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Synopsis
When you study SA-510 ‘Initial Engagements Opening Balances’as an auditing standard, the critical points that you, as an auditor need to stress upon, is the verification of opening balances. In the given article, the authors stress on the important areas that an auditor should carefully verify, viz. unaudited prior period balances, reliance on the financial statements audited by the previous auditor.
• For an initial audit engagement, where prior period balances were unaudited, should the auditor be held responsible for opening balances which he never audited?
• Why can’t the auditor rely on work performed by the predecessor auditor where the balances of the prior period were audited by the predecessor auditor?
• Can the auditor request for a review of the work papers of his predecessor?
• Should the auditee be made to undergo ‘fatigue’ once again in assisting the incoming auditor reestablishing the veracity of balances which were already audited by the predecessor auditor in the prior period?
One could easily reach these suppositions on a plain reading of SA 510 Initial Audit engagements – Opening balances. These conjectures gain more relevance in current times, particularly with the requirement of auditor rotation seeming to be a reality as envisaged in the Companies Act, 2013.
SA 510 lays down the guiding principles for performing audit procedures on opening balances where financial statements for the prior period were either not audited or were audited by a predecessor auditor. SA 510 underlines the nature and extent of audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances which depend on such matters as follows:
a. the accounting policies followed by the entity;
b. the nature of the account balances, classes of transactions and disclosures and the risks of material misstatement in the current period’s financial statements;
c. the significance of the opening balance relative to the current period’s financial statements; and
d. whether the prior period’s financial statements were audited and, if so, whether the predecessor auditor’s opinion was modified.
SA 510 requires the auditor to obtain sufficient appropriate evidence about whether:
1. Opening balances contain misstatements that materially affect the current period’s financial statements.
2. Accounting policies reflected in the opening balances have been consistently applied in the current period’s financial statements
3. Changes in accounting policies have been properly accounted for, adequately presented, and disclosed in accordance with the applicable financial reporting framework.
Procedures to address these requirements could include:
• Determining whether prior period closing balances are brought forward correctly to the current period or when appropriate, any adjustments have been any adjustments have been disclosed as prior period items in the current year’s Statement of Profit and Loss;
• Determining whether opening balances reflect appropriate application of accounting policies
• Evaluating whether current period audit procedures provide evidence about opening balances
• Performing specific audit procedures to obtain evidence regarding opening balances.
We will try to understand the above requirements with the help of a case study.
Case Study
ABC Limited (‘ABC’) was incorporated on 1 April, 20X0 with an initial paid-up capital of Rs. 15 crores for undertaking the business of production and trading of welding equipments.
ABC took a long-term loan of Rs. 20 crores on 1st June, 20X0 from Universal Bank repayable after 3 years. The loan was taken to fund the setting up of plant for manufacturing welding equipments. The completion of plant set up and commencement of commercial operations was achieved within three months, i.e., by 31st August, 20X0. ABC management was of the view that the project was a qualifying asset and interest on borrowed funds was eligible to be capitalised to the cost of the asset. Interest of Rs. 1 crore for the period 1st June, 20X0 until 31st March, 20X1 payable on the loan from bank was capitalised to the cost of assets as follows:
For depreciating plant and machinery and furniture and fixtures, management adopted the straight line method of depreciation and the estimated useful life was considered as 10 years and 5 years respectively.
Purchases of tools and components were made from local vendors and finished welding equipments are sold through a dealer network. Inventory of raw materials as at 31st March, 20X1 was valued on ‘FIFO’ basis whereas finished goods were valued at cost or net realisable value whichever is lower.
During the year, ABC spent Rs. 5 crore on advertising and launch expenses of its brand – ‘BestWeld’. ABC management capitalised the entire amount of Rs. 5 crore as cost of brand development as an ‘intangible asset under development’. ABC has plans to spend a further amount of Rs. 8 crore during 20X2 towards advertising its brand – BestWeld in the print and other media as well in trade fairs.
The state of affairs of ABC as at 31st March, 20X1 is summarised below.
Statement of Profit and Loss for the year ended 31st March, 20X1
Balance Sheet as at 31st March, 20X1
The statement on accounting policies in the audited financial statements articulates the accounting policies for capitalisation of interest on borrowed funds, accounting for costs of brand development, depreciation and valuation of inventories.
The accounts for the year ended 31st March 20X1 were audited by M/s. PQR & Co., (‘PQR’) a proprietor audit firm and an unqualified opinion was issued thereon. PQR were reappointed as auditors for the year ending 31st March, 20X2 in the annual general meeting of ABC held in September, 20X1.
In the month of February, 20X2, PQR expressed their unwillingness to continue as auditors on account of ill health of the proprietor and tendered their resignation. ABC appointed M/s. XYZ & Associates (‘XYZ’) as their auditors in March, 20X2. XYZ attended the physical count of inventories which was conducted by the management of ABC on 31st March, 20X2. XYZ plans to commence the audit of ABC in the month of May, 20X2.
I. What audit procedures should XYZ perform to comply with the requirements of SA 510?
II. Continuing with the case study, how would the audit approach be different had the fact pattern around inventory been the following?
III. Can XYZ request for a review of the workpapers of PQR?
IV. Would the solution be different if the prior period financial statements were unaudited?
We will evaluate procedures the incoming auditor, XYZ needs to perform to comply with the requirements of SA 510.
Analysis – I
1. As the financial statements for the year ended 31st March, 20X1 were audited by PQR, the present auditors, XYZ could obtain comfort over opening balances by perusing the audited financial statements and could also seek and peruse other relevant documents such as supporting schedules to the audited financial statements for year ended 31st March, 20X1.
2. XYZ would need to trace whether the prior period’s closing balances have been correctly brought forward to the current period. While in a smaller and less complex accounting set-up, this could be relatively straightforward, tracing the opening balances in a multi-locational ERP set-up could pose a challenge entailing involvement of IT experts.
3. Accounting policies – SA 510 requires the incoming auditor to evaluate whether the opening balances reflect the application of appropriate accounting policies. The following points of focus in this case study need consideration:
a. Ordinarily, XYZ could place reliance on the closing balances as contained in the financial statements audited by PQR. However, in the present case, while performing audit procedures on the financial statement captions such as tangible fixed assets and intangible assets under development for the current year, XYZ would need to evaluate the possibility of misstatement of the opening balances, in view of the accounting policies followed for these captions. ABC has capitalised cost of brand development as intangible asset. Cost of internally generated brands is specifically prohibited from being recognised as ‘intangible assets’ under AS 26 – Intangible Assets. Similarly, given
that the plant was set up within a period of four months, it cannot be classified as a ‘qualifying asset’ for capitalisation of the interest costs on related borrowings under AS 16 – Borrowing Costs.
b. In the instant case, the accounting policy followed for the capitalisation of borrowing costs and brand development costs is inconsistent with the requirements of Indian GAAP. As such, the opening balances of fixed assets and intangible assets under development contain a misstatement which affects the financial statements for the year
ended 31st March, 20X2. The amount of interest capitalised to tangible fixed assets (net of the amount written off as depreciation in 20X1) and brand development cost would need to be charged off to the statement of profit and loss for the year ended 31st March, 20X2. ABC would also need to make necessary disclosures in the notes explaining the prior period charge and XYZ would need to ensure that these disclosures are appropriate.
c. It may be noted that the restatement of
the prior period financial statements does
not exist in the Indian scenario, hence the
adjustments to opening balances would need
to be disclosed as ‘prior period items’ in the
current year’s statement of profit and loss.
d. Where the management refuses to make
adjustments as stated above, XYZ would
need to consider issuing a qualified or an
adverse opinion even though the predecessor
auditor had issued an unqualified opinion
for the prior period.
4. For current assets and liabilities, XYZ would need
to obtain some evidence about the opening balances
as part of the audit for the year ended 31st
March, 20X2 to get comfort on assertions such
as existence, rights and obligations, completeness
and valuation. For
e.g., for debtors, XYZ
would need to obtain evidence around collection
of opening debtors. Similarly, for creditors,
evidence around payments to creditors during
20X2 would need to be examined.
5. Inventories – Physical verification procedures
performed on inventories by XYZ as at 31st
March, 20X2 would provide limited assurance on
the opening inventory as at 31st March, 20X1.
Given that appointment of XYZ was made in
latter part of the year 20X2, it may be difficult
to perform a rollback of quantities physically
verified as on 31st March, 20X2 and reconciling
the same to the quantities as at 31st March,
20X1. In such cases, XYZ could consider the procedures
around valuation of opening inventory,
verification of management papers on physical
verification of inventory and cut-off.
6. For non-current assets such as plant and machinery,
furniture and fixtures, audit evidence
relating to these captions obtained during the
course of audit for the year ended 31st March,
20X2 could provide assurance on underlying
opening balances. The title deeds/agreement
for sale could be examined to obtain comfort
over opening balance for land.
7. For long-term debt, review of loan agreement,
charge documents and trail of receipt of funds
could provide evidence of the existence of
the loan as at 31st March, 20X1. The source
and application of loan amounts would also
be reviewed for the purpose of reporting in
the Companies Auditor’s Report Order, 2003
(CARO).
8. XYZ would need to ensure that the accounting
policies which are appropriate for opening balances
are consistently applied to the current
period financial statements, so in the instant
case, the policy on depreciation and inventory
valuation which was followed for the year ended
31st March, 20X1 should be consistently applied
for the year ended 31st March, 20X2 as well.
9. XYZ may consider stating in an Other Matter
paragraph in the auditor’s report that the corresponding
figures (for the year ended 31st
March, 20X1) were audited by another auditor
whose report expressed an unqualified opinion
on those statements. Such a statement does
not, however, relieve XYZ of the requirement
to obtain sufficient appropriate audit evidence
that the opening balances do not contain misstatements
that materially affect the financial
statements for the year ended 31st March, 20X2.
Analysis – II
1. XYZ was appointed as auditors of ABC in March,
20X2 and thus, did not observe the counting
of the physical inventories at the beginning of
the year. XYZ was also unable to obtain assurance
by alternative means concerning inventory
quantities held at 31st March, 20X1 in view of
the database issue. Since opening inventories
enter into the determination of the results of
operations and cash flows from operating activities,
in the absence of adequate alternative
audit procedures, XYZ would need to consider
whether to issue a qualified/modified opinion
for the year ended 31st March, 20X2.
Analysis – III
1. In India, the Code of Ethics prohibits a
Chartered Accountant in practice from
disclosing information acquired in the course
of his professional engagement to any
person other than his client. As such, an auditor
cannot provide access to his working papers
to another auditor. Therefore, keeping in view
the requirements of Code of Ethics, XYZ may
not be able to review working papers of PQR.
2. It may be noted that the draft revised Code of
Ethics finalised by the Ethical Standards Board
(ESB) of the ICAI in January, 2014 proposes that
disclosure of client information by a member
would be appropriate where such disclosure is
required by law and is authorised by the client
or where disclosure is required for compliance
with technical standards.
Analysis – IV
1. The fact that previous period’s figures were unaudited
does not absolve XYZ from its responsibility
of obtaining evidence on opening balances.
XYZ should consider including under an Other
Matter paragraph in the auditor’s report stating
that the corresponding figures are unaudited.
Concluding remarks
Compliance of SA 510 would enable an auditor
to satisfy himself that the opening balances do
not contain misstatements that materially affect
the current period’s financial statements and appropriate
and consistent accounting policies are
followed in both the prior and current periods.
This would also increase the credibility of the financial
statements by ensuring comparability even
though the auditors may have changed during the
year. As is the practice internationally, review of
work papers of predecessor auditor by successor
auditor is a proposition worth considering, more
so in light of audit rotation requirements stipulated
in the Companies Act, 2013. Such disclosure
of client information could be subject to the adequate
safeguards in terms of prior consent with
the client, hold harmless agreements
etc. This is
a subject matter which may gain more traction
in coming times.
