audits
13. Banking terminology and schemes should be well understood
14. Guidance notes issued by ICAI on audit of banks
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15. Internal circulars issued by the banks for assisting their staff for
maintaining of books of accounts
16. All the banks have computerized their accounts. The auditor
must understand the software and study the report of system
auditor.

The auditor should prepare detailed audit programme which

should adequately cover his scope of work giving proper weightage
to areas of weak internal controls.

12.5 AUDITOR’S REPORT

In the case of a nationalized bank, the auditor is required to

make a report to the Central Government in which he has to state
the following:

(a) Whether, in his opinion, the balance sheet is a full and fair
balance sheet containing all the necessary particulars and is
properly drawn up so as to exhibit a true and fair view of the affairs
of the bank, and in case he had called for any explanation or
information, whether it has been given and whether it is
satisfactory;

(b) Whether or not the transaction of the bank, which have to

come to his notice, have been within the powers of that bank;

(c) Whether or not the returns received from the offices and
branches of the bank have been found adequate for the purpose of
his audit;

(d) Whether the profit and loss account shows a true balance of
profit or loss for the period covered by such accounts; and

(e) Any other matter which he considers should be brought to be

the notice of the Central Government.

The report of auditors of State Bank of India is also to be

made to the Central Government and is almost identical to the
auditor’s report in the case of a nationalized bank.

The auditor’s report in the case of subsidiaries of State Bank

of India is identical to the auditor’s report in the case of a
nationalized bank, except that all references to central Government
have to be construed instead as references to the State Bank of
India. Similar is the position in the case of regional rural banks,
except that the references are instead to the bank concerned.
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 Format of Audit Report

The auditor’s central as well as branch, should also ensure
that the audit report issued by them complies with the requirements
of Revised SA 700, “Forming an Opinion and Reporting on
Financial Statements”, SA 705 , “Modifications to the Opinion in
Independent Auditor’s Report” and SA 706, “Emphasis of Matter
Paragraphs and Other Matter Paragraphs in the Independent
Auditor’s Report”. The auditor should ensure that not only
information relating to number of unaudited branches is given but
quantification of advances, deposits, interest income and interest
expense for such unaudited branches has also been disclosed in
the audit report. Such disclosure in the audit report is not only in
accordance with the best international trends but also provides
useful information to users of financial statements,.

In addition to matters on which he is required to report to the

shareholders under the Companies Act, 1956, the auditor of a
banking company is also required to state in his report:

(a) Whether or not the information and explanations required by

him have been found to be satisfactory;

(b) Whether or not the transactions of the company which have

come to his notice have been within the powers of the company;

(c) Whether or not the returns received from the branch offices of
the company have been found adequate for the purpose of his
audit.

(d) Whether the profit and loss account shows a true balance of
profit or loss for the period covered by such account; and

(e) Any other matter which he considers should be brought to

the notice of the shareholders of the company.

It may be noted that in the case of a banking company, by

virtue of the provisions of clause (d) of sub-section (3) of section
227 of the Companies Act, 1956, the auditor has to specifically
report whether, in his opinion, the profit and loss account and
balance sheet of the banking company comply with the accounting
standards referred to in sub-section (3C) of section 211 of the
Companies Act, 1956.

The Companies (Amendment) Act, 2000 has inserted two

new clauses (e) and (f) in section 227(3) of the Companies Act,
1956. Clause (e) requires that the auditor’s report shall state “in
thick type or in italics the observations or comments of the auditors
which have any adverse effect on the function of the company”.
Clause (f) requires the auditor to report “whether any director is
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disqualified from being appointed as director under clause (g) of

sub-section (1) of section 274”. Member’s attention is invited to the
Revised Guidance Note on section 227(3) (e) and (f) of the
Companies Act, 1956.

It may also be noted the Companies (Auditor’s Report)

Order, 2003 (Revised in 2005), is not applicable to banking
companies.

 Long Form Audit Report

Besides the audit report as per the statutory requirements
discussed above, the terms of appointment of auditor of public
sector banks, private sector banks and foreign banks [as well as
their branches], require the auditors to also furnish a long form
audit report (LFAE). The matters which the banks require their
auditors to deal with in the long form audit report have been
specified by the RBI.

12.6 POWERS OF AUDITOR

The auditor of a banking company has the same powers as

those of a company auditor in the matter of access to the books,
accounts, documents and vouchers. He is also entitled to require
from the offices of the bank such information and explanations as
he mey think necessary for the performance of his duties. In the
case of a banking company, he is entitled to receive notice relating
to the any general meeting. He is also entitled to attend any general
meeting and to be heard there at on any part of the business, which
concerns him as an auditor.

It is important to note that under section 10 of the Banking

Companies (Acquisition and Transfer of Undertakings) Act,
1970/1980, the auditor of a nationalized bank may employ
accountants or other persons at the expense of the bank to assist
him in audit of accounts.

12.7 AUDIT OF SOME IMPORTANT ITEMS

1. Share Capital
The auditor should verify the opening balance of capital with
reference to the audited balance sheet of the previous year. In case
there has been an increase in capital during the year, the auditor
should examine the relevant documents supporting the increase.
For example, in case of an increase in the authorized capital of a
banking company, the auditor should examine the special
resolution of shareholders and the memorandum of association. An
increase in subscribed and paid-up capital of a banking company,
on the other hand, should be verified with reference to
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prospectus/other offer document, reports received from registrars to

the issue, bank statement, etc. Compliance with section 14 of the
Banking Regulation Act, 1949, should also be examined. In cae of
increase in capital of a nationalized bank through fresh
contributions by the government, the auditor should examine
correspondence/government notification or order, bank statement,
etc.

In the case of newly formed banking companies/ places of

business established in India for the first time by a banking
company incorporated outside India, the auditor should also
examine compliance with the provisions of section 11 and 12 of the
Banking Regulation Act,1949.

The auditor should also check the compliance with capital

adequacy requirements for banks. The auditor should verify the
compliance with the RBI reporting and other requirements issued
from time to time.

As per the Act, capital of the bank should disclose separately

the authorized capital, issued capital and subscribed capital, stating
separately the number of shares and the value of shares. If the
bank has issued shares for consideration other than cash then
proper disclosure of the same should be made.

2. Reserves and Surplus

The auditor should verify the opening balances of various
reserves with reference to the audited balance sheet of the
previous year. Additions to or deductions from reserves should also
be verified in the usual manner, e.g., with reference to board
resolution. In the case of statutory reserves and securities
premium, compliance with legal requirements should also be
examined. Thus, the auditor should specifically examine whether
the requirement of the governing legislation regarding transfer of
the prescribed percentage of profits to reserve fund have been
complied with. In case the bank has been granted exemption from
such transfer, the auditor should examine the relevant documents
granting such exemption. Similarly, it should be examined whether
the appropriations from securities premium account conform to the
relevant legal requirements.

Where the local laws or regulations governing overseas

branches requires creation of certain reserves, the auditor should
examine compliance with the relevant requirements concerning the
quantum and manner of disclosure of such reserves. The auditor
should also ascertain that whenever necessary to secure
compliance with the local laws of the respective foreign countries,
separate identity of such reserves has been maintained in the
balance sheet of the bank as a whole. The auditor should also
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ascertain that all provisions. Regarding eligibility criteria and

quantum of dividend have been fulfilled in respect of dividend paid
by the bank, if any, during the year.

The auditor should examine the nature of various accounts

included under this head to ensure that only accounts in the nature
of reserves are included. The auditor should verify whether the
utilizations of reserves are in accordance with regulatory and
statutory requirements and whether the reporting requirements
have been complied with in terms of the requirements of Banking
Regulation Act, 1949 and the Guidelines of the RBI, issued from
time to time.

“Statutory Liquidity Ratio (SLR)” Banking companies are

required to maintain cash, gold or unencumbered securities on
account as determined by RBI from time to time of aggregate of
their demand and time liabilities in India as on last Friday of
preceding fortnight.

The auditor should verify the compliance of SLR on 12

selected odd dates in different months not being Fridays.

As per RBI guidelines following points should be verified in this

regards:
 Composition of items of DTL
 Verification of trial balance and cash balance for 12 selected
dates by the branch auditor
 Inclusion of demand and time liabilities in consolidated
statements
 Net credit balance in Branch Adjustment A/c
 Liquid Asset should include deposits with RBI, cash balance
with the bank and with RBI, excess balance with RBI u/s 42
and net balance in current A/c
 Price of gold should not exceed market price.
The auditor should ensure that 20% of the current year profit
of the bank has been transferred to reserve fund as per the
provisions of section 17 of the Act. He should also verify the
appropriations made out of this reserve.

3. Deposits
Banks accept various deposits which are current deposits or
time deposit such as current accounts, fixed deposits, saving
deposits etc.

Current deposits: The auditor should verify balances in individual

accounts on test check basis. He should also obtain confirmations
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from some of them. He should also see that total of individual

account is in confirmation with control accounts Debit balances in
currents accounts should not be subtracted from credit balances of
current accounts. They should be shown under the head advances
(Schedule No.9) special attention should be given in operative
accounts.

Saving bank account: The auditor should verify balances in

individual accounts on test check basis. He should also see that
total of individual account is in confirmation with control accounts.
The auditor should also check interest calculation on sampling
basis.

Term Deposits (fixed deposits): The auditor should evaluate the

internal control system. Ensure that serial numbers are given to
deposit receipts and cash certificates. Unissued and unused
deposit certificates and cash certificates are in proper custody.
Examine and ensure that the rates of interest calculation are
properly done. Check the entries in relevant register.

In carrying out audit of deposits and liabilities, the auditor is

primarily concerned with obtaining reasonable assurance that all
known liabilities are recorded and stated at appropriate amounts.

The auditor may verify various types of deposits in the

following manner:

Current Accounts
The auditor should verify the balances individual accounts
on a sampling basis. He should also examine whether the balances
as per subsidiary ledgers tally with the related control accounts in
the General Ledger. In case of any differences, the auditor should
examine the reconciliation prepared by the branch in this regard.

Some banks have a procedure for obtaining confirmation of

balances periodically. The auditor should examine whether the
procedure laid down in this behalf has been followed consistently
throughout the year. He should also examine, on a sampling basis,
the confirmations received.

The auditor should ensure that debit balances in current

accounts are not netted out on the liabilities side but are
appropriately included under the head ‘advances’.

Inoperative accounts are a common area of frauds in banks.

While examining current accounts, the auditor should specifically
cover in his sample some of the inoperative accounts revived
during the year. The auditor should also ascertain whether
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inoperative accounts are ‘revived’ only with proper authority. For

this purpose, the auditor should identify cases where there has
been a significant reduction in balances compared to the previous
year and examine the authorization for withdrawals.

Saving Bank Deposits

The auditor should verify the balances in individual accounts
on a sampling a basis. He should also examine whether the
balance as per subsidiary ledgers tally with the related control
accounts in the General Ledger. In case of any differences, the
auditor should examine the reconciliation prepared by the branch in
this regards.

The auditor should also check the calculations of interest on

a sampling basis. It is not unusual for branches to compute interest
savings bank up to a date close to the end of the accounting period
e.g. 25th March based on the actual balances with interest for the
remaining period on an estimated basis at the head office level.

As in the case of current accounts, the auditor should ay

special attention to inoperative savings bank accounts.

Term Deposits
While evaluating the internal controls over term deposits, the
auditor should specifically examine whether the deposit receipts
and cash certificates are issued serially and all of them are
accounted for in the register. The auditor should also satisfy himself
that there is a proper control over the unused forms of deposit
receipts and cash certificates to prevent their misuse.

As stated earlier, the rate of interest on Certificates of

Deposits (CDs) is negotiable with the counter-foils of the receipts
issued and with the discharged receipts returned to the bank. The
reconciliation of subsidiary records for various types of term
deposits with the related control accounts in the General Ledger
should be examined. The auditor should also examine whether
provision has been made for interest accrued on the deposits up to
date of the balance sheet. Auditor should ensure that proper
provision for interest payable on deposits is made.

In some cases, banks employ some persona as ‘collectors’

to collect the deposits from depositors, e.g., in case of recurring
deposits. In such cases, the auditor should specifically examine the
efficacy of the internal control procedures for reconciling the
records of the bank with those of the collectors.

The term deposits from banks are usually (though not

necessarily) in round figures. Any odd balances should, therefore,
put the auditor to enquiry.
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Deposits Designated in Foreign Currencies

In the case of deposits designated in a foreign currency,
e.g., foreign currency non-resident deposits, the auditor should
examine whether they have been converted into Indian rupees at
the rate notified in this behalf by the head office. The auditor should
also examine whether any resultant increase or decrease has been
taken to the profit and loss account. It may also be seen that
interest on deposits has been paid on the basis of 360 days in a
year. Further, in case of conversion of FCNR (B) deposits into NRE
deposits or vice versa before maturity has been subjected to the
provisions relating to premature withdrawal.

Interest Accrued But Not Due

The auditor should examine that interest accrued but not
due on deposits is not included under the relevant deposits but is
shown under the head ‘other liabilities and provisions’.

4. Borrowings
The auditor should examine documentary evidence for
borrowings, classification of borrowing in India and outside India,
secured and unsecured. He should also ensure that inter branch
transactions/balances are not shown under this head. Refinance
obtained from RBI is shown under this head.

Borrowings usually take place only at a few designated

branches authorized in this behalf by the head office of other
controlling authority either generally or specifically in respect of a
particular borrowing. As such, this item generally does not figure in
the balance sheets of most branches of the bank.

Borrowings from RBI, other banks/financial institutions, etc.

should be verified by the auditor with reference to confirmation
certificates and other supporting documents such as, agreements,
correspondence, etc. Audit evidence in the form of external
confirmations received directly by the auditor from appropriate
conforming parties may assist the auditor in obtaining audit
evidence that the auditor requires to respond to significant risks of
material misstatement.

The auditor should also examine whether a clear distinction

has been made between ‘rediscount’ and ‘reference’ for disclosure
of the amount under the above head since rediscount does not
figure under this head.

The auditor should examine whether borrowings of money at

call and short notice are properly authorized. The rate of interest
paid/payable on, as well as duration of such borrowings should also
be examined by the auditor.
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The auditor should similarly examine the relevant

correspondence or other documents to ensure that the branch has
been authorized by the head office to borrow/retain other
borrowings and that the terms on which borrowings have been
made are in accordance with the authorization.

The auditor should examine whether the amount shown in

the branch accounts is properly classified based on security or
other wise.
The auditor may verify the various items under the head
‘other liabilities and provisions’ in the following manner.

5. Bills Payable
The auditor should evaluate the existence, effectiveness and
continuity of internal controls over bills payable. Such controls
should usually include the following:
(a) Drafts, mail transfers, traveler’s cheques, etc. should be
made out in standards printed forms.

(b) Unused forms relating to drafts, traveler’s cheques, etc.

should be kept under the custody of a responsible offices.
(c) The bank should have a reliable private code known only to
the responsible officers of its branches coding and decoding
of the telegrams should be done only by such officers.

(d) The signatures on a demand draft should be checked by an

officer with the specimen signature book.

(e) All the telegraphic transfers and demand drafts issued by a

branch should be immediately confirmed by advices to the
branches concerned.

On payment of these instrument, the paying branch should

send a debit advice to the originating branch.

(f) If the paying branch does not receive proper confirmation of

any telegraphic transfers or demand draft from the issuing
branch, it should take immediate steps to ascertain the
reasons.

(g) In case an instrument prepared on a security paper, e.g.

draft, has to be cancelled (say, due to error in preparation), it
should be ensured that the manner of cancellation is such
that the instrument cannot be misused. (For example, in the
case of drafts, banks generally cut the distinctive serial
number printed on the form and paste it in the book in which
drafts issued are entered). Cases of frequent cancellation
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and re-issuance of drafts, pay order, etc. should be carefully

looked into by a responsible official.

Based on his evaluation of the efficacy of the relevant

internal controls, the auditor should examine an appropriate sample
of outstanding items comprised in bills payable accounts with the
relevant registers. Reasons for old outstanding debits in respect of
drafts or other similar instruments paid without advice should be
ascertained. Correspondence with other branches after the year-
end (e.g., responding advices received from other branches,
advices received from other branches in respect of drafts issued by
the branch and paid by the other branches without device) should
also be examined specially in so far as large value items
outstanding on the balance sheet date are concerned.

6. Others (Including Provisions)

It may be noted that the figure of advances and investments
in the balance sheet of a bank excludes provisions in respect
thereof made of the satisfaction of auditors. The auditor should
examine other provisions and other items of liabilities in the same
manner as in the case of other entities.

7. Cash
The auditor should count the balance of cash on hand. As
far as possible, the auditor should visit the branch at the close of
business on the last working day of the year or before the
commencement of business on the next day for carrying out the
physical verification of cash. If, for any reason, the auditor is unable
to do so, he should carry out the physical verification of cash as
close to the balance sheet date as possible. It is sometimes
arranged by the branch to deposit a large portion of its cash
balance with the RBI or the State Bank of India or any other bank
on the closing day, in which case, the work of the auditor is reduced
substantially; however, the auditor must request the branch to
provide sufficient appropriate evidence for the same.

Care should be taken to ensure that if cash is kept

separately in different departments or at different locations (e.g. at
extension counters), all the balances are verified by the auditor
simultaneously. He should also ensure that there is no movement
of cash till the counting is over.

The auditor should evaluate the effectiveness of the system

of internal controls in branch regarding daily verification of cash,
maintenance of cash related registers and vault register, custody of
keys, daily cash holding and retention limit of the branch, etc. The
auditor should ensure that a global policy has been taken for safety
of cash from a theft or burglary and such policy is effective.
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For physically verifying the cash-on-hand, the auditor may

proceed as below:

(a) Physically verify the cash-on-hand. The extent of verification

would depend upon the auditor’s assessment of the efficacy of
internal control system including adherence to cash retention limits
fixed by the head office, mode of custody of cash

(b) Obtain a certificate indicating denomination-wise cash

balance as per physical verification.

8. Balance with RBI

In a bank, only a few select branches are designated to have
account with the RBI. Thus, this item would not appear in the
balance sheet of every branch. The following procedures, therefore,
applicable only to branches having account with the RBI.

The auditor should verify the ledger balances in each

account with reference to the bank confirmation certificates and
reconciliation statements as at year end. The auditor should review
the reconciliation statements. He should pay special attention to the
following items appearing in the reconciliation statements: (i) cash
transactions remaining responded; (ii) revenue items requiring
adjustments/write-offs; and (iii) old outstanding balances remaining
unexplained/unadjusted for over one year.

The auditor should obtain a written explanation from the

management as to the reasons for old outstanding transaction in
bank reconciliation statements remaining unexplained / unadjusted
for over one year.

9. Balance with Banks (Other than Reserve Bank of India)

The auditor should also apply the procedures described in

paragraphs above in examining the balances with banks other than
RBI. While reviewing the reconciliation statements, the auditor
should pay particular attention to the following:

(a) Examine that no debit for charges or credit for interest is

outstanding and all the items which ought to have been taken to
revenue for the year have been so taken. This should be
particularly observed when the bills collected, etc., are credited with
net amount and entries for commission, etc., are not made
separately in the statement of account.

(b) Examine that no cheque sent or received in clearing is

outstanding. As per the practice prevalent among banks, any
cheque returned unpaid are accounted for on the same day on
which they were sent in clearing or on the following day.
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(c) Examine that all bills or outstanding cheque sent for collection
and outstanding as on the closing date have been credited
subsequently.

The auditor should also examine the large transactions in

inter-bank accounts, particularly towards the year-end, to ensure
that no transactions have been put through for window-dressing.

In respect of balances in deposit accounts, original deposit

receipts should be examined in addition to confirmation certificates
obtained from banks in respect of outstanding deposits. Balances in
deposit accounts are usually (though not necessarily) in round
figures. Where such balances are in odd figures, the auditor should
enquire whether the account concerned is actually of the nature of
a deposit account.

The balances with banks outside India should also be

verified in the manner described above. These balances should be
converted into the Indian currency at the exchange rates prevailing
on the balance sheet date.

10. Money at Call and Short Notice:

The auditor should examine whether there is a proper

authorization, general or specific, for lending of the money at call or
short notice. Compliance with the instructions or guidelines laid
down in this behalf by the head office or controlling office of the
branch, including the limits on lending’s in inter-bank call money
market, should also be examined.

Call loans should be verified with the certificates of the

borrowers and the call loan receipts held by the bank. The auditor
should examine whether the aggregate balances comprising this
item as shown in the relevant register tally with the control accounts
as per the general ledger. He should also examine subsequent
repayments received from borrowing banks to verify the amounts
shown under this head as at the year-end. It may be noted that call
loans made by a bank cannot be netted off against call loans
received.

Like deposits with banks, moneys at call and short notice are
also usually (though not necessarily) in round figures. Any odd
balances should, therefore, put the auditor to enquiry.

The auditor should also examine that money market

lending’s for more than 6 days are not classified under this head,
but are classified as ‘deposits’ or ‘advances’, depending on the
nature of lending and the parties to whom the moneys have been
lent.
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It may be noted that as per the directions of the RBI, banks

cannot pay any brokerage on deposit and call loans, except to the
extent specified in paragraph 8(e) of the RBI circular dated July 22,
1974.

The auditor should examine whether interest has been

properly accrued and accounted for on year-end outstanding
balances of money at call and short notice.

Nostro & Vostro Accounts :

NOSTRO ACCOUNT : Bank maintains stock of foreign currencies

in the form of bank account with their overseas branches. These
accounts are called as NOSTRO Account. The auditor should
obtain & examine the reconciliation statement between Indian
Branch and overseas Branch, Un reconciled nostro account
indicates unauthorized payments, unauthorized withdrawals and
unauthorized debits to minor accounts. The auditor should also
evaluate interal control regarding inward and outward messages.
Any discrepancy should be properly dealt with. The auditor should
check the confirmation certificate received from the overseas
branch.

VOSTRO ACCOUNT : This is opposite of Nostro Account. A

foreign bank in another country maintains stock of Indian rupees
with its Indian correspondent bank. The auditor should audit this on
the same lines with Nostro Accounts.

11. Investments

Banks are required to classify their entire investments

portfolio into three categories: held-to-maturity, available-for-sale
and held-for-trading.

(i) Held-to-maturity (HTM)

This category would comprise securities acquired by the

bank with the intention to hold them up to maturity.

(ii) Held-for-trading (HFT)

This category would comprise securities acquired by the

bank with the intention of trading, i.e. to benefit from short-term
price/interest rate movements.

(iii) Available-for-sale (AFS)

This category will comprise securities, which to not qualify

for being categorised in either of the above categories. i.e., those
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that are acquired neither for trading purpose nor for being held till
maturity.

The auditor’s primary objective in audit of investments is to

satisfy himself as to their existence and valuation. Examination of
compliance with statutory and regulatory requirements is also an
important objective in audit of investment in as much as non-
compliance may have a direct and material effect on the financial
statements. The latter aspect assumes special significance in the
case of banks where investment transactions have to be carried out
within the numerous parameters laid down by the relevant
legislation have to be carried out within the numerous parameters
laid down by the relevant legislation and directions of the RBI. The
auditor should keep this in view while designing his audit
procedures relating to investments.

Internal Control Evaluation and Review of Investment Policy

The auditor should familiarise himself with the instructions

issued by the RBI regarding transactions in securities. He should
review the investment policy of the bank to ascertain that the policy
conforms, in all material respects, to the RBI’s guidelines as well as
to any statutory provisions applicable to the bank. While examining
the internal controls over investments (including those on SGL
forms and BRs), the auditor should particularly also judge their
efficacy. The auditor should satisfy himself that investments made
by the bank are in accordance with the laid down investment policy.
A review of the reports on concurrent audit of treasury transactions
and follow-up action taken by the management thereon may be
useful to the auditor. The auditor should also review the half yearly
review of portfolio by the Board of the bank and also review
inspection report of the RBI carried out under Section 35 of the Act.

Examination of Reconciliation

The auditor should examine the reconciliation of the

investment account, physically verify the securities on hand, obtain
confirmations of SGL balances with the PDO, and examine the
control and reconciliation of BRs issued by the bank. Needless to
add, the actual control and reconciliations etc., are to be carried out
by the bank’s management; however, the auditor should examine
the same.

Examination of Documents

The auditor should examine whether the legal requirements

governing the bank, in so far as they relate to investments, have
been complied with and the investments made by the bank are not
ultra virus the bank.
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The auditor should satisfy himself that the transactions for

the purchase/sale of investments are supported by due authority
and documentation. The acquisition/disposal of investments should
be verified with reference to the broker’s contract note, bill of costs,
receipts and other similar evidence. The auditor should pay special
attention to ascertaining whether the investments have been
purchased or sold cum-dividend/ex-dividend, cum-interest/ex-
interest, cum-right/ex-right, or cum-bonus/ex-bonus. He should
check whether appropriate adjustments in this regard have been
made in the cost/sales value of securities purchased or sold.

The auditor should satisfy himself that In the case of a right

issue and as regards bonus shares. appropriate care is taken by
the bank.

Physical Verification

The auditor should verify the investment scrips physically at

the close of business on the date of the balance sheet. In
exceptional cases where physical verification of investment scrips
on the balance sheet date is not possible, the auditor should carry
out the physical verification on a date as near to the balance sheet
date as possible.

12. Advance

Amounts disclosed in the balance sheet under the head

‘advances’ comprise-

(a) Money lent by the bank to its customers and interest accrued
and due there on {net of amount shown in (d)};

(b) Debit balances in deposit accounts;

(c) Amount of participation on risk-sharing basis under inter-bank

participation schemes in capacity as a participating bank; and

The amount to be included here is net of the amount allotted to

other banks under inter-bank participation schemes on risk-sharing
basis

(d) Amount receivable from Government of India under the

Agricultural Debt Waiver Scheme 2008.

Advances generally constitute the major part of the

assets of the bank. There are large number of borrowers to whom
variety of advances are granted. The audit of advances requires the
major attention from the auditors.
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In carrying out audit of advances, the auditor is primarily

concerned with obtaining evidence about the following:

a. Amounts included in balance sheet in respect of advnces are

outstanding at the date of the balance sheet.
b. Advances represent amount due to the bank.

c. Amounts due to the bank are appropriately supported by Loan

documents and other documents as applicable to the nature of
advances.
d. There are no unrecorded advances.
e. The stated basis of valuation of advances is appropriate and
properly applied, and that the recoverability of advances is
recognized in their valuation.
f. The advances are disclosed, classified and described in
accordance with recognized accounting policies and practices and
relevant statutory and regulatory requirements.
g. Appropriate provisions towards advances have been made as
per the RBI norms, Accounting Standards and generally accepted
accounting practices.

The auditor can obtain sufficient appropriate audit evidence

about advances by study and evaluation of internal controls relating
to advances, and by:

 Examining the validity of the recorded amounts:

 Examining loan documentation;
 Reviewing the operation of the accounts;
 Examining the existence, enforceability and valuation of the
security;
 Checking compliance with RBI norms including appropriate
classification and provisioning; and
 Carrying out appropriate analytical procedures.

In carrying out his substantive procedures, the auditor

should examine all large advances while other advances may be
examined on a sampling basis. The accounts identified to be
problem accounts however need to be examined in detail unless
the amount involved in insignificant. The extent of sample checking
would also depend on the auditor’s assessment of efficacy of
internal controls. As a general rule, however, an advance may be
considered to be a large advance if the year-end balance is in
excess of Rs. 2 crore or 5% of the aggregate year-end advances of
the branch, whichever is less.
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Advances which are sanctioned during the year or which are

adversely commented by RBI inspection team, concurrent auditors,
bank’s internal inspection, etc. should generally be included in the
auditor’s review.

Evaluation of Internal Controls over Advances

The auditor should examine the efficacy of various internal

controls over advances to determine the nature, timing and extent
of his substantive procedures. In general, the internal controls over
advances should include, inter alia, the following:

 The bank should make an advance only after satisfying itself as

to the credit worthiness of the borrower and after obtaining
sanction from the appropriate authorities of the bank. The
sanction for an advance should specify, among other things, the
limit of borrowing, nature of security, margin to be kept, interest,
terms of repayment etc. It also needs to be ensured that the
loans sanctioned are as per the Loan Policy of the bank and
adhere to the regulatory (RBI) norms unless a specific
exemption is taken in this regard.

 All the necessary documents (e.g. agreements, demand

promissory notes, letters of hypothecation, etc.) should be
executed by the parties before advances are made.

 The compliance with the terms of sanction and end use of funds
should be ensured.

 Sufficient margin as specified in the sanction letter should be

kept against securities taken so as to cover for any decline in
the value thereof. The availability of sufficient margin needs to
be ensured at regular intervals.

 It the securities taken are in the nature of shares, debentures,

etc., the ownership of the same should be transferred in the
name of the bank and the effective control of such securities be
retained as a part of documentation.

 All securities requiring registration should be registered in the

name of the bank or otherwise accompanied by documents
sufficient to give title to the bank.

Classification of Advances

The guidelines require banks to classify their advances into

four broad categories for the purpose of provisioning as follows.
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(a) Standard assets

A standard asset is one which does not disclose any

problems and which does not carry more than normal risk attached
to the business. Such an asset is not a non-performing asset.

(b) Sub-standard assets

With effect from March 31, 2005, a sub-standard asset is

one which has remained NPA for a period less than or equal to 12
months. In such cases, the current net worth of the borrower /
guarantor or the current market value of the security charged is not
enough to ensure recovery of the dues to the bank in full.

(c) Doubtful assets

With effect from March 31, 2005, an asset is classified as

doubtful if it has remained in the sub-standard category for a period
of 12 months. Such an asset has all the inherent weaknesses as in
a doubtful asset and an added characteristic that the weaknesses
make the collection or liquidation in full highly improbable or
questionable.

(d) Loss assets

A loss asset is one where loss been identified by:

(a) The bank; or

(b) The internal or external auditors; or
(c) The RBI inspection, but the amount has not been
written off fully.

Non-Performing Assets

Under the guidelines, income recognition, and provisioning

in respect of a credit facility are based on its status of classification
as performing or non-performing. A credit facility becomes non-
performing “when it ceases to generate income for a bank”.
Detailed guidelines have been laid down for determining the status
of different kinds of credit facilities (term loans, cash credits and
overdrafts, bills purchased and discounted, and other credit
facilities) as performing or non-performing. These are discussed
below.

Criteria for Classification of Various Types of Credit Facilities

In line with the international best practices and to ensure

greater transparency, the RBI has directed the banks to adopt the
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’90 days’ overdue norm for identification of NPAs from the year
ending March 31, 2004.

Banks have been charging interest at monthly rests, form

April 1, 2002. However, the banks were advised that the date of
classification of an advance as NPA would not be changed on
account of charging of interest at monthly rests. Banks should,
therefore, continue to classify an account as NPA only if the interest
charged during any quarter is not serviced fully within 90 days from
the end of the quarter.

An account should be treated as ‘out of order’ if the

outstanding balance remains continuously in excess of the
sanctioned limit/drawing power. In cases where the outstanding
balance in the principal operating account is less than the
sanctioned limit/drawing power, but there are no credits
continuously for 90 days as on the date of Balance Sheet or credits
are not enough to cover the interest debited during the same
period, these accounts should be treated as ‘out of order’. Further,
any amount due to the bank under any credit facility is ‘overdue’ if it
is not paid on the due date fixed by the bank.

The following criteria are to be applied for determining the

status of various types of credit facilities:

a) Term Loans: A term loan is treated as non-performing asset

(NPA) if interest and/or instalment of principal remain overdue for a
period of more than 90 days.

b) Cash Credits and Overdrafts : A cash credit or overdraft

account is treated as NPA if it remains out of order as indicated
above.

c) Bills Purchased and Discounted : Bill purchased and

discounted are treated as NPA if they remain out of order as
indicated above.

d) Securitisation: The asset is to be treated as NPA if the amount

of liquidity facility remains outstanding for more than 90 days, in
respect of a securitization transaction undertaken in terms of
guidelines on securitization dated February 1, 2006.

13. Fixed Assets

Fixed assets comprise premises and other fixed assets such

as furniture and fixtures, motor vehicles, office equipment’s
computers, etc.
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In carrying out the audit of fixed assets, the auditor is

concerned, primarily, with obtaining evidence about their existence
and valuation. For this purpose, the auditor should review the
system of internal controls relating to fixed assets, particularly the
following:

 Control over expenditures incurred on fixed assets acquired or

self-constructed;
 Accountability and utilisation controls; and
 Information controls for ensuring availability of reliable
information about fixed asses.

The branch auditor should ascertain whether the accounts in

respect of fixed assets are maintained at the branch or centrally,
Similarly, he should ascertain the location of documents of title or
other documents evidencing ownership of various items of fixed
assets. The procedures described in the following paragraphs
would be relevant only to the extent the accounts and documents of
title, etc., of fixed assets take place at branches / other officers, but
accounting of fixed assets is done at the head office, the branch
auditor should examine whether acquisitions, disposals, etc.
effected at the branch during the year have been properly
communicated to the head office.

Premises

The auditor should verify the opening balance of premises

with reference to schedule of fixed assets, ledger or fixed assets
register. Acquisition of new premises should be verified with
reference to authorisation, title deeds, record of payment, etc. Self-
constructed fixed assets should be verified with reference to
authorization and documents such as, contractors’ bills, work order
records and record of payments. The auditor should also examine
whether the balances as per the fixed assets register reconcile with
those as per the ledger and the final statements.

In the case of leasehold premises, capitalisation and

amortisation of lease premium, if any, should be examined. Any
improvements to leasehold premises should be amortized over
their balance residual life.

In case the title deeds are held at the head office or some
other location, the branch auditor should obtain a written
representation to this effect from the branch management and
should bring this fact to the notice of the central statutory auditor
through a suitable mention in his report. This fact should also be
brought in the Long Form Audit Report (LFAR).
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Where premises are under construction, it should be seen

that they are shown under a separate heading, e.g. ‘premises
under construction’. Advances to contractors may be shown as a
separate item under the head ‘fixed assets’ or under the head
‘other assets’. It should be ensured that where the branch has
obtained the licence to commence business and is ready for use
then the same is not shown as “premises under construction”. In
such cases even if all the bills/documents from the
contractors/suppliers are not received, at the year end, an estimate
of the expenditure thereon should be made and capitalised on a
provisional basis.

Where the premises (or any other fixed assets) are re-
valued, the auditor should examine the appropriateness of the
basis of revaluation. The auditor should also examine whether the
treatment of resultant revaluation surplus or deficit is in accordance
with Accounting Standard (AS) 10, “Accounting for Fixed Assets”1.
The auditor should also check the impairment, if any, by applying
the principles laid down in Accounting Standard (AS) 28,
“Impairment of Assets”.

The auditor should specifically keep in mind the provisions of

section 9 of the Banking Regulation Act, 1949, which prohibit a
banking company from holding any immovable property, howsoever
acquired (i.e. whether acquired by way of satisfaction of claims or
otherwise), for a period exceeding seven years from the date of
acquisition, except such as is required for its own use. The auditor
should specifically examine that no immovable properties other
than those required for the own use of the bank have been
included in fixed assets (own use would cover use by employees of
the bank, e.g. residential premises provided to employees). The
branch auditor should also obtain a written representation to the
above effect from the branch management.

Other Fixed Assets

The procedures discussed above regarding premises also

apply, to the extent relevant, to verification of other fixed assets. In
respect of moveable fixed assets, the auditor should pay particular
attention to the system of recording the movements as well as other
controls over such fixed assets.

14. Other Assets

The following items broadly are to be disclosed under the

head ‘Other Assets’:

 Inter-office adjustments (net)

 Interest accrued
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 Tax paid in advance/tax deducted at source

 Stationery and stamps
 Non-banking assets acquired in satisfaction of claims
 Others

As per RBI circular credit card outstanding is not to be

included under ‘Other Assets’. Instead, they have to be shown as
part of advances.

Other Assets
The branch auditor may carry out the audit of various items
appearing under the head ‘other assets’ in the following manner.

15. Inter-Office Adjustments

The balance in the inter-branch accounts, if in debit, is to be
shown under this head. The inter-branch accounts are generally
sub-divided into segment or specific areas, e.g., ‘Demand Drafts
Paid’, ‘Inter-branch Remittances’, ‘Head Office Account’, etc. The
net aggregate of all such accounts should be shown under this
head.

16. Interest Accrued

The main components of this item are interest accrued but
not due on investments and advances and interest due but not
collected on investments. As banks normally debit the borrower’s
account with interest due on the balance sheet date, there would
not usually be any amount of interest accrued but not due on
advances On the other hand interest on government securities,
debentures, bonds, etc. which accrues from day to day should be
calculated and brought into account, in so far as it has accrued on
the date of the balance sheet. The auditor should examine this item
in the usual manner, i.e., by reference to terms of payment of
interest, rate of interest, period elapsed till the date of balance
sheet, etc.

The auditor should ensure that only such interest as can be

realized in the ordinary course of business should be shown under
this head. This is based on the principle, recognized in AS 9, that
revenue cannot be recognized if there is a significant uncertainty
about its collectability. Dividends recognized as income but not
received may be included in the residuary sub-head of ‘others’.
Dividends and interest on investments would be recognized in the
books of the branch only if it is handling the work relating to
investments or receipt of income on investments.

17. Tax Paid in Advance/Tax Deducted at Source

Generally, this item is dealt with at the head office level only
and would, therefore, not appear in the balance sheet of a branch,
except that tax deducted at source on fixed deposits and other
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products/services is handled at the branch level. The procedures to

be followed by the branch auditor for verification of tax deducted at
source by the branch would be similar to those in an audit of other
types of entities. The branch auditor needs to ensure that the
certificates for such tax deducted at source is collected by the
branch and the original copy is sent to the Head Office along with
the transfer of such Tax Deducted at Source (TDS) amount to Head
Office on periodic basis as defined.

At Head Office level, the availability of all the TDS

Certificates, submission of the same with Income Tax
Department/Claim of the same in Income Tax returns filed should
be checked to ensure the justification of the claim towards such
certificates.

18. Stationary and Stamps

Internal controls over stationery of security items (like term
deposit receipts, drafts, pay order, cheque books, traveler’s
cheques, gift cheques, etc.) assume special significance in the
case of banks as their loss or misuse could eventually lead to a
misappropriation of the most valuable physical asset of a bank, viz.,
cash. The branch auditor should study and evaluate the existence,
effectiveness and continuity of internal controls over these items in
the normal course of his audit. It may be noted that the branch
auditor is required to specifically comment on the adequacy of the
relevant internal controls in his LFAR.

The item “Stationery and Stamps” should include only

exceptional items of expenditure on stationary like, bulk purchase
of security paper, loose leaf or other ledgers, etc., which are shown
as quasi-asset to be written off over a period of time. In other
words, the normal expenditure on stationary may be treated as an
expense in the profit and loss account, while unusually heavy
expenditure may be treated as an asset to be written off based on
issue/consumption. At the branch level, the expenditure on latter
category may not appear since a considerable part of the stationery
is supplied to branches by the head office.

The auditor should physically verify the stationery and

stamps on hand as at the year-end, especially stationery of security
items. Any shortage should be inquired into as it could expose the
bank to a potential loss from misuse. The auditor should examine
whether the cost of stationery and stamps consumed during the
year has been properly charged to the profit and loss account for
the year in the context of the accounting policy/instructions from the
head office regarding treatment of cost of stationery and stamps.
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19. Non-Banking Assets Acquired in Satisfaction of Claims

Under this heading, will be included, those immovable
properties/tangible assets, which the bank has acquired in
satisfaction of debts due or its other claims and are being held with
the intention of being disposed of.

While examining this item, the auditor should specifically

keep in mind the provisions of Section 9 of the Banking Regulation
Act, 1949, which prohibit a banking company from holding any
immovable property, however, acquired (i.e. whether acquired by
the of satisfaction of claims or otherwise), except such as is
required for its own use, for any period exceeding seven years from
te date of acquisition thereof. During this period, the bank may deal
or trade in any such property for the purpose of facilitating the
disposal thereof. The RBI has the power to extend the aforesaid
period in a particular case up to another five years. (it may be noted
that the aforesaid section is applicable to banking companies only
and not to other types of banks like nationalized banks).

Except when held for its own use, AS 10, “Accounting for
Fixed Assets” would not be applicable on those fixed assets which
are held with the bank in satisfaction of claim. At the data of
acquisition, the assets should be recorded at amount lower of the
net book value of the advance or net realizable value of asset
acquired. At each balance sheet date, net realizable value of such
assets may be re-assessed and necessary adjustment may be
made. The auditor should verify such assets with reference to the
relevant documentary evidence, e.g., terms of settlement with the
party, order of the Court or the award of arbitration, etc. he should
satisfy himself that the ownership of the property has legally vested
in the bank. If there is any dispute or other claim about the property,
the auditor should examine whether the recording of the asset is
appropriate or not. Incase the dispute arises subsequently, the
auditor should examine whether a provision for liability or disclosure
of a contingent liability is appropriate, keeping in view the
requirements of AS 29 Provisions.

20. Others
This is the residual heading, which will include items not
specifically covered under othe sub-heads e.g., claims which have
nt been received, debit items representing additions to assets or
reductions in liabilities which have not been adjusted for technical
reasons or want of particulars, etc., receivables on account of
government business, prepaid expenses, accrued income other
than interest (e.g., dividend declared but not received) may also be
included under this head. The audit procedure relating to some of
the major items included under this head are discussed below.
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21. Contingent Liabilities

In respect of contingent liabilities, the auditor is primarily
concerned with seeking reasonable assurance that all contingent
liabilities are identified and properly valued. To this end, the auditor
should, generally follow the audit procedures give below:

(a) The auditor should ensure that there exists a system

whereby the non fund based facilities or additional/ad hoc credit
facilities to parties are extended only to their regular constituents,
etc.

(b) Ascertain whether there are adequate internal controls to

ensure that transactions giving rise to contingent liabilities are
executed only by persons authorized to do so and in accordance
with the laid down procedures.

(c) The auditor should also ensure that in case of LCs for import
of goods, as required by the above mentioned Master Circular on
guarantees and co-acceptances, the payment to the overseas
suppliers is made on the basis of shipping documents and after
ensuring that the said documents are in strict conformity with the
terms of LCs.

(d) Ascertain whether the accounting system of the bank

provides for maintenance of adequate records in respect of such
obligations and whether the internal controls ensure that contingent
liabilities are properly identified and recorded.

(e) Perform substantive audit tests to establish the

completeness of the recorded obligations. Such tests include
confirmation procedures as well as examination of relevant records
in appropriate cases.

(f) Review the reasonableness of the year-end amount of

contingent liabilities in the light of previous experience and
knowledge of the current year’s activities.

(g) Review whether comfort letters issued by the bank has been
considered for disclosure of contingent liabilities.

(h) Obtain representation from the management that

(i) all contingent liabilities have been disclosed;
(ii) the disclosed contingent liabilities do not include any
contingencies which are likely to result in a loss/expense and
which, therefore, require creation of a provision in the financial
statements.
(iii) the estimated amounts of financial effect of the
contingent liabilities are based on the best estimates in terms of
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Accounting Standard 29, including any possibility of any

reimbursement;

(iv) in case of guarantees issued on behalf of the bank’s

directors, the bank has taken appropriate steps to ensure that
adequate and effective arrangements have been made so that the
commitments would be met out of the party’s own resources and
that the bank will not be called upon to grant any loan or advance to
meet the liability consequent upon the invocation of the said
guarantee(s) and that no violation of section 20 of the Banking
Regulations Act, 1949 has arisen on account of such guarantee;
and

(v) such contingent liabilities which have not been disclosed

on account of the fact that the possibility of their outcome is remote,
include the management’s justification for reaching such decision
in respect of those contingent liabilities.

(i) The auditor should also examine whether the bank has given
any guarantees in respect of any credit (buyer’s credit or seller’s
credit)*. The period of guarantees is co-terminus with the period of
credit reckoned from the date the shipment.

(j) Verify whether bank has extended any non-fund facility or

additional/ad hoc credit facilities to other than its regular customers.
In such cases, auditor should ensure concurrence of existing
bankers of such borrowers and enquire regarding financial position
of those customers.

The specific procedures to be employed by the auditor to

verify various items of contingent liabilities are discussed in the
following paragraphs. It may be noted that many of the items
discussed in the following paragraphs, may be designated in
foreign currencies.

22. Claims against the Bank Not Acknowledged as Debts

The auditor should examine the relevant evidence, e.g.,
correspondence with lawyers/other, claimants, workers/officers,
and workmen’s/officers’ unions. The auditor should also review the
minutes of meetings of board of directors/committees of board of
directors, contracts, agreements and arrangements, list of pending
legal cases, and correspondence relating to taxes, and duties, etc.
to identify claims against the bank. The auditor should ascertain
from the management the status of claims outstanding as at the
end of the year. A review of subsequent events would also provide
evidence about completeness and valuation of claims.
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23. Liability of Account of Outstanding Forward Exchange

Contracts
The auditor may verify the outstanding forward exchange
contracts with the register maintained by the branch and with the
broker’s advice notes. In particular, the net “position” of the branch
in relation to each foreign currency should be examined to see that
position is generally squared and not uncovered by a substantial
amount. The net “position” as reported in the financial statements
may be verified with reference to the foreign exchange position
report prepared by the back office.

24. Guarantees Given on Behalf of Constituents

The auditor should ascertain whether there are adequate
internal controls over issuance of guarantees, e.g., whether
guarantees are issued under proper sanctions, whether adherence
to limits sanctioned for guarantees is ensured, whether margins are
taken from customer before issuance of guarantees as per the
prescribed procedures, etc.

The auditor should ascertain whether there are adequate

controls over unused guarantee forms, e.g., whether these are kept
under the custody of a responsible official, whether a proper record
is kept of forms issued, whether stock of forms are periodically
verified and reconciled with the book records, etc.

The auditor should examine the guarantee register to seek

evidence whether the prescribed procedure of marking off the
expired guarantees is being followed or not.

The auditor should check the relevant guarantee registers

with the list of outstanding guarantees to obtain assurance that all
outstanding guarantees are included in the amount disclosed in this
behalf. The auditor should also examine that expired guarantees
are not included in this head. He should verify guarantees with the
copies of the letters of guarantee issued by the bank and with the
counter-guarantees received from the customers. He should also
verify the securities held as margin. If a claim has arisen, the
auditor should consider whether a provision is required in terms of
the requirements of AS 29, “Provisions, Contingent Liabilities and
Contingent Assets”.

The auditor should obtain a written confirmation from the

management that all obligations in respect of guarantees have
been duly recorded and that there are no guarantees issued up to
the year end-end which are yet to be recorded.

25. Acceptances, Endorsements and Other Obligations

The auditor should evaluate the adequacy of internal
controls over issuance of letters of credit and over custody of
 329

unused LC forms in the same manner as in the case of guarantees.

The auditor should verify the balance of letters of credit from the
register maintained by the bank. The register indicates the amount
of the letters of credits and payments made under them. The
auditor may examine the guarantees of the customers and copies
of the letters of credit issued. The security obtained for issuing
letters of credit should also be verified.

26. Other Acceptances and Endorsements

The auditor study the arrangements made by the bank with
its customers. He should test check the amounts of the bills with
the register maintained by the bank for such bills. The auditor
should also examine whether such bills are marked off in the
register on payment at the time of maturity.

In respect of letters of comfort, the auditor should examine

whether the bank has incurred a potential financial obligation under
such a letter. If a comfort letter does not cast any such obligation on
the bank, no contingent liability need to be disclosed on this
account.

Common Procedures
The auditor should obtain a written confirmation from the
management that all obligation assumed by way of acceptances,
endorsements and letters of credit have been duly recorded and
there are no such obligations assumed up to the year-end, which
are yet to be recorded.
The auditor should ascertain whether a contingent obligation
assumed by a bank either by way of acceptance, endorsement etc.
has resulted in an actual obligation owing to any act or default on
the part of its constituent. In such a case, a provision would have to
be made in the accounts for the bank’s obligation. The amount of
the provision should be determined taking into account the
probable recovery from the customer.

27. Other Items for which the Bank is Contingently Liable

The auditor should examine whether commitments under all
outstanding underwriting contracts have been disclosed as
contingent liabilities. For this purpose, the auditor should examine
the terms and conditions of the relevant contracts.
Rediscounting is generally done with the RBI, Industrial
Development Bank of India or other financial institutions or, in the
case of foreign bills with foreign banks. If the drawer dishonors the
bill, the rediscounting bank has a right to proceed against the bank
as an endorse of the bill. The auditor may check this item from the
register of bills rediscounted maintained by the branch. He should
satisfy himself that all the bills are properly market off on payment
at the time of maturity.
 330

In respect of disputed tax demands, the auditor should

examine whether there is a positive evidence or action on the part
of the bank to show that it has not accepted the demand for
payment of tax of duty. Where an application for rectification of
mistake has been made by the entity, the amount should be
regarded as disputed. Where demand notice/intimation for the
payment of tax is for a certain amount and the dispute related to
only a part and not the whole of the amount, only such should be
treated as disputed. A disputed tax liability may require a provision
or suitable disclosure as per provisions of AS 29, “Provisions,
Contingent Liabilities and Contingent Assets”. In determining
whether a provision is required, the auditor should, among other
procedures, make appropriate inquiries of management, review
minutes of meeting of the board of directors and correspondence
with the entity’s lawyers, and obtain appropriate management
representations.

Disputed tax liabilities in respect of income-tax and similar

central taxes would not form part of balance sheet of a branch as
these items are dealt with at the head office level. However, the
principles enunciated above should be followed in dealing with
taxes and duties (such as, local taxes) dealt with at the branch
level.

The auditor should also look into the manner of disclosure of

interest rate swaps in the financial statements of the bank. The
interest rate swaps would be treated as real or contingent liability
depending upon the facts and circumstances of each case in
accordance with the provisions of the Accounting Standard (AS) 29.

The auditor as in the case of other entities may verify other

items under this head.

28. Bills for Collection

The auditor should ensure that the bills drawn on other
branches of the bank are not included in bills for collection.

Inward bills are generally available with the bank on the

closing day and the auditor may inspect them at that time. The
bank dispatches outward bills for collection soon after they are
received. They are, therefore, not likely to be in hand at the balance
sheet. The auditor may verify them with reference to the register
maintained for outward bills for collection.

The auditor should also examine collections made

subsequent to the date of the balance sheet to obtain further
evidence about the existence and completeness of bills for
collection.
 331

In regard to bills for collection, the auditor should also

examine the procedure for crediting the party on whose behalf the
bill has been collected. The procedure is usually such that the
customer’s account is credited only after the bill has actually been
collected from the drawee either by the bank itself or through its
agents, etc. This procedure is in accordance with the nature of
obligation of the bank in respect of bills for collection.

The commission of the branch becomes due only when the

bill has been collected. The auditor should, accordingly, examine
that there exists adequate internal control system that debits the
customer’s account with the amount of bank’s commission as soon
as a bill collected is credited to the customer’s account. The auditor
should also examine that no income has been accrued in the
accounts in respect of bills outstanding on the balance sheet date.

29. Co-acceptance of Bills

The auditor should ensure that the bank has instituted an
adequate internal control system to comply with the safeguards as
set out by the RBI’s Master Circular on Guarantees and Co-
acceptances.

PROFIT & LOSS ACCOUNT

30. Income
In carrying out an audit of income, the auditor is primarily
concerned with obtaining reasonable assurance that the recorded
income arose from transaction, which took place during the relevant
period and pertain to the bank, that there is no unrecorded income,
and that income is recorded in proper amounts and is allocated to
the proper period. In view of the mandatory requirement of
recognition of income, the recognition of revenue will have to be
subjected to examination vis-à-vis the guidelines.

31. Interest Income

As a measure of control and also to ensure that the legal
remedies against defaulting borrowers are not adversely affected,
banks commonly follow the procedure of recording interest on non-
performing advances in separate account styled as ‘Interest
Suspense’ or other similar account. Amounts lying in Interest
Suspense Account do not represent income of the bank and have
also to be deducted from the relevant advances. The auditor should
also check whether, in terms of the income recognition guidelines
issued by the RBI, the bank has either reversed or made provision
in respect of interest accrued and credited to income account, in
respect of an advance (including bills purchased and discounted)
that becomes NPA as at the close of any year.
 332

In case of accounts under Corporate Debt Restructuring

(CDR) scheme, the auditor should see whether the income on
projects under implementation which have been classified as
standard has been accounted for on accrual basis pursuant to the
RBI’s income recognition norms. Banks are not permitted to
recognize income on accrual basis from projects under
implementation which have been classified as ‘sub-standard’ asset.
Bank may recognize income in such accounts only on realization
on cash basis.

Income in respect of Funded Interest and where loans are

converted into Equity, debentures or any other instrument is to be
recognized on the same basis as in the case of Restructuring and
Reschedulement of loans.

The said norms also require that the banks should not
recognize income from those projects under implementation which
have been classified as substandard should be recognized only on
cash basis. The auditor should also, accordingly, see whether any
interest on such projects which has been recognized as income in
the past is either reversed or a provision for an equivalent amount
is made in the accounts.

As per Accounting Standard (AS) 9, “Revenue

Recognition”, income is recognized on accrual basis, i.e., as it is
earned. It is an essential condition for accrual of Income that it
should not be unreasonable to expect its ultimate collection. In view
of the significant uncertainty regarding ultimate collection of Income
arising in respect of NPA, banks should not recognize interest on
NPA until it is actually received. Further, recognition of interest
should be deferred where there is uncertainty regarding its
collection.

These norms are also applicable to all Government

guaranteed accounts i.e., if Government guaranteed advances
become NPA, interest on such advances should not be taken to
income account unless interest has been realized.

The auditor should, on a sample basis, check the rates of

interest, etc. (with sanctions and agreements) as well as the
calculation of interest to satisfy himself that-

(a) Interest has been charged on all the performing accounts up

to date of the balance sheet

(b) Interest rates charged are in accordance with the banks

internal regulation, directives of the RBI and agreements with the
respective borrowers. The scrutiny of interest rates charged is
 333

particularly important in the case of advances made on floating

interest rate basis.

(c) Discount on bills outstanding on the date of the balance sheet

has been properly apportioned between the current year and the
following year.

(d) Interest on inter-branch balances has been provided at the

rates prescribed by the head office; and

(e) Any interest subsidy received (or receivable) from RBI in

respect of advances made at concessional rates of interest is
correctly computed.

The auditor should also satisfy himself that interest on non-

performing assets has not been recognized unless realized.

Dividends received should be checked with reference to

counterfoils of dividend warrants. As per AS 9, “Reserve
Recognition”, dividends should be recognized when the right to
receive payment is established, i.e. dividend has been declared by
the corporate body at its Annual General Meeting and the owner’s
right to receive payment is established.

In determining the extent of sample checking, the auditor

should take into account, inter alia, the results of the analytical
procedures and the reports, if any, on income and
expenditure/revenue audit as well as other internal and RBI
inspection reports. The auditor’s assessment of the effectiveness of
concurrent audit would also affect the extent of his detailed
checking of interest earned. In determining the extent of sample
checking, the auditor may place greater emphasis on examining
interest on large advances.

The auditor may check the items of commission, exchange

and brokerage on a test basis. The auditor should examine whether
the commission on non-funded business (e.g. letters of credit,
guarantees and bills for collection) has been properly apportioned
between the current year and the following year.

The auditor should also check whether any fees of

commission earned by the banks as a result of re-negotiations or
rescheduling of outstanding debts has, in terms of the income
recognized on an accrual basis over the period of time covered by
the re-negotiated or rescheduled extension of credit.

According to the guidelines for income recognition, asset

classification, etc., issued by the RBI, if interest income from assets
in respect of a borrower becomes subject to non-accrual, fees,
 334

commission and similar income with respect to same borrower that

have been accrued should cease to accrue for the current period
and should be reversed or provided for with respect to past periods,
if uncollected. The auditor should examine whether the bank has
accordingly made suitable adjustments for de-recognition/reversal
of uncollected commission, etc.

Profit on Sale of Investments: Investments are dealt in the

course of banking activity and hence the profit & loss in sale of
investments are taken to profit & loss account. As investments are
usually dealt with at the head office level, this item may not appear
in the profit and loss account of a branch.

Profit/Loss on Revaluation of Investments: In terms of

guidelines issued by RBI investments are to be valued at periodical
intervals and depreciation or appreciation in valuation is to be
recognized under this head. As investments are usually dealt with
at the head office level, this item may not appear in the profit and
loss account of a branch.

The auditor can check authority for disposal fixed assets, if

any, sold during the year under audit; and non-banking assets
acquired in satisfaction of claims.

The auditor should also vouch transactions in evidence of

profit/loss recorded by the Branch in respect of assets, as
aforesaid.

32. Profit/Loss on Re-valuation of Fixed Assets

The auditor should satisfy himself about the appropriateness

and proper application of the basis of revaluation of fixed assets
adopted by the bank. Where revaluation is based on an appraisal
by approved values, the auditor should examine the appraisals to
the extent possible and satisfy himself about their adequacy for
audit purposes.

The revaluation of fixed assets can be done on the basis of

appraisals by competent valuers such as engineers or architects, or
on the basis of indexation of historical cost, or with reference to
current proces. The auditor should satisfy himself about the
appropriateness and proper application of basis of valuation
adopted by the bank. Where revaluation is based on an appraisal
by valuers, the auditor should examine the appraisals to the extent
possible and satisfy himself about their adequacy for audit
purposes.

The auditor should also examine that the bank has complied
with the provisions of AS 28, Impairment of Assets. In terms of
 335

paragraph 58 of AS 28, an impairment loss should be immediately

recognized as an expense in the Profit and Loss Account
immediately, unless the asset is carried at revalued amount im
accordance with AS 10. In such a case, any impairment loss of a
revalued asset should be treated as a revaluation decrease under
AS 10.

The Notes and Instructions for compilation of profit and loss

account, issued by the Reserve Bank, require that in case any item
under this head exceeds one per cent of the total income,
particulars thereof may be given in the notes.

EXPENDTURE:
33. Interest Extended
The auditor may assess the overall reasonableness of the
figure of interest expense by working out the ratio of interest on
different types of deposits and borrowings to the average quantum
of the respective liabilities during the year. For example, the
auditor may obtain from the bank an analysis of various types of
deposits outstanding at the end of each quarter. From such
information, the auditor may work out a weighted average interest
rate. The auditor may then compare this rate with the actual
average rate of interest paid on the relevant deposits as per the
annual accounts and enquire into the difference, if material. The
auditor may also compare the average rate of interest paid on the
relevant deposits with the corresponding figures for the previous
years and analyses any material differences.

The auditor should, on a sample basis, check the calculation

of interest. He should satisfy himself that-

(a) Interest has been provided on all deposits and borrowings up to

the date of the balance sheet; and verify whether there is any
excess or short credit of material amount.

(b) Interest rates are in accordance with the bank’s internal

regulations, of the R B I directives and agreements with the
respective depositors.

(c) In case of Fixed Deposits it should be ensured that the Interest

Rate in the accounting system are in accordance with the Interest
Rate mentioned in the Fixed Deposit Receipt/Certificate.

d) Interest on Savings Account should be checked on a sample

basis in accordance with the rules framed by the bank in this
behalf.
 336

e) Discount on bills outstanding on the date of the balance sheet

has been properly apportioned between the current year and the
following year.

f) Payment of brokerage is properly authorized; and

g) Interest on inter-branch balances has been provided at the rates
prescribed by the head office.

h) Interest on overdue/matured term deposits should be estimated

and provided for.

34. Operating Expenses

Generally the audit procedures followed by auditors in any

entity are to be followed. Payments to and Provisions for
Employees. The auditor should ascertain the procedure followed by
the bank in this regard while verifying this item.

The auditor should check the calculation of salaries and

allowances, etc. on a sample basis with reference to relevant
agreements/awards. He may also assess the reasonableness of
expenditure on salaries, allowances, etc. by working out their ratio
to total operation expenses and comparing it with the
corresponding figures for previous years.

Rent, Taxes and Lighting

The auditor may check the following on a sample basis:
 Rent paid and verifies whether adjustments have been
made for the full year on account of rent at the rates as
applicable and as per agreement in force.
 Rent does not include House Rent Allowance to
employees.
 Whether municipal rates/taxes are duly paid/adjusted for
the year under audit.
 Enquire whether any disputed liability exists on this
account upto the year end.

Printing and Stationery

The auditor should accordingly verify this item with reference
to documents evidencing purchase/debit note received.

Advertisement and Publicity

Expenditure incurred by the bank for advertisement and
publicity, including printing charges of publicity material is verified
with the documents.
 337

Depreciation on Bank’s Property

The auditor should ascertain the exact procedure followed by
the bank while verifying this item.

This item includes depreciation on bank’s own property, motor

cars and other vehicles, electrical fittings, vaults, lifts, leasehold
properties, non-banking assets, etc, Depending on the procedure
followed in the bank, provision for depreciation may either be
centralized at the head office level or decentralized.

The auditor should check Head Office instructions as regards

adjustments of depreciation on the fixed assets of the Branch.

The auditor should also check whether depreciation on fixed

assets has been adjusted at the rates and in the manner required
by H.O.

The auditor may also report unadjusted depreciation on assest

acquired but not capitalised.

The auditor should ascertain the exact procedure followed by

the bank while verifying this item.

i) Directors’ Fees, Allowances and Expenses : Expenditure

incurred in this regard are recorded under this head. This item is
dealt with at the head office level and would not therefore be
relevant at the branch level.

ii) Auditors’ Fees and Expenses : Remuneration payable to

Statutory Auditors and Branch auditors and expenses in connection
with audit like reimbursements are recognized under this head. This
item is usually dealt with at the head office level and would not
therefore be relevant at the branch level.

iii) Law Charges : All legal expenses and reimbursement of

expenses incurred in connection with legal services are to be
included here. Auditors should verify the legal charges payable by
the bank in respect of all legal disputes/cases currently being
fought at various courts of laws, etc. are accounted for in the
accounts. For this purpose, the auditor may go through the list of
contingent liabilities prepared by the bank as at the year end to
verify the disputes/cases which the bank is contesting.

iv) Postage Telegrams, Telephones, etc : This item includes all

postal charges like stamps, telegrams, telephones, tele-printers,
etc.
 338

v) Repairs and Maintenance : This item includes repairs to bank’s

property, their maintenance charges, etc.

vi) Insurance : This item is usually dealt with at the head office
level and may not therefore be relevant at the branch level.

vii) Other Expenditure : This item includes all expenses other than
those included in any of the other heads, like, licence fees,
donations, subscriptions to papers, periodicals, entertainment
expenses, travel expenses, etc. The Notes and Instructions for
compilation of profit and loss account, issued by the Reserve Bank,
require that in case any particular item under this head exceeds
one per cent of the total income, particulars thereof may be given in
the notes.

35. Provisions and Contingencies

Provisions in respect of NPA and NPI should be verified with
the regulatory requirements to ensure full provisioning. The other
provisions for expenditure, taxes, etc. are to be examined with the
circumstances warranting the provisioning and the adequacy of the
same.

36. Audit of Branches

Audit of branches of banking companies is required under
section 228 of the Companies Act, 1959. It is thus obligatory for a
banking company to get the financial statements of each of its
branch offices audited except where exemption from audit is
obtained in respect of certain branches under the Companies
(Branch Audit Exemption) Rules, 1961 and as per the guidelines of
the RBI issued from time to time.

The branch auditor has the same powers and duties in respect
of audit of financial statements of the branch as those of the central
auditors in relation to audit of head office. The branch auditor’s
report on the financial statements examined by him is forwarded to
the central auditors with a copy to the financial statements
examined by him is forwarded to the central auditors with a copy to
the management of the bank. The branch auditor of a public sector
bank, private sector bank or foreign bank is also required to furnish
a long form audit report to the bank management and to send a
copy thereof to the central auditors. The central auditors, in
preparing their report on the financial statements of the bank, deal
with the branch audit reports in such manner as they consider
necessary.

37. Internal Audit

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 operating. Banks
 339

generally have a well-organised system of internal audit. The

internal audit is carried out either by a separate department within
the bank or by independent firms of chartered accountants. Apart
from these, the inspectors of RBI also review the system and
transactions of important branches.

RBI has advised banks to adopt a framework for Risk-Based

Internal Audit to ensure that the internal audit is undertaken in the
bank in a risk focused manner. This would also facilitate in adoption
of the Risk-based Supervision framework.

38. Revenue Audit

Revenue audit is usually conducted at large and medium-
sized branches and is aimed at identifying cases of leakage of
revenue due to wrong computation of interest, non-application of
interest on time, application of incorrect rates of interest/ exchange/
commission, non-application of penal interest, non-recovery or
short-recovery of service charges on guarantees and letters of
credit, etc. This type of audit is also know as ‘income and
expenditure audit’ or ‘income leakage audit’.

39. Concurrent Audit

A system of concurrent audit at large and other selected
branches has been in vogue in most of the banks for quite long.
Recognizing the importance of concurrent audit in the banking
sector, the RBI, vide its circular no. BC.82/16.13.100/93-94 dated
October 11, 1993, addressed to all scheduled commercial banks
(except regional rural banks) formally advised such banks to
institute an appropriate system of concurrent audit.

12.8 THE THIRD SCHEDULE TO THE BANKING

REGULATION ACT, 1949
The Third Schedule
To the Banking Regulation Act, 1949
(See Section 29)
FORM ‘A’
Form of Balance Sheet
Balance Sheet of______________ (here enter name of the Banking
Company) Balance Sheet as on 31st March-(Year) (000’s omitted)

Schedule As on As on
31.3____ 3.3____
(current (previous
year) year)
Capital & Liabilities
Capital 1
Reserves & Surplus 2
Deposits 3
 340

Borrowings 4
Other liabilities and 5
provisions
Total
Assets
Cash and Balances with 6
Reserve Bank of India
Balances with banks and 7
money at call and short
notice
Investments 8
Advances 9
Fixed Assets 10
Other Assets 11
Total
Contingent Liabilities Bill 12
for Collection
Schedule I
Capital
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. For Nationalised Banks
Capital (Fully owned by Central
Government)
II. For Banks Incorporated Outside
India
Capital (The amount brought in by
banks by way of start-up capital as
prescribed by RBi should be shown
under this head.) Amount of deposit
kept with RBI under section 1(2) of
the Banking Regulation Act, 1949.
Total
III. For Other Banks
Authorised Capital
(. . . . . . .shares of Rs.. . . each)
Issued Capital
(. . . . . . .shares of Rs.. . . each)
Subscribed Capital
(. . . . . . .shares of Rs.. . . each)
Called-up Capital
(. . . . . . .shares of Rs.. . . each)
Less: Calls unpaid
Add: Forfeited shares
Total
 341

Schedule 2
Reserves & Surplus

As on As on
31.3___ 31.3___
(current (previous
year) year)
I. Statutory Reserves
Opening Balances
Additions during the year
Deductions during the year
II. Capital Reserves
Opening Balances
Additions during the year
Deductions during the year
III. Share Premium
Opening Balances
Additions during the year
Deductions during the year
IV. Reserves and Other Reserves
Opening Balances
Additions during the year
Deductions during the year
V. Balance in Profit and Loss
Account

Total (I, II, III,IV and V)

Schedule 3
Deposits
As on As on
31.3___ 31.3___
(current (previous
year) year)
A. I. Demand Deposits
i) From banks
ii) From others
II. Savings Bank Deposits
III. Term Deposits
i) From banks
ii) From others
Total (I, II, and III)
B. i) Deposits of branches in India
ii) Deposits of branches outside
India
Total
 342

Schedule 4
Borrowings
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. Borrowings in India
i) Reserve Bank of India
ii) Other banks
iii) Other institutions and agencies
II. Borrowings outside India
Total (I and II)
Secured borrowings included in I & II
above-Rs.

Schedule 5
Other Liabilities and Provisions
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. Bills payable
II. Inter-office adjustments(net)
III. Interest accrued
IV. Others (including provisions)
Total

Schedule 6
Cash and Balances with Reserve Bank of India
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. Cash in hand
(including foreign currency notes)
II. Balances with Reserve Bank of
India
(i) in Current Account
(ii) in Other Account
Total (I & II)
 343

Schedule 7
Balances with Banks and Money at Call & Short Notice
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. In India
(i) Balances with banks
(a) in current account
(b) in other deposit accounts
(ii) Money at call and short notice
(a) with banks
(b) with other institutions
Total (i & ii)
II. Outside India
(i) in current accounts
(ii) in other deposit accounts
(iii) Money at call and short notice
Total
Grand Total (I & II)

Schedule 8
Investments
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. Investments in India in
i) Government securities
ii) Other approved securities
iii) Shares
iv) Debentures and bonds
v) Subsidiaries and/or joint ventures
vi) Others (to be specified)
Total
I. Investments Outside India in
i) Government securities
(including local authorities)
ii) Subsidiaries and/or joint ventures
abroad
iii) Other investments
(to be specified)
Total
Grand Total (I & II)
 344

Schedule 9
Advances
As on As on
31.3___ 31.3___
(current (previous
year) year)
A. (i) Bills purchased and discounted
(ii) Cash credits, overdrafts and
loans repayable on demand
(iii) Term loans
Total
B. (i) Secured by tangible assests
(ii) Covered by bank/Government
guarantees
(iii) Unsecured
Total
C. (I) Advances in India
i) Priority sectors
ii) Public sector
iii) Banks
iv) Others
Total
(II) Advances outside India
i) Due from banks
ii) Due from others
a) Bills purchased
and discounted
b) Syndicated loans
c) Others
Total
Grand Total (C.I & C.II)

Schedule 10
Fixed Assets
As on As on
31.3___ 31.3___
(current (previous
year) year)
I. Premises
At cost as on 31st March of the
preceding year
Additions during the year
Deductions during the year
Depreciation to date
 345

II. Other Fixed Assets

(including furniture and fixtures)
At cost as on 31st March of the
preceding year
Additions during the year
Deductions during the year
Depreciation to date
Total (I & II)

Schedule 11
Other Assests
As on 31.3___ As on 31.3___
(current year) (previous year)
I. Inter-office adjustments (net)
II. Interest accrued
III. Tax paid in advance/tax deducted
at source
IV. Stationery and stamps
V. Non-banking assets acquired in
satisfaction of claims
VI. Others*
Total
* In case there is any unadjusted balance of loss the same may be
shown under this item with appropriate footnote.

Schedule 12
Contingent Liabilities
As on 31.3___ As on 31.3___
(current year) (previous year)
I. Claims against the bank not
acknowledged as debts
II. Liability for partly paid
Investments
III. Liability on account of
outstanding forward exchange
contracts
IV. Guarantees given on behalf of
constituents
(a) In India
(b) Outside India
V. Acceptances, endorsements and
other obligations
VI. Other items for which the bank is
contingently liable

Total
 346

Form ‘B’
Form of Profit & Loss Account
For the year ended 31st March ______
Year ended Year ended
31.3___ 31.3___
(current (previous
year) year)
I. Income
Interest earned
Other income
Total
II. Expenditure
Interest expended
Operating expenses
Provisions and
contingencies
Total
III. Profit / Loss
Net Profit/loss ( ) for the
year
Profit/loss ( ) brought
forward
Total
IV. Appropriations
Transfer to statutory
reserves
Transfer to other reserves
Transfer to –
Government/Proposed
dividend Balance-sheet
Total

Schedule 13
Interest Earned
Year ended Year ended
31.3___ 31.3___
(current (previous
year) year)
I. Interest/discount on
advances/bills
II. Income on investments
III. Interest on balances with
Reserve Bank of India and other
Inter-bank funds
IV. Others

Total
 347

Schedule 14
Other Income
Year ended Year ended
31.3___ 31.3___
(current (previous
year) year)
I. Commission, exchange and
brokerage
II. Profit on sale of investments
Less: Loss on sale of
investments
III. Profit on revaluation of
investments
Less: Loss on revaluation of
investments
IV. Profit on sale of land, buildings
and other assets
Less: Loss on sale of land,
buildings and other assets
V. Profit on exchange transactions
Less: Loss on exchange
transactions
VI. Income earned by way of
dividends etc. from subsidiaries,
Companies and/or joint ventures
Abroad/in India
VII. Miscellaneous income

Total

Note: Under items II to V, loss figures may be shown in brackets.

Schedule 15
Interest Expended
Year ended Year ended
31.3___ 31.3___
(current (previous
year) year)
I. Interest on deposits
II. Interest on Reserve Bank of
India/inter bank borrowings
III. Others

Total
 348

Schedule 16
Operating Expenses
Year ended Year ended
31.3___ 31.3___
(current (previous
year) year)
I. Payment to and provisions for
employees
II. Rent, taxes and lighting
III. Printing and stationery
IV. Advertisement and publicity
V. Depreciation on bank’s property
VI. Directors’ fees, allowances
and expenses
VII. Auditor’s fees and expenses
(including branch auditors’ fees
and expenses)
VIII. Law Charges
IX. Postage, telegrams, telephones,
etc.
X. Repairs and maintenance
XI. Insurance
XII. Other expenditure

Total


 349

Question Paper 2012

N.B.: 1) Attempt Question Nos. 1 and 2 which are

compulsory.
2) Attempt any four questions from Question Nos. 3 to 9.
Thus in all six questions to be attempted.
3) Figures to the right indicate full marks.

1. As an Auditor, how would you deal with/comment/react on

the following situations: (20)

A) SBK Ltd. has declared the dividend out of the propfits

before providing for depreciation. The Directors state that
the market values of all depreciable assets, are increased
during the period under audit.
B) Gajanan Ashish Ltd. paid Rs. five lacs as under writing
commission to M/s. Vinayak Bros. The company had
debited the complete expenditure of Rs. five lacs to the
Profit and Loss Account of the year under audit. The
Accounts Manager of the company states that considering
the huge turnover and the profit of the company, the
concerned expenditure is of small amount.
C) Vishwas Co-operative Credit Society earned a net profit of
Rs. 5,00,000 before appropriation of funds. During the year
under audit the society had transferred Rs. 1,00,000 to
Reserve Fund.
D) On 31-03-2011, the stock of the company was valued at
cost price. But now the management of the company
proposes to value the closing stock on 31-03-2012 at
market price.
E) M/s. C.D. Doshi & Co., a Chartered Accountants and
previous auditors of the company, have retained some
documents of the company for non-payment of their dues.
Such documents were handed over to them without the
knowledge of the Board of Directors of the company, during
the course of the audit.
2 A Select most appropriate option for the following sentences
and rewrite the statement (8)

i) -------------------- is basically responsible for prevention

and detection of errors and frauds
a) Auditor c) Management
b) Accountant d) Cashier
ii) Audit plans should be based on knowledge of the
clients------------
a) Profits c) Net worth
b) Business d) Reputation
 350

iii) Insurance business is controled by-

a) Insurance Rules, 1939
b) IRDA Regulation, 2002
c) Insurance Act, 1938
d) All of the above.
iv) --------------- section of the Company Act, 1956, relates
of Financial Audit of a company.
a) S. 233B c) S. 227
b) S. 233A d) S. 56
v) Discount on Bills is shown by a Bank
a) In schedule of Interest Earned
b) In schedule of Advances
c) In schedule of Interest expended
d) In schedule of other Income
vi) Financial statements need to be prepared in
accordance with
a) Accounting standard issued by the Institute of
Chartered Accountants of India.
b) Relevant statutory requirements
c) Guidance notes issued by the Institute of Chartered
Accountant of India.
d) All the above.
vii) The earning in Foreign Exchange from export of goods.
a) are disclosed in notes to accounts on CIF basis.
b) are disclosed in notes to accounts on FOB basis.
c) are disclosed in notes to accounts only in Foreign
Currency.
d) Non of the above.
viii) Banks should make general provisions for standard
assets at-
a) 0.25% c) 1%
b) 2% d) 0.40%
B Match the following- 8
‘A’ ‘B’
1) Audit programme a) M/A and A/A
2) Performance Audit b) SA 230
3) Special Audit of Company c) Sec. 44AB
4) Tax Audit d) Sec. 233A
5) SA dealing with working e) Effectiveness Audit and
papers Efficiency Audit
6) Bonus shares f) Sec. 205(2) of Company Act,
1956
7) SA dealing with Audit g) Nature, timing and extent of
Planning Audit Procedure
8) Provision for depreciation h) Accumulated Profits and
Reserves
i) SA 300
 351

3. A Describe briefly how would you audit the following ledger

accounts- 8
i) A suppliers Account
ii) Outstanding Expenses Account.
B How would you audit the following payments made by a
company- 8
i) Remuneration/Commission paid to Directors
ii) Directors sitting fees.

4. A Explain the provisions in Company’s Act, 1956 and

Auditors duty in relation to following- 8
i) Buy-Back of shares
ii) Redemption of preference shares
B Write short notes on (any two) 8
i) Sweat Equity Shares
ii) Contingent Liabilities
iii) Capital Redemption Reserve.

5. Explain the various matters to be included in the Companies

(Auditors Report) Order, 2003. 16

6. Explain the provisions given in SA-230 in relation to Audit

documentation. 16

7. Explain the provisions of SA-500 with regard to- 16

a) Audit procedure for obtaining Audit Evidence.
b) Selecting items for testing to obtain Audit Evidence.

8. A Discuss the ‘Performance Audit’ based on the

‘Performance Auditing Guidelines’ published by the C & AG
of India. 16
B Write a note on – Audit of a Firm.

9. Explain the provisions of Section 44AB in relation to- 16

a) Tax Auditor b) Tax Audit Procedure.


 M.Com. (Part - II)
-: Accountancy Group :-
Advanced Auditing
(Paper-IV)
{April – 2016}