Q.1. Write Short notes on the following:
(a) Walk through Tests
(b) Cut-off Procedures
Answer:
(a) Walk through Tests: A walk through is a procedure in which an auditor traces a transaction from its initiation through the company’s information systems to the when it is reflected in the financial reports. The auditor should perform one walk through, at a minimum, for each major class of transactions. A walk-through provides evidence to confirm that the auditor understands (1) the process flow of transactions, (2) the design of identified controls for internal control components, including those related to preventing and detecting fraud, and (3) whether all points in the process have been identified at which misstatements related to relevant financial statement assertion could occur. Walk through also provide evidence to evaluate the effectiveness of the controls design and confirm that the controls have been placed in operation.
When performing the walk-through, the auditor should:
1. Be sure that the walk-through encompasses the complete process (initiation, authorization, recording, processing and reporting) for each significant process identified, including controls intended to address fraud risk.
2. Ask the entity’s personnel, at each of key stage in the process, about their understanding of what the company’s prescribed procedures require.
3. Determine whether processing procedures are performed as expected on a timely basis, and look for any exceptions to prescribed procedures and controls.
4. Evaluate the quality of evidence provided and perform procedures that produce a level of evidence consistent with the auditor’s objectives. The auditor should follow the whole process, using the same documents and technology that company staff use, asking questions of different personnel at each significant stage and asking follow-up questions to identify any abuse of controls or fraud indicators.
Once a walk-through is performed, the auditor may carry forward the documentation, noting updates, unless significant changes make preparation new documentation more efficient. If such significant changes occur in the process flow of transactions or supporting computer applications, the auditor should evaluate the nature of changes and the effect of related accounts. The auditor should determine whether it is necessary to walk through transactions that were processed both before and after the change.
(b) Cut-off Procedures: Cut-off procedures mean procedures employed to ensure the separation f transactions at the end of one year from those in the commencement of the next year. Usually, the problem of overlapping is found in inventory accounting since quite often goods are sold but passed on to the buyer only after the year is over or goods are bought but received only after the close of the year. The situation may create considerable problem for the proper stock taking of inventory. Therefore, the principal areas of application of cut-off procedures involve sales, purchase and stock. The auditor should satisfy himself by examination and test check that these procedures adequately ensure that:
(a) Goods purchased for which property has passed to the client have in fact been included in inventories and that the liability if any, has been provided for.
(b) Goods sold have been excluded from the inventories and credit has been taken for sales.
The auditor may examine a sample of documents evidencing the movement of stocks into and out of stores, including documents pertaining to period shortly before and shortly after the cut-off date, and check whether the stocks represented by those documents were included or excluded, as appropriate, during the stock-taking.
Q.2. Designing an Audit Strategy is the backbone of the “Audit Planning” process. Discuss.
Answer:
Audit strategy is concerned with designing optimized audit approaches that seeks to achieve the necessary audit assurance at the lowest cost within the constraints of the information available. The formulation of audit strategy as shall be evident from the process as explained in the following paragraphs in fact shall form the basis of audit planning to achieve the audit objectives in the most efficient and effective manner. Audit strategy generally involves the following steps:
1. Obtaining Knowledge of Business: SA 315 and SA 300 “Identifying and Assessing the Risk of Material Misstatement Through Understanding the Entity and its Environment” and “The Auditor’s Responses to Assessed Risks” states that in performing an audit of financial statements, the auditor should have or obtain knowledge of the business sufficient to enable the auditor to identify and understand the events, transactions and practices that, in the auditor’s judgement, may have a significant effect o the financial statements or on the examination or audit report. Knowledge of the business is a frame of reference within which the auditor exercises professional judgement. Understanding the business and using this information appropriately assists the auditor in assessing risks and identifying problems, planning and performing the audit effectively and efficiently. It also ensures that the audit staff assigned to an audit engagement obtains sufficient knowledge of the business to enable them to carry out the audit work delegated to them. This would also ensure that the audit staff understands the need to be alert for additional information and the need to share that information with the auditor and the other audit staff.
2. Performing Analytical Procedures: The purpose of analytical procedures at the planning stage is attention-directing; corroboration is not normally necessary at this stage. The use of the analytical procedures during the planning stage requires the extensive use of accounting and business knowledge and experience to assess the potential for material misstatement in the financial statements as a whole, because the key aspect of the task is to identify the relevant risk indicators and to interpret them properly. Furthermore, analytical techniques applied during the planning stage are not generally as precise as the analytical techniques at the substantive stage.
3. Evaluating Inherent Risk: To assess inherent risk, the auditor would use professional judgement to evaluate numerous factors such as quality of accounting system, unusual pressure on management, etc. having regard to his experience of the entity from previous audit engagements of the entity, any controls established by management to compensate for a high level of inherent risk, and his knowledge of any significant changes which, might have taken place since his last assessment.
4. Evaluating Internal Control: The auditor’s assessment of the control environment is crucial to the decision on whether to make an extended assessment of controls. This is because a good control environment is conducive to the maintenance of a reliable system of accounting and control procedures. For strategy purposes, the auditor should obtain a sufficient understanding of the control environment. The auditor needs an understanding of the accounting systems, regardless of whether the audit strategy will involve an extended assessment of internal accounting controls. This is done by:
(a) considering the results of gathering or updating information about the client; and
(b) making preliminary judgements about materiality, inherent risk and control effectiveness. These will include identification of the system(s) the auditor proposes to subject to an extended assessment of controls.
Thus, the audit strategy is evolved after considering the engagement objectives, the results of the business review, preliminary judgements as to materiality and identified inherent risks. Audit strategy also considers main points relating to planning and controlling the audit or comments on adequacy of the existing arrangements. Thus, the overall audit plan involving determination of timing, manpower, coordination and the directions in which the audit work has to proceed is dependent upon the audit strategy formulated by the audit firm.
Q.3. Corporate accountability and civil and criminal penalties for white collar crimes. Comment on the major provisions of Sarbanes Oxley Act.
Answer:
Major provisions of Sarbanes Oxley Act: The Sarbanes Oxley Act of 2002 established corporate accountability and civil and criminal penalties for white – collar crimes. This act also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commodity called SOX or Sarbox; is a United States federal law passed in response to a number of major corporate and accounting scandals including those affecting Enron, Tyro international, and WorldCom. These scandals resulted in a decline of public trust in accounting and reporting practices.
This Act provides regulatory bodies and courts to take various actions-civil and criminal proceedings in connection of misstatements amounting to accounting scandals and fraudulent financial reports, other frauds on securities matters, obstruction of justice and retaliating against corporate whistleblowers. The Act also enforce tougher civil and criminal penalties for fraud and accounting scandals, securities fraud and certain other forms of obstruction of justice. As per SOX protect employer against corporate whistle blowers (person who provide evidence of fraud in the company).
Some of the major provisions of Sarbanes-Oxley Act of 2002 are:
· Creation of the Public Company Accounting Oversight Board (PCAOB);
· A requirement that public companies evaluate and disclose the effectiveness of their internal controls as they relate to financial reporting, and that independent auditors for such companies “attest” (i.e. agree, or qualify) to such disclosure;
· Certification of financial reports by chief executive officers and chief financial officers;
· Auditor independence, including outright bans on certain types of work for audit clients and pre-certification by the company’s Audit Committee of all other non-audit work;
· Ban on most personal loans to any executive officer or director;
· Accelerated reporting of insider trading;
· Prohibition on insider trades during pension fund blackout periods;
· Enhanced criminal and civil penalties for violations of securities law;
· A requirement that companies listed on stock exchanges have fully independent audit committees that oversee that relationship between the company and its auditor;
· Additional disclosure;
· Significantly longer maximum jail sentences and larger fines for corporate executives who knowingly and willfully misstate financial statements, although maximum sentences are largely irrelevant because judges generally follow the Federal Sentencing Guidelines in setting actual sentences;
· Employee protections allowing those corporate fraud whistleblowers who file complaints with OSHA within 90 days to win reinstatement, back pay and benefits, compensatory damages, and congressional page abatement orders, and reasonable attorney fees and costs.
Q.4. On-line real time processing system and batch processing system have their inherent strengths and weaknesses. Please comment.
Answer:
On-line Real Time Processing System vs. Batch Processing System In an on-line real-time (OLRT) processing system, transactions are entered as they occur, and are processed as they are entered. These systems from the heart of management information systems. Given the continuous updating of the database as transactions are entered, the status of such files as accounts receivable, accounts payable, and inventory may be determined at any time. In an on-line real-time processing system, individual transactions are entered at terminal devices, validated and used to update related computer files immediately. An example is the application of cash receipts directly to customer’s accounts. The results of such processing are then available immediately for inquiries or reports.
In a system with on-line batch processing, individual transactions are entered at a terminal device, subjected to certain validation checks and added to a transaction file that contains other transactions entered during the period. Later, during a subsequent processing cycle, the transaction file may be validated further and then used to update the relevant master-file. For example, journal entries may be entered master-file being updated on a monthly basis. Inquiries of, or reports generated from, the master-file will not include transactions entered after the last master-file update. In a batch processing system which is not on-line, transactions are accumulated and processed in group sales orders for the day, invoices to be recorded, and daily cash receipts might each be viewed as a “batch” of transactions, to be processed as a group. Batch processing systems are distinguished by their relative simplicity and reliability. They do not process transactions as quickly as the more advanced systems, not do they possess the potential for providing timely information concerning the files updated by transactions processing. Given these limitations, the use of networked PCs terminals has become widespread, even among small entities. Batch processing systems are rarely found in today’s systems environment.
Although powerful in terms of information capability, OLRT systems are more complex than batch processing systems. Moreover, they ordinarily do not provide the extent of audit trail documentation produced by batch system and for this they are more difficult to audit in terms of obtaining satisfaction concerning the existence of necessary controls, and of designing substantive testing procedures.
Conversely, in a batch processing system, the transaction are accumulated and processed in batches or groups. Control totals, both monetary and documentary, are also available for review to ensure completeness and accuracy of data being processed. The system is simple and reliable. However, its deficiency lies in the MIS is not updated on a concurrent basis and, therefore, information is not available on a timely basis.
Accordingly, it is a question of cost-benefit analysis as to which the system will be more preferable to an entity.
Q.5. The method of collecting Audit evidence and evaluating the same changes drastically under CIS Environment. Comment on the above.
Answer:
Auditor must provide a competent, independent opinion as to whether the financial statements records and report a true and fair view of the state of affairs of an entity. However, computer systems have affected how auditors need to collect and evaluate evidence. These aspects are discussed below:
1. Changes to Evidence Collection – Collecting evidence on the reliability of a computer system is often more complex than collecting evidence on the reliability of a manual system. Auditors have to face a diverse and complex range of internal control technology that did not exist in manual system, like:
(a) accurate and complete operations of a disk drive may require a set of hardware controls not required in manual system.
(b) system development control include procedures for testing programs that again are not necessary in manual control.
Since, Hardware and Software develop quite rapidly, understanding the control technology is not easy. With increasing use of data communication for data transfer, research is focused a cryptographic controls to project the privacy of data. Unless auditor’s keep up with these developments, it will become difficult to evaluate the reliability of communication network competently.
The continuing and rapid development of control technology also makes it more difficult for auditors to collect evidence on the reliability of controls. Even collection of audit evidence through manual means is not possible. Hence, auditors have to run through computer system themselves if they are to collect the necessary evidence. Though generalized audit softwares are available the development of these tools cannot be relied upon due to lack of information. Often auditors are forced to compromise in some way when performing the evidence collection.
2. Changes to Evidence Evaluation – With increasing complexity of computer systems and control technology, it is becoming more and more difficult for the auditors to evaluate the consequences of strength and weaknesses of control mechanism for placing overall reliability on the system.
Auditors need to understand:
(a) whether a control is functioning reliably or multi functioning.
(b) traceability of control strength and weakness through the system. In a shared data environment a single input transaction may update multiple data item used by diverse, physically disparate user, which may be difficult to understand.
Consequences of errors in a computer system are a serious matter as errors in computer system tend to be deterministic, i.e. an erroneous program will always execute data incorrectly. Moreover, the errors are generated at high speed and the cost and effort to correct and rerun program may be high. Errors in computer program can involve extensive redesign and reprogramming. Thus, internal controls that ensure high quality computer systems should be designed implemented and operated upon. The auditors must ensure that these controls are sufficient to maintain assets safeguarding, data integrity, system effectiveness and system efficiency and that they are in position and functioning.
Q.6. Different types of controls which operate over date moving into, through and out of the computer. Auditor is required to review such control. Comment.
Answer:
The review process for controls in a computerized information system (CIS) environment: In a CIS environment there are different types of control which operate over data moving into, through and out of the computer. These are designed in such a way that the correct, complete and reliable processing and storage is ensured. It is necessary for the auditor to review such controls in order to get the correct result from the date entered. The review process can be laid down as follows:
1) Organization structure and control: The entity may have different functions under the CIS environment. These will be Date Administrator who will formulate data policies, plans the evaluation of the corporate data bases and maintain the data documentation. The data base administrator will be responsible for operational efficiency of the database. The data base administrator will be responsible for operational efficiency of the database, the system Analyst will manage the information requirements for new and existing applications, and designs the information system, the System programmer will maintain and enhance the Operating system software, application programmer will design the Programmer to meet the information requirement. Operation Specialist plans and control day-to-day operations, monitors and improves operational efficiency along with capacity planning and Librarian maintains library of magnetic media and documentation. The auditor will see that the responsibilities of each job position are clear and that the person understands the duties, authority and responsibilities. The duties have to be separated to ensure the internal control is established.
2) Documentation Control: The auditor has to see that there is proper and adequate documentation for approval of system flowcharts Programme flowcharts, Programme changes, operator’s instructions and programmed description and the changes made in the above are also documented and approved by the authorized persons.
3) Access Control: The auditor has to ensure the system prevents the persons who are authorized for access from accessing restricted data and programmed and also prevents unauthorized persons gaining access to the system as a whole.
4) Input controls: The control in respect of input has to be effective to ensure that only properly authorized and approved data goes in the input into the CIS system. For validation of input controls the auditor can apply some procedures like Check digit control, completeness totals control, reasonableness checks, field checks, record checks, file checks, etc.
5) Processing controls: These controls are must for integrity of data. Processing validation checks should be applied.
6) Recording Controls: This is for enabling the records to be kept free of errors.
7) Storage Controls: The data is the heart of CIS system. Back up and recovery facilities will ensure the proper data availability to the management.
8) Output controls: The data processed must go to the authorized person in the manner it is required and for this purpose input controls are maintained. The auditor is interested to know whether the audit trail relating to output is provided.
Q.7. Auditor’s liability to third parties in relation to issue of Prospectus. Discuss.
Answer:
Section 62 of the Companies Act, 1956 lays down the civil liability for misstatement in a prospectus issued to invite persons to subscribe for shares in or debentures of a company. The professional accountant will in such a case be liable to pay compensation to every person who subscribes for any shares or debentures on the faith of the prospectus for any loss or damage sustained because of an untrue statement made by him as an expert.
However, professional accountants will not be liable if they can prove that:
i) the prospectus was issued without his knowledge or consent and that on becoming aware of its issue he forthwith gave reasonable public note that it was issued without his knowledge or consent; or
ii) he withdrew his consent in writing before delivery of the prospectus for registration; or
iii) after the delivery of prospectus for registration but before allotment of shares, on becoming aware or the untrue statement, he withdrew his consent in writing and gave reasonable public notice of the withdrawal, and of the reasons therefore; or
iv) he was competent to make the statement and that he had reasonable grounds to believe and did up to the time of allotment of the shares or debentures believe that the statement was true.
Q.8. As an auditor, state your view on the following:
The Statutory Auditors of a Government Company have issued a qualified Audit Report on the accounts of the company. In this supplementary audit, the Comptroller and Auditor General of India (C and AG) has also made further qualifications on the accounts of the company.
But the report of the Board of Directors of the Company is silent on the comments of statutory auditors and those of C and AG.
Answer:
Board’s Report and Qualifications in the Auditor’s Report: Section 217(3) of the Companies Act, 1956 imposes a duty on the Board of Directors of a company to give the fullest information and explanations in the Director’s report regarding every reservation, qualification or adverse remarks contained in the auditor’s report. The remarks of the Board on the auditor’s report are to be given as addendum to the report and are to form part of the main body of the report as per section 217(3). Hence there is failure on the part of the Board of directors in not having offered its explanation on the reservations, qualifications or adverse remarks made in the auditor’s report.
However in the absence of similar provisions in section 217(3) of the Companies Act, 1956 requiring the company to give their reply on the reservations, qualifications etc. contained in the supplementary audit report made by the C&AG, the Board of Directors of such a company is not bound to give information or explanation in respect of such comments. Therefore, in the absence of any legal provision, the Board, has not committed any default by not giving any explanation on comment of the C&AG.
Q.9. Write a short note on – Reporting on the compilation engagement.
Answer:
SA 4410 “Engagements to Compile Financial Information” The objective of a compilation engagement is to use accounting expertise, as opposed to auditing expertise, to collect, classify and summarize financial information. This ordinarily entails reducing detailed data to a manageable and understandable form without the requirement to test the assertions underlying that information. The procedures employed are not designed and do not enable the member to express any opinion on the financial information. Therefore, it is essential that the member clearly brings out the nature of association with the financial statement and the nature of the work performed by him. The following may be noted in this regard.
1. The title of the report should be “Accountant’s Report on Unaudited Financial Statement and not An Auditor’s Report”.
2. The report should be addressed to the appointing authority.
3. The report should identify the financial information compiled, also stating that it is based on the information provided by the management.
4. The report should clearly state that the financial statements are not audited.
5. In describing the engagement, ambiguous terms such as review, general review, check, etc. should not be based.
6. Date of the report should be mentioned.
7. Name and address of the firm of the member appointed for carrying out the compilation engagement should be mentioned.
8. Signature and the designation (sole proprietor / partner) and membership number should appear in the report.
Q.10. While doing the audit of consolidated Financial Statements, which current period consideration adjustments are to be taken into account ?
Answer:
Current period adjustments are those adjustments that are made in the accounting period for which the consolidation of financial statements is done. Current period consolidation adjustments primarily relate to elimination of intra-group transactions and account balances including intra-group interest paid and received, or management fees, unrealized intra-group profits on assets acquired from other subsidiaries; intra-group indebtedness; adjustments related to harmonizing the different accounting policies being followed by the parent enterprise and its subsidiaries; adjustments made for the effects of significant transactions or other events that occur between the date of the financial statements of the parent and one or more of the components, if the financial statements to be used for consolidation are not drawn upto the same reporting date; and determination of movement in equity attributable to the minorities since the date of acquisition of the subsidiary.
While doing the audit of consolidated Financial Statements, current period consolidation adjustments should be taken into account. The auditor should review the memorandum records to verify the adjustment entries made in the preparation of consolidated financial statements. This would also help the auditor in ascertaining whether there is any difference in the elimination. Apart from reviewing the memorandum records, the auditor should:
a) verify that the inter-group transactions and account balances have been eliminated.
b) verify that the consolidated financial statements have been prepared using uniform accounting policies for like transactions and other events in similar circumstances.
c) verify that adequate disclosures have been made in the consolidated financial statements of application of different accounting policies in case, it was impracticable to do so;
d) verify the adjustments made to harmonise the different accounting policies; and
e) verify that the calculation of minorities interest has been correctly done.
Q.11. Describe the procedure for verification of the following balances appearing in the account books of a bank:
(i) Drafts paid without advice
(ii) Branch adjustment account
Answer:
(i) Drafts paid without advice: This balance is in the nature of a suspense account in as much as it represents payments made on account of drafts issued by other branches but for which the relevant advice from those branches have not been received. It is, therefore, most important to examine the system of internal control operating in the bank in this respect. The testing of the internal control system has to be made mainly with regard to the following:
a) the system of verifying the authenticity of the draft by reference to specimen signature of the signing authority and the prima facie correctness and completeness of the draft in all respects;
b) the system of co-relating drafts paid with advices subsequently received; and
c) the system of sending reminders where advices are not received within a reasonable time and the recording of reasons for their non receipt.
The composition of the balances appearing in this account should be verified with particular reference to any long outstanding items. The auditor should also verify whether the items appearing in this account have been subsequently cleared on receipt of the relevant advices. It would also be useful to have on record the names and addresses of the payees of such drafts. The auditor may also seek confirmation of transactions relating to such outstanding cases.
(ii) Branch Adjustment Account: In the final balance sheet of the bank, this balance represents the difference between inter branch debits and credits and should normally comprise items which are in transit as on the closing date. This account is the one which is most commonly used by unscrupulous persons in committing a fraud. The verification of this account is, therefore, of great importance. The procedure for verification is as follows:
a) See that all branch accounts are periodically reconciled.
b) Check all adjustments in the account and ensure that the adjustments are done properly and supported by adequate documentary evidence as to its validity.
c) Verify that reversal entries are made under proper authority and after due explanation and evidence.
Q.12. Describe the audit procedures to be followed by a Statutory Auditor of a bank for audit of contingent liabilities.
Answer:
Verification of Contingent Liabilities: In respect of contingent liabilities, the auditor is primarily concerned with seeking reasonable assurance that all contingent liabilities are identified and properly valued. To this end, the auditor should, generally follow the audit procedures given below:
i) the auditor should ensure that there exists a system whereby the non fund based facilities of additional / ad hoc credit facilities to parties are extended only to their regular constituents, etc.
ii) Ascertain whether there are adequate internal controls to ensure that transactions giving rise to contingent liabilities are executed only by persons authorized to do so and in accordance with the laid down procedures.
iii) The auditor should also ensure that in case of LCs for import of goods, as required by the above mentioned Master Circular on guarantees and co-acceptances, the payment to the overseas suppliers is made on the basis of shipping documents and after ensuring that the said documents are in strict conformity with the terms of LCs.
iv) Ascertain whether the accounting system of the bank provides for maintenance of adequate records in respect of such obligations and whether the internal controls ensure that contingent liabilities are properly identified and recorded.
v) Performs substantive audit tests to establish the completeness of the recorded obligations. Such tests include confirmation procedures as well as examination of relevant records in appropriate cases.
vi) Review the reasonableness of the year-end amount of contingent liabilities in the light of previous experience and knowledge of the current year’s activities.
vii) Review whether comfort letters issued by the bank has been considered for disclosure of contingent liabilities.
viii) Obtain representation from the management that
a) all contingent liabilities have been disclosed;
b) the disclosed contingent liabilities do not include any contingencies which are likely to result in a loss/ expense and which, therefore, require creation of a provision in the financial statements;
c) the estimated amounts of financial effect of the contingent liabilities are based on the best estimates in terms of Accounting Standard 29, including any possibility of any reimbursement.
d) In case of guarantees issued on behalf of the bank’s directors, the bank has taken appropriate steps to ensure that adequate and effective arrangements have been made so that the commitments would be met out of the party’s own resources and that the bank will not be called upon to grant any loan or advances to meet the liability consequent upon the invocation of the said guarantee(s) and that no violation of section 20 of the Banking Regulations Act, 1949 has arisen on account of such guarantee; and
e) Such contingent liabilities which have not been disclosed on account of the fact that the possibility of their outcome is remote, include the management’s justification for reaching such a decision in respect of those contingent liabilities.
ix) The auditor should also examine whether the bank has given any guarantees in respect of any trade credit (buyer’s credit or seller’s credit). The period of guarantees is co-terminus with the period of credit reckoned from the date of shipment.
x) Verify whether bank has extended any non-fund facility or additional/ ad hoc credit facilities to other than its regular customers. In such cases, auditor should ensure concurrent of existing bankers of such borrowers and enquire regarding financial position of those customers.
Q.13. How will you evaluate the internal control system in the area of credit card operations in a bank ?
Answer:
Evaluation of internal control system in the area of credit card operations: The evaluation of internal control system in the area of credit operations in the bank would have to be done in respect of following aspects:
i) Segregation of Responsibilities: The activities relating to credit card operations can be divided in specific areas, namely, beginning from the receipt of application form, evaluating the credit assessment, sanctioning the issuance of card, making and dispatch of card would form part one of operations. Later on, particularly, from the accounting view, the significant operations would include receipt of statement from vendors / merchants, raising bills to customers, realization either by directly debiting the customer’s accounts or payment received through cheques, periodic reconciliation, etc. While evaluating internal controls, it would have to be seen that adequate division of responsibilities have been carried out to avoid any collusion and independent checks have been built in the system. While evaluating the internal control, it may also be considered whether some part of the operations have been outsourced or performed in-house.
ii) Credit Assessment System: Each application is scrutinized with reference to different parameters for assessing the credit limits to be awarded. The system must be able to generate exception reports at this stage itself. In fact, at the application stage itself, the system must ensure that the applicant was holding one card earlier or has defaulted in respect of any other agency.
iii) Control Over issuance of Cards: The internal control system must ensure that the cards are under the control of responsible official. A detailed record along with relevant pin codes, etc. have been kept. See that he system has built-in features that it is almost impossible to make counterfeit cards as also photographs are affixed to prohibit any unauthorized use of the same.
iv) Reconciling Merchant Records: It is to be checked whether the system has built-in flexibility of reporting of the payments to be made to merchants and making prompt payment to them. Simultaneously, it should be seen that customer statements are also generated automatically and dispatched to them.
v) Periodic Reconciliation and follow-up: It may be seen whether periodic reconciliation of customer’s accounts is done and regular follow-up of overdue accounts takes place. The person who are responsible for maintaining customer’s records are not entrusted with the responsibility of reconciliation and follow-up.
Q.14. Write a short note on – Vostro and Nostro Accounts.
Answer:
Vostro and Nostro Accounts: Bank’s maintain stocks of foreign currencies in the form of Bank Accounts with their overseas branches / correspondents. Such foreign currency accounts maintained by Indian banks at other overseas centres are designated by it as “Nostro Account”. For example, all banks in India would be maintaining a US Dollar Account with their New York office / branch / correspondents, such account would be designated by the Indian office as Nostro Account. “Vostro Account” is the opposite of Nostro accounts. Here a foreign bank in another country maintains stocks of Indian rupees with their Indian branch/ correspondent/local bank. Such Indian Rupee Accounts are designated s a Vostro Account. For example, a German Bank might maintain a Vostro Account in rupees in terms with Indian Bank. While examining the transaction in foreign exchange, the auditor should also pay attention to reconciliation of Nostro Accounts with the respective minor account. The amount in the Nostro account is stock of foreign currency in the form of bank accounts with the overseas branches and correspondents. Unreconciled Nostro Accounts, on an examination, may reveal unauthorized payments from the foreign currency account, unauthorized withdrawals, and unauthorized debit to minor account. The auditor should also evaluate the internal control with regard to inward / outward messages. The inward / outward messages should be properly authenticated and discrepancies noticed, should be properly dealt with, in the books of accounts.
The auditor should also verify whether prescribed procedure in relation to inter bank confirmation in the Vostro account is followed or not. In case balance confirmation certificate have been received but the same have not been reconciled, or where confirmation has not been received the same should be reported, in respect of each Vostro Account.
Q.15. Write a short note on – Facultative reinsurance under insurance Act, 1938.
Answer:
Facultative Reinsurance: It is that type of reinsurance whereby the contract relates to one particular risk and is expressed in the reinsurance policy. This is the oldest method of reinsurance and it necessitates consideration of each risk separately. Each transaction under facultative reinsurance has to be negotiated individually. Each party to the transaction has a free choice, i.e. for the ceding company to offer and the reinsurer to accept. The main drawbacks of this type of insurance are the volume of work involved and time taken to cover the risk. It is, however, still used even today, mainly when:
i) automatic covers have already been exhausted.
ii) the risk is excluded from the Treaties.
iii) the insurer does not want his reinsurance treaties overburdened with particularly heavy and abnormal risks.
iv) the insurer has no automatic cover at his disposal in a particular branch, where he issues policies rarely.
v) the nature of business is such that technical guidance or consultation with the reinsurer is required at every stage of acceptance of the risk itself or for a type of business where the number of risks is very small, for example, in atomic energy installations, oils rigs, etc.
Q.16. Under what circumstances, an auditor is required to submit a special report to the registrar of Co-operative Societies ?
Answer:
During the course of audit, if the auditor notices that there are some serious irregularities in the working of the society he may report these special matters to the Registrar, drawing his specific attention to the points. The Registrar on receipt of such a special report may take necessary action against the society. In the following cases, for instance a special report may become necessary:
i) Personal profiteering by members of managing committee in transactions of the society, which are ultimately detrimental to the interest of the society.
ii) Detection of fraud relating to expenses, purchases, property and stores of the society.
iii) Specific examples of mis-management. Decisions of management against co-operative principles.
iv) In the case of urban co-operative banks, disproportionate advances to vested interest groups, such as relatives of management, and deliberate negligence about the recovery thereof, Cases of reckless advancing, where the management is negligent about taking adequate security and proper safeguards for judging the credit worthiness of the party.
Q.17. You are the auditor of IJK Ltd., a NBFC registered with RBI. How would you proceed to ensure the compliance of Prudential Norms directions by it.
Answer:
Compliance of Prudential Norms by NBFC
i) The auditor has to verify the compliance of prudential norms relating to (1) income recognition, (2) Income from investments; (3) Asset classification; (4) Provision for bad and doubtful debts; (5) Capital adequacy norm; (6) Prohibition of granting loans against its own shares; (7) Prohibition on loans and investments for failure to repay public deposits and (8) Norms for concentration of credit etc.
ii) The auditor shall ensure that Board of the NBFC shall frame a policy for granting demand/call loans and implement the same.
iii) The auditor should verify the classification of advances and loans as standard / substandard / doubtfulness / loss and that proper provision has been made in accordance with the directions.
iv) Auditor should ensure that unrealized income from non-performing assets has not been taken to profit and loss account.
v) The auditor should check all NPAs of the previous years to verify whether during the current year any payments have been received or still they continue to be NPA during the current year also.
Q.18. State with reasons whether an auditor conducting tax audit ‘certifies’ or ‘reports’ on information contained in the statement of particulars attached to the tax audit report under Section 44 AB of Income-tax Act, 1961.
Answer:
Section 44AB of the Income-tax Act, 1961 requires the auditor to submit the audit report in the prescribed form and setting forth prescribed particulars. The statement of particulars as required in Form 3CD (assessee carrying on a business) of Form 3CE (assessee carrying on a profession) are required to be annexed to the main audit report. The audit report is in two parts. The first part requires the auditor to give his opinion as to whether or not the accounts audited by him give a true and fair view and the second part of the report is in the form of an “Annexure” containing statement of particulars in respect of certain specified matters. The tax auditor has to report whether particulars are true and correct.
In this context, it is important to appreciate the distinction between the terms “report” and “certificate”. Briefly, speaking, the term “certificate” is used where the auditor verifies the accuracy of facts while the term “report” is used in case the auditor is expressing an opinion. Strictly speaking, having regard to the usage of the word true and correct, these particulars require definitive information compiled from the books of account. Hence, it can be said that an auditor conducting tax audit ‘certifies’ the information contained in the statement of particulars. However, having regard to the distinction, it is significant to examine whether all thirty two clauses included in the statement of particulars are capable of being simply certified auditor(s) may hold different opinion. For instance, clause 12 dealing with valuation of closing stock would require the auditor to examine and opine on the basis adopted for ascertaining the cost and, thus, to ensure that method followed for valuation of stock results in disclosure of correct profits and gains. Similarly clause 14 relating to depreciation would require the auditor to exercise judgement having regard to the facts and circumstances of the case, etc. Thus, there are several matters on which the auditor is required to exercise judgement while giving his report on various amounts included in the statement of particulars. No doubt that the auditor obtains the statement of particulars in Form No.3CD duly authenticated by the assessee, it does not merely involve checking the corresponding figures with the documents and books of account but requires the auditor to exercise his judgement which may at times lead to different figures by different persons reporting thereon. There can also be situations leading to difference of opinion between the tax auditor and the assessee. Therefore, it can be said that an auditor conducting tax audit “reports” on certain information, apart from certifying certain factual information contained in the statement of particulars annexed to the tax audit report under section 44AB of the Income-Tax Act, 1961.
Q.19. Mr. X, who conducts the tax audit u/s 44AB of the Income-tax Act, 1961 of M/s. ABC, a partnership firm has received the entire audit fees of `.25,000 in April, 2010 in respect of the tax audit for the year ended 31.3.2010. The audit report was however signed in September, 2010. Comment.
Answer:
Receipt of Tax Audit Fees in Advance: Under Section 226(3)(d) of the Companies Act, 1956, a person is disqualified from being an auditor if he is indebted to the company for more than `.1,000. This provision for disqualification would apply only in case of an auditor appointed under the Companies Act, 1956. The intention of the Companies Act, 1956 is to ensure that the auditor is not under any financial obligation of the company.
When a chartered accountant is appointed to conduct a tax audit u/s. 44AB of the Income-tax Act, 1961, his appointment is not under the Companies Act, 1956 but under the Income-tax Act, 1961. In the Income-tax Act, 1961 there is no such provision for a person to be disqualified on his becoming indebted to the company. Thus in the instant case, though the entire audit fees are taken in advance, Mr. X would still be able to carry out the audit and he would not be disqualified. However, having regard to the professional ethics in general an auditor must avoid such situations and may consider disclosing the same.
Q.20. In the context of tax audit under Section 44AB of the Income-tax Act, 1961, discuss the provision of Section 145 of the said Act regarding the method of accounting and accounting standards notified there under.
Answer:
Accounting Standards and the Income-tax Act, 1961: As per Section 145 of the Income-tax Act, 1961*
1) Income chargeable under the head ‘Profits and gains of business or profession’ or ‘Income from other sources’ shall, subject to the provisions of sub-section (2), be computed in accordance with either cash or mercantile system of accounting regularly employed by the assessee.
2) The Central Government may notify in the Official Gazette from time to time accounting standards to be followed by any class of assesses or in respect of any class of income.
3) Where the Assessing Officer is not satisfied about the correctness or completeness of the accounts of the assessee, or where the method of accounting provided in sub-section (1) or accounting standards as notified under sub-section (2), have not been regularly followed by the assessee, the Assessing Officer may make an assessment in the manner provided in Section 144.*
Standards notified by Government – AS(IT) – In exercise of the powers conferred by section 145(2), the Central Government has by Notification No. S.O.69(E), dated 25th January, 1996 notified two AS(IT). This notification came into force with effect from 1st day of April, 1996, and is accordingly applicable from assessment year 1997-98 and subsequent assessment years.
These AS (IT) are given below:
Accounting Standards to be followed by all assesses following mercantile system of accounting.
A. Accounting Standard I relating to disclosure of accounting policies.
B. Accounting Standard II relating to disclosure of prior period and extraordinary items and changes in accounting policies.
The above Accounting Standards are to be followed by all assesses following mercantile system of accounting. Therefore, it is clear that those assesses who are following cash system of accounting need not follow the Accounting Standards notified above.
Section 145 provides that the AS (IT) notified under that section should be followed by the assesses to whom they are made applicable. It should be noted that the tax auditor auditing accounts under section 44AB is not computing the income but is – (a) reporting on accounts, and (b) reporting on the relevant information furnished in Form No.3CD. Now, the revised Form No.3CD vide clause 11(d) requires reporting of the details of deviation, if any, in the method of accounting employed in the previous year from accounting standards prescribed under section 145 and the effect thereof on the profit or loss. Further, it may be noted that there is no material difference between AS(IT)-I and AS(IT)-2 notified by the Government and the corresponding AS-1 and AS-5 of the ICAI respectively.
Q.21. XYZ Private Limited is engaged in the wholesale business of buying and selling silk sarees. The accounts are maintained under the Companies Act from 1st October to 30th September each year. The Chief Accountant of the Company is requesting the tax auditor to conduct tax audit U/s. 44AB of the I.T. Act for the period for which accounts have been maintained under the Companies Act. As the tax auditor of XYZ Private Limited, how will you react to the Chief Accountant’s request ?
Answer:
Accounting Period under Section 44AB: In relation to the question as to whether u/s 44AB the tax auditor can audit and certify the amounts for the period for which accounts have been maintained under the Companies Act (in this case from October to September) or whether the tax auditor will have to certify the accounts for the relevant financial year which is the uniform accounting year for tax purposes, the CBDT have considered the matter and are of the opinion that as the income of the previous year is chargeable to tax and for the purposes of income-tax Act, 1961, the previous year is the financial year, the tax auditor would have to carry out the audit u/s 44AB in respect of the period covered by the previous year i.e., the relevant financial year. He proviso for the aforesaid section 44AB, therefore, covers only the cases where the accounts are audited under any other law in respect of the financial year. Where the accounting year is different from the financial year, the proviso to section 44AB will not apply. Consequently the tax auditors would have to carry out the tax audit in respect of the period covered by the relevant financial year and submit has report Form 3CB, as required in rule 6G(I)(b) of the I.T. Rules (Circular No.561, dated 22.5.90).
Q.22. As a tax auditor, which are the accounting ratios required to be mentioned in the report in case of manufacturing entities ? Explain in detail any one of the above ratios and how does it help the tax auditor in his analytical review.
Answer:
The ratios which are to be calculated for manufacturing entities are:
· Gross profit / Turnover
· Net Profit / Turnover
· Stock-in-trade / Turnover
· Material consumed / Finished goods provided
Ratio analysis constitutes a substantive auditing procedure designed to obtain evidence as to the completeness, accuracy and validity of data produced by the accounting system. Such assessment is necessary in organization having large volumes of transactions and in the organization following mechanized accounting system where it is not possible to check each and every transaction. It has the merit of bringing to focus the abnormal deviations and unexpected variations which the normal routine checking in auditing may fall to reveal. Ratios highlight only symptoms and that too as of a particular day and the auditor should study these symptoms properly, correlate them and reach definite conclusions or identify areas for further enquiries. The auditor should by relating sales with the net profit, various items of direct and indirect costs and gross profit gather information about the profitability and operating efficiency of an enterprise; variations in any of these ratios in a particular year should be inquired by the auditor. The fall in the gross profit ratio and profitability ratio should be carefully examined by him. The gross profit gather information about the profitability and operating efficiency of an enterprise; variations in any of these ratios in a particular year should be inquired by the auditor. The fall in the gross profit ratio and profitability ratio should alert the auditor who should ask the management for the reasons thereof and which should be carefully examined by him.
These ratios have to be given for the business as a whole and not product wise. While calculating these ratios, the tax auditor should assign a meaning to the terms used n the above ratios having due regard to the generally accepted accounting principles. All the ratios mentioned in the clause are to be calculated in terms of value only.
The relationship of stock-in-trade to turnover over a period of time would reveal whether the entity has been accumulating stocks or there is a decline in the same. The auditor may obtain data for about 7-10 years, compute ratio of stock-in-trade/turnover and plot it on a graph paper over a period of time. This may give rise to several possibilities such as parallel horizontal lines, vertical rising line or a vertical falling line. A study of this relationship would reveal whether stocks are being accumulated or they are dwindling over a period. Such information would provide an input to tax auditor as to whether figures of either stock or turnover are being manipulated. Sometimes, while studying the relationship, it may show sudden decline or increase at a point of time which reflect that there is definitely something wrong with the figures of stock. Therefore, a close examination of such ratios helps the tax auditor to focus on major deviations and consequently reasons for the same.
Q.23. Write a short note on – Method of accounting in Form No.3CD of Tax Audit.
Answer:
Method of accounting in Form NO.3CD of Tax Audit: Clause 11 of Form No.3CD of the tax audit requires to state
(a) Method of accounting employed in the previous year.
(b) Whether there has been any change in the method of accounting employed vis-a-vis the method employed in the immediately preceding previous year.
(c) If answer to (b) above is in the affirmative, give details of such change, and the effect thereof on the profit or loss.
(d) Details of deviation, if any, in the method of accounting employed in the previous year from accounting standards prescribed under Section 145 and the effect thereof on the profit or loss.
Section 145 provide that method of accounting be either cash or mercantile. Hybrid system is not permitted.
Q.24. Draft an Audit programme for conducting the audit of a Public Trust registered under section 12A of the Income-tax Act, 1961.
Answer:
An auditor should conduct routine checking during the course of audit of a public trust, in the following manner:
i) Check the books of account and other records having regard to the system of accounting and internal control
ii) Vouch the transactions of the trust to satisfy that:
a) the transaction falls within the ambit of the trust
b) the transaction is properly authorized by the trustees or other delegated authority as may be permissible in law;
c) all incomes due to the trust have been properly accounted for on the basis of the system of accounting followed by the trust;
d) all expenses and outgoings appertaining to the trust have been recorded in the basis of system of accounting followed by the trust;
e) amounts shown as applied towards the object of the trust are covered by the objects of trust as specified in the document governing the trust.
iii) Obtain trial balance on the closing date certified by the trustees duly certified by the trustee;
iv) Obtain Balance Sheet and Profit & Loss Account of the trust authenticated by the trustees and check the same with the trial balance with which they should agree.
Q.25. Mr. R, the Tax Auditor finds that some payments inadmissible under Section 40 A(3) were made, and advised the client to report the same in form 3CD. The client contends that cash payments were made since the other parties insisted upon the same and did not have Bank Accounts. Comment.
Answer:
Form 3CD: The audit under section 44AB of the Income Tax Act 1961 requires that the tax auditor should report whether in his opinion the particulars in respect of Form 3CD are true and correct. It is the primary responsibility of the assessee to prepare the information in form 3CD. The auditor has to examine whether the information given is true and correct. The form 3CD is not a report of Tax Auditor. The report is in the form of 3CA and 3CB depending on the nature of the organization of the entity. If the tax auditor is satisfied that the information contained in form 3CD is true and correct then he can given unqualified report in form 3CA or 3CB saying “in my opinion and to the best of my information and according to the explanations given to me and considering the materiality the particulars given in form 3CD are true and correct.” But in the given case the tax auditor has found that the form 3CD contains the incomplete, misleading and false information.
Disallowance under section 40A(3) is attracted if the assessee incurs any expense in respect of which payment of aggregate of payments made to a person in a day, otherwise than by an account payee cheque drawn on bank or account payee draft exceeds `.20,000/-. However, exemption is provided in respect of certain expenditure in Rule 6DD. In such cases, disallowance under section 40A(3) would not be attracted.
Under clause 17(h) of Form 3CD, amounts inadmissible under section 40A(3), read with Rule 6DD, have to be reported. Cash payment made on insistence of other parties on the contention that they do not have bank accounts is not covered under the list of exceptions provided under Rule 6DD.
Mr. R has to report the payments inadmissible under section 40A(3) under clause 17(h) of Form 3CD.
Q.26. What is the purpose served by introduction of Cost Audit ?
Answer:
According to the Institute of Cost and Management Accountants of England, cost audit represents the verification of cost accounts and a check on the adherence to cost accounting plan. Cost audit, therefore, comprises:
i) verification of the cost accounting records such as the accuracy of the cost accounts, cost reports, cost statements, cost data and costing techniques and
ii) examination of these records to ensure that they adhere to the cost accounting principles, plans, procedures and objectives.
The undernoted circumstances may warrant the introduction of cost audit:
a) Price fixation – The need for fixation of retention prices in the case of materials of national importance, like steel, cement etc. may be useful in knowing the true cost of production.
b) Cost variation within the industry – Where the cost of production varies significantly from unit to unit in the same industry, cost audit may be necessary to find the reasons for such differences.
c) inefficient management – Where a factory is run inefficiently and uneconomically, institution of cost audit may be necessary. It may be particularly useful for the Government before it takes over any unit.
d) Tax-assessment – Where a duty or tax is levied on products based on cost of production, the levying authorities may ask for cost audit to determine the correct cost of production.
e) Trade disputes – Cost audit may be useful in setting trade disputes about claim for higher wages, bonus, etc.
Q.26. Enumerate the main areas to be covered by the auditor in the case of environment audit of an industrial unit.
Answer:
Main areas to be covered in the case of environment audit of an industrial unit
i) Layout and Design – The layout to be sketched in the style which will allow adequate provisions for installing pollution and control devices, as well as provision for up gradation of pollution control measures and the meeting of the requirements of the regulations framed by the Government. In the course of the audit, the area which requires attention but not attended to by the industry to be pinpointed as well as the future requirements of the environmental measures required in commensuration with the proposed future course of working plan are to be identified.
ii) Management of Resources – Management resources includes air, water, land, energy, raw materials and human resources besides others. The use of all resources is interlinked ad the best uses in a synchronized manner results the best output and minimum waste. The waste of resources to the minimum possible extent is good for the health of the industry as well as the environment.
iii) Pollution Control System – An effective system of pollution control should be in existence. One aspect should be whether all required pollution control measures are in vogue or not next aspect should be whether the same is effective or not, further it is to investigate, whether more measures are required, keeping ill view the type of industry and its nature of working with respect to its grade of polluting the environment.
iv) Emergent Safety Arrangement – The chemical, gas, etc. industries which are prone to sudden requirement of safety arrangements, must remain alert all the while. The emergency plans are to be reviewed periodically; sufficiently staff along with other required safety amenities should be kept ready. The staff, remained so engaged, must possess the required awareness and alertness to meet the contingency. The degree of awareness, however, can be upgraded with proper training provisions.
v) Medical & Healthcare Facilities – The medical services should be maintained. The health of the workers should be a big consideration for the management.
vi) Industrial Hygiene – Proper system should be in vogue to eliminate industrial unhygienic state.
vii) Occupational Health – The requirement for safeguarding against occupational health hazards should be available for all the workers. As the occupational health hazards varies from industry to industry due to the difference in the nature of working atmosphere and the pollutants present in it, the concerned industry must pay proper weightage to those disease which are prone to that particular type of industry.
viii) Information Assimilation and Reporting System – The information system should be strengthened to generate and its reporting system should be proper, keeping in view, the authorities, responsibilities and subsequent delegations. A report of compliance of all statutory environmental laws along with other preventive and precautionary measures should be put to Board at regular intervals.
ix) EIA Methodology – The Environmental Impact Assessment (EIA) is usually are pre-requisites to start an industry. This is done considering the known spheres of activities in the existing environmental conditions. But the predictions necessarily deviate from the actual happenings when the industry starts working. To accommodate the deviation in the system is also to be incorporated in the EIA report, if it is noticed that the degradation to the environment caused on the establishment and running of the industry is much higher than what was predicted, the mitigatory measures suggested must also be furthered.
x) Compliance to the Regulatory Mechanism – As the process who are directly working with the system, may be unaware of the latest developments and requirements for the compliance of stipulations and standards prescribed by the various regulatory authorities, they should be trained and instructed on regular basis, to avoid making the Board / owner vulnerable to prosecution and penalty.
xi) Concern for the Society – The industry very often transforms the agrarian environment into an industrial environment. The people so displaced by industrialization feel alienated and develop a feeling of facing the gaseous, dustful, clumsy state of surroundings. The audit should look into this aspect how the industry is making a balance between its own development and the society’s concern.
Q.27. Write short note on Rolling Settlements
Answer:
Rolling Settlements: A rolling settlement is one in which trades outstanding at the end of the day have to be settled (payments made for purchases or deliveries in the case of sale of securities) within “X” business days from the transaction date. Thus, in a T+2 rolling settlement, a transaction entered into on Monday for instance, will be settled on Wednesday when the pay-in or pay-out takes place.
In the rolling settlement, trades on each single day are settled separately from the trades done earlier or subsequent trade days. The netting of trades is done only for the day and not for multiple days.
SEBI has gradually mandated most of the scrips to be settled exclusively on Rolling Settlement basis (T+2). The transactions in the Compulsory Rolling Settlement (CRS) are settled on T+2 basis, i.e. both pay-in and pay-out of monies and securities for transactions in scrips on transaction day (T day) would take place on the day after immediately following day.
However, transactions in ‘Z’ group securities are settled only on trade to trade basis on T+2, i.e., the facility of netting up of buy and sell transactions of the same day, as available in other securities, is not available with securities falling under ‘Z’ group. In other words, if an investor buys and sells X no. of shares on the same day then he shall be first have to actually deliver and then receive the securities on the settlement day.
Value at Risk (VaR) based margining approach has been adopted for transactions done in CRS scrips with effect from July 2, 2001. In the VaR system of margining, historical volatilities of scrips and overall market volatility is considered to arrive at a VaR margin percentage for scrip. Further, the mark-to-market differences are collected on a daily basis and the broker members are required to maintain a capital level, as prescribed by the Exchange, adequate to support their exposure at all times.
In case, a member fails to deliver the shares sold in rolling settlement, the Exchange conducts an auction session on T+2, to meet the shortfall created by non-delivery of shares. In this auction session, offers are invited from the other members to deliver the shares sold by originally selling member, since delivery has to be made to the buying member. In case no shares are received in auction, the sale transaction is closed-out at a close-out price, determined by higher of the following:
Highest price recorded in the scrip from the settlement in which the transaction took place upto a day prior to the auction.
OR
20% above the closing price on a day prior to the auction.
In this case, the auction price/close-out and difference between sale price, if positive is payable by the seller who failed to deliver the scrips. In case, auction/close out price is less than sale price, the difference is not given to the seller is credited to Investor Protection Fund.
Q.28. Write short notes on the following:
(a) Circuit filters / Circuit breakers.
(b) Purpose of appointing inspecting officer of a Depository.
Answer:
(a) Circuit filters / Circuit breakers:
i) This is the price band that set the upper and lower limit within which a stock can fluctuate on any particular day.
ii) A price band for a day is a function of the previous day’s closing price.
iii) According to SEBI directions circuit filter is applied on scrips traded in rolling settlement, if their price fluctuate more than 10% of the closing price of scrip on the previous day.
iv) Thus circuit filters restrict extreme price movement and resist price manipulation.
v) This also protects investor from extreme fluctuations.
(b) SEBI appoints inspecting officers to investigate or inspect the affairs of a depository for any of the following purposes.
i) To ensures that the books of accounts are maintained in the names specified in the regulations
ii) To look into the complaints received from depositor’s participants, beneficial owners or other persons.
iii) To ascertain whether the provisions of the Act, bye-laws agreements and these regulations are being compiled.
iv) To ascertain whether the systems, procedures and safeguards are being followed in the interests and to secure the market.
v) To ensure that the affairs are being conducted in the interest of the Investors / Securities markets.
Q.29. What are the major differences between Financial and Operational Auditing ?
Answer:
Difference between Financial and Operational Auditing – The major differences between financial and operational auditing can be described as follows:
i) Purpose – The financial auditing is basically concerned with the opinion that whether the historical information recorded is correct or not, whereas the operational auditing emphasizes on effectiveness and efficiency of operations for future performance.
ii) Area – Financial audits are restricted to the matters directly affecting the appropriateness of the presented financial statements but the operational auditing covers all the activities that are related to efficiency and effectiveness of operations directed towards accomplishment of objectives of organization.
iii) Reporting – The financial audit report is sent to all stock holders, bankers and other persons having stake in the Organisation. However the operational audit report is primarily for the management.
iv) End Risk – The financial audit has reporting the findings to the persons getting the report as its end objective, however, the operational auditing is not limited to reporting only but includes suggestions for improvement also.
The main objective of operational auditing is to verify the fulfillment of plans, and sound business requirements. Operational auditing is considered as specialized management information tool. Operational auditing is essentially a function of internal auditing staff. Operational auditing is a systematic process of evaluating an organization’s effectiveness, efficiency and economy of operations under management control and reporting to appropriate persons, the result of the evaluation along with recommendations for improvements. Operational audit concentrates on effectiveness, efficiency and economy of operations and therefore it is future oriented. It does not end with the reporting of the findings but also recommends the steps for improvements in future. Operational auditing is not different from internal auditing; it is merely an extension of internal auditing into operational areas.
While in financial auditing, the concentration is more in the financial and accounting areas to ensure that possibilities of loss, wastages and fraud are minimized or removed. In financial auditing, an auditor is called upon to review the financial statements of an enterprise to ascertain whether they reflect true and fair view of its state of affairs and of its working results. He may analyse the operations of an enterprise to appraise their cost effectiveness and also he may seek evidence to review the managerial performances.
Q.30. Write a short notes on – Summary Written Report.
Answer:
Summary written reports: These are known as flash reports. They are significant highlights for immediate attention to top management. Generally suspected defalcations are reported briefly to the appropriate management official on the ‘flash’ basis, often ending up in referral for criminal investigation and legal action. It is common practice in number of companies of issuing a report quite frequently summarizing the various individual reports issued and describing the range of their contents in a very brief and comprehensive manner where only important points are highlighted. Such reports are primarily issued for audit committees of Board of Directors and for other top level managers who do not have sufficient time to go through the elaborate reports and matters which are required to be brought to their notice for immediate action.
Q.31. Sri Raghav is above 80 years old and wishes to sell his proprietary business of manufacture of specialty chemicals. C Ltd. wants to buy the business and appoints you to carry out a due diligence audit to decide whether it would be worthwhile to acquire the business.
What procedures you would adopt before you could render any advice to C Ltd. ?
Answer: A due diligence audit on behalf of C Ltd. with a view to acquiring the business shall involve following steps:
a) Brief history of the target and background of its promoters: The accountant should begin the financial due diligence review by looking into the history of the company and the background of the promoters. The details of how the company was set up and who were the original promoters have to be gone into, before verification of financial data in detail. An eye into the history of the target may reveal its turning points, survival strategies adopted by the target from time to time, the market share enjoyed by the target and changes therein, product life cycle and adequacy of resources. It could also help the accountant in determining whether, in the past, any regulatory requirements have had an impact on the business of the target. Broadly, the accountant should make relevant enquiries about the history of target’s business products, markets, suppliers, expenses, operations.
b) Accounting policies – The accountant should study the accounting policies being followed by the target and ascertain whether any accounting policy is inappropriate. The accountant should also see the effects of the changes in the accounting policies. The target might have changed its accounting policies in the recent past keeping in view its intention of offering itself for sale. The overall scope has to be based on the accounting policies adopted by the management. The accountant has to look at the main effect of accounting policies on the overall profitability and their correctness. It is reiterated that the accountant should mainly look at all material changes in Accounting Policies in the period subjected to review very carefully.
The accountant’s report should include a summary of significant accounting policies used by the target, that changes that have been made to the accounting policies in the recent past, the areas in which accounting policies followed by the target are different from those adopted by the acquiring enterprise, the effect of such differences.
c) Review of Financial Statements – Before commencing the review of each of the aspect covered by the financial statements, the accountant should examine whether the financial statements of the target have been prepared in accordance with the Statute governing the target, Framework for Preparation and Presentation of the Financial Statements and the relevant Accounting Standards. If not the accountant should record the deviations from the above and consider whether it warrant in inclusion in the final report on due diligence.
After having an overall view of the financial statements, as mentioned in the above paragraphs, the accountant should review the operating results of the target in great detail. It is important to make an evaluation of the profit reported by the target. The reason being the price of the target would be largely based upon its operating results. The accountant should consider the presence of an extraordinary item of income or expense that might have affected the operating results of the target. It is advisable to compare the actual figures with the budgeted figures for the period under review and those of the previous accounting period.
d) Taxation – Tax due diligence is a separate due diligence exercise but since it is an integral component of the financial status of a company, it is generally included in the financial due diligence. It is important to check if the company is regularly in paying various taxes to the Government. Generally taxes are levied both by the Central Government as well as the State Government. Further taxes may be direct or indirect. Most of the tax laws require the enterprise to register itself with the government and it is important to check if all necessary registrations have been made. The accountant has to also look at the tax effects of the merger or acquisition.
e) Cash Flow – A review of historical cash flows and their pattern would reflect the cash generating abilities of the target company and should highlight the major trends. It is important to know if the company is able to meet its cash requirements through internal accruals or does it have to seek external help from time to time. It is necessary to check if a) Is the company able to honour its commitments to its creditors, to the banks, to government and other stakeholders; b) How well is the company able to turn its debtors and stocks; c) How well does it deploy its funds; d) Are there any funds lying idle or is the company able to reap maximum benefits out of the available funds ?
f) Financial Projections – The accountant should obtain from the target company the projections for the next five years with detailed assumptions and workings. He should ask to give projections on optimistic, pessimistic and most likely bases.
Ordinarily, it would be desirable that the accountant evaluates the appropriateness of assumption used in the preparation and presentation of financial projections. If, the accountant is of the opinion that as assumption used by the target is unrealistic, the accountant should consider its impact on the overall valuation of the company. He should offer his comments on all the assumption, highlighting those which, in his opinion are not inappropriate. In case he feels the projections provided by the target are not achievable or aggressive he has to mention this in his report. He should thoroughly check the arithmetic of the calculations made for financial projections.
g) Management and Employee – In the Indian context, the status of work force, staff and employees and their demands is a complex problem. In most of the companies which are available for take over the problem of excess work force is often witnessed. It is important to work out how much of the labour force has to be retained. It is also important to judge the job profile of the administrative and managerial staff to gauge which of these match the requirements of the new incumbents. Due to complex set of labour laws applicable to them, companies often have to face protracted litigation from its workforce and it is important to gauge the likely impact of such litigation.
It is important to see if all employee benefits like Provident Fund (P.F.), Employees State Insurance(E.S.I.), Gratuity, leave and Superannuation have been properly paid / provided for / funded. In case of un-funded. Gratuity, an actuarial valuation of the liability has to be obtained from a reputed actuary. The assumptions regarding increase in salaries, interest rate, retirement etc. have to be gone into to see if they are reasonable. It is also necessary to see if the basic salary / wage considered for the valuation is correct and includes all elements subject to payment to payment of Gratuity. In the case of PF, ESI, etc. the accountant has to see if all eligible employees have been covered.
It is very important to consider the pay packages of the key employees as this can be a crucial factor in future costs. One has to carefully look at Employees Stock Option Plans; deferred compensation plans; Economic Value Addition and other performance linked pay; sales incentives that have been promised etc. It is also important to identify the key employees who will not continue after the acquisition either because they are not willing to continue or because they are to be transferred to another company within the ‘group’ of the target company.
h) Statutory Compliance – During a due diligence this is one aspect that has to be investigated in detail. It is important therefore, to make a list of laws that are applicable to the entity as well as to make a checklist of compliance required from the company under those laws. If the company has not been regular in its legal compliance it could lead to punitive charges under the law. These may have to be quantified and factored into the financial results of the company.
In addition to the above steps, the following further points have to be seen:
i) Reason for sale of business and the effect on turnover and profits due to the exits of the present proprietor.
ii) The length of the lease under which business has been operating.
iii) The unexpired period of patents if any held by the vendors.
iv) The age of managerial staff and prospectus of their continuing in service in the new environment; the effect of trained managerial staff learning the organization in production / sales / administrative and the financial liability to pay terminal benefits / compensation, etc.
v) If bulk sales are to a few limited customers, the profitability should be discounted greatly, because any substantial withdrawal of customers might cause business crashes.
vi) A company with a sound financial structure can better withstand the stresses and strains of business. A low debt-equity ratio would indicate an ability to grow through debt financing without raising equity.
vii) The cash generated from operations; the need for redeployment of resources and funds needed for repayment of loans become major factors in determining growth potential;
viii) The valuation of goodwill if any should be on reasonable basis having regards to all factors mentioned above.
Q.32. A company engaged in manufacturing of chemicals is consistently recording higher sales turnover, but declining net profits since the last 5 years. As an investigator appointed to find out the reasons for the same, what are the points you would verify ?
Answer:
Decline in Net Profits despite Increasing Sales: As per the facts that there has been consistently high turnover but declining net profits is an anomalous situation. It may be attributed to one or more following reasons requiring further investigation:
i) Unfavuorable Sales mix: Where the company sells different chemical products with different product margins, the product with the maximum PV ratio / margin should have a higher share in the total sales. If due to revision of sales mix, more quantities of unprofitable products are sold, profits will be reduced in spite of an increase in sales.
ii) Negative Impact of Financial Leverage: Where the company does not have sufficient own funds (equity) but has a higher debt-equity ratio, the interest commitments will be higher. As the volume of its operation increases, higher debt and interest charges would result in lower profits.
iii) Other items included in Sales: The figure of sales as per Profit and Loss Account may include incidental revenues, e.g. freight, excise duty, sales-tax. etc. where the amount of excise duty goes up considerably the total sales may show an increase which is not represented by a real increase in sales quantity / value.
iv) High Administrative and Selling Expenses: Administrative and selling costs are generally period costs which are fixed in nature. Their increase is generally not proportional to sale increase. However, a reduction in profit could also be due to increase in administrative overheads and sales overheads at a rate higher than the rate of increase in sales.
v) Cost-Price Relationship: If the increase in cost of raw materials and labour has not been compensated by a corresponding increase in the sales price this would also result in higher sales and declining profits. In spite of sales quantity, for the increasing cost of raw materials and other services, per unit values of the product has been increased which is however unmatched by the increase in cost.
vi) Competitive Price: Where sales have been made at cut-throat prices in order to eliminate competition from the market, the profits would be in the declining trend in the short-run.
vii) Additions to Fixed Assets: Where there are heavy additions to fixed assets and consequent depreciation charges in the initial years of additions, there may be reduction in profits in spite of increased sales.
Q.33. Explain the objectives of Peer Review.
Answer:
Objectives of Peer Review:
1) To ensure that members while performing attestation services comply with the technical standards, Ethical Standards and Professional Standards laid down issued by the institute;
2) To ensure that such a member has in place proper system (including documentation system) for maintaining the quality of attestation services performed by him;
3) To ensure adherence to various statutory and other regulatory requirements and
4) To enhance the reliance placed by the users of financial statements from economic decision making.
5) To provide a framework of the Peer Review process and what is expected of a member during the conduct of a peer review.
Q.34. Write short note on “Reporting” stage in Peer Review.
Answer:
Reporting stage in Peer Review : This includes the following steps:
1. Preliminary Report of Reviewer – At the end of the on-site review, the reviewer is required to send a preliminary report to the practice unit before making any report to the Board on the areas in case systems and procedures of the practice unit reviewed have been found to be deficient or where non-compliance with reference to any other matter has been noticed by the reviewer during the course of review. The reviewer has to take care that the report does not contain name of any individual of the practice unit. However, no preliminary report is required in case no deficiencies or non-compliance are noticed by the reviewer.
The reviewer while preparing the preliminary report should review and assess the conclusions drawn from the review that indicates the deficiencies to be reported upon. The preliminary report is addressed to the practice unit. The report, apart from mentioning the areas where systems and procedures of the practice unit have been found to be deficient, should also contain a paragraph that discusses the scope of the review performed by the reviewer. If the reviewer draws a conclusion that there existed a limitation on scope of review, the fact, along with such limitation on the scope of the review, should also be communicated to the practice unit through the preliminary report. The reviewer should prepare the report on his letterhead. The report should be dated and also contain the reviewer’s signature and membership number and reviewer’s code number allotted by the Board.
2. Reply to Preliminary Report – The practice unit has to send its submissions or representations, in writing, to the reviewer, on the areas mentioned in the preliminary report. The reply to the preliminary report should be sent by the practice unit within a period of 21 days from the receipt of the preliminary report from the reviewer.
3. Qualified Report of the Reviewer – If the reviewer is not satisfied with the reply of the practice unit, the reviewer has to submit a qualified report to the Board. The report so submitted should clearly indicate that it is a “qualified report”. The Board may then order after twelve months for follow up review by appointing a new reviewer. The new reviewer is then required to submit the follow up report to the Board for consideration.
4. Final Report of the Reviewer – If the reviewer is satisfied with the reply of the practice unit, the reviewer shall submit his final report to the Board. The final report should incorporate the findings as discussed with the practice unit.
Q.35. Briefly explain the Collection of evidences by Peer reviewer.
Answer:
Collection of Evidence by Peer Reviewer: A Peer Reviewer collects evidence by applying the following methods:
a) Inspection mainly consists of examination of documentation (working papers) and other records maintained by the practice unit.
b) Observation consists of witnessing a procedure or process being performed by others. For example, while conducting on-site review, the reviewer may review the performance of internal control.
c) Inquiry consists of seeking appropriate information from the partner (designated by the practice unit for the purpose)/ sole proprietor or other knowledgeable persons within the practice unit. The inquiries may originate from the responses to the questions given in the questionnaire. The inquiries may also arise from the inspection of documentation maintained y the practice unit.
While observation and inquiry may be considered as external independent sources of review evidence, inspection remains the most significant method for confirming the effective observation of control procedures in the practice unit. Observation and inquiry may also corroborate the evidence provided by inspection. The reviewer, in order to carry out the review effectively, should have an understanding of the documentation maintained by the practice unit.
Q.36. Write short notes on the “Focus of a Peer Review”
Answer:
Focus of a Peer Review: As per the Statement of Peer Review issued by the Institute of Chartered Accountants of India, “Peer Review” means an examination and review of the systems and procedures to determine whether they have been put in place by the practice unit for ensuring the quality of attestation services as envisaged and implied / mandated by the Technical Standards. Ethical Standards and Professional Standards and whether these were effective or not during the period under review.
The Review shall focus on :
i) Compliance with Technical Standards
ii) Compliance with Ethical Standards
iii) Compliance with Professional Standards
iv) Quality of Reporting
v) Office systems and procedures for carrying out attestation services
vi) Training Programmes for staff (including Articled and Audit Assistants) concerned with attestation functions, including availability of appropriate infrastructure therefore.
