Category: Article

In this article, the evolution of audit practices from paper-based documentation to digital platforms is illuminated, highlighting how technology has revolutionized the approach towards Audit. This Article further explains how this transition to electronic documentation (“E-Documentation”) has helped significantly in improving efficiency, accuracy and transparency in audits. It allows for secure storage, easy retrieval and structured organization of audit files, which enhances internal and external review processes. Digital tools like automated resource management, cost management and certain electronic tools streamline the operations, while advanced data analytics techniques for sampling and journal entry testing bolster audit effectiveness by detecting errors and anomalies with greater precision. Embracing these innovations enables audit firms to elevate their practices, moving from routine tasks to insightful analyses, ensuring consistent and efficient audit procedures in the digital age.

“Change is the only constant”, as rightly quoted by Heraclitus, a Greek philosopher. The field of audit has embraced this notion of believing that change has always been by its side.

From handwritten documentation to digital algorithms, the evolution of audit has been a journey “from paper to pixels”. In this article, we explore the advancements that have shaped the audit scope, exploring how technology has upgraded the way audits are conducted and how professionals navigate to understand the audit processes adopted in the digital age.

As industries adapt to the rapid pace of technological advancement, the audit profession has been at the forefront of innovation, embracing digitalisation to revolutionise its practices. From the rigorous scrutiny of paper documents to the swift analysis of digital data, the evolution of audit has been nothing short of extraordinary.

In this article, we will delve into the importance of the article by discussing the following aspects:

•  The shift from paper-based to digital audit practices.
•  Evaluating the risk of the client before accepting a new client or an existing client.
• Facilitating communication between the client and the engagement team.
•  Advanced tools like data analytics which enhance transparency, accuracy and efficiency.

In the field of auditing, the transition from paper-based processes to digital platforms has resulted in exceptional efficiency, accuracy and transparency.

DIGITALISATION OF AUDIT DOCUMENTATION – “E-DOCUMENTATION”

Before digitalisation, audit documentation was primarily done using physical / paper-based methods. This involved extensive manual processes like paperwork, handwritten notes, printed financial statements and physical files for audit engagement. Auditors would manually document their findings, observations and procedures. The process of compiling and organising audit documentation was labour-intensive and time-consuming. Storage and retrieval of paper-based audit files posed significant challenges in terms of  space, security, confidentiality and maintaining documents in a systematic way. Overall, the pre-digitalisation era of audit documentation relied heavily on manual processes, paper-based records and physical documentation, which were susceptible to inefficiencies, errors and limitations in terms of accessibility and flexibility.

The era of digitalization paved the way for ‘E- documentation’. E- Documentation stands for Electronic Documentation and refers to securing, maintaining confidentiality and storing the documents electronically. This revolutionary change has proved to be significant for all the professionals pursuing the practice of audit.

The introduction of electronic documentation with various accounting and auditing tools, such as Suvit, facilitates the process of audit documentation. This has various built-in features, such as risk evaluation forms, auto-populated workpapers / questionaries, and communications within the audit team and between the audit team and the management. The auditor can analyze the level of risk for a particular audit engagement as well as it shall also help the auditor to design effective audit procedures to be undertaken for the audit engagement. Moreover, the work performed, findings and reports of an auditor right from the audit planning phase to the conclusion phase can be stored for a prolonged period of seven years as per SA 230 and can be retrieved whenever required. This features robust functionality for maintaining compliance with the maker-checker policy. Additionally, it incorporates a mechanism to imprint immutable timestamps, ensuring the integrity and non-editable nature of the records. E-Documentation serves as a trail for all the actions performed by the auditor during an audit.

Some of the merits of E-Documentation are mentioned below:

•  Internal review

The cloud-based tool can be accessed by the audit team at any point in time. This facilitates smooth review within the audit team and between the audit team and the Subject Matter Experts (‘SMEs).

•  External review

Due to the storage of documentation in a structured manner, it helps in efficient reviews by the external person as well (such as a peer reviewer, or any other regulatory body). All the relevant information and data related to the entity being audited is stored in a centralised manner. E- Documentation also ensures retrieval for a prolonged period, which enables any person to review the work done at any point in time.

•  Roll forward

Apart from the merits mentioned above, the documentation stored in the audit file for a particular year can be utilised in subsequent years by rolling it forward. This process involves transferring audit documentation such as audit memos, workpapers, checklists, auditor’s assessment and conclusion from the previous year to subsequent years. This feature facilitates in planning procedures for subsequent year’s audits.

•  Standard checklists

E-Documentation tool includes checklists designed to facilitate and support auditors’ work. These checklists feature questions related to audit procedures conducted related to various critical areas such as Going concern, impairment of investments / assets, etc. Audit firms can embed/customize standard checklists on Accounting Standards (AS), Auditing Standards, Company Auditor’s Report Order (CARO), 2020, Internal Financial Control, Companies Act, etc., in the software to ensure uniformity across all the engagements / clients. The audit team uses these checklists to document their actual work performed in the respective areas under examination. Further, these checklists also help in ensuring that any important thing in relation to the audit is not missed out.

•  Restricted access

Further, access to the E-Documentation tool can be restricted to the audit team until and unless access is granted to the extended team members with prior approvals. This ensures privacy, confidentiality and security of sensitive client information and data. Further, since working papers are the property of the auditor, utmost care should be taken so that the independence of the audit is maintained before access is granted to any external member.

EVALUATING RISKS AT THE FIRM LEVEL — CLIENT ONBOARDING

The client acceptance procedures shall be focused on ensuring that the clients who are chosen to serve should represent an appropriate balance of risk and reward. The firm minimises the exposure to high-risk clients by identifying each before accepting any engagement and then determining whether the firm is willing to manage the exposure. Additionally, internal risk evaluations, annual inspections, practice risk assessment and continuous monitoring are all integral for ensuring that when a firm chooses to serve a client, the firm follows the policies and procedures and meets the industry standards. The client acceptance process shall be workflow-driven and shall be dependent on the type of services warranted by the client and the size of the engagement. It must require more than one level of approval (in terms of maker and checker), each of which shall be generated electronically to avoid any bias.

•  Apart from assessing a new client, it is equally important to assess the existing client relationships / engagements as well. Hence, evaluating client continuance should be a periodic process due to which the risk parameters of an existing client are revalued/reassessed. Further, the client assessment should also be carried out if there is a significant change in the composition of Those Charged with Governance (TCWG).
•  Engagement acceptance is required to be performed prior to initiating a new engagement, irrespective of whether the firm has continuously performed the engagement for an existing client or will be performed for a new client. The EAF shall be completed and approved prior to the commencement of an engagement.

Hence, the firm should have these kinds of electronic forms which help in assessing the acceptance of a client or an engagement, and if there is any risk on account of any fraud, litigation, etc., against the TCWG / management, then the tool will populate the risk to the engagement team to evaluate the matter in detail.

EFFICIENT ELECTRONIC DATA EXCHANGE BETWEEN THE CLIENTS AND AUDIT TEAM

As mentioned above, in the pre-digitalisation era, exchanging data within the audit team and between the audit team and the client used to be chaos. Various difficulties were faced with respect to its storage and collation; to a certain extent, this might have hampered the overall quality of the audit. However, the digitalisation of the audit processes has led to better work management.

These tools automate the preparation of detailed requirement lists and facilitate secure file sharing, which enables auditors to manage audits effectively. These tools facilitate a collaborative environment for auditors and the client, ensuring real-time progress tracking and simplifying data management. These tools function as centralized digital platforms that manage and organize documents, making it easier for users to locate and access necessary information by arranging documentation within a unified digital repository. It also facilitates the retention of data and information for a prolonged period.

Due to such pioneering change, since the storage of data is now centralized, it has become easier to streamline the audit.

DIGITAL TOOLS

Let us delve into the use of various digital tools and their purpose, which can be used in the audit processes. Maximising audit effectiveness entails harnessing the power of data analytics to transform traditional auditing practices. By integrating sophisticated data analytical tools and techniques, auditors can revolutionize: Resource and cost management; communicating initial audit requirements to the client; selection of samples & vouching and testing of journal entries (JE).

A. RESOURCE MANAGEMENT

Resource management involves planning, allocation and optimisation of resources efficiently to achieve the goals of the firm. Keeping meticulous track of time spent on engagements is pivotal for preserving the trust and transparency vital to professional relationships. The time spent by the audit team and keeping a record of this is of utmost importance. This helps in demonstration of the time spent by partner and manager on engagements which is paramount in ensuring the success and credibility/quality of the overall audit.

This brings a wealth of experience and expertise to the table, which is essential for maintaining high-quality standards throughout the audit process. Their involvement is crucial in overseeing audit procedures meticulously, analyzing financial statements accurately and drawing well-supported audit conclusions.

Moreover, partners and managers play a pivotal role in managing audit risks effectively by identifying potential issues early on and implementing appropriate responses. Their technical knowledge allows them to address complex accounting matters with precision, ensuring compliance with auditing standards and regulatory requirements. Beyond technical aspects, their interaction with clients fosters clear communication, manages expectations and strengthens client relationships.

Additionally, partners and managers provide rigorous review and oversight of audit work performed by junior staff, ensuring thoroughness and accuracy in audit findings. Ultimately, the time invested by partners and managers in audit engagements not only enhances the quality of audits but also upholds the firm’s commitment to integrity, independence and ethical practices in auditing. By aligning costs with the services provided, clients are assured of fair invoicing, reinforcing confidence in the partnership. Moreover, this practice facilitates efficient resource allocation and project management, empowering firms to evaluate process effectiveness, pinpoint areas for enhancement and refine future resource distribution strategies.

B. EFFECTIVE COST MANAGEMENT

The documentation of work conducted during engagements serves multifaceted purposes. It not only provides a detailed record of audit procedures but also furnishes invaluable support for quality control evaluations. Assigning unique job codes to each engagement streamlines this process, simplifying cost analysis and bolstering accountability by correlating time expenditures with specific client projects or internal endeavours. This systematic methodology not only optimises billing procedures but also fortifies project management structures, culminating in an overall improvement of operational efficacy across the organisation.

C. COMMUNICATING INITIAL AUDIT REQUIREMENTS “PREPARED BY THE CLIENT (PBC)”:

“PBC” stands for “Prepared by Client.” This term refers to the documents and schedules that the client prepares and provides to the auditors as part of the audit process. These documents facilitate the auditors’ examination of the Company’s records and support the information presented in the financial statements. This typically includes reports, schedules, listings, vouchers and reconciliations.

Numerous interactions between clients and auditors make it challenging to track all the requirements and communications. To address this, an electronic PBC tool can be adopted to streamline the process. This tool allows the insertion of agreed timelines for data sharing and ensuring deadlines are met. It provides a robust review mechanism and enables task assignment to team members on both the auditor and the client sides. It also helps in improving collaboration and accountability. Importantly, it allows critical issues to be highlighted for partners or managers efficiently.

Adopting an electronic PBC tool enhances transparency and efficiency in the audit process. It ensures all communications and document submissions are tracked accurately, which reduces the risk of oversight.

This technology fosters a more organized and effective audit, leading to better outcomes and smoother operations for both auditors and the client.

D. SAMPLING AND VOUCHING

Diverse sampling methods in auditing, such as statistical, random, systematic, stratified, block, judgmental and haphazard sampling, offer tailored approaches to the auditor. Each method presents distinctive benefits, ensuring comprehensive, effective and efficient audit.

A FEW OF THE SAMPLING METHODS ARE EXPLAINED BELOW:

Statistical sampling: A method of selecting a subset of items from a population using statistical techniques to ensure that the selected subset is representative of the entire population.

Random sampling: A technique where each item in the population has an equal chance of being selected, eliminating bias and ensuring that the sample is representative of the entire population.

Systematic sampling: A method where items are selected at regular intervals from the entire population, starting from a randomly chosen number and then every 10th item of the entire population.

Stratified sampling: A technique where the population is divided into distinctive sub-groups (strata) based on specific characteristics, and samples are extracted from each sub-group to ensure that the selected sub-group is representative of the entire population.

Block sampling: A method where the population is divided into blocks or clusters, and entire blocks / clusters are selected randomly to form the  sample, often used when items within blocks / clusters are more like each other than items in the other blocks / clusters.

Judgmental sampling: A non-random method where the auditor selects items based on professional judgment, often used when specific items are believed to be significant, and the selection will be representative of the entire population.

Haphazard sampling: A non-random method where items are selected without any specific plan or pattern.

Further, for vouching, the audit team can also deploy data analytics, which enhances transaction verification, automates tasks and improves accuracy, thus streamlining processes and conserving resources. Advanced data analytical tools enable efficient cross-referencing of transactions with source documents which further helps in minimising errors.

E. JOURNAL ENTRY (JE) TESTING

JE Testing involves reviewing and verifying the accuracy and validity of financial transactions recorded in the Company’s books of account. Through data-driven approaches, auditors can identify patterns, anomalies and trends within large datasets, allowing for more targeted and efficient sampling methodologies (to a certain extent mentioned in the earlier sections).

Advanced data analytics enable auditors to scrutinise transactions with greater precision, enhance the detection of errors and irregularities, and ensure a more thorough examination of financial transactions, thus providing the outcome efficiently. Further, these data analytical tools help in scrutinising journal entries for accuracy and legitimacy, which facilitates the auditor to flag suspicious entries and provide deeper insights into financial transactions.

VARIOUS TESTS IN JE TESTING ENCOMPASS:

•  Keyword analysis: Search for specific words or phrases like “bribe” or “charity” within worksheets.
•  Year-End entries: Analyse journal entries made nearer to year-end dates.
•  Public holiday entries: Review entries on holidays to detect unusual or large transactions and assess their reasonability.
•  Weekend entries:Scrutinise entries, especially passed on weekends and evaluate their nature.
•  Materiality assessment: Review entries above the materiality to identify unusual transactions.
•  Single entry verification: This means that basic accounting method where each transaction is recorded once rather than using a double-entry system. It is important to ensure that no single entries are mistakenly passed into the books of account.

Incorporating digital tools and data analytics enhances audit effectiveness by optimising resource management, improving cost efficiency and facilitating clear communication of audit requirements. Advanced sampling techniques and JE testing with data analytics further strengthen accuracy and reliability, ensuring thorough scrutiny of financial transactions. These innovations not only streamline processes but also uphold integrity, independence and compliance with auditing standards, ultimately fostering robust audit outcomes and client & regulatory satisfaction.

CONCLUSION

Hence, the suggested tools for audit digitalization and optimization are merely a starting point and not an exhaustive list. These tools exemplify how technology can significantly enhance the audit process, from manual documentation to resource management to risk assessment; effective communication between the client and the engagement team and using Digital tools truly harnesses the benefits of these advancements.

Audit firms and their quality control departments must mandate the use of these digital tools, ensuring consistent, accurate and efficient audit practices.

By embracing these innovations, audit firms can transform their practices from routine tasks to insightful analyses, unlocking new levels of precision and efficiency. The future of auditing is bright and with these tools, firms will be well-equipped to lead the charge into this exciting new era

BCAJ Admin

Statutory Audit of financial statements is mandatory for all companies under the Companies Act, 2013. Whilst audit process commences well before the close of the financial year, for issuing the audit report attention needs to be paid to certain key matters as at the financial year end. Regulators like SEBI, NFRA, ROC, etc. are also keeping a close watch on the information contained the financial statements and the audit report through inspection of the audit work papers and other documents. The focus areas for the regulators generally cover matters regarding modified audit report, reliance on estimates, fraud risk factors, related party transactions, communication to those charged with governance and compliance with laws and regulations keeping in mind the overarching principle of materiality. Any slippages in these critical areas can make or break the reputation of the audit firms and their personal.

1. INTRODUCTION

Presentation and disclosure in financial statements play an important role in providing transparency to stakeholders. They help users to understand the financial health and performance of a company. Regulators are putting more emphasis on presentation and disclosures in financial statements due to increased stakeholder expectations, higher focus on public interest, and ongoing efforts to enhance global harmonization and prevent financial irregularities and frauds.

In today’s volatile market, every company is grappling with multiple challenges. Uncertainty in laws and regulations and economic volatility have put immense pressure on companies. Whereas earlier the annual reports were a thin booklet, currently, their size has increased manifold, which includes the financial statements and statutory auditors report issued to the members of a company under the Indian Companies Act, 2013 “(the Act”). Further, even though the audit report is addressed to the members since the annual report is mandatorily required to be hosted on the company’s website by listed companies under SEBI guidelines, there is no limit on the public accessibility thereof, making companies more accountable.

Finally, regulators like the Securities and Exchange Board of India (SEBI), Registrar of Companies (RoC), National Financial Reporting Authority (NFRA), etc., are keeping a close watch on the information, especially the audited financial statements and the report thereon which are available in public domain.. These regulators have regulatory powers to conduct inspections to delve into the working papers and documents of an audit firm to check if there is any lacuna in the audit procedures followed by the auditor and whether the auditor has complied with relevant Standards on Auditing (“SAs”).

With the end of the financial year (FY) 2024-25 around the corner, the hustle and bustle of audit have already commenced. This article presents some of the key year-end considerations for the auditors that they should keep in mind while performing the audit.

KEY CONSIDERATIONS PERTAINING TO AUDITOR’S REPORT

On completion of the audit, the auditor is required to issue an audit report to express the audit opinion. The following Standards on Auditing deals with respect to audit conclusions and reporting:

•  SA 700 (Revised), Forming an Opinion and Reporting on Financial Statements
•  SA 701, Communicating Key Audit Matters in the Independent Auditor’s Report
•  SA 705 (Revised), Modifications to the Opinion in the Independent Auditor’s Report
•  SA 706 (Revised), Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor’s Report
• SA 720 (Revised), The Auditor’s Responsibilities Relating to Other Information

SA 700 (Revised) prescribes the content of an audit report, which should, at a minimum, be forming part of the audit report. The following are certain issues requiring careful consideration:

A. QUANTIFICATION IN QUALIFICATIONS

It is pertinent to note that pursuant to paragraph 21 of SA 705 (Revised) if there is a material misstatement of the financial statements that relate to specific amounts in the financial statements (including quantitative disclosures in the notes to the financial statements), the auditor is required to include in the Basis for Opinion paragraph a description and quantification of the financial effects of the misstatement, unless impracticable. If it is not practicable to quantify the financial effects, the auditor is required to state that fact in this section. Where an accurate quantification is not possible, but a management estimate is available, the auditor performs such audit tests on those management estimates as are possible and clearly indicates that the amount quantified is based on management’s estimate. If it is impracticable for the auditor to quantify or estimate the effect of the misstatement, this fact needs to be included in the Basis for Modified Opinion paragraph.

Therefore, the auditor needs to quantify the financial effects of the misstatement, and only if it is impracticable, the auditor can include the qualification without quantification. The word ‘impracticable’ is not defined in Standards on Auditing but is commonly understood as ‘after making every reasonable effort’ to do so.

B. OTHER MATTER

As per paragraph 10 of SA 706 (Revised), if the auditor considers it necessary to communicate a matter other than those that are presented or disclosed in the financial statements that, in the auditor’s judgment, is relevant to users’ understanding of the audit, the auditor’s responsibilities or the auditor’s report, the auditor is required to include an “other matter” paragraph in the auditor’s report, provided:

•  That is not prohibited by law or regulation; and
•  When SA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the auditor’s report.

An auditor should not include other matter paragraph for matters adequately disclosed in the financial statements. It can be included, for example, to highlight that in case the audit of some of the components of a company has been audited by other auditors, then this fact is required to be presented in the audit report to the consolidated financial statements under the “Other Matters” paragraph. However, in view of the recommendation by NFRA for revision of SA-600 on the lines of ISA 600, it needs to be seen whether the reference to the work of other auditors will be permissible.

C. EMPHASIS OF MATTER VS. QUALIFIED OPINION

Another important area is the use of the ‘Emphasis of matter’ (EOM) paragraph in the auditor’s report.
As per paragraph 8 of SA 706 (Revised), if the  auditor considers it necessary to draw users’ attention to a matter presented or disclosed in the financial statements that, in the auditor’s judgment, is of such importance that it is fundamental to users’ understanding of the financial statements, the auditor should include an Emphasis of Matter paragraph in the auditor’s report provided:

•  The auditor would not be required to modify the opinion in accordance with SA 705 (Revised) as a result of the matter; and
•  When SA 701 applies, the matter has not been determined to be a key audit matter to be communicated in the auditor’s report.

EOM paragraph should not be included as a substitute for modification. For example, if the company has not provided adequate requisite disclosures in its financial statements, the auditor should evaluate the requirement to express a qualified opinion on the basis of the requirement of SA 705 (Revised) and should not include an EOM paragraph.

Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter paragraph are:

•  Uncertainty relating to the future outcome of exceptional litigation or regulatory action.
•  A significant subsequent event that occurs between the date of the financial statements and the date of the auditor’s report.
•  Early application (where permitted) of a new accounting standard that has a material effect on the financial statements.
•  A major catastrophe that has had, or continues to have, a significant effect on the entity’s financial position.

KEY CONSIDERATIONS PERTAINING TO ESTIMATES (INCLUDING USING THE WORK OF MANAGEMENT EXPERTS)

The auditor is required to perform adequate procedures to obtain sufficient appropriate audit evidence for estimates and complex transactions. The auditor should maintain documentation in sufficient detail to demonstrate the following:

•  Competence, capabilities and objectivity of management experts have been determined (the auditor should consider the self-interest threat of the management expert when numerous valuation assignments from other group companies were being performed by the same valuer);
•  Evaluating for management bias;
•  Procedures performed in order to determine the reasonableness of the assumptions/methods used by management experts;
•  Procedures performed by the auditor over management assessment;
•  Professional judgements made by the auditor in concluding on high-estimate areas;
•  In case of critical estimates/balances, involve internal experts for determining the appropriateness of the assumptions/methods used for valuation;
•  In case there are caveats in the valuation report, legal opinions, etc., documentation on how the auditor has dealt with those

KEY CONSIDERATIONS PERTAINING TO COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE (TCWG)

SA 260 (Revised), Communication with TCWG requires the auditor to communicate significant findings from the audit with those charged with governance. This is another key focus area for the regulators. Some of the key considerations are as follows:

•  TCWG comprises a Board of Directors, Audit Committee and Management. Communication with the Audit Committee is not sufficient.
•  Auditors should maintain documented evidence for:

– Communication of the planned scope and timing of the audit with TCWG.

– Minutes (“what and when”) of meeting with the TCGW/Audit Committee, including the team’s conclusion on the matters discussed.

– Accounting/auditing matters discussed with TCWG during the initial planning meeting and their final resolution

•  Critical matters should be communicated to TCWG, and regular discussions with the management should be documented.
•  Audit committee presentation contains only management’s estimate/representation, does not include audit procedures performed and auditor’s conclusion
•  Minimum communication with TCWG to ensure compliance with SA 260

– Auditor Independence

– The Auditor’s Responsibilities in Relation to the Financial Statement Audit

– Planned Scope and Timing of the Audit

– Significant Findings from the Audit, including the auditor’s assessment

– Inquiries with TCWG and response thereto

NFRA recently issued “The Auditor-Audit Committee Interactions Series 1”, which draws the attention of the auditors to the potential questions the Audit Committee / Board of Directors (BoD) may ask them in respect of accounting estimates and judgements. The first in the series in this regard includes aspects pertaining to the audit of Expected Credit Losses (ECL) for financial assets and other items as required by Ind AS 109, Financial Instruments.

SA 260 also requires the auditor to communicate with TCWG about qualitative aspects of the accounting practices, policies and disclosures. The reason behind such a communication is that the views of the auditor would be particularly relevant to TCWG in discharging their responsibilities for oversight of the financial reporting process.

This series put forwards some key questions relating to the following topics which the BoD / Audit Committee may ask the auditor regarding the audit of ECL:

•  Audit of ECL computation
•  Test of design and operating effectiveness of control mechanism over recognition and measurement of ECL
•  Audit of methodology used for ECL computation

KEY CONSIDERATIONS RELATED TO INTERNAL CONTROLS OVER FINANCIAL REPORTING (ICFR)

The auditor has to report under section 143(3) of the Act as to whether the company has adequate internal financial controls in place and the operating effectiveness of such controls. As per the Act, the term ‘internal financial controls’ means the policies and procedures adopted by the company for ensuring the orderly and efficient conduct of its business, including adherence to the company’s policies, the safeguarding of its assets, the prevention and detection of frauds and errors, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information. The Guidance Note on Audit of Internal Financial Controls Over Financial Reporting states that the auditor’s objective in an audit of internal financial controls over financial reporting is to express an opinion on the effectiveness of the company’s internal financial controls over financial reporting and the procedures in respect thereof are carried out along with an audit of the financial statements. Because a company’s internal controls cannot be considered effective if one or more material weakness exists, to form a basis for expressing an opinion, the auditor must plan and perform the audit to obtain sufficient appropriate evidence to obtain reasonable assurance about whether material weakness exists as of the date specified in management’s assessment.

Some of the key areas which require careful consideration are as follows:

•  Evaluation of controls over management override as part of entity-level controls; the auditor should maintain adequate documentation and procedures for controls around management override (remain cautious that deviation to the process might be a red flag for management override).
•  Evaluation of management testing of ICFR is critical, and its impact on ICFR conclusion should be documented. Inquiries with the internal auditor and evaluation of the role of the internal auditor, and a review of internal audit reports and the auditor’s conclusion should also be documented.
•  Adequate testing/focus even on non-critical areas (e.g. PPE)

KEY CONSIDERATIONS RELATING TO SIGNIFICANT UNUSUAL OR HIGHLY COMPLEX TRANSACTIONS

Material misstatement of financial statements, including fraudulent financial reporting, can arise from significant unusual or highly complex transactions, including situations that pose difficult “substance over form” questions, such as transactions not in the ordinary course of business undertaken with related parties. The Standards on Auditing give particular attention to the accounting for and disclosure of such transactions in the context of the auditor’s identification and assessment of risks of material misstatement, whether due to error or fraud and the auditor’s responses thereto.

The auditors are required to exercise professional judgment and maintain professional skepticism throughout the planning and performance of an audit and, among other things, identify, assess and respond to risks of material misstatement, whether due to fraud or error. Accordingly, the auditor plans and performs an audit with professional skepticism, recognising that circumstances may exist that cause the financial statements to be materially misstated. Maintaining professional skepticism throughout the audit is necessary if the auditor is, for example, to reduce the risks of overlooking unusual circumstances. The auditor is required to:

•  Evaluate whether information obtained about the entity indicates that one or more fraud risk factors are present; for example:

♦ Significant related party transactions not in the ordinary course of business or with related entities not audited or audited by another firm; and

♦ Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions

♦ Inquire of management and others within the entity as appropriate about the existence or suspicion of fraud, including, for example, employees involved in initiating, processing or recording complex or unusual transactions and those who supervise or monitor such employees;

♦ Inquire of management and others within the entity, and perform other risk assessment procedures considered appropriate to obtain an understanding of the controls, if any, that management has established to:

♦ authorise and approve significant transactions and arrangements with related parties; and

♦ authorise and approve significant transactions and arrangements outside the normal course of business;

If the auditor identifies significant transactions outside the normal course of business, inquire management about the nature of these transactions and whether related parties could be involved.

Fraudulent financial reporting often involves management override of controls that otherwise may appear to be operating effectively. Management override of controls or other inappropriate involvement by management in the financial reporting process may involve such techniques as omitting, advancing or delaying recognition in the financial statements of events and transactions that have occurred during the reporting period or engaging in complex transactions that are structured to misrepresent the financial position or financial performance of the entity. The auditor is required to treat the risk of management override of controls as a risk of material misstatement due to fraud and, thus a significant risk.

COMPLIANCE WITH LAWS AND REGULATIONS

Compliance with laws and regulations is a crucial aspect which engages the attention of auditors for which they need to keep in mind the requirements laid down in SA-250. Auditors are primarily concerned with the non-compliance with Laws and Regulations that materially affect financial statements, which includes the following, amongst others:

•  Form and content of financial statements, including amounts to be reflected and disclosures to be made (Schedule III, Banking Regulation Act, Insurance Act, SEBI Mutual Fund guidelines, etc.)
•  Conducting of business including licensing and registration (Banks, Mutual Funds, NBFCs, Pharmaceutical companies, fertilizer companies, etc.), which could have potential going concern issues
•  Operating aspects of the business (Provisioning, valuation, taxation, safety aspects etc.) with possible financial consequences like fines, penalties, etc.

Adequate and appropriate procedures need to be performed to identify instances of non-compliance:

•  Inquiries with the Management.
•  Inspecting correspondence with relevant statutory authorities.
•  Reading the minutes.
•  Appropriate Control and Substantive procedures for industry-specific requirements like provisioning, valuation, accrual of expenses for retirement benefits, computation of incentives and subsidies etc.

Following are some of the instances of non-compliance which need to be considered in the context of year-end financial reporting:

•  Non-payment / delayed payment of statutory dues (CARO reporting).
•  Non-compliance with certain statutory and procedural requirements under various laws in respect of certain transactions or investigations by government departments resulting in fines and penalties or other demands and consequential disclosure of contingent liabilities or making provisions.
•  Unsupported transactions, especially with related parties.

KEY CONSIDERATIONS PERTAINING TO MATERIALITY

The concept of materiality is the final test which determines the nature and extent of reporting and the issuance of the final opinion in the audit report as to whether the financial statements present a fair view. It helps to determine the material misstatements. As per SA 320, misstatements are material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of the users taken on the basis of financial statements. Whilst generally materiality is determined on a quantitative basis, in certain situations, misstatements may be qualitatively material, which needs to be kept in mind during year-end reporting as follows:

•  Transactions resulting in changing loss into profit and vice versa.
•  Transactions having an impact on compliance with debt covenants (e.g. current ratio, DSCR, etc.)
•  Transaction has an impact on contractual agreements.
•  Transaction has an impact on compliance with regulatory provisions.
•  Transaction has an effect on variable compensation payable to Key Managerial Person.
•  Transaction resulting in fraud or omission or commission.

The following are the different stages in the calculation of materiality.

•  Planning Materiality: It is computed as the overall materiality representing a threshold above which the financial statements could be misstated and would affect the economic decision of the user of the financial statements. It depends on the size of the organization, types of transactions, character of management and auditor’s judgement and is set as a percentage of the profit, assets or net worth depending upon the nature of the entity.
•  Performance Materiality: It is an amount less than overall materiality and acts as a safety buffer to lower the risk of aggregate uncorrected and undetected misstatements, which could be material for overall financial statements.
•  Specific Materiality: It is established for a class of transactions, account balances and disclosures.

The materiality must be appropriately calculated since that has a bearing on the aggregate uncorrected and undetected misstatements and the consequential impact on the overall audit opinion.

CONCLUSION

Audit of financial statements is no longer about simply issuing an audit report but demonstrating and documenting the conclusions reached in respect of all auditing standards, as applicable to a particular company, especially in respect of matters requiring modification, reliance on estimates, fraud risk factors and related party transactions, amongst others whilst at the same time ensuring compliance of all relevant laws and regulations keeping in mind the overarching principle of materiality. With the constant inspections to which the auditors are exposed, any material deviations, especially in the aforesaid critical areas, can make or break the reputation and hard work built by the audit firms and the individual partners/proprietors and senior audit team members with severe consequences like fines and penalties and debarring the firm from undertaking audits.

BCAJ Admin

Old mobile phones. Plastic wrapper of a chocolate bar. Used tyres. Most people would think of this kind of detritus as a future landfill, as the bulk of these wastes goes unprocessed. The ever-growing pile of waste is causing irreversible damage to the environment.

But not anymore. Indian lawmakers are waking up and passing / amending Rules under the Environment (Protection) Act, 1986, to enforce Extended Producer Responsibility for certain entities. These Rules cast an obligation on producers / brand owners / importers for environmentally sound management of their products that have reached their end of life and are now considered a waste. Extended Producer Responsibility includes collection / recycling of waste as prescribed in the Rules.

Based on the ‘Polluter-Pays Principle’ the purpose of these Rules is neither to transfer public expenditure to these entities nor to penalise them, but to set appropriate signals in place in the economic system so that environmental costs are incorporated in the decision-making process and hence arrive at sustainable development that is environment-friendly. These Rules have continuously been expanded to cover major categories of wastes and include manufacturers and importers irrespective of the selling technique used, such as dealers, retailers, e-retailers,etc (i.e. producers) and online platforms / market places and supermarkets/retail chains (i.e., brand owners). Following is a high-level summary of some of the key Rules:

These Rules raise certain fundamental questions regarding accounting for the cost of fulfilling the legal obligation to recycle / collect waste. Some of them are discussed below:

WHEN IS THE OBLIGATING EVENT?

A provision under Ind AS 37 is recognised when an entity has a present obligation (legal / constructive) as a result of a past event, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision should be recognised.

The definition of a legal obligation refers to an obligation that derives from a contract (through its explicit or implicit terms), legislation or other operation of law. It is worth mentioning that the concept of an obligating event is open to interpretation and requires the exercise of significant judgement, as the obligating event is not always easy to identify. The following views are possible in the extant case:

View I – Sale of goods is the obligating event

The proponents of this view believe that the sale of goods is the event which triggers compliance under the Rules. The timing of recognition of the cost of fulfilment should be contemporaneous with the timing of revenue recognition. Provision should be made for all unfulfilled obligations emanating from historical sales as well as sales made during the current year (for which obligation to recycle would occur in subsequent years). The proponents argue as follows:

• The minimum recycling targets, as summarised above, are generally based on the products ‘placed in the market’ or products ‘purchased / manufactured / imported’ previously. A product is placed on the market when it is made available for the first time on the market, i.e. when it is first supplied for distribution, consumption or use on the market in the course of a commercial activity, whether in return for payment or free of charge. Thus, the placing of a product in the market occurs on its sale to customers. A similar connotation is relevant where products are purchased, imported, etc.

• The Rules aim to recycle end-of-life (i.e., waste) products and reduce the consequential damage to the environment. The expiration of the life of the product and the damage to the environment potentially begins when the customer starts using the products. Accordingly, the sale of products is the foundational tenet of these Rules.
• Going concern basis envisages that the financial statements would continue for the foreseeable future. Thus, these entities would be economically compelled to incur the cost of recycling of all products sold to date, including sales made in the current year.
• Analogy can be drawn from a similar situation where a lessor is obligated to return the leased premise in the same state that existed at the inception of the lease. For example, if an entity has erected partitioning in a leasehold building and the partitioning must be removed at the end of the lease term, then provision is made for this cost at the time of putting up the partition wall.

View II – Existence of the producer on the measurement date is the obligating event

This view is based on the premise that the cost associated with the fulfilment of Extended Producer Responsibility is akin to a levy as described in Appendix C to Ind AS 37. Proponents of this view argue that the obligation can be avoided if the entity ceases to exist on the measurement date. Under this approach, any unfulfilled obligation in relation to historical sales should be provided for. No provision is required for sales made in the current year (for which the obligation to recycle would occur in subsequent years). The following are the relevant arguments:

• A levy is an outflow of resources embodyingeconomic benefits imposed by Governments (including Government agencies) other than those covered under other Ind AS e.g. income taxes under Ind AS 12 and fines or other penalties imposed for legislationbreaches. As long as the payments are required by law, they are generally considered to be imposed by the government.

Under the Rules, the obligation should be met through authorised recycling agencies, which will inter alia provide the certificates of recycled quantity to the entities. Instead of paying a charge directly to the Government for recycling the waste products, the charge would be paid to the Government’s agents. Thus, the payment made for the purchase of certificates from Government authorised recycling agencies is in the nature of a levy. Appendix C is specific guidance for the accounting of levies that builds on the principles of Ind AS 37. Thus, the assessment of the obligating event of wastes should be based on Appendix C to Ind AS 37.

• Under Appendix C, the obligating event that gives rise to a liability to pay a levy is the activity that triggers the payment of the levy, as identified by the legislation. For example, if the activity that triggers the payment of the levy is the generation of revenue in the current period and the calculation of that levy is based on the revenue that was generated in a previous period, the obligating event for that levy is the generation of revenue in the current period. The generation of revenue in the previous period is necessary, but not sufficient, to create a present obligation.

Under the above Rules, the payment to recyclers will arise only if the producer exists during the measurement period. For example, a producer would be obligated to meet the obligation in FY 2023-2024 only if the producer is in operation in such year. Since the activity that triggers the payment of the levy is the existence of the producer in the current period and the calculation of that levy is based on the products sold in a previous period, the obligating event for that levy is the existence of the entity in the current period. The sale of products in the previous period is not the activity that triggers the payment of the levy but only affects the measurement of the liability.

• Merely preparing financial statements under the going concern assumption does not imply that the entities have a present obligation to pay a levy triggered by operating in a future period.

Closing entries:

• It would be appropriate to follow View II. The accounting policy of a listed company provides as follows:

Provision for E-Waste/Plastic-Waste management costs is recognized when the liability in respect of products sold to customers is established in accordance with E-waste Management Rules, 2016, as notified by the Government of India. Initial recognition is based on liability computed based on Extended Producer Responsibility as promulgated in said Rules, including the cost to comply with the said regulation and as reduced by the expected realisation of collectable waste. The Company has assessed the liability to arise on a year-to-year basis.

• View II would also be in line with global practices such as the European Union’s Directive on Waste Electrical and Electronic Equipment. The Directive prescribes that the cost of waste management for equipment should be borne by producers of that type of equipment that is in the market during the period specified in the applicable legislation. The manufacturers have to contribute to costs in proportion to their respective share of the market by type of equipment.
• The International Financial Reporting Interpretations Committee (IFRIC), as set up by the International Accounting Standards Board, has issued certain guidance on the manner of recognition of liability under the above Directive. ¹IFRIC 6 concludes that the event that triggers liability recognition is participation in the market during the measurement period. The measurement period is a period in which market shares are determined for the purposes of allocating waste management costs. IFRIC 6 states that this date, rather than the date of production of the equipmentor incurrence of costs, is the triggering event for liability

1   IFRIC on Liabilities Arising from Participating in a Specific Market – Waste Electrical and Electronic Equipment

Measurement of obligation

The above Rules mandate entities to purchasecertificates from authorised recyclers to meet their Extended Producer Responsibility. The cost of obligation is derived basis the target quantity multiplied by the rate per unit as agreed with the authorised recycler. For example, if an entity is required to recycle 100MT of plastics and the authorised recycler charges ₹10 per MT; then an expense of INR 1,000 should be recognised at the end of the current year. The amount of unfulfilled obligation, if any, should be classified as a provision in the Balance Sheet.

Closing entries:

• Making a reliable estimate is one of pre-conditions for recognition of a provision under Ind AS 37. The Standard takes the view that a sufficiently reliable estimate can almost always be made for a provision except for extremely rare cases. In the extremely rare case where no reliable estimate can be made, a liability exists that cannot be recognised.
• In certain cases, entities face significant challenges in measuring the obligation. These challenges can stem from the non-availability of certificates with the authorised recyclers or the lack of necessary information to estimate the amount of cash outflow required to recycle a particular category of waste. Relevant extracts from the financial statements of a listed company are as follows:

On 21st July, 2022, the Ministry of Environment, Forest and Climate Change issued notification containing Regulations on Extended Producer Responsibility (EPR) for Waste Tyre applicable to Tyre manufacturers and Recyclers. As per the notification, the Company has a present legal obligation as at31st March, 2023, to purchase EPR certificates online from Recyclers of waste tyre registered with the Central Pollution Control Board to fulfil its obligations,which is determined based on a certain percentage of the quantity of tyres manufactured in the year ended 31st March, 2021.

Currently, the modalities of the above regulations are dynamic. They would be fine-tuned in line with the changing requirements, including measurement of obligation and timeline for achieving compliance by tyre manufacturing companies in consultation with the Industry forum of Tyre companies. Accordingly, the Company has not recognised any provision towards EPR obligation for the year ended 31st March, 2023.

BCAJ Admin

This is the second and final article to cover an overview of the first five NFRA inspection reports. The inspection process, timelines and the structure of the inspection reports were covered in the February 2024 issue of The BCAJ on page 21, including the summary of NFRA observations related to governance and leadership structures or lack / non-disclosure thereof, international and domestic network / affiliations. The article also covered issues pointed out by NFRA related to non-audit services provided to audit clients and SQC 1.

This second part is on the remaining observations of NFRA on audit quality control systems, independence, engagement quality control and points arising from the review of engagement files based on selected areas. From these two articles, one will be able to draw practical nuances relating to Standards on Auditing and other applicable laws and regulations.

At the cost of repetition, the purpose of this compilation is to enable auditors and audit firms to understand the focal points and key issues arising from these inspections. By understanding key features, firms can take the necessary steps to be compliant with applicable regulations.

The five reports covered are as below and referred to with the last two digits to identify the reports:

PART B OF REPORTS

The subheadings in all five reports are different in both sequence and content. Excluding leadership, structure, and Independence matters, which are covered in The BCAJ, vide article of February 2024 on page 21, let us consider Documentation, Engagement Quality Control and some observations arising from the review of the audit files.

FIRM WIDE AUDIT QUALITY CONTROL SYSTEM

1) EQCR Partner: The firm’s procedures fall short of SA 220 and SA 230 and the Firm’s Policy. Two samples selected contained incomplete work papers without sufficient evidence of EQC review done. (Para 30, Report No 01)

2) The practice of deleting all review comments should be reviewed as they may constitute a discussion between the Engagement Team and EQCR, which is mandatory under SQC 1 and SA 220. (Para 31, Report No 01)

3) Evidence of performance of EQCR, i.e., the EQCR docket (summary of EQCR work performed) was not made part of the Engagement Management System (EMS). However, EQCR clearance was obtained prior to the issuance of the audit report. This is despite the firm’s Policy of generating the EQCR docket via the EQCR portal to be incorporated in the EMS. (Para 26 & 27, Report No 02)

4) There was an instance of lack of reassessment of audit risk upon finding some suspicious transactions, etc., which was not in accordance with Para 31 of SA 315 and Firm’s Policy Manual. This matter led to reporting under Section 143(12) to the central government, adverse opinion and eventual resignation from audit later that year whereas suspicious transactions were noticed in the second quarter itself. (Para 18–22, Report No 02)

5) Consultation was taken, a decision taken on that basis, but the rationale was not recorded which is not in accordance with Para 56 of SQC1, which is not in accordance with the firm’s own Policy Manual. (Para 30–32 Report No 02)

6) Engagement Management System (EMS) required annual and engagement level independence confirmations. However, EMS permitted access to audit without obtaining the engagement level independence confirmations (which is an additional control), which is in violation of the Audit Firm’s Policy Manual and Para 18 of SQC 1. (Para 17 Report No 02)

7) An Independence compliance audit done by a network firm partner identified that “35% of the Partners, the sole Executive Director, 55% of the Directors and 38% of the Sr. Manager/Managers had not reported the financial relationships, required to be reported in accordance with the Firm’s independence policies”. Such high rates of non-compliance with the firm’s own independence policies were of serious concern to the NFRA. Despite such significant violations, the sample size was reduced compared to the prior year. The firm failed to provide the complete Independence Compliance Audit Report for FY 2020–21. A sample test of five audit engagements revealed that independence confirmations were absent in the case of some members of the engagement team and in some cases, independence declarations were obtained after the issue of the audit report. The Independence Compliance Tool is not aligned with Indian laws. (Para 22–26 Report No 03)

8) EQCR needs to be a partner who is a member of the ICAI as per SA 220 and SQC 1. However, the Firm’s EQCR Policy did not specify that EQCR shall be a member of the ICAI. (Para 23 Report No 04)

9) There is no document explaining the rationale or criteria for the selection of engagement files for internal quality inspection and specific areas for review by the inspection team. (Para 30 Report No 04)

10) Firm persons interviewed by the NFRA inspection team did not have much clarity on how to choose the value of assurance factor for the desired level of testing so far as sampling was concerned. (Para 28 Report No 04)

11) The Firm had a policy of doing background checks of the auditee company from the database of the network entity. In some cases, background check reports were not positive and yet the firm did not carry out alternative tests to assess client integrity for accepting / continuing. The firm’s reliance solely on a single source (network entity database) was found insufficient and not in accordance with Para 28 of SQC 1. (Para 25 Report No 05)

12) No audit documentation was found in relation to the evaluation of the competence and capabilities of the audit firm to undertake the engagement. (Para 27 Report No 05)

13) Audit documentation by EQCR is not fully compliant with Para 25, SA 220. (Para 28 Report No 05). Working papers had no documentation of the work done by EQCR. (Para 30 Report No 05)

AUDIT DOCUMENTATION

1) The firm’s policies and procedures to ensure integrity of its electronic audit documentation were not fully in accordance with the requirements of SQC 1 (Para 77, 79, 80). (Para 13 Report No 01)

2) The audit evidence, which is reviewed and signed as final, can be edited, altered or modified subsequently without affecting the previously provided signoff. While a report gives information about edits, it doesn’t identify the exact changes made in the document. (Para 13 Report No 01). Such weakness can lead to signing a blank folder and then allowing the engagement team to add documents before archival.

3) The electronic documentation system does not meet the requirement of Para 9 of SA 230. Neither the preparer nor reviewer date marks the completion of an audit procedure.

4) The archival process of the firm’s electronic work papers lacks integrity as the copy of the achieved file is editable while it is used for other post-archival purposes and, therefore, does not serve the purpose of audit documentation under Para 3 of SA 230. (Para 15, Report No 1)

5) Audit Work papers can be modified after sign-off. The application supports multiple sign-offs by the same and / or different people. It does not mandate modifier sign-off after the modification. A blank paper after sign-off can be filled out later without affecting sign-off. In the instances sighted by NFRA, there was no evidence of why and when documents were modified and who made and reviewed the changes. This was in non-compliance with Para 79 of SQC 1 and Para 8, 9 and 13 of SA 230. NFRA noted that “sufficient appropriate audit evidences are not obtained before issue of audit report as evidenced from large scale modification of AWPs post issue of audit report and without signing off AWPs after such modification.”(Para 29–30, Report No 3)

6) Signing partner is not the same as Engagement Partner in violation of Para 46 and 56 of SA 700 and 6.b of SQC 1. In FY 2020–21, there were 40 cases where Engagement Partners did not sign the audit reports. (Para 32, Report No 3)

7) The firm needs to put in place policies to deal with complaints and allegations about non-compliance with professional standards, regulatory compliance or legal requirements or the firm’s system of QC to ensure compliance with Para 101 of SQC 1. (Para 34, Report No 3)

8) NFRA desired that there should not be paper files and electronic files and all papers should be scanned and kept in electronic files. (Para 26, Report No 4)

9) Physical files are neither scanned nor incorporated by electronic files via cross-referencing of paper files with electronic files. Files lacked integrity prior to archival. (Para 12, Report No 5)

10) Sources of audit documents — whether from clients, etc., — were not available. This is a potential risk under SA 500, SA 540 and SA 550. (Para 13, Report No 5)

PART C OF REPORTS — NFRA OBSERVATIONS ON REVIEW OF INDIVIDUAL AUDIT FILES

NFRA selected a few Engagement Files for review (Refer to page 21, The BCAJ, February 2024) and selected three significant audit areas in respect of those selected engagements: Revenue, Trade Receivables and Investments.

1) The Audit Engagement team did not document its judgment for not recognising applicable types of revenue, revenue transactions and assertions as a fraud risk as necessitated by SA 240 to determine the risk of material misstatement due to fraud in the audit of revenue. (Para 32, Report No 1)

2) Audit Evidence in respect of year-end balance was not found in work papers and was obtained from the custodian during the course of the NFRA review. (Para 34, Report No 2)

3) Existence Assertion in respect of Investments at year-end, being 1 per cent, was necessary to be obtained at year-end and not obtaining such evidence was not in conformity with the firm’s policy manual and SA 230. (Para 35-36, Report No 2)

4) NFRA appreciated Non-Audit Services (NAS) guidelines voluntarily issued by the firm with effect from 1st April, 2020. At the same time, the firm delivered tax services related to DRP to an audit client in respect of years when such an entity was not an audit client. The firm had in place certain safeguards where the tax and these fell under transitional provisions of its internal NAS Guidelines. (Para 37–42, Report No 2)

5) In the case of two company audits, the financial statements did not disclose full particulars of the loans given, the investment made or guarantee given or security provided and the purpose for which the loan or guarantee or security was proposed to be utilised by the recipient of the loan or guarantee or security, thus not complying with Section 186(4) of the Companies Act 2013. The auditor did not report on it in CARO para (iv) despite its reporting responsibility. (Para 36, Report No 3)

6) Final financial statements (FS) and independent auditors’ report (IAR) were not available on the audit file and the draft FS and IAR that were on the file were different from those on the website of BSE in violation of Para 30 of SA 330. The firm accepted this as an inadvertent error. (Para 37, Report No 3)

7) In respect to 3 out of 5 selected companies, the firm was found deficient in performing appropriate audit evidence in respect to impairment of investments. (Para 38–42, Report No 3)

a. In respect of one auditee company, uponacquisition of a group of companies under Ind AS 103 Business Combinations, the firm relied on a two-year-old valuation report in respect of the subsidiary and did not perform any audit procedures for identification of impairment indicators. There was also no working in respect of how the amount in respect of investment was arrived at.

b. In respect of the same auditee, the firm wrongly concluded that no impairment loss was required to be recognised:

i. On the grounds that the subsidiary was in the process of issuing shares to an unrelated MNC which will increase the share price in the near future.

ii. On the grounds that the subsidiary was a dividend paying company and 100 per cent subsidiary, therefore, it did not perform impairment testing.

iii. Since it involved the work of a valuation specialist engaged by another audit team which audited that subsidiary was not evaluated.

c. In respect of another auditee, the audit firm wrongly presumed a subsidiary as 100 per cent owned whereas it was 84.18 per cent owned. NFRA stated that had the correct percentage of investment been considered, the impairment value would have been material to be recognised. The detailed enterprise value relied upon by the firm was also not available on the audit file.

d. In the case of another auditee, the Firm concluded that no impairment was required to be recognised for the investment in an associate, on the basis that the associate company had issued shares to unrelated market participants at a value higher than the carrying value. However, the Firm did not perform any audit procedure to check that the referred market participants were not related to the auditee company.

8) The Audit Firm’s Information System Audit Team identified certain deficiencies in the IT Control Environment, i.e., Access to Programs and Data, Entity level controls and Period-end Financial Reporting. The audit firm did not issue a modified audit opinion in respect of the IFC report despite these critical inadequacies and deficiencies. The audit file did not contain any work paper concluding that a modified opinion was not required. (Para 40–41, Report No 4)

9) The Engagement Team’s selection of a sample size of only 25 was not commensurate with the risk level. (Para 40–41, Report No 4)

10) ET had planned to obtain a ‘Low’ level of substantive evidence despite the significantly weak IT General Control environment identified by the Information Systems Audit Team. The total monetary value of transaction testing was ₹19.5 crores, which was 2.09 per cent of Total Revenue of ₹930.14 crores. As a result, the ET did not have sufficient appropriate audit evidence to support its unmodified opinion on the financial statements. The Audit Firm’s response was not accepted as it was not in accordance with the SA 530. (Para 44–47, Report No 4)

11) ET did not perform any substantive audit procedure to check the accuracy and correctness of the ‘price details’ applied to the actual invoices generated. (Para 48–49, Report No 4)

12) The entity’s significant accounting policy in respect to the recognition and measurement of revenue at the fair value of the consideration received or receivable was not in accordance with the Ind AS 115. (Para 50–51, Report No 4)

13) The Engagement Team’s audit in respect of verifying and ensuring the entity’s recognition and measurement for impairment loss allowance in accordance with the ECL approach of Ind AS 109 was inadequate and inappropriate (Para 8(a), A13, Para 8(c), A24, A25 and Para19 of SA 5409).

a. The account policy followed was not in accordance with the accounting policy disclosed.

b. The ET did not check how the management had adjusted the historically observed default rates to forward-looking estimates.

a. The entity had not made the disclosures required as per Para 35M and 35N of Ind AS 107 in respect to the credit risk exposure of Trade Receivables.

(Para 52, Report No 4)

14) Invoice-wise matching of customer collections which had an impact on the aging report was not done. This had a direct consequence on the calculation of impairment loss allowance for Trade Receivables. (Para 54, Report No 4)

15) Although the actual PBT benchmark for calculating materiality was significantly lower than planned materiality levels based on the past 3–5 years PBT, the overall materiality and performance materiality were not changed. This was a non-compliance with SA 450. (Para 56–59, Report No 4)

16) While evaluating the impact of misstatements identified during the audit, the ET had, while computing the uncorrected misstatements as a percentage of PBT, considered the number of uncorrected misstatements net of tax instead of gross of tax, leading to erroneous computation of the impact of uncorrected misstatements and the extent of audit procedures. (Para 60, Report
No 4)

17) The audit file did not have the auditee company’s policy on related party transactions. There was no evidence of obtaining a complete list of related parties at the start of the audit and the audit team having verified management assertion that RPT had taken place at arm’s length. The engagement team was, therefore, in violation of SA 550 (Para 24). In one case, the firm also stated that since the RPT were with subsidiaries, they did not pose an elevated risk. NFRA specifically stated that such presumption was not appropriate. (Para 61–63, Report No 4)

18) For evaluating impairment of investments, the audit firm did not independently evaluate significant assumptions of the auditee. Such assumptions of the auditee were found to be not appropriate and in excess. (Para 32, Report No 5)

19) The assessment of the auditor regarding the forward contract to acquire remaining shares from NCI is not separately traceable from the audit file. The disclosures in the financial statements for FY 2020–21 (year reviewed by NFRA) and 2019–20 in respect of the forward contract to acquire additional shares at a future date and the related contingent consideration arrangements are not in compliance with the requirements of Para B64(g) of Ind AS 103. A disclosure of the arrangement and basis of determining contingent consideration was necessary in the CFS of both years. (Para 33–35, Report No 5)

20) There was non-compliance with Section 186 of the Companies Act, 2013 and Companies (Number of layers) Rules as there was no evidence that the auditee met the criteria of CIC-ND-SI NBFC when it had 92 subsidiaries and 52 associates. The audit firm should have reported this in CARO, which was not done. (Para 36–37, Report No 5)

21) The EP failed to consider the possible effects of misstatements on financial statements, which were material and pervasive and, thus, required consideration of Adverse or Disclaimer Opinion as per SA 705. The possible effect was not only confined to investments but also to other balances such as loans and advances, provisions etc., which indicate their pervasiveness. (Para 38–40, Report No 5)

22) An auditee company having 286 subsidiaries out of which 255 were loss-making. Although there were indicators of impairment, the firm had relied on a management representation letter stating that there was no impairment loss and there was no assessment on AWP. (Para 41–42, Report No 5)

23) AWP did not have sufficient appropriate audit evidence of KAM in respect of the going concern assumption. (Para 43–44, Report No 5)

Part D contained a chronology of events. The appendix at the end of each report carried the actual responses given by each firm.

All five inspection reports make a good read considering they are part of the first set. We can expect several more inspection reports in the coming months and years on the next set of audit firms. I am sure the NFRA reports with time will also become uniform and nuanced and an annual summary of all points brought out during a year will make a good collection for users of such inspection reports. We can expect NFRA to receive a ‘follow up action taken’ from audit firms inspected as a desirable outcome.

BCAJ Admin

This article
provides (a) key recent updates in the financial reporting global space;
(b) insights into an accounting topic, viz. convenience translation; (c)
compliance aspects of transition disclosure under Ind AS 116 from the
lessee’s perspective; (d) a peek into an international reporting practice in
the Auditor’s report; and concludes with (e) an extract from a
regulator’s speech from the past on MD&A disclosure

KEY RECENT UPDATES

Revised International Standard on Auditing (ISA 315)

On 19^th December, 2019 the IAASB issued ISA 315 (Revised
2019), Identifying and Assessing the Risks of Material Misstatement.
ISA 315 (Revised) sets out enhanced requirements and application material
to support the auditor’s risk assessment process. The revised ISA has enhanced
requirements related to exercise of professional scepticism,
separate focus on understanding the applicable financial reporting
framework, clarifications on which controls need to be identified
for the purposes of evaluating the design of a control, and determining whether
the control has been implemented and also considerations for using automated
tools and techniques incorporated within the application material of the standard.
A new Appendix (Appendix 6) has also been added to provide the auditor with considerations
for understanding general IT controls.

The revised ISA is
effective for audits of financial statements for periods commencing on or after
15^th December, 2021.

SEC Guidance on Reporting KPIs and Metrics in MD&A

On 30^th January, 2020 the US SEC issued a Guidance on
Management Discussion and Analysis (MD&A) related to disclosure of
Key Performance Indicators (KPIs) and metrics. SEC registrants are required to
discuss and analyse statistical data in the MD&A section that in the
company’s judgement enhances a reader’s understanding. Such information could
constitute KPIs and other metrics.

The SEC, based on
the issued guidance, expects the following disclosures to accompany the metric:
(i) a clear definition of the metric and how it is calculated, (ii) a
statement indicating the reasons why the metric provides useful information
to investors, and (iii) a statement indicating how management uses the
metric in managing or monitoring the performance of the business. A company
should also consider whether there are any estimates / assumptions underlying
the metric or its calculation and whether disclosure of such items is necessary
for the metric not to be materially misleading.

It may be noted
that examples of metrics to which the guidance applies include operating
margin, same store sales, sales per square foot, average revenue per user,
active customers, total impressions, traffic growth, employee turnover rate, number
of data breaches, etc.

USGAAP – Simplifying the Accounting for Income Taxes

The FASB issued
Accounting Standards Update (ASU) No. 2019-12 in December, 2019, Simplifying
the Accounting for Income Taxes, amending Topic 740, Income Taxes.
The ASU makes a number of amendments and is part of the FASBs USGAAP
simplification initiative. One such amendment relates to intra-period tax
allocation.

Intra-period tax
allocation is the process of allocating income tax expense (or benefit) to
components of income statement, i.e. continuing and discontinuing operations,
other comprehensive income and equity. Under extant USGAAP, the general
accounting principle is that an entity determines the tax expense / benefit for
continuing operations and then proportionally allocates the remaining tax
expense / benefit to other items. USGAAP made an exception to this general
principle in a situation when there was a loss in continuing operations and a
gain / surplus in OCI / discontinuing operations. The ASU has removed the exception
and the amended position is that ‘the tax effect of pre-tax income or
loss from continuing operations should be determined by a computation that does
not consider the tax effects of items that are not included in continuing
operations’. This has an impact in situations when income from
continuing operations is subject to a tax rate that is different from the tax
rate applicable to chargeable / capital gains on discontinued operations / OCI.

The amendment is
effective for public companies for fiscal years commencing 15^th
December, 2020. It may be noted that IFRS (IAS 12, Income Taxes) does
not explicitly provide guidance on such intra-period tax allocation.

RESEARCH: CONVENIENCE TRANSLATION

Introduction

Convenience
translation is ‘a display of financial statements or selected
portions of financial statements in a currency other than the
presentation currency, as a convenience to some users’.

Setting the
Context

An analysis of a
sample of four companies’ data based on their annual reports filed with the US
Securities Exchange Commission (SEC) is provided below.

It may be noted
that the ‘functional currency’ is the currency of the primary
economic environment in which an entity operates.

The ‘presentation currency’ (or the reporting currency) is the
currency in which the financial statements are presented.

As can be seen from
the above table, Company 1 presents its financial statements in RMB although
its functional currency is US$. It also presents US$ figures for the latest
financial year based on a convenience translation converting all balance sheet
and income statement items at the year-end exchange rate.

Company 3 and 4
are India listed entities whose functional currency is the INR. Company 4 presents
its financial statements in US$ (applying IAS 21) while the other company
presents its financial statements in INR with a convenience translation of only
the current period figures in US$ [based on year-end exchange rate (applying
SEC Regulation S-X)].

In the following
sections an attempt is made to address the following questions:

1.  What is the current position with respect to
convenience translation under prominent GAAPs?

2.  Is there consistency among GAAPs with respect
to convenience translation?

3.  Is there a difference between displaying
financial statements in a presentation currency (that is different from an
entity’s functional currency) and convenience translation of financial
statements?

4.  Is convenience translation an option or mandatory
for a US listed entity?

5.  Why do entities adopt convenience translation
if it is optional?

The position
under prominent GAAPs

US GAAP

USGAAP does not
contain any guidance on convenience translation. Even the SEC
regulations do not permit full-fledged convenience translations for foreign
private issuers (FPIs) with the exception of a ‘limited convenience
translation’.

The Accounting
Standards Codification (ASC 830) that covers the accounting topic Foreign
Currency Matters in USGAAP states that, ‘this topic does not cover
translation of the financial statements of a reporting entity from its
reporting currency into another currency for the convenience of readers
accustomed to that other currency’. (ASC 830-10-15-7).

US-listed
entities that are subject to SEC regulations may
at their option present convenience translation of financial statements.
The salient aspects of the said rule [Regulation S-X, Rule 3-20 (b)] are
summarised below.

a.  An FPI shall state amounts in its
primary financial statements in the currency which it deems appropriate.

b. If the reporting currency is not the US
dollar, dollar-equivalent financial statements or convenience translations
shall not be presented, except a translation may be presented of the
most recent fiscal year and any subsequent interim period presented using
the exchange rate as of the most recent balance sheet, except that a rate
as of the most recent practicable date shall be used if materially different.

IFRS and Ind AS

IAS 21 The
Effects of Changes in Foreign Exchange Rates permits an entity to present
its financial statements in any currency or currencies.

IFRS also does not prohibit an entity from providing, as
supplementary information, ‘a convenience translation’. Such a
‘convenience translation’ may display financial statements (or selected
portion of financial statements) in a currency other than the presentation
currency as a convenience to some users. The ‘convenience translation’ may be
prepared using a translation method other than that required by the
Standard. These types of ‘convenience translations’ should be clearly
identified as supplementary information to distinguish them from information
required by IFRSs and translated in accordance with IAS 21 (para 57 and BC14).

The position under IND
AS 21 The Effects of Changes in Foreign Exchange Rates is the same
as under IAS 21.

AS

AS 11 The
Effects of Changes in Foreign Exchange Rates does not contain any explicit
guidance with respect to ‘convenience translation’. It also does not prohibit use
of a currency other than the currency of country of domicile as the reporting
currency:

Conclusion

At present there is
no consistent principle underlying the preparation and presentation of financial
statements applying convenience translation across GAAPs. USGAAP and AS do not
contain explicit guidance on this topic. IFRS (and Ind AS) does permit
convenience translation, albeit it does not contain the prescriptions
available when financial statements are translated into a presentation currency
(other than the functional currency). The SEC regulations provide the
methodology to be adopted for presenting convenience translation figures that
is very limited in scope.

Presenting
financial statements in a presentation currency (both under IFRS and USGAAP)
requires standard procedures to be adopted (with balance sheet items being
translated at closing rate and income statement figures at average rates and
resultant exchange differences accounted in other comprehensive income).
Convenience translation, on the other hand, under SEC regulations requires all
items in the balance sheet and income statement to be translated at closing
rate (with no comparatives). Some entities that have dual listing status opt for
providing additional information by way of such a translation for the
convenience of their investors. A summary of the case studies is provided in
the table below:

GLOBAL ANNUAL REPORT EXTRACTS: ‘APPLICATION OF
MATERIALITY’ IN
AUDIT REPORT

Background

Unlike SA 701 in
the Indian context, International Standard on Auditing (UK) 701 Communicating
Key Audit Matters in the Independent Auditor’s Report issued by the
Financial Reporting Council (FRC), UK also deals with the auditor’s
responsibility to communicate other audit planning and scoping matters
in the auditor’s report (paragraph 1-1).

As per para 16-1 of
ISA (UK) 701, Communicating other Audit Planning and Scoping Matters,
the auditor’s report is required to provide:

1   An explanation of how the auditor applied
the concept of materiality in planning and performing the audit. Such
explanation shall specify the threshold used by the auditor as
being materiality for the financial statements as a whole

2   An overview of the scope of the audit
including an explanation of how such scope: addressed each Key Audit Matter
relating to one of the most significant risks of material misstatement
disclosed and was influenced by the auditor’s application of the materiality
disclosed

It may be noted
that ISA (UK) 701 that was effective 2016 has undergone a revision in November,
2019 (further updated in January, 2020) and amendments require the auditor’s
report to specify the threshold used by the auditor as being materiality
for financial statement as a whole and performance materiality, and
to also provide an explanation of the significant judgements made by the
auditor in determining materiality and performance materiality. The revised ISA
is effective for audits of financial statements for periods commencing on or
after 15^th December, 2019.

Extracts from an
Independent Auditor’s Report

Company:
Whitbread PLC (2018/19 revenues: GBP 2.05 billion, FTSE 100)

Our Application of Materiality

We define
materiality as the magnitude of misstatement in the financial statements that
makes it probable that the economic decisions of a reasonably knowledgeable
person would be changed or influenced. We use materiality both in planning the
scope of our audit work and in evaluating the results of our work. Based on our
professional judgement, we determined materiality for the financial statements
as a whole as follows (refer to the table below):

We agreed with the Audit Committee that we
would report to the Committee all audit differences in excess of GBP
1.25 m (2018: GBP 1.3 m), as well as differences below that threshold that,
in our view, warranted reporting on qualitative grounds. We also report to the
Audit Committee on disclosure matters that we identified when assessing the
overall presentation of the financial statements.

COMPLIANCE: TRANSITION
DISCLOSURE UNDER IND AS 116

Background:

Ind AS 116 Leases became effective from 1^st April,
2019. The ensuing fiscal year ending 31^st March, 2020 financial statements of Ind AS preparers need to
incorporate disclosures mandated
by Appendix C – Effective Date and Transition of Ind AS
116.

The disclosure requirements from the lessee’s perspective is a
function of the transition option elected and a
ready reference to the same is provided in the table given below: (Disclosures – A Referencer)

FROM THE PAST – ‘DISCLOSURES ARE DRIVEN BY WHAT INVESTORS
WANT TO KNOW’

Extracts from a
speech made by Elisse B. Walter (former Commissioner, US SEC) at the
Stanford Directors’ College meeting in June, 2013 are reproduced below:

‘Regulations
are the floor but not the ceiling. They tell
companies what, at a minimum, should be covered, but it’s up to the company to
make sure the story gets told. That’s where MD&A
(Management’s Discussion and Analysis) becomes a real opportunity for
the company to tell shareholders what’s really going on. No MD&A
should be merely a recitation of the financial statements. Give
investors the when, the where, the why and, perhaps most importantly, the what’s
next. You should address your investors like they are your business
partners, and the MD&A should reflect that perspective. Disclosure isn’t driven
by what the company wants to disclose but by what the investors want to know.
That should be front and centre as you review the MD&A.