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Category: Auditing Standards

SA 250: Consideration of Laws and Regulations in an Audit of Financial Statements

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Laws and regulations form the substratum of any economy to ensure the
forbearance of any acts, deeds or inaction by the regulated which may be
detrimental to the interest of the economy or part thereof. Compliance
with laws and regulations by corporates is imperative, both on the
frontiers of survival and continuance. In present times, given the
multifold increase in the complexity of applicable laws and regulations,
enterprises are finding it extremely difficult to keep pace with the
plethora of changes in regulatory landscape and effective implementation
and compliance.

SA 250 Consideration of Laws and Regulations in
an Audit of Financial Statements requires auditors to ensure compliance
with the applicable framework of laws and regulations by the audited.
However, as is time and again proclaimed, auditors are watchdogs and not
bloodhounds. The responsibilities advocated by this Standard are a
direct function of ‘ifs and buts’. The auditor is not responsible for
preventing non-compliance and cannot be expected to deter non-compliance
with all laws and regulations that apply to an enterprise.

Specific
attention must be paid to the fact that compliance or non-compliance
with all laws and regulations applicable to an enterprise does not find
an immediate reflection in the financial statements. For example, while
the contribution made by an employer to Employees’ Provident Fund is
reflected in the financial statements, but say for instance,
non-compliance with the requirements of filing of returns for effluent
disposal with the Pollution Control board by a chemical manufacturing
company need not necessarily find a mention in the financial statements.

SA 250 draws a thin line between those laws and regulations
which have and which do not have a direct effect on the determination of
material amounts and disclosures in the financial statements.
Accordingly, depending on which category these laws fall under, the
auditor’s responsibilities stand differentiated. For the former, the
auditor’s responsibility is to obtain sufficient appropriate evidence
about compliance with the provisions of those laws and regulations. For
the latter category, the auditor’s responsibility is limited to
undertaking specified audit procedures to help identify non-compliance
with those laws and regulations that have a material effect on the
financial statements. However, when the line between the black and white
is grey, the auditor is supposed to exercise his professional judgment
while determining the umbrella the law falls under.

Just like
every other SA, SA 250 cannot be applied in complete isolation. As
required by SA 200, professional skepticism needs to be maintained in
the backdrop of applicable laws and regulations applicable on the
entity. While adhering to SA 250, the auditor has to also bear in mind
SA 315, which requires the auditor to obtain a general understanding of
legal and regulatory framework applicable to the industry where the
entity operates. At times, when the outcome of non-compliance is severe,
questions get raised on the validity of the growing concern assumption,
in which case, the auditor would need to consider the requirements of
SA 570. The auditor can seek written representations from the management
in terms of SA 580 about management’s knowledge of identified or
suspected non-compliance with applicable laws. However, receipt of
written representations must not affect the nature and extent of other
evidence to be obtained by the auditor in this regard.

Further,
audit procedures applied to form an opinion on the financial statements
may bring instances of noncompliance or suspected non-compliance with
laws and regulations to the auditor’s attention. Such audit procedures
may include reading of minutes, inquiring of the entity’s management and
in-house legal counsel or external legal counsel concerning litigation,
claims and assessments; and performing substantive tests of details of
classes of transactions, account balances or disclosures – for e.g.,
scrutiny of payments made to government authorities towards
fines/penalties, scrutiny of legal and professional expenses to
understand whether unusual payments have been made for
legal/retainership fees as also to seek evidence of legal cases pending
against the company etc.

The next obvious question which arises
is – What is the auditor supposed to do in case of identified or
suspected non-compliance? Firstly, the auditor must have a discussion
with the management or where appropriate, with those charged with
governance, and if sufficient information is not obtained, the auditor
may evaluate the need of obtaining legal advice. If satisfactory
information is still not obtained, the auditor shall consider its effect
on the audit opinion.

A non-compliance with applicable law or
regulation does not merely impact the financial statements.
Noncompliance can also impact the level of reliance that the auditor
places on the integrity of the management or employees. It can also
cause the auditor to reassess the possibility of material misstatements
in other areas, as also the faith the auditor places in the management’s
Written Representations.

However, if the auditor suspects that
the management is involved in non-compliance, the auditor can escalate
the issue to those charged with governance and also consider the impact
of such non-compliance on the audit opinion. If the auditor concludes
that the non-compliance has a material effect on the financial
statements, and has not been adequately reflected in the financial
statements, the auditor may express a qualified or adverse opinion on
the financial statements. This standard also provides for the scenario
that if the auditor has identified or suspects noncompliance with laws
and regulations, the auditor shall determine whether he has a
responsibility to report the same to parties outside the entity, for
instance – regulatory and enforcement authorities.

Let us now examine certain case studies.

Case Study I
ABC
Limited (‘ABC’) is engaged in the manufacturing of pharmaceutical
products, having operations in many countries across the globe. During
the year, a manufacturing unit of ABC, which accounted for over 60% of
the company’s production, received notices from the Food and Drug
Administration Authority of the United States of America and regulators
in other countries, stating that pursuant to the inspection of the
manufacturing processes at the said unit, violations of Good Medical
Practices (GMP) were observed. Several prohibitions were imposed on the
functioning of the said unit, including a prohibition to sell the
products manufactured by the unit to US regulated markets. ABC decided
to voluntarily shut down its operations in this unit on a temporary
basis to examine ‘what went wrong’. ABC however is in dialogue with
regulatory authorities to assuage the restrictions. What would be the
auditor’s responsibility in such a scenario?

Analysis

The auditor must discuss with the management the severity of the case, and the company’s current standing in this regard. The auditor has also to bear in mind that the plant accounted for over 60% of the company’s production and also the fact that other markets may also raise questions on the acceptability of products manufactured in this plant. The auditor would also need to consider whether there is a need for reduction in the carrying value of inventories, whether any provisions are required for fines/penalties, accounting for possible sales returns and if such provisions are required to be made, then the basis used by the management for arriving at such estimates. Further, in such cases, there are inherent uncertainties regarding the future actions of the regulators, the impact of which may not be ascertainable and therefore, the actual amounts incurred may eventually differ from the estimates made. If the auditor concludes that this is a significant matter, he should also consider highlighting the same as a Matter of Emphasis (MOE) in the audit report.

    Case Study II

PQR Limited (‘PQR’) is a company engaged in production of steel. During the year, the company and some of its competitors received notices from Competition Commission of India (CCI) for alleged cartelization by certain steel manufacturing companies. CCI imposed a penalty of Rs. 100 Crores on PQR against which PQR has filed an appeal before Competition Appellate Tribunal. The Company has not made any provision in this regard. What would be the auditor’s responsibility in this case?

    Analysis

The auditor must assess the facts and circumstances, and must have a detailed discussion with the management on the Company’s standing in the case. The auditor, if he deems necessary, must also take an independent legal opinion to deduce whether the company has a fit case or whether there is a need for making provision on a best estimate basis of the likely penalty that may be levied. The auditor should also have a joint discussion with the company’s legal counsel in this regard. Depending on the significance of the matter, the auditors may consider including a ‘Matter of Emphasis’ in the audit opinion.

    Case Study III

LMN Limited is a public listed company engaged in the manufacture of automobiles. During the year ended 31 March 20X0, LMN has incurred loss of Rs.120 crore. LMN has paid to its Managing director Mr.DEF (‘DEF’) (who is also the promoter shareholder holding 51% of the paid up capital of LMN) managerial remuneration exceeding the limits set out by the Companies Act, 2013.

As LMN has incurred losses for the year, LMN was required to obtain approval from the shareholders as well as the Central Government for payment of remuneration to DEF as the same exceeded the limits set out in the Companies Act, 2013. LMN management contends that seeking approval of the shareholders was only a compliance formality as the Managing Director himself holds more than 51% of the paid up capital of LMN. What are the duties of the auditor in this regard?

    Analysis

Since LMN Limited had no profits for the year, it was required to comply with the requirements of Schedule V to the Companies Act, 2013 which sets out the limits for maximum managerial remuneration payable to managerial personnel for public listed entities in the event of a loss or inadequate profits. The auditor would need to explain the management the legal position and advise the client to seek approvals of the shareholders and the Central Government or alternatively recover the remuneration paid in excess of the prescribed limits from DEF. In the event DEF chooses not to return the excess payment, the auditor would need to qualify the audit opinion for non-compliance with the requirements of the Companies Act, 2013.

    Case Study IV

STU Limited (‘STU’) is engaged in the business of providing mobile telecommunication services. As per TRAI (Telecom Regulatory Authority of India) regulations, a prescribed percentage of Adjusted Gross Revenue (AGR) earned by a telecom operator is payable to the department of telecommunications as license fees. STU has been paying license fees on revenue earned from providing telecom services to its customers. According to TRAI, license fees are also payable on non-telecom revenues like profit on sale of fixed assets, rent, dividend and treasury income. TRAI has accordingly raised a demand of Rs.500 crore as license fees payable on non-telecom revenue earned by STU from inception till date. The definition of AGR is currently being challenged by all telecom operators including STU. The telecom operators have contested this interpretation of TRAI and have filed a petition before the appellate tribunal seeking injunction against TRAI demands. What would be the auditor’s responsibilities in such a case?

    Analysis

The issue of payment of license fees on non-telecom revenue seems to be a pan-industry issue as against being specific to STU. The company has contested the demand raised by TRAI. However, the auditor would need to discuss with the Company’s legal counsel the basis of demands raised by TRAI and their tenability. The auditor may consider requesting STU to obtain a formal legal opinion in this regard. It would also help if the auditor were to understand as how this issue has been dealt with by STU’s competitors. Based on this evaluation, the auditor would need to assess whether a provision is warranted or a disclosure as contingent liability would be sufficient compliance.

    Case Study V

HIJ Pharma Limited (HIJ) is a pharmaceutical company engaged in the manufacture of life saving drugs. HIJ is required to adhere to pricing norms as prescribed under Drug Price Control Order (DPCO). During the year ended 31 March 20X1, it was observed that some of the drugs were sold at prices much higher than those prescribed under the DPCO. Under DPCO, companies are liable to deposit the overcharged amount to the Credit of Drug Prices Equalization Account, which was not actioned by HIJ. HIJ received demand for payment of Rs.400 crores to the credit of the Drug Prices Equalisation Account under Drugs (Price Control) Order for few of its products, which was contested by HIJ. Based on its best estimate, HIJ made a provision of Rs.100 crore in its books of accounts towards the potential liability related to principal and interest amount demanded under the aforesaid order and believed that the possibility of any liability that may arise on account of penalty on this demand is remote. What are the Auditor’s duties in this regard?

    Analysis

The management believes that the company would not be liable for any penalties. The auditor must ensure that adequate provisions are made in books to the extent of overcharged amount and interest thereon. Considering the provisions of AS 29 – Provisions, Contingent Liabilities and Contingent Assets – the auditor must also evaluate whether any need arises for disclosure as Contingent Liability of the amount of penalties leviable by DPCO.

    Concluding remarks

The auditor’s responsibilities for reporting compliance with applicable laws and regulations have increased manifold with the increasingly changing regulatory landscape in India. Though the auditor’s professional duty to maintain confidentiality of client information precludes reporting of an identified or suspected non-compliance with laws and regulations to any third party, given the legal framework in India, the confidentiality consideration is overridden by statute, the law or courts of law. For instance, under the present legal and regulatory framework for financial institutions in India, the auditor has a statutory duty to report the occurrence, or suspected occurrence of non-compliance with laws and regulations to the supervisory authorities. The auditor therefore needs to perform his duty with due care and exercise adequate professional skepticism while providing assurance on compliance with applicable laws and regulations.

Is internal audit function relevant in a financial statement audit?

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In a financial statement audit, amongst the various factors that an external auditor considers in his risk assessment and in determining the nature, timing, and extent of auditing procedures to be performed, one of the very relevant factors is the existence and operation of a competent and effective internal audit function. Internal audit is an appraisal activity which may be constituted as a function within a company or may be outsourced to an external service provider.

The internal audit function is most likely to be relevant for the external auditor if the responsibility assigned to the internal auditor is related to the entity’s financial reporting and other internal control related processes on which the external audit will rely while conducting his audit. Certain internal audit activities may not be relevant to an audit of the entity’s financial statements, for example, the internal auditors’ procedures to evaluate the efficiency of certain management decision-making processes are ordinarily not relevant to a financial statement audit.

While determining whether the work of the internal auditor is relevant and adequate for the purpose of the audit, the external auditor has to evaluate parameters set out in the table below:


The external auditor would need to consider the materiality of the account balances or classes of transactions which were covered by internal audit, the risk of material misstatement of the assertions related thereto and the degree of subjectivity involved in the evaluation of the audit evidence gathered in support of the assertions. As the materiality of the financial statement amounts increases and either the risk of material misstatement or the degree of subjectivity increases, the need for the auditor to perform his or her own tests of the assertions increases. Where an auditor elects to use the work of internal audit, audit documentation prepared by him should include the auditor’s evaluation of internal audit, the nature and extent of the work used and the basis for that decision, the audit procedures performed by the auditor to evaluate the adequacy of the work used, and an overall evaluation of the evidence obtained. The nature and extent of the procedures the auditor would perform when making this evaluation is a matter of judgment. Ordinarily, an external auditor should not use the work of internal audit when performing procedures related to controls that have a higher risk of failure (e.g., internal controls intended to address assertions where a significant judgment or a risk of fraud has been identified).

Unlike in situations of branch audits or audits of subsidiaries for the purpose of consolidation where an external auditor has the latitude of using and relying on the work of other independent auditors, he does not have the same autonomy as far as using the work of internal auditors is concerned. The external auditor remains solely responsible for the audit opinion issued on the financial statements audited by him. At the same time, it is not obligatory for the auditor to rely on the work performed by internal audit.

We will consider two case studies to understand the above concepts:

Case Study 1 – Relevance of Internal Audit function to the External Auditor

Background

LMN Private limited is a company which is engaged in the business of travel and tourism. The management has constituted an in-house internal audit function. The scope of internal audit as decided by the management includes the following:

1) Monitoring the controls over bookings from customers and recording of revenue in the ERP system.
2) Review of the monthly, quarterly and yearly financial statements prepared by the company and. verifying that these comply with the financial reporting framework
 3) Verifying the process of pre-departure formalities necessary to be completed like insurance and visa application to ensure compliance with the processes set out in the procedure manual of the company.
4) R eview of contracts entered into with the vendors who provide services to the company including hotels and coordinators for transfers. Ensure that the standard operating procedures for vendor selection as set by the management have been followed.
5) Verifying the process of background verification of the employees joining the company.

PMR and Associates (PMR) have been appointed as the statutory auditors of the company. Which of the above would be relevant and adequate to the work conducted by PMR?

Analysis
As per SA 610 ‘Using the work of the internal auditors’, the external auditor may use the work performed by the internal auditor if he considers it relevant to his audit. Some procedures performed by the internal auditor may impact the nature or timing or extent of the work performed curtailing his planned work for a particular area during the course of audit. In the given scenarios, factors that could be considered in evaluating the relevance of the scope of internal audit function have been explained below.

1) T he work performed by the internal audit function could be used by the external auditor to understand the process over tour bookings and revenue recognition. If there are significant internal control issues identified by the internal auditor, these could be factored in by the external auditor to modify the procedures that he would perform to test revenue. The external auditor may examine some of the controls or transactions that the internal auditors examined or examine similar controls or transactions not actually examined by the internal auditors. In reaching conclusions about the internal auditors’ work, the auditor should compare the results of his tests with the results of the internal auditors’ work.

2) Though the review of the monthly, quarterly and yearly financial statements by the internal audit team is directly related to the financial reporting process, the external auditor cannot merely rely on the work performed by the internal auditor. His review of the financial statements and assurance of compliance with financial reporting framework remains independent of the review performed by the internal auditor. However, the external auditor should be wary of control lapses in the accounts closing process, if any, which have been identified by the internal auditor and ensure that the risk of possible misstatements emanating therefrom is adequately addressed, for e.g., if the internal auditor has commented about the lack of robustness in the he process for provision for expenses for pending bills, the external auditor would need to more skeptical in verifying the completeness of provisions for expenses. He would need to enlarge the sample size, perform a more robust testing of expense booking/payments in the subsequent period, trend analysis etc.

3) One of the objectives of the internal audit function is to test the orderly conduct of business operations consistent with the processes set by the management. Verifying whether the process of completion of predeparture formalities would ensure compliance to the service standards of the company however this is not likely to have any direct impact on financial reporting, as such, may not be relevant from a financial statement audit perspective.

4)    The external auditor can use the observations made in the internal audit reports on vendor contracts entered during the period under audit and evaluate whether these have any impact on reporting on internal controls or financial reporting – for e.g., any onerous terms entailing provision/disclosures etc. the internal audit reports could also possibly highlight non-compliance with standard operating procedures in selection and awarding  of  vendor  contracts.  The  external  auditor would be in a position to evaluate whether such non- compliance is indicative of fraud. Internal audit function can act as a good checkpoint for fraud prevention and reporting.

5)    Background verification of employees would prevent the company from hiring fraudulent employees or employees  with  malicious  intent.    Though  there  is no direct implication of this on the financial reporting of the company, the procedures performed by the internal auditor may help the external auditor address the  risk  of  fraud  over  employee  hiring.  The  auditor based on his assessment of internal audit could use their work in this area to re-engineer the substantive work necessary to be performed by him audit for addressing fraud risk.

 Case study 2- Adequacy and use of work performrd by the Internal Auditor

background
ABC limited has appointed M/s. XYZ and Co. (XYZ) as   their   internal   auditors.   The   statutory   auditors   of the  company  –  M/s.PQR  &  associates  (PQR)  need  to evaluate the adequacy of the work performed by XYZ. Consider the following scenarios:

1)    XYZ is a reputed firm of chartered accountants with a  sizeable  client  portfolio.    the  recruitment  policy of the firm specifies that only qualified Chartered accountants or students pursuing Chartered accountancy course can be recruited in the internal audit department. The firm follows a policy of training new joiners in accordance with XYZ’s audit manual which helps new joiners understand the audit methodology to be followed while conducting internal audits. XYZ also ensures that the team composition on any client comprises of at least one experienced member with relevant industry knowledge.  The work performed by the internal audit team goes through various levels of reviews by partners and managers before the final reports are issued to the clients. As far as relationship with ABC limited is concerned, XYZ occupies an independent status and reports directly to the board of directors of ABC Limited. XYZ presents its observations in the monthly operations meeting of the company and the line managers of the company are responsible to take corrective action within an agreed timeline. XYZ organises meetings with the external auditors – PQR on a monthly basis to discuss their findings and also to assess the requirements of the external auditors if any, when planning their scope for the year. Determine whether the work performed by the internal auditor can be considered as adequate for the purpose of the audit by the external auditor

2)    Assume that for the year ended 31st march 20X0, XYZ has performed a comprehensive review of revenue cycle of ABC Limited. There were no adverse findings. in view of the background information given in (1) above,  mr.  Khanna,   audit  manager  –  PQR  decided not to perform any work on revenue as this area was extensively covered by XYZ. Mr. Khanna elected to rely on the work already performed by XYZ and was contemplating requesting XYZ to provide them with a copy of their report as well as work papers for his audit file documentation.

Analysis
1)    In the given scenario, the internal audit function comprises of a highly prestigious firm with set procedures  and  hierarchy  of  reviews.  The  internal audit division has qualified accountants and trainees. New recruits are provided adequate training. It  is also ensured that at all times there is at least once experienced member in the engagement team due to which the entire team gets the requisite guidance. The internal auditor enjoys an independent position with ABC Limited. Internal audit reports directly to the board which is indicative of minimal interference by operating management. Management takes cognizance of internal audit findings and has in place a mechanism to address these in a time bound manner. Internal auditors communicate the observations emanating from their audits with the external auditors. Internal auditors take cognizance of the requirements and expectations of the external auditors from the internal auditors. These are indicators of effective implementation of internal audit function within the organisation. In such an environment, the external auditors – PQR may be able to conclude that the internal audit function is effective and may undertake to modify the extent of testing for that they would undertake on those account captions which have been subjected to internal audit.

2)    (a) It would not be appropriate for mr. Khanna to conclude that no work should be performed on the revenue cycle. Given that revenue is presumed to have fraud risk, the auditor should not entirely rely on the work of internal audit when performing procedures related to controls that are intended to address assertions which are susceptible to fraud risk. Mr. Khanna would need to devise his own testing plan, he may consider modifying the testing approach in terms of controls testing and substantive procedures. Given the existence of a robust internal audit system, he may elect to test fewer key controls, rationalize the sample size, undertake substantive procedures which are less time consuming etc.

(b)    In the indian context, the Code of ethics provides that a chartered accountant in practice would be deemed to be guilty of professional misconduct if he discloses information acquired in the course of his professional engagement to any person other than his client. As such, XYZ would not be in a position to share their work papers with PQR without prior consent from the Company.

(c)    Even   considering   a   scenario   where   PQR provides access to XYZ access to its work papers (after prior approval from the company), it would be incumbent upon PQR to test or re-perform the work performed by XYZ by obtaining evidence directly  from the management of the Company supporting the samples verified by XYZ as opposed to reviewing the documentation provided by XYZ. PQR may exercise its judgment as to whether all samples tested by XYZ should  be  tested  again  by  PQR  or  whether  PQR should select an entirely new sample. Mere reliance on the documentation provided is not sufficient.

   Closing Remarks
Using the work of an internal auditor could assist the external auditor in performing a more efficient and effective audit. However, the external auditor would continue to be solely responsible for the audit opinion.

The   Companies   act,   2013   has   re-emphasied   the importance of a robust internal financial control environment by casting specific responsibility on the Board of directors of a company to establish internal financial controls and ensuring that these are adequate and they operate effectively. internal audit will play a very significant role in providing a comfort to the Board  in this regard. Statutory auditors are also required to comment in their report, whether the company has an adequate internal financial controls system in place and the operating effectiveness of such controls. The statutory auditors too would need to take cognisance of the work performed by internal auditors on testing of controls. This will entail increased cohesiveness between internal and external auditors however, the external auditor would continue to be responsible for his opinion on the design and operative effectiveness of internal controls.

Audit Documentation – a relevant defense or mere record keeping

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Robert H. Montgomery in his book, ‘Montgomery’s Auditing (1912)’ had
said, “The skills of an accountant can always be ascertained by an
inspection of his working papers.” More than a century has passed, but
this statement has not lost its relevance. On the contrary, over the
years, given the quantum of litigation that the auditors have had to
face the world over, these words have become all the more significant.
‘Work not documented is work not done’ is a maxim that is sworn by most
reviewers from regulatory or audit oversight bodies particularly in
jurisdictions overseas.

SA 230 on Audit Documentation provides
guidance on the nature of documentation that needs to be maintained
which would provide sufficient and appropriate record of the basis on
which audit was concluded and the audit opinion issued. Audit
documentation also serves as an evidence that the audit was planned and
performed in accordance with Standards on Auditing and the applicable
legal and regulatory framework. Audit documentation should be such that
an experienced auditor, having no previous familiarity with the audit,
can independently review and reach similar conclusions as those reached
by the present auditor.

During the course of his audit, the
auditor usually encounters issues where an expert’s opinion has to be
called for, or a reservation is expressed by either the management or
the auditor on the treatment of a particular transaction or a position.
It is imperative for the auditor to design the audit procedures in a
manner that by performing such procedures, all the material and relevant
factors having an impact on the true and fair opinion are brought to
light. While it is imperative that the position taken is based on sound
judgment and in compliance with the applicable accounting/regulatory
framework, it is equally important that such judgment is well
articulated in the audit documentation. The first defense for an auditor
is his documentation which should be robust enough to prove that audit
was conducted in adherence to the standards.

The form and
content of audit documentation should be designed to meet the
circumstances of the particular audit. The extent of documentation is
influenced by various factors such as:

a. Nature of the audit
b. Audit procedures intended to be performed
c. Audit evidence to be collected
d. Significance of such evidences
e. Audit methodology and tools used

Documentation
obtained during the course of audit can be segregated into those
forming part of the PAF (Permanent Audit File) and CAF (Current Audit
File). A PAF contains those documents, the use of which is not
restricted to one time period, and extends to subsequent audits as well.
E.g. Engagement letters, Communication with previous auditor,
Memorandum of Association, Articles of Association, Organization
structure, List of directors/partners/ trustees/ bankers/lawyers, etc.
On the other hand, a CAF contains those documents relevant for the
period of audit.

Typically, audit documentation would cover the following –
– Client evaluation and acceptance
– Risk Assessment
– Audit planning discussions
– Audit programs
–
Working papers relating to all significant areas documenting the
approach, risks and controls to the relevant area tested, substantive
and analytical procedures performed and the conclusions reached
– Evidence supporting the use and reliance on the work of experts, internal audit etc.
– Evidence of review by partner and manager
– Evidence of communication with those charged with governance
– Management representations

Audit
documentation may be in the form of physical papers or in electronic
form. In past years, audit documentation was maintained in physical
paper files complete with links and notations necessary for independent
understanding and review of work performed. The working papers are the
property of the auditors and the auditor is not bound to provide access
to these work papers to the client.

Over the last few years,
audit documentation has witnessed radical refinement in the manner in
which it is maintained. It has taken form of electronic files which are
prepared using software specifically designed for documentation
purposes. Such software coupled with advancements in telecommunications
has enabled teams working across multiple locations/geographies to
remotely access the same electronic audit documentation file and
document the work performed for their respective client location. Such
software also results in significant economies on a year-on-year basis,
as the base documentation relating to IT systems, processes, audit
programs needs to be done only once at the time of set up of the
electronic audit file. These software enable the electronic audit file
to be ‘rolled forward’ for the next accounting period. As such, the base
documentation relating to knowledge of the client, the industry, IT
systems, processes, flow charts, audit programs etc. gets pre-populated
in the next year’s audit file and the team would then need to update
these for current changes. Such documentation software has features such
as restrictive access rights to the audit file, enabling audit trail by
way of sign off of completion of the work performed by the team member
and its review by manager/partner, enabling reminders to owners of the
file for pending documentation, compulsory archiving of files post
expiry of the mandatory close-out period and many more. Electronic
documentation has revolutionised the manner in which audit work is
documented and has resulted in huge savings in terms of avoiding of
documentation that is repetitive, easy access to and reference of work
done in the past, ease in acquainting of new team members with the
client’s background, reduction in storage costs (for physical files) and
many other benefits. Physical files are maintained only for filing
certain essential documents such as engagement letters, confirmations,
representation letters, original signed copies of the financial
statements etc. The auditor would however need to establish an adequate
IT infrastructure to support electronic documentation of work done.

A
pertinent question that an auditor usually faces is whether he is
required to document all the evidences procured during the course of his
audit. It actually depends on the significance as well as the
materiality of the financial statement caption and the inherent risk of
material misstatement related thereto. The regulatory compliances and
disclosures may also impact the level of documentation. For instance,
the level of documentation required for testing of rental deposits
accepted by a real estate company may not be as detailed as that
required for a borrowing made by the same company. The compliance and
disclosure requirements for borrowings are more onerous and detailed as
compared to rental deposit, as such the level of documentation that
would support auditor’s verification would also get influenced by such
factors.

The administrative process of completion of the
assembly of the final audit file after the date of the auditor’s report
does not construe as performance of new audit procedures or the drawing
of new conclusions. Changes may, however, be made to the audit
documentation during the final assembly process if they are
administrative in nature. Examples of such changes include:

i. Deleting or discarding superseded documentation.
ii. Sorting, collating and cross referencing working papers.
iii. Signing off on completion checklists relating to the file assembly process.
iv.    Documenting audit evidence that the auditor has obtained, discussed, and agreed with the relevant members of the engagement team before the date of the auditor’s report.

However, the auditor is expected to complete the administrative process of assembling the final audit file on a timely basis after the date of the auditor’s report.   The Standard on Quality Control (SQC) 1 requires firms to establish policies and procedures for the timely completion of the assembly of audit files. An appropriate time limit within which to complete the assembly of the final audit file is ordinarily not more than 60 days after the date of the auditor’s report. The retention period for audit engagements, as per SQC 1, ordinarily is no shorter than seven years from the date of the auditor’s report, or, if later, the date of the group auditor’s report.

If, in exceptional circumstances, the auditor performs new or additional audit procedures or draws new conclusions after the date of the auditor’s report, the auditor is required to document:

–    the circumstances encountered;
–    the new or additional audit procedures performed, audit evidence obtained, and conclusions reached, and their effect on the auditor’s report; and
– When and by whom the resulting changes to audit documentation were made and reviewed.

Examples of exceptional circumstances include facts which become known to the auditor after the date of the auditor’s report but which existed at that date and which, if known at that date, might have caused the financial statements  to be amended or the auditor to modify the opinion in the auditor’s report.

We will now consider some case studies on audit documentation.

Case Study i
Documentation after completion of audit -Key considerations
The  audit  team,  post  completion  of  audit,  receives  a confirmation from the sole debtor of the company confirming NIL balance whereas the balance appearing in the financial statements  was  Rs.  80  million  which  is  material  to  the financial statements. In the absence of the confirmation, alternate audit procedures were performed to obtain evidence on the accuracy of the balance and the same was documented sufficiently and appropriately.

Is there a need to take into consideration the confirmation received post finalisation of the audit and how would that be documented?

Analysis and conclusion
As per SA 230, this situation is an example of an exceptional circumstance. This situation reflect facts which become known to the auditor after the date of the auditor’s report but which existed as at that date and which, if known on that date, might have caused the financial statements to be amended or the auditor to modify his audit opinion. The resulting changes to the audit documentation would need to be reviewed and the engagement partner would need to assume final responsibility for the changes.

In this case, the auditor is required to document:
–    the circumstances encountered;
–    the new or additional audit procedures performed, audit evidence obtained, and conclusions reached, and their effect on the auditor’s report; and
–    When and by whom the resulting changes to audit documentation were made and reviewed.

The above situation will also need to be evaluated in terms of the requirements of the Guidance note on revision of the audit reports as well as SA 560 Subsequent events issued by the Council of the institute of Chartered accountants of india, which states that a revision of the audit report may be warranted in several instances involving reasons such as apparent mistakes, incorrect information about facts, subsequent discovery of facts existing at the date of the audit report, etc.

Case Study ii
Revision in work papers
The audit team, during the finalisation of the audit of a client in the pharmaceutical industry, had several revisions in the financial statements. Consequently, the related working  papers  also  underwent  numerous  changes. the audit manager is of the opinion that the old papers can be destroyed wherever there were revisions and it is enough to preserve the final version. However, the audit team is of the opinion that all revisions need to be filed for traceability. Which opinion is right ?

Analysis and conclusion
As  per  para  A22  of  SA  230,  “the  completion  of  the assembly of the final audit file after the date of the auditor’s report is an administrative process that does not involve the performance of new audit procedures or the drawing of new conclusions. Changes may, however, be made to the audit documentation during the final assembly process if they are administrative in nature. Examples of such changes include: deleting or discarding superseded documentation.”

Hence, old papers which have been revised may be deleted or discarded.

Closing Remarks
An auditor simply cannot get away with documentation or its importance. in fact, audit documentation commences even before the auditor accepts an audit engagement. Given the empowerment to statutory authorities for re-opening  of financial statements as provided by the Companies Act, 2013 coupled with increased regulatory supervision on the functioning of the audit profession, auditors would need to ensure that timely, adequate and robust documentation is maintained to support the basis on which audit opinion has been issued. this will be all the more accentuated where areas of judgment and estimation uncertainty is involved. oral explanations by the auditor on his own do not represent adequate support for the work performed by him but these may be used to clarify or explain audit documentation. On the other hand, too much documentation can be inefficient and may impact the profitability/recovery rates for the auditor. So for most of the firms, the challenge would be to maintain the right balance. SA 230 sets out the guiding  principles in this regard and compliance with SA 230 would result in sufficiency and appropriateness of audit documentation.

Audit materiality – a precision cast in stone or a subjective variable measure….continued

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In the previous article, we attempted to understand
the concept of materiality as elucidated in SA 320 ‘Materiality in
Planning and Performing an Audit’, and discussed case studies around the
practical application of this concept from a quantitative measurement
viewpoint. In the present article, we will dwell on the qualitative
aspects. We will discuss aspects such as setting of materiality for
specific financial statement captions at amounts lesser than the
materiality level determined for the financial statements taken as a
whole, and consider circumstances when adjustments to materiality
benchmark and revision of materiality is necessary. We will also try to
understand the practical application of these concepts through case
studies.

Evaluating qualitative factors
Evaluating
qualitative factors often requires subjective judgment. While
establishing the overall strategy for the audit, the auditor should
consider whether there are particular significant accounts or
disclosures in the financial statements for which misstatements of
lesser amounts than materiality for the financial statements as a whole
could reasonably be expected to influence the economic decisions of
users taken on the basis of the financial statements. Any such amounts
determined represent lower materiality levels to be considered in
relation to the particular items in the financial statements. For
instance, the magnitude of a misstatement that the auditor considers
material when caused by an illegal act or irregularity may be far lower
than the magnitude of a misstatement caused by an error.

Some of the factors to be considered are:

Whether
accounting standards, laws, or regulations affect users’ expectations
regarding the measurement or disclosure of certain items (for example,
related party transactions and the remuneration of management and those
charged with governance)?

The key disclosures in relation to the
industry or the environment in which the entity operates (for example,
research and development costs for a pharmaceutical company).

Whether
attention is focused on the financial performance of a particular
subsidiary or division that is separately disclosed in the consolidated
financial statements (for example, for a newly acquired business)?

Normalisation
There
may be particular circumstances that cause the materiality benchmark
amount to be at an unusual level for the current period — either
unusually high or unusually low. If so, it may be appropriate and
necessary to normalise the benchmark amount for the current period.
However, if the entity has recurring charges or credits, then
normalising for those items is inappropriate.

Examples of charges that may result in an exceptional decrease in profit before tax from continuing operations may include:
Unusual restructuring charges

Impairment of fixed assets or long-term investments not in the ordinary course of business

Changes in accounting methods/estimates

Examples of credits that may result in an exceptional increase in profit before tax from continuing operations may include:

One-time gains arising from the settlement of legal matters

One-time
gains arising from the sale of a component of a business (where the
ongoing business model of the entity is not focused on acquisitions and
disposals of components).

Use of another benchmark or
normalising the benchmark may also be appropriate if profit before tax
from continuing operations is nominal (i.e., small and close to zero) in
the current period. However, if an entity has a past history of low
earnings from continuing operations in relation to large revenues and
expects to continue generating income at such levels, this may represent
the normal operating results for the entity, and consequently,
normalisation of profit before tax from continuing operations in such
cases may not be appropriate.

Audit documentation needs to
explicitly substantiate as to why the identified benchmark is required
to be normalised and the corroborative factors that caused the
normalisation. It may not be sufficient if the documentation merely
states that the factor causing the normalisation is considered unusual
or exceptional without stating the basis on which such a conclusion was
reached.

Revision in materiality
At times,
particularly where an interim audit is performed before the year-end,
the auditor may need to set materiality for planning purposes based on
the entity’s annualised interim financial statements or financial
statements of one or more prior annual periods. While setting
materiality in such cases, the auditor needs to be cognisant of:

observations
emanating from the audit of the previous period i.e., control
deficiencies previously communicated to those charged with governance,

the effects of major changes in the entity’s circumstances (for example, a significant merger),

the effectiveness of the entity’s internal control,

any
public information about the entity relevant to the evaluation of the
likelihood of material financial statement misstatements,

relevant changes in the economy as a whole or the industry in which the entity operates.

Because
it is not feasible for the auditor to anticipate all situations that
may ultimately influence judgments about materiality in evaluating the
audit findings at the completion of the audit, the auditor’s judgment
about materiality for planning purposes may differ from the judgment
about materiality used while evaluating the audit findings at audit
completion. For example, while performing the audit, the auditor may
become aware of additional quantitative or qualitative factors that were
not initially considered but that could be important to users of the
financial statements and that should be considered in making judgments
about materiality when evaluating audit findings.

If the auditor
concludes that a lower materiality level than that initially determined
is appropriate, the auditor should reconsider the related levels of
tolerable misstatement and appropriateness of the nature, timing, and
extent of further audit procedures. The auditor should consider whether
the overall audit strategy and audit plan needs to be revised if the
nature of identified misstatements and the circumstances of their
occurrence are indicative that other misstatements may exist that, when
aggregated with identified misstatements, could be material. The auditor
should not assume that a misstatement is an isolated occurrence.

If
the aggregate of the misstatements (known and likely) that the auditor
has identified during the course of his audit approaches the set
materiality, it would be prudent for the auditor to evaluate the risk
that the possibly unidentified misstatements together with the
identified misstatements may exceed the materiality level. If in the
auditor’s judgment, such a risk is perceptible, then the nature and
extent of further audit procedures would need to be reconsidered.

Let us consider some case studies to understand the practical application of the above concepts.

Case Study I – Materiality at account balance and qualitative factors

Background

CAB Private Limited (‘CAB’ or ‘the Company’) is a trader of fans and has three streams of revenue. Revenue from sale of high speed ceiling fans comprises 60% of the total revenue, revenue from sale of automatic fans comprises 30% of the total revenue and the balance 10% represents revenue from table fans. High speed ceiling fans are sold entirely to XYZ Private Limited, a company in which one of the directors of CAB has a majority stake. M/s. ABC & Associates are the auditors of the Company and Mr. A is the audit in-charge on the job. The Company is profit making and accordingly Mr. A selected profit before tax as the benchmark for the purpose of materiality. The materiality for the purpose of audit of the financial statements for the year ending 31st March 20X1 as ascertained in the planning stage was set at Rs. 80 million.

The table below sets out the position of sales and debtor balances as on 31 March 20X1:

Account
description

Amount
in Rs.

Revenue from high speed ceiling fans

600 million

Revenue from automatic fans

300 million

Revenue from table fans

100 million

Account
description

Amount in Rs.

Outstanding
for

 

 

more
than 90 days

Debtors –
high speed

250 million

Rs. 60
million

ceiling fans

 

 

 

Debtors – automatic fans

150
million

Rs.

5 million

Debtors – table fans

80
million

Rs.

5 million

As per Company policy, debtors outstanding for more than 90 days are fully provided for. However, for the year ended 31st March 20X0, management has not made any provision for debtors. In light of the concept of materiality evaluate the following:

I)    Considering the fact that there are no other unadjusted misstatements in the financial statements, as an auditor, is the above misstatement material for reporting purposes?

    What will be the situation in case where the outstanding debtors for more than 90 days is nil for Debtors – high speed ceiling fans, Rs. 35 million under Debtors – automatic fans and Rs. 50 million for Debtors under table fan category?

    The Company received share application money from its parent company located overseas in the month of May 20X0 aggregating to $ 1.66 million (Rs. 100 million) against which shares aggregating to $ 1.42 million (Rs. 85 million) were allotted. No allotment or refund has been done for the balance amount till date. For the shares allotted, the Company did not file

Form FC-GPR with the Reserve Bank of India within prescribed timelines. Non-compliance with the above provisions would be reckoned as a contravention under FEMA Act and could attract penal provisions. Let us evaluate what would be the implications of this situation.

    Analysis I

As per SA 320, one or more particular class of transactions, account balances or disclosures may exist for which misstatements of lesser amounts than materiality for the financial statements as a whole could reasonably be expected to influence the economic decisions of users. In such a case, the auditor may consider the account balance or transaction or disclosure as material.

It is pertinent to note that more than 50% of the debtor balance is due from a related party. Further, 60% of the aggregate sales are to related party. Accordingly in the above case even though the aggregate misstatement of Rs. 70 million is below materiality, i.e., Rs. 80 million, Mr. A could consider having a lower threshold as far as debts due from related party are concerned rather than applying the benchmark selected for the financial statements as a whole.

    Analysis II

In the second situation though the account balances individually are below materiality but on aggregate level the total misstatement exceeds the materiality of Rs. 80 million and accordingly, Mr. A needs to consider the said misstatement as material and perform necessary procedures.

    Analysis III

As per the Circular No. RBI/2007-08/213 dated 14th December 2007 issued by the Central Government under Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000, the Company is either required to allot shares within 180 days from the date of receipt of the application money or intimate Reserve Bank of India (‘RBI’) if 180 days have elapsed as on the date of notification.

In the above situation, the Company is in violation of FEMA regulations and accordingly although the un-allotted amount (Rs. 15 million) is below materiality (Rs. 80 million), the auditor will have to consider the same as material information for disclosing the same to the users of the financial statements and consider reporting the same in his report.

Case Study II – Normalisation

Background

FAT Private Limited (‘FAT’ or ‘the Company’) is a gem manufacturing company. The said Company has shut two of its plants in the current year. The financial position for FAT is given below:

 

Rs. in Millions

Financial
statement caption

Amount

Total Assets

500

Total Revenue

1,200

Net Assets

150

Profit before tax

400


This is a first year audit by MTS and Associates and the audit engagement partner has determined that the most appropriate benchmark to use in determining materiality is profit before tax from continuing operations. As shown above, the estimated profit before tax from continuing operations for the period is Rs. 400 million. This amount is net of Rs. 80 million restructuring charge for the closure of entity’s plant. In the light of the concept of materiality, evaluate the following:

I. Whether the auditor should consider profit before tax of Rs. 400 million for the purpose of materiality?

    Now consider a situation where FAT has two divisions where total revenue and profit before tax for Division
A is Rs. 800 million and Rs. 30 million and that for Division B is Rs. 1,200 million and Rs. 400 million respectively. The profit before tax from the Division A has historically been low as compared to Division B.

Since the profit from Division A is very low, the auditors have decided not to consider the same for the purpose of materiality. Evaluate if the approach is appropriate?

    Analysis

    As per SA 320, when the materiality for the financial statements as a whole is determined for a particular entity based on a percentage of profit before tax from continuing operations, circumstances that give rise to an exceptional decrease or increase in such profit may lead the auditor to conclude that the materiality for the financial statements as a whole is more appropriately determined using a normalised profit before tax from continuing operations figure based on past results.

In the current scenario, the current-period profit before tax from continuing operation includes a significant amount that is on account of an unusual transaction and is not a recurring expenditure. Accordingly the audit team needs to normalise the benchmark amount by excluding the restructuring charge from the current-period profit before tax from continuing operations.

    In situation II, although the profits from Division A are low as compared with the profits from Division B, it is not exceptional in nature. The profits have been historically low from Division A and accordingly if the Company expects that the same will be continued, the auditor should consider the profit of Division A for the purpose of calculating the benchmark for materiality.

    Case Study III – Revision in materiality

Financial
position

20X1

20X0

 

Rs. Millions

Rs. Millions

 

 

 

Total Assets

400

250

Total Revenue

1200

1000

Net Assets

50

30

Profit before tax

10

(0.2)


GFT and Associates are the auditors of Small Ltd. (‘the Company’). The following is the financial position of the Company:

Based on financial position given above, the auditor decided to use revenue as the benchmark for the purpose of calculating materiality for 20X1. During the course of audit while performing cut off procedures, the audit team realized that the Company had recognized excess revenue of Rs. 200 million. This amount was substantial comprising approximately 16.66% of the total revenue. Should the audit team revise the materiality?

What would be the answer had there been an under-recognition of revenue by Rs. 200 million, should the auditor revise the materiality?

    Analysis

As per SA 320, the auditor shall revise materiality for the financial statements as a whole in the event of becoming aware of information during the audit that would have caused the auditor to have determined a different amount (or amounts) initially. In the given scenario, as the revenue amount has been revised significantly the auditor would need to revise the materiality amount. As a higher materiality figure was earlier used to scope account balances/transactions for scrutiny, the likelihood of the risk of misstatements remaining undetected may not have been adequately addressed.

On the contrary, in a situation where the revenue recognised was lower by Rs. 200 million and accordingly the materiality calculated was also lower, the auditor may use his professional judgment to evaluate whether it is necessary to revise the materiality.

    Concluding remarks

In conclusion, auditors need to make materiality judgments on every audit which is a difficult process as it requires both qualitative and quantitative aspects to be evaluated. Additionally there is no formal or scientific method to compute materiality. Materiality judgments are crucial for conduct of a successful audit as poor judgments can result in an inappropriate audit opinion or may result in the audit being inefficient or ineffective.

An auditor’s expert – a mere specialist or a Man Friday?

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Where an enterprise involves an expert to provide information necessary for the preparation of the financial statements, the auditor would need to decide whether he has the requisite knowledge and experience to evaluate on his own, the work performed by the expert or whether he needs to engage an ‘auditor’s expert’ so as to decrease the risk that material misstatement will not be detected.

In the previous article, we explained aspects that an auditor would need to consider where he himself chooses to evaluate the work of the expert rather than employing an ‘auditor’s expert’. We will now focus on audit considerations where an auditor elects to engage his own expert. SA 620 provides the requisite guidance in this regard.

An auditor’s expert refers to a person or organisation possessing expertise in a field other than accounting or auditing, employed or engaged by the auditor to assist him to obtain sufficient appropriate audit evidence for the purpose of the audit. SA 620 accentuates the need for the auditor to evaluate the expert’s objectivity and to establish a proper understanding with the expert of the expert’s responsibilities for the purposes of the audit.

An auditor’s expert could be an internal expert or an external expert. An auditor’s internal expert may be a partner or staff of the auditor’s firm or of a network firm. The internal expert could therefore be subject to quality control policies and procedures of the auditor’s firm. The auditor would be in a better position to exercise oversight over the functioning of the expert where he engages an internal expert.

Whereas an auditor’s external expert is not a member of the engagement team and may not be subject to quality control policies and procedures instituted by the audit firm. Where the auditor engages an external expert, he would need to exercise greater diligence in evaluating the objectivity of the external expert. Some of the factors that the auditor should be cognisant of while engaging an external expert are:

i. Enquire from the client of any interest or relationship that the client has with the auditor’s external expert that may affect the expert’s objectivity.

ii. Discuss with the expert whether he has any other interest in the client other than the present engagement for which he is being engaged by the auditor. Interests and relationships that may be relevant to discuss with the auditor’s expert include financial interests, business and personal relationships and provision of other services.

iii. Discuss whether there are any safeguards to prevent his objectivity from being impaired. Such safeguards could be in terms of code of conduct/independence requirements as prescribed by the professional body of which the expert is a member.

iv. The auditor should consider obtaining a written representation from the auditor’s external expert about any interests or relationships with the entity of which that expert is aware.

Other aspects that the auditor needs to consider while engaging internal or external experts are:

i. Whether the work of the auditor’s expert relates to a significant matter that involves subjective and complex judgments.
ii. Whether the auditor’s expert is performing procedures that are integral to the audit, rather than being consulted to provide advice on an individual matter.
iii. The competence, capabilities and objectivity of the auditor’s expert.
iv. Obtaining an understanding of the auditor’s expert’s field of expertise.
v. The nature, scope and objectives of the auditor’s expert’s work are agreed between the auditor and the auditor’s expert, regardless of whether the expert is an auditor’s external expert or an auditor’s internal expert.
vi. Whether the auditor’s expert will have access to sensitive or confidential entity information.

Application of SA 620 in practice
• Engagement of auditor’s internal expert
Due to complexities involved in various matters, which in turn leads to specialisation, many firms have separate departments which offer direct tax, indirect tax, transfer pricing and other advisory services. These departments employ professionals other than qualified accountants as well like lawyers, engineers, management graduates, corporate finance professionals etc., for rendering tax and advisory services.

It is a usual practice for auditors to refer client’s matters involving direct and indirect taxes having implications on financial reporting to tax specialists within their firm. These specialists need not necessarily be qualified accountants (could be tax lawyers). An illustrative list of factors that need to be borne in mind are:

a) Such specialists would be subject to relevant ethical requirements including those pertaining to independence.

b) Where an auditor engages such internal experts, it is important that such experts understand the interrelationship of their expertise with the audit process.

c) The fact that the auditor would be involving an internal expert from a different service line should be clearly articulated and agreed to in the terms of engagement agreed with the client.

d) T here should be a clear agreement between the auditor and the internal expert covering aspects such as, who would test the source data, consent of the expert to discuss his findings or conclusions with the client, whether the auditor would get access to and could retain the work papers of the expert and the manner and form of the report/findings that would be communicated by the expert.

For example, the auditor may seek assistance from an internal tax expert to evaluate the likelihood of pending cases involving tax demands raised by tax authorities being decided against the client. In such cases, there needs to be a clear agreement as to whether the internal expert would evaluate only the likelihood of the demands fructifying in favour or against the client or would the tax expert also comment on the adequacy of the tax provisions carried in the books. Likewise, in order to obtain comfort on the adequacy of tax expense/provision, the auditor may seek clearance from his internal tax expert on whether the transactions with related parties are at the arms’ from a transfer pricing perspective.

Similarly, the auditor may seek clearance from indirect tax experts on disputed indirect tax cases involving service tax, customs duty, excise etc. from the perspective of recording a provision or disclosure as contingent liability or otherwise.

A vital factor that the auditor should be cognisant of is whether the tax specialist (auditor’s internal expert) is rendering tax advisory services to the client. In such cases, the auditor needs to assure himself that the position advocated by the tax specialist in respect of tax matters that the audit team has requested for evaluation is not in any manner influenced by the existing relationship that the tax specialist has with the client. The auditor should be mindful of whether the quantum of fees billed by the tax specialist would in any manner impair the objectivity of the tax specialist in providing his clearance.

Another area where an auditor may seek assistance from an internal expert is testing of automated IT controls surrounding an accounting system to the extent that such controls have a bearing on financial reporting. Where clients deploy sophisticated IT systems to process large amounts of data for financial reporting, it may not be possible for the auditor to perform substantive testing manually. Take for instance, testing of revenue for a telecom client involving millions of subscribers or testing of interest on deposits accepted by bank having thousands of deposit accounts. In such cases, the Company would need to deploy high end ERP systems to initiate, record, process and report transactions. Given the IT environment in these enterprises, one would need to engage IT experts to test the general IT controls and application controls. The auditor may engage his internal expert having expertise in information technology to assist him in testing the controls. This would entail sharing of sensitive client data with the internal expert. Here again, the auditor would need to ensure that adequate safeguards are in place to maintain confidentiality of client information that is shared with the IT expert. Further, the auditor would need to verify the origin of the data, obtain an understanding of the internal controls over the data and review the data for completeness and internal consistency.

Another practical example of involvement of auditor’s internal expert relates to the involvement of specialists in corporate finance/financial risk management for testing the valuation of complex derivatives, business purchase, brand valuation etc. In these cases, management would have obtained the valuation of the derivatives/business purchase from a management expert and the auditors would need to obtain assurance that the valuation is appropriate. Given the highly technical nature of the valuation, an auditor may engage an internal expert to evaluate the underlying assumptions and methods for arriving at the valuation.

    Engagement of auditor’s external expert

Typically, general insurers need to make an estimate on the ultimate cost of claims to know the full cost of paying claims in order to set future premium rates. Further, they also need to set up reserves in their accounts to ensure that they have sufficient assets to cover their liabilities. Such reserves are in the form of Incurred But Not Reported (IBNR) and Incurred But Not Enough Reported (IBNER).

Assuming a year end of 31st March, IBNR claim reserve is required in respect of claims that have occurred before 31st March, but the claim has not yet been reported to the insurer whereas IBNER is required in respect of claims that have been reported, but not yet closed.

In other words, IBNR is the liability for future payments on losses which have already occurred but have not yet been reported in the insurer’s records whereas IBNER refers to expected future development on claims already reported (i.e., claims which have not yet been recorded in full to its ultimate loss value).

Reserve for IBNR/IBNER is recorded by management based on actuarial valuation carried out by a management appointed actuary. In such determination, the appointed actuary follows the guidance issued by the professional body governing the actuarial profession in concurrence with the directions issued in this regard by the statutory authority regulating insurance business. The quantum of such reserves would be material to the financial statements of the insurance company.

In India, auditors usually include in their report a comment to the effect that they have placed reliance on the management appointed actuary for valuation of liabilities for IBNR and IBNER claims.

Auditors in certain jurisdictions overseas may appoint their own actuary(external expert)to assess the appropriateness of management’s judgments and assumptions used in the calculation of the reserves for reported claims. The actuary would review the methodology and assumptions used for calculating the reserve and comment whether they are in line with the related regulations and also comment on the reasonableness.

The auditors would nevertheless need to have discussions with the client and the actuaries and would need to perform the following with the assistance of its own expert:

    Determine the client’s overall methodology for generating the reserves for reported claims including changes compared to the previous period.

    Assess whether the auditor appointed actuary has adequately reviewed the appropriateness of managements judgments and assumptions used in the calculation of the reserves.

    Assess whether the overall reasonableness of the reserves for reported claims is appropriate given the consideration of historical evidence of the reasonableness of the previous periods level of the reserves for reported claims.

    Perform reconciliation of net earned premium, net claims paid together with net claims outstanding as appearing in the financial statements and the actuarial data inputs used by the actuary for the IBNR/IBNER computation.

Closing remarks

The decision of auditors of whether to employ their own experts or otherwise, should be taken only after very careful consideration of the risk of material misstatement in the relevant area of the financial statements and scrutiny of the status and the work of the management’s expert. Any decision in this regard should be influenced by the knowledge that, ultimately, the audit opinion is the sole responsibility of the auditor, and that this responsibility is not reduced by reliance on the work of a management’s expert or an auditor’s expert.

In terms of requirements of Indian GAAS, the auditor is not permitted to refer to the work of the auditor’s expert in the audit report containing an unmodified opinion, unless required by law or regulation. Further, even if any local law were to permit inclusion of such reference in the audit report, SA 620 mandates the auditor to state that such reference does not in any manner reduce his responsibility for the opinion issued.

Auditing outsourced services – Auditors’ predicament

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Cost optimisation – the genesis of outsourcing
Many enterprises operate more efficiently and profitably by outsourcing certain functions to other organisations that have the personnel, expertise or infrastructure to accomplish these tasks. The past several years have seen rapid growth in outsourcing of various business functions to service organisations. This growth has been fueled by a number of factors, including economic recession, pressure to improve operational costs, an increasingly virtual workforce and lack of internal resources to support a process or function. Traditionally the term ‘outsourcing services’ would elicit reference to services such as book keeping, payroll processing, clearing house services, mortgage services and medical claims processing amongst others. However, with advancement of information technology, the outsourcing space has witnessed emergence of a plethora services such as Software as a Service (SaaS), Application Service Providers (ASP), Cloud Computing, Credit Card Processing platforms, Internet Service Providers (ISP), Data Centers, Tax processing etc.

How is an outsourced function relevant to audit?
In some cases the outsourced work generates information that is included in the outsourcer’s financial statements. Consider the example of a claims processor (third party administrator (TPA)) who processes claims for an insurance company. When the claims processing function is outsourced to a TPA, health plan customers are instructed to submit their claims directly to the TPA, which processes the claims based on rules established by the insurance company, such as rules related to eligibility and the amount to be paid against each claim. The claims processor provides the insurers with data, such as the cost of claims processed during a period, and this information flows through to the insurance company’s financial statements i.e., the expense claims and the related liability. Even though this information is generated by the claims processor, the insurance company is responsible for the accuracy of that information because the same is included in its financial statements.

For the auditors of the insurance company, the responsibility for auditing the information generated by the claims processor is the same as it would have been for auditing other financial statement information generated by the insurance company itself. The auditors must find a way to obtain evidence that supports the assertions in the insurers’ financial statements that include or are affected by the information generated by the claims processor. Under auditing parlance, the claim processor is termed as a ‘service organisation’, the insurance company would be a ‘user organisation’ whereas the auditor of the user organisation would be called as ‘user auditor’.

Auditors’ Responsibilities under SA 402
SA 402 – ‘Audit Considerations Relating to an Entity Using a Service Organisation’ expands on the factors that an auditor needs to bear in mind while auditing the financial statements of an entity that outsources functions that affect its financial statements. Services provided by a service organisation are relevant to the audit of a user entity’s financial statements when those services, and the controls over them, are part of the user entity’s information system, including related business processes, relevant to financial reporting.

In some cases, management of a user entity is able to monitor the quality of the data it receives from a service organisation by establishing controls to prevent, or detect and correct, misstatements in its financial statements resulting from errors in the data received from a service organisation. This would be the case if the user entity initiates and records the transactions it submits to the service organisation for processing. A good example of such services are payroll processing services.

In other cases, the user entity relies on the service organisation to initiate, execute and record the transactions. Consider for example where a user entity that grants an investment manager the authority to purchase and sell investments on its behalf based on written guidelines provided by the user entity.

Even though such controls are located and operating at the service organisation, they are relevant to the user entity’s internal control over financial reporting because they are designed to prevent, or detect and correct, errors in the information provided to user entities. The question is whether the auditor of a user organisation is required to test these controls and if yes, what approach would enable the user auditor to obtain sufficient information that such controls are designed and are operating effectively. Testing of controls at a service organisation.

SA 402 requires that where a user entity establishes controls over the services provided by a service organisation, the user auditor should test those controls which impact financial reporting to evaluate whether the same are operating effectively. Where the user auditor is satisfied that such controls at the user entity are operating effectively, he is not required to test controls established by the service organisation in relation to the services outsourced by the user entity. This may usually be the case where the process is less complex and the transaction volume is not substantial, for e.g., payroll processing for a small/medium sized enterprise.

Where the services provided by a service organisation involve highly automated processing, a user entity may not be able to implement effective controls over the transactions processed by the service organisation and may need to rely on the controls at the service organisation. From the user auditor’s perspective, he may be unable to obtain sufficient evidence by performing substantive procedures alone at the user entity. In such cases, the user auditor shall obtain an understanding through one or more of the following procedures:

a) O btaining a Type 1 or Type 2 report, if available

b) Contacting the service organisation, through the user entity, to obtain specific information

c) Visiting the service organisation and performing procedures that will provide the necessary information about the relevant controls at the service organisation; or

d) U sing another auditor to perform procedures that will provide the necessary information about the relevant controls at the service organisation.

A Type I report is a report by the service auditor on the design of the controls whereas a Type II report is a report on the design and operating effectiveness of controls at the service organisation.

The following case study highlights the procedures that a user auditor would perform to obtain sufficient evidence for risk assessment in relation to the services performed by a service organisation.

Case Study

World Wanderers Private Limited (WWPL) a wholly owned Indian subsidiary of World Wanderers Inc. USA (WWI) is an online travel company offering outbound and inbound travel services. WWI commenced operations in India in June 20X0. In order to rationalise the operating costs, the parent company, WWI outsourced the accounting for accounts payable function for all its subsidiaries including WWPL to Rapidex Accounting Services (RAS), an outsourcing firm based out of Philippines. The processing of accounts payable for WWPL happened at RAS whereas the general ledger was maintained by WWPL in India. WWI and all its subsidiaries used a globally renowned ERP system called ‘Apex’. Access to the Apex accounts payable module was provided by WWI to RAS. RAS used Apex for its other clients as well.

Under the accounts payable process, raising of purchase orders in Apex and approval of receipt of goods and services against these purchase orders was performed by authorised staff of WWPL. RAS accounts payable team was responsible for invoice and payment processing, reconciliations, journal posting in Apex and vendor helpdesk services. WWPL maintained a documentation imaging database called OMNI to which the designated accounts personnel from RAS accounts were given access. Scanned images of the invoices duly authorized by WWPL would be uploaded on OMNI. WWPL would provide a list of scanned images of specimen signatures of WWPL staff who were authorised to approve invoices. A designated team leader (TL) authorised by RAS would need to match the signatures on the invoices with the specimen provided and where these matched, the invoices were to be processed in Apex. A quality check was performed by RAS QC team on a test check basis.

Apex generated details of payments to be released to vendors based on due date which were compared    by RAS accounts payable team with the payment authorisation received from personnel of WWPL. The request was then uploaded on the bank’s website by RAS Team Leader and payments released after sign off by WWPL. The contractual terms agreed by WWI with RAS included the requirement of RAS furnishing a Type 2 report on a calendar year basis for all the subsidiaries by an independent firm of IT auditors.

RAS engaged a service auditor ABC & Co. (‘ABC’) a firm based in Philippines to provide his opinion on the design and effectiveness of controls over the accounts payable function. The period of coverage was from 1st January 20X0 to 31st December 20X0. The significant controls tested by ABC inter alia included the following critical controls:

a.    Controls provide reasonable assurance that invoices posted by RAS are authorised and accurate.

b.    Controls provide reasonable assurance that only authorised payments are processed accurately by RAS.

c.    Controls provide reasonable assurance that RAS IT resources used to provide services to WWPL are restricted to authorised personnel only.

ABC provided a Type 2 report stating that all controls related to accounts payable process were designed and operated effectively, other than the following controls:

•    For 3 out of 25 samples, the verification of the payments uploaded on bank website by RAS was done using the ID of a resigned Team Leader of RAS.

•    For 1 out of 25 samples, the verification of payment uploaded on the bank website was done using an ID which could not be associated with any of the Team Leaders of RAS assigned to WWPL.

•    For 2 out of 25 samples, the evidence for verification by the TL on the bank website was not available.

ABC & Co. qualified their opinion on the above count.

WWPL had also outsourced its tax planning and processing function to XYZ & Co. (‘XYZ’),  an  Indian firm of chartered accountants. XYZ was responsible for filing of all statutory returns such as Service tax returns, withholding tax returns, and income-tax returns as well as providing assistance in tax assessments.

The accounting period for WWPL ended on 31st March 20X1. M/s.PQR & Associates (‘PQR’) were appointed as auditors of WWPL.

Let us now examine what procedures would  PQR  would need to perform to ensure compliance with the requirements of SA 402:

1.    PQR may need to enquire whether WWPL has maintained independent detailed records or documentation of invoices processed and payments made by RAS on its behalf. It could be possible that no independent records could be maintained by WWPL on account of costs and operational efficiency.

2.    Auditors generally have broad rights of access established by legislation. PQR would need to obtain an understanding of the legislation applicable in Philippines to determine whether appropriate access rights can be obtained to RAS systems. PQR could consider requesting WWPL to incorporate rights of access in the contractual arrangements between  the WWPL and RAS. PQR may need to consider Inspecting records and documents held by RAS.

3.    PQR may need to obtain evidence as to the adequacy of controls operated by RAS over the completeness and integrity of WWPL’s accounts payable data for which RAS is responsible.

4.    If independent records of accounts payable are being maintained by WWPL, PQR could consider obtaining confirmations of balances and transactions from RAS for corroborating WWPL’s records. This may constitute reliable evidence confirming existence of transactions and balances.

5.    Given the significant volume of payments, performing substantive procedures or testing of operating effectiveness of controls at WWPL by PQR would not be sufficient. It would be imperative that the design and operative effectiveness of controls over processing of invoices as well as payments which occurred at RAS were tested by PQR.

6.    As ABC is a firm based out of Philippines and assuming that ABC is not registered with ICAI, PQR would need to evaluate the professional competence of ABC, its independence from WWPL and the adequacy of the standards under which ABC has issued the Type 2 Report. PQR may need to make enquiries about ABC to ABC’s professional organization and enquire whether ABC is subject to regulatory oversight.

7.    (a) If PQR is satisfied as to the professional competence of ABC, PQR could use ABC to perform procedures on the WWPL on its behalf such as testing of controls at RAS (other than those covered by the Type 2 Report) or substantive testing on WWPL financial statement transactions and balances maintained by RAS.

(b)    Alternatively, PQR could use another auditor to perform test of controls or substantive procedures at RAS on its behalf. The results of such procedures performed could be used by PQR to support its audit opinion. In such a case, it would be essential for ABC and PQR to agree to the form of and access to audit documentation.

(c)    PQR may visit RAS to perform tests of relevant controls if RAS agrees to it.

8.    As far as reliance on Type 2 Report is concerned, the controls tested by ABC and the results thereof would need to be evaluated by PQR to determine whether these support PQR’s risk assessment. In the present case it is pertinent to note that:

(a)    The period covered by the Type 2 report is until 31st December 20X0 whereas the period under audit ended on 31st March 20X1. PQR would need to discuss with WWPL or where permissible with RAS whether there were any significant changes to the relevant controls at WWPL outside of the period covered by ABC’s Type 2 report. PQR could consider extending tests of controls over the remaining period or testing  WWPL’s  monitoring of controls. PQR may also review current documentation of such controls as provided by RAS

(b)    PQR would need to evaluate the scope of work performed by ABC, i.e., the controls tested, the appropriateness of the sample sizes and whether there were significant changes to the relevant controls beyond the period covered by the Type 2 Report.

(c)    The service was designed with the assumption that WWPL user will have controls in place for authorizing invoices before they are sent to RAS for processing. Other control to consider would be whether an updated list of signatories authorized to approve invoices was sent by WWPL to RAS. PQR would need to consider whether such complementary controls at WWPL were relevant to the service provided to WWPL.

(d)    Merely because ABC had issued a qualified opinion does not imply that  ABC’s  report  will  not be useful for the audit of WWPL’s financial statements in assessing the risks of material misstatement. Subject to considerations explained in paragraph 7(a) above, the exceptions giving rise to the qualified opinion in ABC’s report should be considered in PQR’s assessment of the testing of controls performed by ABC.

(e)    The exceptions pertained  to  inconsistency  in  the login IDs used by RAS team to process transactions on Apex. PQR would need to evaluate how these exceptions impacted the overall control environment around accounts payable processing, any remedial was taken post  31  December  20X0 and whether alternative checks were available to prevent or detect and correct errors in misstatement.

(f)    The involvement of ABC or another auditor does not alter PQR’s responsibility to obtain sufficient appropriate audit evidence as a basis for forming his opinion. PQR would not be in a position to make a reference to ABC’s report as a basis for PQR’s opinion on WWPL’s financial statements. However, if PQR were to modify its opinion based on ABC’s opinion, then PQR could refer to the ABC’s report in its own audit opinion with prior consent of ABC.

9.    As regards tax processing services performed by XYZ, a report on controls at XYZ may not be available and visiting XYZ may be the most effective procedure for PQR to gain an understanding of controls XYZ   as there is likely to be direct interaction of WWPL’s management with XYZ.

The above is an illustrative inventory of procedures that SA 402 mandates auditors to perform. The procedures may be customised to meet the requirements of an actual scenario.

CONCLUDING REMARKS
Increasingly, enterprises are outsourcing their business functions to achieve cost  efficiencies.  The  rise  of cloud computing has played a key role in the number    of businesses that outsource functions to service organisations. Cloud computing providers offer user entities access to applications, data storage, and numerous other computing functions on a pay-as-you- go basis. Controls at a service organisation that are related not only to user entities’ internal control over financial reporting but also to other critical aspects such as data privacy of customers and other stakeholders have gained prominence. User entity would continue to remain responsible for such data though the same resides with the service organisation.

SA 402 provides useful guidance to auditors to understand the nature and significance of services provided by service organisations and to  design  and  perform  procedures to respond to risk of material misstatements related thereto.

Is an auditor expected to be omniscient?

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Auditors are experts in accounting and auditing matters, but are they expected to possess competencies in fields not usually related to their profession? Quite frequently, auditors are confronted with situations which require expertise that transcends well beyond the realm of accounting and auditing. Consider for instance the following scenarios:

• For an oil exploration company, if the results of exploration and drilling indicate the presence of oil and gas reserves which are considered to be commercially viable, the expenditure incurred on exploration and drilling is capitalised and amortised (depleted) on a ‘unit of production’ basis computed based on proved reserves in the oilfield. How would an auditor estimate the quantum of oil reserves in an oil field?

• In case of a coal mining company, it is necessary to remove overburden and other barren waste materials from the land pit to access ore from which minerals can economically be extracted. Costs incurred for removal of such waste materials during the initial development phase of the mine are generally capitalised. These costs are usually amortised using a proportion of the quantity of ore extracted during a period over the estimated ore reserves. How would one estimate the ore reserve in a mine?

• How would an auditor obtain assurance over the reported liabilities of a company that has made a provision for costs arising as a consequence of an environmental disaster for which the company is culpable?

• How would an auditor obtain sufficient appropriate evidence to support the ‘true and fair’ opinion on the financial statements of a company that owns expensive jewelry, works of art or antiques, either as trading or as investment assets.

The above scenarios present situations where it is imperative to involve an expert to provide necessary information for preparation of the financial statements.

Other areas where experts may be involved are actuarial valuation of liabilities associated with insurance contracts and employee benefit plans, valuation of intangible assets such as brands, patents and trademarks, site clean-up costs, interpretation of contracts, laws and regulations, analysis or valuation of complex derivatives or financial instruments etc.

Depending on the nature, significance and complexity of the matter that requires the involvement of an expert, an auditor may determine whether he has the expertise to evaluate the work of the expert engaged by the management (known as management’s expert), or whether he needs to engage an ‘auditor’s expert’ so as to decrease the risk that material misstatement will not be detected.

An ‘auditor’s expert’ is an individual or organisation possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist him in obtaining sufficient appropriate audit evidence. An auditor’s expert may be either an auditor’s internal expert (from within his own firm) or an external expert. It is pertinent to note that an auditor’s expert is engaged by the auditor and not by the client (‘auditee’).

In the present article, we will focus on aspects that an auditor would need to consider where he himself chooses to evaluate the work of the expert rather than employing an ‘auditor’s expert’.

SA 500 Audit Evidence provides guiding principles for auditors where information to be used as evidence has been prepared using the work of a management’s expert.

Having regard to the significance of the expert’s work for audit purposes, the auditor would need to evaluate the competence, capabilities and objectivity of the expert when assessing the risk of material misstatements; obtain an understanding of the work performed by him and evaluate the appropriateness of the expert’s work as audit evidence for the relevant assertion.

Let us understand the application of SA 500 with certain practical real-life scenarios.

1. Actuarial valuation of retirement benefits

Use of actuaries in valuation of retirement benefits/longterm employee benefits is one of the most common practice followed by enterprises world over. While auditors are not expected to re-work the valuation performed by the actuary, an auditor is expected to be cognisant of key factors considered in the valuation and to perform corroborative audit procedures. An illustrative inventory of procedures that need to be performed are as under:

i. Testing the assumptions and methods used by the actuary with empirical data available in public domain as well as historical data of the enterprise. The procedures that could be followed while testing some of these assumptions are listed below –

a. Salary increments – could be tested based on past history of increments given by the enterprise and the general level of increment in the industry in which the enterprise operates.

b. Mortality – could be tested by reference to the mortality tables used by insurance companies

c. Attrition – could be tested based on past history/ experience of employees exiting the enterprise. The workforce could be categorised into various age profiles and a graded attrition rate be applied to each profile.

d. Discount rate – could be tested by reference to yields on government bonds with a maturity that corresponds to the remaining service life considered by the actuary.

e. Expected return on plan assets – could be tested by reviewing the profile of investments comprised in the plan.

f. An analytical review of the various components of the actuarial valuation such as current service costs, return on plan assets, actuarial gains/losses, past service costs etc. in relation to the previous year may also provide directional insights to the auditor.

ii. T esting whether the assumptions and methods are generally accepted by the actuarial profession and are appropriate for financial reporting purposes

iii. Testing whether the source data provided by the enterprise to the actuary was relevant, complete and accurate, for e.g., employee data provided by the enterprise relating to salary, date of joining, leave policy and accumulated leave balances (in case of valuation of compensated absences) etc.

iv. Whether the actuary is a member of any statutory professional body governing the actuarial profession and is subject to ethical/accreditation standards of that body.

v. T he auditor could also consider discussing with the actuary on any aspect relating to the actuarial valuation where clarifications are needed. The personal experience with previous work of the expert could also assist the auditor in evaluating the competence of the actuary.

vi. T he auditor should also be mindful of circumstances that would impair objectivity of the actuary, for e.g. , whether the actuary has any financial interest in the enterprise, whether he provides other services and has any business/personal relationships with the enterprise (other than the engagement for actuarial services).

vii. I t may however be noted that the auditor continues to be responsible for opining on the financial statements which incorporate the retirement benefits liability accounted using the valuation provided by the actuary.

2. Valuation of employee stock option plans

Generally, listed companies in india which issue employee stock options (ESOP) are required to obtain a valuation of the ESOP using an appropriate valuation model for the purpose of determining the fair value of the options for accounting/disclosure purposes. Such valuations are performed by a valuation expert using an appropriate model such as Black Scholes or Binomial models. Usually, in such cases, an auditor does not engage an ‘auditor’s expert’ for evaluating the work performed by the  management  expert.  though  the  valuation  may  be performed by the management expert, the auditor can validate the same by independently testing some of the assumptions/data used by the management expert in valuing the options such as –

i.    dividend yield – by reviewing the past dividend history to validate this assumption
ii.    Volatility – by reviewing the fluctuation in the share prices of the Company over the valuation period
iii.    testing the number of options granted,  exercised and lapsed during the qualifying period

Even in this case, the auditor continues to be responsible while opining on the financial statements which include the ESOP charge accounted based on the valuation provided by the management’s expert.

3.    Estimation of reserves in an oilfield

Enterprises engaged in such industries would  have  their own internal team of professional engineers and geologists or may seek the services of external experts to deduce the expected reserves in an oil field. Such a team of experts may evaluate data to determine whether oil can be economically produced from the well, whether infrastructure exists to enable the marketing of production to be obtained from the field, findings from prior years, their own knowledge of relevant formations and drilling, completion and production techniques applied by the Company etc.

Some of the significant points of focus for oil reserve valuation by an expert could be –

i.    The nature, scope and objectives of the expert’s report – whether the report is prepared solely for the exclusive use of the enterprise and forms the basis for the assessment of impairment of property, plant and equipment.

ii.    Whether the expert acknowledges the fact that the auditors use the report for the purposes of the year end audit?

iii.    Whether the evaluation of reserves is a routine part of the expert’s business?

iv.    Are these experts employed by other oil and gas development and exploration companies to perform such evaluations and thus have established procedures and guidelines that are followed as part of the reserve evaluation process?

v.    Whether the expert  compares  the  data  provided  by the management with public information before incorporating the data in to the model used for computing the reserve. Whether assumptions are reviewed and tested  by  management  to  ensure  the reliability and consistency of the output with expectations and actual results?

vi.    Whether the expert is required to comply with the ethical standards of any governing body and whether the report issued has under any statutory sanction?

vii.    Whether the expert has any direct or indirect interest in the enterprise which could impair his objectivity?

viii.    Based on the complexity involved, the auditors could consider incorporating a ‘matter of emphasis’ in the audit report clearly expressing his reliance on the technical evaluation done by the expert of the expected oil reserves which has formed basis of providing for amortization of the exploratory and drilling costs of the oil well.

4.    Valuation of Artworks

Where an enterprise is engaged in trading of artworks/ antiques, one would need the involvement of a valuation expert to test whether the net realisable value of such items exceeds the cost so as to comply with the requirements of AS 2 – Valuation of inventories.

The valuation of artworks is influenced by factors such as the identity of artist, the art style deployed (such as contemporary, modern etc.), the age of the artwork, the medium used i.e., whether  the  artwork  is  on  canvas or paper, at what price have the paintings of the artist concerned been sold in the recent past, recognition of the artist by art galleries/auctioneers, demand and supply of the artworks of the concerned artist etc. In addition to the generic audit procedures discussed in the preceding cases, the auditor would need to be aware of these nuances while verifying the valuation performed by the expert.

5.    Physical verification of stock pile of minerals

For enterprises that transact in/consume minerals such as natural gypsum (usually found in rock form) or coal, it may not be practical to conduct a physical verification of the entire stock by weighment, where the quantum of stock at the year-end is substantial. In such cases, the enterprise may engage a surveyor to certify the quantum of stock based on volumetric measurement.   The auditors in such cases should not merely rely on the report furnished by the surveyor but perform alternative procedures such as an overall reconciliation of quantity of materials purchased, expected material consumption (relative to finished goods produced) and derived closing inventory.

Concluding Remarks
Where enterprises involve experts to provide information necessary for preparation of the financial statements, auditors would need to decide whether they have the requisite knowledge and experience to evaluate the  work performed by the experts and not merely rely on their reports. ultimately, the audit opinion is the sole responsibility of the auditor, and that this responsibility is not reduced by reliance on the work performed by   the expert.

Related Party Transactions – A Potential for Abuse?

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While auditing related party transactions, an auditor is usually confronted with questions such as:

“Why should auditing related party transactions be any different from like transactions that are entered into with unrelated parties?”

“How does one ensure completeness of identification of all related party relationships and transactions with such parties?”

“How does an auditor deal with situations where the related party is the only source of supply of goods or services for an enterprise?

Related party transactions can be legitimate and value-enhancing for a corporation but they can also serve as a vehicle for illegitimate expropriation of corporate value by management or controlling shareholders. Related party transactions do not merely pose the potential harm of direct expropriation of value from minority investors, but they also reinforce negative perception of the country’s capital markets as a whole, and lead to a general discounting of equity markets.

Generally, related party transactions are not regarded as mechanisms for fraud, and their presence need not indicate fraudulent financial reporting. It is important for the auditor to understand the benign nature of most related party transactions, the differentiating features between benign and fraudulent transactions, and the importance of evaluating a company’s related party transactions in light of its broader corporate governance structure. However, at the same time, the auditor should not discount the fact that, related party relationships may present a greater opportunity for collusion, concealment or manipulation.

Enterprises establish a matrix of related party entities/ structures for tax efficiencies, compliance with regulatory requirements, ring fencing promoter interests, protecting intellectual property rights, providing common services etc. At times, related parties may be the only source of supply of goods and services. It is imperative that management designs, implements and maintains adequate controls over related party relationships and transactions so that these are identified and appropriately accounted for and disclosed in accordance with the reporting framework. In their oversight role, those charged with governance are required to monitor how management discharges its responsibility for such controls.

Standard on Auditing (SA) 550 Revised – Related Parties deals with the auditor’s responsibilities regarding related party relationships and transactions when performing an audit of financial statements.

As per the standard, the objectives of the auditor are:

a) Irrespective of whether the applicable financial reporting framework establishes related party requirements, to obtain an understanding of related party relationships and transactions sufficient to be able:

i. To recognise fraud risk factors, if any, arising from related party relationships and transactions that are relevant to the identification and assessment of the risks of material misstatement due to fraud; and

ii. To conclude whether the financial statements, insofar as they are affected by those relationships and transactions:

– Achieve a true and fair presentation (for fair presentation frameworks); or

– Are not misleading (for compliance frameworks); and

(b) In addition, where the applicable financial reporting framework establishes related party requirements, to obtain sufficient appropriate audit evidence about whether related party relationships and transactions have been appropriately identified, accounted for and disclosed in the financial statements in accordance with the framework.

Now, let us understand the application of SA 550 considering the following two case studies.

Case study I- Fraudulent financial reporting

ABC limited (‘ABC’) was engaged in the business of selling electronic items to retail, individual customers. The Company operates through retail outlets across the country and recognises revenue on sale to the retail customer on transfer of ownership of the goods. During the financial year ended 31st March 20X0, the Company entered into an arrangement with XYZ Limited (‘XYZ’) to sell goods and the Company recognised revenue on delivery of goods at the premises of XYZ. XYZ would in turn sell goods to retail customers. XYZ is an entity in which a whole time director of ABC owns 51% of the share capital. XYZ would fall within the definition of related party as per Accounting Standard 18-Related Parties (AS-18) as a key managerial personnel of ABC is able to exercise significant influence over XYZ. Sales made to XYZ constitute 15% of ABC’s total sales for the year. Initially, the auditor’s procedures were restricted to verification of documents such as delivery challans and sales invoices and ensuring that appropriate disclosures have been made as per the requirements of the AS- 18. Further, management asserted that related party transactions were conducted on terms equivalent to those prevailing in an arm’s length transaction.

The facts that were not discovered by the audit team were as follows:

• The risks of ownership were not transferred from ABC Limited to XYZ Limited on delivery of goods as XYZ was required to pay ABC only on further sale of goods and collection of money from XYZ’s end customers.

• Further, XYZ had an unlimited right to unilaterally return unsold goods back to ABC.

• The prices at which the goods were sold to XYZ were substantially higher prices than those charged to other customers.

• ABC limited also had a retail outlet in close proximity of XYZ Limited.

• The auditor should have obtained sufficient appropriate audit evidence supporting management’s representation that the transactions with XYZ were at arm’s length.

This above facts came to light when the internal auditors identified that XYZ had returned goods in the subsequent financial year and such returns constituted a significant value and volume of sales pertaining to earlier periods.

Analysis with respect to SA 550

Auditors’ Responsibilities

1 Identification and assessment of risk of material misstatement associated with related party transactions

Historically, the Company had not entered into any such transactions with any related/unrelated party as the Company’s ordinary business constituted selling of goods to individual end-customers. The Company already had an outlet in close proximity of XYZ. The sales were undertaken at prices higher than those with normal customers. Hence, this transaction should have been considered as a significant related party transaction giving rise to significant risk of fraud while performing risk assessment procedures.

2. Response to the risk of material misstatement

– The auditor should have then appropriately responded to the identified risk by performing the following procedures:

a. Inspecting the underlying contract with XYZ and evaluating –

i. The business rationale (or lack thereof) of the transaction which may suggest the same has been entered into to engage in fraudulent financial reporting.

ii. Consistency of the terms of transactions with management’s representation

b. Obtaining evidence that the transactions have been appropriately discussed and approved.

c. Where applicable, reading the financial statements of the related party or other relevant financial information, if available, for evidence of accounting of transactions in the accounting records of related party.

d. Confirming the purpose, specific terms or amounts of the transactions with the related parties. (This procedure will be less effective where the auditor judges that the Company is likely to influence the response of the related party)

3.  Communication to those charged with governance:
    The auditor in the above case would need to promptly communicate to those charged with governance to arrive at a common understanding of the issues involved and the expected resolution. The auditor would also need to communicate the impact on the financial statements and any resultant impact on the auditor’s report.

4.  Independent Auditor’s report:
    The auditor would need consider the requirement to appropriately modify the main report considering the materiality of amounts involved. Further, the auditor would also have to appropriately modify the reporting relating to paragraph 4(xxi) of the Companies (Auditor’s Report) Order, 2003 (‘CARO’) report.

We would now evaluate another case study which involves a complex structure of related party transactions.

Case Study 2
Mr. P and Mrs. P, well-known fashion designers, incorporated ABC Ltd. in April 20X0 as a 100% export oriented company to be engaged in the business of manufacturing and export of garments. The initial capital contribution was Rs. 5 crore. Given their expertise, the couple were able to attract investment from other individual shareholders of Rs. 45 crore. The shareholding pattern of ABC comprised of promoter shareholding of 51% held by Mr. P and Mrs. P whereas the balance 49% was held by other non-related shareholders. The shareholder agreement with individual shareholders mandated appointment of 3 independent directors. This appointment was made with the objective of protecting the interests of the minority shareholders.

During the year 20X1, ABC Ltd. incorporated XYZ Ltd (‘XYZ’), a subsidiary in the United States of America (US) with 60% shareholding by ABC and the balance 40% held by Mr. P and Mrs. P. ABC entered into an exclusive arrangement with XYZ by virtue of which the entire production of ABC was to be sold to XYZ. The agreement stipulated that given the commitment to buy-out the entire production, the sales consideration to be paid by XYZ to ABC for goods purchased should be just sufficient for ABC to earn a margin of 10% on cost of goods sold. This arrangement was approved by all the directors (including the 3 independent directors) in the board meeting held on 1st April 20X1. The arrangement was also approved in an extra ordinary general meeting held on 15th April
20X1 wherein only Mr. P and Mrs. P were present as shareholders.

XYZ in turn sold the goods purchased from ABC at a margin of 5% to M/s. PQR & Co., a partnership firm formed by Mr. P and Mrs. P in the US.  M/s. PQR & Co. sold the goods in the retail market in the US at a margin of 40% of its cost. Against the aggregate purchases of Rs. 30 crore made by XYZ from ABC during the years 20X1-20X4, payments made by XYZ to ABC aggregated to only Rs. 10 crore. The balance payment of Rs. 20 crore could not be made by XYZ pending collection from PQR. The chief accountant at XYZ provided a confirmation to ABC for the year-end balance. PQR & Co. too provided a balance confirmation to XYZ for the amount due. The financial statements of ABC and XYZ have been audited by M/s. DEF & Associates (‘DEF’) since incorporation. Let us examine the factors which the auditors of ABC Ltd. would need to be cognizant of to comply with the requirements of SA 550

1.  While assessing the risk of material misstatement, the auditors would need to assess the isk associated with related party transactions as significant risk given the existence of a related party with dominant influence–Mr. P and Mrs. P were significant shareholders in ABC and XYZ.

2.  The auditors would need to understand the controls established by ABC and XYZ for identifying, accounting and disclosing related party relationships. DEF were the auditors for both ABC and XYZ. Assuming that Mr. P and Mrs. P would have disclosed their interest in the partnership firm, M/s. PQR & Co. in the notice of disclosure, DEF as auditors would need to ensure that the sales made by XYZ to PQR were disclosed as related party transactions in the financial statements of XYZ.

3.  The terms of the contract between ABC and XYZ were authorised by the board as well as by the shareholders by an ordinary resolution. Authorisation and approval alone, however, may not be sufficient in concluding whether risks of material misstatement due to fraud are absent  because authorisation and approval could have been ineffective, given that ABC was subject to the dominant influence of a related party.

4.  Given that the related party transaction involved a clear conflict of interest, the auditors of ABC would need to consider whether the independent directors had appropriately challenged the business rationale of the contract, for  e.g., by seeking advice from external professional advisors.

5.  The contract was approved by way of an ordinary resolution passed by Mr. P and Mrs. P in their capacity as shareholders. DEF would need to consider whether the contract should have been approved by members (other than Mr.P and Mrs.P) who were not interested in the contract and whether all facts were made available to these members to enable decision -making.

6.  DEF would need to evaluate the business rationale of the contract from the perspective of the related parties, XYZ and PQR to better understand the economic reality of the transaction. The subsidiary XYZ was used as a conduit to transfer goods to PQR at a price far lower than the market price so as to benefit the dominant shareholders. DEF would need to evaluate whether the transactions between the related parties were at arms’ length and complied with the benchmarking norms as per local transfer pricing regulations. Another important aspect was the disparity in the margins earned by PQR on the re-sale of goods to retail customers as against the margin earned by XYZ on
sale of goods to PQR. DEF in their capacity as auditors of PQR would need to be cognizant of this aspect in their risk assessment for related party transactions.

7.  In view of the non-collection of the amounts due from PQR, the ability of XYZ to settle the receivable of Rs. 20 crore was significantly impacted. The mere fact that XYZ had provided a confirmation of the balance due to ABC would not be sufficient evidence in support of the recoverability of the amount due. The auditor would need to evaluate the realisability of receivables in the books of ABC.

Concluding remarks

Considering that a large number of frauds in the corporate world involve related parties, governments and standard setting bodies have adopted stronger and proactive standards and laws to provide for guidance and monitoring of companies and auditors for accounting, disclosures and validation requirements of related party transactions.The Companies Act, 2013 has widened the scope of coverage in terms of the definition of related party and the nature of transactions covered and at the same time mandated approval of such transactions by the audit committee/board of directors/shareholders as applicable. The tax laws have also been amended to cover transactions with specified domestic related parties in addition to cross border transactions with overseas affiliates and has made it obligatory on the tax payer to substantiate that such transactions are at arms’ length.  With sweeping changes in legislation, the auditor would need to exercise heightened professional skepticism in identification of related party transactions, related risk of material misstatement (including fraud risk) and design adequate procedures to ensure compliance with the financial reporting and legal framework.

SA 540 Accounting Estimates

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Synopsis

An accounting estimate is defined as an approximation of the amount of an item in the absence of a precise means of measurement. There are various items in the Financial Statements that cannot be measured with precision and therefore are required to be estimated. SA 540 describes the auditor’s responsibility with respect to the auditing of accounting estimates and related disclosures made by the management. Read on to know more about SA 540 with respect to the objective of the auditor, procedure to be followed, analysis to be done, approach to be used while auditing accounting estimates with the help of two case studies.

An estimate is made when there is an absence of a precise means to measure. This applies in accounting parlance as well, whereby certain items of financial statements cannot be measured with precision and are therefore required to be estimated based on reliable information and justifiable assumptions available at a point in time.

Accounting estimates (other than fair value accounting estimates) Fa ir v alue a c c ounting estimates
Allowance for doubtful Complex financial
accounts instruments, which are not
Inventory obsolescence traded in an active and open
Warranty obligations market
Depreciation method or Share-based payments
asset useful life Property or equipment held
Provision against the for disposal
carrying amount of an Certain assets or liabilities
investment where there acquired in a business
exists uncertainty regarding combination, including
its recoverability goodwill and intangible
Outcome of long term assets
contracts Transactions involving
Costs arising from litigation, settlements and judgments. the exchange of assets or liabilities between independent parties without
monetary consideration, for example, a non-monetary exchange of plant facilities in different lines of business.

An accounting estimate is defined as an approximation of the amount of an item in the absence of a precise means of measurement. An illustrative list of financial statement captions where estimates are used is summarised below:

SA 540 describes the auditor’s responsibility with respect to the auditing of accounting estimates, including fair value accounting estimates, and related disclosures made by the management, wherein the objective of the auditor is to obtain sufficient appropriate audit evidence as to whether in the context of the applicable financial reporting framework:

a) accounting estimates, including fair value accounting estimates, in the financial statements, whether recognised or disclosed, are reasonable; and

b) related disclosures in the financial statements are adequate.

In order to evaluate the reasonableness of recognition of accounting estimates, the auditor shall:

a) obtain an understanding of how management identifies those transactions, events and conditions that may give rise to the need for accounting estimates to be recognised or disclosed in the financial statements and

b) understand how the estimates have been made and what data and assumptions have been used to make such estimates

The understanding so obtained will enable the auditor to assess:

a) for recurring estimates, the historical reliability of the entity’s estimates and the appropriateness of changes, if any, in the existing accounting estimates or in the method or assumptions for making them from the prior period;

b) the completeness and accuracy of key data used in making the estimate;

c) evaluation of management’s use of an expert;

d) the reasonableness of management’s significant assumptions, including any indication of management bias and, where relevant, management’s intent to carry out specific courses of action and its ability to do so;

e)    the reasonableness of management’s estimate, including whether the selected measurement basis for the accounting estimate and management’s decision to recognise or not recognise the estimate is in accordance with the require-ments of the applicable financial reporting framework;
f)    subsequent events or other subsequent information, if any, that may affect the estimate;
g)    the consistency of application of judgments or estimates to similar transactions;
h)    business or industry specific factors that may have significant effect on the assumptions

For accounting estimates that give rise to significant risks at the financial statement assertion level, the auditor needs to evaluate how management has considered alternative assumptions and their outcomes on accounting estimates and reasons for their rejection/acceptance. Such examples include estimates pertaining to useful life of tangible assets particularly for entities operating in specialised sectors such as aviation, oil exploration, power generation, infrastructure etc, estimate of useful life of intangible assets such as toll collection rights purchased by a toll operating company, cash flows from a cash generating unit for the purpose of impairment testing, allowances for doubtful debts, inventory obsolescence in technology driven industries, etc.

Sensitivity analysis is one of the methods that can be used to evaluate how an accounting estimate varies with different assumptions. The objective of this evaluation is to obtain sufficient appropriate audit evidence to ensure that management has assessed the effect of estimation uncertainty on accounting estimates. Where management has not considered alternative assumptions or outcomes, the auditor would need to discuss with the man-agement as to how it has addressed the effects of estimation uncertainty and where empirical external evidence is available, evaluate the appropriateness of the estimate considered by the management.

Once the auditor understands the process, there are generally two approaches that the auditor can use:
a)    test the process used by management to make the estimate, including testing the reliability of the underlying data, or alternatively
b)    develop an independent expectation of the estimate and compare this with the estimate developed by the management.

The choice between these two approaches will depend on the magnitude and complexity of the account balance. An example of the latter ap-proach is the comparison of provision for warranty costs with the estimates made by the management in recent past to determine its reasonableness.

While assessing the methods and assumptions used, the auditor may also need to consider whether management has engaged an expert having specialised knowledge or skills in determining an accounting estimate. Actuarial valuation of employee benefits by an actuary, surveyor’s estimation of the quantum of inventory in certain specialised industries using items such as coal, natural gypsum etc., certification of completion of project work by project engineers to facilitate revenue recognition in construction contracts are some of the elementary examples of involvement of an expert to determine an accounting estimate. The auditor would need to review the appropriateness of estimates made by the expert. For e.g., in case of actuarial valuation of retirement benefits, the auditor would need to evaluate the appropriateness of the estimate of discount rate by reviewing economic reports for interest rates, estimate of salary growth and attrition by reviewing industry reports, estimate of mortality by reviewing annuity/life tables used by insurance companies etc. Similarly for estimation of inventory by surveyors, the auditor would need to assess the estimation methodology used by the surveyor, quantum of inventory holding vis-à-vis consumption pattern, subsequent production of finished goods and other related factors to obtain assurance over the appropriateness of the inventory estimated by the surveyor.

Another pertinent area where estimates are used is for impairment testing for fixed assets. Asset impairment is based either on appraisal of current market value of the asset or based on estimated cash flows from the continuing use of such asset for its remaining useful life. Estimates of future cash flows provided by the management need to be analysed for the reasonableness of the assumptions and consistency with current and predicted future results.

Management may be satisfied that it has adequately addressed the effects of estimation uncertainty in accounting estimates that give rise to significant risks in the preparation of financial statements, however, the auditor may consider this to be inadequate due to non- availability of sufficient appropriate audit evidence or where the auditor believes there exists an indication of management bias in making the estimates. The auditor in such a case may evaluate the reasonableness of the accounting estimate by developing a point estimate or a range. This can be understood with the help of the following example:

Case study 1 (Accounting estimates):

XYZ Ltd (‘XYZ’) is a reputed watch manufacturer and has been in this business for the last 5 years. XYZ commenced its operations during the year ended 31st March 20X0. XYZ formulated a policy of providing free repairs to its customers for a period of 1 year from the date of sale. The sale contract gives the customer, a right to have the watches repaired free of cost for defects that get contracted within a period of one year from the date of purchase of the product. Since inception, XYZ has been providing for warranty costs @ 3% of the value of watches sold during the year.

During the year ended 31st March 20X6, XYZ upgraded its quality testing equipment enabling introduction of certain additional quality checks in the manufacturing process. Management expects that these additional checks would result in more stringent quality clearance of finished products for ultimate sale to customers. Therefore for the year ended 31st March 20X6, management decided to provide for warranty costs at a lower rate of 1% of the value of sales made during the year.

Let us examine the procedures that auditors would need to follow in terms of the requirements of SA 540:

Though the accounting framework does not prescribe a method or model to provide or compute warranty provision, management is required to make a best estimate of the warranty cost based on cumulative experience of the industry, customer base and the likely cost of repairs.

Auditors would need to review the outcome of accounting estimates included in the prior period financial statements and their subsequent re-estimation for the purpose of the current period. Auditors would need to perform a subsequent period testing to deduce actual costs incurred against the provision and effectiveness of controls on accounting of such costs.

Auditors would need to review the trend of actual repair costs incurred over the years and evaluate whether the basis of measurement (as a percentage of sales) needs modification.

Auditor would compare the nature of the earlier warranty claims and how the new machines would take care of these complaints to reduce the warranty costs.

Obtain written representations from management whether they believe significant assumptions used in making accounting estimates are reasonable.

Auditors would need to evaluate whether the management decision to change the estimate basis is indicative of a possible management bias.

Case study 2 (Fair value accounting estimate):

Double Dip Ltd. (DDL) has given 100 options to its employees to receive remuneration in the form of equity settled instruments, for rendering services over a defined vesting period of three years.

The options will vest in three tranches over a period of three years as follows:

Period within which options    % of options
will vest to the participant    that will vest

End of 12 months from the

 

date of grant of options

34

End of 24 months from the

 

date of grant of options

34

End of 36 months from the

 

date of grant of options

32

DDL measures options granted by reference to the fair value of the instrument at the date of grant. The expense is recognised in the statement of income with a corresponding increase to the share based payment reserve, a component of equity.

The fair value determined at the grant date is ex-pensed over the vesting period of the respective tranches of such grants. The stock compensation expense is determined based on DDL’s estimate of equity instruments that will eventually vest over a period of three years.

The key assumptions used to estimate the fair value of options are given below:

The options were granted on 31st December 20XX and DDL has recognized Rs. 10 crore as fair value cost of options granted.

Analysis

Risk-free interest rate

8%

Expected Life

3 years

Expected volatility

46%

Expected dividend yield

0.02%

Price of the underlying share

 

in market at the time of

 

option grant

Rs. 250

Expected forfeiture rate

3%

In the given example, the fair value of options as arrived by the management is an estimate and the same has been derived on the basis of various assumptions considered by the management.

The auditors of the Company would need to verify whether the fair value of the options as estimated by the management is reasonable. For this purpose, various assumptions considered by the management would need to be evaluated and assessed independently i.e., completeness and accuracy of data considered for arriving at business and industry specific factors like risk free interest rate etc.

The auditors would also need to consider estimation uncertainty i.e. possible effects of the various alternatives. In the given case, expected volatility is the factor wherein the auditor would need to assess various assumptions and data used to compute the volatility benchmark and what would be the possible effects on the expected volatility if there is a change in the underlying assumptions as well as the overall effect on the fair value of the options because of change in expected volatility.

The auditor needs to ensure that work done by management to mitigate the risk of estimation uncertainty is sufficient enough to support the appropriateness of the estimate. In the event where work done by management is inadequate, the appropriateness of the estimate would have to be assessed independently by the auditors, if required, through point of estimation or range. The auditor may obtain assurance on the expected volatility, based on an analysis of data of entities in similar industry having issued similar options.

Conclusion

An estimate can be significantly affected by management bias and estimation uncertainty. An estimate is a complex process of arriving to an answer where we do not have precise measure of calculating an item of provision. There are accounting estimates as well as as fair value estimates that requires thorough review by an auditor of the process and assumptions used by the management of arriving the same. As such, significant estimates require the exercise of signifi-cant judgment by the auditor and documentation of those judgments is critical to understanding how conclusions were reached. In some cases, even small changes in inputs can result in large changes in value. Hence, an estimate is an estimate; it is not a precise answer.

Auditing Opening Balances – How Far Should an Auditor Go?

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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.

SA 560 (Revised) – Subsequent Events – Hindsight Better Than Foresight?

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It is often said that hindsight provides new eyes. Reality looks much more obvious in hindsight than in foresight.

Events that occur post balance sheet date can provide hindsight on the conditions that existed as on the date of the financial statements. SA 560 (Revised) provides guiding principles to auditors in evaluating events that occur post the balance sheet date and the auditors’ responsibilities for facts which become known to the auditor post issuance of his report. The emphasis here is on ‘facts that become known to the auditor’ which would imply that the scope of subsequent events review transcends well beyond enquiries of management by the auditors. In the Indian context, we have observed how external investigations into the affairs of the auditee enterprises have lead auditors to withdraw their audit opinions (on account of newer facts becoming known which have resulted in the audit opinion being rendered inappropriate).

SA 560 (Revised) has been aligned with International Standards on Auditing (ISA) 560 on ‘Subsequent Events’. SA 560 (Revised) requires auditors to evaluate facts that become known to the auditor after the date of issuance of the auditor’s report, where such facts have a bearing on the financial statements covered by the audit report issued.

SA 560 (Revised) requires auditors to consider the following time periods over which facts need to be evaluated:
• from the date of the audit report but before the date when financial statements are issued
• after the date when financial statements are issued

Per SA 560 (Revised), the term ‘date when financial statements are issued’ is defined to be the date when financial statements are made available to third parties.

Financial statements may be impacted by events that occur after the date of the financial statements. Such events can be broadly classified into two categories:
(a) Those that provide evidence of conditions that existed at the date of the financial statements; and
(b) Those that provide evidence of conditions that arose after the date of the financial statements.

Adjustments to assets and liabilities are not appropriate for events occurring after the balance sheet date, if such events do not relate to conditions existing at the balance sheet date. The date of the audit report informs the reader that the auditor has considered the effect of all subsequent events and transactions which he became aware of and that occurred up to that date.

Let us understand the applicability of SA 560 (Revised) by considering an elementary case study involving an event that has occurred between the date of the financial statements and the date of the auditor’s report and the underlying responsibility of management and the auditors’ to respond to this event.

Case Study 1

 XYZ Limited (‘the Company’) has a legal proceeding pending against it in a Court of Law for breach of a contract. As at the balance sheet date, 31st March 20XX, the Company represented to its auditors that it had not breached the contract and provided a legal opinion supporting its position as the most likely outcome. No provision towards damages for breach of contract was recognised in the draft financial statements for the year ended 31st March 20XX. A week prior to the board meeting (scheduled to be held on 1st June 20XX to approve the accounts for the year ended 31sts March 20XX), the Court delivered an adverse ruling and held the Company liable for damages of Rs. 10 crore. The Company does not have recourse to appeal before a higher judiciary.

In the given case, in light of the judgment which was delivered subsequent to the balance sheet date, management should adjust the financial statements by accounting for provision for damages of Rs 10 crores because the judgment provides sufficient evidence that an obligation existed at the balance sheet date. The auditor on his part would need to take cognisance of the adverse ruling and perform audit procedures to obtain sufficient appropriate audit evidence for provision of damages. These procedures would include:
• obtaining from the Company’s legal counsel, the updated status of pending litigation or the Court ruling,
• reading minutes of board meetings, if any,

• verifying that provision for damages made in the accounts is adequate,

• inquiry of management and, where appropriate, those charged with governance as to whether any other subsequent events have occurred which might require disclosure in or adjustment to the financial statements and

• obtaining written representation from management that subsequent events have been appropriately adjusted/disclosed.

Review of subsequent events essentially involves making enquiries of management about developments occurring post the balance sheet date such as those relating to recoverability of assets, measurement of estimates, updates in the litigation status, onerous commitments etc. More importantly, where events occurring post the balance sheet date cast a doubt on the ability of the enterprise to continue as a going concern, the auditor would need to weigh the appropriateness of the basis of accounting, i.e., whether the accounts should be prepared on a going concern basis or on liquidation basis.

It needs to be noted that the auditor has no obligation to perform any audit procedures regarding the financial statements after the date of the auditor’s report.

A. Auditors’ responsibilities for facts that he becomes aware of before the financial statements are issued

There could arise a situation where after the date of the auditor’s report but before the date the financial statements are issued, a fact becomes known to the auditor that, had it been known to the auditor as on the date of the audit report, the same would have caused the auditor to amend the audit report. In such a case, the auditor would need to make enquiries of the management or those charged with governance and determine whether the financial statements need amendment and, if so inquire how management intends to address the matter in the financial statements.

In a situation where management amends the financial statements, the auditor would need to perform necessary audit procedures and provide a new audit report dated no earlier than date of approval of amended financial statements.

In certain circumstances, management may not be restricted from amending the financial statements only to incorporate the effect of the subsequent events and such amended financial statements may be permitted to be approved by the approving authority to the extent of the amendment. In such cases, the auditor is permitted to restrict audit procedures to that amendment and amend the audit report by dual dating it for the specific subsequent event or provide new or amended report including an emphasis of matter (EOM) or other matter paragraph clearly conveying that the auditor’s procedures are restricted solely to the amendment of the financial statements as described in the relevant note to the financial statements.

Where amendment of financial statements is considered necessary and management refuses to do so, the auditor would need to issue a modified opinion, if the audit report is yet to be provided to the entity.

If the audit report has been provided to the entity, the auditor would need to notify management not to issue the financial statements and the auditor’s report thereon. If the financial statements are nevertheless issued by the entity, the auditor would need to take appropriate action to prevent reliance on the auditor’s report as released by the entity.

B. Auditors’ responsibilities for facts that he becomes aware of after the financial statements are issued

The auditor has no obligation to perform any audit procedures after the financial statements have been issued. Where a fact becomes known to the auditor that, had it been known to the auditor as on the date of the audit report, the same would have caused the auditor to amend the audit report, the auditor would need to perform the same procedures as explained in paragraph

(A)    above. In addition, the auditor would need to review the steps taken by management to ensure that anyone in receipt of the previously issued financial statements together with the auditor’s report thereon is informed of the situation.

Case Study 2

The Board of Directors of ABC Limited (ABC) approved an equity dividend of Rs. 6 per share on the paid up equity capital of 1,000,000 equity shares of Rs. 10 each at the board meeting held on 28th May 20XX. The Company recorded proposed dividend of Rs. 6,000,000 which was subject to approval by the shareholders at the annual general meeting scheduled on 5th September 20XX. The audit opinion was signed by the auditors on 28th May 20XX. On the date of the AGM, the Board of Directors convened a board meeting to recommend an enhanced dividend of Rs. 9,000,000 (as against Rs. 6,000,000 which was recommended on 28th May 20XX). The shareholders approved the enhanced dividend of Rs. 9,000,000 in the AGM held on the same date. What would be the course of action in this case?

Consistent with the requirement of Accounting Standard 4 – Contingencies and Events Occurring after the Balance Sheet date, the recording of proposed divided at the time of approval of accounts by the board of directors of ABC was appropriate. As a usual practice, the dividend recommended by the board gets approved by the shareholders. However, in the instant case, the dividend proposed by the Board was enhanced by the Board subsequent to the approval of the accounts on 28th May 20XX. The enhanced dividend was approved by the shareholders. It is entirely within the competence of the Board of Directors to amend the accounts and resubmit them to the statutory auditors for report before the accounts are placed before the annual general meeting. Consequently, management could amend the accounts for the year ended 31st March 20XX to account for the enhanced proposed dividend (as well as dividend tax thereon). In such a case, the auditors would need to perform procedures to verify the increase and its corresponding effects on the result for the period and the net reserves. A detailed note in the financial statements explaining the facts of the case would need to be inserted. The auditor may amend the original report to include an additional date to inform users that the auditors’ procedures on subsequent events are restricted solely to the amendment of the financial statements to the extent these relate to proposed dividend (more simply known as dual dating). Alternatively, the auditor may provide a new or amended report that includes a statement in an Emphasis of Matter paragraph (EOM) or Other Matter paragraph clearly mentioning that the auditors’ procedures on subsequent events are restricted solely to the amendment of the financial statements in relation to reversal of proposed dividend.

Revision to the financial statements – a recent example

The original accounts of Essar Oil Limited (‘EOL’) for the year ended 31st March 2012 which were revised post issuance is a pertinent example of subsequent events resulting in amendment to the financial statements after these were issued. In January 2012, the Hon’ble Supreme Court of India ruled against EOL’s claim of eligibility for sales tax incentives for the financial years 2008-09 to 2010-11. The Company sought approval from the Ministry of Corporate Affairs (MCA) to reopen its books of account for the financial years 2008-09 to 2010-11 for the limited purpose of reflecting true and fair view of the sales tax incentives/ liabilities, etc. for the individual accounting years commencing 2008-09 and ending 2011-12. The MCA approval was received during the financial year 2012 -13. The original financial statements for the year ended 31st March 2012 which were approved by the board of directors and the auditors on 12th May 2012 were revised post receipt of MCA approval and approved by the shareholders in November 2012.

In the Indian context, there have also been cases where auditors have in accordance with SA 560 (Revised) informed management of the auditee enterprises that the audit reports issued should not be relied upon in view of purported crisis relating to the auditee’s business operations reported in public domain. Further, in a case where management admits to falsification of the accounts, the auditors would need to inform management as well as regulatory authorities that their opinion on the financial statements would be rendered inaccurate and unreliable.

Concluding remarks

If recent developments in India Inc. were to be diagnosed, withdrawal of audit opinions have had ramifications on reliability of financial information presented of the auditee enterprise, market capitalisation and more importantly maintenance of public trust and confidence.

With the changes in corporate regulation on the horizon and the availability of easy access to information and technology, auditors have the wherewithal to seek facts about the enterprises which they audit from sources other than the auditee. SA 560 (Revised) makes it incumbent upon auditors to assess whether based on the facts known, they have reasons to believe that the audit report which they have issued stands compromised. The standard also provides direction to auditors where management refuses to take cognisance of subsequent events that have an impact on the financial statements issued. The revised standard is in a way a welcome step in safeguarding interests of stakeholders.

External Confirmations – Proving Existence with External Evidence?

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Audit evidence is considered to be more reliable when obtained in a documented form directly by the auditor from sources independent of the entity being audited. The higher the auditors’ assessment of risk of material misstatement (including risk of fraud or error), the greater would be the need to obtain persuasive evidence to address those risks. Unless, there exists reasons to conclude otherwise, the auditor would usually place a higher reliance on evidence obtained directly from third parties or corroborating evidence obtained from independent sources. SA 505 provides guidance on the auditor’s use of external confirmation procedures to obtain audit evidence.

‘External confirmations’ is a process of obtaining audit evidence through direct written communication from a third party in response to a request for information about a particular financial item in the financial statements. For certain financial captions, circularising and obtaining independent external confirmations, is one of the most reliable substantive audit procedures, to assist auditors to obtain sufficient appropriate audit evidence to validate the assertion of ‘existence’. Robust confirmation procedures can also serve as an effective tool to respond to fraud risks.

Confirmation requests are generally of two types:

a. Positive confirmation request—through this request, the confirming party responds directly to the auditor indicating whether the party agrees or disagrees with the information requested, or providing the requested information.

b. Negative confirmation request—the confirming party responds directly to the auditor only if the confirming party disagrees with the information provided in the request.

Usually, negative confirmations are used where there are a large number of small balances and the risk of material misstatement is assessed as low. A good example where negative confirmation can be used is for confirming vendor registration status under the Micro, Small and Medium Enterprises Development Act, 2006 (MSMED Act, 2006). Negative confirmation requests may be sent to vendors requesting them to confirm within a stipulated time, whether they are registered enterprises under the MSMED Act, 2006, failing which these would be considered as ‘nonregistered’ enterprises. Where detection risk is high, or the materiality of the account balance is high, positive confirmation will be needed to provide substantive evidence.

In common parlance, external confirmations are understood to be restricted to only bank balances, accounts receivables and payables. External confirmations could also be circularised for investments, borrowings, related party transactions, inventory in custody of third parties, loans and advances, property title deeds mortgaged, guarantees, contingent items, litigation and claims or items that are significant or outside the normal course of business.

External confirmations may also be used to confirm terms of agreements, contracts, or transactions between an entity and other parties or the absence thereof. For example, a request for confirmation of bank balances could also include the bank to confirm whether there exists any other exposure in respect of any other facilities availed by the enterprise. These could be in the nature of letters of credit, derivative contracts, forward contracts outstanding, bank guarantees provided, etc. All these could have implications for accounting and/or disclosures in the financial statements.

Generally, enterprises from whom external confirmation is sought are likely to be independent, ensuring that the evidence is reliable. However, the auditor needs to exercise greater professional scepticism and diligence in cases of related parties or where the confirming party might be economically dependent on the entity.

General reluctance to confirm is more likely due to misunderstanding of the purpose of the request. Debtors may misinterpret the confirmation as a demand for payment. Other parties may fear that confirmation might be binding if they should subsequently discover an error in their own records. Some respondents disclaim responsibility should their response be in error. This is usually the case with bank confirmations. However, this does not necessarily compromise the reliability of the confirmation. It is also pertinent to note that confirming parties may be more likely to respond indicating their disagreement with a confirmation request when the information in the request is not in their favour, and less likely to respond otherwise.

It is interesting to note that SA 505 provides guidance on audit procedures to be followed where an enterprise uses a third party to co-ordinate and provide responses to confirmation requests. Though not prevalent in India, this is a practice widely used in the US. In fact, certain financial institutions including banks in the US have taken the position not to respond to confirmation requests that are mailed or faxed, but accept audit confirmation requests sent only through Capital Confirmation, Inc. (CCI or Confirmation.com), a third party service provider which provides secure electronic confirmation services for auditors and their shared clients. The auditor in such cases would need to consider controls over the information sent by the entity to the service provider, the controls applied on processing of the data and controls over preparation and sending of the confirmation response to the auditor.

Let us now examine the practical application of SA 505 with a case study.

Case Study
ABC Limited is in the business of manufacturing and selling of chemical products. Sales are made to various dealers across the country. The usual credit period is 90 days. The sales for the year ended 31st March 20X0 aggregated Rs. 200 crore and debtors as at 31st March 20X0 amounted to Rs. 75 crore. The debtors listing comprised 350 customers. The management does not follow the practice of obtaining balance confirmations from its debtors.

The auditors of ABC are M/s. PQR & Co (PQR).Roger Smith, Assistant Manager with PQR, was the audit in-charge posted at ABC for the yearend audit. Roger selected 30 high value debtors having debit balances aggregating to Rs. 25 crore for circularisation. In respect of one customer – Genuine Chemicals Limited (GCL), from whom the outstanding was Rs. 10 crore (a material amount outstanding beyond the due date), the management refused to allow Roger to send the confirmation request as the management represented that currently there were ongoing negotiations with GCL, the resolution of which would get impacted by an untimely confirmation request. The mailing addresses for 27 parties were obtained by Roger from ABC’s sales account manager. Since the audit was currently under progress and Roger was posted at ABC’s office premises, Roger decided to courier the physical letters through the courier agency whose services were usually availed by ABC. The proof of dispatch (POD) had to be retained by the dispatch section of ABC as supporting evidence for payment of courier charges billed by the agency. The sales manager informed Roger that in respect of the remaining 2 parties, the business operations had moved to a new location and the new mailing address was not available. Hence for these parties, he requested that e-mails be sent by Roger for balance confirmation which were sent accordingly. For both the physical and the e-mail confirmation requests, the confirmation format used was as prescribed in PQR’s audit documentation standard. Further, return self-addressed envelopes were also enclosed with the physical confirmations couriered. Roger maintained a photocopy of all the confirmation requests circularised.

The debtors ledger for the year ended 31st March 20X0 was finalised by 10th April 20X0 and confirmations were sent by Roger on 15th April 20X0. The accounts were to be cleared by 5th May 20X0 as the board meeting to approve the accounts was scheduled for 10th May 20X0.

Responses were received from only 6 debtors (out of 29 circularised) as per details below.

On enquiry with the sales account manager, Roger was explained that even in the past when balances were circularised, the response received was abysmal. The customer pattern of ABC comprised a large pool of customers with small value balances. As such, the circularisation was not done with adequate rigour. Further, given the short time period between the date of circularisation and the date of accounts finalisation, the sales account manager informed that it was quite likely that some responses could be received post audit closure. For customers from whom no response was received, Roger verified subsequent payments, to the extent these were received until the date of audit. For customers from whom responses were received, Roger compared the confirmations received with the photocopies that he had retained in his file. He believed that the confirmations were in order. In respect of amount due to Genuine Chemicals Limited, Roger felt that given the sensitivity surrounding the pending negotiations, it would be appropriate not to send a confirmation request. Roger concluded on the work paper file that adequate work was done to comply with the requirements of SA505. Was Roger right in his conclusion?
 

Case Study analysis with the requirements of SA 505.

Design and dispatch of confirmation requests
•    There was no management’s authorisation or encouragement to the customers selected for confirmation to respond to PQR’s request. Response rate to confirmation requests sent by auditors, particularly in case of debtors, is to a large extent driven by management’s intent and the degree of follow-up.

•    Only high value positive balances were selected for circularisation. Roger should have built in an element of unpredictability by selecting even credit balances, if any, in the sample. Further, some debtors with low value amounts could also have been selected.

•    For circularising balance confirmation in respect of Genuine Chemicals Limited, the management’s refusal to send a confirmation request should have been a trigger to evaluate its implication on the assessment of risk of material misstatement, including risk of fraud and whether such a refusal results in a scope limitation. Roger should have corroborated the explanations provided by the management by examining correspondence, if any, that ABC had with the customer evidencing the impending negotiations. He should have by enquiry or by performing procedures such as verifying lawyers’ confirmations/invoices deduced whether any legal case was filed against Genuine Chemicals. Further, given that the amount was material and outstanding beyond the due date, the auditor should have determined the implication of the non-recovery on the financial statements as well as on the audit opinion. This would also need to be communicated to those charged with governance at ABC.

•    SA 505 requires the auditor to determine that the requests are properly addressed including testing the validity of some or all of the addresses on confirmation requests before these are sent out. Roger merely took the addresses as furnished by the sales account manager and did not perform procedures to verify the authenticity of the addresses provided.

•    It is pertinent to note that for administrative convenience, the courier agency usually employed by ABC was used by the auditor. SA 505 stipulates that the auditor needs to maintain control over confirmation requests sent. Use of client courier may preclude maintenance of independence and control over requests sent. Where the requests are sent under the control of the auditor, he is better positioned to track the status of deliveries. As the client courier was used, proof of dispatches and deliveries was not maintained as evidence of circularisation. Reputed courier enterprises provide an online-tracking status of confirmations couriered together with delivery status. Roger should have also enquired into the status of delivery of confirmations couriered and whether there were any undelivered returns.

•    The general practice is to circularise confirmations for year-end or quarter-end balances, but given the short period of time available post year-end for audit closure, Roger could have considered circularising confirmations for balances as at 28th February 20X0 in the month of March 20X0 and then performing roll-forward procedures performed from 28th February 20X0 until 31st March 20X0.

•    SA 505 mandates the auditor to send out additional confirmation request where a reply to the previous request has not been received. There were no second/third reminders sent by Roger in the instant case.

Results of External Confirmation procedures

Roger compared the original responses received with the photocopies of the confirmations that he had retained in the file to ensure that there were no alterations made to the confirmations sent originally. This was a good verification procedure followed for testing the authenticity of responses.

Now, let us evaluate whether the response received for each of the six confirmation requests were in order.

1    Universal Chemicals

The confirmation had an exception being the difference of Rs. 3 lakh in the amount confirmed. Roger did not merely rely on the explanation provided by the sales account manager that the difference was on account of delay in accounting by Universal Chemicals. He rightly performed additional procedures to corroborate the same. He obtained confirmation over a telephonic call and further backed it up with a reconciliation explaining the difference from the customer. He also tested year-end sales to Universal Chemicals for further corroborative support.

2    Cosmos Traders

The very fact that the revised confirmation did not have any difference as against a difference of Rs. 32 lakh (in the original confirmation) should have lead Roger to use more professional scepticism and consider performing additional work like testing the transactions with Cosmos and understanding the reasons for the difference and how the same was reconciled.

3    Jupiter Chemicals

The confirmation provided was signed by the purchase executive of Jupiter. Roger should have evaluated whether reliance should be placed on the person authorising the confirmation, the purchase executive in this case. Usually depending on the size and set -up of an enterprise, one would expect accounts staff with appropriate authority to authorise the confirmation. Further, the confirmation was delivered at ABC’s address as against PQR’s office. The auditor should have insisted that the confirming party send the confirmation directly to him duly authorised by a person responsible to do so.


4    Neptune Chemicals

The confirmation was provided by Neptune Dye-Stuff, a Neptune Chemicals affiliate, i.e., not by the original intended confirming party. Such a confir-mation should have raised doubts over reliability of the response received. Further, this would also have implications on the auditor’s assessment of risk of material misstatement (including fraud risk) requiring Roger to modify the nature, timing and extent of other planned audit procedures.

5    Star Traders

This response was received electronically through an Internet email account and has a risk of reliability because proof of origin and authority of the respondent may be difficult to establish, and alterations may be difficult to detect. In this case, the confirmation was sent from an Internet e-mail account and not from the own domain of the confirming party. In such instances, it would be difficult to validate/corroborate the identity of the sender. In case of e-mail confirmations, the auditor needs to consider whether the mail was encrypted, signed electronically using digital signatures, and apply procedures to verify website authenticity. The auditor may also telephone the confirming party to determine whether the confirming party did, in fact, send the response.

6    Mars Chemitech Private Limited

Given the fact that MCPL has been making losses, Roger should have applied greater professional scepticism in evaluating MCPL’s ability to pay the debtor balance due rather than mere reliance on the confirmation provided by it directly.

Roger should have performed adequate alternate audit procedures to mitigate the risk of low response. Fewer responses to confirmation requests than anticipated may indicate a previously unidentified fraud risk factor that requires evaluation in accordance with SA 240.

Concluding remarks

One of the prominent reasons for genesis of frauds which corporate India has witnessed is the ineffectiveness in implementation of external confirmation procedures.

Obtaining external confirmations is a basic audit procedure which has been in audit theory for years but has not been practiced with the rigor that it deserves. To a large extent, the success of these procedures is driven by management’s rigour and follow -up with the confirming party to respond to the auditor which brings back the question of management’s intention to reflect a true and fair position of the enterprise’s affairs. SA 505 sets out the procedures that need to be performed for external confirmations to be an effective audit procedure which auditors should bear in mind while discharging their duties.

GAP in GAAP Accounting for Warranty Obligations

In the case of construction companies, the issue of
accounting for revenue and warranty obligations subjects itself to
multiple possibilities. Consider a construction company that executes a
long term contract, which takes 2 years to complete and which comes with
a warranty period of 2 years. The question is, how does the contractor
account for revenue and warranty costs in accordance with (AS) 7,
‘Construction Contracts’ and other accounting standards. Let us take an
example. The total contract value is 120.

View 1

Paragraph
11 and 14 of Accounting Standard (AS) 29, ‘Provisions, Contingent
Liabilities and Contingent Assets’, states as follows:

“11. An
obligation is a duty or responsibility to act or perform in a certain
way. Obligations may be legally enforceable as a consequence of a
binding contract or statutory requirement. Obligations also arise from
normal business practice, custom and a desire to maintain good business
relations or act in an equitable manner.”

“14. A provision should be recognised when:

(a)    an enterprise has a present obligation as a result of a past event;

(b)    it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and

(c)    a reliable estimate can be made of the amount of the obligation.

If these conditions are not met, no provision should be recognised.”

In
the extant case, let us further assume that the contractor is bound to
rectify, rework and compensate any defects, short supplies, operational
problems of the individual equipment already supplied/ work already done
under construction contracts. In other words, the contractual
obligation in respect of warranty coexists from the date of first supply
and not from the date of completion of contract. Thus, there exists a
contractual/customary present obligation in respect of warranty service,
which will require out-flow of resources embodying economic benefits to
settle the obligation. Therefore a provision in respect of warranty
service should be recognised.

As far as timing of recognition of
provision is concerned, the following relevant paragraphs 15, 16 and 21
of AS 7, are reproduced below:

“15. Contract costs should comprise:

(a)    costs that relate directly to the specific contract; …

16.    Costs that relate directly to a specific contract include: …

(g)    the estimated costs of rectification and guarantee work, including expected warranty costs; and …”

“21.
When the outcome of a construction contract can be estimated reliably,
contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by
reference to the stage of completion of the contract activity at the
reporting date. …”

Based on the above, it may be argued that the
estimated warranty cost is a contract cost which is directly related to
the specific contract. When the outcome of a construction contract can
be estimated reliably, contract revenue and contract costs associated
with the construction contract should be recognised as revenue and
expenses respectively by reference to the stage of completion of the
contract activity at the balance sheet date. Accordingly, following the
percentage of completion method, the contract costs, including provision
for expected warranty costs should be recognised by reference to stage
of completion of the contract activity at the reporting date. Thus, the
present obligation in respect of contractual warranty as per the
provisions of AS 29 arises from the performance of a contract activity
in respect of which contract cost is recognised even during the progress
of the contract and as such, the proportionate warranty cost can be
included as ‘cost incurred’ to determine the stage of completion for
recognition of revenue as per the principles of AS 7.

This view
is also aligned to the current practice with respect to sale of goods
which contains a warranty obligation. The current practice is to
recognise the entire revenue when the goods are sold, and make a
provision with respect to warranty costs.

View 2

It
is questionable whether the warranty on the project commences as each
equipment in the project is installed. Generally the warranty is on the
entire project, and it commences on the handover of the project to the
customer. The activities involved in ensuring that the equipments are in
working condition during the construction of the project are more in
the nature of a project activity rather than a warranty activity. If
this be the case, then the warranty provisions and the corresponding
revenue would be recognised at the end of Year 2. Therefore the only
difference in view 1 and 2 is the timing of the recognition of the
warranty provisions and the corresponding revenue.

View 3

Paragraph
26 of AS 7 states as follows, “A contractor may have incurred contract
costs that relate to future activity on the contract. Such contract
costs are recognised as an asset provided it is probable that they will
be recovered. Such costs represent an amount due from the customer and
are often classified as contract work in progress”.

Since the
warranty activity is a future activity, any provision for the
contractual obligation on the warranty should also be correspondingly
recognised as an asset. However, no revenues/costs are recognised when
the contract is in progress with regards to warranty. Once the project
is commissioned and the warranty commences, revenue and cost with
respect to warranty is recognised. For sake of simplicity, the margins
on the contract activity and warranty activity in the above example have
been maintained at the same level. However, in practice the margins may
differ.

Conclusion

The author believes that each of the above views may be tenable under current Indian accounting standards.

SA 330 – The Auditor’s Responses to Assessed Risks

While planning an audit of financial statements, the auditor identifies risks of material misstatement both at the financial statement level and at the assertion level. The objective of the auditor is to obtain sufficient and appropriate audit evidence to address this risk and he does so by designing and implementing appropriate responses to such risks. How the auditor designs these responses will be influenced by the auditor’s assessment of the risk of material misstatement at the assertion level for each class of transactions, account balances and disclosures including:

  • the likelihood of material misstatement due to the particular characteristics of the relevant class of transactions, account balances, or disclosures (i.e., inherent risk); and

  • the existence and operation of relevant controls (i.e., control risk), thereby requiring the auditor to obtain audit evidence to determine whether the controls are operating effectively and whether reliance can be placed on their operating effectiveness in determining the nature, timing and extent of substantive procedures.

Let us break the auditor’s responses to assessed risks into two parts and look at each one of them independently and in conjunction, bearing in mind the auditor’s objectives while performing an audit of financial statements:

1)    Overall response to the risks identified at financial statement level
2)    Audit procedures which are responsive to assessed risks of material misstatements at the assertion level.

Overall response to the risks identified at financial statement level

Guilelessly put, risk of material misstatements at the financial statement level is the risk that the financial statements as a whole may not reflect a true and fair view. Risk of material misstatement as we know is a function of inherent risk and control risk. To address this risk, the auditor may include the following responses while planning the audit of financial statement:

  • Incorporating additional elements of unpredictability in the selection of further audit procedures to be performed (like varying the timing of audit procedures, selecting items for testing that have lower amounts or are otherwise outside customary selection parameters, etc.)

  • Making generic changes to the nature, timing or extent of audit procedures, for example: performing substantive procedures at the period end instead of at an interim date; or modifying the nature of audit procedures to obtain more persuasive audit evidence.

  • Emphasising to the audit team the need to maintain professional skepticism.

  • Assigning more experienced staff or those with special skill sets or using experts and providing increased levels of supervision

The auditor’s assessment of the financial statement level risks, and thereby his overall responses, are affected by his understanding of the control environment. An effective control environment may allow him to have more confidence in internal controls and the reliability of audit evidence generated internally within the entity. The overall response by an auditor to the financial statement risks generally has a noteworthy bearing on the auditor’s general approach towards an audit. Hence it is important that these responses are evaluated and implemented by the auditor in the planning stage of an audit.

Audit procedures which are responsive to assessed risks of material misstatements at the assertion level

The nature, timing and extent of audit procedures are based on the assessment of risk of material misstatement at the assertion level of financial statement captions by the auditor and the auditors’ approach to address a specific risk may vary. For example:

  • He may choose to perform only test of operating effectiveness of controls if he feels that he may achieve an effective response to the risk of material misstatement for a particular assertion.

  • He may choose to perform only substantive procedures if he concludes that there are no effective controls relevant to that particular assertion.

  • He may choose to have a combined approach using both test of controls and substantive procedures.

The design of further audit procedures to be performed by the auditor is generally based on:

1)    The auditor’s assessment of inherent risk and control risk assigned to an assertion, and
2)    Persuasiveness of audit evidence required to address the degree of risk identified.

Let us consider a case study to understand the above concepts.

Case study

Addressing risks at the financial statement level

Background

KKM and Company (‘KKM’) is a financial institution operating in a highly regulated environment. Based on the following scenarios, let us examine the approach that the auditors of KKM, M/s. ALB and Associates would need to adopt to address the risk of material misstatement at financial statement level.

1.    Based on the experience obtained during the past audits, management inquiries conducted and the results obtained while evaluating the design and implementation of higher level controls, the auditors have assessed the control environment to be effective.

2.    The engagement team is comparatively new and is undertaking the audit of this company for the very first time.

3.    The management of the company is well aware of the audit procedures performed by the audit team on a year on year basis. They are ready with all the information required by the audit team at the commencement of the audit. All the information required to be given to the auditors is entirely reviewed by the management to identify any errors and changes and any identified changes are duly incorporated in the information sent to auditors for audit.

4.    As per the policy in place at ALB and Associates, based on the risk grading assigned to KKM while performing the engagement acceptance formalities, the audit team is required to have at least two managers reviewing the work done by the engagement team. However, the engagement partner is of the belief that one manager is sufficient to review the audit.

Evaluation

As per SA 330, the auditor is required to address the risk of material misstatement at financial statement level. He may do so by changing the nature, timing and extent of his audit procedures.

1.    In this scenario, the auditor has concluded that the control environment of the entity is effective. Based on the efficacy of the control environment and existence and operation of internal controls, the reliability of the audit evidence generated internally by the entity increases. This may help the auditor to reduce the nature, timing and extent of audit procedures to be performed by him. Such a reliance on internal controls may help him to place less emphasis on substantive procedures and elect to have a controls based approach towards audit. Such an approach would also help the auditor save time and resources.

2.    In such a scenario where the engagement team is relatively new to the client, the engagement manager/ partner need to ensure that the team is appropriately trained and guided to apply professional skepticism during the course of the audit. The audit team may also find it useful to engage the work of experts wherever required. The audit team should also be made to attend trainings on audit methodology and procedures so as to equip them with the requisite knowledge about the client and the industry. The audit team should familiarise themselves with the client and the industry in which it operates by perusing the previous year’s work papers to obtain an understanding of the issues which were identified in the prior year audit as well as to address any carried forward issues from the previous year’s audit.

3.    In the current scenario, the audit team has been performing identical audit procedures over a period of time due to which the client is well aware of these procedures. In such a scenario, the audit team should include surprise procedures so as to eliminate the consistency of audit procedures so as to incorporate an element of unpredictability in the procedures applied. This surprise element will also help the audit team to address the fraud risk, if any, for certain classes of transactions. For example the audit team may perform a surprise visit for one of the branches of the company for verification of cash balances, select certain low value debtors or debtors with credit balances for balance circularisation etc.

4.    The engagement partner is deviating from the policy followed by the firm while performing the audit of this entity. In the given scenario, based on the risk grade assigned to the entity, at least two managers are to be assigned to this engagement. Hence the engagement partner should increase the number of managers on the job to two. This would increase the supervision on engagement, thus also helping the auditors to address the risk of material misstatement at the financial statement level.

Closing Remarks

Assessing risk lies at the core of the audit process and this article has introduced and explained some of the terminology used by SA 330, giving guidance to auditors on how to respond to assessed risks. In general, tests of control are short, quick audit tests, whereas substantive procedures will require more detailed audit work. SA 330 requires that, irrespective of the assessed risks of material misstatement, the auditor would need to design and perform substantive procedures for each class of transactions, account balance and disclosures. We will discuss the concept of assessing risks at the assertion level in our next article.

Substantive Analytical Procedures: Relevance and Efficacy in an Audit

During the course of an audit of financial statements, an auditor is required to obtain sufficient and appropriate audit evidence to ensure that the financial statements are not materially misstated. The procedures adopted for this purpose are enquiry, observation, testing and re-performance. The procedures around testing involve testing of controls as well as test of details. The test of details may comprise of substantive testing or use of substantive analytical procedures (SAPs) or a combination of both.

SAP procedures consist of evaluating financial information through analysis of plausible relationships among both financial and non-financial data. It also consists of investigation of identified fluctuations or relationships that are inconsistent with other relevant information or that differ from expected values by a significant amount. The basic presumption behind the use of SAP by an auditor is that correlation between data can be expected to exist in the absence of any condition either financial or non-financial disturbing such relationship. However it is to be noted that while performing any form of SAP, prior knowledge of the industry in which the entity operates is very crucial along with the understanding the efficiencies and limitations that are harbored in adapting such procedures. SAP are subject to auditor judgment including evaluation of the data to be used and understanding the conclusions reached.

SAP may be performed using various methods like statistical techniques and Computer Assisted Audit Techniques (“CAAT’s”). They can be performed at financial caption level or at a disaggregated detailed level of information. The auditor may choose to apply SAP on financial statements as a whole or on any specific component of the financial statements. The decision about which audit procedures to perform, including whether to use SAP, is based on the auditor’s experience about the expected effectiveness and efficiency of the available audit procedures to reduce audit risk at the assertion level to an acceptably lower level.

SAP are generally used by the auditor at the following stages of audit:

  •     Risk assessment procedures (termed as planning SAP) which assist the auditor in identifying and assessing the risks of material misstatement thus allowing them to provide a basis for designing and implementing the audit procedures. For instance – revenue trend analysis, gross margin analysis, effective tax rate reconciliation, etc.

  •     Substantive procedures (termed as SAP) to obtain corroborative audit evidence about relevant assertions and the risks attached to such assertions. For instance, payroll logic test, interest costs as a percentage of borrowings, etc.

  •     Final analytical procedures – to perform an overall review of the financial statements (termed as final SAP) to aid the auditor while forming an overall conclusion as to whether the financial statements are consistent with the auditor’s understanding of the entity and its business.

Suitability of a particular analytical procedure for a given assertion:

SAP are generally more applicable to large volumes of transactions that tend to be predictable over time. However, the suitability of a particular analytical procedure will depend upon the auditor’s assessment of how effective it will be in detecting a misstatement that, individually or when aggregated with other misstatements, may cause the financial statements to be materially misstated. Different types of SAP provide different levels of assurance.

For example building up an expectation of payroll cost (as demonstrated in the case study discussed later) can provide persuasive evidence and may eliminate the need for further verification by means of tests of details, provided the information used and the elements of the payroll cost is appropriately tested.

On the other hand, calculation and comparison of effective tax rate to profit before tax can be deemed as a means of confirming the completeness of tax provision, however this will provide less persuasive evidence, but may be reduce the detail of work that needs to be performed for other audit steps performed on the caption.

It is imperative that the auditor has adequate assurance over the efficacy of the internal controls around over financial reporting of an enterprise before he concludes to place reliance solely on analytical procedures to get comfort over any financial statement caption.

    Reliability of data

Before placing reliance on the assurance obtained from SAP the auditor needs to evaluate and confirm the data used to perform SAP. The reliability of data is influenced by its source and nature and is dependent on the circumstances under which it is obtained. Some of the parameters that may be considered by an auditor to evaluate the reliability of the data are:

    i. Source of the information available, for instance, information may be more reliable when it is obtained from independent sources outside the entity.

    ii. Comparability of the information available, for instance, information from the same industry may be more reliable than information of the entities operating in the cluster of industries.

    iii. Nature and relevance of the information available. For example, whether budgets have been established as results to be expected rather than as goals to be achieved; and

    iv. Controls over the preparation of the information that are designed to ensure its completeness, accuracy and validity. For example, controls over the preparation, review and maintenance of accounting information. The auditor may choose to test the operative effectiveness of controls over preparation of data giving him further assurance on the reliability of the data used to perform SAP.

While devising substantive analytical procedures, an auditor considers comparison of the entity’s financial information with:

  •     Comparable information of the prior period for the caption on which assurance is planned to be achieved through SAP.

  •     Anticipated results of the entity including budgets and forecasts made by the management.

  •     Expectations made by the auditor, for example – comparing actual with estimated lease rent or an estimation of depreciation.

  •     Information of the industry in which the entity operates – for instance, the comparison of the debtors’ turnover ratio of the enterprise with that of the industry to identify nuances in the entity’s operating cycle, industry growth with sales growth of the enterprise.

The auditor also considers relationships amongst the various elements of financial information to obtain assurance on the trend/variation in financial statement captions. An illustrative inventory of such relationships is as given below:

  • relationship between variation in turnover and debtors
  • variation in material cost consumption with variation in input prices, manufacturing yield, capitalization of new machinery, variation in cost of repairs of plant and machinery
  • correlation of variation in payroll costs with employee count, labor turnover

correlation between labor efficiency rates and production costs

  • variation in power and fuel consumption costs with variation in manufacturing output/power tariffs.

Let us understand SAP with the help of a practical example:

Background:

ABC India Private Limited (‘ABC’) is a service provider whose primary business is to act as customer care center for its clients. The business model involves setting up of a call center with relevant IT, telecommunication and other infrastructure facilities and hiring and training graduates with good communication skills who are required to attend to customer calls. As far as execution of services is concerned, the employee pyramid comprises of a large number of graduates, related proportion of supervisors/ team leaders and delivery heads. ABC also has a robust sales and marketing team. The company has signed agreements with various customers where its revenue is
based on an agreed charge-out rate and the number of executives requested for by the customer. the executives may be assigned on a 24×7 basis or otherwise depending on     the    customer     requirements.    The    major    expenses     for ABC comprise of payroll cost.  

Application of SAP on Payroll Cost


the auditor may use SaP to obtain evidence surrounding ‘C’ of salary costs. to start with the auditor would need to build up an expectation for the payroll cost. he may do so by using the average salary earned per employee and the average number of employees which were employed by the company during the year. he also needs to determine the amount of variance from the expectation so worked out with the actual cost which can be accepted without further investigation.     This     amount     is influenced by the materiality, the assurance that is desired by the auditor while performing this analytical procedure and the assessed     risk     for     the    financial    caption    assertion.    Let us assume that the auditor has set the amount of allowable difference as rs. 2 crore. he may arrive at his expectation of the salary cost as follows

Scenario 1:
The    salary    cost    of    the    company    as    per    the    draft    financials    
is rs. 32.10 crore which is different than the salary cost as arrived by the auditor in his expectation. however the difference between the expectation i.e. rs. 31.26 crore and the actual cost (rs. 32.10 crore) is rs. 84 lakh which is within the limit of allowable difference set by the auditor. In such a situation the audit may choose not to perform any further scrutiny on the difference and conclude to have obtained the desired level of assurance from this procedure that he initially set out to obtain.

Scenario 2:
The    salary    cost    of    the    company    as    per    the    draft    financials     is rs. 34.57 crore which is different than the salary cost as arrived by the auditor in his expectation. however the difference between the expectation  i.e.rs. 31.26 crore and the actual cost (rs. 34.57 crore) is rs. 3.31 crore which is greater than the allowable difference set by the auditor during the commencement of this exercise.

In such a case the auditor would investigate into the reasons for the variance arrived at by him so as to bring the variance to an acceptable level. he may also chose to do further audit procedures on this caption to get the required level of assurance.

Some reasons for variance may be:

  • Joining of senior personnel in a band with salary far higher than average

  • Large number of joiners at month end or vice versa

  • Increment during the period for certain bands of employees, including mid-term increment

  • Exceptional/discretionary bonus or other payouts, etc.

  • Revision is statutory obligations such as percentage of provident fund/superannuation contribution, minimum wages payable under labor laws, changes in retiral benefits    such    as    gratuity,    basis    of    leave    encashment

  • Revision in assumptions made for payroll liabilities which are actuarially valued such as pension, compensated benefits, gratuity, post medical retirement benefits etc.

After investigating the difference, the auditor may rebuild his expectation so as to take effect of the newly identified factors and modify his evaluation of the difference identified based on those factors.

In this case, the auditor may also be able to build up an expectation on the revenue for a reporting period for ABC as the revenue model is entirely based on the category of employees who have been assigned to customers. one could apply the agreed charge out rates on the average number of employees employed during a period and arrive at the expectation. a similar exercise of comparing and challenging the actual results against the actual results could provide insights on what further audit procedures need to be undertaken to obtain assurance on the revenue recognised during a given period.

Conclusion

Use of SAP during the planning, execution and completion stages of an audit enables an auditor to obtain sufficient and appropriate audit evidence to address the risk of material misstatement as also brings efficiencies in the audit process by way of reduced effort on substantive testing. Substantive analytical procedures provide the auditor with an overall perspective of the financial impact of significant events that have taken place in an enterprise during the reporting period. It could be said that SAP aids the auditor in setting the level of professional skepticism in terms of identifying areas where additional or detailed substantive testing may be required to be performed.