UNIT

NATURE, OBJECTIVE AND SCOPE

OF AUDIT

Names of Sub-Units

Nature, Objective, Scope of Audit- Standards- Setting Process, Role of International

Auditing and Assurance Standards Board (IASSB) & Auditing and Assurance Standards
Board (AASB)- Qualities of Auditor, Ethical requirements relating to an audit of financial
statement, Inherent limitation of an audit, Precondition for an audit, Audit Engagement,
Agreement on Audit Engagement Terms, Acceptance and Continuance of Client
Relationships and Audit Engagements.

Overview

The unit starts with basics of auditing covering then the two most important organization
of Auditing, i.e. IASSB and ASSB and then covering all important aspects of audit like
qualities one must have as an Auditor, Limitation of audit , how to ensure that the
relationship with client is maintained.

Learning Objectives

In this Unit you will learn –

 The Meaning of audit and understand the objectives of audit, principles governing
audit etc.
 Distinguish between auditing and investigation.
 Understand the limitation of audit
 Learn how auditing standards are made in India
 Understand the national and international organization working in the area of audit
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 Overview of audit engagement
 Understand the pre-conditions for an audit

Learning Outcomes

At the end of this unit, you would:

 Have a fair understanding on the auditing and its scope and objective.
 Analyze the agencies and the purpose for which they are formed
 Examine why financial statements cannot be 100% error free
 Understand the qualifications required for an auditor

Pre-Unit Preparatory Material

 https://drive.google.com/file/d/1hwTdHYmu8qXSupo2j0LC_fhWRNcRTSOD/view
 https://youtu.be/pkKO9ZNyOIc

1.1 Introduction

Auditing originates from the Latin term “Audire”, which means “to hear”. In olden times, auditors
used to listen to officers and people of authority to confirm the validity of their words. Over the
years, the role of auditing evolved to verifying written reports: specifically, the financial records
of individuals and businesses.

By definition, auditing is an official inspection and verification of the credibility of financial reports.
Audits can be conducted by either a business’s management as an internal control process or by
the government, in case they notice suspicious financial activity.

1.2 Meaning of Audit

Audit is an independent examination of financial information of any entity, whether profit oriented
or not, and irrespective of its size or legal form, when such an examination is conducted with a view
to expressing an opinion thereon.

1. Audit is Independent examination of Financial information.

2. of any entity – that entity may be profit oriented or not and irrespective of its size or legal
form. For example – Profit oriented – Audit of Listed company engaged in business. On the
other hand, Audit of NGO – not profit oriented.
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3. The objective of the audit is to express an opinion on the financial statements

1.3 Objective of Audit

As per SA-200 “Overall Objectives of the Independent Auditor”, in conducting an

audit of financial statements, the overall objectives of the auditor are:

(a) To obtain reasonable assurance about whether the financial statements as a whole are free
from material misstatement, whether due to fraud or error, thereby enabling the auditor to
express an opinion on whether the financial statements are prepared, in all material
respects, in accordance with an applicable financial reporting framework; and

(b) To report on the financial statements, and communicate as required by the SAs, in
accordance with the auditor’s findings.

Objective of audit

Given in SA 200

Financial Accounts
Report the
are free from error
auditor's findings
and frauds

1.4 Scope of Audit

The scope of an audit of financial statements will be determined by the auditor on

the basis of:
a) The terms of the engagement,
b) The requirements of relevant legislation,
c) The pronouncements of the Institute and

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d) The legal judgements given by various courts of law.
The terms of engagement cannot, however, restrict the scope of an audit in relation to
matters which are prescribed by legislation or by the pronouncements of the Institute.

The following points merit consideration in regard to scope of audit:

1. The audit should be organized to cover adequately all aspects of the enterprise relevant to
the financial statements being audited.

2. To form an opinion on the financial statements, the auditor should be reasonably satisfied
as to whether the information contained in the underlying accounting records and
other source data is reliable and sufficient as the basis for the preparation of the financial
statements.
3. In forming his opinion, the auditor should also decide whether the relevant information
is properly disclosed in the financial statements subject to statutory requirements, where
applicable.
4. The auditor assesses the reliability and sufficiency of the information contained in the
underlying accounting records and other source data by:
(a) making a study and evaluation of accounting systems and internal controls and
(b) carrying out such other tests, enquiries and other verification procedures of accounting
transactions and account balances as he considers appropriate in the particular
circumstances.
5. The auditor determines whether the relevant information is properly disclosed in the
financial statements by:
(a) comparing the financial statements with the underlying accounting records and other
source data to see whether they properly summarize the transactions and events recorded
therein;
(b) considering the judgments that management has made in preparing the financial
statements accordingly, the auditor assesses the selection and consistent application of
accounting policies, the manner in which the information has been classified, and the
adequacyof disclosure.

6. The auditor is not expected to perform duties which fall outside thescope of his
competence. For example, the professional skill required of an auditor does not include
that of a technical expert for determining physical condition of certain assets.

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1.5 Role of International Auditing and Assurance Standard Board

The International Auditing and Assurance Standards Board (IAASB) was founded in March
1978. It was previously known as the International Auditing Practices Committee (IAPC). In
1977, the International Federation of Accountants (IFAC) was set up with a view to bringing
harmony in the profession of accountancy on an international scale. In pursuing this
mission, the IFAC Board has established the International Auditing and Assurance
Standards Board (IAASB) to develop and issue, in the public interest and under its own
authority, high quality auditing standards for use around the world.

The International Auditing and Assurance Standards Board (IAASB) is an independent

standard-setting body that serves the public interest by setting high-quality international
standards for auditing, quality control, review, other assurance, and related services, and by
facilitating the convergence of international and national standards. In doing so, the IAASB
enhances the quality and uniformity of practice throughout the world and strengthens
public confidence in the global auditing and assurance profession.

The IAASB achieves this objective by:

 Establishing high quality auditing standards and guidance for financial statement audits
that are generally accepted and recognized by investors, auditors, governments, banking
regulators, securities regulators and other key stakeholders across the world;

 Establishing high quality standards and guidance for other types of assurance services on
both financial and non-financial matters;

 Establishing high quality standards and guidance for other related services;

 Establishing high quality standards for quality control covering the scope of services
addressed by the IAASB; and

 Publishing other pronouncements on auditing and assurance matters, thereby advancing

public understanding of the roles and responsibility of professional auditors and assurance
service providers

1.6 Role of Auditing and Assurance Standards Board

In India, Auditing and Assurance standards are issued by ICAI. In 1982, ICAI set up
Auditing and Assurance Standard Board (AASB) to prepare auditing standards.
Accordingly, AASB issues Statements on Standard Auditing Practices and Auditing and
assurance Standards under the authority of the Council.
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The following are the objectives and Functions of the Auditing and Assurance Standards
Board (AASB):

1. To review the existing and emerging auditing practices worldwide and identify areas in
which Standards on Quality Control, Engagement Standards and Statement on Auditing
need to be developed.
2. To formulate Engagement Standards, Standards on Quality Control and Statement on
auditing so that these may be issued under the authority of the Council of the Institute.
3. To review the existing Standards and Statements on Auditing to assess their relevance in
the changed conditions and to undertake their revision, if necessary.
4. To develop guidance notes on issues arising out of any Standard, auditing issues
pertaining to any specific industry or on generic issues, so that those may be issued under
the authority of the Council of the Institute.
5. To review the existing Guidance Notes to access their relevance in the changed
circumstances and to undertake their revision, if necessary.
6. To formulate General Clarifications, where necessary, on issues arising from Standards.
7. To formulate and issue Technical Guides, Practice Manuals, Studies and other papers
under its own authority for guidance of professional accountants in the cases felt
appropriate by the Board.

1.7 Procedure for Issuing Standards

Auditing and Assurance Standards Board (AASB) of the Institute formulates the auditing
standards. Broadly, the following procedure is adopted for the formulation of Standards
on Auditing (SAs):

 The Auditing and Assurance Standards Board identifies the areas where auditing
standards need to be formulated and the priority in regard to their selection.
 In the preparation of Auditing Standards, AASB is assisted by study groups/task force
constitute to consider specific project. Study group comprising of a cross section of
members of the Institute.
 The study group/task force is responsible for preparing the primarily draft of Standards.
 Based on the work of the study groups, an exposure draft of the proposed Standards is
prepared by the Committee and issued for comments by members of the ICAI.
 After taking the comments into consideration, AASB finalize the draft and submit to the
Council of the Institute.

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 The Council on its review of the draft, makes suitable modifications in consultations with
the AASB and then Standards/Statements is issued under the authority of the Council.

While formulating the auditing standards, the Board also takes into consideration
International Standards on Auditing (ISA) issued by the International Auditing Practices
Committee (IAPC), applicable laws, customs, usages and business environment in the
India.

Comments
Identification of Finalisation of
received on
area exposure draft
exposure draft

Constitution of Considering views

Modification and
of different bodies
study group siginging of draft
on draft

Prepration of
circulation of draft Issue of AS
draft

Diagram 1: Procedure of issuing the accounting standards

1.8 Qualities of an Auditor

Audits are crucial to any organization as the report given by an auditor has a say on the
reliability of financial statements. To ensure that audits are performed correctly, it is
important to consider that the effectiveness of an audit depends upon the competence of
the auditor performing it. Auditors, who occupy a position of trust, must possess basic
human qualities besides technical training and professional education. Some of the
personal traits of an auditor are:

1. Integrity, Objectivity and Independence

Integrity refers to honesty and sincerity of auditor; Objectivity means his impartial and
unbiased attitude; Independence means he should be free from any such interest which
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may affect his integrity and objectivity. He should maintain an impartial attitude and
both be and appear to be free of any interest.
2. Ability to express and communicate :
It is essential that an auditor possesses good communication skills, both oral and written.
This shall help him to translate the results of his examination into an audit report. He should
be able to draft a report which is clear and unambiguous.

3. Confidentiality
The auditor should respect the confidentiality of information acquired in the course of his
work and should not disclose any such information to a third party without specific
authority or unless there is a legal or professional duty to disclose. It is well saidthat an
auditor keeps his ears and eyes open, but his mouth shut. He should disclosethe
information only when:-
a) He has obtained permission of his client.
b) There is legal or professional duty to do so.

4. Skills and Competence

Audit work should be performed with due care and skill. Auditor should have specialized skills
and competence which are acquired through general education, technical knowledge and practical
training. He should also be aware of continuing developments, pronouncements of ICAI and
other statutory requirements.

5. Aware of the latest developments

An auditor should stay abreast with any latest developments that may impact his audit
work such as changes in laws, regulations, professional pronouncements, technological
factors, etc.

1.9 Ethical Requirements relating to Audit of Financial Statements

 The auditor shall comply with relevant ethical requirements including independence.
 For this purpose, the Code of Ethics are issued by ICAI. The Code establishes the following
as the fundamental principles of professional ethics relevant to the auditor when
conducting an audit of financial statements;
a) Integrity;
b) Objectivity;
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c) Professional competence and due care;

d) Confidentiality; and
e) Professional behavior.
 In the case of an audit engagement it is in the public interest and, therefore, required by
the Code of Ethics, that the auditor be independent of the entity subject to the audit. The
Code describes independence as comprising both independence of mind and
independence in appearance (i.e. auditor should not only be independent but also appear
to be independent to others).

SA 220 sets out the engagement partner’s responsibilities with respect to relevant ethical
requirements. These include evaluating whether members of the engagement team have complied
with relevant ethical requirements. SA 220 recognises that the engagement team is entitled to rely
on a firm’s systems in meeting its responsibilities with respect to quality control procedures.

1.10 Inherent Limitations of Audit

According to SA 200 on “Overall Objectives of the Independent Auditor and the Conduct of an Audit
in accordance with Standards on Auditing”, the objective of an audit of financial statements,
prepared within a framework of recognised accounting policies and practices and relevant statutory
requirements, is to enable an auditor to express an opinion on such financial statements. In forming
his opinion on the financial statements, the auditor follows procedures designed to satisfy himself
that the financial statements reflect a true and fair view of the financial position and operating
results of the enterprise.

The Auditor is not expected to and cannot reduce audit risk to zero and hence cannot absolutely
guarantee on financial statements to be free from all errors and frauds.
The process of auditing, however, is such that it suffers from certain inherent limitations, i.e., the
limitation which cannot be overcome irrespective of the nature and extent of audit procedures. Such
limitations arise because of following:
a) Test Check: Auditor always faces lack of time and so he is not able to conduct full audit
and he relies upon test audit only. When he is just doing test audit, every kind of frauds and
errors may not be detected.

b) Exercise of judgment in the auditor’s work in deciding the extent of audit procedures and
exercising judgement also in assessing the reasonableness of the judgment and estimates
made by the management in preparing the financial statements.

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c) The audit evidence obtained by an auditor is generally persuasive in nature rather than
conclusive in nature. Such evidence available to the auditor can enable him to draw only
reasonable conclusions therefrom. Therefore, absolute certainty in auditing is rarely
attainable. There is also likelihood that some material misstatements of the financial
information resulting from fraud or error, if either exists, may not be detected.

d) Inherant Limitations of Internal Controls: The entire audit process is generally dependent
upon the existence of an effective system of internal control. The internal control system
also suffers from certain inherent limitations since any system of internal control is
ineffective against fraud involving collusion among employees or fraud committed by
management. Certain levels of management may be in a position to override controls; for
example, by directing subordinates to record transactions incorrectly or to conceal them,
or by suppressing information relating to transactions

Some Brain Capsule

Amazing M.COM Ltd requested the auditor CA PASS Exam to provide for
absolute assurance in respect of its ten branches which are situated all over
India and confirm that the financial statements are free from material
misstatement due to fraud or error. Advise
The auditor is not expected to, and cannot, reduce audit risk to zero and cannot
therefore obtain absolute assurance that the financial statements are free from
material misstatement due to fraud or error. This is because there are inherent
limitations of an audit, which result in most of the audit evidence on which the
auditordraws conclusions and bases the auditor’s opinion being persuasive rather
thanconclusive.

1.11 Pre-Conditions for an Audit

As per SA 210 “Agreeing the Terms of Audit Engagements”, preconditions for an audit may
be defined as the use by management of an acceptable financial reporting framework in
the preparation of the financial statements and the agreement of management and, where
appropriate, those charged with governance to the premise on which an audit is
conducted

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In order to establish whether the preconditions for an audit are present, the auditorshall:
(a) Determine whether the financial reporting framework is acceptable; and

(b) Obtain the agreement of management that it acknowledges and understandsits

responsibility:

(i) For the preparation of the financial statements in accordance with theapplicable
financial reporting framework;
(ii) For the internal control as management considers necessary; and

(iii) To provide the auditor with:

 Access to all information such as records, documentation andother matters;

 Additional information that the auditor may request frommanagement for the purpose
of the audit; and

 Unrestricted access to persons within the entity from whom theauditor determines it
necessary to obtain audit evidence.

1.12 Agreement on Audit Engagement Terms

 The auditor shall agree the terms of the audit engagement with management.
 The agreed terms of the audit engagement shall be recorded in an audit engagement
letter or other suitable form of written agreement and shall include:
a) The objective and scope of the audit of the financial statements;
b) The responsibilities of the auditor;
c) The responsibilities of management;
d) Identification of the applicable financial reporting framework for the preparation of the
financial statements; and
e) Reference to the expected form and content of any reports to be issued by theauditor.
If law or regulation prescribes in sufficient detail the terms of the audit engagement, the auditor
need not record them in a written agreement, except for the fact that such law or regulation applies
and that management acknowledges and understands its responsibilities.
 The above agreement would be in form of a letter which would be written by the
auditor to his client and is known as Letter of Engagement or Engagement Letter.

1.13Acceptance and Continuance of Client Relationships and Audit Engagements

The engagement partner shall be satisfied that appropriate procedures regardingthe

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acceptance and continuance of client relationships and audit engagements have been
followed.
SQC 1 requires the firm to obtain information before accepting an engagement. Information such
as the following assists the engagement partner in determining whether the decisions regarding
the acceptance and continuance of audit engagements are appropriate:

 The integrity of the principal owners, key management and those chargedwith governance
of the entity;

 Whether the engagement team is competent to perform the auditengagement and has the
necessary capabilities, including time and resources;

 Whether the firm and the engagement team can comply with relevant ethical

requirements; and

 Significant matters that have arisen during the current or previous audit

engagement, and their implications for continuing the relationship

1.15 Summary

 An audit is independent examination of financial information of any entity, whether profit

oriented or not, and irrespective of its size or legal form, when such anexamination is
conducted with a view to expressing an opinion thereon.
 As per SA-200 “Overall Objectives of the Independent Auditor”,in conducting an audit
of financial statements, the overall objectives of the auditorare to obtain reasonable
assurance about whether the financial statements as a whole are free from material
misstatement and to report on the financial statements.
 The auditor should get the scope of his duties and responsibilities defined by obtaining
instructions in writing
 The auditor is not expected to, and cannot, reduce audit risk to zeroand cannot
therefore obtain absolute assurance that the financial statements are free from material
misstatement due to fraud or error. This is because there are inherent limitations of an
audit.
 A significant step has been taken aimed at bringing in the desired transparency in the
working of the Auditing and Assurance Standards Board, through participation of
representatives of various segments of the society and interest groups, such as,
regulators, industry and academics

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 The auditor shall comply with relevant ethical requirements including those pertaining to
independence. Relevant ethical requirements ordinarily comprise the Code of Ethics for
Professional Accountants related to an audit of financial statements.
 The Code establishes the five fundamental principles of professional ethics relevant to the auditor
when conducting an audit of financial statements. (a) Integrity; (b) Objectivity; (c) Professional
competence and due care; (d) Confidentiality; and (e) Professional behavior.

Self-Assessment Questions

Essay questions

1. Explain clearly meaning of Auditing. How would you as an auditor perform the audit.

2. “The independent audit of an entity’s financial statements is a vital service to investors,

trade payables, and other participants in economic exchange”. Explain

3. “Integrity’” and “Objectivity” are among the fundamental principles ofprofessional ethics
relevant to an auditor enshrined in IESBA code. Distinguish between the two

4. There is a pre-defined method to set accounting standards. Elaborate.

5. No auditor can assure zero error in the financial statements. Elucidate the limitation of audit.

1.16 POST-UNIT READING MATERIAL

 https://archive.mu.ac.in/myweb_test/study%20TYBCom%20Accountancy%20Auditing-II.pdf
 https://resource.cdn.icai.org/66597bos53774-cp1.pdf

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 UNIT

CODE OF ETHICS AND CONDUCT

Names of Sub-Units

Concepts of Auditor’s Independence, Threats to Independence, Safeguard

Overview

The unit starts with meaning of Independence of Auditor, what are the major threats to
the independence and what are the methods to safeguard the independence.

Learning Objectives

In this Unit you will learn –

 The meaning of the term independence of auditor
 Understand the various reasons behind the loss of independence
 To explain how this independence can be safeguarded

Learning Outcomes
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At the end of this unit, you would:

 Be able to do analyses whether the auditor is independent or not
 Evaluate the reason as to what is causing the threat to independence
 Articulate how the independence of the auditor can be safeguarded

Pre-Unit Preparatory Material

 http://kb.icai.org/pdfs/PDFFile5b28d196f0f1d1.64038450.pdf
 http://www.igidr.ac.in/pdf/publication/WP-2010-020.pdf

2.1 Introduction

An Auditor is expected to provide an unbiased and professional opinion on the work of audit.
An auditor who lacks independence virtually renders their accompanying auditor report useless
to those who rely on them since the opinion is biased.

For example, consider Mr. X a potential investor in ABC Company. If Mr. X know that the auditor
for ABC Company keeps a close, personal relationship with the CEO of the company, how much
would Mr. X trust that the audited work is a fair representation of the company’s financial
standing? How can Mr. X be certain that the auditor and CEO did not collude to issue a biased
(favorable for company ) audit report?

The auditor therefore shall comply with relevant ethical requirements, including those
pertaining to independence, relating to financial statement audit engagements. Relevant
ethical requirements ordinarily comprise the Code of Ethics for Professional Accountants (IESBA
Code) related to an audit of financial statements.

The fact is that auditors who lack independence compromise the integrity of financial
markets and the reliability of information. Investors would not be willing to extend capital to
companies, knowing that the audited information was performed by an auditor who is not
independent. Furthermore, banks would not be willing to issue a loan for fear that the auditor
might’ve provided a biased audit report.

2.2 Meaning of Independence

The essential characteristic for an auditor is: Professional integrity and independence.
Independence implies that the judgement of a person is not subordinate to the wishes or
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direction of another person who might have engaged him which means his decision is not
affected because of other person.
It is not possible to define “independence” precisely. Rules of professional conduct dealing with
independence are framed primarily with a certain objective. The rules themselves cannot create
or ensure the existence of independence. Independenceis a condition of mind as well as
personal character. It should not be confused with the superficial and visible standards of
independence which are sometimes imposed by law.
There are two interlinked perspectives of independence of auditors, one, independence of mind;
and two, independence in appearance.
The Code of Ethics for Professional Accountants issued by International Federation of
Accountants (IFAC) defines the term ‘Independence’ as follows:

“Independence is:

(a) Independence of mind – the state of mind that permits the provision of an opinion without
being affected by influences allowing an individual to act with integrity, and exercise objectivity
and professional skepticism; and
(b) Independence in appearance – the avoidance of facts and circumstancesthat are so
significant that a third party would reasonably conclude an auditor’s integrity, objectivity or
professional skepticism had been compromised.”
Independence of the auditor has not only to exist in fact, but also appear toso exist to all
reasonable persons.
For Example: Mr. A and Mr. B are partners in a CA Firm. During the financial year 2020-21, Mr. A
was appointed as auditors of XYZ Limited. The brother of Mr. A was involved in the
management of XYZ Limited. Mr. A being aware of the whole situation, did not accept the
appointment as auditors of XYZ Limited as it would act as a threat (familiarity threat) and affect
independence of auditors
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Independence

Independence Independece
of Mind in appearance

The objective of an audit of financial statements is to enable an auditor to expressan opinion

on such financial statements. The auditor’s opinion helps determination of the true and fair view
of the financial position and operating results of an enterprise. The user should not assume
that the auditor’s opinion is an assuranceas to the future viability of the enterprise or the
efficiency or effectiveness with which management has conducted the affairs of the enterprise.
The auditor should be straightforward, honest and sincere in his approach to his professional
work. He must be fair and must not allow prejudice or bias to override his objectivity. He should
maintain an impartial attitude and both be and appear to be free of any interest which might be
regarded as being incompatible with integrity and objectivity.

Many different circumstances, or combination of circumstances, may be relevant and

accordingly it is impossible to define every situation that creates threats to independence and
specify the appropriate mitigating action that should be taken.In addition, the nature of
assurance engagements may differ and consequentlydifferent threats may exist requiring the
application of different safeguards.

2.3 Threats to Independence

The Code of Ethics for Professional Accountants, prepared by the International

Federation of Accountants (IFAC) identifies five types of threats. These are:

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Threat

Self Interest Self Review Advocacy Familiarity Intimidation

Threat Threat Threat Threat Threat

1. Self-interest threats

It occur when an auditing firm, its partner or associate could benefit from a financial interest
in an audit client. Examples include (i) direct financial interest or materially significant indirect
financial interest in a client, (ii) loan or guarantee to or from the concerned client, (iii) undue
dependence on a client’s fees and, hence, concerns about losing the engagement, (iv) close
business relationship with an audit client, (v) potential employment with the client, and (vi)
contingent fees for the audit engagement. Like, in case an audit firm unduly relies on fees
from aclient, it may result in threat to self interest of auditor and he may not work objectively
for the fear of losing client.

2. Self-review threats

This occur when during a review of any judgement or conclusion reached in a previous audit
or non-audit engagement (Non audit services include any professional services provided to an
entity by an auditor, other than audit or review of the financial statements. These include
management services, internal audit, investment advisory service, design and implementation
of information technology systems etc.), or when a memberof the audit team was previously
a director or senior employee of the client. Instances where such threats come into play are (i)
when an auditor having recently been a director or senior officer of the company, and (ii)
when auditors perform services that are themselves subject matters of audit.
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3. Advocacy threats
It occur when the auditor promotes, or is perceived to promote, a client’s opinion to a point
where people may believe that objectivity is getting compromised, e.g. when an auditor deals
with shares or securities of the audited company, or becomes the client’s advocate in litigation
and third party disputes. In such situations, auditor can be perceived as backing and
championing causes of auditee client and it may lead to belief that auditor is not acting and
working objectively.

4. Familiarity threats
These can be easily found and occur when auditors form relationships with the client where
they end up being too sympathetic to the client’s interests. This can occur in many ways:
(i) close relative of the audit team working in a senior position in the client company,
(ii) former partner of the audit firm being a director or senior employee of the client,
(iii) long association between specific auditors and their specific client counterparts, and
(iv) acceptance of significant gifts or hospitality from the client company, its directors or
employees.
Provisions in Companies Act, 2013 regarding rotation of auditors mainly address these very
familiarity threats. Such provisions prescribe that auditor is rotated after a certain number of
years so that auditors do not become too familiar with their clients.

5. Intimidation threats
It which occur when auditors are deterred from acting objectively with an adequate degree of
professional skepticism. Basically, these could happen because of threat of replacement over
disagreements with the application of accounting principles, or pressure to disproportionately
reduce work in response to reduced audit fees or being threatened with litigation. Such threats
attempt to intimidate auditors to deter them from acting objectively.
 Types of Threat Example Result

A self-interest threat The audit team is The audit team might be

exists if the auditor preparing to conduct its tempted to issue a
holds a direct or indirect 2023 audit for ABC favorable report so that
financial interest in the Company. However, the the company is able to
company or depends on audit team has not secure a loan to settle the
the client for a major fee received its audit fees fees outstanding for their
that is outstanding. from ABC Company for 2022 audit.
its 2022 audit.

A self-review threat The auditor prepares By having the auditor

exists if the auditor is the Financial review his or her own
auditing his own work or statements for ABC work, the auditor cannot
work that is done by Company while also be expected to form an
others in the same firm. serving as the auditor for unbiased opinion on the
ABC Company. financial statements.
The auditor is assisting
An advocacy threat The auditor may issue a
in selling ABC Company
exists if the auditor is favorable report to
while also serving as the
involved in promoting increase the sale price of
auditor for the company.
the client, to the point ABC Company.
where their objectivity is
potentially
compromised.
A familiarity threat ABC Company has been
The auditor may have
exists if the auditor is audited by the same
become too familiar with
too personally close to auditor for over 10 years
the client and, thus, lack
or familiar with and the auditor regularly objectivity in their work.
employees, officers, or plays golf with the CEO
directors of the client and CFO of ABC
company. Company.
An intimidation threat ABC Company is The auditor’s
exists if the auditor is unhappy with the
independence may be
intimidated by conclusion of the audit compromised, as ABC
management or its report and threatens to
Company is their biggest
directors to the point switch auditors next
client and they, quite
that they are deterred year. ABC Company is
naturally, do not want to
from acting objectively. the biggest client of the
lose such a client.
auditor.
 JGI JAIN
DEEM ED-T O-BE UNI VE R SI TY UNIT 2: Code of Ethics and Conduct
Therefore, the auditor may
issue a report that
appeases ABC Company.

2.4 Safeguards to Independence

The Chartered Accountant has a responsibility to remain independent by taking into account the context
in which they practice, the threats to independence and the safeguards available to eliminate the threats.
For the public to have confidence in the quality of audit, it is essential that auditors should always be
and appears to be independent of the entities that they are auditing.
In the case of audit, the key fundamental principles are integrity, objectivity and professional skepticism,
which necessarily require the auditor to be independent.
Before taking on any work, an auditor must conscientiously consider whether it involves threats to his
independence.
When such threats exist, the auditor should either desist from the task or put in place safeguards that
eliminate them.
If the auditor is unable to fully implement credible and adequate safeguards, then he must not accept
the work.

The following are the guiding principles in this regard: -

1. For the public to have confidence in the quality of audit, it is essential that auditors should always be
and appears to be independent of the entities that they are auditing.
2. In the case of audit, the key fundamental principles are integrity, objectivity and professional
skepticism, which necessarily require the auditor to be independent.

3. Before taking on any work, an auditor must conscientiously consider whetherit involves threats to
his independence.

4. When such threats exist, the auditor should either desist from the task or putin place safeguards
that eliminate them.

5. If the auditor is unable to fully implement credible and adequate safeguards, then he must not accept
the work.

2.5 Summary

 The Chartered Accountant should ensure his independence in all assurance services including
concurrent audit, tax audit and internal audit.

 The chartered accountant should make it certain that his independence is not jeopardized.
Where he feels that his independence is jeopardized, he should refrain from accepting the
assignment.

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UNIT 2: Code of Ethics and Conduct JGI JAIN
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 An Auditor is considered to lack independence if the partner of the audit firm deals with shares
and securities of the audited entity.
 The Council feels that there are adequate safeguards provided in the Companies Act, 1956 as
well as in the Chartered Accountants Act, 1949.

 Independence, being a state of the mind, is not necessarily affected by the fact of mere
relationship any more than it should be existence if the relationship did not exist.

 Auditor independence is the ability of a person conducting an audit to do so autonomously and

with integrity.

 Auditors must be able to review material objectively and come up with a neutral, accurate, and
honest report on the outcome of their investigations.

 Independence, shall be maintained during both

a) The engagement period and
b) The period covered by the financial statements

Self-Assessment Questions
A. Essay type questions
1. What is meant by independence of auditor?
2. What are the various threats to the independence of auditor
3. What are the safegaurads against independence?
4. Companies Act provides safegaurad against independence. Illustrate the same.
5. Write a short note on independence of mind.

1.10 POST-UNIT READING MATERIAL

 https://resource.cdn.icai.org/66597bos53774-cp1.pdf
 http://www.lawstreetindia.com/experts/column?sid=528
 UNIT
AUDIT STRATEGY, AUDIT PLANNING
AND AUDIT PROGRAMME

Names of Sub-Units

Audit Strategy, Audit Planning, Audit Program, Development of Audit Plan and
Programme, Control of Quality of Audit Work, Materiality and Audit Plan, Revision of
Materiality, Documenting the materiality, Performance Materiality

Overview

In this unit you will learn what is audit planning, how to create an audit plan, then what is
audit program how to develop one of them and finally the concept of materiality.

Learning Objectives

In this Unit you will learn –

 The meaning of audit plan and program
 The difference between the two
 How to create an overall audit program
 The overall strategy for audit
 Concept of materiality
 Evaluate the importance of materiality

Learning Outcomes
 JGI JAIN
DEEM ED-T O-BE UNI VE R SI TY UNIT 3 : Audit Strategy, Audit Planning and Audit Programme
At the end of this unit, you would:
 Understand the Audit Planning and Overall Audit Strategy for an audit.
 Draft audit programme.
 Understand Audit Planning and Materiality.
 Learn to develop the Audit Plan and Program.
 Gain the knowledge of control of quality of audit work w.r.t delegation and
supervision of audit work

Pre-Unit Preparatory Material

 https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=&ved=
2ahUKEwj2jez30az8AhXjA7cAHcC4D4oQFnoECEEQAQ&url=https%3A%2F%2
Fstatic.careers360.mobi%2Fmedia%2Fuploads%2Ffroala_editor%2Ffiles%2FAu
dit-Strategy%252C-Audit-Planning-and-Audit-
Programme.pdf&usg=AOvVaw3KZRi-1LWSP05VE5cO3mHE
 http://www.oas.org/juridico/PDFs/mesicic4_grd_audit2.pdf

3.1 Introduction

After understanding the basics of auditing it is very important to understand a very

important aspect of audit i.e. audit plan and audit program. Audits evaluate the effectiveness
of an organization’s internal controls. Having an audit program in place helps businesses
maintain an effective system of internal controls, obtain objective insights on operations,
identify risks of fraud and misappropriation of assets, and lastly, ensure compliance with
relevant laws or regulations.

3.2 Audit Planning

(a) Establishing
the overall audit
strategy (a) Developing an
audit plan

Planning an audit involves:

“The auditor should plan his work to enable him to conduct an effective audit in an
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efficient and timely manner. Plans should be based on knowledge of the client’s business”.
Plans should be made to cover, among other things:

a) acquiring knowledge of the client’s accounting systems, policies and internal control
procedures;
b) establishing the expected degree of reliance to be placed on internal control;
c) determining and programming the nature, timing, and extent of the audit
procedures to be performed; and

d) coordinating the work to be performed

3.3 Audit Strategy

3.3.2 What areas are covered under Audit Strategy?

1. The scope of the audit engagement.

2. Reporting objectives.
3. Timing of the audit.
4. The characteristics of the engagement.
5. The nature, timing, and extent of the resources involved in the audit engagement.
6. The engagement budgets.
7. Changes in laws, regulations, and accounting standards.
8. The knowledge gained on other audit engagements.
9. Nature of communications with the management and client.
10. Preliminary engagement activities and the results.
11. Significant factors involved in directing team efforts in the audit engagement.

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3.3.3 Importance of Auditing Strategy

The audit strategy can be highly crucial for various reasons. One of the most critical of these
includes setting the scope of an audit engagement. On top of that, it also establishes the
time frame for the audit. This process is also crucial in determining the resources deployed
and used in the engagement. The timing of the audit also allows audit firms to manage the
personnel involved in the process.
Essentially, an audit strategy allows audit firms to complete audit engagements effectively
and efficiently. It sets the audit approach that auditors follow throughout an audit. On top
of that, it also establishes the documentation requirements for the audit methods. Overall,
the audit strategy minimizes audit risks and allows for a complete approach to handling
audits.

3.4 Audit Plan

3.4.1 Introduction

In almost every branch of economic activity, planning is a compulsory activity. In audit

operations also planning plays a very important role to ensure that the purpose of audit is
achieved. It gives an opportunity to organize different aspects of audit activities.

3.4.2 Meaning

The auditor shall develop an audit plan that shall include a description of

a) The nature, timing and extent of planned risk assessment procedures, as determined
under SA 315 “Identifying and Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment”.

b) The nature, timing and extent of planned further audit procedures at theassertion
level, as determined under SA 330 “The Auditor’s Responses to Assessed Risks”.

c) Other planned audit procedures that are required to be carried out so that the
engagement complies with SAs

3.4.3 Difference between Audit Plan and Strategy

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The audit plan is more detailed than the overall audit strategy that includes the nature,
timing and extent of audit procedures to be performed by engagement team members.
Planning for these audit procedures takes place over the course of the audit as the audit
plan for the engagement develops

3.4.4 Factors to be considered during Audit Planning

1. Size and complexity of the company

2. Commercial environment in which it operated
3. Reporting requirement
4. Method of processing transactions

3.4.5 Audit Plan Sample

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3.5 Audit Program

3.5.1 Introduction

Once the scope of audit is fixed and the auditor has gained knowledge of the business,
accounting, and internal control system, he needs to draw up a plan of action. The plan of
action is called an audit program.

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3.5.2 Meaning

Professor Meigs defines, “An audit program is a detailed plan of the auditing work to be
performed, specifying the procedures to be followed in the verification of each item in the
financial statements and giving the estimated time required.”

An audit program is a set of policies and procedures that dictate how an evaluation
of a business is done.

This generally involves specific instructions on how much the evidence must be collected
and evaluated, who will collect and analyze the data and when this should be done.

3.5.3 Objectives of the Audit Program

The objectives of the audit program are to:

 Determine compliance with company policy and procedures.

 Determine the effectiveness of the policy and procedures.
 Determine the accuracy of reports generated by department personnel.
 Evaluate the adequacy of internal controls.
 Determine compliance with applicable state and federal regulations of the function
under review.
 Search for value-added recommendations that improve the efficiency and
contribution of the function under review.

3.5.4 Benefits of audit program

There are many benefits of having an audit programme in place, including the following

 Improved efficiency and effectiveness of audits- By having a planned and

structured approach, audits can be conducted more efficiently and effectively,
saving time and resources
 Improved quality of audits- Having an audit programme in place can help to ensure
that audits are conducted to a high standard, providing valuable insights and
recommendations.
Greater transparency and accountability- An audit programme can help improve
transparency and accountability within an organisation, as it provides a clear

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JGI JAIN
DEEM ED-T O-BE UNI VE R SI TY UNIT 3 : Audit Strategy, Audit Planning and Audit Programme
framework for conducting audits.
 Reduced risk of errors and fraud- A well-designed audit programme can help to
reduce the danger of mistakes and fraud occurring, as it provides clear guidelines on
how audits should be conducted. This can ultimately help to protect your
organisation’s reputation and bottom line.
Improved decision-making- Organisations that have an effective audit programme
in place are better placed to manage risk, improve performance and make informed
decisions.
Strengthened internal controls– Businesses can achieve their strategic goals and
improve overall performance with the aid of an audit programme. It may also offer
insightful information on areas that want improvement.

3.5.5 Advantages of audit program

 It provides the assistant carrying out the audit with total and clear set of instructions of
the work generally to be done.
 It is essential, particularly for major audits, to provide a total perspective of the work to
be performed.
 Selection of assistants for the jobs on the basis of capability becomes easier
 When the work is rationally planned, defined and segregated.
 Without a written and pre-determined programme, work is necessarily to be carried
out on the basis of some ‘mental’ plan. In such a situation there is always a danger of
ignoring or overlooking certain books and records. Under a properly framed
programme, such danger is significantly less and the audit can proceed systematically.
 The assistants, by putting their signature on programme, accept the responsibility for
the work carried out by them individually and, if necessary, the work done may be
traced back to the assistant.
 The principal can control the progress of the various audits in hand by examination of
audit programmes initiated by the assistants deputed to the jobs for completed work.
 It serves as a guide for audits to be carried out in the succeeding year

3.6 Control of Quality of Audit Work

An audit is a complex task involving number of people at different levels. As we observed in

the preparation and development of audit programme, the auditorwould naturally have to
depend upon number of technical experts as well. During the course of his work, the auditor
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is also likely to use the work performed by other auditors also.

A lot of work is delegated by auditor to his assistants. The auditor should carefully direct,
supervise and review work delegated to assistants. The auditor should obtain reasonable
assurance that work performed by other auditors or experts is adequate for his purpose. SA
220, “Quality Control for an Audit of Financial Statements” lays down standards on the
quality control.

The objective of the auditor is to implement quality control procedures at the engagement
level that provides the auditor with reasonable assurance that:

 The audit complies with regulatory and legal requirements

 The audit report issued is appropriate to the circumstances

3.7 Materiality and Audit Plan

3.7.1 Introduction

The concept of materiality is fundamental to the entire audit process and is applied by the
auditor:
 in determining the nature, timing and extent of risk assessment procedures;
 in identifying and assessing the risks of material misstatement;
 in determining the nature, timing and extent of audit procedures to gather sufficient
appropriate audit evidence;
 in evaluating the effect of identified misstatements on the audit and of uncorrected
misstatements, if any, on the financial statements
 in forming the opinion in the auditor’s report on the financial statements

3.7.2 Meaning

SA 320 “ Materiality in Planning and Performing an Audit” explains materiality:

Misstatements, including omissions, are considered to be material if they, individually or in
the aggregate, could reasonably be expected to influence the economic decisions of users
9
JGI JAIN
DEEM ED-T O-BE UNI VE R SI TY UNIT 3 : Audit Strategy, Audit Planning and Audit Programme

taken on the basis of the financial statements.

Materiality applies not only to amounts in the financial statements, but also to disclosures
that are non-quantitative.

For example, non-disclosure or inadequate disclosure of accounting policy for a material

financial statement area may influence the economic decision of the user of financial
statements.

Materiality is a relative rather than an absolute concept. A misstatement of a given

magnitude might be material for a small company, whereas the error of the same amount
could be immaterial for a large one.
For example, an unadjusted misstatement of Rupees one lakh on account of non-
provisioning for doubtful debtors will result in material misstatement of financial statements
of a company having a turnover of Rupees Ten lakhs and a net profit of Rupees One lakh.
However, the same unadjusted misstatement will be not be material to the financial
statements of a company having a turnover of Rupees thousand crores and a profit of
Rupees fifty crores.

3.7.3 Factors affecting materiality

In determining overall materiality:

The auditor makes judgments in light of the circumstances surrounding the entity and which
are affected by the size and nature of the misstatement, or a combination of both;
Judgments about matters that are material to users of the financial statements are based on
a consideration of the common financial information needs of users as a group, not each
user individually (such as a bank, debenture-holder, or shareholder).

3.8 Revision in Materiality level as the Audit Progresses

Materiality for the financial statements as a whole (and, if applicable, the materiality level or
levels for particular classes of transactions, account balances or disclosures) may need to be
revised as a result of a change in circumstances that occurred during the audit (for example,
a decision to dispose of a major part of the entity’s business), new information, or a change
in the auditor’s understanding of the entity and its operations as a result of performing
further audit procedures.
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 UNIT 3 : Audit Strategy, Audit Planning and Audit Programme JGI JAIN
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If during the audit it appears as though actual financial results are likely to be substantially
different from the anticipated period end financial results that were used initially to
determine materiality for the financial statements as a whole, the auditor revises that
materiality.
3.9 Documenting the Materiality
The audit documentation shall include the following amounts and the factors considered in
their determination:
 Materiality for the financial statements as a whole;
 If applicable, the materiality level or levels for particular classes of transactions, account
balances or disclosures;
 Performance materiality; and
 Any revision of (a)-(c) as the audit progressed

3.10 Performance Materiality

Performance materiality means the amount or amounts set by the auditor at less than
materiality for the financial statements as a whole to reduce to an appropriately low level
the probability that the aggregate of uncorrected and undetected misstatements exceeds
materiality for the financial statements as a whole.
If applicable, performance materiality also refers to the amount or amounts set by the
auditor at less than the materiality level or levels for particular classes of transactions,
account balances or disclosures. Performance materiality recognizes the fact that
errors/omissions detected in a particular area may not breach the overall materiality level
but when all the errors/omissions in all the areas is combined or added together, the overall
materiality could be breached.

3.11 Summary

 After establishment of the overall audit strategy, an audit plan can be developedto
address the various matters identified in the overall audit strategy, taking into account the
need to achieve the audit objectives through the efficient use of the auditor’s resources.
 Audit planning is a very important step in audit
 Planning is not a discrete phase of an audit, but rather a continual and iterative process
that often begins shortly after (or in connection with) the completion of the previous
1
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 JGI JAIN
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audit and continues until the completion of the current audit engagement.

 The auditor shall document (a) the overall audit strategy;(b) the audit plan; and (c)any
significant changes made during the audit engagement to the overall audit strategy or the
audit plan, and the reasons for such changes.

 AN AUDIT PROGRAMME is a detailed plan and consists of a series of verification

procedures to be applied to the financial statements and accounts of a given company for
the purpose of obtaining sufficient evidence to enable the auditor toexpress an informed
opinion on such statements. For framing an audit programmethe following points should
be kept in view

 SA 320 on “Materiality in Planning and Performing an Audit” requires that an auditor

should consider materiality and its relationship with audit risk while conducting an audit.
 The auditor’s preliminary assessment of materiality related to specific account balances
andclasses of transactions helps the auditordecide such questions as what items to
examine and whether to use sampling
Self-Assessment Questions

Essay type

1. Discuss the importance of audit planning to ensure the correctness of financial

statements.

2. “Once the overall audit strategy has been established, an audit plan can be developed
to address the various matters identified in the overall audit strategy”. Explain.

3. ”The nature, timing and extent of the direction and supervision of engagement team
members and review of their work vary depending on many factors.” Explain.

4. “The utility of the audit programme can be retained and enhanced only by keeping the
programme and also the client’s operations and internal control under periodic review so
that inadequacies or redundancies of the programme may be removed’. Discuss stating
clearly the advantages of anaudit programme.

5. “Determining materiality involves the exercise of professional judgment”. Discuss

stating the factors that may affect the identification of an appropriate benchmark. Also give
example.

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3.12 POST-UNIT READING MATERIAL

 https://case.edu/auditservices/audit-plan-proces
 https://us.aicpa.org/content/dam/aicpa/research/standards/auditattest/downl
oadabledocuments/au-c-00300.pdf

1
3
 UNIT

AUDIT DOCUMENTATION AND AUDIT

EVIDENCE

Names of Sub-Units
Concepts of Audit Documentation, Nature and Purpose of Audit Documentation, Forms,
Content and Extent of Audit Documentation, Ownership and Custody of Audit
Documentation, Audit Procedure for obtaining Audit Evidence- Sources of Evidences,
Relevance and Reliability of Audit Evidences, Sufficient appropriate audit evidence,
Evaluation of Audit Evidence, Written representation as Audit Evidence

Overview
In this unit you will learn what is audit documentation, what is the importance of audit
documentation, what all is included in documentation and who is the owner of such
papers. Next we will learn about how the evidences are collected, what are the various
sources of evidences and how one can ensure reliability and relevance of evidence. Last
we will learn about the written representation and its importance.

Learning Objectives
In this Unit you will learn –
 Understand the concepts of audit documentation, nature and purpose of audit
documentation, Form, content and extent of audit documentation, audit
documentation summary, audit file, assembly of the final audit file, ownershipof audit
documentation, nature of related party relationships and transactions.
JGI JAIN
DEEM ED-T O-BE UNI VE R SI TY UNIT 4: Audit Documentation and Audit Evidence

 Gain the knowledge of written representations and the objectives of the auditor
regarding written representation.
 Identify Audit Evidence—Specific Considerations for Selected Items, External
confirmation.

Learning Outcomes

At the end of this unit, you would:

 Learn the audit documentation, its purpose and how it is prepared
 Evaluate the audit evidences and which sources are reliable
 The importance of written representation

Pre-Unit Preparatory Material

 https://resource.cdn.icai.org/66599bos53774-cp3.pdf
 https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=&ved=2ahUK
Ewitvv_KkMH8AhXgyXMBHa1QAksQFnoECCYQAQ&url=https%3A%2F%2Fcag.gov.in
%2Fuploads%2Fmedia%2F1210-AUDIT-DOCUMENTATION-12-10-2021-
20211020143124.ppt&usg=AOvVaw2iJx6-z20egUwQ3glVd9di

Table of Topics
4.1 Introduction
4.2 Meaning of Audit Documentation
4.3 Nature of Audit Documentation
4.4 Purpose of Audit Documentation
4.5 Forms, Content and Extent of Audit Documentation
4.6 Ownership and Custody of Audit Documentation
4.7 Audit Procedure for obtaining Audit Evidence- Sources of Evidences
4.8 Relevance and Reliability of Audit Evidences
4.9 Sufficient appropriate audit evidence- Evaluation of audit evidence
4.10 Written representation as Audit Evidence

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4.1 Introduction

SA 230 on “Audit Documentation”, deals with the auditor’s responsibility to prepare audit
documentation for an audit of financial statements. It is to be adapted as necessary in the
circumstances when applied to audits of other historical financial information
Audit documentation is an essential element to ensure that the audit’s quality is of the
prescribe standards. Although documentation alone does not guarantee audit quality, the
process of preparing sufficient and appropriate documentation contributes to the quality
of an audit.

4.2 Meaning of Audit Documentation

Audit documentation refers to the record of audit procedures performed, relevant audit
evidence obtained, and conclusions the auditor reached (terms such as working papers
or workpapers are also sometimes used).
Examples of Audit Documentation

Confirmations from the company, Correspondence, Audit Programs and letters of

representation

4.3 Nature of Audit documentation

Audit documentation provides:

(a) evidence of the auditor’s basis for a conclusion about the achievement of the overall
objectives of the auditor; and
(b) evidence that the audit was planned and performed in accordance with SAs and
applicable legal and regulatory requirements.

4.4 Purpose of Audit Documentation

The following are the purpose of Audit documentation:

 Assisting the engagement team to plan and perform the audit.
 Assisting members of the engagement team to direct and supervise the audit work,
and to discharge their review responsibilities.
 Enabling the engagement team to be accountable for its work.
 Retaining a record of matters of continuing significance to future audits.

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DEEM ED-T O-BE UNI VE R SI TY UNIT 4: Audit Documentation and Audit Evidence

 Enabling the conduct of quality control reviews and inspections in accordance with
SQC 1.
 Enabling the conduct of external inspections in accordance with applicable legal,
regulatory or other requirements

4.5 Form, Content and Extent of audit Documentation

The auditor shall prepare audit documentation that is sufficient to enable an experienced
auditor, having no previous connection with the audit, to understand:

a) The nature, timing and extent of the audit procedures performed.

b) The results of the audit procedures performed and the audit evidence obtained and
c) Significant matters arising during the audit and the conclusions reached thereon and
significant professional judgements made in reaching those conclusions.

The form, content and extent of audit documentation depend on factors such as:
 The size and complexity of the entity.
 The nature of the audit procedures to be performed.
 The identified risks of material misstatement.
 The significance of the audit evidence obtained.
 The nature and extent of exceptions identified
 The need to document a conclusion or the basis for a conclusion not readily
determinable from the documentation of the work performed or audit evidence
obtained.
 The audit methodology and tools used.

4.6 Ownership and Custody of Audit Documentation

Unless otherwise specified by law or regulation, audit documentation is the property of

the auditor.

He may at his discretion, make portions of, or extracts from, audit documentation
available to clients, provided such disclosure does not undermine the validity of the work
performed, or, in the case of assurance engagements, the independence of the auditor or
of his personnel.

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4.7 Audit Procedures for Obtaining Audit Evidence – Sources of Evidences

Introduction
Auditing evidence is the information collected for review of a company's financial
transactions, internal control practices, and other items necessary for the certification
of financial statements by an auditor or certified public accountant (CPA). The amount
and type of auditing evidence considered vary considerably based on the type of firm
being audited as well as the required scope of the audit.

Audit evidence to draw reasonable conclusions on which to base the auditor’sopinion is

obtained by performing:
a) Risk assessment procedures; and
b) Further audit procedures, which comprise:
 Test of controls, when required by the SAs or when the auditor haschosen
to do so; and
 Substantive procedures, including tests of details and substantiveanalytical
procedures

Audit procedures to obtain audit evidence can include:

a) Inspection
b) Observation
c) External Confirmation
d) Recalculation
e) Reperformance
f) Analytical Procedures
g) Inquiry

1. Inspection of documents and records - Inspection involves examining records or

documents, whether internal or external, in paper form, electronic form, or other media,
or a physical examination of an asset. Inspection of records and documents provides audit
evidence of varying degrees of reliability, depending on their nature and source and, in
the case of internal records and documents, on the effectiveness of the controls over their
production

2. Observation - It Involves looking at a process or procedure. It may provide evidence that

a control is being operated, e.g. double staffing or a cheque signatory.

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You need to remember that this is only evidence that the control was operating properly
at the time of the observation, and the auditor's presence may have had an influence on
the client's staff's behaviour.

3. Confirmation - This refers to the auditor obtaining a direct response (usually written)
from an external, third party. Examples include:
 confirmation of bank balances in a bank letter;
 confirmation of actual/potential penalties from legal advisers; and
 confirmation of inventories held by third parties.

4. Recalculation - This involves checking the arithmetical accuracy of the client's

calculations, e.g. depreciation amounts.

5. Re-performance - This involves reperforming client procedures, e.g. test checking

inventory counts.

6. Analytical procedures - Analytical procedures are substantive tests

Analytical procedures are used to identify trends and understand relationships between
sets of data. This in itself will not detect misstatement but will identify possible sources.
As such, analytical procedures cannot be used in isolation and should be coupled with
other, corroborative, forms of testing, such as enquiry of management.
In order to perform a thorough analytical review auditors do not simply look at current
figures in comparison to last year. Auditors may consider other points of comparison,
such as budgets and industry data. Other techniques are also available, including:
ratio analysis;
trend analysis; and
proof in total, for example: an auditor might create an expectation of payroll costs for the
year by taking last year's cost and inflating for pay rises and changes in staff numbers.

7. Enquiry - Whilst a major source of evidence, the results of enquiries will usually need to
be corroborated in some way through other audit procedures. This is because responses
generated by the audit client are considered to be of a low quality due to their inherent
bias.
The answers to enquiries may themselves be corroborative evidence. In particular, they
may be used to corroborate the results of analytical procedures.
Management representations are part of overall enquiries. These involve obtaining

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written responses from management to confirm oral enquiries. These are considered
further in chapter on completion and review.

4.8 Relevance and Reliability of Audit Evidence

While audit evidence is primarily obtained from audit procedures performed during the
course of the audit, it may also include information obtained from other sources.

Relevance
To be relevant audit evidence has to address the objective/purpose of a procedure.
Relevance deals with the logical connection with, or bearing upon, the purpose ofthe
audit procedure and, where appropriate, the assertion under consideration. The
relevance of information to be used as audit evidence may be affected by the direction
of testing
For example:
Attendance at an inventory count provides us with a good example of the relevance of
procedures. During counting the auditor considers the relationship between inventory
records and physical inventories, as follows:
identifying items of physical inventory and tracing them to inventory records to confirm
the completeness of accounting records; and
identifying items on the inventory record and tracing them to physical inventories to
confirm the existence of inventory assets.
Whilst the procedures are perhaps similar in nature their purpose (and relevance) is to
test different assertions regarding inventory balances.

Reliability
Auditors should always attempt to obtain evidence from the most trustworthy and
dependable source possible. Evidence is considered more reliable when it is:
 obtained from an independent external source;
 generated internally but subject to effective control;
 obtained directly by the auditor;
 in documentary form; and
 in original form.
Broadly speaking, the more reliable the evidence the less of it the auditor will need.
However, the converse is not necessarily true: if evidence is unreliable it will never be
appropriate for the audit, no matter how much is gathered

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4.9 Sufficient appropriate Audit Evidence – Evaluation of Audit Evidence

"The objective of the auditor is to design and perform audit procedures in such a way to
enable the auditor to obtain sufficient appropriate audit evidence to be able to
draw reasonable conclusions on which to base the auditor's opinion.' Sufficiency relates
to the quantity of evidence. Appropriateness relates to the quality and reliability of
evidence.

Sufficient evidence
There needs to be enough' evidence to support the auditor's conclusion. What is enough
at the end of the day is a matter of professional judgement. However, when determining
whether they have enough evidence on file the auditor must consider:
 the risk of material misstatement;
 the materiality of the item;
 the nature of accounting and internal control systems;
 the auditor's knowledge and experience of the business;
 the results of controls tests;
 the size of a population being tested;
 the size of the sample selected to test; and
 the reliability of the evidence obtained.
Consider, for example, the audit of a bank balance:
Auditors will confirm year-end bank balances directly with the bank. This is a good
source of evidence but on its own is not sufficient to give assurance regarding the
completeness and final valuation of bank and cash amounts. The key reason is timing
differences. The client may have received cash amounts or cheques before the end of the
year, or may have paid out cheques before the end of the year, that have not yet cleared
the bank account. For this reason, the auditor should also perform a bank reconciliation.
In combination these two pieces of evidence will be sufficient to give assurance over the
bank balances.

Appropriateness is the measure of the quality of audit evidence; that is, its relevance
and its reliability in providing support for the conclusions on which the auditor’s opinion
is based. The reliability of evidence is influenced by its source and by its nature, and is
dependent on the individual circumstances under which it is obtained.
SA 330, “The Auditor’s Responses to Assessed Risks” requires the auditor to conclude

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whether sufficient appropriate audit evidence has been obtained. Whether sufficient
appropriate audit evidence has been obtained to reduce audit risk to an acceptably low
level, and thereby enable the auditor to draw reasonable conclusions on which to base
the auditor’s opinion, is a matter of professional judgement. SA 200 contains discussion
of such matters as the nature of audit procedures, the timeliness of financial reporting,
and the balance between benefit and cost, which are relevant factors when the auditor
exercises professional judgement regarding whether sufficient appropriate audit
evidence has been obtained.

4.10 Written Representation as an Evidence

Written representations may be defined as a written statement by management

provided to the auditor to confirm certain matters or to support other audit
evidence. Written representations in this context do not include financial
statements, the assertions therein, or supporting books and records.

Audit evidence is all the information used by the auditor in arriving at the conclusions
on which the audit opinion is based. Written representations are necessary information
that the auditor requires in connection with the audit of the entity’s financial statements.
Accordingly, similar to responses to inquiries, written representations are audit evidence.

Written representations are requested from those responsible for the preparation and
presentation of the financial statements. Although written representations provide
necessary audit evidence, they do notprovide sufficient appropriate audit evidence on
their own about any of the matters with which they deal. Furthermore, the fact that
management has provided reliable written representations does not affect the nature or
extent of other audit evidence that the auditor obtains about the fulfillment of
management’s responsibilities, or about specific assertions.

Summary

 Audit documentation (SA 230) refers to the record of audit procedures performed,
relevant audit evidence obtained, and conclusions the auditor reached. Audit
documentation provides evidence of the auditor’s basis for a conclusion and evidence
that the audit was planned and performed in accordance with SAs. Audit file refers to
one or more folders or other storage media containing the records that comprise the

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audit documentation for a specific engagement.

 The auditor shall assemble the audit documentation in an audit file and complete the
administrative process of assembling the final audit file on a timely basis after the date
of the auditor’s report
Audit evidence may be defined as the information used by the auditor in arriving at
https://slideplayer.com/slide/12877387/
the conclusions on which the auditor’s opinion is based
https://www.investopedia.com/terms/a/auditing-evidence.asp
 Reasonable assurance is obtained when the auditor has obtained sufficient appropriate
audit evidence to reduce audit risk to an acceptably low level.
 Sufficiency is the measureof the quantity of audit evidence. Appropriateness is the
measure of the quality of audit evidence.
 The reliability of information to be used as audit evidence, and therefore of the audit
evidence itself, is influenced by its source and its nature, and the circumstances under
which it is obtained, including the controls over its preparation and maintenance where
relevant.
 External confirmation may be defined as an audit evidence obtained as a direct written
response to the auditor from a third party (the confirming party), in paper form, or by
electronic or other medium.

Self-Assessment Questions
A. Essay type
a. “Audit documentation summary may facilitate effective and efficient
reviews and inspections of the audit documentation, particularly for large and complex
audits”. Explain.
b. “Although written representations provide necessary audit evidence yet they do not
provide sufficient appropriate audit evidence on their own about any of the matters with
which they deal”. Discuss
c. What is audit Documentation? Explain with the help of an example.
d. “There are various sources from where the audit evidences may be obtained” Explain
e. Write a note on the written representation as an audit evidence.

4.11 POST-UNIT READING MATERIAL

 https://slideplayer.com/slide/12877387/
 https://www.investopedia.com/terms/a/auditing-evidence.asp

10
 UNIT

RISK ASSESSMENT AND INTERNAL

CONTROL

Names of Sub-Units
Audit Risk, Identifying and Assessing the Risk of Material Misstatement, Risk Assessment
Procedures- Understanding the entity and its environment, Internal Control, Documenting the
Risks- Evaluation of Internal Control System, Testing of Internal Control system, Internal Control
and IT Environment.

Overview
In this unit you will how an auditor identifies and evaluates risk while auditing and what is
the procedure for risk assessment. Also, what is internal control, how to test internal control
along with the procedure. Overall learning of how an auditor assess risk , practice internal
control and tests control.

Learning Objectives
In this Unit you will learn –
 Understand the concepts of risk assessment, Identifying and Assessing the Risk of
Material Misstatement, Risk assessment procedures, Understanding the entity and its
environment
 Internal Control and IT Environment, Gain the knowledge of Internal Control
Documenting the Risk, Evaluation of Internal Control systemand Testing of Internal
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 And understand how Internal Control and IT Environment

Learning Outcomes

At the end of this unit, you would:

 Learn the risk assessment while auditing, its purpose and procedures of the same.
 Evaluate Internal control
 The relation of Internal Control and IT Environment

Pre-Unit Preparatory Material

 https://static.careers360.mobi/media/uploads/froala_editor/files/Risk-Assessment-and-
Internal-Control.pdf
 https://reciprocity.com/blog/risk-assessment-and-internal-controls/

Table of Topics
5.1 Introduction
5.2 Audit Risk
5.3 Identifying and Assessing the Risk of Material Misstatement
5.4 Risk assessment procedures
5.5 Understanding the entity and its environment
5.6 Internal Control
5.6.1 Meaning
5.6.2 Objective of Internal Control
5.7 Documenting the Risk
5.8 Evaluation of Internal Control system
5.9 Testing of Internal Control
5.10 Internal Control and IT Environment
5.11 Summary

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5.1 Introduction

It is very important for the auditor that before performing the audit, he understands and
check completely for the various audit risk involved in the process and how strong is the
internal control system. Checking these aspects helps auditor to understand the extent, time
and nature of audit and ensure that audit is performed to the best.

5.2 Audit Risk

Meaning - Audit risk means the risk that the auditor gives an inappropriate audit opinion
when the financial statement is materially misstated. Thus, it is the risk that the auditor may
fail to express an appropriate opinion in an audit assignment.

Audit risk is a function of the risks of material misstatement and detection risk.

Audit Risk

Risk of Material
Detection Risk
Mis-statement

Inherent Risk

Control Risk

From the above, it is clear that –

Audit Risk = Risk of Material Misstatement x Detection Risk

Risk of material misstatement may be defined as the risk that the financial statements are
materially misstated prior to audit. This consists of two components, described as follows at
the assertion level:

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(a) Inherent risk—The susceptibility of an assertion about a class of transaction, account

balance or disclosure to a misstatement that could be material, either individually or when
aggregated with other misstatements, before consideration of any related controls.

(b) Control risk—The risk that a misstatement that could occur in an assertion about a class
of transaction, account balance or disclosure and that could be material, either individually
or when aggregated with other misstatements, will not be prevented, or detected and
corrected, on a timely basis by the entity’s internal control.

The auditor should maintain the high level of the assurance/confidence while expressing the
audit opinion, and this is the most important steps in the audit planning to ensure that the
audit team will gather competent, relevant and reasonable audit evidence at minimum cost.

There is an inverse relationship between materiality and the level of audit risk that is, the
higher the materiality level, the lower the audit risk and vice versa. Auditor should take note
of the inverse relationship between materiality and audit risk when determining the nature,
timing and extent of audit procedure.

Detection risk: The risk that the procedures performed by the auditor to reduce audit risk
to an acceptably low level will not detect a misstatement that exists andthat could be
material, either individually or when aggregated with othermisstatements.

Suppose auditor of a company uses certain audit procedures for the purpose of obtaining
audit evidence and reducing audit risk, but still there will remain a risk that audit
procedures used by the auditor may not be able to detect a misstatementwhich by
nature is material, then that risk is known as Detection Risk.

5.3 Identifying and Assessing the Risk of Material Misstatement

Before discussing how auditors should assess the risk of material misstatement, it is
important to consider what is meant by 'misstatement'.

Misstatement refers to a difference between the amount, classification, presentation, or

disclosure of a reported financial statement item and the amount, classification,
presentation, or disclosure that is required for the item to be in accordance with the
applicable financial reporting framework. Misstatements can arise from error or fraud.

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Misstatements can arise from fraud or error.' In other words, a misstatement arises where
there is a difference between the reported figures, and what is expected to be reported in
order for the financial statements to be fairly presented (or show a true and fair view).
Misstatements can be factual, in the case of a clear breach of a requirement of a financial
reporting standard, or could be judgmental, arising from unsuitable estimation techniques
or the selection of inappropriate accounting policies.

(i) The auditor shall identify and assess the risks of material misstatement at:
 the financial statement level
 the assertion level for classes of transactions, account balances, and disclosures to
provide a basis for designing and performing further audit procedures

(ii) For the purpose of Identifying and assessing the risks of material misstatement, the
auditor shall:
 Identify risks throughout the process of obtaining an understanding of the entity and
its environment, including relevant controls that relate to the risks, and by considering
the classes of transactions, account balances, and disclosures in the financial
statements;
 Assess the identified risks, and evaluate whether they relate more pervasively to the
financial statements as a whole and potentially affect many assertions;
 Relate the identified risks to what can go wrong at the assertion level, taking account
of relevant controls that the auditor intends to test; and
 Consider the likelihood of misstatement, including the possibility of multiple
misstatements, and whether the potential misstatement is of a magnitude that could
result in a material misstatement.

5.4 Risk Assessment Procedures

The auditor shall perform risk assessment procedures to provide a basis for the identification
and assessment of risks of material misstatement at both, the financial statement levels and
assertion levels. Risk assessment procedures by themselves, however, do not provide
sufficient appropriate audit evidence which would be the base for audit opinion. Following
is included in Risk assessment procedures:

1. Collection of Information/ Records of Auditee - Before going for the audit planning,
it is necessary for an auditor to have thorough understanding of the auditee entity and its

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operations, which helps in designing an efficient and effective audit approach so that the
audit resources are focused on the areas of greatest risk and audit methods which meet
audit objectives at minimum cost are adopted in obtaining competent, relevant and
reasonable evidence to support the audit judgment and conclusions.

The audit team should:

1. Familiarize itself with-

 The operations and organisation of the auditee entity
 The financial statement
 The regulatory framework
 The general legal framework governing the entity operations

a) Understand the accounting processes and the degree of the technology involvement
b) Access the overall control environment and in particular the control to prevent
irregularity, illegality and fraud;
c) Perform preliminary analytical procedures
d) Analyze the financial statement in to account areas.

2. Preparation of Audit Checklist - The audit checklist assists auditors in conducting a

thorough, systematic and consistent audit.

The checklists are used to guide and help the auditor to assess whether evidence meets
audit criteria. It is important to remember that checklists are used to guide the auditors and
do not rigidly dictate exactly what is to be audited as in various event the auditor need to
check beyond the checklist and the compliance requirement is different according to the
nature and business of the company.

Accordingly, the audit checklists support the audit process in identification of the various
compliance requirements and have their own benefits for the performance of the audit.
Though for all organization a uniform checklist can be considered but same need to be
customized as per the organization and the scope of the audit.

The benefits of the audit checklists are as under:

 Promote planning for the audit.
 Ensure a consistent audit approach.

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 Act as a sampling plan and time manager.

 Serve as a memory aid.
 Provide a repository for notes collected during the audit process

3. Inquiries of Management and Others Within the Entity - Much of the information
obtained by the auditor’s inquiries is obtained from management and those responsible for
financial reporting. However, the auditor may also obtain information, or a different
perspective in identifying risks of material misstatement, through inquiries of others within
the entity and other employees with different levels of authority

Example
 Inquiries directed towards those charged with governance may help the auditor
understand the environment in which the financial statements are prepared.
 Inquiries directed toward internal audit personnel may provide information about
internal audit procedures performed during the year relating to the design and
effectiveness of the entity’s internal control and whether management has satisfactorily
responded to findings from those procedures.
 Inquiries of employees involved in initiating, processing or recording complex or unusual
transactions may help the auditor to evaluate the appropriateness of the selection and
application of certain accounting policies.
 Inquiries directed toward in-house legal counsel may provide information about such
matters as litigation, compliance with laws and regulations, knowledge of fraud or
suspected fraud affecting the entity, warranties, post-sales obligations, arrangements
(such as joint ventures) with business partners and the meaning of contract terms.

4. Analytical Procedures - Analytical procedures performed as risk assessment procedures

may identify aspects of the entity of which the auditor was unaware and may assist in
assessing the risks of material misstatement in order to provide a basis for designing and
implementing responses to the assessed risks. Analytical procedures performed as risk
assessment procedures may include both financial and non-financial information, for
example, the relationship between sales and square footage of selling space or volume of
goods sold.

Analytical procedures may help identify the existence of unusual transactions or events, and
amounts, ratios, and trends that might indicate matters that have audit implications. Unusual

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or unexpected relationships that are identified may assist the auditor in identifying risks of
material misstatement, especially risks of material misstatement due to fraud.

However, when such analytical procedures use data aggregated at a high level (which may
be the situation with analytical procedures performed as risk assessment procedures), the
results of those analytical procedures only provide a broad initial indication about whether
a material misstatement may exist. Accordingly, in such cases, consideration of other
information that has been gathered when identifying the risks of material misstatement
together with the results of such analytical procedures may assist the auditor in
understanding and evaluating the results of the analytical procedures.

5. Observation and Inspection - Observation and inspection may support inquiries of

management and others, and may also provide information about the entity and its
environment.

5.5 Understanding the Entity and its Environment

Obtaining an understanding of the entity and its environment, including the entity’s internal
control (referred to hereafter as an “understanding of the entity”), is a continuous, dynamic
process of gathering, updating and analysing information throughout the audit. The
understanding establishes a frame of reference within which the auditor plans the audit and
exercises professional judgment throughout theaudit, for example, when:

 Assessing risks of material misstatement of the financial statements;

 Determining materiality in accordance with SA320;
 Considering the appropriateness of the selection and application of accounting
policies;
 Identifying areas where special audit consideration may be necessary, for example,
related party transactions, the appropriateness of management’s use of the going
concern assumption, or considering the business purpose of transactions;
 Developing expectations for use when performing analytical procedures;
 Evaluating the sufficiency and appropriateness of audit evidence obtained, such as the
appropriateness of assumptions and of management’s oral and written
representations.

ILLUSTRATION The auditor of ABC Textiles Ltd chalks out an audit plan without

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understanding the entity’s business. Since he has carried out many audits of textile
companies, there is no need to understand the nature of business of ABC Ltd. Advise the
auditor how he should proceed.

SOLUTION Obtaining an understanding of the entity and its environment, including the
entity’s internal control (referred to hereafter as an “understanding of the entity”), is a
continuous, dynamic process of gathering, updating and analysing information

The Required Understanding of the Entity and Its Environment,

The auditor shall obtain an understanding of the following:

a. Relevant industry, regulatory, and other external factors including the applicable financial
reporting framework.

b. The nature of the entity, including:

 its operations;
 its ownership and governance structures;
 the types of investments that the entity is making and plans to make, including
investments in special-purpose entities; and
 the way that the entity is structured and how it is financed; to enable the auditor to
understand the classes of transactions, account balances, and disclosures to be
expected in the financial statements.

(c) The entity’s selection and application of accounting policies, including the reasons for
changes thereto. The auditor shall evaluate whether the entity’s accounting policies are
appropriate for its business and consistent with the applicable financial reporting framework
and accounting policies used in the relevant industry.

(d) The entity’s objectives and strategies, and those related business risks that may result in
risks of material misstatement.

(e) The measurement and review of the entity’s financial performance.

ILLUSTRATION - Prince Blankets is engaged in business of blankets. Its major portion of

sales is taking place through internet. Advise the auditor how he would proceed in this

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regard as to understanding the entity and its environment.

SOLUTION - While understanding entity and its environment, internet sales is being
perceived as risky area by the auditor and thereby would be spending substantial time and
extensive audit procedures on this particular area.

5.6 Internal Control

5.6.1 Meaning

Internal control is a process, effected by an entity’s board of directors, management and

other personnel, designed to provide reasonable assurance:

 That information is reliable, accurate and timely

 Of compliance with applicable laws, regulations, contracts, policies and procedures
 Of the reliability of financial reporting

Internal controls are intended to prevent errors and irregularities, identify problems and
ensure that corrective action is taken. In many cases, process owners within your department
perform controls and interact with the control structure on a daily basis, sometimes without
even realizing it because controls are built into operations.

Control definition reflects certain fundamental concepts:

 Internal control is a process. It is a means to an end, not an end in itself.

 Internal control is effected by people. It is not merely policy manuals and forms, but also
people at every level of an organization.
 Internal control can be expected to provide only reasonable, not absolute, assurance to
an entity’s management and board.

Internal controls are established to further strengthen:

 The reliability and integrity of information

 Compliance with policies, plans, procedures, laws and regulations
 The safeguarding of assets
 The economical and efficient use of resources

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 The accomplishment of established objectives and goals for operations or programs

5.6.2 Objectives of Internal Control

a) transactions are executed in accordance with managements general or specific

authorization;
b) all transactions are promptly recorded in the correct amount in the appropriate accounts
and in the accounting period in which executed so as to permit preparation of financial
information within a framework of recognized accounting policies and practices and
relevant statutory requirements, if any, and to maintain accountability for assets;
c) assets are safeguarded from unauthorized access, use or disposition; and
d) the recorded assets are compared with the existing assets at reasonable intervals and
appropriate action is taken with regard to any differences

ILLUSTRATION - Auditor AR and Associates, appointed for audit of XYZ Ltd, a

manufacturing company engaged in manufacturing of various food items. While planning
an audit, the auditor does not think that it would be necessary to understand internal
controls. Advise the auditor in this regard.

SOLUTION - The auditor shall obtain an understanding of internal control relevant to the
audit. Although most controls relevant to the audit are likely to relate to financial reporting,
not all controls that relate to financial reporting are relevant to the audit. It is a matter of the
auditor’s professional judgment whether a control, individually or in combination with
others, is relevant to the audit.

5.7 Documenting the Risk

Risk statements are typically documented in a standard format that contains the risk context,
conditions, and consequences of occurrence. The risk context provides additional
information about the risk such as the relative time frame of the risk, the circumstances or
conditions surrounding the risk that has brought about the concern, and any doubt or
uncertainty.

The risks identified during the risk identification are typically documented in a risk register
that, includes (at this stage):

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 Risk description;
 How and why the risk can happen (i.e. Causes and consequences); and
 The existing internal controls that may reduce the likelihood or consequences of the risks.
 It is essential when identifying a risk to consider the following three elements:
 Description/event - an occurrence or a particular set of circumstances;
 Causes - the factors that may contribute to a risk occurring or increase;
 The likelihood of a risk occurring; and
 Consequences - the outcome(s) or impact(s) of an event. It is the combination of these
elements that make up a risk and this level of detail will enable an Institution to better
understand its risks.

5.8 Evaluation of Internal Control System

In addition to documenting identified risks, it is also necessary to document the risk

identification process to help guide future risk identification exercises and to ensure good
practices are maintained by drawing on lessons learned through previous exercises.

Documentation of this step should include:

 the approach or method used for identifying risks;

 the scope covered by the identification; and
 the participants in the risk identification and the information sources consulted.

Experience has shown that management often disregards well controlled risks when
documenting the risk profile of the Institution. It is stressed that a well-controlled risk must
still be recorded in the risk profile of the Institution. The reason for this logic is that the
processes for identifying risks should ignore at that point any mitigating factors.

5.9 Testing of Internal Control

Test of controls include tests of elements of the control environment where strengths in the
control environment are used by auditors to reduce control risk.

Some of the procedures performed to obtain the understanding of the accounting and
internal control systems may not have been specifically planned as tests of control but may
provide audit evidence about the effectiveness of the design and operation of internal

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controls relevant to certain assertions and, consequently, serve as tests of control. For
example, in obtaining the understanding of the accounting and internal control systems
pertaining to cash, the auditor may have obtained audit evidence about the effectiveness of
the bank reconciliation process through inquiry and observation.

When the auditor concludes that procedures performed to obtain the understanding of the
accounting and internal control systems also provide audit evidence about the suitability of
design and operating effectiveness of policies and procedures relevant to a particular
financial statement assertion, the auditor may use that audit evidence, provided it is
sufficient to support a control risk assessment at less than a high level.

While obtaining audit evidence about the effective operation of internal controls, the auditor
considers how they were applied, the consistency with which they were applied during the
period and by whom they were applied.

The concept of effective operation recognises that some deviations may have occurred.
Deviations from prescribed controls may be caused by such factors as changes in key
personnel, significant seasonal fluctuations in volume of transactions and human error.

When deviations are detected the auditor makes specific inquiries regarding these matters,
particularly, the timing of staff changes in key internal control functions. The auditor then
ensures that the tests of control appropriately cover such a period of change or fluctuation.
Based on the results of the tests of control, the auditor should evaluate whether the internal
controls are designed and operating as contemplated in the preliminary assessment of
control risk.

The evaluation of deviations may result in the auditor concluding that the assessed level of
control risk needs to be revised. In such cases, the auditor would modify the nature, timing
and extent of planned substantive procedures. Before the conclusion of the audit, based on
the results of substantive procedures and other audit evidence obtained by the auditor, the
auditor should consider whether the assessment of control risk is confirmed. In case of
deviations from the prescribed accounting and internal control systems, the auditor would
make specific inquiries to consider their implications.

Where, on the basis of such inquiries, the auditor concludes that the deviations are such that
the preliminary assessment of control risk is not supported, he would amend the same unless

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the audit evidence obtained from other tests of control supports that assessment.

Where the auditor concludes that the assessed level of control risk needs to be revised, he
would modify the nature, timing and extent of his planned substantive procedures. It has
been suggested that actual operation of the internal control should be tested by the
application of procedural tests and examination in depth. Procedural tests simply mean
testing of the compliance with the procedures laid down by the management in respect of
initiation, authorization, recording and documentation of transaction at each stage through
which it flows.

An auditor testing the internal controls on sales should invariably test whether any of the
aforesaid procedures have been omitted. If credit has actually been granted without a
reference to the credit section to know the creditworthiness of the party, it is possible that
the amount may prove bad because of the financial crisis or deadlock in the management
of the party, a fact which could have been easily gathered from the credit section. Similarly,
if an order is received without a reference to the inventory section, it is likely due to non-
availability of the inventory on the stipulated date; execution of the order may be delayed
and the company may have to compensate the buyer for the damages suffered by him.

Test of controls may include:

 Inspection of documents supporting transactions and other events to gain audit evidence
that internal controls have operated properly, for example, verifying that a transaction has
been authorized.
 Inquiries about, and observation of, internal controls which leave no audit trail, for
example, determining who actually performs each function and not merely who is
supposed to perform it.
 Re-performance involves the auditor’s independent execution of procedures or controls
that were originally performed as part of the entity’s internal control, for example,
reconciliation of bank accounts, to ensure they were correctly performed by the entity.
 Testing of internal control operating on specific computerized applications or over the
overall information technology function, for example, access or program change controls.

5.10 Internal Control and IT Environment

Characteristics of Manual and Automated Elements of Internal Control Relevant to the

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Auditor’s Risk Assessment: An entity’s system of internal control contains manual elements
and often contains automated elements.

The characteristics of manual or automated elements relevant to the auditor’s risk

assessment and further audit procedures are explained hereunder-

(i) Controls in Manual and IT System: The use of manual or automated elements in internal
control affects the manner in which transactions are initiated, recorded, processed, and
reported:

 Controls in a manual system may include such procedures as approvals and reviews of
transactions, and reconciliations and follow-up of reconciling items. Alternatively, an
entity may use automated procedures to initiate, record, process, and report
transactions, in which case records in electronic format replace paper documents.

 Controls in IT systems consist of a combination of automated controls (for example,

controls embedded in computer programs) and manual controls. Further, manual
controls may be independent of IT, may use information produced by IT, or may be
limited to monitoring the effective functioning of IT and of automated controls, and to
handling exceptions.

(ii) Use of IT: An entity’s mix of manual and automated elements in internal control varies
with the nature and complexity of the entity’s use of IT.

(iii) Generally, IT benefits an entity’s internal control by enabling an entity to:

 Consistently apply predefined business rules and perform complex calculations in

processing large volumes of transactions or data;
 Enhance the timeliness, availability, and accuracy of information;
 Facilitate the additional analysis of information;
 Enhance the ability to monitor the performance of the entity’s activities and its policies
and procedures;
 Reduce the risk that controls will be circumvented; and
 Enhance the ability to achieve effective segregation of duties by implementing security
controls in applications, databases, and operating systems

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(iv) IT also poses specific risks to an entity’s internal control, including, for example:

 Reliance on systems or programs that are inaccurately processing data, processing

inaccurate data, or both.
 Unauthorized access to data that may result in destruction of data or improper changes
to data, including the recording of unauthorized or non- existent transactions, or
inaccurate recording of transactions. Particular risks may arise where multiple users
access a common database.
 The possibility of IT personnel gaining access privileges beyond those necessary to
perform their assigned duties thereby breaking down segregation of duties.
 Unauthorized changes to data in master files.
 Unauthorized changes to systems or programs.
 Failure to make necessary changes to systems or programs.
 Inappropriate manual intervention.
 Potential loss of data or inability to access data as required.

(v) Suitability: Manual elements in internal control may be more suitable where judgment
and discretion are required.

(vi) Reliability: Manual elements in internal control may be less reliable than automated
elements because they can be more easily bypassed, ignored, or overridden and they are
also more prone to simple errors and mistakes. Consistency of application of a manual
control element cannot therefore be assumed.

(vii) Nature of Entity’s Information System: The extent and nature of the risks to internal
control vary depending on the nature and characteristics of the entity’s information system.
The entity responds to the risks arising from the use of IT or from use of manual elements
in internal control by establishing effective controls in light of the characteristics of the
entity’s information system.

Summary

A risk assessment can help you identify which critical processes might be susceptible to
errors and create quantitatively and qualitatively significant risks for your company. It can
help you determine what impacts the company might sustain if such errors occurred and
help you focus on the ones that matter most to your business strategy and operations.

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Self-Assessment Questions
A. Essay type

1. Test of controls include tests of elements of the control environment where strengths
in the control environment are used by auditors to reduce control risk.

2. There is direct relationship between materiality and the degree of audit risk.

3. Risk of material misstatement may be defined as the risk that the financial statements
are materially misstated prior to audit.

4. ELABORATE - Evaluation of Internal Control system

5. Before going for the audit planning, it is necessary for an auditor to have thorough
understanding of the auditee entity and its operations, which helps in designing an
efficient and effective audit approach

5.11 POST-UNIT READING MATERIAL

 https://www2.deloitte.com/content/dam/Deloitte/us/Documents/audit/internal-
controls-and-risk-assessments-pov1.pdf
 https://www.in.gov/sboa/files/Hofherr_Internal-Controls-and-Risk-Assessment.pdf

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18
 UNIT

FRAUD AND RESPONSIBILITIES OF THE

AUDITOR IN THIS REGARD

Names of Sub-Units
Responsibility for prevention and detection of fraud, Fraud Risk Factors, Risks of Material
Misstatement due to Fraud, Communication of Fraud

Overview
In this unit you will how an auditor identifies and evaluates fraud while auditing and what
is the procedure for identifying fraud risk factors. Also, what is risk of material misstatement
due to fraud and finally how fraud is communicated.

Learning Objectives
In this Unit you will learn –
 Understand the types of errors and frauds.
 Understand reasons behind management/ employees
 Determine fraud risk factors and circumstances relating to possibility of fraud.
 How is fraud communicated

Learning Outcomes

At the end of this unit, you would:

JGI JAIN
DEEM ED-T O-BE UNI VE R SI TY UNIT 6: Fraud and responsibilities of the Auditor in the Regard

 Analyze the duty of an auditor regarding detection of fraud and error.

 Understand responsibility of an auditor in case of withdrawal from the engagement
if encounter any circumstances that bring into question his ability to continue due to
fraud.

Pre-Unit Preparatory Material

 https://resource.cdn.icai.org/66601bos53774-cp5.pdf

Table of Topics
6.1 Introduction - Fraud
6.2 Types of Fraud
6.3 Responsibilities for the Prevention and detection of Fraud
6.4 Fraud Risk Factors
6.5 Risk of Material Misstatement Due to Fraud
6.6 Communication of Fraud
6.7 Summary

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6.1 Introduction - Fraud

The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements” defines

the term ‘fraud’ as-

“an intentional act by one or more individuals among management, those charged with
governance, employees, or third parties, involving the use of deception to obtain an unjust
or illegal advantage”.

The auditor is concerned with fraud that causes a material misstatement in the financial
statements.

Two types of intentional misstatements are relevant to the auditor–

 Misstatements resulting from fraudulent financial reporting and

 Misstatements resulting from misappropriation of assets.

Although the auditor may suspect or, in rare cases, identify the occurrence of fraud, the
auditor does not make legal determinations of whether fraud has actually occurred.

6.2 Types of Fraud

Fraud against a company can be committed either internally by employees, managers,

officers, or owners of the company, or externally by customers, vendors, and other parties.
Accordingly, the fraud consists of some deceitful practice or willful device, resorted to with
intent to deprive another of his right, or in some manner to do him an injury.

1. The Financial & Accounting Fraud - It include the fraud relating to the financial
statement by overstating revenue, earnings and assets – along with understating liabilities
(or just plain concealing them) are the most common activities found with this type of fraud.
The asset misappropriation is also a most susceptible fraud in the companies which are
closely held. Further the tampering, accounts receivable skimming, fake billing schemes,
payroll schemes, fake or duplicate expense reimbursement schemes and inventory schemes
are also the part of the financial and accounting fraud. Also, the misuse of company assets
is one of the problematic and serious kinds of fraud, as the unauthorized use of company
assets, significant open up the company to liability. Also, under the growing technology and

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easy exchange of information and technology, the chances of the theft of intellectual
property and trade secrets are increased and such fraud damage the position of the
company in the market and its Research activities.

2. Non-Financial Fraud

This fraud includes the false or misleading information, inadequate disclosure produced by
the companies to the public or regulatory bodies, false reporting of governance norms and
doing business surpassing the regulatory requirement and approvals from the shareholders

6.3 Responsibilities for the Prevention and Detection of Fraud

“The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements”, the

primary responsibility for the prevention and detection of fraud rests with both those
charged with governance of the entity and management of the entity. It is important that
management, with the oversight of those charged with governance, place a strong emphasis
on fraud prevention, which may reduce opportunities for fraud to take place, and fraud
deterrence, which could persuade individuals not to commit fraud because of the likelihood
of detection and punishment. This involves a commitment to creating a culture of honesty
and ethical behavior which can be reinforced by an active oversight by those charged with
governance.

Broadly, the general principles laid down in the SA may be noted as under:

 An auditor conducting an audit is responsible for obtaining reasonable assurance that the
financial statements taken as a whole are free from material misstatement, whether caused
by fraud or error.

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 The risk of not detecting a material misstatement resulting from fraud is higher than the
risk of not detecting one resulting from error. This is because, fraud may involve
sophisticated and carefully organized schemes designed to conceal it.
 Furthermore, the risk of the auditor not detecting a material misstatement resulting from
management fraud is greater than for employee fraud, because management is frequently
in a position to directly or indirectly manipulate accounting records, present fraudulent
financial information or override control procedures designed to prevent similar frauds by
other employees.
 When obtaining reasonable assurance, the auditor is responsible for maintaining an
attitude of professional skepticism throughout the audit, considering the potential for
management override of controls and recognizing the fact that audit procedures that are
effective for detecting error may not be effective in detecting fraud. The requirements in
this SA are designed to assist the auditor in identifying and assessing the risks of material
misstatement due to fraud and in designing procedures to detect such misstatement.

CASE STUDY

While auditing ABC Ltd., the auditor was told by Mr. Mahesh, the CEO of the company, that
he would be responsible for the fraud & errors, if any, occurring in the books of accounts of
the company.

Auditor’s Responsibilities for Detection of Fraud and Error: As per SA 240 “The Auditor’s
Responsibilities relating to fraud in an audit of Financial Statements”, an auditor conducting
an audit in accordance with SAs is responsible for obtaining reasonable assurance that the
financial statements taken as a whole are free from material misstatement, whether caused
by fraud or error.

Owing to the inherent limitations of an audit, there is an unavoidable risk that some material
misstatements of the financial statements will not be detected, even though the audit is
properly planned and performed in accordance with the SAs.

When obtaining reasonable assurance, the auditor is responsible for maintaining an attitude
of professional skepticism throughout the audit, considering the potential for management
override of controls and recognizing the fact that audit procedures that are effective for
detecting error may not be effective in detecting fraud.

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An auditor conducting an audit in accordance with SAs is responsible for obtaining

reasonable assurance that the financial statements taken as a whole are free from material
misstatement, whether caused by fraud or error.

The auditor also has the responsibility to communicate the misstatement to the appropriate
level of management on a timely basis and consider the need to report to it to those charged
with governance. He may also obtain legal advice before reporting on the financial
information or before withdrawing from the engagement. The auditor should satisfy himself
that the effect of fraud is properly reflected in the financial information or the error is
corrected in case the modified procedures performed by the auditor confirms the existence
of the fraud.

The auditor should also consider the implications of the frauds and errors, and frame his
report appropriately. In case of a fraud, the same should be disclosed in the financial
statement. If adequate disclosure is not made, there should be a suitable disclosure in his
audit report.

6.4 Fraud Risk Factors

Fraud Risk Factors may be defined as events or conditions that indicate an incentive or
pressure to commit fraud or provide an opportunity to commit fraud.

Examples of Fraud Risk Factors: The fraud risk factors identified here are examples of such
factors that may be faced by auditors in a broad range of situations. Separately presented
are examples relating to the two types of fraud relevant to the auditor’s consideration, i.e.,

(A) Fraudulent financial reporting, and

(B) Misappropriation of assets.

For each of these types of fraud, the risk factors are further classified based on the three
conditions generally present when material misstatements due to fraud occur:

 incentives/pressures,
 opportunities, and
 attitudes/rationalizations.

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Although the risk factors cover a broad range of situations, they are only examples and,
accordingly, the auditor may identify additional or different risk factors. Not all of these
examples are relevant in all circumstances, and some may be of greater or lesser significance
in entities of different size or with different ownership characteristics or circumstances. Also,
the order of the examples of risk factors provided is not intended to reflect their relative
importance or frequency of occurrence.

(A) Risk Factors Relating to Misstatements Arising from Fraudulent Financial

Reporting: The following are examples of risk factors relating to misstatements arising from
fraudulent financial reporting-

Incentives/Pressures: Financial stability or profitability is threatened by economic, industry,

or entity operating conditions, such as (or as indicated by):

 High degree of competition or market saturation, accompanied by declining margins.

 High vulnerability to rapid changes, such as changes in technology, product
obsolescence, or interest rates.
 Significant declines in customer demand and increasing business failures in either the
industry or overall economy.
 Operating losses making the threat of bankruptcy, foreclosure, or hostile takeover
imminent.
 Recurring negative cash flows from operations or an inability to generate cash flows
from operations while reporting earnings and earnings growth.
 New accounting, statutory, or regulatory requirements.

Opportunities: The nature of the industry or the entity’s operations provides opportunities
to engage in fraudulent financial reporting that can arise from the following:

 Significant related-party transactions not in the ordinary course of business or with

related entities not audited or audited by another firm.
 A strong financial presence or ability to dominate a certain industry sector that allows
the entity to dictate terms or conditions to suppliers or customers that may result in
inappropriate or non-arm’s-length transactions.
 Assets, liabilities, revenues, or expenses based on significant estimates that involve
subjective judgments or uncertainties that are difficult to corroborate.
 Significant, unusual, or highly complex transactions, especially those close to period
end that pose difficult “substance over form” questions.

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Attitudes/Rationalizations: Communication, implementation, support, or enforcement of

the entity’s values or ethical standards by management, or the communication of
inappropriate values or ethical standards, that are not effective.

 Known history of violations of securities laws or other laws and regulations.

 Excessive interest by management in maintaining or increasing the entity’s inventory
price or earnings trend.
 Management failing to remedy known significant deficiencies in internal control on a
timely basis.
 An interest by management in employing inappropriate means to minimize reported
earnings for tax-motivated reasons.
 The owner-manager makes no distinction between personal and business transactions.
 The relationship between management and the current or predecessor auditor is
strained, as exhibited by the following:

Frequent disputes with the current or predecessor auditor on accounting, auditing, or

reporting matters.

Unreasonable demands on the auditor, such as unrealistic time constraints regarding the
completion of the audit or the issuance of the auditor’s report.

Restrictions on the auditor that inappropriately limit access to people or information or the
ability to communicate effectively with those charged with governance.

Domineering management behavior in dealing with the auditor, especially involving

attempts to influence the scope of the auditor’s work or the selection or continuance of
personnel assigned to or consulted on the audit engagement.

(B) Risk factors from misappropriation of Assets: Risk factors that relate to misstatements
arising from misappropriation of assets are also classified according to the three conditions
generally present when fraud exists: incentives/ pressures, opportunities, and attitudes/
rationalization. Some of the risk factors related to misstatements arising from fraudulent
financial reporting also may be present when misstatements arising from misappropriation
of assets occur.

The following are examples of risk factors related to misstatements arising from
misappropriation of assets-

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Incentives/Pressures: Personal financial obligations may create pressure on management

or employees with access to cash or other assets susceptible to theft to misappropriate those
assets.

Adverse relationships between the entity and employees with access to cash or other assets
susceptible to theft may motivate those employees to misappropriate those assets. For
example, adverse relationships may be created by the following:

 Known or anticipated future employee layoffs.

 Recent or anticipated changes to employee compensation or benefit plans.
 Promotions, compensation, or other rewards inconsistent with expectations.

Opportunities: Certain characteristics or circumstances may increase the susceptibility of

assets to misappropriation. For example, opportunities to misappropriate assets increase
when there are the following:

 Large amounts of cash on hand or processed.

 Inventory items that are small in size, of high value, or in high demand.
 Easily convertible assets, such as bearer bonds, diamonds, or computer chips.
 Fixed assets which are small in size, marketable, or lacking observable identification of
ownership.

Inadequate internal control over assets may increase the susceptibility of misappropriation
of those assets. For example, misappropriation of assets may occur because there is the
following:

 Inadequate segregation of duties or independent checks.

 Inadequate oversight of senior management expenditures, such as travel and other
reimbursements.
 Inadequate record keeping with respect to assets.
 Inadequate system of authorization and approval of transactions (for example, in
purchasing).
 Inadequate physical safeguards over cash, investments, inventory, or fixed assets.
 Lack of complete and timely reconciliations of assets.
 Lack of timely and appropriate documentation of transactions, for example, credits for
merchandise returns.
 Lack of mandatory vacations for employees performing key control functions.

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 Inadequate management understanding of information technology, which

 enables information technology employees to perpetrate a misappropriation.
 Inadequate access controls over automated records, including controls over and review
of computer systems event logs.

Attitudes/Rationalizations: Disregard for the need for monitoring or reducing risks related
to misappropriations of assets.

 Disregard for internal control over misappropriation of assets by overriding existing

controls or by failing to take appropriate remedial action on known deficiencies in
internal control.
 Behavior indicating displeasure or dissatisfaction with the entity or its treatment of the
employee.
 Changes in behavior or lifestyle that may indicate assets have been misappropriated
 Tolernce of petty theft.

6.5 Risk of Material Misstatement Due to fraud

The risk of material misstatement is the risk that the financial statements of an
organization have been misstated to a material degree. This risk is assessed by auditors
at the two levels noted below. When the risk of material misstatement is high, the level
of detection risk is lowered (increases the amount of evidence obtained from substantive
procedures). Doing so reduces the overall audit risk.

A. Risk of Material Misstatement at the Assertion Level

This risk is further subdivided into inherent risk and control risk. Inherent risk is the
susceptibility of an assertion to misstatement because of error or fraud, before
considering controls. Control risk is the risk of misstatement that will not be prevented
or detected by a reporting entity's internal controls.

B. Risk of Material Misstatement at the Financial Statement Level

This risk relates to the financial statements as a whole. This risk is more likely when there
is a possibility of fraud.
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The following are potential pervasive risks for employee benefit plan audits at the financial
statement level:

 Lack of oversight and monitoring of plan operations and service providers

 Lack of financial reporting expertise
 Lack of communication about plan events between the preparer of the financial
statements and others in the plan sponsor organization, such as treasury, finance, and
human resources
 Lack of segregation of duties and safeguarding assets
 Changes in service providers
 Changes in human resource information system or payroll system
 Changes in plan personnel
 Lack of Employee Retirement Income Security Act of 1974 (ERISA) counsel involvement
 Decision to terminate or curtail the plan
 Plan amendments
 Sale of plan sponsor
 Financial difficulty of the plan sponsor or contributing employers
 Plan transfers (plan mergers, spin-offs, or other transfers)

6.6 Communication of Fraud

Reporting of fraud is governed by Companies Act, 2013 and it provides for a standard
procedure to be dealt with while a fraud is reported by the auditor. Fraud reporting is done
to Central Government or to management depending upon the amount involved. If the
amount is less than Rs. 1 cr than it is only reported to management, if it exceeds Rs. 1 cr
then the fraud is to be reported to the Central Government as well.

1. Reporting to the Central Government: As per sub-section (12) of section 143 of

the Companies Act, 2013, if an auditor of a company in the course of the performance of
his duties as auditor, has reason to believe that an offence of fraud involving such amount
or amounts as may be prescribed, is being or has been committed in the company by
its officers or employees, the auditor shall report the matter to the Central Government
within such time and in such manner as may be prescribed.

In this regard, Rule 13 of the Companies (Audit and Auditors) Rules, 2014 has been
prescribed. Sub-rule (1) of the said rule states that if an auditor of a company, inthe
course of the performance of his duties as statutory auditor, has reason to believe that an

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offence of fraud, which involves or is expected to involve individually an amount of Rs. 1

crore or above, is being or has been committed against the company by its officers or
employees, the auditor shall report the matter to the Central Government.

The manner of reporting the matter to the Central Government is as follows:

 the auditor shall report the matter to the Board or the Audit Committee, as the case may
be, immediately but not later than 2 days of his knowledge of the fraud, seeking their
reply or observations within 45 days;

 on receipt of such reply or observations, the auditor shall forward his report and the
reply or observations of the Board or the Audit Committee along with his comments (on
such reply or observations of the Board or the Audit Committee) to the Central
Government within 15 days from the date of receipt of such reply or observations;

 in case the auditor fails to get any reply or observations from the Board or the Audit
Committee within the stipulated period of 45 days, he shall forward his report to the
Central Government along with a note containing the details of his report that was
earlier forwarded to the Board or the Audit Committee for which he has not received
any reply or observations;

 the report shall be sent to the Secretary, Ministry of Corporate Affairs in a sealed cover
by Registered Post with Acknowledgement Due or by Speed Post followed by an e-mail
in confirmation of the same;

 the report shall be on the letter-head of the auditor containing postal address, e-mail
address and contact telephone number or mobile number and be signed by the auditor
with his seal and shall indicate his Membership Number; and

 the report shall be in the form of a statement as specified in Form ADT-4.

2. Reporting to the Audit Committee or Board: Sub-section (12) of section 143 of the
Companies Act, 2013 further prescribes that in case of a fraud involving lesser than the
specified amount [i.e. less than ` 1 crore], the auditor shall reportthe matter to the audit
committee constituted under section 177 or to the Board in other cases within such time
and in such manner as may be prescribed.

In this regard, sub-rule (3) of Rule 13 of the Companies (Audit and Auditors) Rules, 2014
states that in case of a fraud involving lesser than the amount specified insub- rule (1)
[i.e. less than Rs. 1 crore], the auditor shall report the matter to Audit Committee

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constituted under section 177 or to the Board immediately but not later than 2 days of his
knowledge of the fraud and he shall report the matter specifying the following:

 Nature of Fraud with description;

 Approximate amount involved; and

 Parties involved.

3. Disclosure in the Board’s Report: Sub-section (12) of section 143 of the Companies
Act, 2013 furthermore prescribes that the companies, whose auditorshave reported frauds
under this sub-section (12) to the audit committee or the Board, but not reported to the
Central Government, shall disclose the details about such frauds in the Board’s report in
such manner as may be prescribed.

In this regard, sub-rule (4) of Rule 13 of the Companies (Audit and Auditors) Rules, 2014
states that the auditor is also required to disclose in the Board’s Report the following
details of each of the fraud reported to the Audit Committee or the Board under sub- rule
(3) during the year:

 Nature of Fraud with description;

 Approximate Amount involved;

 Parties involved, if remedial action not taken; and

 Remedial actions taken.

Summary

 SA 240 “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial

Statements” defines the term ‘fraud’ as “an intentional act by one or more individuals
among management, those charged with governance, employees, or third parties,
involving the use of deception to obtain an unjust or illegal advantage”.
 Two types of intentional misstatements are relevant to the auditor–misstatements
resulting from fraudulent financial reporting and misstatements resulting from
misappropriation of assets.
 Misstatements in the financial statements can arise from either fraud or error.
 The distinguishing factor between fraud and error is whether the underlying action that
results in the misstatement of the financial statements is intentional or unintentional.

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 Fraud, whether fraudulent financial reporting or misappropriation of assets, involves

incentive or pressure to commit fraud, a perceived opportunity to do so and some
rationalization of the act.
 Fraudulent financial reporting involves intentional misstatements including omissions of
amounts or disclosures in financial statements to deceive financial statement users.
 Misappropriation of Assets involves the theft of an entity’s assets and is often perpetrated
by employees in relatively small and immaterial amounts.
 Fraud is to be reported appropriately by the auditor based on the amount involved.

Self-Assessment Questions
Essay type

1. During the Statutory Audit of a Public Limited Company , XYZ Ltd. its auditor, Mr. Bajaj
, the engagement partner of Bajaj Chopra & Associates , encounters some exceptional
circumstances that bring into question his ability to continue performing the audit while
suspecting a fraud arising from material misstatements. Explain the steps to be taken in such
a case.
2. Enlist the instances which induce Management/Employees to commit fraud
3. You notice a misstatement resulting from fraud or suspected fraud during the audit
and conclude that it is not possible to continue the performance of audit. As statutory
Auditor, how would you deal?
4. Fraud Risk Factors are the events or conditions that indicate an incentive or pressure to
commit fraud or provide an opportunity to commit fraud.

6.7 POST-UNIT READING MATERIAL

 https://www.techtarget.com/searchsecurity/definition/fraud-detection
 https://scholar.google.co.in/scholar?q=audit+fraud+detection+ppt&hl=en&as_sdt=0&a
s_vis=1&oi=scholart

14
 UNIT

AUDIT SAMPLING AND ANALYTICAL

PROCEDURES

Names of Sub-Units
Meaning of Audit Sampling - Designing an Audit Sample - Types of Sampling; Sample
Size and Selection of Items for Testing; Sample Selection Method - Meaning, Nature,
Purpose and Timing of Analytical Procedures; Substantive Analytical Procedures,
Designing and Performing Analytical Procedures prior to Audit; Investigating the Results
of Analytical Procedures

Overview
In this unit you will how an auditor identifies samplings and evaluates analytical procedures
while auditing and what is the procedure for the same. Overall learning of how an auditor
assess samples , and follow analytical procedures

Learning Objectives
In this Unit you will learn –
 Define Audit Sampling as per Standards and it importance.
 Identify the Approaches to Audit Sampling and Sample Selection Methods.
 Understand the sampling techniques and how/when to apply them to audit
procedures.
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DEEM ED-T O-BE UNI VE R SI TY UNIT 7: Audit Sampling and Analytical Procedures

Learning Outcomes

At the end of this unit, you would:

 Define Audit Sampling as per Standards on Auditing 530 and it importance.
 Understand the Approaches to Audit Sampling and Sample Selection Methods.
 Evaluate how sampling is done

Pre-Unit Preparatory Material

 https://resource.cdn.icai.org/66603bos53774-cp7.pdf
 https://resource.cdn.icai.org/66604bos53774-cp8.pdf

Table of Topics
7.1 Introduction
7.2 Meaning of Audit Sample
7. 3 Designing of Audit Samples
7.4 Types of Sampling
7.5 Sample Size and Selection of items for testing
7.6 Sample Selection Method
7.7 Meaning, Purpose and Timing of Analytical Procedures
7.8 Substantive Analytical Procedures, Designing and Performing Analytical Procedures
prior to Audit
7.9 Summary

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7.1 Introduction

To ensure auditing is carried out effective it is very important for the auditor to choose the
samples to be checked properly and hence he needs complete knowledge on how samples
are to be selected.

7.2 Meaning of Auditing Sample

Audit sampling”, ‘audit sampling’ refers to the application of audit procedures to less than
100% of items within a population of audit relevance such that all sampling units have a
chance of selection in order to provide the auditor with a reasonable basis on which to
draw conclusions about the entire population.

The objective of the auditor when using audit sampling is to provide a reasonable basis for
the auditor to draw conclusions about the population from which the sample is selected.

The auditor should select sample items in such a way that the sample can be expected to
be representative of the population. This requires that all items in the population have an
opportunity of being selected.

7.3 Designing of Audit Samples

While planning for designing an audit sample, the auditor shall consider various factors
such as: the purpose of the audit procedures and the characteristics of the population
from which the sample will be drawn.

The auditor shall determine a sample size sufficient to reduce sampling risk to an acceptably
low level. The auditor shall select items for the sample in such a way that each sampling
unit in the population has a chance of selection.

When designing an audit sample, auditor shall consider:

 The specific purpose to be achieved and the combination of audit procedures that is
likely to best achieve that purpose.
 Consideration of the nature of the audit evidence sought and possible deviation or
misstatement conditions or other characteristics relating to that audit evidence will assist

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the auditor in defining what constitutes a deviation or misstatement and what population
to use for sampling.
 Whether the requirement of SA 500 Audit Evidence, is achieved or not.
 The auditor’s consideration of the purpose of the audit procedure includes a clear
understanding of what constitutes a deviation or misstatement so that all, and only, those
conditions that are relevant to the purpose of the audit procedure are included in the
evaluation of deviations or projection of misstatements.

Therefore, it may not be appropriate to consider this a misstatement in evaluating the

sample results of this particular audit procedure, even though it may have an important
effect on other areas of the audit, such as the assessment of the risk of fraud or the
adequacy of the allowance for doubtful accounts.

7.4 Types of Sampling

There are two types of auditing sample:

1. Statistical audit sampling

Statistical sampling is an approach where random selection of sample units is done;

and the use of probability theory to evaluate sample results,including measurement of
sampling risk characteristics.

It involves a sampling approach where the auditor utilizes statistical methods such as
random sampling to select items to be verified. Random sampling is used when there are
many items or transactions on record.

For example, with statistical sampling, ten items are selected from the total population
randomly. Every single item within the 100 has an equal probability of being selected and
tested for accuracy as a result. Again, it benefits auditors since they can still make an
audit opinion but do not have to check all 100 transactions.

2. Non-statistical audit sampling

In contrast to statistical audit sampling, non-statistical audit sampling items are not
chosen randomly. Instead, they are chosen based on the auditor’s judgment, and the
result of the testing from the selections is not used to infer the conclusion for the entire
population.
In the example earlier, ten inventory transactions can be used to infer the opinion on all

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100 transactions. In non-statistical audit sampling, the auditors may choose to select
items based on criteria such as:
The value of items (e.g., items greater than $100,000)
Items with specific information (e.g., items related to a certain company)

7.5 Sample Size and Selection of Items for Testing

The level of sampling risk that the auditor is willing to accept affects the sample size
required. The lower the risk the auditor is willing to accept, the greater the sample size will
need to be.

The sample size can be determined by the application of a statistically-based formula or

through the exercise of professional judgment. There are various factors typically have on
the determination of sample size. When circumstances are similar, the effect on sample size
of factors will be similar regardless of whether a statistical or non- statistical approach is
chosen.

The auditor may consider the following factors in order to determine the sample size:

 Sampling Risk: As already discussed the lower the auditor is willing to take audit risk the
more sample size needs to be selected.
 Tolerable error: It is the maximum error the auditor is willing to accept in the population,
the less the Tolerable error the more the sample needs to be selected.
 Expected Error: If the auditor expects risk to be high then more samples needs to be
checked.

When there is an increase in the extent to which the auditor’s risk assessment takes into
account relevant controls. The more assurance the auditor intends to obtain from the
operating effectiveness of controls, the lower the auditor’s assessment of the risk of material
misstatement will be, and the larger the sample size will need to be. When the auditor’s
assessment of the risk of material misstatement at the assertion level includes an
expectation of the operating effectiveness of controls, the auditor is required to perform
tests of controls. Other things being equal, the greater the reliance the auditor places on
the operating effectiveness of controls in the risk assessment, the greater is the extent of
the auditor’s tests of controls (and therefore, the sample size is increased). Thus, sample
size will increase.

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 If there is an increase in the tolerable rate of deviation. Then sample size will decrease, as
lower the tolerable rate of deviation, larger the sample size needs to be.
 When there is an increase in the expected rate of deviation of the population to be tested
then sample size will increase, as higher the expected rate of deviation, larger the sample
size needs to be so that the auditor is in a position to make a reasonable estimate of the
actual rate of deviation. Factors relevant to the auditor’s consideration of the expected rate
of deviation include the auditor’s understanding of the business (in particular, risk
assessment procedures undertaken to obtain an understanding of internal control),
changes in personnel or in internal control, the results of audit procedures applied in prior
periods and the results of other audit procedures. High expected control deviation rates
ordinarily warrant little, if any, reduction of the assessed risk of material misstatement.
 An increase in the auditor’s desired level of assurance that the tolerable rate of deviation
is not exceeded by the actual rate of deviation in the population will increase the sample
size. Thus, the greater the level of assurance that the auditor desires that the results of the
sample are in fact indicative of the actual incidence of deviation in the population, the
larger the sample size needs to be.
 In case of large populations, the actual size of the population has little, if any, effect on
sample size. For small populations however, audit sampling may not be as efficient as
alternative means of obtaining sufficient appropriate audit evidence. Therefore, there will
be negligible effect on sample size due to increase in the number of sampling units in the
population
 With statistical sampling, sample items are selected in a way that each sampling unit has a
known probability of being selected. With non-statistical sampling, judgment is used to
select sample items. Because the purpose of sampling is to provide a reasonable basis for
the auditor to draw conclusions about the population from which the sample is selected,
it is important that the auditor selects a representative sample, so that bias is avoided, by
choosing sample items which have characteristics typical of the population.
 The principal methods of selecting samples are the use of random selection, systematic
selection and haphazard selection.

7.6 Sample Selection Method

Sample should be selected in such a manner that it is representative of the population from
which the sample is being selected. It will necessitate that each item in the population has
an equal chance of being included in the sample.

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Some of the important methods of selecting the sample are discussed below -

(1) Random Sampling: Random selection ensures that all items in the population or within
each stratum have a known chance of selection. It may involve use of random number
tables. Random sampling includes two very popular methods which are discussed below–

i. Simple Random Sampling: Under this method each unit of the whole population
e.g. purchase or sales invoice has an equal chance of being selected. The mechanics
of selection of items may be by choosing numbers from table of random numbers by
computers or picking up numbers randomly from a drum. It is considered that
random number tables are simple and easy to use and also provide assurance that
the bias does not affect the selection. This method is considered appropriate
provided the population to be sampled consists of reasonably similar units and fall
within a reasonable range.
ii. Stratified Sampling: This method involves dividing the whole population to be
tested in a few separate groups called strata and taking a sample from each of them.
Each stratum is treated as if it was a separate population and if proportionate of items
are selected from each of these stratum. The number of groups into which the whole
population has to be divided is determined on the basis of auditor judgment.

Example

In the above case, trade receivables balances may be divided into four groups as follows:

(a) balances in excess of Rs. 10,00,000;

(b) balances in the range of Rs. 7,75,001 to Rs. 10,00,000;
(c) balances in the range of Rs. 5,50,001 to Rs. 7,75,000;
(d) balances in the range of Rs. 2,25,001 to Rs. 5,50,000; and
(e) balances Rs. 2,25,000 and below.

From these above groups the auditor may pick up different percentage of items from each
of the group. From the top group i.e. balances in excess of ` 10,00,000, the auditor may
examine all the items; from the second group 25 per cent of the items; from the third group
10 per cent of the items; and from the lowest group 2 per cent of the items may be selected.

The reasoning behind the stratified sampling is that for a highly diversified population,
weights should be allocated to reflect these differences. This is achieved by selecting

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different proportions from each strata. It can be seen that the stratified sampling is simply
an extension of simple random sampling.

Therefore, we can say that random selection method is applied through random number
generators, for example, random number tables).

(2) Interval Sampling or Systematic Sampling: Systematic selection is a selection method

in which the number of sampling units in the population is divided by the sample size to
give a sampling interval, for example 50, and having determined a starting point within the
first 50, each 50th sampling unit thereafter is

selected. Although the starting point may be determined haphazardly, the sample is more
likely to be truly random if it is determined by use of a computerized random number
generator or random number tables. When using systematic selection, the auditor would
need to determine that sampling units within the population are not structured in such a
way that the sampling interval corresponds with a particular pattern in the population.

Example

To minimise the effect of the possible known buyers through a pattern in the population,
more than one starting point may be taken. The multiple random starting point is taken
because it minimises the risk of interval sampling pattern with that of the population being
sampled.

(3) Monetary Unit Sampling: It is a type of value-weighted selection in which sample size,
selection and evaluation results in a conclusion in monetary amounts.

(4) Haphazard sampling: Haphazard selection, in which the auditor selects the sample
without following a structured technique. Although no structured technique is used, the
auditor would nonetheless avoid any conscious bias or predictability (for example,
avoiding difficult to locate items, or always choosing or avoiding the first or last
entries on a page) and thus attempt to ensure that all items in the population have a
chance of selection. Haphazard selection is not appropriate when using statistical sampling.

(5) Block Sampling: This method involves selection of a block(s) of contiguous items from
within the population. Block selection cannot ordinarily be used in audit sampling because
most populations are structured such that items in a sequence can be expected to have
similar characteristics to each other, but different characteristics from items elsewhere in

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the population. Although in some circumstances it may be an appropriate audit procedure

to examine a block of items, it would rarely be an appropriate sample selection technique
when the auditor intends to draw valid inferences about the entire population based on the
sample.

7.7 Meaning, Purpose and Timing of Analytical Procedures

Since routine checks cannot be depended upon to disclose all the mistakes or manipulation
that may exist in accounts, certain other procedures also have to be applied like
comparisons, trend and ratio analysis in addition to reasonable tests. These collectively are
known as overall tests.

With the passage of tests, analytical procedures have acquired lot of significance as
substantive audit procedure. SA-520 on Analytical Procedures discusses the application of
analytical procedures during an audit.

Meaning of Analytical Procedures –

Let us understand the concept of Analytical Procedure with an example.

CA Amar wants to verify the payments made by XYZ Ltd. on account of building rent
during the FY 2020-21. The rent amounts to Rs. 50,000/- per month for theyear. The
monthly rent payments are consistent with the rent agreement. However, the other
companies in the similar industry are paying rent of Rs. 10,000/- per month for a similar
location. How will applying the analytical procedures impact the verification process of
such rental payments by XYZ Ltd.?

If CA Amar checks in detail the monthly rent payments, he may find that such payments
are consistent with the rent agreement i.e. XYZ Ltd. paid Rs. 50,000/- per month as rent
and the same is getting reflected in the rent agreement. Here, CA Amar may not be able
to find out the inconsistency in the rent payment with respect to rent payment prevalent
in the similar industry for rent of the similar location.

If CA Amar applies analytical procedure i.e. compares the rent payment by XYZ Ltd. with
the similar payments made by companies in similar industry and similar area,he will
notice an inconsistency in such rent payments as the other companies are paying a very
less monthly rent in similar industry for similar area.

However, if CA Amar does not make such comparison and only checks the monthly

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DEEM ED-T O-BE UNI VE R SI TY UNIT 7: Audit Sampling and Analytical Procedures

payments and rent agreement of XYZ Ltd., he would not have found such inconsistency
and as such the misstatement may remain undetected.

The term “analytical procedures” means evaluations of financial information through

analysis of plausible relationships among both financial and non-financial data. Analytical
procedures also encompass such investigation as is necessary of identified fluctuations or
relationships that are inconsistent with other relevant information or that differ from
expected values by a significant amount.

Purpose of Analytical Procedures

Analytical procedures use comparisons and relationships to assess whether account

balances or other data appear reasonable.

For instance, establishing the relationship that exists between certain balances included in
the Balance Sheet and the Statement of Profit and Loss and comparing them with those
that existed between the same set of balances in the previous year, reconciling the physical
balances of assets with the relevant financial record; obtaining of account from the bankers,
account receivables and account payables and reconciling with relevant balances in books
of account; confirming amounts of outstanding income and expenses by preparing
reconciliation statements, etc. These are helpful in the detection of unusual state of affairs
and mistakes in accounts.

The overall tests can be extended for making inter-firm and intra-firm comparison of
trading results.

Example

 Similarly, it would also be possible to compare the balances on the Statement of Profit
and Loss with that of the previous period, it would be possible to find out the reasons for
increase or decrease in the amount of profits of those years.
 By setting up certain expenses ratios on the basis of balances included in the Statement
of Profit and Loss, for the year under audit, comparing them with the same ratios for the
previous year, it is possible to ascertain the extent of increase or decrease in various items
of expenditure in relation to sales and that of trading profit in relation to sales.
 If differences are found to be material, the auditor would ascertain the reasons thereof
and assess whether the accounts have been manipulated to inflate or suppress profits.

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 Thus, it is important to note that Analytical procedures may help identify the existence of
unusual transactions or events, and amounts, ratios, and trends that might indicate
matters that have audit implications. Unusual or unexpected relationships that are
identified may assist the auditor in identifying risks of material misstatement, especially
risks of material misstatement due to fraud.
 Experienced auditors use analytical procedures in all stages of the audit. Analytical
Procedures are required in the planning phase and it is often done during the testing
phase. In addition, these are also required during the completion phase.

Timing of Analytical Procedures

Experienced auditors use analytical procedures in all stages of the audit. Analytical
Procedures are required in the planning phase and it is often done during thetesting
phase. In addition, these are also required during the completion phase.

7.8 Substantive Analytical Procedures, Designing and Performing Analytical Procedures

prior to Audit

The auditor’s substantive procedures at the assertion level may be tests of details,
substantive analytical procedures, or a combination of both. The decision about which audit
procedures to perform, including whether to use substantive analytical procedures, is based
on the auditor’s judgment about the expected effectiveness and efficiency of the available
audit procedures to reduce audit risk at the assertion level to an acceptably low level.

The auditor may inquire of management as to the availability and reliability of information
needed to apply substantive analytical procedures, and the results of any such analytical
procedures performed by the entity. It may be effective to use analytical data prepared by
management, provided the auditor is satisfied that such data is properly prepared

Factors to be considered for Substantive Audit Procedures are:

 Availability of Data
 Disaggregation
 Account type
 Source
 Predictability
 Nature of Assertion
 Inherent Risk or "What can go Wrong"
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The auditor should consider the following factors for Substantive Audit Procedures:

Availability of Data – The availability of reliable and relevant data will facilitate effective
analytical procedures.

Disaggregation – The degree of disaggregation in available data can directly affect the
degree of its usefulness in detecting misstatements.

Account Type – Substantive analytical procedures are more useful for certain types of
accounts than for others. Income statement accounts tend to be more predictable because
they reflect accumulated transactions over a period, whereas balance sheet accounts
represent the net effect of transactions at a point in time or are subject to greater
management judgment.

Example

Source – Some classes of transactions tend to be more predictable because they consist of
numerous, similar transactions, (e.g., through routine processes). Whereas the transactions
recorded by non-routine and estimation SCOTs (Significant Classes of Transactions) are
often

Predictability – Substantive analytical procedures are more appropriate when an account

balance or relationships between items of data are predictable (e.g., between sales and cost
of sales or between trade receivables and cash receipts). A predictable relationship is one
that may reasonably be expected to exist and continue over time.

Nature of Assertion – Substantive analytical procedures may be more effective in

providing evidence for some assertions (e.g., completeness or valuation) than for others
(e.g., rights and obligations). Predictive analytical procedures using data analytics can be
used to address completeness, valuation/measurement and occurrence.

Inherent Risk or “What Can Go Wrong” – When we are designing audit procedures to
address an inherent risk or “what can go wrong”, we consider the nature of the risk of
material misstatement in order to determine if a substantive analytical procedure can be
used to obtain audit evidence. When inherent risk is higher, we may design tests of details
to address the higher inherent risk. When significant risks have been identified, audit
evidence obtained solely from substantive analytical procedures is unlikely to be sufficient.

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7.9 Investigating the results of Analytical Procedures

If analytical procedures performed in accordance with SA 520 identify fluctuations or

relationships that are inconsistent with other relevant information or that differ from
expected values by a significant amount, the auditor shall investigate such differences by:

(i) Inquiring of management and obtaining appropriate audit evidence relevant to

management’s responses: Audit evidence relevant to management’s responses may be
obtained by evaluating those responses taking into account the auditor’s understanding of
the entity and its environment, and with other audit evidence obtained during the course
of the audit.

(ii) Performing other audit procedures as necessary in the circumstances: The need to
perform other audit procedures may arise when, for example, management is unable to
provide an explanation, or the explanation, together with the audit evidence obtained
relevant to management’s response, is not considered adequate.

Summary

 SA 530 “Audit Sampling”, defines ‘audit sampling’ as application of audit procedures to

less than 100% of items within a population of audit relevance such that all sampling units
have a chance of selection in order to provide the auditor with a reasonable basis on
which to draw conclusions about the entire population.

 The objective of the auditor when using audit sampling is to provide a reasonable basis
for the auditor to draw conclusions about the population from which the sample is
selected.

 Audit sampling can be applied using either non-statistical or statistical sampling

approaches.

 Sample should be selected in such a manner that it is representative of the population

from which the sample is being selected. Some of the sample selection methods are
Random Sampling (Simple/Stratified), Systematic Sampling, Monetary Unit Sampling,
Haphazard Sampling, Block Sampling etc.
 The auditor shall evaluate the results of the sample; and whether the use of audit sampling
has provided a reasonable basis for conclusions about the population that has been
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tested.
 Analytical procedures use comparisons and relationships to assess whether account
balances or other data appear reasonable.
 Analytical Procedures are required in the planning phase, testing phase and during the
completion phase.
 These Analytical procedures are used to obtain relevant and reliable audit evidence when
using substantive analytical procedures; and to design and perform analytical procedures
near the end of the audit that assist the auditor when forming an overall conclusion as to
whether the financial statements are consistent with the auditor’s understanding of the
entity.
 The auditor’s substantive procedures at the assertion level may be tests of details,
substantive analytical procedures, or a combination of both.
 The reliability of data is influenced by its source and nature and is dependent on the
circumstances under which it is obtained.

Self-Assessment Questions

A. Essay type
1. While applying the Substantive Analytical Procedures what techniques can be used by
the statutory auditor of a company to obtain sufficient and appropriate audit evidence?
2. Explain how a statutory auditor of a company can apply analytical procedures at the
planning phase of audit.
3. What is the meaning of Sampling? Also discuss the methods of Sampling.
4. With reference to Standard on Auditing 530, state the requirements relating to audit
sampling, sample design, sample size and selection of items for testing.
5. While planning the audit of S Ltd. you want to apply sampling techniques. What are
the risk factors you should keep in mind?

7.10 POST-UNIT READING MATERIAL

 https://www.techtarget.com/searchsecurity/definition/fraud-detection
 https://scholar.google.co.in/scholar?q=audit+fraud+detection+ppt&hl=en&as_sdt=0&a
s_vis=1&oi=scholart

16
 UNIT

AUDIT REPORT

Names of Sub-Units
Forming an opinion on financial statements, Auditor’s Report- Basic Elements, Types of Modified
Opinion, Circumstances where a modification to the auditor’s opinion is required, Qualification,
Disclaimer, Adverse Opinion, SA 706 Emphasis of Matter Paragraph and other matter paragraphs
in the Independent Auditor’s Report, Nature of Comparative Information, Corresponding Figures,
Comparative Financial Statements

Overview
The unit starts with basics of audit report, how it is prepared. Next is various kinds of
opinion given by the auditor, then comes some technical topics like how emphasis on
matter is done and how other matters are informed. Then details about comparative and
corresponding figures are given.

Learning Objectives
In this Unit you will learn –
 Develop the ability to form an Audit opinion on Financial statement and
 Understand the components of Audit Report Identify the Approaches to Audit
 Evaluate how other matters and matters are to be referred
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DEEM ED-T O-BE UNI VE R SI TY UNIT 8: Audit Report

Learning Outcomes

At the end of this unit, you would:

 Learn what are the essential abilities to form an Audit opinion on Financial
statement.
 Understand the components of Audit Report

Pre-Unit Preparatory Material

 https://cleartax.in/s/sa-700-forming-an-opinion-and-reporting-on-financial-
statements

Table of Topics
8.1 Introduction
8.2 Meaning of Audit Report
8.3 Forming an Opinion on the Financial Statement
8.4 Auditor’s Report – Basic Elements
8.5 Types of Modified Opinion
8.6 Circumstances when a Modification to the Author’s Opinion Required
8.7 Qualification, Disclaimer, Adverse Opinion
8.8 SA 706-Emphasis of Matter Paragraphs
8.9 Other Matter Paragraphs in the Independent Auditor’s Report
8.10 Nature of Comparative Information, Corresponding Figures and Comparative
financial statements

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8.1 Introduction

An audit is conducted to assure the stakeholders of the company that all the transactions
recorded in the company’s accounting system throughout the year are truly reflected in
the financial statements. Auditors are expected to have immense knowledge of accounting,
finance, tax, and corporate laws that ensure the company is following a sound corporate
governance structure.

8.2 Meaning of Audit Report

An auditor's report is a written report from the auditor containing their opinion on whether
a company's financial statements comply with generally accepted accounting principles
(GAAP) and are free from material misstatement and thus they represent a true and fair view
or not.

An audit report is issued to the user of an entity's financial statements. The user may
rely upon the report as evidence that a knowledgeable third party has investigated and
rendered an opinion on the financial statements. An audit report that contains a clean
opinion is required by many lenders before they will loan funds to a business. It is also
necessary for a publicly-held entity to attach the relevant audit report to its financial
statements before filing them with the Securities and Exchange Commission.

8.3 Forming an Opinion on the Financial Statement

The auditor shall form an opinion on whether the financial statements are prepared, in all
material respects, in accordance with the applicable financial reporting framework. In order
to form that opinion, the auditor shall conclude as to whether the auditor has obtained
reasonable assurance about whether the financial statements as a whole are free from
material misstatement, whether due to fraud or error.

SA 700 (Revised)- “Forming an Opinion and Reporting on Financial Statements”, deals

with the auditor’s responsibility to form an opinion on the financial statements. It also
deals with the form and content of the auditor’s report issued as a result of an audit of
financial statements.

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That conclusion shall take into account:

 The auditor’s conclusion, in accordance with SA 330, whether sufficient appropriate audit
evidence has been obtained;
 The auditor’s conclusion, in accordance with SA 450, whether uncorrected misstatements
are material, individually or in aggregate and
 The evaluations required according to standards.

The auditor shall evaluate whether the financial statements are prepared, in all material
respects, in accordance with the requirements of the applicable financial reporting
framework. This evaluation shall include consideration of the qualitative aspects of the
entity’s accounting practices, including indicators of possible bias in management’s
judgments.

In particular, the auditor shall evaluate whether, in view of the requirements of the applicable
financial reporting framework:

 The financial statements adequately disclose the significant accounting policies selected
and applied;
 The accounting policies selected and applied are consistent with the applicable financial
reporting framework and are appropriate;
 The accounting estimates made by management are reasonable;
 The information presented in the financial statements is relevant, reliable, comparable, and
understandable;
 The financial statements provide adequate disclosures to enable the intended users to
understand the effect of material transactions and events on the information conveyed in
the financial statements; and
 The terminology used in the financial statements, including the title of each financial
statement, is appropriate.

When the financial statements are prepared in accordance with a fair presentation
framework, the evaluation required shall also include whether the financial statements
achieve fair presentation. The auditor’s evaluation as to whether the financial statements
achieve fair presentation shall include consideration of:

 The overall presentation, structure and content of the financial statements; and

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 Whether the financial statements, including the related notes, represent the underlying
transactions and events in a manner that achieves fair presentation.

The auditor shall evaluate whether the financial statements adequately refer to or describe
the applicable financial reporting framework.

8.4 Auditor’s Report – Basic Elements

The auditor’s report shall be in writing. The Auditor’s Report for Audits Conducted in
Accordance with Standards shall include the following:

1. Auditing Title - The auditor’s report shall have a title that clearly indicates that it is the
report of an independent auditor.

For example, “Independent Auditor’s Report,” distinguishes the independent auditor’s

report from reports issued by others.

2. Addressee - The auditor’s report shall be addressed, as appropriate, based on the

circumstances of the engagement.

The auditor’s report is normally addressed to those for whom the report is prepared,
often either to the shareholders or to those charged with governance ofthe entity whose
financial statements are being audited. In case of a company, the report is addressed to
the shareholders of the company.

3. Auditor’s Opinion - The first section of the auditor’s report shall include the auditor’s
opinion, and shall have the heading “Opinion.”

The Opinion section of the auditor’s report shall also:

 Identify the entity whose financial statements have been audited
 State that the financial statements have been audited;
 Identify the title of each statement comprising the financial statements;
 Refer to the notes, including the summary of significant accounting policies; and

Specify the date of, or period covered by, each financial statement comprising the financial
statements.

4. Basis for Opinion - The auditor’s report shall include a section, directlyfollowing
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the Opinion section, with the heading “Basis for Opinion”, that:
 States that the audit was conducted in accordance with Standards on Auditing;
 Refers to the section of the auditor’s report that describes the auditor’s

responsibilities under the SAs;

 Includes a statement that the auditor is independent of the entity in accordancewith
the relevant ethical requirements relating to the audit and has fulfilled the auditor’s
other ethical responsibilities in accordance with these requirements.
 States whether the auditor believes that the audit evidence the auditor has

obtained is sufficient and appropriate to provide a basis for the auditor’s opinion.

Thus, the Basis for opinion section provides important context about the auditor’s

opinion.

1) Going Concern: Where applicable, the auditor shall report in accordancewith SA

570 (Revised).

 Under the going concern basis of accounting, the financial statements are prepared
on the assumption that the entity is a going concern and will continue its operations for the
foreseeable future. General purpose financial statements are prepared using the going
concern basis of accounting, unless management either intends to liquidate the entity or to
cease operations, or has no realistic alternative but to do so.

 When the use of the going concern basis of accounting is appropriate, assets and
liabilities are recorded on the basis that the entity will be able to realizeits assets and
discharge its liabilities in the normal course of business.

 The auditor shall evaluate whether sufficient appropriate audit evidence has been
obtained regarding, and shall conclude on, the appropriateness of management’s use of the
going concern basis of accounting in thepreparation of the financial statements.

 Based on the audit evidence obtained, the auditor shall conclude whether, in the
auditor’s judgement, a material uncertainty exists related to events or conditions that,
individually or collectively, may cast significant doubt on the entity’s ability to continue as a
going concern.

2) Key Audit Matters: For audits of complete sets of general purpose financial
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statements of listed entities, the auditor shall communicate key audit matters in the auditor’s
report in accordance with SA 701.

When the auditor is otherwise required by law or regulation or decides to communicate

key audit matters in the auditor’s report, the auditor shall do so in accordance with SA 701.

Law or regulation may require communication of key audit matters for audits of entities
other than listed entities

3) Responsibilities for the Financial Statements: The auditor’s report shall include a
section with a heading “Responsibilities of Management for the Financial Statements.”

 Preparing the financial statements in accordance with the applicable financial

reporting framework, and for such internal control as management determines is
necessary to enable the preparation of financial statements that are free from material
misstatement, whether due to fraud or error;[because of the possible effects of fraud on
other aspects of the audit, materiality does not apply to management’s acknowledgement
regarding its responsibility for the design, implementation, and maintenance of internal
control (or for establishing and maintaining effective internal control over financial
reporting) to prevent and detect fraud.] and

 Assessing the entity’s ability to continue as a going concern and whether the use
of the going concern basis of accounting is appropriate as well as disclosing, if applicable,
matters relating to going concern. The explanation of management’s responsibility for this
assessment shall include a descriptionof when the use of the going concern basis of
accounting is appropriate.

4) Auditor’s Responsibilities for the Audit of the Financial Statements: The auditor’s
report shall include a section with the heading “Auditor’s Responsibilities for the Audit
of the Financial Statements.”

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Objectives of the auditor

That reasonable level of assurance is

Auditors responsibility section high level of assurance and not
to state gaurantee

That misstatements can arise from

fraud and error

5) Location of the description of the auditor’s responsibilities for the auditof the
financial statements

6) Signature of the Auditor: The auditor’s report shall be signed. The report is signed
by the auditor (i.e. the engagement partner) in his personal name. Wherethe firm is
appointed as the auditor, the report is signed in the personal name of the auditor and in the
name of the audit firm.

The partner/proprietor signing the audit report also needs to mention the membership
number assigned by the Institute of Chartered Accountants of India. They also include the
registration number of the firm, wherever applicable, as allotted by ICAI, in the audit
reports signed by them.

7) Place of Signature: The auditor’s report shall name specific location, which

is ordinarily the city where the audit report is signed?

8) Date of the Auditor’s Report: The auditor’s report shall be dated no earlier than the
date on which the auditor has obtained sufficient appropriate audit evidence on which to
base the auditor’s opinion on the financial statements, including evidence.

8.5 Types of Modified Opinion

Following are different types of auditor’s opinion:

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1. Qualified Opinion - The auditor issues a qualified opinion when there is a misstatement
in the financial statement but usually related to a transaction or process. In most cases, the
auditor is not sure about transaction or unable to confidently rely upon it and hence issue a
qualified opinion.

2. Adverse Opinion - The financial statements are materially misstated but it has a pervasive
effect on the whole financial statement. These are sufficiently incorrect and it might impact
upon economic decisions. It might also indicate possibilities of fraud.

3. Disclaimer of Opinion - The auditor accepts the engagement of the audit but found that
the financial statements are materially misstated and are pervasive. Also, the auditor in his
professional judgment concludes that there are multiple uncertainties on the entity’s ability
to continue the going concern. This also states that the auditor has not obtained sufficient
and appropriate audit evidence to form an opinion thereon.

4. Clean Opinion - The auditor found that the financial statements in all material respects
are prepared in accordance with the accounting standard. The auditor also states that
appropriate disclosures have been made regarding any uncertainty and provisions and
contingencies have been incorporated in the financial statements.

8.6 Circumstances when a Modification to the Author’s Opinion Required

The auditor shall modify the opinion in the auditor’s report when:
a. The auditor concludes that, based on the audit evidence obtained, the financial
statements as a whole are not free from material misstatement; or
b. The auditor is unable to obtain sufficient appropriate audit evidence to conclude that
the financial statements as a whole are free from material misstatement

8.7 Qualification, Disclaimer, Adverse Opinion

Qualification/Qualified Opinion

The auditor shall express a qualified opinion when:

(a) The auditor, having obtained sufficient appropriate audit evidence, concludes that
misstatements, individually or in the aggregate, are material, but not pervasive, to the
financial statements; or

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(b) The auditor is unable to obtain sufficient appropriate audit evidence on which to base
the opinion, but the auditor concludes that the possible effects on the financial statements
of undetected misstatements, if any, could be material but not pervasive.

Adverse Opinion - The auditor shall express an adverse opinion when the auditor, having
obtained sufficient appropriate audit evidence, concludes that misstatements, individually
or in the aggregate, are both material and pervasive to the financial statements.

Disclaimer of Opinion - The auditor shall disclaim an opinion when the auditor is unable
to obtain sufficient appropriate audit evidence on which to base the opinion, and the auditor
concludes that the possible effects on the financial statements of undetected misstatements,
if any, could be both material and pervasive.

The auditor shall disclaim an opinion when, in extremely rare circumstances involving
multiple uncertainties, the auditor concludes that, notwithstanding having obtained
sufficient appropriate audit evidence regarding each of the individual uncertainties, it is not
possible to form an opinion on the financial statements due to the potential interaction of
the uncertainties and their possible cumulative effect on the financial statements.

8.8 SA 706-Emphasis of Matter Paragraphs

If the auditor considers it necessary to draw users’ attention to a matter presented or

disclosed in the financial statements that, in the auditor’s judgment, is of such importance
that it is fundamental to users’ understanding of the financial statements, the auditor shall
include an Emphasis of Matter paragraph in the auditor’s report provided:

The auditor would not be required to modify the opinion in accordance with SA 705
(Revised) as a result of the matter; and

When SA 701 applies, the matter has not been determined to be a key audit matter to be
communicated in the auditor’s report.

When the auditor includes an Emphasis of Matter paragraph in the auditor’s, the auditor
shall:

(a) Include the paragraph within a separate section of the auditor’s report with an
appropriate heading that includes the term “Emphasis of Matter”;

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(b) Include in the paragraph a clear reference to the matter being emphasized and to where
relevant disclosures that fully describe the matter can be found in the financial statements.
The paragraph shall refer only to information presented or disclosed in the financial
statements; and

(c) Indicate that the auditor’s opinion is not modified in respect of the matter emphasized.

8.9 Other Matter Paragraphs in the Independent Auditor’s Report

If the auditor considers it necessary to communicate a matter other than those that are
presented or disclosed in the financial statements that, in the auditor’s judgment, is
relevant to users’ understanding of the audit, the auditor’s responsibilities or the auditor’s
report, the auditor shall include an Other Matter paragraph in the auditor’s report,
provided:

 This is not prohibited by law or regulation; and

 When SA 701 applies, the matter has not been determined to be a key audit matter to
be communicated in the auditor’s report.

8.10 Nature of Comparative Information, Corresponding Figures and Comparative financial

statements

The nature of the comparative information which is presented in financial statements of the
entity is governed by the requirements of relevant financial reporting framework. The two
approaches to the reporting responsibilities of an auditor in respect of comparative
information include:

 Corresponding figures
 Comparative financial statements

The approach which needs to be adopted by an auditor is often stipulated by regulation or

law, however, it might also be prescribed in the terms of engagement. The key audit
reporting differences between the approaches are:

 In case of corresponding figures, only the current period is referred for the opinion of
the auditor on financial statements; whereas.
 In case of comparative financial statements, each period for which such financial
statements are presented is referred for the purpose of auditor’s opinion.

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Corresponding figures

When the corresponding figures are presented, the opinion of an auditor shouldn’t refer to
corresponding figures barring the following circumstances:

In case auditor’s report on the financial statement of the prior period, as previously issued,
including a disclaimer of opinion, a qualified opinion, or an adverse opinion and matters that
required modification which is unresolved.

In case an auditor gathers audit evidence that the material misstatement exists in financial
statements of the prior period in which previously an unmodified opinion was issued.

In case financial statements of the prior period weren’t audited

For the circumstances mentioned in the aforesaid point

(1). the auditor should modify his/her audit opinion on financial statements of the current
period. In Basis for Modification paragraph in his/her audit report, the auditor should either:

a) Refer to current period as well as the corresponding figures in the description of the
matter requiring modification when effects or likely effects of such matter on the figures of
the current period are material.

OR

b) The auditor in other cases should explain that his/her audit opinion has been modified
due to the effects or likely effects of an unresolved matter on comparability of figures of the
existing period and such corresponding figures.

Comparative Financial Statements

When the comparative financial statements are presented, each period for which such
financial statements are presented and audit opinion is expressed should be referred for
auditor’s opinion. When reporting on financial statements of a prior period in connection
with audit of the current period, if the opinion of the auditor on the financial statements of
prior period differs from the opinion expressed by the auditor previously, the auditor should
disclose applicable reasons for such different opinion in the Other Matter paragraph as per
SA 706.

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Summary

 The audit report is the culmination of the audit process.

 Management is responsible for the preparation of the financial statements.
 The purpose of an audit is to enhance the degree of confidence of intended users of the
financial statements.
 The aforesaid purpose is achieved by the expression of an independent reporting by the
auditor.
 The objectives of the auditor as per SA 700 (Revised), “Forming An Opinion And Reporting
On Financial Statements” are to form an opinion on the financial statements based on an
evaluation of the conclusions drawn from the audit evidence obtained; and to express
clearly that opinion through a written report.
 The auditor shall modify the opinion in the auditor’s report when the auditor concludes
that, based on the audit evidence obtained, the financial statements as a whole are not
free from material misstatement; or the auditor is unable to obtain sufficient appropriate
audit evidence to conclude that the financial statements as a whole are free from material
misstatement.
 There are three types of modified opinions, namely-a qualified opinion, an adverse
opinion, and a disclaimer of opinion. As per SA 706 (Revised) on “Emphasis of
Matter Paragraphs and Other Matter Paragraphs

Self-Assessment Questions
A. Essay type

1. Mr. Rajendra, a fellow member of the Institute of Chartered Accountants of India, working
as Manager of Shrivastav and Co., a Chartered Accountant firm, signed the audit report of
Om Ltd. on behalf of Shrivastav & Co.
2. Necessity of a disclaimer of opinion may arises. Elaborate
3. There are various types of Audit Report Opinions. Elaborate
4. The auditor shall modify the opinion in the auditor’s report only when the auditor
concludes that, based on the audit evidence obtained, the financial statements as a whole
are not free from material misstatement.
5. Communicating key audit matter in the auditor’s report constitutes a substitute for
disclosure in the financial statements.

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8.11 POST-UNIT READING MATERIAL

 https://www.business-standard.com/company/titan-company-1016/annual-
report/auditors-report
 https://www.oil-india.com/Document/Financial/Auditreport_201718_OIIL.pdf

14
 UNIT

Internal Audit, Management And Operational Audit

Names of Sub-Unit
Provisions of internal audit as per Companies Act ,2013, Scope of Internal Auditing,
Relationship between internal and external auditor, Basics of Internal Audit Standards issued
by the ICAI, drafting of internal audit report, Management Audit and Operational Audit.

Overview
In this unit you will provisions of internal audit, then the scope of internal audit, relation
between external and internal audit and the standards issed by ICAI and then how report is
drafted.

Learning Objectives
In this Unit you will learn –
 The purpose, object and scope of internal audit
 Relationship of internal and external audit
 The ability to form an Internal Audit Report;
 Management Auditand Operational Audit Reports as well.
 ElucidateonInternal Auditandcontrast thesamewithManagement Audit and Operational Audit.
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Learning Outcomes
At the end of this Unit you would -
 Understand internal auditor’ concept and for which companies it is compulsory
 Learn what are the essential bifurcations on Internal and External Audit.
 Understand the formats and concerpts of Audit Reports.

Unit Pre- requisites

NOT AVAILABLE

Pre-Unit Preparatory Material

 https://cleartax.in/s/sa-700-forming-an-opinion-and-reporting-on-financial-
statements

Table of Topics
9.1 Introduction
9.2 Provisions of Internal Audit as per Companies Act, 2013
9.2.1 Meaning of Internal Audit
9.2.2 Objective of internal audit
9.2.3 WHO CAN BE AN INTERNAL AUDITOR
9.2.4 Applicability of the provisions of internal audit
9.3 Scope of Internal Auditing;
9.4 Relationship between Internal and External Auditor
9.5 Basics of Internal Audit Standards issued by the ICAI
9.6 Drafting of Internal Audit Report
9.7 Management Audit
9.8 Operational Audit

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9.1 Introduction

According to the modern view, Internal Audit is no longer a routine checking and review of
records. Instead, Internal Audit is an independent approvable function established within
an organization just like external and ither audits to examine and evaluate its activities as a
service to the organization. The objective of internal auditing is to assist the members of
the organization. To this end, internal auditing furnishes them with the analysis, appraisals,
recommendations counsel and information concerning the activities reviewed.

In other words, an internal auditor has to go beyond the books of account and records and
appraise the various functions of the organization.

As all Internal, External, Management and Operational Audits are important and vital part
for the corporate check.

9.2 Provisions of Internal Audit as per Companies Act, 2013

9.2.1 Meaning of Internal Audit

Internal Audit is an independent management function, which involves a continuous and critical
appraisal of the functioning of an entity with a view to suggest improvements thereto and add value
to and strengthen the overall governance mechanism of the entity including entity’s strategic risk
management and internal control system.

Internal Controls are systematic measures (such as reviews, checks and balances, methods and
procedures) instituted by an organization to

(1) conduct its business in an orderly and efficient manner,

(2) safeguard its assets and resources,
(3) deter and detect errors, fraud, and theft,
(4) ensure accuracy and completeness of its accounting data,
(5) produce reliable and timely financial and management information, and
(6) ensure adherence to its policies and plans.

9.2.2 Objective of internal audit

Internal audit is carried out with the following objective :

 To establish better policies and procedures

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 To evaluate and improve risk management system, internal control and governance
processes
 To ensure better compliance of law
 To avoid unwarranted legal action
 Fraud detection
 Integrity and Accountability
 To protect the interest of Shareholders

9.2.3 WHO CAN BE AN INTERNAL AUDITOR

Internal Auditor shall either be a –

 Chartered Accountant, or

 Cost Accountant, or
 Such other Professional as may decide by the Board.
 Internal Auditor may or may not be an employee of the Company

9.2.4 Applicability of the provisions of internal audit

Applicability of Provisions of Internal Audit: As per section 138 of the Companies Act, 2013, following class of
companies (prescribed in rule 13 of Companies (Accounts) Rules,2014) shall be required to appoint an
internal auditor which may be either an individual or a partnership firm or a body corporate, namely-

(a) every listed company;

(b) every unlisted public company having-
(i) paid up share capital of fifty crore rupees or more during the preceding
financial year; or
(ii) turnover of two hundred crore rupees or more during the preceding
financial year; or
(iii) outstanding loans or borrowings from banks or public financial
institutionsexceeding one hundred crore rupees or more at any point
of time during the preceding financial year; or
(iv) outstanding deposits of twenty five crore rupees or more at any point
of time during the preceding financial year; and
(c) every private company having-
(i) turnover of two hundred crore rupees or more during the preceding
financial year; or
(ii) outstanding loans or borrowings from banks or public financial
institutions exceeding one hundred crore rupees or more at any point
of time during the preceding financial year.

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9.3 Scope of Internal Auditing

Internal audit may be defined as, an independent appraisal function established within an
organization to examine and evaluate its activities as a service to the organization. The scope of the
internal audit is determined by the management. Internal auditing includes a series of processes
and techniques through which an organizations own employees ascertain for the management, by
means of on-the-job observation, whether established management controls are adequate, and are
effectively maintained; records and reports financial, accounting and otherwise reflect actual
operation and results accurately and properly; each division, department or other units are carrying
out the plans, policies and procedures for which they are responsible.

Also the scope can be enumerated as -

Reliability and Integrity of Information- The internal auditor should review the reliability
and integrity of financial and operating information and examine the effectiveness of the
means used to identify, measure, classify, and to report such information.

Compliance with Policies and Procedure: The systems and procedure also have
considerable impact on the operation of the business enterprise. The internal auditor should
gauge the effectiveness and impact of such systems and report thereon.

Safeguarding the Assets: The internal auditor should review the existing system for
safeguarding the assets and if necessary should verify the existence of such assets.

Economical and Efficient Use of Resources: The internal auditor should also appraise the
economy and efficiency with which the resources are employed.

Accomplishment of the Established Objectives and Goals: The internal auditor should
make a review of the operations or programmes of the enterprise and should ascertain
whether the results are not inconsistent with the established goals and objectives of the
enterprise. He should also ascertain whether the programmes are carried out as per plan.

9.4 Relationship between Internal and External Auditor

Internal audit and external audit both compliments each other. It is a good practice that the
external auditors get access to the reports of internal audit, and knows important facts and
figures to draw good results. The external auditors usually communicate with internal
auditing team to inform on any important matters that could affect the services

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A good communication system between external auditors and internal auditors can result
in efficient exchange of information and effective control over the financial statements.
Through this, both the internal and external auditors can plan timings of their work,
minimizing the interference with the management.

Benefits from co-operative co-ordination and relation between internal and external
audit.

A range of benefits may be obtained from co-operation. The specific benefits, and the scale
to which they can be achieved, will depend on the particular organisation. They may include;

 more effective audit based on a clearer understanding of respective audit roles and
requirements
 a reduced audit burden resulting in less disruption
 a better informed dialogue on the risks facing the organisation leading to more
effective focussing of audit effort and consequently to more useful advice to
management
 better co-ordinated internal and external audit activity based on joint planning and
communication of needs
 a better understanding by each group of auditors of the results arising from each
other’s work which may inform respective future work plans and programmes
 increased scope for use by both internal and external auditors of each others work
 the opportunity for each party to draw on a wider and more flexible skills base

All these benefits enhance the effectiveness of audit and thus assist senior management
to provide a high quality of public service.

Difference Between Internal & External Auditors

BASIS FOR INTERNAL AUDIT EXTERNAL AUDIT
COMPARISON
1. Meaning It refers to an ongoing audit It is an audit function
function performed within an performed bythe independent
organization by a separate body which is not apart of the
internal organization.
auditing department.
2. Examination The Internal auditor examines The External auditor examines
the the

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Operational efficiency of Accuracy and Validity of

the FinancialStatements.
organisation.
3. The Internal auditor is The External auditor is
Appointmen appointed bythe Management. appointed bythe Members.
t
4. Users of The user of internal audit The user of external audit
Report report isManagement. report isStakeholders.
5. Period Internal audit is a An External audit is done
ContinuousProcess once in ayear.
throughout the year.
6. Opinion The opinion is provided on The opinion is provided on
the the
effectiveness of the operational truthfulness and fairness of
activities of the organization. thefinancial statement of the
company.
7. Status of The Internal auditor could be The External auditor is
Auditor anemployee of the company. mandatorilynot an employee of
the company.

9.5 Basics of Internal Audit Standards issued by the ICAI

The Internal Audit Standard Board of the ICAI has, with other pronouncements, issued five
Standards on Internal Audit (SIAs) in November 2018. The SIAs are a set of minimum
requirements that apply to all members of the ICAI while performing internal audit of any
entity or body corporate. However these are not mandatory to be undertaken by other
professional bodies such as Cost Management Accountants and Company

Need for Standards on Internal Audit

The Standards on Internal Audit (SIAs) establish uniform evaluation criteria, methods,
processes and practices. The Standards are pronouncements which form the basis for
conducting all internal audit activity. These pronouncements are designed to help the
internal auditor to discharge his responsibilities.

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9.6 Drafting of Internal Audit Report

he internal auditor should carefully review and assess the conclusions drawn from the audit
evidence obtained, as the basis for his findings contained in his report and suggest remedial
action. However, in case the internal auditor comes across any actual or suspected fraud or
any other misappropriation of assets, it would be more appropriate for him to bring the
same immediately to the attention of the management.

On the basis of the internal audit work completed, the Internal Auditor shall issue a clear,
well documented Internal Audit Report which includes the following key elements:

(a) An overview of the objectives, scope and approach of the audit assignments;

(b) The fact that an internal audit has been conducted in accordance the Standards of
Internal Audit;

(c) An executive summary of key observations covering all important aspects, and specific
to the scope of the assignment;

(d) A summary of the corrective actions required (or agreed by management) for each
observation; and

(e) Nature of assurance, if any, which can be derived from the observations.

The content and form of the Internal Audit Report are to be established by the Internal
Auditor based on his best professional judgement, in consultation with the auditee and, if
necessary, with inputs from other key stakeholders. No internal audit report shall be issued
in final form unless a written draft of the report has previously been shared with the auditee.

The internal audit report shall be issued within a reasonable time frame from the completion
of the internal audit work.

Conclusions reached shall be based on all the findings rather than on a few deviations or
issues noted. Controls operating effectively have their own importance and should be
acknowledged, while the risk and significance of observations noted have a role to play in
prioritising the matters to be reported.

1. Basis of Internal Audit Report: Each internal audit report is prepared on the basis of
the conclusions made.

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2. Conducted in Accordance with SIAs: Where the internal audit is conducted in

compliance with the Standards of Internal Audit, (within the Framework governing Internal
Audits), and the internal auditor can substantiate the same with supporting evidence and
documentation, the internal audit report shall include a statement confirming that “the
internal audit was conducted in accordance with the Standards of Internal Audit issued by
the Institute of Chartered Accountants of India”.

3. Content and Format of Internal Audit Report: The manner in which the internal audit
report is drafted and presented is a matter of professional judgment and choice and could
be influenced by the preferences of the recipients. The SIA does not mandate any particular
format or list of contents since the Internal Auditor is expected to exercise his best
professional judgement on matters regarding how and what to report. Where some level
of assurance is being provided, the form and content of the report shall be as per SIA
380, “Issuing Assurance Reports”.

4. Documentation: To confirm compliance of audit procedures with this SIA, the list of
documents required is as follows:

(a) Copies of draft and final internal audit reports to be maintained, appropriately cross
referenced to specific observations.

(b) If appropriate, management action plans may be counter signed by respective

management personnel.

9.6 Management Audit and Operational Audit

According to T.G. Rose, “The management audit would therefore concern itself with the whole field of
activities of the concern, from top to bottom, starting, as always where management control is concerned,
from the top, because we are primarily concerned with whether the general management is functioning
smoothly and satisfactorily. If it is not, it may be due to the functional management being faulty and,
therefore, we pass on to examine that in its turn, in order to find the missing or faulty link which is causing
the trouble”.
Operational audit is an audit for the management; it is undertaken at the instance of the
management for providing it with information and appraisal of operations and activities. A parallel
development in auditing is getting shaped as a management audit. Management audit is an “audit
of the management” also.

The scope and content of management audit should cover everything that we know as
operational audit and, in addition, it should also include a review of the adequacy and
competence of the objectives, plans, policies and decisions of the top management.

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Difference between Management Audit & Operational Audit

• Management audit is concerned with the “Quality of managing”, whereas operational

audit focuses on the “Quality of operations”.

• Management audit is the “Audit of management” while the operational audit is the
“Audit for the management”. The focus of Management Audit is on “Quality of Decision
Making” rather than the effectiveness or efficiency of operations.

• The basic difference between the two audits, then, is not in method, but in the level of
appraisal. In a management audit, the auditor is to make his tests to the level of top
management, its formulation of objectives, plans and policies and its decision making.
It is not that he just verifies the operations of control and procedures and fulfillment of
plans in conformity with the prescribed policies.

Relationship between Internal Auditing and Operational Auditing

Internal auditing is an independent appraisal activity within an organisation for the review
of operations as a service to organisation. When an auditor is concerned with the appraisal
of operations, he becomes an operational auditor. According to the Institute of Internal
Auditors, “the overall objective of internal auditing is to assist all members of management
in the objective discharge of their responsibilities, by furnishing them with objective
analysis, appraisals, recommendations and pertinent comments, concerning the activities
reviewed.”

Internal auditors may act as operational auditors when the objective is the deep-dive
analysis of operations only.

9.7 SUMMARY

 Internal auditing is an independent, objective assurance and consulting activity

designed to add value and improve an organization’s operations.
 It helps an organization accomplish its objectives by bringing a systematic, disciplined
approach to evaluate and improve the effectiveness of risk management, control, and
governance processes.
 Performed by professionals with an in-depth understanding of the business culture,
systems, and processes, the internal audit activity provides assurance that internal
controls in place are adequate to mitigate the risks, governance processes are effective
and efficient, and organizational goals and objectives are met.

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 Internal audit is a process through which the companies get to know the loopholes in
the system and improve the respective aspects for making businesses more efficient.
 Compliance, IT, Performance, Operational, and Environmental audits would be a few
commonly found internal audits.
 It is different from external audits in which auditors validate the accuracy of the financial
documents and send reports to stakeholders and other external members associated
with the organization.

Self-Assessment Questions
A. Essay type

1. State the important aspects to be considered by the External auditor in the evaluation of
the Internal Audit Function.
2. The Operational Audit is carried out effectively when the Operational Auditor responds
with positive traits in a scenario that is blended with behavioural issues. Explain a few
positive traits that help to conclude an Operational Audit, a success
3. Difference between Management Audit & Operational Audit
4. Elaborate relationship between Internal Auditing and Operational Auditing.
5. The Standards are pronouncements which form the basis for conducting all internal audit
activity. Comment

POST-UNIT READING MATERIAL

 https://www.osfi-bsif.gc.ca/Eng/osfi-bsif/rep-rap/iar-rvi/Pages/default.aspx
 https://assets.hcca-
info.org/Portals/0/PDFs/Resources/Conference_Handouts/Audit%20&%20Compl
iance%20Committee%20Conference/SS13presentation2.pdf

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 UNIT

Audit Committee and Corporate Governance

Names of Sub-Unit
Audit committee; Role of Auditor in Audit Committee and Certification of
Compliance of Corporate Governance; Compliances with Laws and Regulations (SA 250
Consideration of Laws and Regulations in an Audit of Financial Statements); Disclosure
Requirements including those of SEBI Regulatory, Requirements of Corporate Governance,
Report on Corporate Governance

Overview
In this unit you will learn what is the role of audit committee, what is the importance of
corporate governance, Next we will learn about the legal framework of Corporate
Governance Last we will learn about Report on Corporate Governance.

Learning Objectives
In this Unit you will learn –

 Understand the legal framework of Corporate Governance and Listing Obligation

and Disclosure Requirement Regulations.
 Envisage Role of Audit Committee under LODR Regulations and as per section 177
of the Companies Act, 2013.
 Gain the knowledge of Role of Auditor in Audit Committee and Certification of
Compliance of Conditions of Corporate Governance.
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DEEMED-TO-BE UNIVERSITY UNIT 10: Audit Committee and Corporate Governance
 Analyse the Statement of Deviations, various Disclosure requirements

Learning Outcomes
At the end of this Unit you would -
 Learn the role of audit committee.
 Role of Audit Committee under LODR Regulations and as per section 177 of the
Companies Act, 2013.
 Compliance of Conditions of Corporate Governance.

Pre-Unit Preparatory Material

 https://www.cfainstitute.org/en/advocacy/issues/audit-committee-role-
practices#sort=%40pubbrowsedate%20descending

Table of Topics :

10.1 Introduction
10.2 Audit committee
10.3Role ofAuditor in Audit Committee andCertification of Compliance of Corporate
Governance;
10.4Compliances with Lawsand Regulations (SA 250 Consideration ofLaws andRegulations
inanAudit of Financial Statements);
10.5 Disclosure Requirements including those ofSEBI
10.6 Regulatory Requirements of Corporate Governance
10.7 Report onCorporate Governance

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10.1 Introduction

The Audit Committee performs various important functions like investigating the matters referred by
board, discuss about internal control system etc. It is compulsory to form audit committee under
Companies Act as well as under LODR. LODR is applicable only to listed companies whereas
Companies Act makes audit committee compulsory for certain sets of companies.

10.2 Audit committee

The audit committee is a committee of the board of directors responsible for oversight of
the financial reporting process, selection of independent auditor, receipt of audit results
from both internal & external auditors. The committee assists the board to fulfil its
corporate governance and overseeing responsibilities in relation to an entity’s financial
reporting, internal control system.

Every listed entity shall constitute a qualified and independent audit committee in accordance with
the terms of reference, subject to the following:
1. The Audit Committee shall have minimum three directors as members. Two-thirds of the members
of audit committee shall be independent directors, however, in case of a listedentity having
outstanding SR (Superior Rights) equity shares, the audit committee shall only comprise of
independent directors.
2. All members of Audit Committee shall be financially literate and at least one member shall have
accounting or related financial management expertise.
Explanation (i): The term “financially literate” means the ability to read and understandbasic
financial statements i.e. balance sheet, profit and loss account, and statement of cash flows.
3. The Chairperson of the Audit Committee shall be an independent director and he/she shall be
present at Annual General Meeting to answer shareholder queries.
4. The Company Secretary shall act as the secretary to the committee.
5. The Audit Committee at its discretion shall invite the finance director or the head of the finance
function, head of internal audit and a representative of the statutory auditor and any other such
executives to be present at the meetings of the committee, provided that occasionally, the Audit
Committee may meet without the presence of any executives of the listed entity.

Meeting of Audit Committee [Regulation 18(2)]

The Audit Committee shall meet at least four times in a year and not more than one hundred and

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twenty days shall lapse between two meetings. The quorum shall be either two members or one
third of the members of the Audit Committee, whichever is greater, but there should be a minimum
of two independent directors present.

Powers of Audit Committee [Regulation 18(2)]

(1) To investigate any activity within its terms of reference.

(2) To seek information from any employee.

(3) To obtain outside legal or other professional advice.

(4) To secure attendance of outsiders with relevant expertise, if itconsiders necessary.

10.3 Role of Auditor in Audit Committee and Certification of Compliance

of Corporate Governance

The Auditor plays a very important role in the audit committee. He is responsible to
oversee and help audit committee in ensuring that they are able to discharge their duties
properly. Some of the role of auditor in the audit committee is as under :

1. Regulation 18(1)(f) of LODR stipulates that a representative of the statutory auditor,

when required, shall be invited to the meetings of the Audit Committee.
2. Similarly, Section 177 of the Companies Act, 2013 provides the auditors of a company
and the key managerial personnel the right to be heard in the meetings of the Audit
Committee when it considers the auditor’s report but they shall not have the right to
vote.
3. The auditor must ensure that he communicates frequently and openly with the Audit
Committee on key accounting or auditing issues that, in the auditor’s judgment, give
rise to a greater risk of material misstatement of the financial statements, and also
ensure that he addresses any questions or concerns voiced by the Audit Committee.
4. He can contribute significantly in assisting and advising the Audit Committee on
improving corporate governance, oversight of financial reporting process,
implementation of accounting policies and practices, compliance with accounting
standards, strengthening of the internal control systems in regard to financial
reporting and reporting processes.
5. The auditor must devote substantial professional time in assisting the management
and the Audit Committee to enable them to discharge their functions effectively and
in certification of the requirements of corporate governance.
6. The auditor has to keep in mind that his role is not to drive corporate governance
directly. Rather, it is the management’s responsibility to do so and, in the process, he

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should play a significant role in assisting management to ensure better standards of

corporate governance.
7. The auditor’s responsibility in certifying compliance with the requirements of corporate governance
relates to the verification and certification of factual implementation of requirements of corporate
governance as stipulated in the LODR Regulations. Such verification and certification is neither an
audit nor an expression of opinion on the financial statements of the company.

10.4 Compliances. with Laws and Regulations (SA 250 Consideration of

Laws and Regulations in an Audit of Financial Statements)

This Standard on Auditing (SA) deals with the auditor’s responsibility to consider laws
and regulations while performing an audit of financial statements and not compliance
with specific laws or regulations.

Effect of Laws & Regulations

The effect on financial statements depends on the fact that whether they are directly or
indirectly related to the operational business. Non-compliance of the same shall attract
fines, litigations or other consequences.

Responsibility of Management

The management must ensure that entity’s operations are conducted in accordance and
with compliance of the various provisions of laws and regulations that determine the
reported amounts and disclosures. The management should:

Ensure employees are properly

Monitor legal requirements
trained

Institute and operate appropriate systems of internal Monitor compliance with code of
controls conduct

Develop, publish and follow a code of conduct Engage legal advisors

In larger companies the policies and procedures are assigned to:

Responsibility of the Auditor

This SA is designed to assist the auditor in identifying material misstatement of the

financial statements. He is responsible for obtaining a reasonable assurance that the
financial statements as a whole are free from any material misstatement. However, due
to inherent limitations of audit there exists an unavoidable risk.
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Objectives: The objectives of an auditor are:—

 To obtain sufficient audit evidence regarding compliance with provisions of laws

and regulations,
 To perform audit procedures to help identify areas to non-compliance,
 To respond appropriately to non-compliance or suspected compliance,
 To maintain an attitude of professional skepticism.

Duties of Auditor

 Obtain knowledge about legal and regulatory framework

 Know-how the entity is complying with the same
 Obtain Audit evidence w.r.t. compliance
 Conduct audit procedures to identity non-compliance
 Ensure compliance by management
 Inspect correspondence, if any, with authorities
 Remain alert to suspection, if any
 Obtain written representations from management where necessary.

Audit Procedures when Non-compliance is Identified or Suspected

Firstly understand the nature of act and circumstances and then evaluate the possible
effects. Then if there is any suspicion, discuss the same with those charged with
governance and if sufficient information is not obtained then the auditor can seek legal
advice.

Reporting Non-compliance to Regulatory and Enforcement Authorities

The auditor’s duty of client confidentiality may be overridden by statute and law as under
the present legal framework, the auditor’s duty is to report the suspected/confirmed
occurrence of non-compliance with laws to the regulatory authorities. Then if there is
any misstatement, discuss the same with those charged with governance and if sufficient
information is not obtained then the auditor can seek legal advice.

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10.5 Disclosure Requirements including those of SEBI

The LODR Regulations on Corporate Governance requires disclosure of certain transactions which are
discussed below.

1. Disclosure and Transparency [Regulation 4]

The listed entity shall ensure timely and accurate disclosure on all material matters
including the financial situation, performance, ownership, and governance of the listed
entity, in the following manner:

(a) Information shall be prepared and disclosed in accordance with the prescribed
standards of accounting, financial and non-financial disclosure.

(b) Channels for disseminating information should provide for equal, timely and cost
efficient access to relevant information by users.

(c) Minutes of the meeting shall be maintained explicitly recording dissenting opinions,
if any.

2. Disclosure of events or information [Regulation 30(1), (5) (8)]

Every listed entity shall make disclosures of any events or information which, in the
opinion of the board of directors of the listed company, is material.

Board of directors of the listed entity shall authorize one or more Key Managerial
Personnel for the purpose of determining materiality of an event or information and
for the purpose of making disclosures to stock exchange(s) under this regulation and
the contact details of such personnel shall be also disclosed to the stock exchange(s)
and as well as on the listed entity's website.

Such disclosures shall be hosted on the website of the listed entity for a minimum
period of five years and thereafter as per the archival policy of the listed entity, as
disclosed on its website.

3 Related Party Disclosure [Regulations 23, 27, 46 and Schedule V]

The listed entity shall submit a quarterly compliance report on corporate governance
in the format as specified by the Board from time to time to the recognised stock
exchange(s) within 21 days from the end of each quarter.

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Details of all material transactions with related parties shall be disclosed therein. The
report shall be signed either by the compliance officer or the chief executive officer
of the listed entity.

The company shall disclose the policy on dealing with related party transactions on
its website and a web link thereto shall be provided in the Annual Report.

The listed entity shall disclose the transactions with any person or entity belonging
to the promoter/ promoter group which hold(s) 10% or more shareholding in the
listed entity, in the format prescribed in the relevant accounting standards for annual
results.

The listed entity shall submit within 30 days from the date of publication of its
standalone and consolidated financial results for the half year, disclosures of related
party transactions on a consolidated basis, in the format specified in the relevant
accounting standards for annual results to the stock exchanges and publish the same
on its website.

Provided that a ‘high value debt listed entity’ shall submit such disclosures
along with its standalone financial results for the half year

4. Disclosure of Accounting Treatment [Schedule V]

Where in the preparation of financial statements, a treatment different from that

prescribed in an Accounting Standard has been followed, the fact shall be disclosed
in the financial statements, together with the management’s explanation as to why
it believes such alternative treatment is more representative of the true and fair view
of the underlying business transaction.

In this regard, the auditor should refer to Sections 133, 134 and 143 of the Companies
Act, 2013. Also, the auditor should refer to the Compliance Certificate issued in
accordance with Regulation 17(8).

10.6 Regulatory Requirements of Corporate Governance

LODR provides for regulatory requirements for ensuring that corporate governance is
complied in the organization. These requirements are :

1. Board of Directors

Board of directors is the decision making body of any company. It is the duty of the
board to comply with all legal rules and regulations. So it is very important that a
company constitutes a board of directors as per the provisions of Companies Act, 2103.

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Composition of Board- Section 149 of the Companies Act, 2013 provides for
appointment of minimum three directors in a public company and two directors in a
private company. A board can have a maximum of fifteen directors but can appoint
more directors subject to special approval.

Women Director- It is mandatory to appoint a women director in the following classes

of company:

 Listed company;
 Public unlisted company having paid-up share capital of one hundred crore
rupees or more, or having a turnover of 300 crore or more.

Resident Director- Section 149(3) mandates that every company will have one director
who has stayed in India for a period of not less than 182 days.

Independent Director- Independent directors are impartial and bring expertise to the
board. They play an important role in resolving conflicts among shareholders and the
company. Section 149(6) provides for the qualifications for appointing an independent
director in a public company. As per Companies Act, 2013 public listed company shall have
at least one-third of directors as independent directors and public unlisted company will
have two directors if they meet the following criteria:

 Public companies having a share capital of 10 crore or more;

 Public companies having a turnover of 100 crore or more;
 Public companies having outstanding loans, debentures and deposits of more
than 50 crores.
According to section 134 of Companies Act, 2013 the director has to give a detailed
financial report which includes the director’s responsibility statement. This provision has
been enacted to make directors accountable for their actions.

2. Stakeholder Relationship Committee

As per section 178(6) of Companies Act, 2013 if a company has more than one thousand
shareholders, debenture-holders, deposit-holders or any other security holders in a
financial year then it is mandatory to constitute a stakeholder relationship committee. The
main of the committee is to resolve the conflicts between the shareholders and the board
of directors and address their grievances. The chairperson of the board shall be a non-
executive director.
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3. Audit Committee

The Audit Committee looks after the financial reports and disclosures of a company. It is
one of the most important components of a corporate governance structure. Under section
177 of Companies Act, 2013 the following class of companies are required to constitute
audit committee and they are as follows:

i. Listed company
ii. Public company having a share capital of more than 10 crores;
iii. Public company having a turnover of Rs. 100 crores;
Public companies having deposits, outstanding loans or debentures more than
iv.
50 crores.
An audit committee will consist of a minimum of 3 directors and independent directors will
form the majority. Section 177(4) provides duties of the audit committee and it has to act
in accordance with the same.

4. Nomination and Remuneration Committee

The nomination and remuneration committee decides the selection criteria for the key
managerial personnel (KMP) and determines the remuneration of the KMP’s and directors.
Section 178 of Companies Act, 2013 mandates the constitution of committee for the
following class of companies:

 Listed company;
 Public company having a share capital of more than Rs. 10 crores;
 Public company having a turnover of Rs. 100 crores;
Public company having deposits, outstanding loans or debentures more than

Rs.50 crores.
The nomination and remuneration committee will consist of a minimum of 3 directors
and independent directors will form the majority.

4.6 Report on Corporate Governance

The listed entity shall submit a quarterly compliance report on corporate governance in
the format as specified by the Board from time to time to the recognised stock

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exchange(s) within 21 days from the end of each quarter. The report shall be signed
either by the Compliance Officer or the Chief Executive Officer of the listed entity.

The auditor should ascertain whether the Board of Directors have included in the Annual
Report of the listed entity, a separate section on corporate governance with a detailed
compliance report on corporate governance.

Any data in the report on corporate governance should not be inconsistent with that
contained in the financial statements. (For detailed contents of Report on Corporate
Governance, students are advised to refer Appendix given at the end of this Chapter)

A proforma of the certificate to be issued by the auditors regarding compliance

of

conditions of corporate governance is shown below:

To,
The Members of................
(Name of the entity)
CERTIFICATE
We have examined the compliance of conditions of corporate
governance by (name of the entity) for the year ended on ........... as
stipulated in Securities Exchange Board of India (Listing Obligations and
Disclosure Requirements) Regulations, 2015 (hereinafter called as “SEBI
(LODR) Regulations, 2015”).
The compliance of conditions of corporate governance is the
responsibility of the management. Our examination was limited to
procedures and implementation thereof, adopted by the company for
ensuring the compliance of the conditions of the corporate governance.
It is neither an audit nor an expression of opinion on the financial
statements of the company.
In our opinion and to the best of our information and according to the
explanations given to us, we certify that the company has complied with
the conditions of corporate governance as stipulated in the above
mentioned Regulations.
OR (as applicable)
In our opinion, and to the best of our information and according to the
explanations given to us, subject to the following:
1) We certify that the company has complied with the conditions of
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JGI JAIN DEEMED-TO-BE UNIVERSITY UNIT 10: Audit Committee and Corporate Governance
corporate governance as stipulated in the above mentioned Regulations.
2) We state that such compliance is neither an assurance as to the future
viability of the company nor the efficiency or effectiveness with which the
management has conducted the affairs of the company.
For & on behalf of
XYZ & Co.
Chartered Accountants (Partner / Proprietor)
Membership No.
Place..........
Date............

4.7 Summary

 The Securities and Exchange Board of India (SEBI) on September 2, 2015, issued the Securities and
Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR
Regulations”), with the objective of streamlining and consolidating the provisions of various listing
agreements in operation for different segments of the capital markets
 Every listed entity shall constitute a qualified and independent audit committee in accordance with
the terms of reference
 The Audit Committee shall meet at least four times in a year and not more than one hundred and
twenty days shall lapse between two meetings
 The auditor must ensure that he communicates frequently and openly with the Audit Committee on
key accounting or auditing issues that, in the auditor’s judgment, give rise to a greater risk of
material misstatement of the financial statements, and also ensure that he addresses any questions
or concerns voiced by the Audit Committee
 Corporate Governance is the system by which companies are directed and governed
by the management.
 Through use of ethical business processes, the management is able to ensure
accountability, transparency and fairness in the company operations, thereby
ensuring that the interests of shareholders and all other stakeholders are protected.
 The Board of Directors are responsible for governance of their companies

Self-Assessment Questions

a. Multiple Choice Questions

1. Who can be invited in the audit committee meetings ?
a) Any director
b) Any officer

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c) Finance director
d) Any one
2. How many meetings of the audit committee should be held in the year ?
a) 4
b) 5
c) 3
d) 2
3. Who shall act as a secretary of audit committee?
a) Any employee
b) CA
c) CS
d) Any director
4. In what time corporate governance report is to be submitted to stock exchange
?
a) Within 10 days
b) Within 20 days
c) Within 15 days
d) Within 21 days
5. Who can be the chairman of the audit committee?
a) Any director
b) Any officer
c) Independent director
d) Dependent Director

b. Essay type
i. Write a note on Corporate Governance
ii. State the main features of the Qualified and Independent Audit Committee
set up SEBI (Listing Obligations and Disclosure Requirements) Regulations,
2015
iii. XYZ Limited has conducted 4 meetings in 2019-20. i.e. April 10, 2019, June 15,
2019, October 18, 2019, and February 10, 2020. Does it comply with provisions
of conducting meeting?
iv. What is the role of auditor in audit committee ?
v. Write a note on corporate governance report.
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Keys to Multiple Choice Questions

1- 3, 2-1, 3-3, 4-4, 5-3

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Post-Unit Reading Material

 https://www2.deloitte.com/content/dam/Deloitte/us/Documents/center-for-
board-effectiveness/us-audit-committee-resource-guide-section-2.pdf
 https://www.accaglobal.com/gb/en/member/sectors/internal-
audit/learn/effective-audit-committees.html

15
 UNIT

Audit of Limited Companies

Names of Sub-Unit
Application of Relevant Provisions under the Companies Act, 2013 relating to Audit and
Auditors and Rules made there under; Powers/rights and Duties of Auditors ; Branch Audit
Significance of True and Fair View; Dividends and Divisible Profits - Financial, Legal, and Policy
ConsiderationsSpecial Features of Audit of Limited Liability Partnerships (LLPs) Audit Report
under the Companies Act, 2013; Reporting under CARO

Overview
In this unit you will learn the relevant provisions under the Companies Act, 2013 relating to
Audit and Auditors and Rules made thereunder.

Learning Objectives
In this Unit you will learn –

 Know the statutory requirements which are essential for the audit of limited
companies.
 Define the phrase ‘True & Fair’ and explain its relevance in the context of audit
report.
 Explain the concept of dividend and divisible profits and the statutory requirements
with respect to that.
 Learn how audit of LLP is done
 JGI JAIN
DEEMED-TO-BE UNIVERSITY UNIT 11 : Audit of Limited Companies

Learning Outcomes
At the end of this Unit you would -
 Learn how the audit of limited companies.
 Understand the idea of audit report and its contents
 learn the relevant provisions under the Companies Act, 2013 relating to Audit

Pre-Unit Preparatory Material

 http://142.93.128.11:8080/jspui/bitstream/123456789/638/3/56-87.pdf

Table of Topics

11.1 Introduction
11.2Application of Relevant Provisions under the Companies Act, 2013 relating to Audit
and Auditors and Rules made there under;
11.3 Powers/rights of Auditor
11.4 Duties of Auditors
11.5 Branch Audit
11.6 Significance of True and Fair View;
11.7 Dividends and Divisible Profits - Financial, Legal, and Policy Considerations
11.8 Depreciation
11.9 Special Features of Audit of Limited Liability Partnerships (LLPs)
11.10 Audit Report under the Companies Act, 2013; Reporting under CARO
11.11 Summary

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11.1 Introduction
Financial statements are prepared and presented to exhibit a true and fair view of the
statement of affairs as well as profitability of the organisation. So emphasis has been
given to explain the concept of true and fair view in the context of financial statements.
The form of auditor’s report and its contents including specific matter, to be dealt with
in the report are given in detail. Independence of auditor being one of the basic
principles in audit is discussed as to its concept and present day importance. So, in this
unit, all the important features of company audit are discussed.

11.2 Application of Relevant Provisions under the Companies Act, 2013

relating to Audit and Auditors and Rules made there under

Appointment of Auditor
Section 139 of the Companies Act, 2013 contains provisions regarding
Appointment of Auditors. Discussion on appointment of auditors may be
grouped under two broad headings-
1. Appointment of First Auditors.
2. Appointment of Subsequent Auditors

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Appointment of First Auditors

Appointment of First Auditors in the case of a company, other than a Government Company:
As per Section 139(6), the first auditor of a company, other than a Government company,
shall be appointed by the Board of Directors within 30 days from the date of registration of
the company and the auditor so appointed shall hold office until the conclusion of the first
AGM. In the case of failure of the Board to appoint the auditor, it shall inform the members of
the company. The members of the company shall within 90 days at an extraordinary general
meeting appoint the auditor. Appointed auditor shall hold office till the conclusion of the first
annual general meeting.
Appointment of First Auditors in the case of Government Company: Section 139(7) provides
that in the case of a Government company or any other company owned or controlled,
directly or indirectly, by the Central Government, or by any State Government, or
Governments, or partly by the Central Government and partly by one or more State
Governments, the first auditor shall be appointed by the Comptroller and Auditor-General of
India within 60 days from the date of registration of the company. In case the Comptroller
and Auditor-General of India does not appoint such auditor within the above said period, the
Board of Directors of the company shall appoint such auditor within the next 30 days. Further,
in the case of failure of the Board to appoint such auditor within next 30 days, it shall inform
the members of the company who shall appoint such auditor within 60 days at an
extraordinary general meeting. Auditors shall hold office till the conclusion of the first annual
general meeting.

Appointment of Subsequent Auditors/Re-appointment of Auditors

Appointment of subsequent auditors in case of Non- Government Companies: Section139(1)
of the Companies Act, 2013 provides that every company shall, at the first annual general
meeting appoint an individual or a firm as an auditor who shall hold office from the
conclusion of that meeting till the conclusion of its sixth annual general meeting and
thereafter till the conclusion of every sixth meeting.

Appointment of subsequent auditors in case of Government Companies: As per Section

139(5), in the case of a Government company or any other company owned or controlled,
directly or indirectly, by the Central Government, or by any State Government or
Governments, or partly by the Central Government and partly by one or more State
Governments, the Comptroller and Auditor- General of India shall, in respect of a financial
year, appoint an auditor duly qualified to be appointed as an auditor of companies under this
Act, within a period of 180 days from the commencement of the financial year, who shall hold
office till the conclusion of the annual general meeting.
ELIGIBILITY AND QUALIFICATION OF AUDITOR :
A person shall be eligible for appointment as an auditor of a company only if he is a
Chartered Accountant. It may be noted that a firm whereof majority of partners practising in
India are qualified for appointment as aforesaid may be appointed by its firm name to be the
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auditor of a company.
Where a firm including a limited liability partnership (LLP) is appointed as an auditor of a
company, partners who are Chartered Accountants, shall be authorised to act and sign on
behalf of the firm

DISQUALIFICATIONS OF AN AUDITOR
Under sub-section (3) of section 141 along with Rule 10 of the Companies (Audit and
Auditors) Rules, 2014, the following persons shall not be eligible for appointment as an
auditor of a company-
(a) a body corporate other than a limited liability partnership registered under the
Limited Liability Partnership Act, 2008;
(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;
This sub-section disqualifies the below mentioned persons from being appointed as auditor
of a company:
(i) partner of an officer of the company;
(ii) employee of an officer of the company;
(iii) partner of an employee of the company;
(iv) employee of an employee of the company.

(d) a person who, or his relative or partner -

(a) is holding any security of or interest in the company or its subsidiary, or of its
holding or associate company or a subsidiary of such holding company.
It may be noted that the relative may hold security or interest in the company of face
value not exceeding rupees one lakh.
It may also be noted that the condition of rupees one lakh shall, wherever relevant, be
also applicable in the case of a company not having share capital or other securities:
(b) is indebted to the company, or its subsidiary, or its holding or associate
company or a subsidiary of such holding company, in excess of rupees five lakh; or
(c) has given a guarantee or provided any security in connection with the indebtedness
of any third person to the Company or its Subsidiary, or its Holding or Associate
Company or a Subsidiary of such Holding Company, in excess of one lakh rupees
(e) a person or a firm who, whether directly or indirectly has business relationship
with the Company, or its Subsidiary, or its Holding or Associate Company or Subsidiary
of such holding company or associate company, of such nature as may be prescribed.
(f) a person whose relative is a Director or is in the employment of the Company as a
director or key Managerial Personnel;
(g) a person who is in full time employment elsewhere or a person or a partner of a
firm holding appointment as its auditor, if such person or partner is at the date of such
appointment or reappointment holding appointment as auditor of more than twenty

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companies other than one person companies, dormant companies, small companies
and private companies having paid-up share capital less than ` 100 crore;
(h) a person who has been convicted by a Court of an offence involving fraud and a
period of ten years has not elapsed from the date of such conviction;
(i) a person who, directly or indirectly, renders any service referred to in section 144 to
the company or its holding company or its subsidiary company.

ROTATION OF AUDITOR
As per rules prescribed in Companies (Audit and Auditors) Rules, 2014, for applicability
of section 139(2) the class of companies shall mean the following classes of companies
excluding one person companies and small companies:
(i) all unlisted public companies having paid up share capital of rupees ten crore or
more;
(ii) all private limited companies having paid up share capital of rupees fifty crore or
more;
(iii) all companies having paid up share capital of below threshold limit mentioned
above, but having public borrowings from financial institutions, banks or public
deposits of rupees fifty crores or more.

As per section 139(2), no listed company or a company belonging to such class or

classes of companies as mentioned above, shall appoint or re-appoint-
(a) an individual as auditor for more than one term of five consecutive years; and
(b) an audit firm as auditor for more than two terms of five consecutive years.
Provided that -
(i) an individual auditor who has completed his term under clause (a) shall not be
eligible for re-appointment as auditor in the same company for five years from the
completion of his term;
(ii) an audit firm which has completed its term under clause (b), shall not be eligible for
re-appointment as auditor in the same company for five years from the completion of
such term.

CEILING ON NUMBER OF AUDITS

It has been mentioned earlier that before appointment is given to any auditor, the
company must obtain a certificate from him to the effect that the appointment, if
made, will not result in an excess holding of company audit by the auditor concerned
over the limit laid down in section 141(3)(g) of the Companies Act, 2013 which
prescribes that a person who is in full time employment elsewhere or a person or a
partner of a firm holding appointment as its auditor, if such person or partner is at the
date of such appointment or reappointment holding appointment as auditor of more
than twenty companies other than one person companies, dormant companies, small
companies and private companies having paid-up share capital less than `Rs. 100
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crore, shall not be eligible for appointment as an Auditor of a Company.

Auditor not to render certain services

Section 144 of the Companies Act, 2013 prescribes certain services not to be rendered
by the auditor. An auditor appointed under this Act shall provide to the company only
such other services as are approved by the Board of Directors or the audit committee,
as the case may be, but which shall not include any of the following services (whether
such services are rendered directly or indirectly to the company or its holding company
or subsidiary company), namely:
(i) accounting and book- keeping services;
(ii)internal audit;
(iii) design and implementation of any financial information system;
(iv) actuarial services;
(v)investment advisory services;
(vi) investment banking services;
(vii) rendering of outsourced financial services;
(viii) management services; and
(ix) any other kind of services as may be prescribed.

AUDITOR’S REMUNERATION
As per section 142 of the Act, the remuneration of the auditor of a company shall be
fixed in its general meeting or in such manner as may be determined therein. However,
board may fix remuneration of the first auditor appointed by it.
Further, the remuneration, in addition to the fee payable to an auditor, includes the
expenses, if any, incurred by the auditor in connection with the audit of the company
and any facility extended to him but does not include any remuneration paid to him
for any other service rendered by him at the request of the company. Therefore, it has
been clarified that the remuneration to Auditor shall also include any facility provided
to him.
Removal of Auditor before Expiry of Term
According to Section 140(1), the auditor appointed under section 139 may be removed
from his office before the expiry of his term only by a special resolution of the
company, after obtaining the previous approval of the Central Government in that
behalf as per Rule 7 of CAAR, 2014:
(1) The application to the Central Government for removal of auditor shall be made
in Form ADT-2 and shall be accompanied with fees as provided for this purpose under
the Companies (Registration Offices and Fees) Rules, 2014.
(2) The application shall be made to the Central Government within 30 days of the
resolution.
The company shall hold the general meeting within 60 days of receipt of approval of
the Central Government for passing the special resolution

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11.3 Rights of the Auditor

The auditor has following powers/rights while conducting an audit:
(a) Right of access to books, etc.– Section 143(1) of the Act provides that the auditor of
a company, at all times, shall have a right of access to the books of account and
vouchers of the company, whether kept at the registered office of the company or at
any other place and he is entitled to require from the officers of the company such
information and explanation as he may consider necessary for the performance of his
duties as auditor
(b) Right to obtain information and explanation from officers- This right of the
auditor to obtain from the officers of the company such information and explanations
as he may think necessary for the performance of his duties as auditor is a wide and
important power. In the absence of such power, the auditor would not be able to
obtain details of amount collected by the directors, etc. from any other company, firm
or person as well as of any benefits in kind derived by the directors from the company,
which may not be known from an examination of the books.
(c) Right to report to the members of the company on the accounts examined by him-
The auditor shall make a report to the members of the company on the accounts
examined by him and on every financial statements which are required by or under this
Act to be laid before the company in general meeting and the report shall after taking
into account the provisions of this Act, the accounting and auditing standards and
matters which are required to be included in the audit report under the provisions of
this Act or any rules made there under or under any order made under this section and
to the best of his information and knowledge, the said accounts, financial statements
give a true and fair view of the state of the company’s affairs as at the end of its
financial year and profit or loss and cash flow for the year and such other matters as
may be prescribed.
(d) Right to Lien- In terms of the general principles of law, any person having the lawful
possession of somebody else’s property, on which he has worked, may retain the
property for non-payment of his dues on account of the work done on the property.
On this premise, auditor can exercise lien on books and documents placed at his
possession by the client for non-payment of fees, for work done on the books and
documents.

11.4 DUTIES OF AUDITORS

Sections 143 of the Companies Act, 2013 specifies the duties of an auditor of a
company in a quite comprehensive manner. It is noteworthy that scope of duties of an
auditor has generally been extending over all these years.
1. Duty of Auditor to Inquire on certain matters: It is the duty of auditor to inquire into
the following matters-
(a) whether loans and advances made by the company on the basis of security have

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been properly secured and whether the terms on which they have been made are
prejudicial to the interests of the company or its members;
(b) whether transactions of the company which are represented merely by book
entries are prejudicial to the interests of the company;
(c) where the company not being an investment company 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 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 documents of the company that any shares 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.

11.5 Branch Audit

As per the Companies Act, 2013 every Registered Company has to maintain the books
of accounts and other relevant documents for its every branch, in addition to the
books of accounts of its Head Office.
The Books of accounts, documents and other relevant documents shall be maintained
in the same manner as of the head office for every financial year which gives a true and
fair view of the state of the affairs of the company.
Such Books of accounts shall be audited either by the Company Auditor or the
Company may appoint a separate auditor to this effect and such auditor shall be called
Branch Auditor.
What is Branch Office?
Section 2 subsection 14 of the Companies Act, 2013 defines a branch office. As per the
section “branch office”, in relation to a company, means any establishment described
as such by the company.
Process for Appointment of Branch Auditor
There shall be no separate procedure for appointment of the branch auditor. The
Process shall be the same as applicable for the appointment of the Statutory Auditor
of the company.
Provisions relating to Branch Audit
As per Section 143(8): Where a company has one or more branch office, the accounts
of that office/offices shall be audited either by the company’s auditor himself or by any
other person, who is qualified to be appointed as an auditor as per the provisions of
the Act to act as branch auditor according to section 139 of the Companies Act, 2013.
Branch Situated outside India
Where the branch office of the Company is situated in a country outside India, the

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accounts of the branch office shall be audited either by the company’s auditor or by an
accountant or by any other person duly qualified to act as an auditor of the accounts
of the branch office in accordance with the laws of that country.
The duties and powers of the company’s auditor in relation to the audit of the branch
and also the branch auditor, if any, shall be such as may be prescribed.
Duties and Powers of Branch Auditor
Section 143(1) to Section 143(4) and Rule 12 of the Companies (Audit and Auditors)
Rules, 2014 define the Powers and Duties of the Branch Auditor.

11.6 Significance of True and Fair view

The concept of true and fair is a fundamental concept in auditing. The phrase “true and
fair” in the auditor’s report signifies that the auditor is required to express his opinion
as to whether the state of affairs and the results of the entity as ascertained by him in
the course of his audit are truly and fairly represented in the accounts under audit. This
requires that the auditor should examine the accounts with a view to verify that all
assets, liabilities, income and expenses are stated as amounts which are in accordance
with accounting principles and policies which are relevant and no material amount,
item or transaction has been omitted.
The importance of the concept of true and fair view can also be understood and
appreciated from the fact that sections 128, 129 and 143 of the Companies Act, 2013
also discusses this concept in relation to books of accounts, financial statements and
reporting on financial statements respectively.
Place of keeping books of accounts
Section 128(1) of the Companies Act, 2013 provides that every company shall prepare
and keep at its registered office books of account and other relevant books and papers
and financial statement for every financial year which give a true and fair view of the
state of the affairs of the company, including that of its branch office or offices, if any.
The company shall be in a position to explain the transactions effected both at the
registered office and its branches. Such books of accounts shall be kept on accrual
basis and according to the double entry system of accounting.
Section 129(1) of the Companies Act, 2013 provides that the financial statements shall
give a true and fair view of the state of affairs of the company or companies, comply
with the accounting standards notified under section 133 of the Companies Act, 2013,
and shall be in the form or forms as may be provided for different class or classes of
companies in Schedule III to the Act.
The term “financial statement” shall include any notes annexed to or forming part of
such financial statement, giving information required to be given and allowed to be
given in the form of such notes under the said Act.

Further, according to section 143(2) of the Act, the auditor is required to make a report

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to the members of the company indicating that, to the best of his information and
knowledge, the financial statements give a true and fair view of the state of the
company’s affairs as at the end of its financial year and profit or loss and cash flow for
the year and such other matters as may be prescribed.
SA 700 “Forming an Opinion and Reporting on Financial Statements”, requires the
auditor to form an opinion on the financial statements based on an evaluation of the
conclusions drawn from the audit evidence obtained; and express clearly that opinion
through a written report that also describes the basis for the opinion. The auditor is
required to express his opinion on the financial statements that it gives a true and fair
view in conformity with the accounting principles generally accepted in India (a) in the
case of the Balance Sheet, of the state of affairs of the Company as at March 31, 20XX;
(b) in the case of the Statement of Profit and Loss, of the profit/ loss for the year ended
on that date; and (c) in the case of the Cash Flow Statement, of the cash flows for the
year ended on that date.

11.7 Dividends and Divisible Profits

Payment of Dividends
(1) Dividends once declared become the liability of the company and must be paid
within 30 days from the date of declaration. Any failure to do so attracts a penalty for
the various persons associated with the management [Section 127].
(2) Payment of dividend on any share should be made only to the registered
shareholder of such share or to his order or to his banker. Dividends are not payable
except in cash; or by cheque or warrant; or in any electronic mode to the shareholder
entitled to the payment of the dividend. But the profits or reserves can be capitalised
for purpose of issuing fully paid-up bonus shares subject to the guidelines issued by
the SEBI, also they may be applied for paying up any amount for the time being
unpaid on any share held by the members of the company.
(3) A company may, if so authorised by its articles, pay dividends in proportion to
the amount paid-up on each share in accordance with Section 51.
(4) The Board may deduct from any dividend payable to any member all sums of
money, if any, presently payable by him to the company on account of calls or
otherwise in relation to the shares of the company [Table F of Schedule I to the
Companies Act, 2013].
As per Accounting Standards (AS) 4 (amended)- Contingencies and Events Occurring
After the Balance Sheet Date and Ind AS 10- Events after the Reporting Period, if
dividends are declared after the balance sheet date but before the financial statements
are approved for issue, the dividends are not recognised as a liability at the balance
sheet date because no obligation exists at that time unless a statute requires
otherwise. Such dividends are disclosed in the notes.
Deposit of amount of Dividend in separate bank account - The amount of the

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dividend, including interim dividend, should be deposited in a scheduled bank in a

separate account within 5 days from the date of declaration of such dividend.

11.8 Depreciation

Section 123 prohibits a company from declaring dividend out of its profits before
providing for depreciation in the manner laid down in the section.
Section 123 provides that the dividend shall be declared or paid by a company for any
financial year out of the profits of the company for that year arrived at after providing
for depreciation in accordance with the provisions of Schedule II “Useful lives to
compute Depreciation”, to the Companies Act, 2013.
Ascertainment of depreciation for computing net profits for the purpose of managerial
remuneration: Under Section 197(1) of the Companies Act, 2013, depreciation
calculated in the manner specified in Section 198 of the Companies Act, 2013 must be
deducted for arriving at the amount of net profits, on which remuneration payable to
managerial personnel is to be calculated.

11.9 Special Features of Audit of Limited Liability Partnerships (LLPs)

• LLP is a separate legal entity from its partners.
• It can raise funds from Partners, Banks, and NBFCs.
• The procedure for Incorporation, conversion, and closure of LLP is simple and easy.
• It has assets and liabilities that are break free that of the promoters.
• LLP can easily Transfer its ownership.
1) The term of auditor holding the office in a company is increased to 5 years
subject to ratification at every AGM as compared to one year in the previous act.
2) Mandatory rotation of auditors in case of listed companies, certain unlisted
companies & certain private companies after 5 years.
3) No. of audits per individual/partner reduced to twenty including private limited
companies.
4) LLP is eligible to be appointed as an auditor
5) A firm/LLP can partner with non-CA’s and still be appointed as auditor.
6) Automatic re-appointment of retiring auditor in case of other companies where
no resolution is passed in AGM
7) Certain services named in Section 144 which an auditor cannot provide to its
auditee
8) Compliances in relation to appointment, resignation of auditor have increased
and changed significantly.

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9) Acts of Relative is included within the ambit of disqualification of an auditor
10) Limits for disqualification in case of holding of security, indebtness to a company
or providing guarantee to a company have increased.
11) Business relationship with a company is bought within the ambit of
disqualification of an auditor
12) As per Section 143 (2), an auditor is required to make a report to the members on
the accounts examined by him and on every financial statement which are required by
or under this Act to be laid in GM report shall after taking into account the provisions
of this Act, the accounting and auditing standards and matters which are required to
be included in the audit report
a. Balance Sheet
b. Profit & Loss Account

11.10 Audit Report under the Companies Act, 2013- Reporting under
CARO

The audit report is absolutely fundamental to the audit. The whole purpose of all the
procedures carried out during the audit is to enable the auditors to express their
opinion in their report to the members. It is the end product of every audit. Thus audit
report declares the medium through which an auditor expresses his opinion on the
financial statements or other data under audit.
A report is a formal statement normally made after an enquiry, examination or review
of specified matters under report and includes the reporting auditor’s opinion thereon.
A certificate, on the other hand, is a written confirmation of the accuracy of the facts
stated therein and does not involve any estimate or opinion.
The auditor’s report should contain a clear written expression of opinion on the
financial statements taken as a whole.

Summary

• Companies Act, 2013 is rule based Act. Sections 139 to 148 of the Companies Act,
2013 (hereinafter referred to as the Act unless otherwise mentioned) deal with
provisions relating to audit of companies
• The auditor has certain qualifications and disqualifications which are compulsory
required to be observed.
• Section 144 of the Companies Act, 2013 prescribes certain services not to be
rendered by the auditor.
• Section 139 of the Companies Act, 2013 contains provisions regarding Appointment
of Auditors. Discussion on appointment of auditors may be grouped under two broad

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headings-
o Appointment of First Auditors.
o Appointment of Subsequent Auditors
• As per section 128(1) of the Companies Act, 2013, every company shall prepare and
keep at its registered office books of account and other relevant books and papers and
financial statement for every financial year which give a true and fair view of the state
of the affairs of the company, including that of its branch office or offices, if any, and
explain the transactions effected both at the registered office and its branches and
such books shall be kept on accrual basis and according to the double entry system of
accounting.

Self-Assessment Questions

a. Multiple choice Questions

1. Who appoints the first auditor of the company ?

a) Central Government
b) NCLT
c) BOD
d) Shareholders
2. Within what time The first Auditor of a Company shall be appointed by the Board of
Directors ?
a) 30 days from the registration
b) 90 days from the registration
c) 1 year of registration
d) 60 days from registration

3. Which of the following services cannot be rendered by an auditor as per Companies

Act 2013?
a) Vouching
b) Verification of assets and liabilities
c) Issuing certificates on relevant matters
d) Providing investment advisory services

4. What is not a right of the auditor ?

a) Right to access books
b) Right to report fraud
c) Right to attend board meetings
d) Right to obtain information

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5. What is the maximum company in which an auditor can be appointed as an auditor?
a) 15
b) 20
c) 25
d) 30

b. Essay type

i. Write a note on the ceiling limit on the number of audits.

ii. Auditor is not allowed to do all the activities. Comment
iii. How is the audit report prepared.
iv. Write a note on Branch Audit.
v. What are the qualification to be an auditor?

Keys to Multiple Choice Questions

1- C, 2- a, 3- d, 4- c, 5- b

Post-Unit Reading Material

 https://www.indiafilings.com/learn/llp-annual-
filing/#:~:text=LLP%20Audit%20Requirement,25%20lakhs.
 https://www.mca.gov.in/MinistryV2/disclosureauditandfilingrequirements.htm

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 UNIT

AUDIT OF PUBLIC SECTOR UNDERTAKINGS

Names of Sub-Unit
Special features, Direction of Comptroller and Auditor General of India, Concept of Propriety
Audit, Performance Audit, Comprehensive Audit.

Overview
In this unit you will learn about how the audit is done for public sector undertaking, who
takes care of that audit. Next you will learn everything about Comptroller and Auditor General
of India and finally few types of audit applicable to Public sector undertaking.

Learning Objectives
In this Unit you will learn –

 To understand how the audit of public sector undertaking is done

 To know complete powers and duties of CAG
 To learn about the propriety audit
 To evaluate how the comprehensive audit is done
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Learning Outcomes
At the end of this Unit you would -
 Be able to tell what is public sector undertaking
 How is the audit of public sector undertaking done
 Understand the role of Comptroller and Auditor General of India
 Have knowledge about various types of audit in PSUs

Pre-Unit Preparatory Material

 https://resource.cdn.icai.org/67254bos54141-cp13.pdf
 https://cag.gov.in/en/page-cag-of-india

Table of Topics :

12.1 Introduction
12.2 Meaning of Public Sector Undertaking
12.3 Special Features of Audit of PSUs
12.4 Direction of Comptroller and Auditor General of India
12.5 Concept of Propriety Audit
12.5.1 Meaning of Propriety Audit
12.5.2 What aspects are checked in Propriety Audit
12.6 Performance Audit
12.6.1 Meaning of Performance Audit
12.6.2 Objective of Performance Audit
12.6.3 The 3 e’s of Performance Audit
12.7 Comprehensive Audit
12.7.1 What is a comprehensive audit?
12.7.2 Areas of Comprehensive audit
12.7.3 Principles of Conducting Comprehensive Audit

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12.1 Introduction
Public sector undertakings in India are fundamentally owned or controlled by Central
Government, or any state government or governments, or partly by the central government
and one or more state governments. The public enterprises have been assigned a key role in
the socio-economic development of the country. The audit of these undertakings is not done
in the normal manner but a separate authority is established for taking care of the audit of
PSUs.

Before understanding how the audit of PSUs is done first let us understand the meaning of
PSUs

12.2 Meaning of Public Sector Undertaking

As defined under section 2(45) of the Companies Act, 2013, a “Government Company” is
a company in which not less than 51% of the paid-up share capital is held by the Central
Government or by any State Government or Governments or partly by the Central
Government and partly by one or more State Governments, and includes a company
which is a subsidiary company of such a Government company.

12.3 Special Features of Audit of PSUs

In India, audit of the above government companies is performed by an independent
constitutional authority, i.e. Comptroller and Auditor General of India (C&AG), through

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the Indian Audit and Accounts Department. The Constitution of India gives a special
status to the C&AG and contains provisions to safeguard his independence.
Some of the features of PSU audit is as under :
1. The audit of PSUs is performed by Comptroller and Auditor General of India ( C&AG)
2. C&AG is appointed by the President of India
3. Audit reports of the C&AG relating to the accounts of the Central/ State Government
should be submitted to the President/Governor of the State who shall cause them to
be laid before Parliament/State Legislative Assemblies.
4. C&AG shall hold office for a term of six years or upto the age of 65 years, whichever is earlier.
5. He can resign at any time through a resignation letter addressed to thePresident.
6. Audit of PSUs not constrained to Financial and Compliance Audit: Audit of public enterprises in
India is not restricted to financial and compliance audit; it extends also to performance (efficiency,
economy and effectiveness with which these operate and fulfill their objectives and goals).
7. The Three parties - Auditor, Responsible Party and Intended Users.
Auditor: The role of auditor is fulfilled by Supreme Audit Institution (SAI), India and by its personnel
delegated with the duty of conducting audits. The Comptroller and Auditor General of India (CAG) and the
Indian Audit and Accounts Department (IAAD) functioning under him, constitute the Supreme Audit
Institution of India
Responsible Party: The relevant responsibilities are determined by constitutional or legislative
arrangement. Generally, auditable entities and those charged with governance of the auditable entities
would be the responsible parties. The responsible parties may be responsible for the subject matter
information, for managing the subject matter or for addressing recommendations.
Intended Users: Intended users are the individuals, organizations or classes thereof for whom the
auditor prepares the audit report.
8. Subject matter, criteria and subject matter information.
• This refers to the information, condition or activity that is
Subject matter measured or evaluated against certain criteria.

• These are the benchmarks used to evaluate the subject matter.

Criteria
• This refers to the outcome of evaluating or measuring the subject
Subject matter matter against the criteria.

information

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12.4 Direction of Comptroller and Auditor General of India

The Comptroller and Auditor General of India will order the audit of Public sector
Companies in the following manner :

(a) Appointment of Auditors under Section 139(5) and 139(7) read with section 143(5) of the
Companies Act, 2013 - Statutory auditors of Government Companies are appointed or re-
appointed by the C&AG. There is thus, a departure from the practice in vogue in the case of privatesector
companies where appointment or re-appointment of the auditors and their remunerationare decided
by the members at the annual general meetings. In the case of government companies, though the
appointment of statutory auditors is done by the C&AG, the remuneration is left to the individual
companies to decide based on certain guidelines given by the C&AG in this regard.
The C&AG may direct the appointed auditor on the manner in which the accounts of the
Government company are required to be audited and the auditor so appointed has to submit a
copy of the audit report to the Comptroller and Auditor-General of India. The report, among other
things, includes the directions, if any, issued by the C&AG, the action taken thereon and its impact
on the accounts and financial statement of the company.
The report under section 143(5) is in addition to the reports issued by the Statutory Auditors under
various other clauses of section 143.
(b) Supplementary audit under section 143(6)(a) of the Companies Act, 2013 - The Comptroller
and Auditor-General of India shall within 60 days from the date of receipt of the audit report have a
right to conduct a supplementary audit of the financial statements of the government company by
such person or persons 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 authorised, on
such matters, by such person or persons, and in such form, as the C&AG may direct.
(c) Comment upon or supplement such Audit Report under section 143(6)(b) of the Companies
Act, 2013 - Any comments given by the C&AG upon, or in supplement to, the audit report issued
by the statutory auditors shall be sent by the company to every person entitled to copies of audited
financial statements under sub-section (1) of section 136 of the said Act i.e. every member of the
company, to every trustee for the debenture-holder of any debentures issued by the company, and
to all persons other than such member or trustee, being the person so entitled and also be placed
before the annual general meeting of the company at the same time and in the same manner as
the audit report.
(d) Test audit under section 143(7) of the Companies Act, 2013 - Without prejudice to the provisions
relating to audit and auditor, the C&AG may, in case of any company covered under sub-section (5)
or sub-section (7) of section 139 of the said Act, if he considers necessary, by an order, cause test
audit to be conducted of the accounts of such company and the provisions of section 19A of the
Comptroller and Auditor-General's (Duties, Powers and Conditions of Service) Act, 1971, shall apply
to the report of such test audit.
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12.5 Concept of Propriety Audit

The propriety audit is confined to examine the validity of appropriations or is concerned

with verifying that there is no leakage of revenue and wastage of funds knowingly or
unknowingly in disregard to any legal requirement or financial or economic consideration.
Under ‘propriety audit’, it is to be seen that the contracts entered into by the concern are in
its best interest and there is a proper check to ensure that the properties are safe. Thus it is
a form of super or higher audit. The propriety Audit is the inter-related aspect of
‘Management Audit’ also.

Propriety Audit: The term ‘propriety’ means ‘justness’ or ‘rightness’. When the term is
applied in audit it signifies the audit of rightness of expenditure incurred or the rightness or
optimum result or rightness of selecting alternative plan of action.

12.5.1 Meaning of Propriety Audit

Propriety is that which meets the tests of public interest, commonly accepted customs and
standards of conducts and particularly as applied to professional performance, a requirement
of regulations and professional codes- E.L. Kohler

12.5.2 What aspects are checked in Propriety Audit

The functions of Auditor in the context of Propriety Audit may be specified as under :

 To see that all expenditure incurred are properly planned.

 To see that the size and channels of expenditure are rightful and expected to give
maximum results.

 To appraise (Audit) whether those expenditure are likely to give optimum result.

 To see that any substitute plan of action can bring about an improvement on
current operation and as well as return from capital expenditure.

 To examine the actions and decisions of the management to see that they are
conductive to public interests and that they meet the standards of conduct.

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12.6 Performance Audit

12.6.1 Meaning of Performance Audit

Performance audit is an independent, objective and reliable examination of whether public

sector undertakings, systems, operations, programmes, activities or organizations are
operating in accordance with the principles of economy, efficiency and effectiveness.

12.6.2 Objective of Performance Audit

The main objective of performance audit is to constructively promote economical,

effective and efficient governance. It also contributes to accountability and
transparency. Performance audit promotes accountability by assisting those charged with
governance and oversight responsibilities to improve performance through an examination
of whether:

a) decisions by the legislature or the executive are efficiently and effectively prepared and
implemented and

b) tax payers or citizens have received value for money.

It does not question the intentions and decisions of the legislature, but examines whether
any shortcomings in the implementation of the law and framing of regulations have
prevented the specified objectives from being achieved. Performance audit focuses on
areas in which it can add value for citizens and which have the greatest potential for
improvement.It provides constructive incentives for the responsible parties to take
appropriate action.

Performance audit promotes transparency by affording all stakeholders an insight into the
management and outcomes of different public sector activities. It thereby directly
contributes to providing useful information to the citizen, while also serving as a basis for
learning and improvements.

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12.6.3 The 3 e’s of Performance Audit

The performance audit addresses the issue of :

(i) Economy- It is minimising the cost of resources used for an activity, having regard to appropriate
quantity, quality and at the best price.

(ii) Efficiency- It is the input-output ratio. In the case of public spending, efficiency is achieved when
the output is maximised at the minimum of inputs, or input is minimised for any given quantity
and quality of output.
Auditing efficiency embraces aspects such as whether:
(a) sound procurement practices are followed;
(b) resources are properly protected and maintained;
(c) human, financial and other resources are efficiently used;
(d) optimum amount of resources (staff, equipment, and facilities) are used in producing or
delivering the appropriate quantity and quality of goods or services in a timely manner;
(e) public sector programmes, entities and activities are efficiently managed, regulated,
organised and executed;
(f) efficient operating procedures are used; and
(g) the objectives of public sector programmes are met cost-effectively.
(iii) Effectiveness- It is the extent to which objectives are achieved and the relationship between the
intended impact and the actual impact of an activity.
In auditing effectiveness, performance audit may, for instance:
(a) assess whether the objectives of and the means provided (legal, financial, etc.) for a new orongoing
public sector programme are proper, consistent, suitable or relevant to the policy;

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(b) determine the extent to which a program achieves a desired level of program results;
(c) assess and establish with evidence whether the observed direct or indirect social and economic
impacts of a policy are due to implementation of the policy or to other causes;

12.7 Comprehensive Audit

12.7.1 What is a comprehensive audit?

A comprehensive audit is a process of objectively obtaining and evaluating a company’s financial
information, its internal structure, whether or not it complies with applicable laws and regulations and if it
achieves its objectives by the appropriate means. This type of audit manages to inform if the company in
question, based on a detailed prior study, fits all the established indicators and criteria.

12.7.2 Areas of Comprehensive audit

The comprehensive audit consists of:
a. Determine if the financial statements of the company conform to generally accepted
accounting principles.
b. Determine if the company has complied or not with its regulations and statutes.
c. Evaluate the internal control structure.
d. Evaluate the degree of efficiency when it comes to achieving business objectives.
e. Evaluate the environmental impact generated by the company, either directly or
indirectly, that may arise during the development of its processes and products.
f. Analyze the age, distribution and structure of the production plants of the company
and the risks associated with it.
g. The integral audit in a company will be carried out by an independent public accountant
to said company.

12.7.3 Principles of Conducting Comprehensive Audit

To understand well what the comprehensive audit refers to, we here detail the general principles that
define it:
a. Independence
The auditors who carry out this type of audit in a company must act outside of any professional or
personal impediment, thus guaranteeing a professional and reliable study.

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b. Objectivity
The judgment and conclusion that the auditor gives must be totally impartial and in accordance with
the reality of the company and its professional activity.
c. Permanence
The advisable thing for any business is that this integral audit is carried out of the periodic and
regular way in the time, to guarantee like this the fulfillment of its objectives in the most efficient way
possible.
d. Certification
The analysis and the reports made by the auditors are true and are fully valid at the official and
public levels.
e. Integrity
The integral audit, as its own name indicates, comprehensively covers all the processes, areas and
goods that make up the company.
f. Supervision
Through the comprehensive audit, everything is supervised, from the processes and resources to the
company personnel. In this way, the auditor will have sufficient information to make an assessment.
g. Shape
The auditor’s report must be submitted in writing. You must respect the structure and paragraphs of
the audit report that are required by law and show your opinion with any of the existing possibilities.

Summary
 Public sector undertakings in India are fundamentally owned or controlled by central government, or any
state government or governments, or partly by the central government and one or more
state governments

 In India, audit of the above government companies is performed by an independent constitutional

authority, i.e. Comptroller and Auditor General of India (C&AG), through the Indian Audit and
Accounts Department.

 The C&AG shall hold office for a term of six years or upto the age of 65 years, whichever is
earlier

 Statutory auditors of Government Companies are appointed or re- appointed by the C&AG

 Performance audit in PSUs is conducted by the C&AG (Supreme Audit Institutions) through various
subordinate offices of Indian Audit and Accounts Department (IAAD).

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 The areas covered in comprehensive audit naturally vary from enterprise to enterprise depending
on the nature of the enterprise, its objectives and operations. However, in general, the covered areas
are those of investment decisions, project formulation, organisational effectiveness, capacity
utilisation, management of equipment, plant and machinery, production performance, use of
materials, productivity of labour, idle capacity, costs and prices, materials management, sales and
credit control, budgetary and internal control systems

 Propriety audit stands for verification of transactions on the tests of public interest, commonly
accepted customs and standards of conduct

Self-Assessment Questions

Multiple choice Questions

1. Who appoints the auditor of government company?
a) Shareholders
b) Directors
c) Comptroller and Auditor General of India
d) Government

2. Who appoints C&AG?

a) The shareholders
b) Prime minister
c) President
d) Parliament

3. Till what age the C&AG can continue the office ?

a) 65 years of age
b) 6 years
c) 65 years of age or 6 years of term whichever is earlier
4. To whom CAG can submit his resignation letter ?
a) Parliament
b) President
c) NCLT
d) Prime minister
5. Railways is an example of which type of PSU?
a) Private entity
b) Public sector
c) Government Department
d) Government Company

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6. Who authorises Government company audit ?
a) Auditor
b) Shareholder
c) CAG
d) Director
7. A company where Central Government is holding 58% stake, what is such company
called ?
a) Public company
b) Government Company
c) Private company
d) Holding company

a. Essay type
1. “A performance audit is an objective and systematic examination of evidence for the purpose
of providing an independent assessment of the performance of a government organization,
program, activity, or function in order to provide information to improve public accountability
and facilitate decision-making by parties with responsibility to oversee or initiate corrective
action.” Briefly discuss the issues addressed by Performance Audits conducted in accordancewith
the guidelines issued by C&AG.

2. Write a short explanatory note on –

a. Areas of propriety audit under Section 143(1) of the Companies Act, 2013.
b. Role of C&AG in the Audit of a Government company.
3. Ceta Ltd. is a company in which 54% of the paid up share capital is held by Rajasthan
Government. The company is engaged in the business of providing consultancy services in
relation to construction projects. The audit of the financial statements of Ceta Ltd. for the
financial year ended 31 March 2020 got completed with lot of intervention of Comptroller &
Auditor General of India, wherein C&AG was giving directions to the auditors on the manner
in which audit should be conducted in respect of certain areas. Further, it also received
comments from C&AG on the audit report of the auditors. Ceta Ltd is seeking advice to go
against C&AG so that they can avoid unnecessary interference of C&AG. You are requiredto
advise Ceta Ltd. with respect to role of C&AG in the audit of a Government company.
4. Write a note on comprehensive audit

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Keys to Multiple Choice Questions

1-c, 2- c, 3- c, 4-a, 5- c, 6- c, 7- b

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 UNIT

Audit of different types of Entities

Names of Sub-Unit
Appointment of Auditor, Audit Procedures and Audit report in respect of different category
of entities: Government, Local Bodies and Non- Profit Organisations, Partnership Firms, Audit
of Different type of undertakings i.e. Educational Institutions, Hotels, Clubs, Hospitals, Basics
of Limited Liability Partnership Audit and Co-operative Societies Audit.

Overview
In this unit you will learn about how the audit is done for various entities like Local Bodies,
NGO Clubs, Hotels etc.

Learning Objectives
In this Unit you will learn –

 Understand the procedures to be adopted for auditing of Not-for-profit

Organizations (NGOs), Charitable Institutions.
 Gain knowledge of auditing procedure of sole trader, firm, educational institutions,
hospitals, clubs, cinema, hotels etc.
 Learn the audit procedure of hire purchase and leasing company accounts.
 Identify the audit procedures of Government, Local Bodies, Co-operative Societies,
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Learning Outcomes
At the end of this Unit you would -
 Identify who does the audit for various organization
 Examine how audit is done for various organisations
 Evaluate the areas to be checked in various audits.

Pre-Unit Preparatory Material

 https://resource.cdn.icai.org/66609bos53774-cp13.pdf

Table of Topics

13.1 Introduction
13.2 Government Audit
13.2.1 Background
13.2.2 Appointment and removal of C&AG
13.2.3 Powers of C&AG
13.3 Audit of Local Bodies
13.3.1 Audit Programme for Local Bodies
13.4 Audit of NGO
13.4.1 Background
13.4.2 Provisions relating to audit
13.5 Audit of Firm
13.5.1 Appointment of Auditor
13.5.2 Matters to be considered before starting audit
13.6 Audit of Educational Institutional
13.7 Audit of Hotels
13.8 Audit of Clubs
13.9 Audit of Hospitals
13.10 Basics of Limited Liability Partnerships(LLP) Audit
13.11 Audit of Co-operative Society
13.12 Summary

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13.1 Introduction

When it comes to audit of different entities various factors are to be kept in mind while
carrying out the audit. Different types of entities needs different type of expertise.

Source: ICAI

13.2 GOVERNMENT AUDIT

13.2.1 Background
Government Audit aims to ensure accountability of the executive in respect of public
revenue and expenditure. Primarily, the Parliament and in case of States, the State
legislatures control all government expenditure through insistence upon demand for
grants. The main idea underlying this control is that no expenditure can be
incurred unless it has been voted upon by the Parliament or State Legislatures and
funds for every such expenditure must be provided from out of the Consolidated
Fund of India or of the State. The audit of such entities is done by C&AG

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13.2.2 Appointment and removal of 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 mis-behaviour or incapacity. As in the case of a Judge
of the Supreme Court, he can be removed only when each House of Parliament decides
to do so by a majority of not less than 2/3rd of the members of the House present and
voting. The Parliament is competent to make laws to determine salary and other
conditions of service and they cannot be varied to his disadvantage after his
appointment. 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.
The Comptroller & Auditor General’s (Duties, Powers and Conditions of Service) Act,
1971 passed in pursuance of the provisions of the Constitution lays down a fixed tenure
of the office prescribing that he shall be paid a salary which is equal to the salary of the
Judge of the Supreme Court thereby further strengthening his independence.

13.2.3 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 is his duty to prepare.
(d) 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 suchlimited
checks in relation to such accounts or transactions as he may determine.

13.3 AUDIT OF LOCAL BODIES

(1) A Municipality can be defined as a unit of local self-government in an urban area. By
the term ‘local self-government’ is ordinarily understood the administration of a locality
– a village, a town, a city or any other area smaller thana state – by a body representing
the local inhabitants, possessing fairly large autonomy, raising at least a part of its revenue

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through local taxation and spending its income on services which are regarded as local
and, therefore, distinct from state and central services.

(2) Municipal government in India covers five distinct types of urban localauthorities-

 the municipal corporations,

 the municipal councils,
 the notified area committees,
 the town area committees and
 the cantonment committees.
(3) Municipal authorities are endowed with specific local functions covering

(a) regulatory,
(b) maintenance and
(c) development activities.

(4) Expenditure incurred by the municipalities and corporations can be

broadly classified under the following heads:
(a) general administration and revenue collection,
(b) public health,
(c) public safety,
(d) education,
(e) public works, and others such as interest payments, etc

The important objectives of audit are:

(a) reporting on the fairness of the content and presentation of financial
statements;
(b) reporting upon the strengths and weaknesses of systems of financial control;
(c) reporting on the adherence to legal and/or administrative requirements;
(d) reporting upon whether value is being fully received on money spent; and

(e) detection and prevention of error, fraud and misuse of resources.

13.3.1 Audit Programme for Local Bodies
(i) APPOINTMENT:-The Local Fund Audit Wing of the State Govt. is generally in- charge
of the audit of municipal accounts. Sometimes bigger municipal corporations e.g.

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Delhi, Mumbai etc have power to appoint their own auditors for regular external
audit. So the auditor should ensure his appointment.
(ii) AUDITOR’S CONCERNS:-The auditor while auditing the local bodies should report on
the
fairness of the contents and presentation of financial statements

 the strengths and weaknesses of system of financial control,

 the adherence to legal and/or administrative requirements;
 whether value is being fully received on money spent.
His objective should be to detect errors and fraud and misuse of resources.
(iii) RULES & REGULATIONS :- The auditor should ensure that the expenditure incurred
conforms to the relevant provisions of the law and is in accordance with the financial
rules and regulations framed by the competent authority.
(iv) AUTHORISATIONS :- He should ensure that all types of sanctions, either special or
general, accorded by the competent authority.
(v) PROVISIONING :- He should ensure that there is a provision of funds and the
expenditure is incurred from the provision and the same has been authorized by the
competent authority.
(vi) PERFORMANCE :- The auditor should check that the different schemes, programmes
and projects, where large financial expenditure has been incurred, are running
economically and getting the expected results.
13.4 AUDIT OF NON-GOVERNMENTAL ORGANISATION (NGO’S)

13.4.1 Background
NGOs can be defined as non-profit making organisations which raise funds from members,
donors or contributors apart from receiving donation of time, energy and skills for
achieving their social objectives like imparting education, providing medical facilities,
economic assistance to poor, managing disasters and emergent situations

13.4.2 Provisions Relating to Audit

The auditors of an NGO registered under the Societies Registration Act, 1860 (or under
any law corresponding to this Act, in force in any part of India) or the Indian Trusts Act
1882 are normally appointed by the Management of the Society or Trust. The auditors
of NGO registered under section 8 of the Companies Act, 2013 are appointed by the
members of the company. Some of the statues such as the
Companies Act, 2013, Foreign Contribution (Regulation) Act 1976, Income Tax Act 1961

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required that the accounts of the NGO be audited and submitted to the prescribed
authorities and failure to do so could lead to forfeiture of certain exemptions and
benefits. In the case of NGO/PDA’s different statutes have specified certain audit reports.
The Foreign Contribution (Regulation) Act 1976 has prescribed the format and requires
that the same be furnished to the Ministry of Home Affairs within 60 days from the closeof
the financial year i.e. by May 30 each year.
While planning the audit, the auditor may concentrate on the following:
(i) Knowledge of the NGO’s work, its mission and vision, areas of operations and
environment in which it operate.
(ii) Updating knowledge of relevant statutes especially with regard to recent
amendments, circulars, judicial decisions viz. Foreign Contribution (Regulation) Act
1976, Societies Registration Act, 1860, Income Tax Act 1961 etc. and the Rules related
to the statutes.
(iii) Reviewing the legal form of the Organisation and its Memorandum of Association,
Articles of Association, Rules and Regulations.
(iv) Reviewing the NGO’s Organisation chart, then Financial and Administrative Manuals,
Project and Programme Guidelines, Funding Agencies Requirements and formats,
budgetary policies if any.
(v) Examination of minutes of the Board/Managing Committee/Governing Body/
Management and Committees thereof to ascertain the impact of any decisions on
the financial records.
(vi) Study the accounting system, procedures, internal controls and internal checks
existing for the NGO and verify their applicability.
(vii) Setting of materiality levels for audit purposes.
(viii) The nature and timing of reports or other communications.
(ix) The involvement of experts and their reports.
(x) Review the previous year’s Audit Report.

13.5 AUDIT OF FIRM

13.5.1 Appointment of Auditors

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 acondition 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. In case
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of change of auditor, it would be duty of incoming auditor to communicate with the
previous auditor.
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.

13.5.2 Matters to be considered before starting audit

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 amongthe
partners or losses shall have to be contributed by them; whether thelosses 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 e.g., creation of reserves, provisionfor 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 caseof non-
trading firms).
7. The rate at which interest will be allowed on the capitals and loans providedby
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?

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13.6 AUDIT OF EDUCATIONAL INSTITUTIONS (SCHOOL, COLLEGE OR

UNIVERSITY)
The special steps involved in their audit are the following-
(A) General :-
Examine the Trust Deed or Regulations, in the case of school or college andnote all the
provisions affecting accounts. In the case of a university, refer to the Act of Legislature
and the Regulation framed thereunder
Read through the minutes of the meetings of the Managing Committee or Governing
Body, noting resolutions affecting accounts to see that these have been duly complied
with, specially the decisions as regards the operation of bank accounts and
sanctioning of expenditure.
(B) Fee from Students :-
1. Check names entered in the Students Fee Register for each month or term, with
the respective Class Registers, showing names of studentson rolls and test
amount of fees charged; and verify that there operatesa system of internal
check which ensures that demands against the students are properly raised.
2. Check fees received by comparing counterfoils of receipts granted with entries
in the Cash Book and tracing the collections in the Fee Registerto confirm
that the revenue from this source has been duly accountedfor.
(C) Other Receipts/Grants & Donations :-
1. Verify rental income from landed property with the rent rolls, etc.
2. Vouch income from endowments and legacies, as well as interest and dividends
from investment; also inspect the securities in respect of investments held.
3. Verify any Government or local authority grant with the memo of grant. If any
expense has been disallowed for purposes of grant, ascertain the reasons
thereof.
(D) Expenditure :-
1. Verify that the Provident Fund money of the staff has been invested in
appropriate securities.
2. Vouch donations, if any with the list published with the annual report. If some
donations were meant for any specific purpose, see that the money was
utilised for the purpose.
(E) Assets & Laibilities :-
1. Report any old heavy arrears on account of fees, dormitory rents, etc.to the
Managing Committee.
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2. Confirm that caution money and other deposits paid by students on
admission, have been shown as liability in the balance sheet not transferred to
revenue, unless they are not refundable.
3. See that the investments representing endowment funds for prizes are kept
separate and any income in excess of the prizes has been accumulated and
invested along with the corpus

(F) Compliances :-

1. Confirm that the refund of taxes deducted from the income from investment
(interest on securities etc.) has been claimed and recovered since the
institutions are generally exempted from the payment of income-tax.
2. Finally, verify the annual statements of account and, while doing so see that
separate statements of account have been prepared as regardsPoor Boys
Fund, Games Fund, Hostel and Provident Fund of staff, etc.

13.7 AUDIT OF HOTELS

The special considerations in a hotel audit can be summarised as follows:
1. Internal Controls - Pilfering is one of the greatest problems in any hotel and the
importance of internal control cannot be undermined. It is the responsibility of
management to introduce controls which will minimise 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
2. Room Sales & Hall Bookings- The charge for room sales is normally posted to guest
bills by the receptionist/ front office 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 numbers of guests are charged for the correct
period.
3. Inventories - The inventories in any hotel are both readily portable and saleable
particularly the food and beverage inventories. It is therefore extremely important that
all movements and transfers of such inventories should be properly documented to
enable control to be exercised over each individual stores areas and sales point.
4. Fixed Assets - The accounting policies for assets of individual hotels are likely to
differ. However, many hotels account for certain assets such as silver and cutlery on
inventory basis.
5. Casual Labour - The hotel trade operates to very large extent on 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.

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6. Travel Agents & Shops -

For ledgers coming through travel agents or other booking agenciesthe bills are
usually made on the travel agents or booking agencies. The auditor should ensure that
money are recovered from the travel agents or booking agencies as per the terms of
credit allowed.
13.8 AUDIT OF CLUB
The special steps involved in such an audit are stated below-
(1) Entrance Fee :- 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.
(2) Subscriptions :- Vouch members’ 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.
(3) Arrears of Subscriptions :- 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.
(4) Arithmetical accuracy :- Check totals of various columns of the Register of members
and tally them across
(5) Irrecoverable Member Dues :- 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.
(6) Pricing :- Verify the internal check as regards members being charged withthe
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.
(7) Member Accounts :- 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.
(8) Purchases :- Vouch purchase of sports items, furniture, crockery, etc. and trace their
entries into the respective inventory registers.
(9) Margins earned :- 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 inventory of unsold provisions and stores, at the end of year, should
be verified physically and its valuation checked.
(10) Inventories :- Check the inventory of furniture, sports material and otherassets
physically with the respective inventory registers or inventoriesprepared at the end

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of the year.

13.9 AUDIT OF HOSPITAL

The special steps involved in such an audit are stated below

1. Register of Patients: 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. Collection of Cash: Check cash collections as entered in the Cash Book withthe
receipts, counterfoils and other evidence for example, copies of patients bills,
counterfoils of dividend and other interest warrants, copies of rent bills, etc.
3. Income from Investments, Rent etc: 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 have been collected.
Legacies and Donations: Ascertain that legacies and donations received for
4.
a specific purpose have been applied in the manner agreed upon.
5. Reconciliation of Subscriptions: Trace all collections of subscription anddonations
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. Authorisation and Sanctions: 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 incrementsto staff have been
duly authorised.
7. Grants and TDS: Verify that grants, if any, received from Government or local
authority has been duly accounted for. Also, that refund in respect of taxes deducted
at source has been claimed.
8. Budgets: 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. Internal Check: Examine the internal check as regards the receipt and issueof
stores; medicines, linen, apparatus, clothing, instruments, etc. so as to insure that
purchases have been properly recorded in the Inventory Register and that issues
have been made only against proper authorisation.
10. Depreciation: See that depreciation has been written off against all the assets at the
appropriate rates.

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11. Registers: Inspect the bonds, share scrips, title deeds of properties and compare their
particulars with those entered in the property and Investment Registers.
12. Inventories: 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.
13. Management Representation and Certificate: Get proper Management
Representation and Certificate with respect to various aspects covered during the
course of audit

13.10 Basics of Limited Liability Partnerships(LLP) Audit

Distinctive Features of an LLP :- LLP is governed by the Limited Liability Partnership
Act 2008, which has come into force with effect from April 1, 2009. It is a form of
business organisation which enshrines in itself the advantages of both the Company
and Partnership forms of Organisation. Minimum of 2 Partners can form an LLP and
atleast two partners would be Designated Partners who would be required to take DPIN
( Designated Partner Identification Number ) The Partnersin an LLP and their rights and
duties are governed by way of an agreement between them .
Whether LLP is required to maintain Books of Accounts :- An LLP shall be under obligation
to maintain annual accounts reflecting true and fair view of its state of affairs. LLP’s are
required to maintain books of accounts which shall contain-
1. Particulars of all sums of money received and expended by the LLP and thematters
in respect of which the receipt and expenditure takes place,
2. A record of the assets and liabilities of the LLP,
3. Statements of costs of goods purchased, inventories, work-in-progress,
finished goods and costs of goods sold,
4. Any other particulars which the partners may decide.

Audit of the Accounts of an LLP :- The accounts of every LLP shall be auditedin
accordance with Rule 24 of LLP, Rules 2009. Such rules, inter-alia, provides that any LLP,
whose turnover does not exceed, in any financial year, forty lakh rupees, or whose
contribution does not exceed twenty five lakh rupees, is not required to getits accounts
audited. However, if the partners of such limited liability partnership decide to get the
accounts of such LLP audited, the accounts shall be audited onlyin accordance with such
rule

Auditor’s Duty Regarding Audit of LLP

1. Engagement Letter :- The auditor should get definite instructions in writing

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as to the work to be performed by him.
2. Minutes Book :- If partners maintain minute book he shall refer it for anyresolution
passed regarding the accounts
3. LLP Agreement :- The auditor should read the LLP agreement & note the
following provisions
(a) Nature of the business of the LLP.
(b) Amount of capital contributed by each partner.
(c) Interest – in respect of additional capital contributed.
(d) Duration of partnership.
(e) Drawings allowed to the partners.
(f) Salaries, commission etc payable to partners.
(g) Borrowing powers of the LLP.
(a) Rights & duties of partners.
(b) Method of settlement of accounts between partners at the time ofadmission,
retirement, admission etc.
(c) Any loans advanced by the partners.
(d) Profit sharing ratio

4. Reporting :- The auditor should mention

(a) Whether the records of the firm appear to be correct & reliable.
(b) Whether he was able to obtain all information & explanation necessaryfor his
work.
(c) Whether any restriction was imposed upon him.

13.11 AUDIT OF CO-OPERATIVE SOCIETIES

(1) The Registrar shall audit or cause to be audited by some person authorised
by him by general or special order in writing in this behalf the accounts of every
registered society once at least in every year.
(2) The audit under sub-section (1) shall include an examination of overdue debts,
if any, and a valuation of the assets and liabilities of the society.
(3) The Registrar, the Collector or any person authorised by general or special order
in writing in this behalf by the Registrar shall at all times have access toall the
books, accounts, papers and securities of a society, and every officer of the
society shall furnish such information in regard to the transactions and working
of the society as the person making such inspection may require.

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“Registrar” means a person appointed to perform the duties of a Registrar of Co-

operative Societies under this Act.
The following points should be kept in mind in connection with the audit of a
co- operative society:
1. Qualifications of Auditors - Apart from a chartered accountant within the
meaning of the Chartered Accountants Act, 1949, some of the State Co-operative Acts
have permitted persons holding a government diploma in co-operative accounts or
in co-operation and accountancy and also a person who has served as an auditor in
the co-operative department of a government to act as an auditor.
2. Appointment of the Auditor - An auditor of a co-operative society is
appointed by the Registrar of Co-operative Societies and the auditor so appointed
conducts the audit on behalf of the Registrar and submits his report to him as also
to the society. The audit fees are paid by the society on the basis of statutory scale
of fees prescribed by the Registrar, according to the category of the society audited.
3. Books, Accounts and other records of Co-operative Societies - Under section 43(h)
of the Central Act, a state government can frame rules prescribing the books and
accounts to be kept by a co-operative society

4. Restrictions on share holdings - According to section 5 of the Central Act, in the case
of a society where the liability of a member of the society is limited, no member of a
society other than a registered society can hold such portion of the share capital of the
society as would exceed a maximum of twenty percent of the total number of shares
or of the value of shareholding to ₹ 1,000/-.

5. Restrictions on loans - Section 29 of the Central Act puts restriction on loan.It states
that a registered society shall not make a loan to any person other than a member.
However, with the special sanction of the Registrar, a registered society maymake a
loan to another registered society

6. Restrictions on borrowings - Section 30 of the Central Act further puts

restriction on borrowings. According to this section, a registered society shall accept
loans and deposits from persons who are not members subject to the restrictions and
limits of the bye-laws of the society. The auditor will have to examine the bye-laws
in this respect.
7. Investment of funds - According to section 32 of the Central Act, a society
may invest its funds in any one or more of the following:
(a) In the Central or State Co-operative Bank.
(b) In any of the securities specified in section 20 of the Indian Trusts Act, 1882.
(c) In the shares, securities, bonds or debentures of any other society with limited
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liability.
(d) In any co-operative bank, other than a Central or State co-operative bank, as
approved by the Registrar on specified terms and conditions.
(e) In any other moneys permitted by the Central or State Government.

Summary
 Government audit has not only adopted the basic essentials of auditing as known
and practised in the profession to suit the requirements of government transactions
but has also added new concepts, techniques and procedures to the audit
profession.
 Government auditing is the objective, systematic, professional and independent
examination of financial, administrative and other operations of a public entity.
 Government audit serves as a mechanism or process for public accounting of
government funds.
 In India, the function of audit of Government accounts is discharged by the
independent statutory authority of the Comptrollerand Auditor General of India
 The auditors of an NGO registered under the Societies Registration Act, 1860 (or
under any law corresponding to this Act, in force in any part of India) or the Indian
Trusts Act 1882 are normally appointed by the Management of the Society or Trust.
The auditors of NGO registered under section 8 of the Companies Act, 2013 are
appointed by the members of the company.
 The external control of municipal expenditure is exercised by the state governments
through the appointment of auditors to examine municipal accounts
 The auditors of a firm are usually appointed by the partners. The object of
examining the partnership agreement, which is an important feature of such an
audit, is that the auditor may be able to report to the partners if the interest of any
partner has been prejudicially affected.
 The accounts of every LLP shall be audited in accordance with LLP Rules 2009. Such
rules provide that any LLP, whose turnover does not exceed, in any financial year,
forty lakh rupees, or whose contribution does not exceed twenty five lakh rupees, is
not required to get its accounts audited

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Self-Assessment Questions

a. Multiple choice Questions

1. Who authorises Government company audit ?
a) BOD
b) Audit Committee
c) C&AG
d) Government

2. Who appoints CAG ?

a) Prime-minister
b) President
c) Parliament
d) Any of the above
3. CAG shall office for a term. What is that term?
a) 4 years
b) 5 years
c) 5 years or 65 years of age
d) 7 years

4. Is audit of Proprietary firm compulsory ?

a) Yes
b) No
c) Depends

5. What is to be checked for Partnership Audit?

(a) Partnership firm
(b) Partnership Agreement
(c) Partnership name
(d) Partners

b. Essay type
1. You have been appointed as an auditor of an NGO, briefly state the points on
which you would concentrate while planning the audit of such an organisation?
2. The general transactions of a hospital include patient treatment, collection of
receipts, donations, capital expenditures. You are required to mention special
points of consideration while auditing such transactions of a hospital?

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3. Explain in detail the duties of Comptroller and Auditor General of India
4. As an auditor , what would be your areas of consideration while auditing the
element of ROOM SALES during the audit of a 5-Star Hotel.
5. State the points which merit consideration in the audit of a CLUB w.r.t its
members.

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Keys to Multiple Choice Questions

1-c, 2-b, 3- c, 4-b, 5-b
(This section will consist of answers to the multiple choice questions)

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 UNIT

Due Diligence , Investigation and

Forensic Audit

Names of Sub-Unit
Due Diligence Review, Audit Versus Investigation, Steps of Investigation, Types of
Investigation, Procedure, Power etc of Investigator, Types of Fraud, Indicators of Fraud,
Follow- up, Forensic Audit- Meaning, Difference between Statutory audit and Forensic Audit,
Forensic Audit Techniques, Forensic Audit Report.

Overview
This chapter is divided into three parts due diligence, Investigation and Forensic Audit. In
Due diligence you will learn what is due diligence, what are the areas covered? What are
steps of investigation and what are types of frauds. Then we will learn about forensic audit
and techniques.

Learning Objectives
In this Unit you will learn –

 Know the concept of Due Diligence, Investigation and Forensic Audit.

 Differentiate between Audit and Investigation.
  Know the steps to be taken at the time of Investigation.
 Understand the purpose of Due diligence and content of its report
 Gain knowledge of Forensic Audit Techniques and content of its report

Learning Outcomes
At the end of this Unit you would -
 Understand due diligence
 Evaluate forensic audit techniques
 How investigation is done ?

Pre-Unit Preparatory Material

 https://resource.cdn.icai.org/67258bos54141-cp16u2.pdf
 https://resource.cdn.icai.org/67259bos54141-cp16u3.pdf
 Table of Topics

14.1 Introduction

14.2 Meaning of Due- Diligence

14.3 Types of Due- Diligence

14.4 How to conduct due-diligence

14.5 Investigation

14.6 Audit versus investigation

14.7 Steps in investigation

14.8 TYPES OF INVESTIGATION

14.10 PROCEDURE, POWERS ETC. OF INSPECTORS

14.10 Types of Frauds

14.11 Indicators of Fraud

14.12 Forensic Audit

14.13 Difference between Statutory Audit and Forensic Audit

14.14 Forensic Audit Techniques

14.15 FORENSIC AUDIT REPORT

14.16 Conclusion
14.1 Introduction

Due diligence is an investigation of a business or person prior to signing a contract,

or an act with a certain standard of care. It can be a legal obligation, but the term
will more commonly apply to voluntary investigations. A common example of due
diligence in various industries is the process through which a potential acquirer/
investor evaluates a target company including its assets for an acquisition. The
theory behind due diligence holds that performing this type of investigation
contributes significantly to informed decision making by enhancing the amount and
quality of information available to decision makers and by ensuring that this
information is systematically used to deliberate in a reflexive manner on the decision
at hand and all its costs, benefits, and risks.

14.2 Meaning of Due- Diligence

Due diligence is integral to business. It is exercised in a simple over-the-counter
transaction or a complicated merger and acquisition transaction. For instance, while
acquiring a company, the buyer must do thorough research of the credentials of
the company, its market valuation, status of accounts receivables, product and
brand involved, position in the debt market, status of legal and statutory
compliances, past performance, etc. It is also essential to study the previous financial
reports to analyze the company’s performance, to check the company background,
its promoters, general reputation, and return to the existing shareholders.
Thus, a due diligence is an investigation or audit of a potential investment. It seeks
to confirm all material facts in regard to a sale. It is a way of preventing
unnecessary harm/hassles to either party involved in a transaction

14.3 Types of Due- Diligence

The different types of Due Diligence may be as follows:
Legal Due Diligence: Legal Due Diligence is used to ensure that there are no legal
issues in buying a business or investing in it. In this, the potential purchaser will
review the important legal documents of the target firm such as employment
contracts, board meeting minutes, articles and memorandum of association and
patents and copyrights or any other property related documents compliance status
of the applicable laws etc.
Tax Due Diligence: This is aimed at ensuring that there are no past tax liabilities
in the seller firm that might have materialized due to mistakes or deception and
could hold the acquirer liable for it.
IP Due Diligence: IP due diligence is focused on establishing what rights the
company may have in various intellectual property and where it might rely on the
intellectual property of another entity. Typical areas of interest are patent, copyright
and trademark filings; descriptions of the company’s IP protection processes;
licensing agreements, IP Assignment document, etc.
Operational Due Diligence: Operational due diligence (ODD) is the process by
which a potential purchaser reviews the operational aspects of a target company
during mergers and acquisitions. The ODD review looks at the main operations of
the target company and attempts to confirm (or not) that the business plan that
has been provided is achievable with the existing operational facilities plus the
capital expenditure that is outlined in the business plan
Commercial Due Diligence: This aims at understanding the market the target
business is operating in. This looks the current market status and the forecast of the
market growth in future and the target’s position in the market with relation to its
competitors. This also involves interaction with the significant customers of the
business to understand their opinion about the business.
Information Technology (IT) Due Diligence: This aims at identifying if there are
any IT issues in the target business. This involves into matters such as scalability of
systems, robustness of the processes, availability of ERP, IT base and infrastructure,
capacity of server, the level of documentation of processes, compliance with the
legislation and ability to integrate various systems.
HR Due Diligence: This aims at understanding the impact of human capital on
the proposed deal. This involves review of number and type of manpower, skills,
employment records, compensation schemes, HR processes, ongoing HR
litigations, effectiveness of the sales force and cultural factors

14.4 HOW TO CONDUCT DUE DILIGENCE

1. Start with an open mind. Do not assume that anything wrong will be found and look for
it.
2. What needs to be done is to identify trouble spots and ask for explanations.
3. Get the best team of people. If you do not have a group of people inside your firm that
cando the task (e.g. lack of staff, lack of people who know the new business because
 you are acquiring a business in an unrelated area, etc.), there are due diligence experts
that you can hire. When hiring such professionals, look for their experience record in
the industry.
4. Get help in all areas like finance, tax accounting, legal, marketing, technology, and any others
relevant to the assignment so that you get a 360-degree view of the acquisition
candidate.
5. Talk to customers, suppliers, business partners, and employees are great resources.
6. Take a risk management approach. So, while you want to do your research, you also want
to make sure that you do not 6ntagonize the team of people of the target company by
bogging them down with loads of questions.
7. Prepare a comprehensive report detailing the compliances and substantive risks/issues.

14.5 Investigation

The term investigation implies a systematic and in- depth examination or inquiry to establish a
fact or to evaluate a specific situation. In other words,investigation means inquiry into facts".

14.6 AUDIT VERSUS INVESTIGATION

Investigation differs substantially from an audit assignment. Audit aims at collection of
sufficient appropriate audit evidence to enable the auditor to form a judgement and express an
opinion on the financial statements or other data under examination. An investigation, on the
other hand, requires special in-depth examination of the particular records or transaction with
the objective of establishing a part or happening or assessing a particular situation. The scope
of audit is broad based and general in nature whereas investigation is narrow and specific.

Audit Investigation

Investigation means an
Audit means the inspection,
inquiry, or is the act of detail
Description examination or verification of
examination of activities so as
a person, organization,
to achieve certain objectives.
system, process, enterprise,
 project or product.

Investigation may be
Audit is conducted on behalf
conducted either by owner of
Owners of owners only and they
the undertaking or by an
make the appointment.
outsider.

To determine the true and Varies from business to

Purpose
fair view. business

Investigation is not a regular

Process Routine process
process

It covers an examination of
the accounts bur also covers
It includes only an
an inquiry into other matter
Scope examination of the accounts
that are connected with the
of a business
purpose for which it
is undertaken

Period Year or six months May cover several years

Employees Does not examine personally May examine personally

Usually conducted before Usually conducted after the

Sequence
investigation of accounts audit of accounts

Person Investigation may be take on

Audit is to be conducted by a
performing even by a non-chartered
chartered accountant
work accountant
 There is no such legal
Legal
Audit is mandatory under law obligations with regard to
Obligations
investigation

14.7 Steps in Investigation

1. Determination of Nature and Scope

The instructions of the client regarding the nature, scope and objective should be
obtained in certain and unambiguous terms. If the instructions are vague, they may
create confusion and problems during investigation. The instructions should cover
the area of the investigation, the purpose of investigation and the period to be
investigated.

2. Formulation of Investigation Programme:

1. An investigation programme cannot be fixed and rigid. Actual investigation
procedures at each stage have to be programmed, depending upon the various
developments in the course of the investigation.

2. The finding of the previous steps will decide the further course of investigation.
While formulating the investigation programme, the broad scope and limits are to
be determined.

3. The list of records and documents to be verified are to be determined at this

stage keeping in view the objective and purpose of the investigation.

3. Conduct of Investigation:
A thorough investigation, i. e, examination of various records and documents, and
examination of various persons of the concern, relating to the investigation area are
to be conducted.

At every stage, the investigator may decide the further course of investigation based
on the circumstances and various findings. The investigator shall maintain, an
exhaustive record of work done, evidences examined, important discussions held
etc., as evidence for the investigation conducted. The record maintained by the
investigator along with the supporting documents may form the basis for
formulation of conclusion and preparation of the investigation report.

4. Investigation Report
The investigator may correlate all his findings, analyze all the supporting documents
and statements, thoroughly examine the investigation records and draw
conclusions. While doing so, he must have an open mind, free from pre-conceived
notions

14.8 TYPES OF INVESTIGATION

The different types of investigation that a chartered accountant is usually called upon to carry out
are given hereunder

1. Statutory - By an inspector under Sections 210, 212, 213 and 216 of the Companies Act,
2013.
2. Non-statutory - These are listed as under:

3.
(a) Investigation on behalf of an incoming partner.
(b) Investigation for valuation of shares in private companies.
(c) Investigation on behalf of a bank proposing to advance loan to a company.
(d) Investigation of frauds.
(e) Investigation on behalf of an individual or a firm proposing to buy a business.
(f) Investigation in connection with review of profit/financial forecast.

14.9 PROCEDURE, POWERS ETC. OF INSPECTORS

Section 217 of the Companies Act, 2013 states the procedures, powers of the Inspectors as
follows:
 Duty of officers and employees of the company towards inspector: It
shall be the duty of all officers and other employees and agents including the
former officers, employees and agents of a company which is under
investigation in accordance with the provisions, and where the affairs of any
other body corporate or a person are investigated under section 219, of all
officers and other employees and agents including former officers,
employees and agents of such body corporate or a person—(a) to preserve
and to produce to an inspector or any person authorised by him in this behalf
all books and papers of, or relating to, the company or, as the case may be,
relating to the other body corporate or the person, which are in their custody
or power; and (b) otherwise to give to the inspector all assistance in
connection with the investigation which they are reasonably able to give.
Inspector may ask information from any body corporate: The inspector
may require any body corporate, other than a body corporate referred to in
point (1), to furnish such information to, or produce such books and papers
before him or any person authorised by him in this behalf as he may consider
necessary, If the furnishing of such information or the production of such
books and papers is relevant or necessary for the purpose of his
investigation.
Not to keep Books and Papers in custody for more than 180 days:
Theinspector shall not keep in his custody any books and papers produced
under sub-section (1) or sub-section (2), for more than 180 days and
return the same to the company, body corporate, firm or individual by
whom, or onwhose behalf the books and papers were produced
 xamine on oath: The inspector may examine on oath any of the persons
referred in (1) above; and with the prior approval of the Central Government,
any other person in relation to the affairs of the company, or other body
corporate or person, as the case may be and for that purpose, may require
any of the persons to appear before him personally.
Inspector to possess all the Powers of Civil Court: The inspector, being
an officer of the Central Government, making an investigation shall have all
the powers as are vested in a civil court under the Code of Civil Procedure,
while trying a suit in respect of specified matters.
Assistance by Officers of Government to Inspector: The officers of the
Central Government, State Government, police or statutory authority shall
provide necessary assistance to the inspector for the purpose of inspection,
investigation etc.
Evidence from place outside India: If in the course of an investigation into
the affairs of the company, an application is made to the competent court
in India by the inspector stating that evidence may be available in a country
or place outside India, such court may issue a letter of request to a court or
an authority in such country or place for seeking such evidence.
unishment for non-compliance of order of Inspector: If any director or
officer disobeys the direction issued by the inspector, or any officer fails
without any reasonable cause or refuses to furnish any information or,
appear before the inspector personally; the director or the officer shall be
punishable with imprisonment and with fine.

14.10 Types of Frauds

Frauds may broadly be categorized as –
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Fraudulent Financial Reporting Mis-appropriation of Assets

Alteration or falsification of records & Embezzlement of receipts in respect of
documents written-off accounts
Misrepresentation in or intentional Stealing physical assets or intellectual
omission of events, transactions properties
orinformation Introduction of fictitious vendors
Intentional misapplication of Payment to fictitious employees
accounting principles
Using entities assets for personal use.
Fictitious Journal Entries
Adjusting assumptions and changing
Judgments
Omitting, advancing or delaying
therecognition of events or
transactions.
Abnormal Year End Transactions.

14.11 Indicators of Fraud

Several indications of possible frauds can be listed as follows : -

Discrepancies in Accounting Records including non-recording or partial recording or

incorrect recording or delayed recording of amounts, misclassifications, etc.
ii. Conflicting or missing evidence including missing documents, altered
documents, significant unexplained items in reconciliations, discrepancies between
entity’s records and confirmations received etc.
Unacceptable management responses such as – denial of access to
records/facilities/employees, undue time pressure to resolve complex issues, unusual
delays in providing requested information, denial for use of Computer Assisted
Audit Techniques, unwillingness to address identified deficiencies in internal control etc.
Other indications such as – Accounting Policies in variance with Industry Norms, Frequent
changes in accounting estimates etc.

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14.12 Forensic Audit

Forensic audit is, in general, referred to as an examination of evidence regarding an assertion

to determine its correspondence to established criteria carried out in a manner suitable to the
court.

As per the definition given in Investopedia, Forensic Audit is an examination and evaluation of
a firm’s or individual’s financial information for use as evidence in court. A Forensic Audit can
be conducted in order to prosecute a party for fraud, embezzlement or other financial claims.
In addition, an audit may be conducted to determine negligence or even to determine how
much spousal or child support an individual will have to pay.

(Source : ICSI)

14.13 Difference between Statutory Audit and Forensic Audit

1. Major difference between Audit and Forensic Audit is discussed as below26:

 Objective of financial auditing is to express opinion as to ‘true & fair’
presentation. Forensic Audit determines correctness of the accounts or whether
any fraud has actually taken place.
 Techniques used in the financial auditing are more of ‘Substantive’ and
‘compliance’ procedures. The techniques used in the forensic auditing are
analysis of past trend and substantive or ‘in depth’ checking of selected
transactions.

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 Normally all transactions for the particular accounting period are covered under
the financial audits. Forensic audits don’t face any such limitations. Forensic
auditors may be appointed to examine the accounts from the beginning.
 For ascertaining the accuracy of the current assets and the liabilities financial
auditor relies on the management certificate or representation of management.
Forensic auditors are required to carry out the independent verification of
suspected or selected items.
 Whenever the financial auditor has adverse findings, then the auditor expresses
the qualified opinion, with/without quantification. In case of the adverse
findings, the forensic auditors are required to quantify the damages to the
clients and is also supposed to point the culprit. Many a times, Legal action will
be sought.

14.14 FORENSIC AUDIT TECHNIQUES

(Source ICAI)

Some of the techniques that a forensic auditor may use are listed below:
(I) General Audit Techniques:

 Testing defenses: A good initial forensic audit technique is to attempt to circumvent these
defenses yourself. The weaknesses you find within the organizations control will most probably
guide you down the sea path taken by suspected perpetrators. This technique requires you
to attempt to put yourself in the shoes and think like your suspect.
(II) Statistical & Mathematical Techniques:

 Trend Analysis: Businesses have cycles and seasons much akin to nature itself. An expense or

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event within a business that would be analogous to a snowy day in the middle of summer is
worth investigating. Careful review of your subject organization's historical norms is necessary in
order for you to be able to discern the outlier event should it arise within your investigation.
 Ratio Analysis: Another useful fraud detection technique is the calculation of data analysis
ratios for key numeric fields. Like financial ratios that give indications of the financial health
of a company, data analysis ratios report on the fraud health by identifying possible
symptoms of fraud.
Technology based /Digital Forensics Techniques: Every transaction leaves a digital footprint in today's computer-
driven society. Close scrutiny of relevant emails, accounting records, phone logs and target company hard drives is
a requisite facet of any modern forensic audit. Before taking steps such as obtaining data from email etc. the forensic
auditor should take appropriate legal advice so that it doesn’t amount to invasion of privacy. Digital investigations
can becomequite complex and require support from trained digital investigators

(I) Computer Assisted Auditing Techniques (CAATs): Changing patterns of businesses, regulatory
framework, scarcity of resources at auditors’ disposal on one side and the ever- increasing
mountainous data on other hand is making audit a complex process. Use of CAATs is, thus,
indispensable to the Auditors and forensic auditors. Computer-assisted audit techniques (CAATs) or
computer-assisted audit tools and techniques (CAATs) are computer programs that the auditors use as
part of the audit procedures to process data of audit significance contained in a client’s information
systems, without depending on him.
(II) Generalised Audit Software (GAS): Generalized Audit Software (GAS) is a class of CAATs that allows
auditors to undertake data extraction, querying, manipulation, summarization and analytical tasks. GAS
focuses on the fully exploiting the data available in the entity’s application systems in the pursuit of
audit objectives. GAS support auditors by allowing them to examine the entity’s data easily, flexibly,
independently and interactively in data-based auditing.
Using GAS, an auditor can formulate a range of alternative hypotheses for a particular potential
misstatement in the subject matter and then test those hypotheses immediately. “What if” scenarios
can be developed with the results and the auditors can examine the generated report rapidly.
Currently, the latest versions of GAS include the Audit Command Language (ACL), Interactive Data
Extraction and Analysis (IDEA) and Panaudit.
(III) Common Software Tool (CST): Due to shortcomings of GASs, CSTs have become popularover a
period. Spreadsheets (like MS Excel, Lotus, etc.), RDBMS (like MS Access, etc.) and Report writers (like
Crystal reports, etc.) are few examples of CSTs. Their widespread acceptability is due to its instant
availability and lower costs. While spreadsheets may be extremely easy to use due to its simplicity
and versatility, other CSTs may need some practice.
Whether one uses GAS or CST, it is imperative that the auditor is aware about the manner and
processes that have led to the data generation, the control environment revolving around the data
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and the source from where the data samples are imported into the GAS/CST.
(IV) Data Mining Techniques: It is a set of assisted techniques designed to automatically mine large
volumes of data for new, hidden or unexpected information or patterns.
Data mining techniques are categorized in three ways: Discovery, Predictive modeling and Deviation
and Link analysis. It discovers the usual knowledge or patterns in data, without a predefined idea or
hypothesis about what the pattern may be, i.e. without any prior knowledge of fraud. It explains
various affinities, association, trends and variations in the form ofconditional logic.

14.15 FORENSIC AUDIT REPORT

A Report is a statement of collected & considered facts, so drawn up as to give clear and concise
information to persons who are not already in possession of the full facts of the subject matter of the report.

Points to be kept in mind while reporting:

Clear thinking:  To whom the report is directed

 Purpose and aim of investigation
 Cool and calm thinking to have logical and
coherentpresentation
 Pattern of presentation
Keep the reader uppermost  Translate technical matters to layman's language
inmind  To visualize the reader's viewpoint
Unbiased approach  To mention the view point of the auditee
Facts and figures to be in proper sequences and suggestion to prevent fraud in
future.

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Summary
 Due diligence is a process of investigation, performed by investors, into the details of a potential
investment such as an examination of operations and management and the verification of material facts.

 It entails conducting inquiries for the purpose of timely, sufficient and accurate disclosure of all material
statements/information or documents, which may influence the outcome of the transaction.

 Due diligence involves a careful study of the financial as well as non-financial possibilities for successful
implementation of restructuring plans.
 The term investigation implies a systematic and in- depth examination or inquiry to establish a fact or
to evaluate a specific situation.
 Investigation differs substantially from an audit assignment. Audit aims at collection of sufficient
appropriate audit evidence to enable the auditor to form a judgement and express an opinion on the
financial statements or other data under examination.
 Forensic” means “suitable for use in the court of law”. Bologna said that it is the application of financial
skills and investigative mentality to unresolved issues, conducted within the context of the rules of
evidence
 A forensic accountant will often look for indications of fraud that are not subject to the scope of a
financial statement audit.

Self-Assessment Questions

a. Multiple Choice Questions

1. What is fraud ?
a) Intentional mistake
b) Error
c) Compensating error
d) Principle error
2. What is due-diligence by investor?
a) audit performed by internal auditor.
b) investigation performed necessarily by statutory auditor
c) audit performed by statutory auditor
d) investigation performed by investors

3. Which of the following activity is part of Due Diligence process and negotiation
Phase?
a) Discussion with the client to gain understanding of the transaction
b) Assessment of the most appropriate scope of work and methodology

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c) Centralized coordination of project team
d) Report drafting, including assistance in the definition of financial aggregates and
wordings of financial clauses.

4. Forensic Auditor is generally involved in which area?

a) Financial accounting, Financial audit and investigation of fraud.
b) Financial Audit, System audit and Computer Forensics
c) Computer Forensics and Expert Testimony
d) Fraud detection, Fraud Prevention, Computer Forensics and Expert Testimony.

5. What is An activity that uses accounting, auditing and investigative skills to assist in
legal matters, is known as ?
a) Fraud Audit
b) System Audit
c) Forensic Audit

b. Essay type
a. Sri Rajan is above 80 years old and wishes to sell his proprietary business of manufacture of
specialty chemicals. Ceta Ltd. wants to buy the business and appoints you to carry out a due
diligence audit to decide whether it would be worthwhile to acquire the business. What
procedures you would adopt before you could render any advice to Ceta Ltd.?
b. “Due diligence is different from audit” – Explain the difference between due diligence and
audit.
c. What do you understand by the word “Forensic” and why the need for forensic audit arises?
d. State the difference between audit and investigation
e. Write a note on audit techniques.

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Keys to Multiple Choice Questions

1-A, 2-D, 3-D, 4-D, 5-C

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 UNIT

Money Laundering

Names of Sub-Unit
Definition of Money Laundering- Anti-Money Laundering Program: Basic elements- The need
for ethical guidance on Money Laundering

Overview
This Unit will assist you in gaining a thorough understanding of the Money Laundering Act,
as well as the primary causes and methods by which black money is circulated and
transformed into legitimate money. Initiatives to combat money laundering and ethical
recommendations on money laundering.

Learning Objectives
In this Unit you will learn –

 Definition of Money Laundering

 Anti-Money Laundering Program: Basic elements
 The need for ethical guidance on Money Laundering
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Learning Outcomes
At the end of this Unit you would -
 Understand the concept of Money laundering.
 Impact of money laundering on the economy of country
 Basic elements of Anti-Money Laundering Program
 Need for ethical guidance on Money Laundering and its importance

Unit Pre- requisites

This unit requires a basic understanding of economy of a country. Practical scenario

related to money laundering.

Pre-Unit Preparatory Material

 https://m.rbi.org.in
 https://www.icai.org
 https://sanctionscanner.com/

Table of Content

Introduction
Understand the concept of Money laundering.
15.1 Definition of Money laundering
15.2 Stages of money laundering
15.3 Methods used for money laundering.
15.4 Common reasons behind money laundering
Impact of money laundering on the economy of country
15.5 The Impact on Money Demand
15.6 Effect on Growth Rates
15.7 The Impact on Income Distribution
15.8 The Impact on Tax Revenues

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15.9 Impact of Financial Institutions

15.10 Impact of Financial Institutions

Basic elements of Anti-Money Laundering Program

Introduction
The global fight against money laundering and
terrorism financing has taken precedence. Money
laundering endangers the soundness and stability of
financial institutions and financial systems, increases
the volatility of international capital flows, and
dampens foreign direct investment. Some of the
actions adopted in this respect include safeguarding
the integrity and stability of the international financial
system, shutting off terrorists' access to resources, and making it more difficult for criminals
to benefit from their illegal operations.

 Understand the concept of Money laundering.

15.1 Definition of Money laundering

Money laundering is the process of concealing financial assets so that they can be utilised
without being discovered as the result of unlawful behaviour. Money laundering is the
process by which a criminal converts monetary earnings from illicit conduct into monies
with an apparent legitimate source. This process has far-reaching societal ramifications. For
one reason, money laundering fuels the operations and expansion of drug traffickers,
terrorists, arms dealers, and other criminals.

Financial Action Task Force on Money Laundering (FATF) defines

money laundering as “the processing of criminal proceeds to disguise
their illegal origin in order to legitimize the ill-gotten gains of crime.”
Money laundering is frequently referred to as a financial crime. It is

According to Section 3 of Prevention of Money Laundering Act, 2002 - Whoever directly or

indirectly attempts to indulge or knowingly assists or knowingly is a party or is actually
involved in any process or activity connected with the proceeds of crime including its
concealment, possession, acquisition or use and projecting or claiming it as untainted
property will be guilty of offence of money-laundering.

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generally defined as “transferring illegally obtained money or investments through an
outside party to conceal the true source.”

15.2 Stages of money laundering

Money laundering is not a single act, but rather a process that consists of three
essential components. These phases can be
completed concurrently throughout the
course of a single transaction, but they can also
occur in easily separate forms one by one.

a. Placement: The Money Launderer, who holds

the proceeds of criminal activity, puts
unlawful monies into the financial
system. This can be accomplished by
dividing large quantities of cash into
smaller sums that are placed directly into a
bank account, or by acquiring a series of
instruments such as checks, bank
draughts, and so on, which are
subsequently collected and transferred into
one or more accounts at another location.

The most popular methods for placement are as follows: Deposit cash in small
sums into one or more bank accounts at several branches of the same or other
financial institutions. Money orders, bank draughts, and other financial
instruments can be purchased. Commingle the monies with real ones. Using a
private exchange, the monies are converted into foreign currencies.

b. Layering is the second stage of money laundering. At this step, the Money
Launderer often takes part in a series of ongoing conversions or moves of monies
through the financial or banking system via many accounts, in order to conceal
their actual origin and remove themselves from their unlawful source. The Money
Launderer may move monies through multiple routes, such as a network of bank
accounts scattered throughout the globe, especially in jurisdictions that do not
cooperate in anti-money laundering investigations.
Methods of separation of money from their illicit origin –
 Buy other securities, insurance contracts, or other readily transferrable
investment vehicles and then sell through a different institution.
 Transfer through check, money order, or bearer bond.
 Transfer monies to numerous accounts and countries while disguising the
transfer as payment for products or services.

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c. Integration- After successfully processing his unlawful gains through the first
two stages of Money Laundering, the Criminal proceeds to the third stage, in
which the funds reach the legitimate economy after being inseparably mingled
with real money received via legal means. The Money Launderer may then opt to
invest the monies in real estate, commercial enterprises, and luxury items, among
other things, in order to enjoy the laundered riches without fear of law
enforcement authorities.

15.3 Methods used for money laundering.

Hawala Bribery and Real estate Cash

Smuggling
Transaction Corruption investment transaction

15.4 Common reasons behind money laundering

People launder money for a variety of reasons. These are some examples:

Legitimating
Growing
Tax evasion proceeds of
revenues
crime:

Avoiding
Hiding wealth
prosecution
 Tax evasion: Criminals might avoid paying taxes on gains from the money.
 Growing revenues: criminals can boost their profits by reinvesting unlawful cash in
enterprises.
 Legitimating proceeds of crime: Criminals can utilize the laundered monies to start a
business and give it respectability.
 Avoiding prosecution: criminals can escape prosecution by distancing themselves from the
unlawful cash.
 Hiding wealth: criminals can hide illegally earned income to prevent its confiscation by
authorities.

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 Impact of money laundering on the economy of country

Money laundering harms financial sector institutions that are crucial to economic progress
by encouraging crime and corruption, which slows economic growth and reduces efficiency
in the real economy. The majority of worldwide study is concentrated on two major money-
laundering industries: drug trafficking and terrorist groups. The apparent result of
successfully clearing drug money is more drugs, more crime, and more bloodshed. The
relationship between money laundering and terrorism can be a little more difficult. For
example, terrorists may steal money so that authorities cannot monitor and prevent their
planned assaults.

15.5 The Impact on Money Demand

It is more common in nations where the danger of money laundering is low. The informal
sector has a high ratio to the national economy in economies where there are no rules on
laundering, where there is a system that records bank or customer information, and where
financial secrecy is strongly maintained. Launderers can easily track cash inputs and
outflows. The quick and unregulated entry of money into the nation is raising spending
rates, particularly luxury expenditure. Nonetheless, considerable increases in exports,
imports, the foreign exchange imbalance, inflation, interest rates, and unemployment rates
may occur. These volatile money demands induced by black money will have a detrimental
impact on monetary policy.

15.6 Effect on Growth Rates

Financial insecurity in the country may have a big impact on the real economy. As a
result, international investors have become increasingly important to businesses. Yet,
attracting foreign investors to the country in money laundering countries is difficult.
Because the price volatility generated by black money in the banking system would
harm the economy's credibility in the external environment, reasonable
entrepreneurs will find it difficult to invest in the nation because they will also
consider the country's risk when investing. If lawful money is prevented from entering
the nation, investment rates will not rise. As a result, long-term sustainable growth
will slow.

15.7 The Impact on Income Distribution

Substantial losses generated by black money to sources of revenue pose
considerable challenges in the running of the financial system. The troubles that the
economy is experiencing have social ramifications. Social deterioration is caused by
the rising richness of select people and groups. One of the most serious
consequences of illicit money is its harmful impact on income distribution. Although
the negative impact of declining revenue sources and income distribution divergence
is difficult to quantify, compensating for social harm is similarly difficult. The disparity

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in economic distribution between individuals enhances the proclivity to commit

crimes and makes money appealing.

15.8 The Impact on Tax Revenues

Tax income accounts for the lion's share of government revenue. If this income is
low, the chance of public revenues falling short of public expenditures increases, and
if this occurs, budget deficits will arise. Black money income is profits that countries
do not tax. Tax revenues will be reduced as a result of these gains.

With declining tax revenues, the state has two options, the first of which is borrowing.
It diminishes the private sector's productive investments as a result of government
crowding out, which draws productive investors through borrowing by the private
sector. Furthermore, when the value of bonds rises as a result of borrowing, market
interest rates rise, causing a slew of issues.

15.9 Impact of Financial Institutions

Rapid changes in financial institutions' assets and liabilities that are mistakenly
exploited in money laundering may occur, posing a risk to the institutions. The news
of these banking firms' money laundering catches the attention of the public
authorities. In that event, the pressure on these institutions' audits would rise, and
the institution's image will suffer.

15.10 Basic elements of Anti-Money Laundering Program

An anti-money laundering (AML) programme is a component of an organization's control

system that protects against money laundering operations through the organisation. A
good AML programme generally contains, internal
rules and processes, a compliance person to oversee
the programme, an ongoing training programme to
improve the understanding of its employees,
independent External Audit etc.
These are the seven critical components that must be
addressed in order to develop an adequate and effective
AML compliance program:

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1. Suspicious Activity Detection
The first goal is to quickly detect money-laundering-related activities such as:

 Money deposits that are unusually big;

 Inadequate information given while creating a bank account;
 The application had fake news.

According to FATF Guideline 20, financial institutions must swiftly notify a Financial
Intelligence Unit of their suspicions if they feel specific funds were obtained illegally or are
linked to fraud and terrorism.

1. Head of the organization and setting culture

Leaders must prioritize and support an AML compliance programme throughout the firm
by setting an example for the rest of the organisation. As a result, excellent leadership must
be truthful, transparent, and equal. An organisation should empower its employees and
offer them a sense of belonging in order to encourage and support ethical behaviour. A
compensation plan may also be used by a company to motivate employees to report
dubious transactions or unethical activity.

2. Experienced Professionals
Having a corporate governance structure with compliance professionals who are
knowledgeable about AML and related regulatory standards is a vital part of an effective
programme. These personnel act as the organization's AML subject matter experts,
ensuring that discovered problems are resolved internally and immediately so that the firm
is not put at further risk.

3. Risk Evaluations
Risk assessments are critical because they tell an organisation about the possible
significance of a risk to its AML goals. In addition to the AML regulatory environment, it
should assess the operational risks of the company. The fundamental purpose of an AML
risk assessment is to assist an organisation in better managing its AML risk through risk
identification, mitigation, and improving an organization's risk appetite and justification.

4. Policy and Processes

The fundamentals of an AML compliance programme include policies and procedures.
Approaches will include vital themes, risk appetites, and proper behaviour as determined
by the company. Such rules and procedures should also be written, changed, publicized,
and utilised on a regular basis.

5. Reporting
One of the most important components of a programme is having an internal escalation
system inside the organisation to report any AML or related issues swiftly and efficiently,

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without unduly interrupting business efficiency. The reporting structure should also be
basic and clear so that all employees can understand it. This would allow the business to
respond to such signals swiftly and appropriately.

6. Ongoing monitoring
An organisation should commit to monitor its compliance procedures on a regular basis. It
can be performed by conducting an annual review exercise or if major internal (such as the
production of new items) or external (such as regulatory changes) changes occur, whichever
occurs first.

 Need for ethical guidance on Money Laundering

1. Accountants (firms and individuals) operating in a nation where money laundering is

illegal are obligated to follow anti-money laundering laws, and failure to do so can result
in harsh penalties.
Guidance is necessary because:
 the legal requirements are onerous;
 money laundering is broadly defined; and
 Accountants may be unknowingly exploited to launder illegal cash.
2. Further guidance is needed to explain how accountants' duties to disclose money
laundering offences relate with their reporting responsibilities, for example:
 reporting to regulators;
 financial statement audit reports from auditors;
 reports to people in charge of governance
 reporting misbehaviour by members of the same organisation
3. Professional accountants must speak with one another when their professional
appointment changes (i.e. "professional etiquette"). Further ethical advice is required on
how to reply to an intimation when a report of suspicion has been made (or is being
considered) in relation to the client in issue.
4. Accountants require ethical guidance when there is a contradiction between legal and
professional obligations. Professional accountants, in particular, owe a responsibility of
secrecy to their customers.

Summary

 Whoever directly or indirectly attempts to indulge or knowingly assists or knowingly is

a party or is actually involved in any process or activity connected with the proceeds of
crime including its concealment, possession, acquisition or use and projecting or
claiming it as untainted property will be guilty of offence of money-laundering.

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 Money laundering endangers the soundness and stability of financial institutions and
financial systems, increases the volatility of international capital flows, and dampens
foreign direct investment
 Several of the tactics used by criminals to launder money or finance terrorists include
the transfer of cash via the financial system.
 The bodies Financial Action Task Force(FATF) and Financial Intelligence Unit of India
(FIU_IND) were set up with an objective to combat money laundering.
 Money laundering has a history of degrading financial institutions and undermining the
role of the financial sector in economic growth. It has a history of encouraging
corruption, crime, and other illicit activities at the price of a country's development,
raising the danger of macroeconomic instability.
 The following economic effects of money laundering (1) undermining the legitimate
private sector; (2) undermining the integrity of financial markets; (3) loss of control over
economic policy; (4) economic distortion and instability; (5) revenue loss; (6) risks of
privatisation efforts; and (7) reputation.

Conclusion

Money laundering is a bane on society. It enriches the wealthy, creating an imbalance in

society. Legalizing the revenues of criminal operations such as drug trafficking, terrorism
funding, people smuggling, and so on has a huge social and economic impact on society.
As a result, money laundering must be combated. Anti-money laundering is the inverse of
money laundering in that it deprives criminals of their unlawful funds, ultimately benefiting
the government and the economy as a whole.

Self-Assessment Questions

Multiple Choice Questions

1. Which of the following is the purpose of Prevention of Money Laundering Act?

a) To prevent money laundering
b) To confiscate property arising out of money laundering
c) Both a and b
d) Neither a nor b

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2. Although Money laundering is a single process however its cycle can be broken down
into three distinct stages. Which of the following is not a layer?
a) Placement
b) Labelling
c) Layering
d) Integration
3. The stage in which money enters the financial system in such a way that original
association with the crime is sought to be obliterated is called
a) Placement
b) Integration
c) Layering
d) Concealing
4. It is the first and the initial stage when the crime money is injected into the formal
financial system
a) Differentiation
b) Placement
c) Layering
d) Integration
5. Which of the following is not an example of Money Laundering?
a) Stock Market Scam
b) Drug Trafficking
c) Bribery and Corruption
d) None of the above
6. Which body was set up with an objective to combat money laundering?
a) Financial Action Task Force (FATF)
b) Financial Intelligence Unit of India (FIU_IND)
c) both A and B
d) None of the above
7. What is money laundering?
a) Any person who is knowingly involved or assists.
b) Any activity connected with proceeds of crime
c) Shall be guilty of offence of money laundering.
d) The concealment of the origins of illegally obtained money, typically by means of
transfers involving foreign banks or legitimate businesses.

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8. Whoever commits the offence of money-laundering shall be punishable with rigorous
imprisonment for a term which shall not be less than three years but which may extend
to?
a) Three Years
b) Five Years
c) Seven years
d) Ten years

9. Objectives of the Prevention of Money Laundering Act, 2002 is:

a) to prevent money laundering
b) to provide for confiscation of property derived from, or involved in, money laundering.
c) to provide for matters connected or incidental to matters stated in (a) and (b) above.
d) All of the above.

10. Money Laundering is a -

a) Civil Offence
b) Criminal Offence
c) Both (a) and (b)
d) None of the above

11. Which of the following can be considered as act of money laundering?

a) Illegal arm sales
b) Drug trafficking
c) Insider trading
d) All

12. Whosoever directly or indirectly attempts to indulge or knowingly assists or knowingly

is a party or is actually involved in any process or activity connected proceeds of crime
including its concealment, possession, acquisition or use and projecting or
shall be guilty of offence of money laundering.
a) claiming it as untainted property
b) Intentionally participates.
c) Unintentionally participate.
d) None

13. Which of the following is not economic effects of money laundering?

a) undermining the legitimate private sector.
b) undermining the integrity of financial markers
c) loss of control over economic policy

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d) None of the above

14. Which of the following is not a reason behind money laundering

a) Avoiding prosecution
b) Tax evasion
c) None of the above
d) All of the above
15. Which of the following is a method used in money laundering
a) Smuggling
b) Hawala Transaction
c) All of the above
d) None of the above

16. Which of the following is not a basic element of Anti-Money Laundering Program.
a) Risk Evaluations
b) Policy and Processes
c) Experienced Professionals
d) None of the above
17. Financial Action Task Force on Money Laundering (FATF) defines money laundering as
“the processing of criminal proceeds to in order to legitimize the ill-gotten
gains of crime”.
a) disguise their legal origin
b) disclose their legal origin
c) disguise their illegal origin
d) None of the above

18. Identify the layer of money laundering, in whicha large quantities of cash into smaller
sums that are placed directly into a bank account.
a) Placement
b) Labelling
c) Layering
d) Integration

19. Banks can prevent money laundering by following the government guidelines which
excludes
a) proper KYC
b) Customer due diligence
c) suspicious activity reporting
d) regular SMS on offer of the banks
20. Which of the following bodies were set up in India for combating money laundering

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a) Financial Action Task Force(FATF)
b) Financial Intelligence Unit of India (FIU_IND)
c) Both a and b
d) None of the above.

b. Detailed question
1. Anti-money laundering is the inverse of money laundering. Comment on the
importance of Anti money laundering practices.
2. Money laundering is a three-step process. Explain the statement with examples.
3. Comment on the need for ethical guidance on Money Laundering from the
perspective of accountant.
4. Money laundering harms financial sector institutions that are crucial to economic
progress by encouraging crime and corruption, which slows economic growth and reduces
efficiency in the real economy. Discuss the ill effects of money laundering on economy.
5. Continuous monitoring is a basic element of Anti-Money Laundering Program.
Comment on the statement and explain other elements of Anti-Money Laundering Program.

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Key to MCQ

1-c 2-b 3-b 4-b 5-d

6- c 7-d 8-c 9- a 10-b
11- d 12-a 13- d 14- c 15-c
16- d 17-c 18-a 19-d 20-c

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